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Are PPS payments adequate? Issues for updating and assessing rates - prospective payment system

Health Care Financing Review, Winter, 1992 by Steven H. Sheingold, Elizabeth Richter

Introduction

Since the implementation of Medicare's prospective payment system (PPS) for inpatient operating costs in 1983, the Federal Government has had the responsibility of setting rates each year. An important aspect of this effort has been determining the methodology for calculating the annual update factor. As the system approaches its 10th year, however, it has become apparent that developing methods for periodically assessing the adequacy of the PPS rates is also critical. That is, it is necessary to examine the cumulative impact of past updates and other factors that affect payments relative to factors that affect the resources necessary to provide patient care.

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PPS is based on a set of standardized rates to which adjustments are applied to determine the payment for each Medicare case. These rates must be updated every year to allow for increases in the costs of providing efficient and quality care for Medicare beneficiaries. Section 1886(e)(4) of the Social Security Act requires that the Secretary of Health and Human Services consider the Prospective Payment Assessment Commission's (ProPAC) recommendations; then the Secretary recommends to Congress update factors that take into account the amounts necessary for the high-quality care. The statute also sets the amount of the update factors that are applied to the standardized amounts.

Trends in hospitals' PPS operating margins have focused attention on this process. Although these margins were initially much higher than anticipated - 13.5 percent in the first year of PPS (hospital fiscal years that began in Federal fiscal year [FY] 1984) and 13.7 percent for PPS2 - they have declined to -3.4 percent in the seventh year of PPS (FY 1990). The hospital industry attributes these negative margins to low updates and inadequate payments. Others, however, have examined factors underlying cost increases and wondered whether they may have been excessive (Fisher, 1992; Ashby and Lisk, 1992; Bradley and Kominski, 1992). The debate raises two important questions: How would policymakers know if PPS rates were adequate? That is, do PPS rates result in too few or too many dollars paid for inpatient services?

In this article, we discuss issues and provide some preliminary estimates relative to these questions. The article is divided into two primary areas. In the first part, we examine the annual update factor recommendations. After describing the current framework, we outline a proposed modification to the update methodology. Results from the current and modified frameworks are then compared. In the second part, we discuss the assessment of the adequacy of the rates at any point in time. We also examine the current use of PPS margins as an assessment tool and discuss some potential alternatives.

Current framework for recommending

updates

The update factor plays a pivotal role in any administered price system. For the PPS, it provides the means for adjusting rates to reflect trends in factors such as inflation, production methods, and outputs. The update factor is crucial in assuring that payments made to hospitals remain consistent with the goals and objectives set forth for the system.

Since FY 1986, the Department of Health and Human Services (DHHS) has used an analytical framework developed by the Office of the Actuary, Health Care Financing Administration (HCFA) (Federal Register, 1985b; Arnett et al., 1985) to formulate that recommendation. The framework is based on an input-to-output relationship which yields the following identity:

[TABULAR DATA OMITTED]

where (A) represents the average cost per discharge, (B) represents DHHS' measure of case-mix constant intensity, (C) represents the case-mix index, (D) represents the inverse of service productivity, and (E) represents the hospital market basket.

This update framework accounts for increases in input prices faced by hospitals as measured by the hospital market basket developed by HCFA. Further, the framework has taken into account both policy adjustment factors and changes in case mix, as well as forecast corrections to previous estimates of the market basket rate of increase. Currently, the framework applies only to the diagnosis-related group (DRG) rates that determine operating payments. That is, the inputs and costs considered exclude capital costs which have recently begun a transition to prospective payment. In the following discussion of the update framework, we remain within this context. DHHS is currently developing an update framework for capital PPS payments that can be merged with the operating framework in the event of a unified PPS (Federal Register, 1992).

The policy adjustment factors consist of measures of change in hospital productivity, quality-enhancing scientific and technological advances, and changes in practice patterns. The productivity measure consists of a normative standard, based partly on economywide increases in productivity, to account for the effect on prices that productivity increases would have in a competitive industry. The science and technology factor adjusts for the diffusion of new technology that is cost-increasing and also quality-enhancing. Finally, the practice pattern adjustment is designed to ensure that the Federal Government shares in any improvements in practice patterns that make the provision of care less costly although maintaining quality of care.

Health Care Industry

Are PPS payments adequate? Issues for updating and assessing rates - prospective payment system

Health Care Financing Review, Winter, 1992 by Steven H. Sheingold, Elizabeth Richter

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