Health Affairs, 22, no. 6 (2003): 175-182 doi: 10.1377/hlthaff.22.6.175 © 2003 by Project HOPE	New Online   Senate Health Reform Bill   Rewarding Providers   Public Option Policy Brief   Health Reform & Abortion   Delivery System Reform

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Commentary

Challenges And Opportunities For Medicare’s Original Prospective Payment System

Abstract

 
The Medicare program initiated prospective payment for inpatient hospital services in 1983. Although the payment system has achieved many of its goals, changes in the health care market and the public nature of the program will continue to present both challenges and opportunities for improvement. Looking forward, policymakers must consider how to balance paying accurately for services with using Medicare to achieve broader policy objectives. Paying for new technologies, responding to market segmentation and specialization, and encouraging quality improvement must also be addressed. To successfully navigate these issues, policymakers and program administrators need accurate and timely information.

This paper looks at these challenges and opportunities, discusses the policy trade-offs they present, and suggests some directions to pursue. We do not address the broader debate over alternatives to administered pricing. While we appreciate the salience of that discussion, prospective payment will continue to have a primary role, at least in the near term.

The Payment System

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The PPS sets per case payment rates in advance, which provides an incentive to manage the costs of inputs needed for the service. The goal of Medicare payment policy is to align payments with reasonably efficient hospitals’ costs of furnishing care, thereby helping to ensure beneficiaries’ access to high-quality services. Achieving this goal generally entails updating and refining the following key design features: the unit of payment (bundled services rather than individual services) and a national base payment rate, a patient classification system based on patients’ expected resource requirements, and rate adjustments that account for local market conditions.

Base payment rate. The PPS has served Medicare well, although some observers have been concerned about the distribution of payments, to rural hospitals in particular.² Recent analyses suggest that a single base rate, rather than separate rates for hospitals in large urban and other areas, might better align payments to costs.³

Patient classification. The diagnosis-related group (DRG) categories, which are intended to group patients with similar expected resource requirements, often combine subgroups of patients with predictably different resource costs.⁴ A refined classification system would assign patients in each DRG into additional severity classes based on combinations of secondary diagnoses, age, and other factors.

Adjustment for local input prices. Improvements to the adjustment for local input price levels would include more accurate wage data, better market definitions, and reconsidering the size of the labor share. The PPS must also respond to changes in the marketplace. In recent years reductions in hospitals’ lengths-of-stay have been largely achieved by shifting care to postacute settings such as rehabilitation and home care. Some hospitals can discharge patients to postacute care more frequently and earlier in an episode of care than others can. In response to this, as well as to the overpayment implied by paying for care twice, in both inpatient and postacute settings, the Centers for Medicare and Medicaid Services (CMS) has begun to pay hospitals a per diem payment (instead of the full DRG amount) for patients transferred to postacute care after a stay that is more than one day shorter than the national average in selected DRGs.⁵ As the market evolves, other changes might be needed.

Achieving Broader Policy Objectives

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Because Medicare is a public, national program that distributes large sums of money—about $100 billion in the inpatient PPS alone in fiscal year 2003—policymakers have used the program to achieve goals beyond paying for patient care. Congress has enacted several payment adjustments that are based partially on systematic differences in hospital costs and partially on meeting other objectives.

Policy adjustments. The disproportionate-share hospital (DSH) adjustment was intended originally to compensate for the added costs of treating low-income Medicare patients. But the impact of patients’ income levels on hospital costs is minimal, and over time the argument for this adjustment has shifted to protecting beneficiaries’ access to care.⁶ The indirect medical education (IME) adjustment compensates for the higher costs of teaching hospitals. However, the adjustment rate is roughly twice the empirically justified level.⁷ The purpose of the additional teaching payment has never been clearly articulated, nor have hospitals been made accountable for use of the funds. The sole community and Medicare-dependent hospital programs provide higher, cost-related payments to many small and isolated rural hospitals. These programs respond partly to the effects of small scale of operation, but neither targets payments directly on that basis.

Implications. Broad objectives such as maintaining access to care in isolated communities and offsetting the financial pressure of uncompensated care are difficult to achieve through Medicare payment policy and create several unintended problems. Subsidies given through payment adjustments apply only to Medicare patients, and the share of hospitals’ patients covered by Medicare varies considerably among hospitals. Therefore, the PPS most likely will not accurately target funds for other purposes. In addition, uneven distribution of these additional payments among hospitals creates apparent inequity in the payment system. Finally, including these adjustments as part of the payment rate leads to inaccurate prices that may stimulate oversupply of services.⁸

Future directions. The PPS can better distribute payments by refining several of the payment adjustments to more closely relate payments to resource requirements, among individual hospitals as well as across inpatient and postacute care. Also, policymakers should consider whether the inpatient PPS, based on Medicare discharges, is the best vehicle for achieving broader policy objectives that are largely unrelated to the costs of serving Medicare patients.

New Technology

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Policymakers have struggled with how to pay for new technology since the in-patient PPS began.⁹ The efficiency incentive should favor new technologies that decrease costs but could restrain adoption of quality-enhancing technologies that increase them. In addition, the process used to set payment rates requires time to establish codes and collect data on costs, which could delay beneficiaries’ access to new technologies. However, clinical and competitive pressures encourage hospitals to adopt new technologies. In addition, new technologies often decline in price and improve in efficiency over time. Few studies have shown widespread access problems among Medicare beneficiaries for specific new technologies.¹⁰

Complicating factors. A number of factors complicate the process of incorporating new technologies into the PPS. First, it is difficult to obtain reliable information on the costs of new technologies and how they affect the costs of delivering care. New technologies often decline rapidly in price shortly after introduction. Delays in setting payments for new technologies give time to gather more information on both their costs and their clinical benefits. Second, introducing new items involves systems changes for the CMS, its contractors, and hospitals, and these changes must be balanced against the desire for stability in the payment system. Third, Medicare pays the hospital, which then negotiates with manufacturers over the adoption and cost of new items. Separate identification and payment of specific new technologies weaken hospitals’ incentives to manage the costs of inputs.

Add-on payments. Nevertheless, in response to concerns over delays in payment for new technologies and a congressional mandate, the CMS recently accelerated the process for assigning codes and implemented so-called add-on payments for new technologies. Clinical experts within the CMS evaluate applications for technologies that could raise the cost of an inpatient stay enough to merit additional payment. The base payment will be received whether or not the technology is eligible for add-on payments. Clinical criteria require that the technology greatly improve—relative to technologies previously available—the diagnosis or treatment of beneficiaries. CMS staff also apply criteria for newness and cost. Only two technologies have met the criteria to date, which has led some critics to assert that the criteria are too restrictive.

Additional payments for new technologies can help ensure beneficiaries’ access to them. However, the difficulties noted above, the need to safeguard the financial viability of the program, and the goal of offering incentives for efficiency, necessitate that additional payments be carefully targeted. The clinical criteria move in this direction. However, they do not consider the value to patients and Medicare of the new technologies’ additional costs.

Future directions. Moving forward, policymakers should look to tools such as value-based purchasing to target new technology payments. This approach would require asking questions such as, If the same clinical outcome is achieved, is it necessary to pay more than is paid for the existing technology? If there are modest clinical gains at a great increase in price, should the program pay? Several methodological issues and the views of competing stakeholders must be addressed before moving in this direction. Indeed, previous attempts to incorporate cost-effectiveness into coverage decisions have failed.¹¹ Nevertheless, a recent survey of large purchasers in the public and private sectors indicates that value-based purchasing is prevalent outside the Medicare program and could be a direction to pursue.¹²

Market Segmentation And Specialization

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Policymakers, analysts, hospital managers, and physicians have focused recently on the rise of specialty hospitals that provide a narrow range of inpatient care, such as cardiovascular surgery, orthopedic surgery, or oncology services. These facilities, which are often owned by for-profit entities along with local physician-investors, have begun to appear in a number of health care markets.¹³ This trend may be just the latest manifestation of ongoing market segmentation in health care. Earlier examples have included both ambulatory care facilities—focused on certain surgical procedures, imaging, pain therapy, or cancer chemotherapy—and specialized inpatient facilities—furnishing psychiatric care, cancer treatment, rehabilitation services, and so forth. Still, what this trend might mean for Medicare and the health care system depends on why specialty facilities are forming and how they will affect local health care markets.

Possible drivers of specialty hospitals. The rise of specialty hospitals could be driven by several motives. Specialty hospital developers might be taking advantage of the payment policies used by private and public payers. Conventional wisdom and some evidence suggest that some types of surgical procedures, such as cardiovascular and orthopedic surgery, are more profitable than others, reflecting the cross-subsidies among services that hospitals have built into their charges.¹⁴

Whether or not they have an ownership stake, specialist physicians might find specialty hospitals attractive because these facilities give them greater ability to control their work environment and enhance practice income by ensuring the availability of needed equipment, supplies, and staff trained for a limited set of procedures; scheduling and maintaining an efficient workflow uninterrupted by emergency cases; and limiting the on-call obligations that they might face practicing in a general hospital. In addition, specialty hospitals might benefit financially if their physicians tend to bring in patients with below-average severity of illness. Such patients could be less costly to treat because they might recover faster than their counterparts in general hospitals.

Potential concerns. Other things being equal, the growth of specialty hospitals might raise few concerns if they treat patients more efficiently or if they simply identify and respond better to the desires of specialty physicians. These outcomes would spur general hospitals to compete by improving their efficiency and responsiveness. Problems could arise for Medicare and the health care system, however, if specialty hospitals are responding primarily to profit opportunities in payment systems. Profit opportunities could exist if Medicare and other payers pay too much for certain types of cases or if they fail to distinguish adequately between patients with different severity levels and resource needs. In this case, payment systems would be sending incorrect signals to providers. Also, specialty hospitals might raise total spending by expanding the overall volume of inpatient care.

Some observers allege that specialty hospitals take away relatively profitable patients that other hospitals depend on to finance less profitable activities, such as operating fully staffed emergency departments, maintaining standby capacity, or furnishing uncompensated care. This reduction in cross-subsidies, if true, could create longer-term access or quality problems. Solving this problem, however, would not be straightforward. If Medicare and other payers were to ensure equal profitability across all types of cases, hospitals’ unfunded activities (such as uncompensated care) would have to be financed some other way. Thus, general hospitals would not necessarily be better off.

Quality Of Care

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Quality of care is an important dimension of payment policy that has growing visibility. Medicare historically limited its quality initiatives to regulatory standards and limited peer review. Statutory language directed that clinical decisions be left to providers, and few guidelines and measures for quality were available.

Improvements and deficits. Recent studies have documented the gap between high-quality care and the care actually delivered.¹⁵ At the same time, additional measures of quality and guidelines for appropriate care have been developed. Medicare participated in these efforts, often leading initiatives to publicly disclose quality information, standardize data collection tools, and give feedback to providers for improvement. However, the focus was often on nonhospital sectors. One study recently found improvement on twenty of twenty-two indicators of quality for Medicare beneficiaries, although considerable room for improvement remains.¹⁶

The current payment system generally fails to financially reward providers who improve quality. Prospective payment in its current form simply determines the price paid for a service. All hospitals receive the same base payment adjusted by the wage index, regardless of quality.

Future directions. Can Medicare find ways to provide incentives for quality within prospective payment? Many private-sector health plans and purchasers have found ways to encourage providers to improve quality by paying bonuses to those who meet quality targets. Some private-sector purchasers, such as General Motors, have also encouraged enrollees to seek higher-quality providers by making such providers less costly for enrollees.¹⁷ Medicare might be able to incorporate similar concepts into the PPS by adopting quality measures for a given DRG and varying provider payments based on quality performance.

However, many issues must be confronted if Medicare is to incorporate quality incentives into the PPS, including overcoming the administrative hurdles of developing measures and data collection systems; ensuring that any incentive structure adequately accounts for differences in the severity of patients’ illness when comparing hospitals; achieving provider acceptance; and considering the equity effects for providers and beneficiaries if quality improvement is less feasible for some providers, such as isolated rural hospitals, than for others.

Fewer common measures exist to compare quality among hospitals than for other Medicare providers such as dialysis facilities, or Medicare contractors such as Medicare+Choice plans. However, Medicare has the opportunity to improve quality by expanding the use of nonfinancial incentives and moving toward incorporating quality into the payment system. A demonstration project recently begun with Premier Inc. hospitals will provide insight into the administrative and other challenges associated with paying for quality outcomes in Medicare.¹⁸

Information To Support Decision Making

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The Medicare program and policymakers rely on information from claims and cost reports submitted by hospitals to make decisions regarding the adequacy and distribution of payments. The timeliness of these data has been a long-standing concern. For example, cost report data are generally not available until eighteen months after the close of the fiscal year being reported on and have been delayed even further in recent years. Special payment provisions, such as IME and DSH, require additional data collection. Policy changes, such as the implementation of a PPS for hospital outpatient services, necessitate changes in data collection systems that can be difficult and time-consuming to design and implement.

Policymakers and analysts must identify the information they need for decision making and work with the CMS to ensure that the required data are available in a timely fashion. They must also balance the costs of acquiring additional information against its expected benefits. Given the number and complexity of policy changes enacted recently and envisioned over the next several years, additional funding for the CMS’s administrative functions could be necessary.

The medicare inpatient pps has encouraged improvements in efficiency over the past twenty years. However, it does not, and cannot be expected to, address increased spending attributable to more admissions, application of costly technologies to a broader population, or broad economic trends such as labor shortages. In addition, policymakers’ desire to use the payment system to achieve objectives other than paying for the costs of providing services to Medicare patients has introduced inaccuracies in matching payments to the costs incurred by efficient hospitals. Hospitals that benefit from these policies might change the way they furnish care to maximize revenues; hospitals that do not benefit might advocate compounding changes.

In looking for ways to refine the PPS, providing incentives for improved quality is clearly a high priority. However, incorporating payment for quality comprehensively will require a long-term effort to address administrative and design challenges. Both quality-improvement incentives and other refinements will likely require major improvements in data collection and information management.

Regarding payment for new technology, the PPS has struck a balance between providing payments that are adequate to ensure access and encouraging overuse. Maintaining that balance will require discipline in applying specific criteria for deciding which technologies merit additional payment.

Finally, more research is needed to understand the motivations driving market segmentation and specialization. If inaccuracies in the payment system make specialization profitable, the payment rates should be amended.

Editor's Notes

Top The Payment System Achieving Broader Policy... New Technology Market Segmentation And... Quality Of Care Information To Support Decision... Editor's Notes NOTES

 
The views expressed here are those of the authors and do not necessarily reflect those of the Medicare Payment Advisory Commission. The authors thank Mark Miller, Karen Milgate, and Sarah Thomas for their valuable insights and comments.

Chantal Worzala is a senior analyst and Julian Pettengill and Jack Ashby are research directors at the Medicare Payment Advisory Commission (MedPAC) in Washington, D.C.

NOTES

Top The Payment System Achieving Broader Policy... New Technology Market Segmentation And... Quality Of Care Information To Support Decision... Editor's Notes NOTES

 

1. L.B.Russell, Medicare’s New Hospital Payment System (Washington: Brookings Institution, July 1989); and G.S.Chulis, "Assessing Medicare’s Prospective Payment System for Hospitals," Medical Care Review (Summer 1991): 167–206.
2. P.L. 108-7 set the base payment rate for all hospitals equal to the large urban rate from April to September 2003. P.L. 108-89 extends the policy through 31 March 2004. Pending legislation might extend this policy further.
3. Multivariate analysis found no significant difference in cost per case between hospitals in large urban and other areas. See Medicare Payment Advisory Commission, Report to the Congress: Medicare Payment Policy (Washington: MedPAC, March 2002), 63–64.
4. See MedPAC, Report to the Congress: Selected Medicare Issues (Washington: MedPAC, June 2000).
5. For FY 2004, the policy was expanded from ten to twenty-nine DRGs.
6. G.F.Kominski and S.H. Long, "Medicare’s Disproportionate Share Adjustment and the Cost of Low-Income Patients," Journal of Health Economics (April 1997): 177–190.
7. MedPAC’s most recent multivariate analysis found that inpatient operating costs increase by 2.7 percent for every 10 percent increase in the ratio of residents to hospital beds, in contrast to the current payment adjustment of 5.5 percent. See MedPAC, Report to the Congress: Medicare Payment Policy (Washington: MedPAC, March 2003), 56–57.
8. For a fuller discussion of the risk of setting rates that differ substantially from providers’ short-run costs, see MedPAC, Report to the Congress: Medicare Payment Policy (Washington: MedPAC, March 2001), 12–14.
9. L.P.Garrison and G.R. Wilensky, "Cost Containment and Incentives for Technology," Health Affairs (Summer 1986): 46–58.
10. See MedPAC, Report to the Congress: Medicare Payment Policy, March 2003, 177–190, and March 2001, 35–45.
11. S.B.Foote, "Why Medicare Cannot Promulgate a National Coverage Rule: A Case of Regula Mortis," Journal of Health Politics, Policy and Law 27, no. 5 (2002): 708–730.
12. P.E.Mohr, P.J. Neumann, and S. Bausch, Paying for New Medical Technology: Lessons for the Medicare Program from Other Large Health Care Purchasers, Report submitted to MedPAC (Bethesda, Md.: Project HOPE Center for Health Affairs, 31 October 2002).
13. U.S. General Accounting Office, "Specialty Hospitals: Information on National Market Share, Physician Ownership, and Patients Served," 15 May 2003, www.gao.gov/atext/d03683r.txt (24 September 2003).
14. J.Ashby, "The Accuracy of Cost Measures Derived from Medicare Cost Report Data," in Cost Accounting for Health Care Organizations, ed. S.A. Finkler (Gaithersburg, Md.: Aspen Publishers, 1994).
15. L.T.Kohn, J.M. Corrigan, M.S. Donaldson, eds., To Err Is Human: Building a Safer Health System (Washington: National Academies Press, 1999); and Institute of Medicine, Crossing the Quality Chasm (Washington: National Academies Press, 2001).
16. S.F.Jencks, E.D. Huff, and T. Cuerdon, "Change in the Quality of Care Delivered to Medicare Beneficiaries, 1998–1999 to 2000–2001," Journal of the American Medical Association 289, no. 3 (2003): 305–312.[Abstract/Free Full Text]
17. See MedPAC, Report to the Congress: Variation and Innovation in Medicare (Washington: MedPAC, June 2003).
18. Premier Inc., "CMS and Premier Quality Demonstration Project Backgrounder," 10 July 2003, www.premierinc.com/all/newsroom/press-releases/03-jul/premier-cms-backgrounder.pdf (24 September 2003).

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