discussion

The 8 Basic Payment Methods in Health Care Kevin Quinn, MA

Eight basic payment methods are applicable across all types of health care. Each method is defined by the unit of payment (per time period, beneficiary, recipient, episode, day, service, dollar of cost, or dollar of charges). These methods are more specific than common terms, such as capitation, fee for service, global payment, and cost reimbursement. They also correspond to the division of financial risk between payer and provider, with each method reflecting a risk factor within the health care spending identity. Financial risk gradually shifts from being primarily on providers when payment is per time period to being primarily on payers when payment is per dollar of charges. Method 4 (per episode) marks the line between epidemiologic and treatment risk. The 8 methods are typically combined to balance risk and thus balance incentives between payers and providers. This tax- onomy makes it easier to understand trends in payment reform— especially the shifting division of financial risk and the movement

toward value-based purchasing—and types of payment reform, such as bundling, accountable care organizations, medical homes, and cost sharing. The taxonomy also enables prediction of conflicts between payers and providers. For each unit of pay- ment, providers are rewarded for increasing units while decreas- ing their own cost per unit. No payment method is neutral on quality because each encourages and discourages the provision of care overall and in particular situations. Many professional norms and business practices have been established to mitigate undesirable incentives. Health care differs from many other in- dustries in that the unit of payment remains variable and unsettled.

Ann Intern Med. 2015;163:300-306. doi:10.7326/M14-2784 www.annals.org For author affiliation, see end of text. This article was published online first at www.annals.org on 11 August 2015.

I propose that 8 basic payment methods apply to alltypes of health care and all payers. I describe their development, implications for provider and payer be- havior, and mathematical relationship within the health care spending identity. The goal is to help clarify de- bates on payment reform and value purchasing. Al- though the examples reflect U.S. experience, the prin- ciples are relevant to payment reforms elsewhere (1).

To be sure, money does not drive many decisions of physicians and other health care providers. For cen- turies, medicine has espoused the value that “The phy- sician's first and primary duty is to the patient” (2). Every health care professional has witnessed patients receiv- ing excellent care regardless of financial incentives.

Yet payment methods clearly affect whether, how, and how much care is provided. Examples include hos- pital length of stay (3), diagnostic imaging in physician offices (4), home health care visits (5), coordination among physicians and hospitals (6), the volume and mix of services under fee-for-service medicine (7), and much more. Financial incentives seem particularly po- tent in situations of clinical ambiguity, such as diagnos- tic tests, follow-up visits, and some procedures (8). Ef- fects of financial incentives often become more evident over time, such as decisions to open and close business lines (9) and medical students' choice of specialty (7).

Health care—rarely pleasurable, often uncomfort- able, and occasionally dangerous—is not purchased for its own sake but rather as a path toward health. As an economic good, however, health is ephemeral (10). Moreover, most purchasing decisions are made not by consumers, but by payers acting on their behalf. Prac- tically speaking, we cannot buy health but we can buy health care. Many recent initiatives aim to close this gap and achieve more health for the health care dollar (1, 11).

THE 8 BASIC PAYMENT METHODS Payment methods are distinct from payment levels.

Although payment methods certainly affect growth in spending over time, there are many alternatives for paying providers for any given level of spending. (Methods and levels are typically negotiated between providers and commercial payers and are set unilater- ally by government payers.) These alternatives can be understood as combinations of the 8 basic methods described in Table 1. The essential difference among methods is the unit of payment, which divides financial risk between payer and provider. The methods are pre- sented in order from top to bottom, with financial risk increasing for payers and decreasing for providers. Al- though the 8 methods form a continuum, method 4 (per episode) marks the line between epidemiologic risk (prevalence of medical conditions) and perfor- mance risk (treatment of medical conditions).

This taxonomy may increase clarity in clinical and policy discussions in which participants often use simi- lar terms to mean different things. Here, for example, “fee for service” means method 6 (per service). The common use of “fee for service” as the counterpoint to capitation is imprecise because it comprises methods 4 through 8. The taxonomy also avoids confusing terms, such as “global” and “bundled” (Table 2).

The U.S. Secretary of Health and Human Services, Sylvia Burwell, recently crystallized Medicare payment reform efforts by stating that within 3 years, 90% of Medicare payments will be tied to quality or value, with 50% of those total payments tied to quality or value through alternative payment models (11). (The percent- ages exclude managed care, which accounted for about one quarter of the $583 billion in Medicare pay- ments in 2013 [23].) Alternative payment models in- clude accountable care organizations, medical homes, bundled payment arrangements, payment per episode

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(method 4), and capitation (method 2). The descrip- tions found in Table 2 place examples of current pay- ment reforms within the framework of the 8 basic methods.

The 8 basic methods are comprehensive and mu- tually exclusive because each method uniquely corre- sponds to a risk factor within the health care spending identity (Table 3). Like other accounting identities, this identity illuminates the relationship between the whole and its parts. Using inpatient care as an example, total hospital charges depend on several factors, including the number of inpatient episodes, average length of stay, and hospitals' markup of charges over cost. In par- allel, the 8 basic payment methods include method 4 (per episode), method 5 (per day), and method 8 (per dollar of charges).

DIVIDING FINANCIAL RISK Table 3 shows why payers seek payment reform.

For example, when payment is calculated as a percent- age of charges—even a low percentage—the payer ab- sorbs the effect of any increase in any of the risk factors in Table 3. Payers try to buffer themselves from pro- vider decisions about charges and cost, but payers also mistrust many provider decisions about the volume of care. They point to an Institute of Medicine panel that estimated that 14% of U.S. health care spending (or $340 billion in 2009) reflected unnecessary or ineffi- ciently delivered services (28). In recent years, payers also have asserted a role in improving the quality and value of care and cite evidence of systemic deficiencies

and unflattering comparisons with other nations (29–31).

Because very few services are wasteful always and everywhere, providers presumably are the best judges of “right care, right time, right way,” so long as they have the appropriate incentives (32). Thus, Medicare shifted risk toward providers in 11 of 13 payment re- forms since 1983 (Table 4). These reforms have had broad influence because many payers emulate Medi- care (33, 34).

Changes in basic payment methods can have sweeping effects—both good and bad. In 1983, Medi- care inpatient payment jumped 3 steps from paying according to hospital costs (method 7 [per dollar of cost]) to paying for diagnosis-related groups (DRGs) (method 4 [per episode]). Payment by DRG led to de- creased hospital costs, shorter lengths of stay, reduced growth in Medicare payment, and even increases in hospital margins (the surplus of revenue over costs) as hospitals became more efficient. This payment change also accelerated the growth in outpatient and post- acute care services, possibly increasing fragmentation of care (34). In 1992, Medicare moved physician pay- ment from method 8 (per dollar of charges) to method 6 (per service). The change insulated Medicare from charge inflation but did not protect it from growth in service volume—both actual and as reported on claim forms (35). In an 8-year period, Medicare spending per beneficiary for physician services grew more than twice as fast as spending for other services and was driven entirely by growth in volume (36). And in 2000, Medi-

Table 1. The 8 Basic Payment Methods in Health Care*

Unit of Payment Common Term Examples (Common Classification Systems)

Comment

1. Per time period Budget and salary Salaried physicians and government hospitals

Typically but not necessarily per year

2. Per beneficiary Capitation Managed care organizations (ACG, CDPS, CMS-HCC, CRG, and DxCG)

More commonly used to pay health plans than to pay individual providers

3. Per recipient† Contact capitation Physician specialist services Not common; an example is a cardiologist accepting financial risk for treatment of cardiac patients

4. Per episode Case rates, payment per stay, and bundled payments

Hospital inpatient (DRG), physician surgeries (RBRVS), home health care (HHRG), and multiple providers (ECR, ETG, MEG, and PFE)

Defined here as related clinical services across multiple days

5. Per day Per diem and per visit Nursing facilities (RUG), hospital outpatient (EAPG), and ambulatory surgical centers (APC)‡

An outpatient visit may be defined as all services on 1 day

6. Per service Fee-for-service Physician services (RBRVS), hospital outpatient (APC)‡, dentists, medical equipment and supplies, and drugs

Separate payments are often made for multiple services per day

7. Per dollar of cost

Cost reimbursement Critical access hospitals, government-owned providers, and nursing facilities

Payers typically pay a percentage of cost as allowed by the payer

8. Per dollar of charges

Percentage of charges Any provider type Based on charges as billed by the provider

ACG = adjusted clinical group; APC = ambulatory payment classification; CDPS = chronic illness and disability payment system; CMS-HCC = Centers for Medicare & Medicaid Services–hierarchical condition category; CRG = clinical risk group; DRG = diagnosis-related group; EAPG = enhanced ambulatory patient group; ECR = evidence-informed case rate; ETG = episode treatment group; HHRG = home health resource group; MEG = medical episode group; PFE = patient-focused episode; RBRVS = resource-based relative value scale; RUG = resource utilization group. * Shown in decreasing order of financial risk borne by the provider or, alternatively, in increasing order of financial risk borne by the payer. The units of payment correspond to financial risk factors within the health care spending identity, as shown in Table 3. † A beneficiary is eligible for care, whereas a recipient has received ≥1 service. ‡ In practice, the incentives of the Medicare APC-based method align most closely with payment per day for ambulatory surgical centers and with payment per service for hospital outpatient care.

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care's shift of home health care payment from method 7 (per dollar of cost) to method 4 (per episode) led to 17% fewer visits per episode but similar patient out- comes, which suggests improved efficiency (5).

If the payer can shift risk to the provider, why stop? Why pay nursing facilities per day when hospitals are paid per episode? Or why is capitation rarely used to

pay individual physicians? The single biggest reason— indeed, arguably the single most important statistic in health policy—is that 5% of persons account for 50% of spending (37). If the provider bears too much financial risk, the provider has an overwhelming incentive to avoid costly patients. This essential tension between ef- ficiency and access is mitigated by classification sys-

Table 2. Current Examples of Major Payment Reforms in the United States

ACOs Although models differ, ACOs generally comprise physicians and hospitals that continue to be paid fee-for-service (method 6) for physician care and by

episode (method 4) for inpatient stays. What is new is that ACOs and payers share savings when total spending falls below benchmarks (12). The effect is similar to capitation (method 2) in damping incentives for providers to generate more volume. Further, ACOs often must adhere to specific quality and performance standards.

Medical homes Medical homes also take many forms, but they, too, are typically paid using previous payment methods. On the basis of performance, they become

eligible for payment adjustments (13). As with ACOs, some medical homes may be paid using capitation or episode payment.

Payment adjustments These increasingly common initiatives also do not change the basic payment method. Current examples include penalties or bonuses for readmission

rates, adoption of electronic health records, and reporting quality measures (14). Further, MACRA, a new law signed in April 2015, consolidates physician payment adjustments within a new Merit-Based Incentive Payment System, with details to be specified later (15).*

Bundling In practice, “bundling” means broadening the unit of payment in 1 of 3 senses: including different provider types (e.g., by requiring ACOs to include

hospitals and physicians); lengthening the time period (e.g., by redefining an inpatient episode to include postacute care and readmissions) (16); or aggregating services, such as Medicare's efforts to move its outpatient hospital payment method from a fee schedule (method 6) toward a visit-based approach (method 5) (17).

�Global” payment Can be a synonym for a fixed budget (method 1) (18), capitation (method 2) (19), or payment per episode (method 4) (20). Because of ambiguity, the term

is best avoided.

Patient cost sharing Payment methods are used to set the amount “allowed” as total payment to a provider. Payers and patients typically pay a portion of the allowed amount.

Without changing the basic payment method, some payers have restructured patient cost-sharing to incentivize cost-conscious choices (21).

Increased transparency Leading examples include Medicare's publication of provider-specific charges and payments for hospital and physician care (22). Although these

initiatives do not involve payment methods per se, the data are published using the units of payment described in Table 1.

ACO = accountable care organization; MACRA = Medicare Access and Children's Health Insurance Program Reauthorization Act. * MACRA also encourages movement to alternative payment models.

Table 3. The Health Care Spending Identity*, Using U.S. Hospital Inpatient Charges as an Example

Risk Factor 2002 2012 Factor Decomposition Change, %

1. Time period 1 1 1.00 0 2. Beneficiaries per time period† 287 625 193 313 914 040 1.09 9 3. Proportion of eligible population that receives care‡ 7.5% 7.2% 0.96 −4 4. Episodes per recipient§ 1.69 1.61 0.95 −5 5. Days of care per episode 4.6 d 4.5 d 0.98 −2 6. Services per day of care� NA NA NA NA 7. Cost per service� $1491 $2299 1.54 54 8. Markup of charges over cost 2.50 3.54 1.42 42

Total charges $626 926 866 973 $1 337 939 745 325 2.13 113

NA = not available. * An analytic approach developed by the author to enable time-series and cross-section comparisons of financial totals (e.g., charges and payment) and utilization (e.g., total services). Each risk factor in the identity corresponds to 1 of the 8 basic payment methods. This table uses the growth in U.S. hospital charges as an example. For 2002, for example, 1 × 287 625 193 × 0.075 × 1.69 × 4.6 × $1491 × 2.50 = $626 926 866 973 (discrepancy due to rounding). The algebra of decomposing a percentage change can be used to illuminate the reasons behind the growth in charges from 2002 to 2012. In the factor decomposition, 1.00 × 1.09 × 0.96 × 0.95 × 0.98 × 1.54 × 1.42 = 2.13. The author infers that the main reasons for the 113% growth in hospital charges were the 54% growth in cost per day from $1491 to $2299 and the 42% increase in hospitals' average markup of charges over cost from 2.50 to 3.54. Other changes had much less effect. † The U.S. resident population (24), consistent with the National Inpatient Sample (25). ‡ The U.S. civilian noninstitutionalized population, which equaled 98.4% of the resident population; 7.5% (26) and 7.2% (27) from the Medical Expenditure Panel Survey were used as proxies for the resident population. § Lines 4 to 8 were calculated using data from the National Inpatient Sample. Total discharges from community hospitals were 36 523 831 in 2002 and 36 484 846 in 2012. � Data were NA for the average number of services per day. Line 7 therefore refers to average hospital cost per day, which comprises the average number of services per day × the average cost per service.

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tems that adjust payments for case mix, so payment is higher for patients who are likely to be more costly. Table 1 shows common examples, such as DRGs, re- source utilization groups for nursing facility days, and various systems used in capitation payment.

Risk shifting is limited by the state of the science in risk adjustment. Classification systems commonly used in capitation models, for example, still explain less than 20% of cost variation across beneficiaries (38). That is not enough to prevent cherry-picking and lemon- dropping. Such risk selection is a particular problem when health plans or providers possess predictive in- formation, such as occupation, race, and prior utiliza- tion, which are typically excluded from classification systems for various good reasons (38). Classification systems for episodes can do better and explain as much as half of cost variation (39–41). The Figure shows payment methods commonly used in the United States for 15 provider types.

PAYMENT METHODS IN PRACTICE In real life, the 8 basic methods often are com-

bined, sometimes to protect providers against extraor- dinary expenses not predicted by a classification sys- tem. Medicare, for example, pays hospitals per stay (method 4) but reserves 5% of payment for outlier pay- ments that depend on cost (method 7). Carve-out and stop-loss provisions similarly protect physician groups paid by capitation. The art in designing payment policy is to strike the right balance without creating a muddle of conflicting incentives.

When an employer pays a managed care plan by capitation but the plan pays physicians per service, the incentive at the bedside is for more services. The incen- tives that matter most are those closest to the clinical decision maker.

In the marketplace, payers and providers inevitably face off against each other. The arena depends on the unit of payment. The consequences of changing pay- ment methods may be unintended, but they can be predicted through analysis of incentives. Whatever the unit of payment, providers are rewarded for increasing units while decreasing their own cost per unit. For ex- ample, when DRG payment (method 4) was introduced in 1983 for hospital care, payers welcomed the result- ing reductions in length of stay but worried about pa- tients being discharged sicker and quicker. Likewise, implementation of the 9000-item Medicare fee sched- ule rewarded physicians who “unbundled” services to bill more codes. Medicare responded with the 1.3 mil- lion edits of the National Correct Coding Initiative (NCCI) (42). If, instead, physicians were paid per epi- sode, the NCCI would be irrelevant and the concern would become stinting on care. In practice, concerns about “too little care” predominate when providers bear considerable risk (methods 1 to 4), whereas con- cerns about “too many units” predominate when the risk is more on payers (methods 5 to 8). From the pro- viders' perspective, methods 1 to 4 usually lead to con- cern over inordinate financial risk, whereas methods 5 to 8 lead to concerns about micromanagement (for example, the NCCI, prior authorization, and cost auditing).

Payment methods cannot be neutral on quality. Each method encourages and discourages provision of care overall and in particular situations. Payers there- fore establish mechanisms outside each payment method to monitor efforts by providers to maximize units and minimize cost per unit. Many professional norms also have arisen to mitigate financial incentives in the market for health care, which is often character- ized by asymmetrical information, considerable uncer-

Table 4. Medicare Initiatives to Change Basic Payment Methods

Year Provider Type Prior Method New Method Classification System for the New Method

1983 Hospital inpatient 7. Per dollar of cost 4. Per episode DRG 1984 Clinical laboratory 8. Per dollar of charges 6. Per service CLFS 1992 Physician 8. Per dollar of charges 6. Per service* RBRVS 1997 Critical access hospital 4. Per episode 7. Per dollar of cost – 1998 Nursing facility 7. Per dollar of cost 5. Per day RUG 2000 Hospital outpatient 7. Per dollar of cost 6. Per service† APC 2000 Home health care 7. Per dollar of cost 4. Per episode HHRG 2002 Long-term care hospital 7. Per dollar of cost 4. Per episode LTC-DRG 2002 Rehabilitation facility 7. Per dollar of cost 4. Per episode CMG 2002 Ambulance 8. Per dollar of charges‡ 6. Per service – 2005 Psychiatric hospital 7. Per dollar of cost 5. Per day – 2008 Ambulatory surgical center 5. Per day 5. Per day† APC 2012 ACO 4. Per episode§

6. Per service� Same as prior method except with savings

incentives most similar to method 2 –

ACO = accountable care organization; APC = ambulatory payment classification; CLFS = Clinical Laboratory Fee Schedule; CMG = case-mix group; DRG = diagnosis-related group; HHRG = home health resource group; LTC-DRG = long-term care DRG; RBRVS = resource-based relative value scale; RUG = resource utilization group. * Physician surgical services are commonly paid per episode. † In practice, the incentives of the Medicare APC-based method align more closely with payment per day for ambulatory surgical centers and with payment per service for hospital outpatient care. ‡ Before 2002, ambulance services were typically but not always paid at a percentage of charges. § Hospital inpatient. � Physician and hospital outpatient.

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tainty, and life-and-death consequences (43). These mechanisms and norms include utilization review, pro- vider profiling and credentialing, public reporting, ap- peals to professional ethics, licensure and certification, peer review, litigation and other disciplinary action, and prohibitions against self-referral (44).

CURRENT INITIATIVES Payment reforms of the past 30 years largely have

been initiatives of dissemination: Medicare's extension of the DRG model to other provider types, the adop- tion of Medicare methods by other payers, and the drive by commercial payers toward capitation in the 1990s. By contrast, payment policy today is a bubbling cauldron of experimentation. Accountable care organi- zations, medical homes, pay for quality, “value not vol- ume,” and other concepts can take very different forms even within the same insurer (Table 2). The 8 basic pay- ment methods remain applicable, but they are being combined in new ways (with increased emphasis on payment adjustments) and reveal unprecedented de- termination by payers to influence clinical practice.

The success of these reforms probably will depend on 4 questions. First, as more payments are based on

capitation and episodes, will providers avoid costly pa- tients? The answer depends on the accuracy of case- mix adjustment and the effectiveness of nonpayment mechanisms to minimize risk selection. Second, will an overabundance of uncoordinated reforms create a muddle of incentives? Some accountable care organi- zations have raised this concern already (45). Third, will providers rebel against the administrative burden and clinical oversight inherent in many initiatives? For exam- ple, the American Medical Association describes the current scene as a “regulatory nightmare” (46). Fourth, will provider mergers subvert efforts to control health care spending? Accountable care organizations and other reforms encourage providers to band together, but consolidation helps providers negotiate higher prices from commercial payers (47).

In contrast to most other industries, the basis of payment in health care—the “product” being purchased and delivered—remains variable and unsettled (48). Seven of the 8 basic methods are widely used within the U.S. health care system, often in combination. (The exception is method 3 [per recipient].) Amid enormous complexity, with the health of hundreds of millions of persons affected by current payment reforms, clarity

Figure. Payment methods commonly used in the United States, by provider type.

Provider Type Basic Payment Method

1. Per Time Period

2. Per Beneficiary

3. Per Recipient

4. Per Episode

5. Per Day 6. Per Service

7. Per Dollar of Cost

8. Per Dollar of Charges

Managed care organization

Hospital inpatient

Hospital outpatient

Ambulatory surgical center

Physician

Dentist

Therapy (outpatient)

Clinical laboratory

Ambulance

Drugs (pharmacy)

Nursing facility

Home health care

Hospice

HCBS*

ICF/DD†

Predominant method used by Medicare

Other methods commonly used in the United States

* *

* *

* * * * * *

* *

*

† †

†

† †

† †

† †

†

† † †

† † †

† † † † †

† †

†

† †

† †† †

† *

HBCS = home- and community-based services; ICF/DD = intermediate care facilities for the developmentally disabled. * Typically provided to persons requiring personal assistance and funded by Medicaid programs per 15-min service unit. † Typically funded by Medicaid programs per day or at a percentage of cost.

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and precision in policy discussion are ever more essential.

From Xerox Corporation, Helena, Montana.

Acknowledgment: The author thanks Richard Fuller, Robert Coulam, and Candida Quinn for their kind and expert assis- tance during the composition of the manuscript.

Disclosures: Disclosures can be viewed at www.acponline .org/authors/icmje/ConflictOfInterestForms.do?msNum=M14 -2784.

Requests for Single Reprints: Kevin Quinn, MA, Xerox Corpo- ration, 34 North Last Chance Gulch, Helena, MT 59601; e-mail, [email protected].

Author contributions are available at www.annals.org.

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Author Contributions: Conception and design: K. Quinn. Drafting of the article: K. Quinn. Critical revision of the article for important intellectual con- tent: K. Quinn. Final approval of the article: K. Quinn.

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