Academic journal article Health Care Financing Review

New Directions for Medicare Payment Systems

Academic journal article Health Care Financing Review

New Directions for Medicare Payment Systems

Article excerpt


During the past decade, the Health Care Financing Administration (HCFA) has developed and implemented two innovative payment systems. The Social Security Amendments of 1983 (Public Law 98-21) changed the method of payment for inpatient hospital services provided to Medicare beneficiaries from a cost-based, retrospective reimbursement system to a diagnosis-specific prospective payment system (PPS). Likewise, the Omnibus Budget Reconciliation Act (OBRA) of 1989 (Public Law 101-239) dramatically changed the method of paying for physician services provided to Medicare beneficiaries from a charge-based system known as customary, prevailing, and reasonable (CPR) to a resource-based Medicare fee schedule (MFS).

Since their implementation, both of these systems have continued to be refined by HCFA and have been adopted by numerous non-Medicare payers.

The focus of this issue of the Health Care Financing Review is on the ongoing development of Medicare payment methodologies, their adoption by non-Medicare payers, and issues to be addressed in the development of other systems based on these methodologies. This article provides a brief history of the development, implementation, and refinement of these payment methodologies. It also briefly describes the ongoing efforts to facilitate the adoption of these methodologies by non-Medicare payers.


Since October 1983, HCFA has used PPS to reimburse hospitals a fixed price for inpatient episodes of Medicare patients, regardless of how long the patient stays or the resources that the patient actually uses. By setting rates prospectively, incentives are built into the reimbursement system to promote efficiency in the provision of inpatient services.

PPS was developed largely in reaction to rising hospital expenditures and concerns about their impact on the Medicare Part A trust fund (Altman and Young, 1993). PPS continued the movement away from retrospective, cost-based reimbursement that began with earlier cost-containment efforts. These included the Nixon Economic Stabilization Program (ESP), Carter-era hospital cost containment, and hospital ratesetting programs in various States (Gold et al., 1993). The article by Ozminkowski, Gaumer, Coit, and Gabay discusses some of the lessons learned from ESP's wage and price controls on hospitals. Among these lessons, the authors discuss the relative merits of wage and price controls versus ratesetting methods like PPS. They point out that, while wage and price controls do not allow relative prices to change, ratesetting methods typically try to set the "correct" price for individual services.

Under PPS, the basis for payment is a national standardized amount that represents an average payment for a typical case. Diagnosis-related groups (DRGs) based on principal diagnosis and other factors are used to group medically similar cases that require comparable resources for treatment. Each DRG is assigned a weight based on its resource costs relative to the national average. These relative weights are recalibrated each year using the latest available charge data for Medicare discharges. To determine the Medicare reimbursement for an individual episode in a particular hospital, the standardized amount is adjusted by the relative weight of the DRG classification of the patient, the area wage level, the extent of the hospital's teaching activity, and the degree to which the hospital serves low-income patients. In addition, PPS established categories of outlier, or extremely costly, cases which receive supplemental payment amounts.

In the decade since PPS was implemented, HCFA has continued to refine the payment system to help ensure equitable payment for services and to address issues raised by the provider community. Some major concerns that have been addressed include the following:

Patient Classification

Under PPS, the DRG assignment based on principal diagnosis is one of the main factors in determining the payment made for hospital inpatient services provided to Medicare patients. …

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