Hailey Tran
Medicare payment systems must be fair to all hospitals, a constraint not faced by private payers. To appear fair, the government must be able to defend its payment methods openly, and its prices must be fully transparent to all market participants. In this regard, Medicare uses what is known as the case-based system for paying hospitals for inpatient care, which means that hospitals receive one single payment for an entire inpatient episode of a given type. Medicare's physician fee-schedule payments are subject to a formula called the Sustainable Growth Rate (SGR) system, enacted in 1987 as a tool to control spending.
| Characteristics | Values |
|---|---|
| Medicare's payment system | Case-based payments for inpatient care; fee-for-service for most types of providers; prospective payment systems for most providers in traditional Medicare |
| Price determination | Set administratively through laws and regulations |
| Payment rates | Specific to each type of provider; adjusted for geographic location and complexity of the patient |
| Payment updates | Annual updates to account for inflation adjustments |
| Outlier payments | Shared cost between Medicare and hospital for unusual severity of the case |
| Transparency | Fully transparent to all market participants |
| Equity | Strives for horizontal equity, paying hospitals in similar situations the same price for the same service |
| Spending | In 2014, Medicare paid $376 billion (63%) for benefits delivered by healthcare providers in traditional Medicare |
| Comparison with commercial insurers | Commercial insurers pay much higher prices for hospitals' and physicians' services than Medicare |
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What You'll Learn
Medicare's 'case base' system for inpatient care
Medicare uses what is known as the "case base" system for inpatient care, which means that hospitals receive one single payment for an entire inpatient episode of a given type. This payment system is referred to as the inpatient prospective payment system (IPPS). Under the IPPS, each case is categorized into a diagnosis-related group (DRG). The DRG-adjusted base payment rate is then calculated, and any outlier payments or adjustments are added. Outlier payments are made for extremely costly cases to promote access to high-quality inpatient care for seriously ill patients.
The national, standardized 30-day period payment for case-mix is based on the patient's condition, care needs, and area wage differences. The wage-adjusted operating costs and capital costs for the base case are adjusted for case severity. This adjustment is made by multiplying the "base rate adjusted for geographic factors" with an index of the relative costliness of the particular grouping into which the inpatient case falls. For example, an appendectomy with a complicated principal diagnosis and major comorbidities or complications has a higher weight than a simple appendectomy without complications.
Medicare also makes additional payments for certain situations, such as hospitals that serve a disproportionate share of low-income patients, approved teaching hospitals, and hospitals participating in clinical trials. These add-on payments help protect hospitals from financial losses and promote access to specialized care.
Medicare's payment systems aim to be fair and transparent, ensuring that hospitals in similar situations receive the same price for the same service. This approach, introduced by Presidents Ronald Reagan and George H.W. Bush, provides a standardized way of paying hospitals for inpatient care.
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How private insurers pay hospitals
Private insurers pay hospitals mainly on the basis of negotiated per-diem rates, which may be adjusted for case severity and the particular day in a hospital episode. For instance, the early days of a hospital episode generally incur higher costs than subsequent days. Private insurers also pay for individual services going into a hospital episode or for some standard procedures, on a case-by-case basis.
The prices paid by private insurers are not transparent to all market participants, as they are treated as proprietary trade secrets. This is in contrast to Medicare, whose payment systems must be fair to all hospitals and transparent to the public. As a result, every change to Medicare's payment system must be publicly defended, sometimes after lengthy study and debate.
In rural areas, hospitals depend on private insurers for the majority of their patient costs. For example, in Alabama, most rural hospitals rely on private insurers for 65-80% of patient costs. However, compensation by private insurers in these areas has remained low, leading to financial strain and even hospital closures.
Private insurers' market dominance in certain regions can also affect their reimbursement rates. In Alabama, Blue Cross and Blue Shield of Alabama holds an estimated 94% of the large-group private insurance market. This gives them significant negotiating power over hospitals, allowing them to pay lower rates than other insurers.
The consolidation of healthcare services, such as hospitals acquiring physician practices, can also drive up prices. As hospitals achieve more market dominance, they can charge higher prices without a corresponding increase in the quality of care. This dynamic has contributed to the financial pressures faced by rural hospitals.
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The 'base rate adjusted for geographic factors'
The base rate adjusted for geographic factors is a sum of the wage-adjusted operating costs and the capital costs for the base case. This sum is then adjusted for case severity. The wage adjustment is necessary because wages vary across the country, so the labour component of operating costs is adjusted using a geographic hospital-wage index.
The base rate adjusted for geographic factors is then multiplied by an index of the relative costliness of the particular grouping into which the inpatient case in question falls. The index for the base case is set to 1. For example, an appendectomy without complicated principal diagnosis and without other co-morbidities or complications has a case weight of 0.9042, while an appendectomy with a “complicated principal diagnosis” and ”major co-morbidities or complications” has a weight of 3.1760.
Adjusting for price and health-risk differences narrows the variation between average per capita spending in high- and low-spending counties. For example, in 2013, 19 of the 20 counties with the highest adjusted Medicare per capita spending were located in southern states, with 9 counties in Texas alone. In contrast, 17 out of the 20 lowest-spending counties were located in western states, including 9 in California.
The convergence or narrowing of variation in county-level Medicare per capita spending has been a trend since the 1970s. This trend is driven by having a traditional Medicare beneficiary population that is poorer and sicker than average, using hospital inpatient services and post-acute care at higher rates and with greater intensity than beneficiaries in lower-spending counties. Counties with relatively high Medicare per capita spending also tend to have a larger supply of certain healthcare providers.
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Case severity and outlier payments
Medicare uses what is known as the "case-base" system for paying hospitals for inpatient care, which means that hospitals receive a single payment for an entire inpatient episode of a given type. Medicare payments vary based on several factors, including the cost of labour, the hospital's location, patient comorbidities, and higher reimbursement for particularly expensive cases.
Inpatient services are categorized into "diagnosis-related groups" (DRGs), which group together patients with similar clinical needs that are expected to require similar levels of hospital resources. Each DRG has a payment weight assigned based on the average resources required to treat Medicare patients grouped in that DRG. These weights are then adjusted for hospital-based factors such as local labour costs and case mix, as well as patient-specific factors such as severity and comorbidities. For example, an appendectomy without complicated principal diagnosis and without other comorbidities or complications has a case weight of 0.9042, while an appendectomy with a “complicated principal diagnosis” and ”major comorbidities or complications” has a weight of 3.1760.
Medicare makes additional outlier payments to reimburse hospitals for cases that are particularly costly. Hospitals that treat a higher share of low-income Medicare and Medicaid patients receive increased reimbursements, as do teaching hospitals. The sum of the wage-adjusted operating costs and the capital costs for the base case is shown in the chart as the “base rate adjusted for geographic factors”. That sum is then adjusted for case severity. Medicare does this by multiplying the “base rate adjusted for geographic factors” with an index of the relative costliness of the particular grouping into which the inpatient case in question falls. The index for the base case is set to 1.
Private insurers pay hospitals mainly on the basis of negotiated per-diem rates, sometimes adjusted for case severity and the particular day in a hospital episode (because the early days of an episode generally incur higher costs than subsequent days), for the individual service going into a hospital episode or for some standard procedures, on a case-by-case basis.
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Medicare's physician fee-schedule payments
Medicare uses a "case-base" system for paying hospitals for inpatient care, which means hospitals receive a single payment for an entire inpatient episode of a given type. This is adjusted for case severity and geographic factors. For example, an appendectomy without complicated principal diagnosis and without other co-morbidities or complications has a case weight of 0.9042, while an appendectomy with a “complicated principal diagnosis” and ”major co-morbidities or complications” has a weight of 3.1760.
The PFS is used when paying for the professional services of physicians and other healthcare providers in private practice, services covered incident to physicians' services (excluding certain drugs), and diagnostic tests (excluding clinical laboratory tests). It is a complete listing of fees used by Medicare to pay doctors or other providers/suppliers. This comprehensive listing of fee maximums is used to reimburse a physician and/or other providers on a fee-for-service basis.
The PFS is updated annually, with the CY 2026 Physician Fee Schedule (PFS) proposed rule announcing and soliciting public comments on proposed policy changes for Medicare payments under the PFS and other Medicare Part B issues.
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Frequently asked questions
Medicare uses the "case base" system for paying hospitals for inpatient care, which means that hospitals receive one single payment for an entire inpatient episode of a given type.
Medicare's payment system aims to be fair and transparent to all market participants. It also strives for horizontal equity, ensuring that hospitals in similar situations receive the same price for the same service.
Medicare uses prospective payment systems to predetermine a base payment rate for a given unit of service, such as a hospital stay or an episode of care. The base payment rate is then adjusted based on factors such as the hospital's geographic location and the complexity of the patient.
No, private insurers primarily pay hospitals based on negotiated per-diem rates, which can be adjusted for case severity and the particular day in a hospital episode. They also pay for individual services within a hospital episode or standard procedures.
Medicare pays hospitals for ambulatory services provided in outpatient departments based on the classification of each service into over 750 categories with similar expected costs.
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