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PayingForHealthServices.pdf
C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 5 7
3.1 inTrODUcTiOn For most products and services purchasing decisions, consumers generally (1) have a choice among many suppliers, (2) can distinguish the quality of competing goods or services, (3) make a (presumably) rational decision regarding the purchase on the basis of quality and price, and (4) pay for the full cost of the purchase.
Decisions around healthcare services are unique when compared with other services and goods. First, often choices for a particular service are limited to a few individuals or orga- nizations. Next, judging the quality among competing providers is difficult, if not impossible. Then, the decision 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. Finally, for most individuals, health insurance from third-party payers (insurers) is paid for or subsidized by employers or government agencies, so many patients are partially insulated from the costs of healthcare.
This highly unusual marketplace for healthcare services has a profound effect on the supply of, and demand for, such services. In this chapter we discuss the concept of insurance, the major payers of healthcare services, and the impact of health reform, past and present, on healthcare reimbursement and costs.
3.2 baSic inSUrance cOncepTS Given that insurance is the cornerstone of healthcare reimbursement in the United States, an appreciation of basic insurance concepts will help you better understand the marketplace for healthcare services.
a SimpLe iLLUSTraTiOn
Consider this simple example to better understand insurance concepts. Assume that no health insurance exists and you face only two possible medical outcomes in the coming year:
Outcome Probability Cost Stay healthy 0.99 $ 0 Get sick 0.01 50,000 1.00
Furthermore, assume that everyone else faces the same medical outcomes at the same odds and with the same associated costs. What is your expected healthcare cost— E(Cost)—for the coming year? To find the answer, we multiply the cost of each outcome by its probability of occurrence and then sum the products:
E(Cost) = (Probability of outcome 1 × Cost of outcome 1) + (Probability of outcome 2 × Cost of outcome 2)
= (0.99 × $0) + (0.01 × $50,000) = $0 + $500 = $500.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e5 8
Assume, for example, that you and every- one else earn $60,000 a year. With this salary, you and everyone else can easily afford the $500 “expected” healthcare cost. The problem, how- ever, 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. A cost of $50,000 could force you, and most people who get sick, into personal bankruptcy.
Now, suppose an insurance policy that pays all 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 (see “Critical Concept: Risk Aversion”), they are will- ing to pay $100 more than 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, which, 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 a 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 have about $100 million to cover administrative costs. It could 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).
baSic characTeriSTicS Of inSUrance
The simple example discussed earlier illustrates why individuals seek health insurance and why insurance companies would be formed to provide such insurance. Needless to say, the concept of insurance is much more complicated in the real world. Insurance typically has four distinct characteristics:
1. Pooling of losses. The pooling, or sharing, of losses is the basis of insurance. Pooling means that losses are spread over a large group of individuals, called a pool, so that each individual realizes the average loss of the pool (plus administrative expenses) rather than the actual loss incurred. In addition,
CRITICAL CONCEPT Risk Aversion
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 and uncertainty. For example, a favorite tool to
control risk is diversification, which in the context of revenues
means lowering risk by having multiple and varied sources
of income. By not depending on one source—say, Medicare
patients—a provider can reduce 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
financial costs of calamitous events, such as fires or hurricanes.
pooling
The spreading of
losses over a large
group of individuals (or
organizations).
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 5 9
pooling involves the grouping of a large number of homogeneous exposure units—that is, people or things having the same risk characteristics—so that the law of large numbers applies. (In statistics, the law of large numbers states that as the size of the sample increases, the sample mean gets closer and closer to the population mean.) Thus, pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accuracy.
2. Payment only for random losses. A random loss is unforeseen and 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 of this chapter.)
3. Risk transfer. An insurance plan almost always involves risk transfer. The sole exception to the element of risk transfer is self-insurance, which is the assumption of a risk by a business (or an individual) itself rather than by an insurance company. (Self-insurance is discussed in a later section.) Risk transfer is the passing of a risk from the insured to the insurer, which typically is in a better financial position to bear the risk than the insured because of the law of large numbers.
4. Indemnification. Indemnification for losses is the reimbursement to the insured if a loss occurs. In 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 a million individuals, (2) the losses on each individual are random (unpre- dictable), (3) the risk of loss is passed to the insurance company, and (4) the insurance company pays for any losses.
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 adverse selection and moral hazard.
Adverse Selection
Adverse selection occurs because individuals and businesses that are more likely to have claims are more inclined to purchase insurance than are those less likely to have claims (see “Critical Concept: Adverse Selection”). For example, an individual without insurance
random loss
A loss that is
unpredictable and
occurs as a result of
chance.
risk transfer
The passing of risk
from one individual or
business to another
(usually an insurer).
indemnification for
losses
The agreement to pay
for losses incurred by
another party.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e6 0
who needs a costly surgical procedure will likely seek health insurance if it is affordable to do so, whereas an individual who does not need surgery is much less likely to purchase insurance. Similarly, consider the likelihood of a 20-year-old to seek health insurance versus the likelihood of a 65-year- old to do so. The older individual, with much greater health risk due to age, is more likely to seek insurance.
If this tendency toward adverse selection goes unchecked, a disproportionate number of sick people, or those most likely to become sick, will
seek health insurance, and the insurer will experience higher-than-expected claims. This increase in claims will trigger premium increases to spread the costs across the pool, which worsens the problem because healthier members of the plan will either pursue cheaper rates from another company (if available) or simply forgo insurance. The adverse selection problem exists because of asymmetric information, which occurs when individual buyers of health insurance know more about their health status than do insurers.
One way health insurers attempt to control adverse selection is by instituting underwriting provisions. Thus, smokers may be charged a higher premium (individual cost for the insurance policy) than nonsmokers. Before the passage of the Affordable Care Act of 2010 (ACA), health insurers in the individual market included preexisting condi- tion clauses in contracts based on individual characteristics. (A preexisting condition is a physical or mental condition of the insured individual that existed before the issuance of the policy.) The ACA prohibits using preexisting conditions and gender to set premiums, along with limits based on age. Previously, a typical clause might state that preexisting con- ditions are not covered until the policy has been in force for some period—say, one or two years. Preexisting conditions present a true problem for the health insurance field 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 set national standards, which could be modified within limits by the states, regarding what provisions could be included in health insurance policies. For example, under a group health policy—say, one that covers employees of a furniture manu- facturer—coverage to individuals cannot be denied or limited, and employees cannot be required to pay more in premiums if they suffer from poor health.
HIPAA also limited insurers’ ability to impose preexisting condition clauses and how long they could delay before beginning coverage. It allowed time credit for preexisting
underwriting
The selection and
classification of
candidates for
insurance.
CRITICAL CONCEPT Adverse Selection
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 popula-
tion to higher-than-anticipated levels.
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 6 1
conditions under one plan to be counted toward a second plan should the employee change jobs, provided no break in coverage occurs. Under the ACA, preexisting condition clauses are banned for health plans after 2014. (See section 3.8 for a discussion of the ACA; also see “For Your Consideration: Adverse Selection and Healthcare Reform.”)
Finally, health insurance cannot be canceled if the policyholder becomes sick, and if a policyholder leaves the company, that person 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 and the ACA protect individuals against actions by insurers when their health status changes for the worse or when they leave the employer.
The best strategy for healthcare insurers to combat adverse selection is to create a large, well-diversified pool of subscribers. If the pool is sufficiently large and diversified, the costs of adverse selection can be absorbed by the large number of enrollees. Many current health policies, such as health insurance exchanges, attempt to limit adverse selection by creating or requiring these large, diversified risk pools.
FOR YOUR CONSIDERATION Adverse Selection and Healthcare Reform
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 (choose to buy the insurance).
However, 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, 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 do without coverage
(Lazar 2010).
The traditional techniques used by insurers to mitigate adverse selection risk have
included denying coverage to or charging higher premiums for individuals with preexist-
ing health conditions or excluding those conditions from the individual’s policy. While
supporting the healthcare insurance system’s viability, these techniques were one major
reason health insurance was viewed in a negative light by many consumers, and health
insurers were largely unwilling to change these practices (Rivlin, Adler, and Butler 2016).
Now, however, healthcare reform (discussed in section 3.8) has eliminated, or limits, most
of the traditional adverse selection risk-management techniques. Instead, the legisla-
tion’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
(continued)
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e6 2
FOR YOUR CONSIDERATION Adverse Selection and Healthcare Reform (continued)
take coverage. This “individual mandate” approach and its associated penalty were
intended to put almost everyone into the insurance pool, thereby eliminating adverse
selection. More than two dozen states, interest groups, and individuals sued the federal
government, arguing that the individual mandate is unconstitutional. Ultimately, the US
Supreme Court upheld the individual mandate in 2012 and again in 2021. Between 2014
and 2016, the penalty associated with the mandate increased from $95 or 1 percent of
annual income to $695 or 2.5 percent of income, whichever was higher. In 2017, how-
ever, the US Congress eliminated the penalty by changing its amount to zero dollars
or 0 percent, effective January 2019. While there is debate around the effect the lack of
penalty could have on health insurance enrollment, some observers have predicted a
moderate effect on the individual insurance market, as opposed to employment-based
health insurance (Morrissey 2020).
What do you think? Will the individual mandate eliminate adverse selection? What
specific provisions are necessary for the mandate to work?
Moral Hazard
Insurance is based on the premise that payments are made only for random losses, and from this premise stems the problem of moral hazard (see “Critical Concept: Moral Hazard”). The most common illustration of moral hazard in a casualty insurance setting is the owner who deliberately sets a failing business on fire to collect the insurance payment.
Moral hazard is also present in health insurance, but in a less dramatic form—few people are willing to voluntarily sustain injury or illness for the purpose of collecting health insur- ance proceeds. However, undoubtedly there are people who purposely use healthcare services that are not medically required. For example, some people might visit a physician or a walk-in clinic for the social value of human companionship rather than to address a medical necessity. Also, some hospital discharges might be delayed for the convenience of the patient rather than for medical purposes.
CRITICAL CONCEPT Moral Hazard
Moral hazard is the risk to an insurer that excess healthcare
services are being consumed because individuals do not bear
the full cost of the services provided. For example, a patient
may be quick to agree to an expensive test, even though that
test is not medically necessary, because most of the cost is
covered by insurance.
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 6 3
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 (paid by the insured individual) before benefits are paid by the insurer. If insured individuals expect not to meet (reach) the deductible for the year, they will expect to pay for the cost of their medical care and act accordingly, but if they are certain they will meet the deductible, their healthcare-seeking behavior will be based on the prices they pay after the deductible is met (Morrissey 2020).
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 of medical expenses incurred each year will be paid by the individual. After this deduct- ible is met, the insurer will pay all eligible medical expenses for the remainder of the year. Yet such a policy would still be problematic for the insurer without further modification.
The primary tools that insurers have to address the moral hazard problem are copay- ments and coinsurance. A 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 the insurer, typically on a percentage basis, in excess of the deductible. For example, the patient bears 20 percent of the costs of a hospital stay, and the insurer pays 80 percent.
Copays and coinsurance serve two primary purposes. First, these payments discour- age 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 oth- erwise. Second, because insured individuals pay part of the cost, premiums can be reduced. Health insurance premiums have risen rapidly since 2010 and, according to a report by the National Conference of State Legislatures (NCSL 2018), cost close to $20,000 annually for family coverage. Employers, on average, pay about 75 percent of the premium costs. Because of this alarming upward trend in health premium costs, employers are seeking ways to reduce them; one way employers do so is to pass on more of the costs 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 banned lifetime limits and is phasing out annual limits on most health plans.
deductible
The dollar amount
that must be spent on
healthcare services
(e.g., $500 per year) by
the insured individual
before any benefits are
paid by the insurer.
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 and
the insurer pays 80
percent of the costs of
hospitalization).
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e6 4
A newer type of health insurance that is gaining popularity is the high-deductible health plan (HDHP). An HDHP typically has a lower premium but has a higher annual deductible (for 2021 and 2022, at least $1,400 for an individual or $2,800 for a family) than traditional plans do (Healthcare.gov 2021). However, 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 popular with executives and other highly paid workers because of the tax shelter benefit, and many employers are offering an HDHP option to their employees to help control the employers’ healthcare costs.
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 (see “Critical Concept: Third-Party Payers”). Because a healthcare organization’s revenues are critical to its financial viability, this section briefly examines the sources of most revenues in the healthcare sector. In section 3.5, the reimbursement methodologies
employed by third-party payers are reviewed in greater detail.
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. Since then, the concept of health insurance has changed dramatically. Today, health insurers fall into two broad categories: pri- vate insurers and public programs.
privaTe inSUrerS
In the United States, the concept of public, or government-provided, health insurance is rela- tively new, while private health insurance has been
high-deductible health
plan (HDHP)
A type of health
insurance that requires
higher deductibles
than traditional plans
but allows insured
individuals to set up
tax-advantaged savings
accounts to pay those
deductibles.
SeLf-TeST QUeSTiOnS
1. How would you briefly explain the concept of health insurance? 2. What is adverse selection, and how do insurers address this problem? 3. What is moral hazard, and how do insurers handle it?
CRITICAL CONCEPT Third-Party Payers
Third-party payers are the insurers that reimburse health ser-
vices organizations and hence are the major source of revenues
for most providers. Third-party payers include private insurers,
such as Blue Cross Blue Shield, and public (government) insur-
ers, such as Medicare and Medicaid. Third-party payers use
several reimbursement methods to pay providers, depending
on the specific payer (e.g., “the Blues” versus Medicare) and
the type of service rendered (e.g., inpatient versus outpatient).
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 6 5
in existence since the early 1900s. In this section, the major private insurers are discussed: Blue Cross Blue Shield, commercial insurers, and self-insurers.
Blue Cross and Blue Shield
Blue Cross Blue Shield organizations trace their roots to the Great Depression of the 1930s, when hospitals and physicians were concerned about their patients’ abilities to pay healthcare 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 purchase some type of hospitalization insurance. Thus, the programs were initially designed to benefit hospitals as well as patients.
The programs were all similar in structure: Hospitals agreed to provide a certain number of services to program members who made periodic payments of fixed amounts 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 insur- ance 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) over- sight of 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 organiza- tion involved was the American Medical Association instead of the AHA. Today, there are 35 Blue Cross Blue Shield (BCBS) organizations, referred to as “the Blues.” Some offer only one of the two plans, but most offer both (BCBS 2021). The Blues are organized as independent corporations, but all belong to a single national association that sets the stan- dards required for using the Blue Cross Blue Shield name. Collectively, the Blues provide healthcare coverage for about one in three Americans across all 50 states, the District of Columbia, and Puerto Rico (BCBS 2021).
Historically, the Blues have been not-for-profit corporations that enjoyed the full benefits accorded to that status, including freedom from taxes. However, in 1986, Congress eliminated the Blues’ tax exemption on the grounds that they engaged in commercial-type
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e6 6
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 is issued by life insurance companies, casualty insurance companies, and companies that were formed exclusively to offer healthcare insurance. Examples of commercial insurers include Aetna, Humana, and UnitedHealth Group. All commercial insurance companies are taxable (for-profit) entities.
Commercial insurers entered the health insurance field in the late 1940s, 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. Also following the war, the Internal Revenue Service ruled that employer-provided health insurance was not taxable, giving employers an incentive to offer this tax-free benefit. Like those covered under Blue Cross Blue Shield, the majority of individuals with commercial health insurance are covered under a group policy, such as those with employee groups, professional and other associations, and labor unions.
Self-Insurers
The third major form of private insurance is self-insurance. Although it may seem as if all individuals who do not have some form of health insurance are self-insurers, this is not the case. Self-insurers make a conscious decision to bear the risks associated with health- care costs and then set aside (or have available) funds to pay for future costs as they occur. Individuals, except the very wealthy, are not good candidates for self-insurance because they face too much uncertainty concerning healthcare expenses.
On the other hand, large groups, especially employers, are good candidates for self- insurance. Today, most large groups 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, however. For example, employees of the State of North Carolina 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 North Carolina.
group policy
A single insurance
policy that covers a
common group of
individuals, such as a
company’s employees
or a professional
association or labor
union’s members.
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 6 7
pUbLic prOgramS
Government is both a major insurer and a direct provider of healthcare services. For example, the US federal government provides healthcare services directly to qualifying individuals through the medical facilities of the US Department of Veterans Affairs; the US Department of Defense and its TRICARE program (health insurance for uniformed service members and their families); and Public Health Service, part of the US Department of Health and Human Services (HHS). In addition, government either provides or mandates a variety of insurance programs, such as workers’ compensation. In this section, however, we focus on the two major federal 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 (see “Critical Concept: Medicare”). According to the Centers for Medicare & Medicaid Services (CMS), the agency within HHS that administers Medicare, about 60 million people have Medicare coverage, which pays for about 21 percent of all US healthcare expenditures (CMS 2020c).
Over the decades, Medicare has evolved to include four major types of coverage:
1. Part A provides hospital and some skilled nursing facility 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 particular disabilities and illnesses (e.g., 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
Centers for Medicare
& Medicaid Services
(CMS)
The federal agency in
the US Department
of Health and
Human Services
that administers the
Medicare and Medicaid
programs.
CRITICAL CONCEPT Medicare
Medicare is a federal health insurance program that primarily
covers individuals aged 65 or older. It consists of four major
parts: Part A covers inpatient services, Part B covers outpatient
services, Part C is managed care coverage that replaces Parts
A and B, and Part D covers prescription drugs. Medicare is
administered by CMS, which is an agency of HHS.
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level. According to the Kaiser Family Foundation (KFF) fact sheet on Medicare, about 93 percent of Part A participants purchase Part B coverage, while about 34 percent of Medicare enrollees elect to participate in Part C, also called a Medicare Advantage plan, rather than Parts A and B (KFF 2019). 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.
Administration of the Medicare program falls under HHS, which creates the specific rules of the program on the basis of enabling legislation. Medicare is administered by CMS, which has ten regional offices that oversee the Medicare program and ensure that regulations are followed (CMS 2020a). Medicare payments to providers are not made directly by CMS but by contractors for 16 Medicare administrative contractor jurisdictions.
Medicaid
Medicaid began in 1965 as a modest program to be jointly funded and operated by the states and the federal government (see “Critical Concept: Medicaid”). The goal was to provide a medical safety net for low-income mothers and children and for elderly, blind, and disabled individuals who receive benefits from the Supplemental Security Income (SSI) program.
Congress mandated that Medicaid cover hospital and physician care, but states were encouraged to expand the basic package of benefits, either by increasing the range of ben- efits or extending the program to cover more people. 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 1997, the Children’s Health Insurance Program (CHIP) was signed into law with the aim of expanding Medicaid coverage to children in families with incomes that are too high to qualify for Medicaid (Medicaid.gov 2021). Further, a key provision of the ACA was the expansion of Med- icaid to all citizens and legal residents aged 19–64 who have household incomes below 138 percent of the federal poverty level. Medicaid expansion primarily benefited childless adults, who previ- ously did not qualify for Medicaid regardless of their income level, as well as low-income parents,
Medicare Advantage
plan
Managed care plan
coverage offered to
Medicare beneficiaries
that replaces Parts A
and B coverage.
Medigap insurance
Insurance taken out by
Medicare beneficiaries
that pays many of
the costs not covered
by Parts A and B. (Its
purpose is to fill the
gaps in coverage.)
CRITICAL CONCEPT Medicaid
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 pro-
gram, while the states fund the remainder. Although general
guidelines are established by CMS, the program is adminis-
tered 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 payments.
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who previously did not qualify even if their children qualified. The US Supreme Court ruled that states could opt out of the Medicaid expansion. Despite this ruling, 39 states and the District of Columbia had expanded the Medicaid eligibility as of 2021 (KFF 2021).
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.
3.4 manageD care OrganiZaTiOnS Managed care organizations (MCOs) combine the provision of healthcare services and the insurance function into a single entity (see “Critical Concept: Managed Care Organiza- tions: HMOs and PPOs”). Traditional plans are created by insurers that either directly own a provider network or create one through contractual arrangements with independent pro- viders. Occasionally, however, MCOs are created by integrated delivery systems that establish their own insurance companies.
One type of managed care plan is the health maintenance organization (HMO). HMOs are based on the premise that the traditional insurer– provider relationship creates incentives that reward providers for treating patients’ illnesses while offer- ing little incentive for providing prevention and rehabilitation services. This is often referred to as volume over value. By combining the financing and delivery of comprehensive healthcare services into a single system, HMOs theoretically have as strong an incentive to prevent illnesses as to treat them. However, from a patient perspective,
SeLf-TeST QUeSTiOnS
1. What are the three major forms of private insurers? 2. Briefly, what are the origins and purpose of Medicare? 3. What is Medicaid, and how is it administered?
CRITICAL CONCEPT Managed Care Organizations: HMOs and PPOs
Managed care organizations (MCOs) combine insurer and pro-
vider functions into a single administrative organization. The
idea is not only to pay for care but also to manage the care
provided. MCOs come in several types, and their primary differ-
ence is in how tightly the care is managed. Health maintenance
organizations (HMOs) tend to exercise the most control over
the types and amount of care provided, while preferred pro-
vider organizations (PPOs) tend to be less controlling. In all
managed care plans, the goal is to provide only services that
are medically required in the lowest-cost setting.
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HMOs have several drawbacks, including a limited network of providers, called a provider panel, and the assignment of a primary care physician as a gatekeeper who authorizes 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-saving strategies of HMOs with features of traditional health insurance plans.
PPOs do not mandate that beneficiaries use specific providers, although financial incen- tives (i.e., patients pay less for going to providers the PPO considers more efficient) encourage members to use providers that are part of the PPO’s preferred provider panel. That panel of providers typically negotiates discounted price contracts with the PPO. Furthermore, PPOs do not require beneficiaries 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 to their conventional plans. Such plans, which are called managed fee-for-service plans, use preadmission certification (review of patient need before a hospital admission), utilization review (examination of services provided to a patient), and second surgical opinions (another physician validates recommended treatment) to control inappropriate utilization.
Although the distinctions between managed care and conventional plans were once readily apparent, considerable overlap now exists in the strategies and incentives employed. Thus, the term managed care now describes a continuum of plans that 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 by which it controls, or at least influ- ences, patients’ utilization of healthcare services.
SeLf-TeST QUeSTiOnS
1. What is meant by the term managed care organization (MCO)? 2. What are the types of MCOs?
provider panel
The group of
providers—say,
doctors and
hospitals—designated
as preferred by a
managed care plan.
Services delivered by
providers outside 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 pay for only
those referral services
approved by the
gatekeeper.
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3.5 aLTernaTive reimbUrSemenT meThODS Regardless of the payer for a particular healthcare service, a limited number of payment methodologies are used to reimburse providers. Payment methods fall into two broad cat- egories: fee-for-service and capitation. In this section, we discuss the mechanics, incentives created, and risk implications of alternative reimbursement methodologies.
fee-fOr-Service
In fee-for-service payment methods, of which many variations exist, the more services provided, the higher the reimbursement (see “Critical Concept: Fee-for-Service Reimbursement”). The three pri- mary 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. Reimbursement is limited to allowable costs, usu- ally defined as those costs directly related to the provision of healthcare services. Nevertheless, for all practical purposes, cost-based reimbursement guarantees that a provider’s costs will be covered by payments from the payer. Typically, the payer makes periodic interim payments to the provider, and a final reconciliation is made after the contract period expires and all costs have been processed through the provider’s managerial (cost) accounting system.
Charge-Based Reimbursement
When payers pay billed charges, or simply charges, they pay according to an official list of prices, called a chargemaster or rate schedule, established by the provider. To a certain extent, this reimbursement system places payers at the mercy of providers in regard to the cost of healthcare services, especially in markets where competition is limited. In the early days of health insurance, all payers reimbursed providers on the basis of charges. Few insurers still reimburse providers according to billed charges; the trend for payers is toward other, less generous reimbursement methods.
CRITICAL CONCEPT Fee-for-Service Reimbursement
Under fee-for-service reimbursement, health services organiza-
tions are paid on the basis of the amount of services provided.
The term service can be defined several ways. For example, a
physician may be paid for each procedure performed, such as
conducting an office visit or reading a CT (computed tomogra-
phy) scan. A hospital may be reimbursed for costs incurred, for
each admission, or for each patient day; a clinical laboratory
may be paid for each test performed. Regardless of the spe-
cific definition of a service, in fee-for-service reimbursement
the greater the amount of services provided, the greater the
revenues. Thus, the risk of utilization (volume of services)
uncertainty is borne by the insurer rather than by the provider.
chargemaster
A provider’s official list
of charges (prices) for
goods, supplies, and
services rendered. Also
called a rate schedule.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e7 2
Most payers that historically reimbursed providers on the basis of billed charges now pay negotiated, or discounted, charges. This is especially true of insurers that have established managed care plans. Additionally, many conventional insurers have bargaining power because of the large number of patients that they bring to a provider, so they can negotiate discounts from billed charges. The effect of these discounts is to create a system similar to hotel or airline pricing, where there are listed rates (i.e., chargemaster prices for providers, like rack rates for hotels or full fares for airlines) that few people pay. Many people argue that chargemaster prices have become meaningless because of the varying discounts and arrangements between providers and payers and hence the entire concept should be abandoned. However, in a significant healthcare sector development, starting in 2021, nongovernmental community hospitals are required to publicly post a list of their standard charges for items and services under the Price Transparency Rule, to allow for informed decisions by consumers, promote competition, and drive down costs across the healthcare sector. The current guideline requires hospitals to make available machine-readable data for standardized charges and make available a list of 300 services in a “consumer shoppable” format along with a plan language summary (CMS 2021a).
Prospective Payment Reimbursement
In a prospective payment system, the rates paid by payers are established by the payer before the services are provided. Furthermore, payments are not directly related to either costs or chargemaster rates. The following are the common units of payment used in pro- spective payment systems:
◆ Per procedure. Under per procedure reimbursement, a separate payment is made for each procedure performed on a patient. Because of the high administrative costs associated with this method when applied to complex diagnoses, per procedure reimbursement is more commonly used in outpatient than inpatient settings.
◆ Per diagnosis. Under 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 diagnosis-related group (DRG) system, which it first used for hospital inpatient reimbursement in 1983. (See “Healthcare in Practice: How Medicare Pays Providers” for examples of per procedure and per diagnosis reimbursement.)
◆ Per diem (per day). Some insurers reimburse institutional providers, such as hospitals and nursing homes, on a per diem (per day) basis. In this approach,
prospective payment
A reimbursement
system meant to cover
expected costs as
opposed to historical
(retrospective) costs.
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 7 3
the provider is paid a fixed amount for each day that service is provided, regardless of the nature of the service. Note that per diem rates, which are applicable only to inpatient settings, can be stratified. 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 another rate for an obstetric day. Stratified per diems recognize that providers incur widely varied daily costs for providing different types of care. Per diem rates may also vary by the day during the length of a patient’s stay, recognizing that early days of care may be more expensive than those later in the patient’s stay.
◆ Bundled (global) reimbursement. Under bundled reimbursement, payers make 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 example, a bundled payment may be made for all obstetric services associated with a pregnancy provided by a single physician, including all prenatal and postnatal visits as well as the delivery. For another example, a bundled payment may be made for all physician and hospital services associated with a joint replacement operation. Bundled payments give hospitals and providers incentives to provide the most efficient and effective care at the lowest cost. Finally, note that, at the extreme, a bundled payment may cover an entire population. In this situation, the payment becomes a global payment, which, in effect, is capitation payment (described in the next section of this chapter).
bundled
reimbursement
The prospective
payment of a single
amount for several
procedures.
HEALTHCARE IN PRACTICE How Medicare Pays Providers
Medicare uses several reimbursement methods to pay for hospital services and physi-
cian services. In this box, we briefly describe the method for each. Understanding the
basics of Medicare reimbursement is important to healthcare managers because many
other third-party payers have adopted these or similar systems.
Hospitals
From its inception in 1965 until 1983, Medicare hospital payments for inpatients were
based on a retrospective system that reimbursed hospitals for all reasonable costs.
In 1983, in an attempt to curb Medicare spending, Congress established the inpatient
prospective payment system (inpatient PPS or IPPS) for acute care hospitals. Under the
(continued)
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HEALTHCARE IN PRACTICE How Medicare Pays Providers (continued)
IPPS, a single payment for each inpatient stay covers the cost of routine inpatient care,
special care, and ancillary services. The amount of the prospective payment is based
on the patient’s DRG.
The starting point in determining the amount of reimbursement is the DRG itself.
Potential patient diagnoses have been divided into 335 base DRGs, or base diagnoses.
These base diagnoses are split into subgroups (Medicare severity [MS]-DRGs) on the
basis of complications or comorbidities. (A comorbidity is the presence of one or more
diseases or disorders in addition to the primary diagnosis.) In all, Medicare has estab-
lished more than 760 total MS-DRGs (CMS 2020b).
To illustrate, consider the MS-DRGs for heart failure. DRG 293 is the base DRG (no
complications or comorbidities [CC]), DRG 292 represents heart failure with CC, and
DRG 291 is heart failure with major CC (CMS 2020b). Each MS-DRG is assigned a rela-
tive weight that represents the average resources consumed in treating that particular
diagnosis relative to resources consumed in treating an average diagnosis. The greater
the weight, the greater the reimbursement amount. The weights and sample payment
amounts for the three heart failure DRGs are as follows (CMS 2021b):
MS-DRG Weight Payment
293 0.6526 $3,844
292 0.8951 5,273
291 1.3409 7,899
The amount of resources required to treat an average inpatient is 1.0. As can be
seen from the data, the DRG with no CC (293) has a lower weight than the DRG with
CC (292), which, in turn, has a lower weight than that with major CC (291). In fact, the
amount of hospital resources consumed to treat a patient with DRG 293 (basic heart
failure) is less than that required to treat an average inpatient. An inpatient diagnosed
with heart failure with CC (DRG 292) is about average in resource consumption, while a
heart failure patient with major CC (DRG 291) uses roughly 48 percent more resources
than the average inpatient (CMS 2021b).
The translation from DRG weight to payment amount (the actual dollar reimburse-
ment) depends on several factors, such as hospital location and teaching status, and
hence is somewhat complex. In essence, the DRG weight is multiplied by an adjusted
(continued)
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HEALTHCARE IN PRACTICE How Medicare Pays Providers (continued)
base rate (dollar amount) that incorporates several factors unique to the hospital and
its geographic location. In the table shown earlier in this section, the representative pay-
ment amounts were calculated using an adjusted base rate of $5,891. For example, the
reimbursement for a typical hospital for DRG 292 would be 0.8951× $5,891 = $5,273.
The bottom line is that the greater the amount of resources needed to treat the diagnosis,
the greater the DRG weight and hence the reimbursement amount.
Note that the single DRG payment reimburses the hospital for all inpatient costs.
To provide some cushion for the high costs associated with severely ill patients in each
diagnosis, Medicare includes a provision for outlier payments. Such payments are
designed to compensate hospitals for treating patients who consume resources that
fall outside normal bounds. Outliers are classified into two categories: length of stay
(LOS) outliers and cost outliers. Medicare makes additional payments when a patient’s
LOS or cost exceeds established cutoff points.
Also, note that hospital outpatient visits are reimbursed on a prospective payment
system that is similar in concept, but different in structure, to the inpatient MS-DRG sys-
tem. The outpatient prospective payment system categorizes outpatient visits into groups
called ambulatory payment classifications (APCs), which are clinically similar and tend
to consume a similar amount of resources. As with MS-DRGs, Medicare multiplies each
APC’s weight by a hospital-specific payment rate to obtain the reimbursement amount.
Physicians
Through 1991, Medicare reimbursed physicians on the basis of the reasonable charge
concept. In essence, Medicare defined a reasonable charge as the lowest of (1) the ac-
tual charge for the service performed, (2) the physician’s customary charge, or (3) the
prevailing charge for that service in the community.
Medicare changed its physician payment system in 1992 to a resource-based rela-
tive value scale (RBRVS) system. Under RBRVS, payments for services are determined
by the resource costs needed to provide them, as measured by weights called relative
value units (RVUs). RVUs consist of three components: (1) a work RVU, which includes
the skill level and training required along with the intensity and time required for the
services; (2) a practice expense RVU, which includes equipment and supplies costs as
well as office support costs, including labor; and (3) a malpractice expense RVU, which
accounts for the relative risk and cost of potential malpractice claims. To illustrate, the
(continued)
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e7 6
HEALTHCARE IN PRACTICE How Medicare Pays Providers (continued)
(total) RVU is 0.52 for a minimal office visit, 1.32 for an average office visit, and 3.06 for
a comprehensive office visit. Furthermore, the average office visit RVU is composed of a
work RVU of 0.67, a practice expense RVU of 0.62, and a malpractice expense RVU of 0.03.
The RVU values are then adjusted to reflect variations in local input prices, and the
total is multiplied by a standard dollar value—called the conversion factor—to arrive at
the payment amount. Medicare’s payment rates may also be adjusted to reflect provider
characteristics, geographic designations, and other factors. The provider is paid the
final amount, less any beneficiary coinsurance. Exhibit 3.1 provides a diagram of this
payment system.
(continued)
eXhibiT 3.1 Medicare Physician Services Payment System
+
+ + =
×
Adjusted for geographic factors
Adjusted for case mix
Adjustment for transfers
Policy adjustments for hospitals that qualify
If case is extraordinarily
costly
Wage index > 1.0
Wage index ≤ 1.0
Indirect medical
education payment
Disproportionate share payment
Full LOS
Short LOS and discharged
to other acute IPPS hospital or post-acute
care*
Operating base
payment rate
Adjusted base
payment rate
Per case payment
rate
Payment
High- cost
outlier (payment
+ outlier
payment)
Per diem
payment rate
Hospital wage index
Adjusted base
payment rate
MS–DRG
Patient characteristics
68.3% adjusted for area wages
62% adjusted for area wages
Principal diagnosis Procedure Complications and comorbidities
Non-labor related portion
Base rate adjusted
for geographic
factors
MS–DRG weight
Source: MedPAC (2019).
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HEALTHCARE IN PRACTICE How Medicare Pays Providers (continued)
Like Medicare’s MS-DRG system for inpatients, the more complicated the patient
treatment, the greater the reimbursement amount. However, because the codes used for
physician reimbursement are specific to the services rendered, no provisions for outlier
payments are given to physicians. In section 3.7 of this chapter, we explain medical cod-
ing, which provides the framework for most reimbursement methods.
capiTaTiOn
Up to this point, the prospective payment methods presented have been fee-for-service methods—that is, providers are reimbursed on the basis of the amount of services provided. The service may be defined as a visit, a diagnosis, a hospital day, an episode, or in some other manner, but the key feature is that the more services that are performed, the greater the reimbursement amount. Capitation, although a form of prospective payment, is an entirely different approach to reimbursement and hence deserves to be treated separately (see “Critical Concept: Capitation”).
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 for handling 100 members of a managed care plan. Capitation payment, which is used primarily by managed care plans, dramatically changes the financial environment of healthcare providers. It has implications for financial accounting, managerial accounting, and financial management. Discussion of how capita- tion, as opposed to fee-for-service reimbursement, affects healthcare finance is included in section 3.6 and as needed throughout the remainder of this book.
Before closing our discussion of reimburse- ment, we should note that many insurers are now creating reimbursement systems that explicitly reward providers for achieving certain bench- marks. These reimbursement systems, which are
CRITICAL CONCEPT Capitation
With capitation, providers are paid a set amount on the
basis of the number of members (patients) assigned to that
provider. Thus, the reimbursement amount is fixed on the
basis of the population served, regardless of the amount of
services provided to that population. In effect, the provider,
rather than the insurer, faces utilization risk, because higher
per member utilization means higher provider costs with
no additional revenues. Critics of capitation contend that
it creates the incentive to withhold needed services, while
proponents argue that it discourages unneeded services and
hence reduces costs.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e7 8
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 adminis- tering 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
FOR YOUR CONSIDERATION Value-Based Purchasing
Value-based purchasing (VBP), a form of pay-for-performance reimbursement, is founded
on the concept that buyers of healthcare services should hold providers account-
able for quality of care as well as costs. In April 2011, Medicare launched the Hospital
Value-Based Purchasing program, which marked the beginning of a historic change
in how Medicare pays healthcare providers. For the first time, 3,500 hospitals across
the country were paid for inpatient acute care services based on care quality, not just
the quantity, of the services provided. The amounts of these payments are made on
outcomes measures such as mortality, healthcare-associated infections, patient safety
and experience, process of cares, and efficiency and cost reduction. Hospitals may be
rewarded for their performance compared with all other hospitals, or for how well they
improved their own performance compared to their baseline performance. Medicare
uses value-based payment programs for end-stage renal disease, skilled nursing facili-
ties, and home health.
The healthcare sector will continue to undergo substantial change in the way it
compensates care as additional value metrics are added, commercial payers introduce
their own value-based models, and evidence of the effectiveness of these new models
is understood.
What do you think? Should providers be reimbursed on the basis of quality of care?
How should quality be measured? Should the additional reimbursement to high-quality
providers be obtained by reductions in reimbursement to low-quality providers?
pay for performance
(P4P)
A reimbursement
system that rewards
providers for meeting
specific goals, usually
related to quality of
care.
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performers and use the savings to increase payments to high performers, forcing some providers to bear the cost of the plan (see “For Your Consideration: Value-Based Purchasing”).
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, consider the experience of obtaining a loan from a bank. Indi- viduals 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.
It is interesting to examine how alternative reimbursement methods affect provider behavior. Under cost-based reimbursement, providers are given a “blank check” to acquire facilities and equipment and incur operating costs. If payers reimburse providers for all costs, then providers will be more inclined to incur costs. Facilities will be lavish and conveniently
SeLf-TeST QUeSTiOnS
1. Briefly explain the following fee-for-service payment methods: • Cost-based reimbursement • Charge-based reimbursement and discounted charges • Per procedure reimbursement • Per diagnosis reimbursement • Per diem reimbursement • Bundled payment
2. How does capitation differ from the aforementioned fee-for-service methods?
3. What is pay-for-performance (P4P) reimbursement?
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e8 0
located, and staff will be available to ensure that patients are given “deluxe” treatment. Furthermore, services that may not be medically required will be provided because more services lead to higher costs and hence higher revenues.
Under charge-based reimbursement, providers have the incentive to set high charge rates, which lead to high revenues. However, in competitive markets, there will be a constraint on how high providers can go. But, to the extent that insurers, rather than patients, are footing the bill, there is often considerable leeway in setting charges. Because charge-based payment is a fee-for-service type of reimbursement in which more services result in higher revenue, a strong incentive exists to provide the highest possible amount of services. In essence, providers can increase utilization, and hence revenues, by churning—that is, by creating more visits, ordering more tests, extending inpatient stays, and so on. Charge-based reimbursement creates incentives for providers to contain costs because (1) the spread between charges and costs represents profits, and the more the better, and (2) lower costs can lead to lower charges, which can increase volume. Still, the incentive to contain costs is weak because charges can be increased more easily than costs can be reduced. Note, however, that discounted charge reimbursement places additional pressure on profitability and hence increases the incentive for providers to lower costs.
Under prospective payment reimbursement, provider incentives are altered. First, under per procedure reimbursement, the profitability of individual procedures varies depend- ing on the relationship between the actual costs incurred and the payment for that pro- cedure. Providers, usually physicians, have the incentive to perform procedures that have the highest profit potential. Furthermore, the more procedures, 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 discour- age (or even discontinue) services that have the least potential. (Why, in recent years, have so many hospitals created cardiac care centers?) Furthermore, to the extent that providers have some flexibility in selecting procedures (or assigning diagnoses) for their patients, an incentive exists to upcode procedures (or diagnoses)—that is, to assign codes corresponding to the ones that provide the greatest reimbursement.
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 LOS and hence costs. Note, however, that when per diem reimburse- ment is used, hospitals have an incentive to increase LOS. Because the early days of a hos- pitalization 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.
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Under bundled reimbursement, providers do not have the opportunity to be reim- bursed for a series of separate services, which is called unbundling. For example, a physician’s treatment of a fracture could be bundled, and hence 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 pricing, when applied to multiple providers for a single episode of care, forces involved providers (e.g., physicians and a hospital) to jointly offer the most cost-effective treatment. Such a joint view of cost containment may be more effective than each provider separately attempting to minimize its own treatment costs because lowering costs in one phase of treatment could increase costs in another.
Finally, capitation reimbursement changes the playing field by completely 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 utilization, and hence increase profits; under capitation, the key to profitability is to work smarter and decrease utilization. As with prospective payment, capitated providers have the incentive to reduce costs, but now they also have the incentive to reduce utilization. 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 an 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 meth- ods 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
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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 cannot make money on their services without sacrificing quality. Today, many hospitals and physicians believe that Medicare and Medicaid reimbursement rates are too low to com- pensate 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 treat- ing government-insured patients, which for many providers would take away more than half their revenues. Whether or not government reimburse- ment is too low is open to debate. Still, prospective payment can place significant financial risk on providers’ operations.
Under capitation, providers assume uti- lization risk along with the risks assumed under the other reimbursement methods (see “Critical Concept: Utilization Risk”). The assumption of utilization risk has traditionally 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 reim- bursement 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 pro- viders. This assumption of risk does not mean that providers should avoid such reimburse- ment methods; indeed, refusing to accept contracts with prospective payment provisions would be organizational suicide for most providers. However, providers must understand
CRITICAL CONCEPT Utilization Risk
Utilization risk is the risk that patients, often members of a
managed care plan, will use more healthcare services than ini-
tially assumed. For example, each employee of General Electric
may be expected to make three visits per year to a primary care
physician. However, the utilization risk is that each employee
will actually make four visits. If the primary care physicians
who treat the employees are paid on a fee-for-service basis,
utilization risk is borne by the insurer (General Electric, because
it is self-insured). The physicians will be paid for the actual
number of visits, and, if employees visit more frequently than
expected, the insurer must bear the added costs. However, if
the physicians are capitated, they will be paid a fixed amount
per employee based on the assumption of three visits. When
employees make four visits, the primary care physicians bear
the extra cost and hence the utilization risk.
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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 code numbers that can be universally recognized and interpreted. The diagnoses and procedures are usually taken from a variety of sources in 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 inpatient settings) 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 for designating diseases plus a wide variety of signs, symptoms, and external causes of injury. Published by the World Health Organization (WHO 2021), ICD codes are used internationally to record many types of health events, including hospital inpatient stays and causes of death. (ICD codes were first used in 1893 to report death statistics.) The WHO periodically revises the diagnostic codes in ICD, which is now in its eleventh version (ICD-11).
The United States has used ICD-10-CM since October 1, 2015. This national variant of ICD-10 was provided by CMS and the National Center for Health Statistics, and the use of ICD-10-CM codes is now mandated for all inpatient medical reporting. There are more than 70,000 ICD-10-CM procedure codes and more than 69,000 diagnosis codes. By comparison, the previous system (ICD-9-CM) had about 3,800 procedure codes and roughly 14,000 diagnosis codes, so converting to the ICD-10 system was a significant undertaking for information technology.
SeLf-TeST QUeSTiOnS
1. What provider incentives are created under (a) cost-based reimburse- ment, (b) prospective payment, and (c) capitation?
2. Which of the three payment methods listed in question 1 carries the least risk for providers? The most risk? Explain your answer.
ICD codes
International
Classification of
Diseases (ICD)
standard alphanumeric
designations used
by hospitals and
other organizations
to specify patient
diagnoses.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e8 4
The ICD-10 codes range from three to seven characters, which may be letters or numerals. The first three characters refer to the category; the next three characters refer to etiology, anatomic site, severity, or other clinical detail; and the seventh character refers to extension. For example, code S52 describes a fracture of the forearm, while 252.521S describes a torus fracture of the lower end of the right radius, initial encounter for closed fracture.
In practice, the application of ICD codes to diagnoses is complicated and technical. Hospital coders have to understand the coding system and the medical terminology and abbreviations used by clinicians. Because of this complexity, and because proper coding can mean higher reimbursement from third-party payers, including those under value-based payments (discussed later in the chapter), ICD coders require a great deal of training and experience to be most effective.
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 language (set of descriptive terms and codes) that accurately describes medical, surgical, and diagnostic procedures. CPT and its corresponding 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 for the coding and transfer of healthcare information. (The same law also requires that ICD codes be used for hospital inpatient services.)
To illustrate CPT codes, there are ten codes for physician office visits. Five of the codes apply to new patients (first visits), while the other five apply to established patients (repeat visits). The differences among the five codes in each category are based on the com- plexity of the visit, as indicated by three components: (1) extent of patient history review, (2) extent of examination, and (3) difficulty of medical decision making. For established patients, the least complex (typically shortest) office visit is coded 99211, while the most complex (typically longest) is coded 99215.
Because Medicare, Medicaid, and other insurers require additional information from providers beyond that contained in CPT codes, CMS developed an enhanced code set, the Healthcare Common Procedure Coding System (HCPCS) (commonly pronounced “hick picks”). This system expands the set of CPT codes to include nonphysician services, (e.g., ambulance transportation) and durable medical equipment (e.g., prosthetic devices). To add further complexity to CPT codes and billing rules, Medicare substantially adjusted rules around billing for synchronous (video) telehealth visits, allowing CPT codes for certain in-person visits to be used for telehealth visits, to encourage the expansion and adoption of
CPT codes
Current Procedural
Terminology codes
developed by the
American Medical
Association that are
used by clinicians to
specify procedures
performed on patients.
Healthcare Common
Procedure Coding
System (HCPCS)
A medical coding
system that expands
the CPT codes for
medical, surgical,
and diagnostic
procedures to include
nonphysician services
and durable medical
equipment.
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 8 5
telehealth during the COVID-19 pandemic in support of social distancing recommenda- tions. Prior to 2020, reimbursement for telehealth was restricted and generally not at parity (equal reimbursement) with in-person visits (CMS 2020d).
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. 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 transform the US healthcare system (see “Critical Concept: Healthcare Reform”). The messy legislative process was completed in early 2010, when President Barack Obama signed the ACA.
Healthcare reform includes a large number of provisions that were expected to take effect over the next several years with the primary goal of helping an Americans obtain health insurance while reducing the uninsurance rate. The provisions included expanding Medicaid eligibility, subsidizing insurance premi- ums, offering incentives for businesses to provide healthcare benefits, prohibiting denial of coverage on the basis of preexisting conditions, establish- ing health insurance exchanges, and providing financial support for medical research. For the most part, reform focused on the insurance side of the healthcare sector as opposed to the provider side. Thus, many people believed that the legisla- tion should be called insurance reform rather than healthcare reform.
In addition to those affecting the insur- ance segment of healthcare, some provisions were designed to offset the costs of reform by instituting a variety of taxes, fees, and cost-saving measures.
SeLf-TeST QUeSTiOnS
1. Briefly, how would you describe the coding system used in hospitals (ICD codes) and medical practices (CPT and HCPCS codes)?
2. What is the link between coding and reimbursement?
CRITICAL CONCEPT Healthcare Reform
Healthcare reform is a generic term used to describe the actions
taken by Congress in 2009 and 2010 to transform the US health-
care system. The legislation, titled the Patient Protection and
Affordable Care Act (ACA), had as its primary purpose to help
an additional 32 million Americans obtain health insurance.
Most of the provisions affect the insurance side of healthcare,
but provisions are also in place to increase the quality and
decrease the costs of healthcare services.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e8 6
Examples included 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 funded 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 included the establishment of pilot programs to explore the feasibility of accountable care organizations (ACOs, discussed later in this section of the chapter), the effectiveness of payment bundling, and the potential quality gains from the medical home model (also discussed later in this section).
Legislative changes may occur that could significantly alter some of the program’s features or eliminate it altogether. An attempt to repeal the ACA in 2017 was unsuccess- ful in the US Senate, after more than 20 equally unsuccessful repeal votes in the House of Representatives between 2011 and 2014 alone. The US Supreme Court further upheld the law in 2021. All these conditions 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 (ACOs), 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. Although ACOs are not radi- cally 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 while meeting quality targets. 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 sometimes impose penalties when targets are missed. To be effective, an ACO should include, at a minimum, primary care physicians, specialists, and a hos- pital, although 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.
accountable care
organization (ACO)
An organization that
integrates physicians
and other healthcare
providers with the goal
of controlling costs and
improving quality.
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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 8 7
In this program, cost and quality targets are established. Any cost savings (costs that are below target) are shared between Medicare and the ACO as long as the ACO also meets its quality targets.
meDicaL hOme mODeL
A medical home, also known as a 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 continual, coordinated, and integrated care throughout a patient’s lifetime to maximize health outcomes. This responsibility includes the provision of preven- tive 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 antici- pate 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 continual 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.
◆ Quality and safety. Quality and patient safety are ensured by a care- planning process, evidence-based medicine, clinical decision–support tools, performance measurement, active participation of patients in decision making, use of information technology, and quality improvement activities.
◆ 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. Payment methodologies recognize the added value provided to patients. Payments should reflect the value of work that falls
medical home
A team-based model
of care led by a
personal physician
who provides, or
arranges with other
qualified professionals
to provide, continual
and coordinated care
throughout a patient’s
lifetime to maximize
health outcomes. Also
known as a patient-
centered medical
home.
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F u n d a m e n t a l s o f H e a l t h c a r e F i n a n c e8 8
outside 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 in 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.
Just hired as Big Sky’s practice manager and now learning the workings of the practice, Jen decided to first focus on the practice’s revenues. Specifically, she wanted to answer two questions to better identify the steps toward increasing revenues and reducing the riskiness associated with those revenues: where Big Sky’s revenue comes from and what methods the payers use to determine the payment amount.
After reviewing Big Sky’s revenue records, Jen found the following payer mix:
Commercial
Fee-for-service 37%
Managed care 15
Total 52%
Government
Medicare 29%
Medicaid 8
Total 37%
Miscellaneous
Self-pay 6%
Other 5
Total 11%
Total 100%
The largest payer category for the practice is commercial insurance, with a total of 52 percent of revenues. (Note that commercial revenues include Blue Cross Blue Shield plans.) Of the commercial patients, 37 percent are enrolled in fee-for-service plans and 15 percent are enrolled in managed care plans. Next largest is government programs (Medicare and Medicaid), constituting 37 percent of Big Sky’s payers, followed by self-pay with 6 percent and other sources at 5 percent. (“Other” sources consist of workers’ compensation and other government programs, a small amount of charity care, and about 2 percent bad debt losses.
Theme Wrap-Up Big Sky’S Revenue SouRceS
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Bad debt losses arise when patients who have the ability to pay fail to do so.) Although not shown in the earlier table, 5 percent of Big Sky’s revenues come from capitated contracts, while the remaining 95 percent are paid on a fee-for-service basis.
This payer mix should present few problems for Big Sky. In general, commercial insurers are considered to be more generous than government programs, so the revenue stream should be adequate and not overly dependent on payments influenced by political decisions related to public funding. In addition, bad debt losses appear not to be a major concern for the practice.
Because Big Sky’s revenue stream is mostly fee-for-service, its physicians have an overall incentive to increase production—that is, to perform more procedures and hence increase revenues. However, the incentive for capitated patients (who make up 5 percent of revenues) is to provide only the services that are absolutely needed. Do the physicians know which patients are fee-for-service and which are capitated? Absolutely. Although capitated revenues provide a steady stream of monthly payments to the practice, they bring with them utilization risk. However, with only a small percentage of capitated revenues, the practice faces minimal risk.
All in all, Big Sky’s revenue stream appears sound, with no significant negative fac- tors. This is the good news for Jen. The bad news is that now she must tackle an issue that is potentially more difficult to deal with—examining Big Sky’s costs and balancing them against the revenue stream. We will help Jen with that task in chapter 4.
This chapter explores the insurance function, the third-party payer system, and reimburse- ment methods. Here are the key concepts:
➤ Health insurance is widely used in the United States because individuals are risk averse and insurers can spread the financial risk over a large population.
➤ Adverse selection occurs when individuals most likely to have claims purchase insurance, while those least likely to have claims do not.
➤ Moral hazard occurs when an insured individual purposely incurs a loss, as opposed to a random loss. In a health insurance setting, moral hazard is more subtle, producing such behaviors as seeking more services than needed and engaging in unhealthy behavior because the potential costs are borne by someone else.
➤ Insurers are classified as either private or public (government). The major private insurers are Blue Cross Blue Shield, commercial insurers, and self-insurers.
➤ The government is a major insurer and direct provider of healthcare services. The two major forms of government health insurance are Medicare and Medicaid.
KeY cOncepTS
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