Module 4-Discussion

4 9

THEME SET-UP: Big sky’s revenue sourCes

C H A P T E R 3

PAYING FOR HEALTH SERVICES

Big Sky Dermatology Specialists is a small group practice in Jackson, Wyoming. The city is located in
the scenic Jackson Hole Valley and is a major gateway to the Grand Teton and Yellowstone National
Parks. In addition, it is home to the world’s largest ball of barbed wire. (It is amazing what you learn
when studying healthcare finance!)

Jen Latimer, a recent graduate of Idaho State University’s healthcare administration program,
was just hired to be Big Sky’s practice manager. One of her first tasks was to review the group’s payer
mix. (Payer mix is a listing of the individuals and organizations that pay for a provider’s services, along
with each payer’s percentage of revenues.) After all, revenues are the first step (of many) needed to
ensure the financial success of any business.

To understand Big Sky’s revenues more thoroughly, Jen focused on two questions. First, who
are the payers? In other words, where does Big Sky’s revenue come from? Second, what methods do
the payers use to determine the payment amount? By gaining an appreciation of the group’s revenues,
Jen believed she could accurately judge the financial riskiness of the practice. Furthermore, she would

00_Reiter_Song (2354) Book.indb 49 3/23/18 2:52 PM

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be able to identify possible steps toward increasing the practice’s revenues and reduce the
riskiness associated with those revenues.

By the end of the chapter, you will have a better understanding of healthcare-provider
revenue sources and how the specific payment method influences provider behavior. Spe-
cifically, you, like Jen, will know more about how these issues affect Big Sky.

After studying this chapter, you will be able to do the following:

➤ List the key features of insurance.

➤ Describe the major types of third-party payers.

➤ Discuss, in general terms, the reimbursement methods used by third-party

payers, and the associated incentives and risks for providers.

➤ Explain how clinical and procedural coding affects reimbursement.

➤ Define the specific reimbursement methods used by Medicare.

➤ Describe the key features of healthcare reform.

LEARNING OBjECTIvES

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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 1

3.1 INTRODUCTION
In most industries, the consumer of the product or service (1) has a choice among many
suppliers, (2) can distinguish the quality of competing goods or services, (3) makes a (pre-
sumably) rational decision regarding the purchase on the basis of quality and price, and
(4) pays for the full cost of the purchase.

The provision of healthcare services does not follow this general model, as healthcare
is delivered under unique circumstances. First, often only a few individuals or organizations
provide a particular service. Second, judging the quality of competing providers is difficult,
if not impossible. Third, the decision (or at least recommendation) on which provider to
use for a particular service typically is not made by the consumer but rather by a physician
or some other clinician. Fourth, the bulk of the payment to the provider is not normally
made by the user (the patient) but by an insurer. Finally, for most individuals, the purchase
of health insurance is paid for (or heavily subsidized) by employers or government agencies,
so many patients are insulated from the true cost of healthcare services.

This highly unusual marketplace significantly influences the supply of and demand
for healthcare services. To gain a better understanding of the unique payment mechanisms
involved, we must examine the healthcare reimbursement system.

3.2 BASIC INSURANCE CONCEPTS
Because insurance is the cornerstone of healthcare reimbursement, an appreciation of basic
insurance concepts will help you better understand the marketplace for healthcare services.

A SIMPLE ILLUSTRATION

Assume that no health insurance exists and that you face only two medical outcomes in
the coming year:

Outcome Probability Cost
Stay healthy 0.99 $ 0
Get sick 0.01 50,000
1.00

What is your expected healthcare cost (in the statistical sense) for the coming year?
To find the answer—$500—multiply the cost of each outcome by its probability of occur-
rence and then sum the products:

Expected 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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Now, assume that everyone else faces the
same medical outcomes and hence faces the same
odds and costs associated with healthcare. Fur-
thermore, assume that you, and everyone else,
make $60,000 a year. With this salary, you can
easily afford the $500 expected healthcare cost.
The problem, however, is that no one’s actual cost
will be $500. If you stay healthy, your cost will be
zero; if you get sick, your cost will be $50,000, and
this amount could force you, and most people who
get sick, into personal bankruptcy, which is a ruin-
ous event. (Do not forget that you have to pay all
of your living expenses out of your $60,000 annual
income in addition to any healthcare costs.)

Now, suppose an insurance policy that pays all
of your healthcare costs for the coming year is available
for $600.Would you take the policy, even though it
costs $100 more than your “expected” healthcare costs?

Most people would, and do. Because individuals are risk averse (see “Critical Concept:
Risk Aversion”), they are willing 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 who, as you will see, is spreading those costs over a large
number of subscribers.

Would an insurer be willing to offer the policy for $600? If the insurer could sell
enough policies, it would know its revenues and costs with some precision. For example,
if the insurer sold 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 are formed to provide such insurance. Next, we will dig a little
deeper into insurance basics.

Insurance typically has four distinct characteristics:

1. Pooling of losses. The pooling (sharing) of losses is the heart of insurance.
Pooling means that losses are spread over a large group of individuals so that

Pooling

The spreading of

losses over a large

group of individuals (or

organizations).

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. For example, a favorite tool to control risk is di-

versification, which in the context of revenues means lowering

risk by having different sources of income. By not depending

on one source—say, Medicare patients—a provider can 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 consequences of calamitous

events, such as fires or hurricanes.

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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 3

each individual realizes the average loss of the pool rather than the actual
loss incurred. In addition, pooling involves the grouping of a large number
of homogeneous exposure units (people or things having the same risk
characteristics). Thus, pooling implies (a) the sharing of losses by the entire
group and (b) the prediction of future losses with some accuracy based on
the law of large numbers. (The law of large numbers implies that predicting
outcomes is easier when many identical trials are involved. For example, if a
coin is flipped only once, you do not know whether the results will be heads
or tails. However, if the coin is flipped 1,000 times, the result will be very
close to 500 heads and 500 tails. In other words, you cannot predict the
results of a single toss with any confidence, but you can predict the aggregate
results if you have a large pool of tosses.)

2. Payment only for random losses. A random loss is unforeseen and occurs as a
result of chance. Insurance is based on the premise that payments are made
only for losses that are random. We discuss the moral hazard problem, in
which losses are not random, in a later section.

3. Risk transfer. An insurance plan almost always involves risk transfer. The
sole exception to the element of risk transfer is self-insurance, whereby an
individual or a business does not buy insurance. (Self-insurance is discussed
in a later section.) Risk transfer means that the risk is shifted from the insured
to the insurer, which typically is in a better financial position to pay the loss
than is the insured because of the premiums collected. In addition, because of
the law of large numbers, the insurance company is better able to predict its
losses.

4. Indemnification. Indemnification is the reimbursement of the insured if a loss
occurs. 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
(unpredictable), (3) the risk of loss is passed to the insurance company, and (4) the insur-
ance 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.

Random loss

An unpredictable

loss, such as one that

results from a fire or

hurricane.

Risk transfer

The passing of risk

from one individual or

business to another

(usually an insurer).

Indemnification

The agreement to pay

for losses incurred by

another party.

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Adverse Selection

Adverse selection occurs because those individu-
als and businesses likely to incur losses are more
inclined to purchase insurance than are those
less likely to incur losses (see “Critical Concept:
Adverse Selection”). For example, an otherwise
healthy individual without insurance who needs a
costly surgical procedure is more apt to get health
insurance if she can afford it, whereas an identi-
cal individual without the threat of surgery is less
likely. Similarly, consider the health insurance

purchase likelihood of a 20-year-old versus that of a 65-year-old. All else the same, the
older individual, with much greater health risk because of age, will probably obtain insur-
ance. (Individuals aged 65 or older consume, on average, more than three times the dollar
amount of healthcare services that younger individuals do.)

If the tendency toward adverse selection goes unchecked, a disproportionate num-
ber of sick people, or those most likely to become sick, will seek health insurance, causing
the insurer to experience higher-than-expected claims. This increase in claims will trigger
a premium increase, which worsens the problem, because healthier members of the plan
will either pursue cheaper rates from another company (if available) or forgo insurance.

One way health insurers attempt to control adverse selection is by instituting
underwriting provisions. Thus, smokers may be charged a higher premium than nonsmokers.
Another way is by including preexisting condition clauses in contracts, although this strategy
was disallowed by the passage of the Affordable Care Act in 2010. (A preexisting condition
is a physical or mental condition of the insured individual that existed before the issuance
of the policy.) A typical clause might state that preexisting conditions 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 condi-
tions under one plan to be counted toward a second plan should the employee change jobs,

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 5 5

provided no break in coverage occurs. Under the Affordable Care Act (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, he 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.

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 (take 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, as Kay Lazar

wrote in a June 30, 2010, Boston Globe article titled “Short-Term Insurance Buyers Drive

up Cost in Mass.,” adverse selection is a factor in increased health insurance costs, and

the higher the costs, the higher the premiums, which means even more individuals will

do without coverage.

The traditional techniques used by insurers to mitigate adverse selection risk have

included denying coverage to or charging higher premiums for individuals with pre-

existing 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.

Now, however, healthcare reform (discussed in section 3.8) has eliminated or limits

most of the traditional adverse selection risk-management techniques. Instead, the

legislation’s aim is to maximize the number of healthy people who obtain coverage by

offering subsidies to lower-income Americans and mandating penalties for those who

refuse to take coverage. This “individual mandate” approach is intended to put almost

everyone into the insurance pool, thereby eliminating adverse selection.

What do you think? Will the individual mandate eliminate adverse selection? What

specific provisions are necessary for the mandate to work? Note that 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.

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Moral Hazard

The fact that insurance is based on the premise
that payments are made only for random (unfore-
seen) losses creates the moral hazard problem (see
“Critical Concept: Moral Hazard”). The most
common illustration of moral hazard is the owner
who deliberately sets a failing business on fire to
collect the insurance.

Moral hazard is also present in health insur-
ance, but its form typically is not so dramatic—not
too many people are willing to sustain injury or
illness voluntarily for the purpose of collecting
health insurance benefits. However, undoubtedly

some people do purposely use healthcare services that are not medically required. For
example, some people who live alone might visit a physician or a walk-in clinic for the
social value of human companionship rather than to address a medical necessity.

Insurers attempt to protect themselves from moral hazard claims by paying less than
the full amount of healthcare costs. Forcing insured individuals to bear some of the cost
lessens their tendency to consume unneeded services or engage in unhealthy behaviors.
One way to make patients pay out of pocket is to require a deductible. Medical policies
usually stipulate a dollar amount that must be satisfied before benefits are paid.

Although deductibles help offset the moral hazard problem, their primary purpose
is to eliminate the need for an insurer to pay a small claim, if that is the only healthcare
expense for the year. In such cases, the administrative cost of processing the claim may be
larger than the amount of the claim itself. To illustrate, a policy may state that the first $500
(or more) of medical expenses incurred each year will be paid by the individual. Once the
deductible is met, the insurer will pay all eligible medical expenses (less any copayments
and coinsurance) for the remainder of the year.

The primary weapons that insurers have against the moral hazard problem are 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 insurer, typically on a
percentage basis. For example, the patient bears 20 percent of the costs of a hospital stay.

Copays and coinsurance serve two primary purposes. First, these payments discourage
overutilization of healthcare services and hence reduce insurance benefits. By extension, by
being forced to pay some of the costs, insured individuals will presumably seek fewer and
more cost-effective treatments and embrace a healthier lifestyle than they would otherwise.
Second, because insured individuals pay part of the cost, premiums can be reduced. Health
insurance premiums (the cost of the policy to the subscriber) have risen rapidly in the past
ten years and now exceed $15,000 annually for family coverage. Employers, on average, pay

Deductible

The dollar amount

that must be spent on

healthcare services

(e.g., $500 per year)

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 of the costs of

hospitalization).

about 75 percent of the premium costs. Because of this alarming trend in health premium
costs, employers are seeking ways to reduce them; one way is to pass more of the costs on
to employees through copays and coinsurance.

Some health insurance policies contain out-of-pocket maximums, whereby the
insurer pays all covered costs, including coinsurance, after the insured individual pays a
certain amount of costs—say, $2,000. Finally, prior to 2010, most insurance policies had
policy limits, for example, $1 million in total lifetime coverage, $1,500 per year for mental
health benefits, or $100 for eyeglasses. These limits were designed to control excessive use
of certain services and protect the insurer against catastrophic losses. The ACA banned
lifetime limits and is phasing out annual limits on most health plans.

Before we move on, we should briefly mention a newer type of health insurance
that is gaining popularity: high-deductible health plans (HDHPs). An HDHP typically
has a lower premium but has a higher annual deductible (more than $2,000 for family
coverage) than traditional plans do. 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 a HDHP option to their employees to help control 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 pay-
ers (see “Critical Concept: Third-Party Payers”).
Because a healthcare organization’s revenues are
key to its financial viability, we first discuss the
sources of most revenues in the healthcare sector.
In section 3.5, we examine the types of reimburse-
ment methods employed by these payers.

Health insurance originated in Europe in
the early 1800s when mutual benefit societies were

High-deductible health

plan (HDHP)

A type of health

insurance that requires

high deductibles

but allows insured

individuals to set up

tax-advantaged savings

accounts to pay those

deductibles.

SELF-TEST QUESTIONS

1. Briefly explain the concept of health insurance.
2. What is adverse selection, and how do insurers deal with the problem?
3. What is moral hazard, and how do insurers handle it?

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 5 7

about 75 percent of the premium costs. Because of this alarming trend in health premium
costs, employers are seeking ways to reduce them; one way is to pass more of the costs on
to employees through copays and coinsurance.

Some health insurance policies contain out-of-pocket maximums, whereby the
insurer pays all covered costs, including coinsurance, after the insured individual pays a
certain amount of costs—say, $2,000. Finally, prior to 2010, most insurance policies had
policy limits, for example, $1 million in total lifetime coverage, $1,500 per year for mental
health benefits, or $100 for eyeglasses. These limits were designed to control excessive use
of certain services and protect the insurer against catastrophic losses. The ACA banned
lifetime limits and is phasing out annual limits on most health plans.

Before we move on, we should briefly mention a newer type of health insurance
that is gaining popularity: high-deductible health plans (HDHPs). An HDHP typically
has a lower premium but has a higher annual deductible (more than $2,000 for family
coverage) than traditional plans do. 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 a HDHP option to their employees to help control 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 pay-
ers (see “Critical Concept: Third-Party Payers”).
Because a healthcare organization’s revenues are
key to its financial viability, we first discuss the
sources of most revenues in the healthcare sector.
In section 3.5, we examine the types of reimburse-
ment methods employed by these payers.

Health insurance originated in Europe in
the early 1800s when mutual benefit societies were

High-deductible health

plan (HDHP)

A type of health

insurance that requires

high deductibles

but allows insured

individuals to set up

tax-advantaged savings

accounts to pay those

deductibles.

SELF-TEST QUESTIONS

1. Briefly explain the concept of health insurance.
2. What is adverse selection, and how do insurers deal with the 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 vs. Medicare) and the type

of service rendered (e.g., inpatient vs. outpatient).

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formed to reduce the financial burden associated with illness or injury. Today, health insur-
ers fall into two broad categories: private insurers and public programs.

PRIvATE INSURERS

In the United States, the concept of public, or government, health insurance is relatively
new, while private health insurance has been in existence since the early twentieth century.
In this section, we discuss the major private insurers.

Blue Cross and Blue Shield

Blue Cross Blue Shield organizations trace their roots to the Great Depression, when both
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 pay small monthly premiums to purchase some
type of hospitalization insurance. Thus, the programs were initially designed to benefit
both patients and hospitals.

The programs were all similar in structure: Hospitals agreed to provide a certain
number of services to program members who made periodic payments to the hospitals
whether services were used or not. In a short time, these programs were expanded from
single-hospital programs to community-wide, multihospital plans that were called hospital
service plans. The American Hospital Association (AHA) recognized the benefits of such
plans to hospitals, so a close relationship was formed between the AHA and the organiza-
tions 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 orga-
nization involved was the American Medical Association instead of the AHA. Today, 36
Blue Cross Blue Shield (the Blues) organizations exist, some of which offer only one of the
two plans (most offer both). The Blues are organized as independent corporations, but all
belong to a single national association that sets the standards required for using the Blue

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Cross Blue Shield name. Collectively, the Blues provide healthcare coverage for about 1 in 3
Americans across all 50 states, the District of Columbia, and Puerto Rico.

Historically, the Blues have been not-for-profit corporations that enjoyed the full
benefits accorded to that status, including freedom from taxes. However, in 1986, Congress
eliminated the Blues’ tax exemption on the grounds that they engaged in commercial-type
insurance activities. However, the plans were given special deductions, which resulted in
taxes that are generally less than those paid by commercial insurers.

In spite of the 1986 change in tax status, the national association continued to require
all Blues organizations to operate entirely as not-for-profit corporations, although they
were allowed to establish for-profit subsidiaries. In 1994, the national association lifted its
traditional ban on member plans becoming investor-owned companies, and several Blues
have since converted to for-profit status.

Commercial Insurers

Commercial health insurance traditionally was issued by life insurance and casualty insur-
ance (home and auto) companies. Today, however, most health insurance is provided by
companies that exclusively write health insurance. Examples of commercial insurers include
Aetna, Humana, and UnitedHealth Group. Most commercial insurance companies are
shareholder owned, and all are taxable entities.

Commercial insurers moved strongly into health insurance following World War II.
At that time, the United Auto Workers negotiated the first contract with employers in which
fringe benefits were a major part of the contract. Like the Blues, the majority of individuals
with commercial health insurance are covered under group policies with employee groups,
professional and other associations, and labor unions.

Self-Insurers

An argument can be made that all individuals who do not have some form of health insur-
ance are self-insurers, but this statement is not accurate. Self-insurers make a conscious deci-
sion to bear the risks associated with healthcare costs and then set aside (or have available)
funds to pay for costs they may incur in the future. Individuals, except the very wealthy,
are not good candidates for self-insurance because, as discussed earlier, individuals who do
not pool risks face much uncertainty in future healthcare costs.

On the other hand, large organizations, especially employers, are good candidates
for self-insurance. In fact, most large companies, and many midsized companies, are self-
insured. The advantages of self-insurance include the potential to reduce costs (cut out the
middleman) and the opportunity to offer plans tailored to meet the unique characteristics
of the organization’s employees. Organizations that self-insure typically pay an insurance
company to administer the plan. For example, employees of the State of North Carolina

Group policy

A single insurance

policy that covers a

common group of

individuals, such as a

company’s employees

or a professional

group’s members.

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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.

PUBLIC INSURERS

Government is both a major insurer and a direct provider of healthcare services. For example,
the government provides healthcare services directly to qualifying individuals through
Department of Veterans Affairs, Department of Defense, and Public Health Service medi-
cal facilities. In addition, it either provides or mandates a variety of insurance programs,
such as workers’ compensation and Tricare (health insurance for military members, their
families, and uniformed services retirees). In this section, however, we focus on the two
major government insurance programs—Medicare and Medicaid—that fund roughly one-
third of all healthcare services provided in the United States.

Medicare

Medicare was established by Congress in 1965, primarily to provide medical benefits to
individuals aged 65 or older (see “Critical Concept: Medicare”). According to the Centers
for Medicare & Medicaid Services (CMS), about 54 million people have Medicare cover-
age, which pays for about 20 percent of all US healthcare expenditures.

Over the decades, Medicare has evolved to include four major types of coverage:

1. Part A provides hospital and some skilled nursing home coverage.

2. Part B covers physician services, ambulatory surgical services, outpatient
services, and other miscellaneous services.

3. Part C is managed care coverage offered
by private insurance companies. It can be
selected in lieu of Parts A and B.

4. Part D covers prescription drugs.

In addition, Medicare covers healthcare costs asso-
ciated with selected disabilities and illnesses (such
as kidney failure) regardless of age.

Part A coverage is free to all individuals eligi-
ble for Social Security benefits. Individuals who are
not eligible for Social Security benefits can obtain
Part A medical benefits by paying monthly premi-
ums. Part B is optional to all individuals who have

CRITICAL CONCEPT
Medicare

Medicare is a federal health insurance program that primarily

covers elderly individuals (those 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 the US Department of Health and Human Services (HHS).

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Part A coverage, and it requires a monthly premium from enrollees that varies with income
level. According to the Kaiser Family Foundation’s fact sheet on Medicare, about 93 percent
of Part A participants purchase Part B coverage, while about 31 percent of Medicare enrollees
elect to participate in Part C, also called Medicare Advantage plans, rather than Parts A and
B. Part D offers prescription drug coverage through plans offered by private companies. Each
Part D plan offers somewhat different coverage, so the cost of Part D coverage varies widely.

Because Parts A and B do not cover all costs of care and the remaining out-of-
pocket costs can be significant, many Medicare participants purchase additional coverage
from private insurers to help cover the gaps in Medicare coverage. Such coverage is called
Medigap insurance.

The Medicare program falls under the purview of HHS, which writes the regu-
lations (i.e., the specific rules of the program) based on enabling legislation passed by
Congress. Medicare is administered by the Centers for Medicare & Medicaid Services
(CMS), which is an agency in HHS. CMS’s eight regional offices oversee the Medicare
and Medicaid programs and ensure that regulations are followed. 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 jointly funded and operated by the indi-
vidual states and the federal government (see “Critical Concept: Medicaid”). The idea was
to provide a medical safety net for low-income mothers and children and for elderly, blind,
and disabled individuals.

Congress mandated that state programs, at a minimum, cover hospital and physician
care but encouraged states to provide additional
benefits either by increasing the range of benefits
or extending the program to cover more people.
States with large tax bases were quick to expand
coverage to many groups, while states with limited
revenues were forced to establish more restrictive
programs. In addition to state expansions, a man-
datory nursing home benefit was added in 1972.
As a consequence, Medicaid is now the largest
payer of long-term care benefits and the largest
single budget item for many states. In total, Med-
icaid covers roughly 70 million individuals and
pays for about 17 percent of all healthcare expen-
ditures in the United States, according to Statista’s
information on Medicaid enrollment and CMS.

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.)

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
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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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) strive to combine the provision of healthcare services
and the insurance function into a single entity (see “Critical Concept: Managed Care Orga-
nizations: HMOs and PPOs”). Typically, MCOs are created by insurers that either directly
own a provider network or create one through contractual arrangements with independent
providers. Occasionally, however, MCOs are created by integrated delivery systems that

establish their own insurance companies.
Historically, the most common type of

MCO was the health maintenance organization
(HMO). HMOs were developed to thwart the
perverse incentives created by traditional insurer–
provider relationships whereby providers were
rewarded for treating patients’ illnesses but given
little incentive to provide prevention and rehabili-
tation services. By combining the financing and
delivery of healthcare services into a single system,
HMOs theoretically have as strong an incentive to
prevent as to treat illnesses. However, because their
organizational structures, ownership, and financial
incentives differ from plan to plan, HMOs can
vary widely in cost and quality.

HMOs use a variety of methods to control
costs. These include limiting patients to particular

SELF-TEST QUESTIONS

1. What are the different types of private insurers?
2. Briefly, what are the origins and purpose of Medicare?
3. What is Medicaid, and how is it administered?

providers, called the provider panel, and using primary care physicians as gatekeepers who
authorize all specialized and referral services. In general, services are not covered if beneficia-
ries 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. They do, however,
offer financial incentives to encourage members to use providers that participate in the
plan. That panel of providers typically negotiates discounted price contracts with the PPO.
Furthermore, PPOs do not require plan members to use preselected gatekeeper physicians.
Finally, PPOs are less likely than HMOs to provide preventive services, and they do not
assume any responsibility for quality assurance because enrollees are not constrained to use
only the PPO panel of providers.

In an effort to achieve the potential cost savings of MCOs, health insurers are now
applying managed care strategies, such as preadmission certification, utilization review, and
second surgical opinions, to their conventional plans. Thus, the term managed care now
describes a continuum of plans 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 to control, or at least influence, patients’ consumption of healthcare
services. Today, most employer-sponsored health coverage is provided by some type of MCO.

3.5 ALTERNATIVE REIMBURSEMENT METHODS
Regardless of payer, only a limited number of payment methods are used to reimburse
providers for healthcare services. Payment methods fall into two broad classifications:

Provider panel

The group of

providers—say,

doctors and

hospitals—designated

as preferred by a

managed care plan.

Services delivered by

providers outside of

the panel may be only

partially covered, or

not covered at all, by

the plan.

Gatekeeper

A primary care

physician who controls

specialist and ancillary

service referrals. Some

managed care plans

only pay for referral

services approved by

the gatekeeper.

SELF-TEST QUESTIONS

1. What is meant by the term managed care organization (MCO)?
2. What are two different types of MCOs?

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 here is not only to pay for care but also to manage the

care provided. MCOs come in different types, and their primary

difference is in how tightly the care is managed. Health mainte-

nance organizations (HMOs) tend to exercise the most control

over the types and amount of care provided, while preferred

provider 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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providers, called the provider panel, and using primary care physicians as gatekeepers who
authorize all specialized and referral services. In general, services are not covered if beneficia-
ries 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. They do, however,
offer financial incentives to encourage members to use providers that participate in the
plan. That panel of providers typically negotiates discounted price contracts with the PPO.
Furthermore, PPOs do not require plan members to use preselected gatekeeper physicians.
Finally, PPOs are less likely than HMOs to provide preventive services, and they do not
assume any responsibility for quality assurance because enrollees are not constrained to use
only the PPO panel of providers.

In an effort to achieve the potential cost savings of MCOs, health insurers are now
applying managed care strategies, such as preadmission certification, utilization review, and
second surgical opinions, to their conventional plans. Thus, the term managed care now
describes a continuum of plans 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 to control, or at least influence, patients’ consumption of healthcare
services. Today, most employer-sponsored health coverage is provided by some type of MCO.

3.5 ALTERNATIVE REIMBURSEMENT METHODS
Regardless of payer, only a limited number of payment methods are used to reimburse
providers for healthcare services. Payment methods fall into two broad classifications:

Provider panel

The group of

providers—say,

doctors and

hospitals—designated

as preferred by a

managed care plan.

Services delivered by

providers outside of

the panel may be only

partially covered, or

not covered at all, by

the plan.

Gatekeeper

A primary care

physician who controls

specialist and ancillary

service referrals. Some

managed care plans

only pay for referral

services approved by

the gatekeeper.

SELF-TEST QUESTIONS

1. What is meant by the term managed care organization (MCO)?
2. What are two different types of MCOs?

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fee-for-service and capitation. In this section, we
discuss the most frequently used reimbursement
methods.

FEE-FOR-SERvICE

In fee-for-service payment methods, of which many
variations exist, the more services 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.

Cost-based reimbursement is retrospective in the sense that reimbursement is based on
what has happened in the past. This type of reimbursement is limited to allowable costs,
usually defined as costs directly related to the provision of healthcare services. For all practi-
cal purposes, cost-based reimbursement guarantees that a provider’s costs will be covered
by revenues generated from the delivery of those services.

Charge-Based Reimbursement

Under a charge-based reimbursement system, when payers pay billed charges, they pay
according to a rate schedule, called a chargemaster, established by the provider. To a certain
extent, this reimbursement system places payers at the mercy of providers, especially in
markets where competition is limited. In the very early days of health insurance, all payers
reimbursed providers on the basis of charges. Now, the trend is shifting toward other, less
generous reimbursement methods, and the only payers expected to pay the full amount
of charges are self-pay (private-pay) patients. Even among those consumers, low-income
uninsured patients often are given discounts from charges or not required to pay at all.

Most insurers that still base reimbursement on charges now pay negotiated, or dis-
counted, charges. Insurers that offer managed care plans, as well as conventional insurers,
often hold bargaining power because they have the capacity to bring a large number of
patients to a provider, which allows them to negotiate discounts that generally range from
20 percent to 50 percent (or more) of charges. The effect of these discounts is to create

Chargemaster

A provider’s official list

of charges (prices) for

goods, supplies, and

services rendered.

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.

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a system similar to hotel or airline pricing, whereby few people pay the listed rates (rack
rates or full fares, respectively). Many people argue that chargemaster prices have become
meaningless, and hence the entire concept should be abandoned. However, old habits die
hard, and chargemaster prices still play a role in some reimbursement methods, so we expect
they will be in use for some time.

Prospective Payment Reimbursement

In a prospective payment system, the rates paid by payers are determined by the payer
before the services are provided. Furthermore, payments are not directly related to either costs
or charges. Here are the common units of payment used in prospective payment systems:

◆ Per procedure. Under per-procedure reimbursement, a separate payment
is made for each procedure performed on a patient. Because of the high
administrative costs associated with this method when applied to complex
diagnoses, per-procedure reimbursement is primarily used in outpatient
settings.

◆ Per diagnosis. In the per-diagnosis reimbursement method, the provider is paid
a rate that depends on the patient’s diagnosis. Diagnoses that require higher
use of resources, 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,
the provider is paid a fixed amount for each day that service is provided.
Often, per diem rates are stratified, which means that different rates are
applied to different services. For example, a hospital may be paid one rate
for a medical/surgical day, a higher rate for a critical care unit day, and yet a
different rate for an obstetric day. Stratified per diems recognize that providers
incur widely varied daily costs for providing different types of inpatient care.

◆ Bundled (global) reimbursement. Under bundled reimbursement, payers
reimburse providers a single prospective payment that covers all services
delivered in a single episode, whether the services are rendered by a single
provider or by multiple providers. For example, a bundled price may be set
for all obstetric services associated with a pregnancy provided by a single
physician, including all prenatal and postnatal visits and the delivery. For
another example, a bundled price may be paid for all physician and hospital

Prospective payment

A reimbursement

system meant to cover

expected costs as

opposed to historical

(retrospective) costs.

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services associated with a cardiac bypass operation. Note that at the extreme, a
bundled price could be set for all services provided to a single patient, which,
in effect, is capitation reimbursement, as described in the next section.

HEALTHCARE IN PRACTICE
How Medicare Pays Providers

Medicare uses different 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

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 334 base DRGs (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 approximately 760 total MS-DRGs.

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. Each MS-DRG is assigned a relative 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:

MS-DRG Weight Payment

293 0.6737 $3,344

292 0.9707 4,818

291 1.4809 7,351

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HEALTHCARE IN PRACTICE
How Medicare Pays Providers (continued)

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 hos-

pital 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 53 percent more resources than the average inpatient.

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

base rate (dollar amount) that incorporates several factors unique to the hospital and

its geographic location. In the table shown earlier in this section, see representative

payment amounts calculated using an adjusted base rate of $4,964. For example, the

reimbursement for a typical hospital for DRG 292 would be 0.9707 × $4,964 = $4,818.

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 de-

signed to compensate hospitals for treating patients who consume resources that fall

outside of 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.
(continued)

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CAPITATION

Capitation is an entirely different approach to reimbursement from fee-for-service (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
to serve 100 members of a managed care plan. Capitation payment, which is used mostly by
managed care organizations to reimburse primary care physicians, dramatically changes the
financial environment of healthcare providers. Its implications are addressed in section 3.6 and
as needed throughout the remainder of this book. (For additional information about capita-
tion, see online chapter 15, which is available at ache.org/books/FinanceFundamentals3.)

Before closing our discussion of reimbursement, we should note that many insurers
are now creating reimbursement systems that explicitly reward providers for achieving certain

HEALTHCARE IN PRACTICE
How Medicare Pays Providers (continued)

Medicare changed its physician payment system in 1992 to a resource-based relative

value scale (RBRVS) system. Under RBRVS, reimbursement is based on three resource

components: physician work, practice (overhead) expense, and malpractice insurance

expense. Each of roughly 8,000 procedure codes is assigned relative value units (RVUs)

for the three resource components, which, after adjustment for geographic cost dif-

ferentials, are summed to arrive at the total number of RVUs per procedure performed.

The total RVUs are then multiplied by a conversion factor that equals the dollar value

of one unit to obtain the dollar reimbursement amount.

For example, consider code 99213, which represents one category of office visit. The

national average physician work RVU is 0.97, the practice expense RVU is 0.40, and the

malpractice insurance RVU is 0.07. For a physician practicing in Marco Island, Florida,

the adjusted RVU values are 0.97, 0.38, and 0.09, respectively. (The overhead costs as-

sociated with a practice in Marco Island are slightly less than the national average, but

malpractice insurance is slightly more.) Assuming the 2016 Medicare conversion factor

is $35.80, the Medicare reimbursement amount for the Marco Island physician would

be (0.97 + 0.40 + 0.09) × $35.80 = 1.46 × $35.80 = $52.27.

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.

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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 9

benchmarks. These reimbursement systems, which
are really modified fee-for-service or capitation
systems, are called pay-for-performance (P4P)
systems.

In most P4P reimbursement schemes,
insurers pay providers an “extra” amount if cer-
tain standards, usually related to quality of care,
are met. For example, a primary care practice may
receive additional reimbursement if it meets speci-
fied goals, such as administering mammograms
to 85 percent of female patients older than 50 or
placing 90 percent of diabetic patients on appro-
priate 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 medi-
cal costs in the long run. In some P4P plans, insurers reduce payments to poor performers
and use the savings to increase payments to high performers, forcing some providers to bear
the cost of the plan (see “For Your Consideration: Value-Based Purchasing”).

Pay for performance

(P4P)

A reimbursement

system that rewards

providers for meeting

specific goals (e.g.,

90 percent patient

satisfaction).

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 pro-

vided 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 incen-

tive to withhold needed services, while proponents argue that

it discourages unneeded services and hence reduces costs.

FOR YOUR CONSIDERATION
Value-Based Purchasing

Value-based purchasing, a form of pay-for-performance reimbursement, is founded on

the concept that buyers of healthcare services should hold providers accountable 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.

“Changing the way we pay hospitals will improve the quality of care for seniors and

save money for all of us,” said HHS Secretary Kathleen Sebelius. “Under this initiative,

Medicare will reward hospitals that provide high-quality care and keep their patients

(continued)

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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 finan-
cial environment. For example, consider the experience of obtaining a loan from a bank.

FOR YOUR CONSIDERATION
Value-Based Purchasing (continued)

healthy. It’s an important part of our work to improve the health of our nation and drive

down costs. As hospitals work to improve quality, all patients—not just Medicare pa-

tients—will benefit.” The measures to determine quality focus on how closely hospitals

follow best clinical practices and how well hospitals enhance patients’ care experiences.

The better a hospital performs on its quality measures, the larger its reimbursement from

Medicare. Hospitals are no longer paid solely on the quantity of services they provide. HHS

set a goal of tying 90 percent of all Medicare fee-for-service to quality or value by 2018.

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?

SELF-TEST QUESTIONS

1. What is the major difference between fee-for-service reimbursement
and capitation?

2. 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

3. What is pay-for-performance reimbursement?

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Individuals can deduct mortgage interest from income for tax purposes, but they cannot
deduct interest payments on personal loans. Loan companies responded to this tax code
regulation by offering home equity loans to homeowners that function as a type of second
mortgage for tax purposes. The intent is not for such loans to be used to finance home
ownership, as the tax laws assumed, but for other expenditures, including paying for vaca-
tions and purchasing cars or appliances. In this instance, tax laws created incentives for
consumers to carry mortgage debt rather than personal debt, and the mortgage loan industry
responded accordingly to accommodate the consumers.

In the same vein, alternative reimbursement methods have an impact on provider
behavior. Under cost-based reimbursement, providers are essentially issued a blank check
to acquire facilities and equipment and incur operating costs. If payers reimburse providers
for all service-related costs, the incentive is to incur such costs. Facilities will be lavish and
conveniently located, and staff will be available to ensure that patients are given red-carpet
treatment. Furthermore, services that are not required will be provided because more services
lead to higher costs, which lead to higher revenues.

Under charge-based reimbursement, providers have the incentive to set high prices
and offer more services. However, in competitive markets, prices will be constrained. Still,
to the extent that insurers, rather than patients, are footing the bill, considerable leeway
exists. Also, because reimbursement paid on the basis of charges is a fee-for-service type of
reimbursement, a strong incentive exists to provide the highest possible amount of services.
In essence, providers can increase utilization, and hence revenues, by creating more visits,
ordering more tests, extending inpatient stays, and so on. Although charge-based reimburse-
ment does encourage providers to contain costs, the incentive is weak because charges can
more easily be increased than costs can be decreased. In recent years, the ability of providers
to increase revenues by raising charges has been greatly offset by insurers through negoti-
ated discounts or constrained reimbursement increases, which place additional pressure on
profitability and hence sweeten the incentive for providers to reduce costs.

Under prospective payment reimbursement, provider incentives are altered. First,
under per-procedure reimbursement, the profitability of individual procedures varies depend-
ing on the relationship between the actual costs incurred and the payment for that procedure.
In other words, because of inconsistencies in reimbursement, some procedures are more
profitable than others. Providers, typically physicians, have the incentive to perform proce-
dures that have the highest profit potential. Furthermore, the more procedures performed,
the better, because each procedure typically generates additional profit.

The incentives under per-diagnosis reimbursement are similar. Providers, usually
hospitals, seek patients with diagnoses that have the greatest profit potential and discourage
(or even discontinue) services that have the least potential. (Why, in recent years, have so
many hospitals created cardiac care centers?)

In all prospective payment methods, providers have the incentive to reduce costs
because the amount of reimbursement is fixed and independent of the costs actually incurred.
For example, when hospitals are paid under per-diagnosis reimbursement, they have the

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incentive to reduce length of stay, which reduces overall costs. However, when per diem
reimbursement is used, hospitals have an incentive to increase length of stay. Because the
early days of a hospitalization typically are more costly than the later days, the later days are
more profitable. However, as mentioned previously, hospitals have the incentive to reduce
costs during each day of a patient stay regardless of the prospective payment method.

Under bundled reimbursement, providers do not have the opportunity to be reim-
bursed for a series of separate services. For example, a physician’s treatment of a fracture
could be bundled and billed as one episode, or it could be unbundled, with separate bills
submitted for making the diagnosis, taking the X-rays, setting the fracture, removing the
cast, and so on. The rationale for unbundling is usually to provide more detailed records
of treatments rendered, but often the result is higher total charges for the parts than would
be charged for the entire package under bundled payment.

In addition, bundled reimbursement, when applied to multiple providers for a
single episode of care, forces those providers (usually physicians and hospitals) to offer the
most cost-effective treatment jointly. A multiprovider view of cost containment may be
more effective than each participant separately attempting to minimize her treatment costs
because the actions of one provider to lower costs could increase the costs of the others.

Finally, capitation reimbursement totally changes the playing field by reversing the
actions that providers must take to ensure financial success. Under all fee-for-service meth-
ods, the key to provider success is to work harder, increase the amount of services provided
(utilization), and hence maximize profits. Under capitation, the key to profitability is to
work more thoughtfully and decrease utilization.

As with prospective payment, capitated providers have the incentive to lower the
cost of the services provided, but now they also have the incentive to reduce the amount
of services provided. Thus, only those procedures that are truly medically necessary should
be performed, and treatment should take place in the lowest-cost setting that can provide
the appropriate quality of care. Furthermore, providers have the incentive to promote
health, rather than just treat illness and injury, because a healthier population consumes
fewer healthcare services.

PROvIDER RISKS

One key issue providers contend with is the impact of various reimbursement methods on
financial risk. Think of financial risk in terms of the effect that the reimbursement 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.

Bundled

reimbursement

The payment of a

single amount for

several procedures.

When reimbursement

is unbundled, separate

amounts are paid for

each procedure.

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In all reimbursement methods, except cost-based payment, providers bear the cost-
of-service risk in the sense that costs can exceed revenues. However, a primary difference
among the reimbursement types is the ability of the provider to influence the revenue–cost
relationship. If providers set charge rates for each type of service provided, they can most
easily ensure that revenues exceed costs. Furthermore, if providers have the power to set
rates above those that would exist in a truly competitive market, charge-based reimburse-
ment could result in higher profits than cost-based reimbursement can realize.

Prospective payment creates additional risk for providers. In essence, payers are set-
ting 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 compensate them adequately for providing healthcare services to those
populations. Thus, the only way for these providers to survive is to recoup these losses from
privately insured patients or stop treating government-insured patients, which for many
providers would take away more than half of their revenues. Whether or not government
reimbursement is too low is open to debate. Still, prospective payment can place significant
financial risk on providers’ operations.

Under capitation, providers assume utilization risk along with the risks assumed
under the other reimbursement methods (see “Critical Concept: Utilization Risk”). The
assumption of utilization risk has traditionally
been an insurance, rather than a provider, func-
tion. 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 reim-
bursement methods is discussed in this descriptive
fashion, an easy conclusion to make is that capitation
is by far the riskiest reimbursement method to pro-
viders, 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 dif-
ferent reimbursement methods. Thus, providers can
face conflicting incentives and differing risk, depend-
ing on the predominant method of reimbursement.

In closing, note that all prospective pay-
ment methods create financial risk for providers.

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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This assumption of risk does not mean that providers should avoid such reimbursement
methods; indeed, refusing to accept contracts with prospective payment provisions would
be organizational suicide for most providers. However, providers must understand the risks
involved in prospective payment arrangements, especially the impact on profitability, 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 medi-
cal diagnoses and procedures into numerical codes that can be universally recognized and
interpreted. The diagnoses and procedures are usually taken from a variety of sources 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 hospitals)
or the procedures performed on the patient (in the case of outpatient settings). Thus, a brief
background on medical coding will enhance your understanding of the reimbursement process,

DIAGNOSIS CODES

The International Classification of Diseases (commonly known by the abbreviation ICD)
is the standard resource for designating diseases and a wide variety of signs, symptoms,
and external causes of injury. Published by the World Health Organization (WHO), ICD
codes are used internationally to record many types of health events, including hospital
inpatient stays and deaths. (ICD codes were first used in 1893 to report death statistics.)

WHO periodically revises the diagnostic codes in ICD, which is now in the tenth
version (ICD-10). Conversion to ICD-10 codes in the United States was slated to occur in
2013; however, in April 2012 HHS proposed a one-year delay of the ICD-10 compliance
date, to October 1, 2014. Another proposal delayed the ICD-10 further until it was officially
launched on October 1, 2015. The conversion was time consuming and costly because ICD-10
contains more than five times as many individual codes as did the previous version, ICD-9.
Of course, the information provided by the new code set is more detailed and complete.

SELF-TEST QUESTIONS

1. What provider incentives are created under (a) cost-based reim-
bursement, (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)

codes are used

by hospitals and

other organizations

to specify patient

diagnoses.

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The ICD-10 codes are three to seven characters. The first three characters denote
the disease category, and additional characters further specify the patient’s condition. For
example, code I21 describes an acute myocardial infarction (heart attack), while code I21.0
is an attack involving the anterior wall of the heart.

In practice, the application of ICD codes to diagnoses is complicated and techni-
cal. Hospital coders must thoroughly understand the coding system as well as the medical
terminology and abbreviations used by clinicians. The medical coding function is highly
complex, and proper reimbursement from third-party payers depends on accurate coding;
therefore, ICD coders require a great deal of training and experience.

PROCEDURE CODES

While ICD codes are used to specify diseases, Current Procedural Terminology (CPT)
codes are used to specify medical procedures (treatments). CPT codes were developed and
are copyrighted by the American Medical Association.

The purpose of CPT is to create a uniform set of descriptive terms and codes that
accurately describe medical, surgical, and diagnostic procedures. CPT codes are revised
periodically to reflect current trends in clinical treatments. To increase standardization and
the use of electronic medical records, federal law requires that physicians and other clini-
cal providers, including laboratory and diagnostic services, use CPT to code and transfer
healthcare information. (The same law also requires that ICD-10-CM/PCS codes be used
to document hospital inpatient services.)

The CPT code set includes ten codes for physician office visits: Five codes apply to
new patients and five apply to established patients on repeat visits. The differences among
the five codes in each category are based on the complexity of the visit, as indicated by
three components: extent of patient history review, extent of examination, and difficulty of
medical decision-making. For repeat patients, the least complex (typically shortest) office
visit is coded 99211, while the most complex (typically longest) is coded 99215.

Because government payers (Medicare and Medicaid) and other insurers require
additional information from providers beyond that contained in CPT codes, 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, such as ambulance services, and durable medical equipment, such
as prosthetic devices.

Although CPT and HCPCS codes are not as complex as the ICD codes, coders still
must have a high level of training and experience to use them correctly. As in ICD cod-
ing, correct CPT coding ensures correct reimbursement. Medical coding is so important
that many businesses offer services, such as books, software, education, and consulting, to
hospitals and medical practices to improve coding efficiency.

CPT codes

Current Procedural

Terminology (CPT)

codes 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 to

include nonphysician

services and durable

medical equipment.

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3.8 HEALTHCARE REFORM
Healthcare reform is a generic term used to describe the actions taken by Congress in 2009
and 2010 to reform the healthcare system (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 num-
ber of provisions that were expected to take effect
over the next several years with the primary goal
of helping an additional 32 million Americans
obtain health insurance. The provisions included
expanding Medicaid eligibility, subsidizing insur-
ance premiums, providing incentives for businesses
to provide healthcare benefits, prohibiting denial
of coverage on the basis of preexisting conditions,
establishing health insurance exchanges, and pro-
viding 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 legislation should be called insurance reform
rather than healthcare reform.

In addition to those affecting the insurance segment of healthcare, some provisions
were designed to offset the costs of reform by instituting a variety of taxes, fees, and cost-
saving measures. 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 qual-
ity 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 the chapter), the effectiveness

SELF-TEST QUESTIONS

1. Briefly 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 ac-

tions taken by Congress in 2010 to transform the healthcare

system. The legislation, titled the Patient Protection and Af-

fordable 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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of payment bundling, and the potential quality gains from the medical home model (also
discussed later).

Legislative changes may occur that could significantly alter some of the program’s
features or eliminate it altogether. All of 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, one of the cornerstone concepts of healthcare reform,
integrate local physicians with other members of the healthcare community and reward
them for controlling costs and improving quality. While ACOs are not radically different
from other attempts to improve the delivery of healthcare services, their uniqueness lies in
the flexibility of their structures and payment methodologies and their ability to assume
risk 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.
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 (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 preventive services,
treatment of acute and chronic illnesses, and assistance with end-of-life issues.

Accountable care

organization (ACO)

An organization that

integrates physicians

and other healthcare

providers with the goal

of controlling costs and

improving quality.

Medical home

(patient-centered

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.

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The medical home model is independent of the ACO concept, but observers anticipate
that ACOs will provide an organizational setting that facilitates implementation of the model.
Supporters of the model claim that it will allow better access to healthcare, increase patient
satisfaction, and improve health. Although the development and implementation of the medi-
cal 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
outside of face-to-face visits, should support adoption and use of health
information technology for quality improvement, and should recognize
differences in the patient populations treated 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.

THEME WRAP-UP: Big sky’s revenue sourCes

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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 9

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.
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.

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G a p e n s k i ’ s F u n d a m e n t a l s 0 f H e a l t h c a r e F i n a n c e8 0

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.

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 sustains 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.

➤ When payers pay billed charges, they pay according to the schedule of charge rates
established by the provider in its chargemaster.

➤ Negotiated charges, which are discounted from billed (chargemaster) charges, are
often used by insurers in conjunction with managed care plans.

➤ Under a retrospective cost system, the payer agrees to pay the provider certain
allowable costs that are incurred in providing services to the payer’s enrollees.

➤ In a prospective payment system, the rates are determined in advance and are not
tied directly to either reimbursable costs or billed charges. Typically, prospective
payments are made on the basis of the following service definitions: (1) per
procedure, (2) per diagnosis, (3) per diem (per day), or (4) bundled reimbursement.

➤ In 1983, the federal government adopted the inpatient prospective payment system
(IPPS) for Medicare hospital inpatient reimbursement. Under this system, the amount
of payment is fixed by the patient’s diagnosis, as indicated by the diagnosis-related
group (DRG).

KEY CONCEPTS

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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 1

➤ Physicians are reimbursed by Medicare using the resource-based relative value
scale (RBRVS) system. Under RBRVS, reimbursement is paid on the basis of three
resource components: (1) physician work, (2) practice (overhead) expenses, and (3)
malpractice insurance.

➤ Medical coding is the foundation of fee-for-service reimbursement systems. In
inpatient settings, ICD codes are used to designate diagnoses, while in outpatient
settings, CPT codes are used to specify procedures.

➤ Healthcare reform is legislation signed into law in 2010 that is expected to have a
significant impact on health insurers. However, its final form will not be known for a
number of years.

➤ Accountable care organizations (ACOs) are a method of integrating physicians with
other members of the healthcare community and rewarding them for controlling
costs and improving quality.

➤ A medical home (patient-centered medical home) is a team-based model of care led
by a personal physician who provides continual and coordinated care throughout a
patient’s lifetime to maximize health outcomes.

The information in this chapter plays a vital role in financial decision-making in health
services organizations. Thus, we will use it over and over in the chapters that follow.

3.1 Briefly describe the major third-party payers.

3.2 a. What are the primary characteristics of managed care organizations (MCOs)?
b. Describe two different types of MCOs.

3.3 What is the difference between fee-for-service reimbursement and capitation?

3.4 What is pay-for-performance?

3.5 Describe provider incentives and risks under each of the following reimbursement
methods:

a. Cost based
b. Charge based, including discounted charges
c. Prospective payment
d. Capitation

3.6 Briefly describe the coding systems for diseases (diagnoses) and procedures.

3.7 How does Medicare reimburse hospitals for inpatient stays?

3.8 How does Medicare reimburse physician services?

3.9 What are the key features of the ACA?

END-OF-CHAPTER QUESTIONS

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