Reforming Medicare: Options, Tradeoffs, and Opportunities

Appendix D: Hospital Service Prices

As explained in chapter 2, Medicare’s prospective payments for inpatient and outpatient hospital services are tied to a complex system of diagnosis-based categories. Controversy surrounds the number and definition of these categories. Complexity Not only are Medicare payments linked to a large number of diagnosis-related groups (DRGs), but each DRG is composed of assorted conditions drawn from the International Classification of Diseases (Clinical Modification), which lists more than 11,500 distinct diseases and conditions.1 Each condition may be manifested in patients whose co-morbidities, age, genetic inheritance , personal tastes for medical care, and physical state indicate treatment that differs in amount and in kind from that on which the payment category is based. As a result, actual costs within each payment category vary widely at any given point in time. Furthermore, they change at different rates over time as a result of learning-by-doing and small changes in technology that raise or lower treatment costs, but that Medicare may not recognize by amending DRG payments. Not every provider has the same mix of cases and patients. Consequently, some 144 Appendix D Hospital Service Prices Appendix D: Hospital Service Prices 145 providers are paid too much and others too little, although outlier payments help match payments to actual incurred costs. Modest increases in the number of payment categories would ameliorate this problem, but not much. In 2000 the Medicare Payment Advisory Commission found that increasing the number of DRGs from 500 to 900 would reduce the standard deviation of the gap between payments and incurred costs by only 5–10 percent and would further complicate administration .2 It would also harm at least one key constituency—small and rural hospitals, which typically handle lower-cost cases within each DRG. These facilities constantly struggle for financial viability because they have few occupied beds over which to spread overhead costs. Linking DRG payments more accurately to costs would cut payments to rural hospitals and complicate their struggle for financial survival. Nonetheless, in 2008 Medicare began a two-year transition to a new system of 744 severityadjusted diagnosis-related groups (Medicare Severity DRGs, or MS-DRGs) to replace the previous system of 538 DRGs.3 Rural hospitals are expected to experience payment cuts between 0.5 and 1.8 percent in 2008, whereas urban, teaching, and disproportionate share hospitals (DSH) stand to gain 0.9 percent on average.4 Controversy Not surprisingly, some providers are discontented with prospective payment rates. The average costs of efficient providers are extraordinarily dif- ficult to measure. Fixed and shared costs, such as management’s salaries or equipment used for many services, vary from one provider to another. So does the number of services among which they must somehow be allocated . Such allocations are inescapably arbitrary. The average cost of providing a service efficiently varies depending on the size and location of the provider, the volume of services supplied by the facility, and the characteristics of patients served. Not all hospitals are equally efficient. Medicare tries to consider such factors, including labor costs, when it sets payments for individual facilities. But not all factors can be taken into account, and for some this imperfection can impose significant financial strain. DRG-Induced Distortions The prospective payment system (PPS) fixed one problem. It ended the incentive—endemic in the cost-based reimbursement system it replaced— 146 Appendix D: Hospital Service Prices to pad revenues by providing care of marginal worth. But prospective payment created other problems. First, providers can improve their margins by stinting on care or by shunning cases expected to cost more than the anticipated fee. Medicare administrators tried to address this issue by providing “outlier” payments for exceptionally costly cases. But to determine the cost thresholds that define “outliers” and the amount above these thresholds Medicare will pay, administrators must make technically difficult and controversial tradeoffs.5 Second, Medicare also overpays for some DRGs. Some payments were set too high to start with, and some have fallen. However overpayments came to exist, entrepreneurial physicians and other investors have an incentive to set up hospitals that specialize in providing just these overpriced services , orthopedic surgery being one. Such hospitals may be quite profitable precisely because Medicare pays too much for some services and too little for others. The profits that specialty hospitals earn come at the expense of multiservice hospitals that...