Health Care Finance
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chpter-3.docxBig sky’s revenue sources
Big Sky Dermatology Specialists is a small group practice in Jackson, Wyoming. The city is located in the scenic Jackson Hole Valley and is a major gateway to the Grand Teton and Yellowstone National Parks. In addition, it is home to the world’s largest ball of barbed wire. (It’s amazing what you learn when studying healthcare finance!)
Jen Latimer, a recent graduate of Idaho State University’s healthcare administration pro- gram, was just hired to be Big Sky’s practice manager. One of her first tasks was to review the group’s payer mix. (Payer mix is a listing of the individuals and organizations that pay for a provider’s services, along with each payer’s percentage of revenues.) After all, revenues are the first step (of many) needed to ensure the financial success of any business.
To better understand Big Sky’s revenues, Jen focused on two questions. First, who are the payers? In other words, where does Big Sky’s revenue come from? Second, what methods do the payers use to determine the payment amount? By gaining an appreciation of the group’s
revenues, Jen believed she could accurately judge the financial riskiness of the practice. Furthermore, she would be able to identify possible steps toward increasing the practice’s revenues and reduce the riskiness associated with those revenues.
By the end of the chapter, you will have a better understanding of healthcare provider revenue sources and how the specific payment method influences provider behavior. Specifically, you, like Jen, will know more about how these issues affect Big Sky.
3.1 introduction
In most industries, the consumer of the product or service (1) has a choice among many suppliers, (2) can distinguish the quality of competing goods or services, (3) makes a (presumably) rational decision regarding the purchase on the basis of quality and price, and (4) pays for the full cost of the purchase.
The provision of healthcare services does not follow this general model, as health- care is delivered under unique circumstances. First, often only a few individuals or organizations provide a particular service. Second, judging the quality of competing providers is difficult, if not impossible. Third, the decision (or at least recommendation) on which provider to use for a particular service typically is not made by the consumer but rather by a physician or some other clinician. Fourth, the bulk of the payment to the provider is not normally made by the user (the patient) but by an insurer. Finally, for most individuals, the purchase of health insurance is paid for (or heavily subsidized) by employers or government agencies, so patients are insulated from the true cost of healthcare services.
This highly unusual marketplace significantly influences the supply of and demand for healthcare services. To gain a better understanding of the unique payment mechanisms involved, we must examine the healthcare reimbursement system.
3.2 basic insurance concepts Because insurance is the cornerstone of healthcare reimbursement, an appreciation of basic
insurance concepts will help you better understand the marketplace for healthcare services.
A Simple illustration
Assume that no health insurance exists and that you face only two medical outcomes in the coming year:
Outcome Probability Outcome Probability
Stay healthy 0.99 Stay healthy 0.99
Get sick 0.01 Get sick 0.01
1.00 1.00
Cost Cost
$ 0 $ 0
50,000 50,000
What is your expected healthcare cost (in the statistical sense) for the coming year? To find the answer—$500—multiply the cost of each outcome by its probability of occurrence and then sum the products:
Expected cost = (Probability of outcome 1 × Cost of outcome 1) Expected cost = (Probability of outcome 1 × Cost of outcome 1)
+ (Probability of outcome 2 × Cost of outcome 2) + (Probability of outcome 2 × Cost of outcome 2)
= (0.99 × $0) + (0.01 × $50,000) = (0.99 × $0) + (0.01 × $50,000)
= $0 + $500 = $500. = $0 + $500 = $5
Now, assume that everyone else faces the same medical outcomes and hence faces the same odds and costs associated with healthcare. Further- more, assume that you, and everyone else, make $60,000 a year. With this salary, you can easily afford the $500 expected healthcare cost. The problem, however, is that no one’s actual cost will be $500. If you stay healthy, your cost will be zero; if you get sick, your cost will be $50,000, and this amount could force you, and most people who get sick, into personal bankruptcy, which is a ruinous event. (Don’t forget, you have to pay all of your living expenses out of your $60,000 annual income in addition to any healthcare costs.)
Now, suppose an insurance policy that pays all of your healthcare costs for the coming year is available for $600.Would you take the policy, even though it costs $100 more than your “expected” healthcare costs?
Most people would, and do. Because individuals are risk averse, they are willing to pay a $100 premium over their expected benefit to eliminate the risk of financial ruin. In effect, policyholders are passing the costs associated with the risk of getting sick to the insurer who, as you will see, is spreading those costs over a large number of subscribers.
Would an insurer be willing to offer the policy for $600? If the insurer could sell enough policies, it would know its revenues and costs with some precision. For example, if the insurer sold 1 million policies, it would collect 1,000,000 × $600 = $600 million in health insurance premiums; pay out roughly 1,000,000 × $500 = $500 million in claims, and hence have about $100 million to cover administrative costs; provide a reserve in case claims are greater than predicted; and make a profit. By writing a large number of policies, the financial risk inherent in medical costs can be spread over a large number of people, reducing the risk for the insurance company (and for each individual).
Critical Concept
Risk aversion is the tendency of individuals and businesses to dislike financial risk. Risk-averse individuals and businesses are motivated to use insurance and other techniques to protect against risk. For example, a favorite tool to control risk is di- versification, which in the context of revenues means lowering risk by having different sources of income. By not depending on one source—say, Medicare patients—a provider can re- duce the uncertainty (riskiness) of its revenue stream. Insurance is another way to limit risk. Individuals buy insurance on the houses they own to limit the consequences of calamitous events, such as fires or hurricanes.
basic characteristics of insurance
The simple example above illustrates why individuals seek health insurance and why insurance companies are formed to provide such insurance. But let’s dig a little deeper into insurance basics.
Insurance typically has four distinct characteristics:
1. Pooling of losses. The pooling (sharing) of losses is the heart of insurance. Pooling means that losses are spread over a large group of individuals so that each individual realizes the
average loss of the pool rather than the actual loss incurred. In addition, pooling involves the grouping of a large number of homogeneous exposure units (people or things having the same risk characteristics). Thus, pooling implies (a) the sharing of losses by the entire group and (b) the prediction of future losses with some accuracy based on the law of large numbers. (The law of large numbers implies that predicting outcomes is easier when many identical trails are involved. For example, if a coin is flipped only once, you do not know whether the results will be a head or a tail. But if the coin is flipped 1,000 times, the result will be very close to 500 heads and 500 tails. In other words, you cannot predict the results of a single toss with any confidence, but you can predict the aggregate results if you have a large pool of tosses.)
2. Payment only for random losses. A random loss is unforeseen, is unexpected, and occurs as a result of chance. Insurance is based on the premise that payments are made only for losses that are random. We discuss the moral hazard problem, in which losses are not random, in a later section.
3. Risk transfer. An insurance plan almost always involves risk transfer. The sole exception to the element of risk transfer is self-insurance, whereby an individual or a business does not buy insurance. (Self-insurance is discussed in a later section.) Risk transfer means that the risk is shifted from the insured to the insurer, which typically is in a better financial position to pay the loss than is the insured because of the premiums collected. Also, because of the law of large numbers, the insurance company is better able to predict its losses.
4. Indemnification. Indemnification is the reimbursement of the insured if a loss occurs. Within the context of health insurance, indemnification occurs when the insurer pays, in whole or in part, the insured or the provider for the expenses related to an insured’s illness or injury.
In summary, we applied these four characteristics to our insurance example: (1) The losses are pooled across 1 million individuals, (2) the losses on each individual are random (unpredictable), (3) the risk of loss is passed to the insurance company, and (4) the insurance company pays for any losses.
Pooling
The spreading of losses over a large group of individuals (or organizations).
Random loss
An unpredictable loss, such as one that results from a fire or hurricane.
Risk transfer
The passing of risk from one individual or business to another (usually an insurer).
Indemnification
The agreement to pay for losses incurred by another party.
real-world problems
Insurance works fine when the four basic characteristics are present. However, if any of these characteristics is violated, problems arise. The two most common problems are ad- verse selection and moral hazard.
Adverse Selection
One of the major problems for insurers is adverse selection. Adverse selection occurs be- cause those individuals and businesses likely to incur losses are more inclined to purchase
insurance than are those less likely to incur losses. For example, an otherwise healthy individual without insurance who needs a costly surgical procedure is more apt to get health insurance if he or she can afford it, whereas an identical individual without the threat of surgery is less likely to purchase insurance. Similarly, consider the health insurance purchase likelihood of a 20-year-old versus that of a 65-year-old. All else the same, the older individual, with much greater health risk because of age, will probably obtain insurance. (Individuals aged 65 or older consume more than three times the dollar amount of healthcare services as younger individuals do.)
If the tendency toward adverse selection goes unchecked, a disproportionate number of sick people, or those most likely to become sick, will seek health insurance, causing the insurer to experience higher-than-expected claims. This increase in claims will trigger a premium increase, which worsens the problem, because healthier members of the plan will either pursue cheaper rates from another company (if available) or forgo insurance.
One way health insurers attempt to control adverse selection is by instituting under- writing provisions. Thus, smokers may be charged a higher premium than nonsmokers. An- other way is by including preexisting condition clauses in contracts. (A preexisting condition is a physical or mental condition of the insured individual that existed before the issuance of for insurance. the policy.) A typical clause might state that preexisting conditions are not covered until the policy has been in force for some period of time—say, one or two years. Preexisting conditions present a true problem for the health insurance industry because an important characteristic of insurance is randomness. If an individual has a preexisting condition, the insurer no longer bears random risk but rather assumes the role of payer for the treatment of a known condition.
Because insurers tend to avoid paying large predictable claims, the US Congress passed the Health Insurance Portability and Accountability Act (HIPAA) in 1996. Among other actions, HIPAA sets national standards, which can be modified within limits by the states, regarding what provisions can be included in health insurance policies. For example, under a group health policy—say, one that covers employees of a furniture manufacturer—coverage to individuals cannot be denied or limited, and employees cannot be required to pay more in premiums if they suffer from poor health.
Although preexisting condition clauses in policies for adults are not currently banned, insurers are limited as to what conditions they can count as preexisting and how long they can delay before beginning coverage. Also, time credit for preexisting conditions under one plan can be credited toward a second plan should the employee change jobs, provided no break in coverage occurs. (Preexisting condition clauses for children are banned under the Patient Protection and Affordable Care Act [ACA] and, if not changed, will be banned for adults in 2014. See section 3.8 for a discussion of the ACA.)
Critical Concept:
Adverse selection, in its simplest form, means that individuals most likely to need healthcare services are most likely to buy health insurance. This tendency creates a problem for insurers because it drives the costs of healthcare for a defined population to higher-than-anticipated levels.
Finally, health insurance cannot be canceled if the policyholder becomes sick, and if a policyholder leaves the company, he or she has the right to purchase insurance (for a limited time) from the insurer that provided the company’s group policy. All in all, the provisions of HIPAA protect individuals against arbitrary actions by insurers when their health status changes for the worse or when they leave the employer.
For Your Consideration
When the cost of health insurance is relatively low, such as in an employer-subsidized plan, most people to whom it is made available will opt in (take the insurance). But when the cost of health insurance is relatively high, the choice is not as easy to make. Often, those who opt in will be more likely to have immediate healthcare needs and hence be more expensive to insure than the population as a whole. Thus, as Kay Lazar wrote in a June 30, 2010, Boston Globe article titled “Short-Term Insurance Buyers Drive up Cost in Mass.,” adverse selection is a factor in increased health insurance costs, and the higher the costs, the higher the premiums, which means even more individuals will forgo coverage.
The traditional techniques used by insurers to mitigate adverse selection risk have included denying coverage to or charging higher premiums for individuals with preexisting health conditions or excluding those conditions from the individual’s policy. Although necessary for the current healthcare insurance system to remain viable, these techniques are one reason health insurance is viewed in a negative light by many con- sumers. Now, however, healthcare reform (discussed in section 3.8) eliminates or limits most of the traditional adverse selection risk management techniques. Instead, the legislation’s aim is to maximize the number of healthy people who obtain coverage by offering subsidies to lower-income Americans and mandating penalties for those who refuse to take coverage. This “individual mandate” approach is intended to put almost everyone into the insurance pool, thereby eliminating adverse selection.
What do you think? Will the individual mandate eliminate adverse selection? What specific provisions (sticks and carrots) are necessary for the mandate to work? Note that more than two dozen states, interest groups, and individuals have sued the federal government, arguing that the individual mandate is unconstitutional. By the time you read this For Your Consideration box, the issue will have been settled by the US Supreme Court.
Moral Hazard
The fact that insurance is based on the premise! that payments are made only for random (un- foreseen) losses creates the moral hazard problem. The most common illustration of moral
hazard is the owner who deliberately sets a failing business on fire to collect the insurance.
Moral hazard is also present in health insurance, but its form typically is not so dramatic—not too many people are willing to voluntarily sustain injury or illness for the purpose of collecting health insurance benefits. How- ever, undoubtedly some people do purposely use healthcare services that are not medically required. For example, some people who live alone might visit a physician or a walk-in clinic for the social value of human companionship rather than to address a medical necessity.
More consequential is the fact that someone other than the patient is usually paying for the healthcare he or she receives, leading to greater consumption of services than would occur if patients bore the full costs. When the full cost or most of the cost of healthcare services is covered by insurance, individuals are more inclined to agree to undergo a $1,000 MRI (magnetic resonance imaging) scan or other high-cost procedure even when its need is questionable. If the same test required total out-of-pocket payment, an individual would probably think carefully before agreeing to such an expensive procedure, unless it is a true medical necessity.
An even more insidious aspect of moral hazard is the impact of insurance on individual behavior. Individuals are less likely to take preventive health actions when the costs of not taking those actions will be borne by insurers. Why worry about getting a flu shot if the monetary costs associated with the treatment are borne by the healthcare services
insurer? Why stop smoking if others will pay for the likely adverse health consequences?
The fact that insurance exists causes some individuals to forgo preventive actions and embrace unhealthy behaviors, both of which might be approached differently in the absence of insurance.
Insurers attempt to protect themselves from moral hazard claims by paying less than the full amount of healthcare costs. Forcing insured individuals to bear some of the cost lessens their tendency to consume unneeded services or engage in unhealthy behaviors. One way to make patients pay out of pocket is to require a deductible. Medical policies usually stipulate a dollar amount that must be satisfied before benefits are paid.
Although deductibles help offset the moral hazard problem, their primary purpose is to eliminate the need for an insurer to pay a small claim, if that is the only healthcare expense for the year. In such cases, the administrative cost of processing the claim may be larger than the amount of the claim itself. To illustrate, a policy may state that the first $500 (or more) of medical expenses incurred each year will be paid by the individual. Once the deductible is met, the insurer will pay all eligible medical expenses (less any copayments and coinsurance) for the remainder of the year.
The primary weapons that insurers have against the moral hazard problem are copayments and coinsurance. Copayment (or copay) is a fixed amount paid by the patient each time a service is rendered, such as $20 per office visit or $75 for each emergency department visit. Coinsurance is the sharing of costs between the patient and insurer, typically on a percentage basis. For example, the patient bears 20 percent of the costs of a hospital stay.
Copays and coinsurance serve two primary purposes. First, these payments discourage overutilization of healthcare services and hence reduce insurance benefits. By extension, by being forced to pay some of the costs, insured individuals will presumably seek fewer and more cost-effective treatments and embrace a healthier lifestyle than they would otherwise. Second, because insured individuals pay part of the cost, premiums can be reduced. Health insurance premiums (the cost of the policy to the subscriber) have risen rapidly in the past ten years and now exceed $15,000 annually for family coverage. Employers, on average, pay about 75 percent of the premium costs. Because of this alarming trend in health premium costs, employers are seeking ways to reduce them; one way is to pass more of the costs on to employees through copays and coinsurance.
Some health insurance policies contain out-of-pocket maximums, whereby the insurer pays all covered costs, including coinsurance, after the insured individual pays a certain amount of costs—say, $2,000. Finally, prior to 2010, most insurance policies had policy limits, for example, $1 million in total lifetime coverage, $1,500 per year for mental health benefits, or $100 for eyeglasses. These limits were designed to control excessive use of certain services and protect the insurer against catastrophic losses. The ACA, as it currently stands, has banned lifetime limits and is phasing out annual limits on most health plans.
Before we move on, we should briefly mention a newer type of health insurance that is gaining popularity: high-deductible health plans (HDHPs). An HDHP has a higher annual deductible (more than $2,000 for family coverage) than traditional plans do. But it allows individuals to set up savings accounts for the sole purpose of paying healthcare costs. Furthermore, contributions to such accounts are tax deductible (up to a set limit) and can roll over from year to year. HDHPs are becoming popular with executives and other highly paid workers because of the tax shelter benefit, but they have not been as widely accepted by blue-collar workers because of the high deductible amount.
Copayment
A fixed cost to the patient each time a service is rendered (e.g., $20 per outpatient visit).
Coinsurance
A sharing of costs between the patient and the insurer (e.g., the patient pays 20 percent of the costs of hospitalization).
High-deductible health plan (HDHP)
A type of health insurance that requires high deductibles but allows insured individuals to set up tax-advantaged savings accounts to pay those deductibles.
3.3 Third-party payers
As mentioned earlier, a large proportion of provider revenues does not come directly from patients (the users of healthcare services) but from insurers, known collectively as third-party payers. Because a healthcare organization’s revenues are key to its financial viability, we first discuss the sources of most revenues in the healthcare industry. In the next section, we examine the types of reimbursement methods employed by these payers.
Health insurance originated in Europe in the early 1800s when mutual benefit societies were formed to reduce the financial burden associated with illness or injury. Today, health insurers fall into two broad categories: private insurers and public programs.
private insurers
In the United States, the concept of public, or government, health insurance is relatively new, while private health insurance has been in existence since the early twentieth century. In this section, we discuss the major private insurers.
Blue Cross and Blue Shield
Blue Cross and Blue Shield organizations trace their roots to the Great Depression, when both hospitals and physicians were concerned about their patients’ abilities to pay health- care bills.
Blue Cross originated as a number of separate insurance programs offered by individual hospitals. At that time, many patients were unable to pay their hospital bills, but most people, except the poorest, could afford to pay small monthly premiums to purchase some type of hospitalization insurance. Thus, the programs were initially designed to benefit both patients and hospitals.
The programs were all similar in structure: Hospitals agreed to provide a certain number of services to program members who made periodic payments to the hospitals whether services were used or not. In a short time, these programs were expanded from single-hospital programs to community-wide, multihospital plans that were called hospital service plans. The American Hospital Association (AHA) recognized the benefits of such plans to hospitals, so a close relationship was formed between the AHA and the organizations that offered hospital service plans.
In the early years, several states ruled that the sale of hospital services by prepayment did not constitute insurance, so the plans were exempt from regulations governing insurance companies. However, the legal status of hospital service plans clearly would be subject to future scrutiny unless their status was formalized. Thus, the states, one by one, passed legislation that provided for the founding of not-for-profit hospital service corporations that were exempt both from taxes and from the capital requirements (reserves) mandated for other insurers. However, state insurance departments had (and continue to have) oversight over most aspects of the plans’ operations. The Blue Cross name was officially adopted by most of these plans in 1939.
Blue Shield plans developed in a manner similar to that of the Blue Cross plans, except that the providers were physicians instead of hospitals and the professional organization involved was the American Medical Association instead of the AHA. Today, 38 Blue Cross/Blue Shield (the Blues) organizations exist, some of which offer only one of the two plans (most offer both). The Blues are organized as independent corporations, but all belong to a single national association that sets the standards required for using the Blue Cross/Blue Shield name. Collectively, the Blues provide healthcare coverage for about 100 million people in all 50 states, the District of Columbia, and Puerto Rico.
Historically, the Blues have been not-for-profit corporations that enjoyed the full benefits accorded to that status, including freedom from taxes. But in 1986, Congress eliminated the Blues’ tax exemption on the grounds that they engaged in commercial-type insurance activities. However, the plans were given special deductions, which resulted in taxes that are generally less than those paid by commercial insurers.
In spite of the 1986 change in tax status, the national association continued to require all Blues organizations to operate entirely as not-for-profit corporations, although they were allowed to establish for-profit subsidiaries. In 1994, the national association lifted its traditional ban on member plans becoming investor-owned companies, and several Blues have since converted to for-profit status.
Commercial Insurers
Commercial health insurance traditionally was issued by life insurance and casualty insurance (home and auto) companies. Today, however, most health insurance is provided by companies that exclusively write health insurance. Examples of commercial insurers include Aetna, Humana, and UnitedHealth Group. Most commercial insurance companies are stockholder owned, and all are taxable entities.
Commercial insurers moved strongly into health insurance following World War II. At that time, the United Auto Workers negotiated the first contract with employers in which fringe benefits were a major part of the contract. Like the Blues, the majority of individuals with commercial health insurance are covered under group policies with employee groups, professional and other associations, and labor unions.
Self-Insurers
An argument can be made that all individuals who do not have some form of health insurance are self-insurers, but this statement is not accurate. Self-insurers make a conscious decision to bear the risks associated with healthcare costs and then set aside (or have available) funds to pay for costs they may incur in the future. Individuals, except the very wealthy, are not good candidates for self-insurance because, as discussed earlier, individuals who do not pool risks face much uncertainty in future healthcare costs.
On the other hand, large organizations, especially employers, are good candidates for self-insurance. In fact, most large companies, and many midsized companies, are self- insured. The advantages of self-insurance include the potential to reduce costs (cut out the middleman) and the opportunity to offer plans tailored to meet the unique characteristics of the organization’s employees. Organizations that self-insure typically pay an insurance company to administer the plan. For example, employees of the State of Florida are covered by health insurance, the costs of which are paid directly by the state, but the plan is administered by Blue Cross/Blue Shield of Florida.
public insurers
Government is both a major insurer and a direct provider of healthcare services. For example, the government provides healthcare services directly to qualifying individuals through Department of Veterans Affairs, Department of Defense, and Public Health Service medical facilities. In addition, it either provides or mandates a variety of insurance programs, such as workers’ compensation and TRICARE (health insurance for military members, their families, and uniformed services retirees). In this section, however, we focus on the two major government insurance programs—Medicare and Medicaid—that fund roughly one-third of all healthcare services provided in the United States.
Medicare
Medicare was established by Congress in 1965 primarily to provide medical benefits to individuals aged 65 or older. About 50 million people have Medicare coverage, which pays for about 20 percent of all US healthcare expenditures.
Over the decades, Medicare has evolved to include four major types of coverage:
1. Part A provides hospital and some skilled nursing home coverage.
2. Part B covers physician services, ambulatory surgical services, outpatient services, and other miscellaneous services.
3. Part C is managed care coverage offered by private insurance companies. It can be selected in lieu of Parts A and B.
4. Part D covers prescription drugs.
In addition, Medicare covers healthcare costs associated with selected disabilities and illnesses (such as kidney failure) regardless of age.
Part A coverage is free to all individuals eligible for Social Security benefits. Individuals who are not eligible for Social Security benefits can obtain Part A medical benefits by paying monthly premiums. Part B is optional to all individuals who have Part A coverage, and it requires a monthly premium from enrollees that varies with income level. About 97 percent of Part A participants purchase Part B coverage, while about 20 percent of Medicare enrollees elect to participate in Part C, also called Medicare Advantage plans, rather than Parts A and B. Part D offers prescription drug coverage through plans offered by private companies. Each Part D plan offers somewhat different coverage, so the cost of Part D coverage varies widely.
Because Parts A and B do not cover all costs of care and the remaining out-of- pocket costs can be significant, many Medicare participants purchase additional coverage from private insurers to help cover the “gaps” in Medicare coverage. Such coverage is called Medigap insurance.
The Medicare program falls under the purview of the federal Department of Health and Human Services (HHS), which creates the specific rules of the program on the basis of enabling legislation. Medicare is administered by an agency in HHS called the Centers
for Medicare & Medicaid Services (CMS). CMS’s eight regional offices oversee the Medicare (and Medicaid) program and ensure that regulations are followed. Medicare payments to providers are not made directly by CMS but by contractors for 15 Medicare Administrative Contractor jurisdictions.
Medicaid
Medicaid began in 1965 as a modest program jointly funded and operated by the individual states and the federal government. The idea was to provide a medical safety net for low-income mothers and children and for elderly, blind, and disabled individuals.
Congress mandated that state programs, at a minimum, cover hospital and physician care but encouraged states to provide additional benefits either by increasing the range of benefits or extending the program to cover more people. States with large tax bases were quick to expand coverage to many groups, while states with limited revenues were forced to establish more restrictive programs. In addition to state expansions, a mandatory nursing home benefit was added in 1972. As a consequence, Medicaid is now the largest payer of long-term care benefits and the largest single budget item for many states. In total, Medicaid covers roughly 70 million individuals and pays for about 15 percent of all healthcare expenditures in the United States.
Over the years, Medicare and Medicaid have provided access to healthcare services for many low-income individuals who otherwise would have no health insurance coverage. Furthermore, these programs have become an important source of revenue for healthcare providers, especially for nursing homes and other providers that treat large numbers of low-income patients. However, Medicare and Medicaid expenditures have been growing at an alarming rate, forcing federal and state policymakers to search for more cost-effective ways to provide healthcare services.
Critical Concept
Medicaid is a joint federal–state health insurance program that primarily covers low-income individuals and families. The federal government funds about half of the costs of the program, while the states fund the remainder. Although general guide- lines are established by CMS, the program is administered by the individual states. Thus, each state, as long as it follows basic federal guidelines, can set its own rules regarding eligibility, benefits, and provider payment
3.4 managed care Organizations
Managed care organizations (MCOs) strive to combine the provision of healthcare services and the insurance function into a single entity. Typi- cally, MCOs are created by insurers that either directly own a provider network or create one through contractual arrangements with independent providers. Occasionally, however, MCOs are created by integrated delivery systems that establish their own insurance companies.
Historically, the most common type of MCO was the health maintenance organization (HMO). HMOs were developed to thwart the per- verse incentives created by traditional insurer–provider relationships whereby providers were rewarded for treating patients’ illnesses but given little incentive to provide prevention and rehabilitation services. By combining the financing and delivery of healthcare services into a single system, HMOs theoretically have as strong an incentive to prevent as to treat illnesses. However, because their organizational structures, ownership, and financial incentives differ from plan to plan, HMOs can vary widely in cost and quality.
HMOs use a variety of methods to control costs. These include limiting patients to particular providers, called the provider panel, and using primary care physicians as gatekeepers who authorize all specialized and referral services. In general, services are not covered if beneficiaries bypass their gatekeeper physician or use providers that are not part of the HMO panel.
The federal Health Maintenance Act of 1973 encouraged the development of HMOs by providing federal funds for HMO operating grants and loans. In addition, the act required larger employers that offer healthcare benefits to their employees to include an HMO as one alternative, if one was available in the area, in addition to traditional insurance plans.
Although the number and sizes of HMOs grew rapidly during the 1980s and 1990s, since that time they have lost some of their luster because healthcare consumers have been unwilling to accept access limitations, even though such limitations might reduce costs. To address consumer concerns and falling enrollments, another type of MCO—the preferred provider organization (PPO)—was developed. These organizations do not wield as much control as HMOs but combine some of the cost-savings strategies of HMOs with features of traditional health insurance plans.
PPOs do not mandate that beneficiaries use specific providers. They do, however, offer financial incentives to encourage members to use providers that participate in the plan. That panel of providers typically negotiates discounted price contracts with the PPO. Furthermore, PPOs do not require plan members to use preselected gatekeeper physicians. Finally, PPOs are less likely than HMOs to provide preventive services, and they do not assume any responsibility for quality assurance because enrollees are not constrained to use only the PPO panel of providers.
In an effort to achieve the potential cost savings of MCOs, health insurers are now applying managed care strategies, such as preadmission certification, utilization review, and second surgical opinions, to their conventional plans. Thus, the term “managed care” now describes a continuum of plans, which can vary significantly in their approaches to providing combined insurance and healthcare services. The common feature in MCOs is that the insurer has a mechanism to control, or at least influence, patients’ utilization of healthcare services. Today, most employer-sponsored health coverage is provided by some type of MCO.
Provider panel
The group of providers—say, doctors and hospitals—designated as preferred by a managed care plan. Services delivered by providers outside of the panel may be only partially covered, or not covered at all, by the plan.
Gatekeeper
A primary care physician who controls specialist and ancillary service referrals. Some managed care plans only pay for referral services approved by the gatekeeper.
3.5 alternative
reimbursement methods
Regardless of payer, only a limited number of payment methods are used to reimburse providers for healthcare services. Payment methods fall into two broad classifications: fee-for-service and capitation. In this section, we discuss the most frequently used reimbursement methods.
Fee-for-Service
In fee-for-service payment methods, of which many variations exist, the more services pro- vided, the higher the reimbursement. The three primary fee-for-service methods of reimbursement are cost based, charge based, and prospective payment.
Cost-Based Reimbursement
Under cost-based reimbursement, the payer agrees to reimburse the provider for the costs incurred in providing services to the insured population. Cost-based reimbursement is retrospective in the sense that reimbursement is based on what has happened in the past. This type of reimbursement is limited to allowable costs, usually defined as costs directly related to the provision of healthcare services. For all practical purposes, cost-based reim- bursement guarantees that a provider’s costs will be covered by revenues generated from the delivery of those services.
Charge-Based Reimbursement
Under a charge-based reimbursement system, when payers pay billed charges, they pay ac- cording to a rate schedule, called a chargemaster, established by the provider. To a certain extent, this reimbursement system places payers at the mercy of providers, especially in markets where competition is limited. In the very early days of health insurance, all payers reimbursed providers on the basis of charges. Now, the trend is shifting toward other, less generous reimbursement methods, and the only payers expected to pay the full amount of charges are self-pay (private-pay) patients. Even among those consumers, low-income uninsured patients often are given discounts from charges or not required to pay at all.
Most insurers that still base reimbursement on charges now pay negotiated, or dis- counted, charges. Insurers that offer managed care plans, as well as conventional insurers, often hold bargaining power because they have the capacity to bring a large number of patients to a provider, which allows them to negotiate discounts that generally range from 20 percent to 50 percent (or more) of charges. The effect of these discounts is to create a system similar to hotel or airline pricing, whereby few people pay the listed rates (rack rates or full fares, respectively). Many people argue that chargemaster prices have become meaningless, and hence the entire concept should be abandoned. But old habits die hard, and chargemaster prices still play a role in some reimbursement methods, so we expect they will be in use for some time.
Prospective Payment Reimbursement
In a prospective payment system, the rates paid by payers are determined by the payer before the services are provided. Furthermore, payments are not directly related to either costs or charges. Here are the common units of payment used in prospective payment systems:
◆ Per procedure. Under per procedure reimbursement, a separate payment is made for each procedure performed on a patient. Because of the high admin- istrative costs associated with this method when applied to complex diagnoses, per procedure reimbursement is primarily used in outpatient settings.
◆ Per diagnosis. In the per diagnosis reimbursement method, the provider is paid a rate that depends on the patient’s diagnosis. Diagnoses that require higher resource utilization, and hence are more costly to treat, have higher reimbursement rates. Medicare pioneered this basis of payment in its diagno- sis-related group (DRG) system, which it first used for hospital inpatient re- imbursement in 1983. (See the Industry Practice box on page 72 for examples of per procedure and per diagnosis reimbursement.)
◆ Per diem (per day). Some insurers reimburse institutional providers, such as hos- pitals and nursing homes, on a per diem (per day) basis. In this approach, the provider is paid a fixed amount for each day that service is provided. Often, per diem rates are stratified, which means that different rates are applied to different services. For example, a hospital may be paid one rate for a medical/surgical day, a higher rate for a critical care unit day, and yet a different rate for an obstetric day. Stratified per diems recognize that providers incur widely varied daily costs for providing different types of inpatient
care.
◆ Bundled (global) reimbursement. Under bundled reimbursement, payers reimburse providers a single prospective payment that covers all services delivered in a single episode, whether the services are rendered by a single provider or by multiple providers. For ex- ample, a bundled price may be set for all obstetric services associated with a pregnancy provided by a single physician, including all prenatal and postnatal visits and the delivery. For another example, a bundled price may be paid for all physician and hospital services associated with a cardiac bypass operation. Note that at the extreme, a bundled price could be set for all services provided to a single patient, which, in effect, is capitation reimbursement, as described in the next section.
capitation
Capitation is an entirely different approach to reimbursement from fee-for-service. Under capitated reimbursement, the provider is paid a fixed amount per covered life per period (usually a month), regardless of the amount of services provided. For example, a primary
care physician might be paid $15 per member per month to serve 100 members of a man- aged care plan. Capitation payment, which is used mostly by managed care organizations to reimburse primary care physicians, dramatically changes the financial environment of healthcare providers. Its implications are addressed in section 3.6 and as needed through- out the remainder of this book. (For additional information about capitation, see Chapter 17, which is available online at ache.org/books/FinanceFundamentals2.)
benchmarks. These reimbursement systems, which are really modified fee-for-service or capitation systems, are called pay-for-performance (P4P) systems.
In most P4P reimbursement schemes, insurers pay providers an “extra” amount if
certain standards, usually related to quality of care, are met. For example, a primary care
practice may receive additional reimbursement if it meets specified goals, such as administering mammograms to 85 percent of female patients older than 50 or placing 90 percent of diabetic patients on appropriate medication and administering quarterly blood tests. A hospital may receive additional reimbursement if it falls in the lower 10 percent of hospitals experiencing medical errors and hospital-acquired infections.
The idea behind P4P is to create financial incentives for providing high-quality care, which may incur higher costs for insurers in the short run but will lead to lower overall medical costs in the long run. In some P4P plans, insurers reduce payments to poor performers and use the savings to increase payments to high performers, forcing some providers to bear the cost of the plan.
3.6 The impact of reimbursement on Financial incentives and risks
Different methods of reimbursement create different incentives and risks for providers. In this section, we briefly discuss these issues.
provider incentives
Providers, like individuals or other businesses, react to the incentives created by the financial environment. For example, individuals can deduct mortgage interest from income for tax purposes, but they cannot deduct interest payments on personal loans. Loan companies responded to this tax code regulation by offering home equity loans to homeowners that function as a type of second mortgage for tax purposes. The intent is not for such loans to be used to finance home ownership, as the tax laws assumed, but for other expenditures, including paying for vacations and purchasing cars or appliances. In this instance, tax laws created incentives for consumers to carry mortgage debt rather than personal debt, and the mortgage loan industry responded accordingly to accommodate the consumers.
In the same vein, alternative reimbursement methods have an impact on provider behavior. Under cost-based reimbursement, providers are essentially issued a “blank check” to acquire facilities and equipment and incur operating costs. If payers reimburse providers
for all service-related costs, the incentive is to incur such costs. Facilities will be lavish and conveniently located, and staff will be available to ensure that patients are given red-carpet treatment. Furthermore, services that are not required will be provided because more ser- vices lead to higher costs, which lead to higher revenues.
Under charge-based reimbursement, providers have the incentive to set high prices and offer more services. However, in competitive markets, prices will be constrained. Still, to the extent that insurers, rather than patients, are footing the bill, considerable leeway exists. Also, because reimbursement paid on the basis of charges is a fee-for-service type of reimbursement, a strong incentive exists to provide the highest possible amount of services. In essence, providers can increase utilization, and hence revenues, by creating more visits, ordering more tests, extending inpatient stays, and so on. Although charge-based reimbursement does encourage providers to contain costs, the incentive is weak because charges can more easily be increased than costs can be decreased. In recent years, the ability of providers to increase revenues by raising charges has been greatly offset by insurers through negotiated discounts or constrained reimbursement increases, which place additional pressure on profitability and hence sweeten the incentive for providers to reduce costs.
Under prospective payment reimbursement, provider incentives are altered. First, under per procedure reimbursement, the profitability of individual procedures varies de- pending on the relationship between the actual costs incurred and the payment for that procedure. In other words, because of inconsistencies in reimbursement, some procedures are more profitable than others. Providers, typically physicians, have the incentive to per- form procedures that have the highest profit potential. Furthermore, the more procedures performed, the better, because each procedure typically generates additional profit.
The incentives under per diagnosis reimbursement are similar. Providers, usually hospitals, seek patients with diagnoses that have the greatest profit potential and discourage (or even discontinue) services that have the least potential. (Why, in recent years, have so many hospitals created cardiac care centers?)
In all prospective payment methods, providers have the incentive to reduce costs because the amount of reimbursement is fixed and independent of the costs actually incurred. For example, when hospitals are paid under per diagnosis reimbursement, they have the incentive to reduce length of stay, which reduces overall costs. However, when per diem reimbursement is used, hospitals have an incentive to increase length of stay. Because the early days of a hospitalization typically are more costly than the later days, the later days are more profitable. However, as mentioned previously, hospitals have the incentive to reduce costs during each day of a patient stay regardless of the prospective payment method.
Under bundled reimbursement, providers do not have the opportunity to be reimbursed for a series of separate services. For example, a physician’s treatment of a fracture could be bundled and billed as one episode, or it could be unbundled, with separate bills submitted for making the diagnosis, taking the X-rays, setting the fracture, removing the
cast, and so on. The rationale for unbundling is usually to provide more detailed records of treatments rendered, but often the result is higher total charges for the parts than would be charged for the entire package under bundled payment.
Also, bundled reimbursement, when applied to multiple providers for a single episode of care, forces those providers (usually physicians and hospitals) to jointly offer the most cost-effective treatment. A joint view of cost containment may be more effective than each provider separately attempting to minimize its treatment costs because the actions of one provider to lower costs could increase the costs of the other provider.
Finally, capitation reimbursement totally changes the playing field by reversing the actions that providers must take to ensure financial success. Under all fee-for-service methods, the key to provider success is to work harder, increase the amount of services provided (utilization), and hence maximize profits. Under capitation, the key to profitability is to work smarter and decrease utilization.
As with prospective payment, capitated providers have the incentive to lower the cost of the services provided, but now they also have the incentive to reduce the amount of services provided. Thus, only those procedures that are truly medically necessary should be performed, and treatment should take place in the lowest cost setting that can provide the appropriate quality of care. Furthermore, providers have the incentive to promote health, rather than just treat illness and injury, because a healthier population consumes fewer healthcare services.
provider risks
One key issue providers contend with is the impact of various reimbursement methods on financial risk. Think of financial risk in terms of the effect that the reimbursement methods have on profit uncertainty—the greater the uncertainty in profitability (and hence the greater the chance of losing money), the higher the risk.
Cost- and charge-based reimbursements are the least risky methods for providers because payers more or less ensure that provider costs are covered, and hence profits will be earned. In cost-based systems, costs are automatically covered. In charge-based systems, providers typically can set charges high enough to ensure that costs are covered, although discounts introduce some uncertainty into the reimbursement process.
In all reimbursement methods, except cost-based payment, providers bear the cost- of-service risk in the sense that costs can exceed revenues. However, a primary difference among the reimbursement types is the ability of the provider to influence the revenue–cost relationship. If providers set charge rates for each type of service provided, they can most easily ensure that revenues exceed costs. Furthermore, if providers have the power to set rates above those that would exist in a truly competitive market, charge-based reimbursement could result in higher profits than cost-based reimbursement can realize.
Prospective payment creates additional risk for providers. In essence, payers are setting reimbursement rates on the basis of what they believe to be sufficient. If
the payments are set too low, providers can- not make money on their services without sacrificing quality. Today, many hospitals and physicians believe that Medicare and Medicaid reimbursement rates are too low to compensate them adequately for providing healthcare services to those populations. Thus, the only way for these providers to survive is to recoup these losses from privately insured patients or stop treating government-insured patients, which for many providers would take away more than half of their revenues. Whether or not government reimbursement is too low is open to debate. Still, prospective payment can place significant financial risk on providers’ operations.
Under capitation, providers assume utilization risk along with the risks assumed under the other reimbursement methods. The assumption of utilization risk has tradition- ally been an insurance, rather than a provider, function. In the traditional fee-for-service system, the financial risk of providing healthcare services is shared between providers and insurers: If costs are too high, providers suffer; if too many services are consumed, insurers suffer. Capitation, however, places both cost and utilization risk on providers.
When provider risk under different reimbursement methods is discussed in this descriptive fashion, an easy conclusion to make is that capitation is by far the riskiest reimbursement method to providers, while cost- and charge-based reimbursement are by far the least risky. Although this conclusion is not a bad starting point for analysis, financial risk is a complex subject, and we have just scratched its surface. For now, keep in mind that payers use different reimbursement methods. Thus, providers can face conflicting incentives and differing risk, depending on the predominant method of reimbursement.
In closing, note that all prospective payment methods create financial risk for providers. This assumption of risk does not mean that providers should avoid such reimbursement methods; indeed, refusing to accept contracts with prospective payment provisions would be organizational suicide for most providers. However, providers must understand the risks involved in prospective payment arrangements, especially the impact on profit- ability, and make every effort to negotiate a level of payment that is consistent with the risk incurred.
3.7 medical coding: The foundation of Fee-For- Service reimbursement
Medical coding, or medical classification, is the process of transforming descriptions of medical diagnoses and procedures into numerical codes that can be universally recognized and interpreted. The diagnoses and procedures are usually taken from a variety of sources within the medical record, such as doctors’ notes, laboratory results, and radiological tests. In practice, the basis for most fee-for-service reimbursement is the patient’s diagnosis (in the case of hospitals) or the procedures performed on the patient (in the case of outpatient settings). Thus, a brief background on medical coding will enhance your understanding of the reimbursement process.
Diagnosis codes
The International Classification of Diseases (commonly known by the abbreviation ICD) is the standard resource for designating diseases and a wide variety of signs, symptoms, and external causes of injury. Published by the World Health Organization (WHO), ICD codes are used inter- nationally to record many types of health events, including hospital inpatient stays and deaths. (ICD codes were first used in 1893 to report death statistics.)
WHO periodically revises the diagnostic codes in ICD, which is now in the tenth revision (ICD-10). However, US hospitals still use a clinical modification of the ninth revision (ICD- 9-CM). Conversion to ICD-10 codes in the United States was slated to occur in 2013; how- ever, in April 2012 HHS proposed a one-year delay of the ICD-10 compliance date, to October
1, 2014. (The conversion is expected to be time consuming and costly because ICD-10 contains more than five times as many individual codes as does ICD-9. Of course, the information provided by the new code set will be more detailed and complete.)
The ICD-9 codes consist of three, four, or five digits. The first three digits denote the disease category, and the fourth and fifth digits provide additional information. For example, code 410 describes an acute myocardial infarction (heart attack), while code 410.1 is an attack involving the anterior wall of the heart.
In practice, the application of ICD codes to diagnoses is complicated and technical. Hospital coders must thoroughly understand the coding system as well as the medical terminology and abbreviations used by clinicians. The medical coding function is highly complex, and proper reimbursement from third-party payers depends on accurate coding; therefore, ICD coders require a great deal of training and experience.
procedure codes
While ICD codes are used to specify diseases, Current Procedural Terminology (CPT) codes are used to specify medical procedures (treatments). CPT codes were developed and are copyrighted by the American Medical Association.
The purpose of CPT is to create a uniform set of descriptive terms and codes that are used by clinicians
accurately describe medical, surgical, and diagnostic procedures. CPT codes are revised periodically to reflect current trends in clinical treatments. To increase standardization and the use of electronic medical records, federal law requires that physicians and other clinical providers, including laboratory and diagnostic services, use CPT to code and transfer healthcare information. (The same law also requires that ICD-9-CM [soon, ICD-10-CM/ PCS] codes be used to document hospital inpatient services.)
The CPT code set includes ten codes for physician office visits: Five codes apply to new patients and five apply to established patients on repeat visits. The differences among the five codes in each category are based on the complexity of the visit, as indicated by three components: extent of patient history review, extent of examination,
and difficulty of medical decision making. For repeat patients, the least complex (typically shortest) office visit is coded 99211, while the most complex (typically longest) is coded 99215.
Because government payers (Medicare and Medicaid) and other insurers require additional information from providers beyond that contained in CPT codes, the Centers for Medicare & Medicaid Services (CMS) developed an enhanced code set, called the Healthcare Common Procedure Coding System (HCPCS) (commonly pronounced “hick picks”). This system expands the set of CPT codes to include no physician services, such as ambulance services, and durable medical equipment, such as prosthetic devices.
Although CPT and HCPCS codes are not as complex as the ICD codes, coders still must have a high level of training and experience to use them correctly. As in ICD coding, correct CPT coding ensures correct reimbursement. Medical coding is so important that many businesses offer services, such as books, software, education, and consulting, to hospitals and medical practices to improve coding efficiency.
3.8 HEALTHCARE REFORM
Healthcare reform is a generic term used to describe the actions taken by Congress in 2009 and 2010 to “reform” the healthcare system. The messy legislative process was completed in early 2010, when President Barack Obama signed the Patient Protection and Affordable Care Act (ACA).
Healthcare reform includes a large number of provisions that are expected to take effect over the next several years with the primary goal of helping an additional 32 million Americans obtain health insurance. The provisions include expanding Medicaid eligibility, subsidizing insurance premiums, providing incentives for businesses to provide healthcare benefits, prohibiting denial of coverage on the basis of preexisting conditions, establishing health insurance exchanges, and providing financial support for medical research. For the most part, reform focuses on the insurance side of the health- care sector as opposed to the provider side. Thus, many people believe that the legislation should be called “insurance reform” rather than “healthcare reform.”
In addition to those affecting the insurance segment of healthcare, some provisions are designed to offset the costs of reform by instituting a variety of taxes, fees, and cost-saving measures. Examples include new Medicare taxes for high-income earners, taxes on indoor tanning services, cuts to the Medicare Advantage (Part C) program, fees on medical devices and pharmaceutical companies, and tax penalties on citizens who do not obtain health insurance.
Finally, other provisions fund pilot programs to test various changes to provider systems and reimbursement methodologies (primarily Medicare) designed to increase quality and decrease costs. Provisions likely to have the greatest impact on providers and how they are reimbursed include the establishment of pilot programs to explore the feasibility of accountable care organizations (ACOs) (discussed below), the effectiveness of payment bundling, and the potential quality gains from the medical home model (also discussed later).
The reform law contains some provisions that went into effect immediately, but most provisions are to be phased in over time until 2018. Detailed guidance will be pro- vided by the government departments responsible for implementing the legislation, so we will not know many of the details until the implementing regulations are promulgated (and, as you know, the devil is in the details).
Finally, legislative changes may occur before some provisions of the law are imple- mented that could significantly alter some of the program’s features. All of these condi- tions create uncertainty for insurers and providers, but the good news is that the finance principles and concepts contained in this book remain valid regardless of the ultimate outcome of healthcare reform.
accountable care Organizations
Accountable care organizations, one of the cornerstone concepts of healthcare reform,
integrate local physicians with other members of the healthcare community and reward
them for controlling costs and improving quality. While ACOs are not radically different from other attempts to improve the delivery of healthcare services, their uniqueness lies in the flexibility of their structures and payment methodologies and their ability to assume risk. Similar to some MCOs and integrated healthcare systems such as the Mayo Clinic, ACOs are responsible for the health outcomes of the population served and are tasked with collaboratively improving care to reach cost and clinical quality targets set by Medicare.
To help achieve cost control and quality goals, ACOs can distribute bonuses when targets are met and impose penalties when targets are missed. To be effective, an ACO should include, at a minimum, primary care physicians, specialists, and a hospital, al- though some ACOs are being established solely by physician groups. In addition, it should have the managerial systems in place to administer payments, set benchmarks, measure performance, and distribute shared savings. A variety of federal, regional, state, and academic hospital initiatives are investigating how to implement ACOs. Although the concept shows potential, many legal and managerial hurdles must be overcome for ACOs to live up to their initial promise.
One feature of healthcare reform is a shared savings program in which Medicare pays a fixed (global) payment to ACOs that covers the full cost of care of an entire
population. In this program, cost targets are established and then any cost savings (costs that are below target) are shared between Medicare and the ACO.
medical home model
A medical home (patient-centered medical home) is a team-based model of care led by a personal physician who works collaboratively with the team’s other healthcare professionals to provide continuous, coordinated, and integrated care throughout a patient’s lifetime to maximize health outcomes. This responsibility includes the provision of preventive services, treatment of acute and chronic illnesses, and assistance with end-of-life issues.
The medical home model is independent of the ACO concept, but observers anticipate that ACOs will provide an organizational setting that facilitates implementation of the model. Supporters of the model claim that it will allow better access to healthcare, increase patient satisfaction, and improve health. Although the development and implementation of the medical home model are in their infancy, the model’s key characteristics are shaping up as follows:
◆ Personal physician. Each patient will have an ongoing relationship with a personal physician trained to provide first contact and continuous and comprehensive care.
◆ Whole-person orientation. The personal physician is responsible for providing for all of a patient’s healthcare needs or for appropriately arranging care with other qualified professionals. In effect, the personal physician will lead a team of clinicians who collectively take responsibility for patient care.
◆ Coordination and integration. The personal physician will coordinate care across specialists, hospitals, home health agencies, nursing homes, and hospices.
◆ Enhanced access. Medical care and information are available at all times through open scheduling, expanded hours of service, and new and innovative communication technologies.
◆ Payment methodologies. It is essential that payment methodologies recognize the added value provided to patients. Payments should reflect the value of work that falls outside of face-to-face visits, should support adoption and use of health information technology for quality improvement, and should recognize differences in the patient populations treated within the practice.
Several ongoing pilot projects are assessing the effectiveness of the medical home and ACO models, and a great deal of information is available online by searching “ac- countable care organizations” online.
