Chapter 9.E.1 (or 3.E.1) -- Traditional Provider Payment Methods



Here is additional discussion and information about provider payment problems and reform:


Atul Gawande has an excellent discussion of physician payment methods and their effects in his March 28, 2005 New Yorker article, "Piecework: Medicine's Money Problem."


June 2013, CMS released national data showing each hospital’s charges compared to Medicare payments for the 100 most common diagnoses, prompting a wave of national media about how irrational hospital pricing is:



Medicare's original language of "reasonable and necessary" costs was taken from the language of an Aetna insurance policy that the federal government provided its employees at the time.  Jacqueline Fox, Medicare Should, but Cannot, Consider Cost: Legal Impediments to a Sound Policy, 53 Buff. L. Rev. 577 (2005).


The following readings address the complexities of measuring costs under Medicare and Medicaid's traditional approach to provider reimbursement. However, cost-based reimbursement is becoming increasingly rare in Medicare. Prospective payment methods now apply to rehabilitation hospitals, hospital outpatient services, nursing homes, and home health agencies.


The Complexity of Medicare's Hospital Reimbursement System
Paradoxes of Averaging
David Frankford
78 Iowa L. Rev. 517, 536-37 (1993)
Reprinted with permission

A relatively simple illustration can show that substantial exercise of discretion exists in determining which costs are "caused" by the patient of a particular insurer. Suppose the patient is a Medicare patient, an elderly woman who is having a hip replaced after a fall. She was brought to the hospital by one of the hospital's ambulances, treated in the emergency room and then admitted for surgery and recovery. During her stay, she is housed in a hospital room located within the hospital's orthopedic unit. While the hospital's brand new birthing center was financed in part by a restricted charitable gift, the construction of the wing where orthopedics is located was financed by the issuance of a tax-exempt bond offering. Her room is maintained by housekeeping; it draws on electricity furnished by a power company to the hospital as a whole; it is heated or cooled by the central air equipment; and its phone is connected to a central switchboard. The patient's care is supported by the hospital's nursing staff, its residents and interns from its affiliated medical school, its laundry and dietary services, and its general maintenance and administrative personnel. The patient uses equipment furnished from the hospital's department of central services and supply, which in turn participates in a joint buying program among area hospitals. Her blood is sent to the hospital's laboratory; her diagnosis occurs through the use of the hospital's imaging equipment and the services of the radiology group with which the hospital contracts; her surgery occurs in one of the hospital's operating theaters; and her recovery takes place in one of the recovery rooms. Her caretakers are insured under the hospital's malpractice policy, and her stay is supervised directly or indirectly by the hospital's utilization review committee. Her anesthesia is provided by the anesthesiology group with which the hospital contracts; her tissue is analyzed by the hospital's pathologists. She receives blood from the blood department, fluids through intravenous therapy, and painkillers supplied by the hospital's pharmacy. After the surgery, the patient's recovery is aided by the hospital's physical therapists; she watches the television supplied in her room by an independent contractor; and the hospital's discharge planning team arranges for a stay in an affiliated but physically separate extended care facility (skilled nursing home), to be followed by the provision of home health care and follow-up visits to her surgeon's office in the hospital's physically separate professional office building. Her family receives instructions from the hospital's family therapists; during their visits they eat in the hospital's cafeteria, use its vending machines, shop in its gift shop, and sleep on its cots. The patient's admission is accomplished by the admissions department; her records are maintained by the hospital's department of medical records; the billing to Medicare is done by the billing department; and her X-rays are later sold to recover their silver content. Each of these units in the hospital supports a multitude of patients, some of whom are, and some of whom are not, insured by Medicare. The expenses of this amazing proliferation of administratively separable units--emergency services, the room, cost of capital, charitable receipts, housekeeping, general maintenance and administrative expenses, nursing, medical education, house staff, purchasing of equipment, blood, operating and recovery rooms, physical therapy, counseling, discharge planning, radiology, pathology, anesthesiology, pharmacy, laundry, dietary, medical records, admissions, and billing--must therefore be allocated between multiple payers. Which of these costs has our particular patient caused?


National Medical Enterprises, Inc. v. Shalala
43 F.3d 691 (D.C. Cir. 1995)

SENTELLE, Circuit Judge:

National Medical Enterprises, Inc., doing business as Century City Hospital (the "Hospital"), appeals a decision ... approving the reclassification of the Hospital's labor costs associated with the administration of intravenous ("IV") therapy to a "routine" care cost center from an "ancillary" cost center....

A fiscal intermediary representing the Medicare program audits the Hospital's cost report to determine its reasonable costs. In its cost reports for 1982 and 1983, the Hospital classified labor costs from the administration of IV therapy in an ancillary cost center it established to keep track of all costs arising from IV therapy, including equipment and supplies. The Hospital had created a separate team of nurses who administered IV therapy and who were also available to perform other duties, such as serving as members of the Cardiac Resuscitation Team. While the fiscal intermediary approved the establishment of the ancillary cost center for IV therapy and the inclusion of costs for IV equipment and supplies, it removed IV labor costs from the ancillary cost center and reclassified them to the routine cost center of the cost report. Under applicable regulations, routine services include "the regular room, dietary, and nursing services, minor medical and surgical supplies, and the use of equipment and facilities for which a separate charge is not customarily made." Ancillary services are those services "for which charges are customarily made in addition to routine services." The Hospital states that the result of this reclassification of IV labor costs was a denial of Medicare reimbursement for a total of approximately $406,000 over the 1982 and 1983 fiscal years.

The Hospital's initial challenge to the reclassification before the Provider Reimbursement Review Board ("Review Board") was successful. The Review Board stated that apportioning IV therapy personnel costs based on the actual charges for IV therapy was the most accurate method for determining the relative costs for such services used by Medicare and non-Medicare patients.... The Deputy Administrator of the Health Care Financing Administration ... reversed the Review Board's decision on the basis that the customary and prevailing practice among hospitals in California is to include IV therapy services, which are not specifically identified as ancillary under the regulations, within routine nursing services and not to bill separately for them....

The importance of the classification of such costs stems from the way these costs are reimbursed by the Secretary. Routine services are reimbursed on a per diem basis, so that if 10% of patients using IV services on a given day are Medicare recipients, the Secretary will reimburse the Hospital for 10% of its routine services on that day. Ancillary services are reimbursed on a utilization basis so that if the same 10% of patients who are Medicare recipients actually account for 20% of the IV charges, the Secretary will reimburse the Hospital for 20% of its IV costs on that day....

[T]he Secretary cited a survey of two fiscal intermediaries that cover approximately 75% of California's acute care hospitals who stated that the vast majority of these hospitals classify IV administration as a routine service.... In short, there was sufficient support for the Secretary's determination that the customary practice in California was not to include IV therapy labor costs as ancillary....

Although we conclude that the Secretary's action was supported by substantial evidence in the record, the Hospital also challenges the Secretary's interpretation of applicable law by asserting that because the Secretary's decision rejected the allegedly more accurate allocation of IV therapy labor costs into an ancillary cost center, it violated the Act's fundamental ban on shifting costs attributable to Medicare patients to non-Medicare patients. See 42 U.S.C. 1395x(v)(1)(A) (in prescribing regulations, the Secretary shall take into account the costs of services so that the necessary costs of delivering services to covered individuals will not be borne by individuals not covered by this program)....

[T]he object of any cost apportionment is to determine the relative costs incurred by Medicare and non-Medicare patients as accurately as possible.... The Hospital maintains that there is ... little correlation between IV therapy and the number of days a patient spends in the hospital so that IV wage costs should ... be allocated to ancillary cost centers....

Congress has not precisely spoken to the question of allocation between specific and general cost centers and therefore, the district court, and we in turn, must approve the Secretary's methodology provided it is reasonable and consistent with the statutory scheme. As this court and others have previously noted, the Secretary has resolved this difficult task by adopting an averaging system wherein costs are balanced between Medicare and non-Medicare patients as a whole and not on a per service basis. See Vista Hill Found. v. Heckler, 767 F.2d 556, 564-66 (9th Cir.1985) (overturning Secretary's decision to exclude children's educational costs from routine cost pool, which was based on the fact that few Medicare patients use such services, because she adopted a system of overall routine cost averaging based on all patients' use of facilities). Medicare patients may be 20% of a hospital's population but generate only 15% of its IV use. Or Medicare patients may, on average, use more of some routine service than do non-Medicare patients. The Secretary's decision to average in the way that she has accommodates the inevitability of specific disparities against the difficulty of exact allocation. Thus, the mere fact that IV labor costs for Medicare patients could be borne by non-Medicare patients in particular circumstances is not a sufficient basis upon which to find the Secretary's methodology unreasonable under the deferential standard of review....

Accordingly, the district court's grant of summary judgment to the Secretary is hereby affirmed.


Notes: Cost Allocation Rules

 1. Manipulating Ratios. Medicare applies several different ratios to apportion shared costs between public and private patients, depending on the type of cost involved. As National Medical Enterprises surveys, the ratio of Medicare patient days to total patient days serves adequately for allocating the costs of routine hospital services (room, board, and nursing care), but not for ancillary services (surgery, radiology, pharmacy, laboratory, etc.) because their use varies widely according to age groups. Therefore, for these costs, Medicare allocates total hospital costs using a ratio of Medicare patient charges to charges for all patients (called the "RCC" formula, for ratio of charges to charges). This gives hospitals ample room for manipulated the measurement of costs because there is no regulatory requirement of a uniform markup of charges over costs. Since charges are used as a proxy for measuring costs, hospitals can overweight Medicare patients by using disproportionate charge markups for those services heavily used by Medicare patients (for instance, by having a 100% markup on laboratory testing and only a 25% markup on obstetrics care, there being very few pregnant Medicare patients). Therefore, this formula must be applied separately to each hospital I.V. ancillary department. Still, hospitals are free to engage in this type of pricing manipulation within each ancillary department. That is why HCFA wanted to take Century City Hospital's labor costs out of its ancillary department.

Finally, certain overhead costs such as administration, interest expense, or building repair cannot be assigned to any particular department and so must be allocated among departments according to some accounting convention. Prof. Frankford describes the additional rules that are needed to prevent further manipulation in this regard:

[T]he hospital is divided into "revenue centers" and "cost centers."... To the extent possible, the costs of the nonrevenue-producing centers are directly allocated to each other and to the revenue centers. Unassigned, indirect expenses are then allocated through the use of various rules-of-thumb.... For example, depreciation of buildings and fixtures are allocated by the square feet of the areas to which these costs are to be assigned; the costs of producing laundry are allocated by the pounds of laundry used by other cost and revenue centers; dietary costs by the number of meals served; housekeeping by hours of service; pharmacy by costed requisitions; and intern-resident service by assigned time. To the extent that the indirect cost to be allocated from one cost center depends upon allocations from other cost centers, either a step-down procedure is used, whereby costs are allocated from the most general cost centers first (e.g., general administrative expenses) and the most specific ones last, or the interactions between the cost centers are captured through the use of simultaneous equations. At the end of this process, all the costs of the [facility] have been allocated to the units used for billing purposes.

David Frankford, The Medicare DRGs: Efficiency and Organizational Rationality, 10 Yale J. Reg. 273, 284-85 (1993).

The recent wave of hospital mergers has presented regulators and courts with the issue of whether a hospital consolidation was a "bona fide" sale, allowing Medicare reimbursement either for a loss or for increased depreciation.  In two cases, courts of appeal have upheld administrative rulings that hospital acquisitions were not negotiated or structured at arm’s length.  Via Christi Regional Medical Center Inc. v. Leavitt, 509 F.3d 1259 (10th Cir. 2007); Lehigh Valley Hospital-Muhlenberg v. Leavitt, 2007 U.S. App. LEXIS 25429 (3d Cir., Oct. 30, 3007).  

Other similar issues that have produced substantial litigation include how to allocate the cost of hospital malpractice insurance premiums between Medicare and non-Medicare patients, Bedford County Mem. Hosp. v. Heckler, 769 F.2d 1017 (4th Cir. 1985), and how to allocate administrative overhead costs to labor and delivery patients, Community Hospital v. Heckler, 770 F.2d 1257 (4th Cir. 1985).

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