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Gaining a Competitive Advantage with Prospective Payment


New payment methods clear a path for better management

Managed care organizations (MCOs) drive profits by effectively sharing and managing risk; i.e., by achieving the appropriate balance between risk assumption and risk transfer.  An important attribute of Prospective Payment is that these systems attempt to allocate risk to payers and providers based on the types of risk that each can effectively manage.  That is, Prospective Payment shifts to the provider the risk of treating patients, using a payment structure that encourages providers to deliver care efficiently and effectively, while MCOs retain the risk for underwriting healthcare utilization in the population of enrollees and the capacity to manage the access of patients to individual providers.

In today’s managed-care environment, Prospective Payment continues to grow as a preferred and proven risk-management strategy.  This article discusses the opportunities for MCOs to gain a competitive edge with Prospective Payment through:

  • Implementing Prospective Payment Systems for commercial populations
  • Casemix-adjusted controls on charge increases (using DRGs)
  • Casemix-adjusted per-diem rates (using DRGs)
  • Out-of-network payments for inpatient and outpatient Medicare Advantage

Using Prospective Payment to Share and Manage Risk

The alignment of risk responsibilities between payers and providers defines the rules of engagement in healthcare, largely driving payment methods used to pay for medical services.  The range of options available to payers to deal with risk includes numerous payment arrangements (discounted charges, fee schedules, per diems, case rates and capitation), requiring varying levels of medical management.  But medical management is costly, does not always yield enough of a return to justify itself, and is generally viewed as adversarial by the medical community. At the same time, capitation, in most cases, has proven to be unpalatable to consumers, unacceptable to providers, and too expensive for payers because they must pay others to accept risk that they could effectively manage on their own. Prospective Payment represents an important alternative strategy.

Prospective Payment’s broad focus on the treatment of an entire case provides a number of advantages over other payment methods.  Prospective Payment holds payers and providers responsible for that portion of risk that they can effectively manage.  In addition, when combined with an appropriate layer of “less intrusive” medical management, such as preadmission certification, each party has the ability to operate more effectively.  Thus, Prospective Payment has emerged as a preferred and proven risk management strategy.  Notable examples include the introduction of Medicare’s Diagnosis Related Group (DRG)-based payments for inpatient care, and the more recent implementation of Ambulatory Payment Classifications (APCs) for outpatient care.

But the benefits of Prospective Payment can also be realized without the formal adoption of payment systems like DRGs and APCs.  For example, case-mix adjustment (using DRGs) can be employed in the context of charge-based payment arrangements to control charge increases.  Similarly, case-mix adjustment can be used to establish and manage inpatient per-diem rates.  In these situations, provider payments can be managed using methods that “shadow” prospective payment, with the attendant benefits, but without formally implementing a Prospective Payment system.

Implementing Prospective Payment Systems for Commercial Populations

The implementation of Medicare’s inpatient Prospective Payment System (PPS) 20 years ago was one of the most dramatic shifts in risk from payers to providers.  The availability of a case-mix adjustment methodology led to widespread adoption of inpatient case rates over the next two decades.  Under DRG-based PPS, providers are held-harmless for clinical differences among patients that are captured by the DRG system.  They remain at risk for other differences in costs including differences in the efficiency with which they provide medical care.

Medicare attempted to achieve a similar alignment of risk for hospital outpatient services when it introduced its Outpatient Prospective Payment System (OPPS) using APCs four years ago.  OPPS places providers at risk for inefficient practices patterns and should result in long-term efficiencies in hospital care, encourage more appropriate decisions about the site of care, and require less intrusive medical management.

To maintain a competitive advantage in today’s healthcare environment, more and more payers will undoubtedly follow Medicare’s lead and adopt Prospective Payment systems for their non-Medicare populations.  This has already taken place for inpatient care where payers have had 20 years to adapt DRGs to commercial populations.  And while many expected a rapid diffusion of APCs into other sectors, in reality, APC expansion has been limited over the past four years because of the complexities of the system, special coding and billing requirements, a lack of clear documentation, and rapid changes in the underlying rules and regulations.  Notwithstanding these difficulties, it seems inevitable that payers will adopt APCs for their commercial contracts because there are few alternatives to control hospital outpatient spending, which continues to grow far more rapidly than inpatient spending. 

Controlling Charge-Based Payments using Prospective Payment

Payers retain full risk when they pay providers on a percent-of-charges (discounted charges) basis, because providers generally get paid as services are rendered.  This type of contracting strategy is relatively attractive to hospitals but leaves payers somewhat vulnerable to the charging practices of hospitals.  Payers typically deal with this problem through the careful negotiation of discounts based on analyses of relative charges and costs across hospitals.

Recently, however, the industry has seen rapid increases in charges for hospital services and puts payers at a growing risk for uncontrolled financial obligations.  One obvious response to rate increases is for payers to renegotiate lower percent-of-charge (POC) rates in its contracts.  Another approach is for payers to include in contracts specific language that ties reductions in the POC rates to increases in hospital charges.  However, determining the rate of increase in charges for individual hospitals is not a straightforward task because there is no single “price” for hospital services.  Instead, hospitals set literally thousands of different prices and adjust those prices differentially based on prevailing market conditions.

Prospective Payment offers a solution to this challenge.  Payers can implement a charge-monitoring methodology based on casemix-adjusted charges to quantify price level changes, and excessive increases can trigger automatic POC changes, contract negotiations, or other responses anticipated in the provider agreement. For example, to quantify prices on a quarterly basis over a two-year moving window, the system would calculate casemix-adjusted charges per case for each quarter.  When a quarter-to-quarter change is considered “large,” certain control provisions would be invoked.

Determining the rate of increase in a hospital’s charges from a baseline to a current period on a casemix-adjusted basis involves four simple steps:

  • Group a hospital’s cases for the two time periods (current and baseline) into a set of casemix categories (e.g., DRGs for inpatient care).
  • Count the number of cases in the baseline time period, by casemix category.
  • Calculate the average charge in each casemix category for the current time period.
  • Compute an overall casemix-adjusted average charge for the current period based on the category-specific numbers computed in step 3, weighting by the baseline number of cases (step 2).
  • Divide the hospital’s casemix-adjusted average charge computed in step 4 by the actual baseline overall average charge per case.

As a final step, casemix-adjusted charge increases are then indexed from one time period to the next, or cumulatively over longer time periods.  And, as described above, large increases can trigger actions specified in the hospital’s provider agreement.

This approach, using DRGs, gives payers the capacity to examine, and respond to, changes in pricing for inpatient hospital services.  The price of outpatient services can be evaluated similarly, using a standard outpatient classification system such as APCs.  However, given the relative size of the dollars involved, payers should begin with the development of an inpatient system and expand into outpatient services once the methodology is proven and its benefits are better quantified. 

Inpatient Per-Diem Rates using DRGs

Per-diems offer a simple strategy for payers to share risk with providers (hospitals).  Payers and providers negotiate daily payment rates for hospital stays, fixing rates for several pre-defined types of stays, such as medical/surgical, delivery and ICU.  Per-diems shift some risk to hospitals by limiting what is paid for each day prospectively.  This creates the incentive for hospitals to control daily costs and utilization while health plans remain at risk for differences in length of stay.

Establishing fair and equitable per-diem rates is critical for this risk sharing to work – set too low, per diems do not provide strong enough incentives for hospitals to reduce costs; set too high, hospitals may not be able to provide appropriate levels of care.  Prospective Payment methods offer payers an effective means of developing appropriate per-diem rates through casemix adjustment using DRGs.  The techniques are analogous to those outlined above for controlling charge-based payment rates.

In general, a hospital’s casemix-adjusted per diem for a particular type of stay is facilitated by the use of DRG-specific per diems, and is computed from a baseline set of data by:

  • Grouping a hospital’s cases in the baseline into a set of casemix categories (DRGs).
  • Calculating baseline average costs per day for each DRG using groupings obtained in step 1.
  • Adjusting DRG-specific costs per day to reflect differences in costs between the baseline and current period.

The DRG-specific per diem calculations derived from step 3 are then used to pay for services in a subsequent period.

Medicare Advantage Out-of-Network Payments

The payment of out-of-network claims for Medicare Advantage plans is an important, and often overlooked, opportunity for payers.  Under the Medicare Advantage program, payers are not required to pay any more for out-of-network claims than the rates in effect for the traditional Medicare programs (i.e., under Medicare’s inpatient and outpatient Prospective Payment systems).  Many Medicare Advantage plans choose to pay providers discounted charges instead of the lower DRG- or APC-based rates established by Medicare.

Payers can save substantial claims dollars by paying for these out-of-network claims using Medicare’s payment systems.  Medicare inpatient (DRG-based) payment rates are typically 30-35% of charges, representing significantly greater discounts than payers are able to negotiate.  For outpatient claims, rough estimates suggest that using APCs can save Medicare Advantage payers between $300 and $450 per out-of-network claim.  Thus, simply following Medicare Advantage rules can be an important Prospective Payment strategy, applying the risk management benefits wherever possible.

Looking Ahead

MCOs have numerous opportunities to use Prospective Payment systems and methods to maintain a competitive advantage in today’s healthcare environment.  These opportunities range from implementing inpatient and outpatient Prospective Payment systems for commercial populations, to using Prospective Payment techniques to effectively manage charge-based and per-diem payments, to managing DRG- and APC-based payments for out-of-network claims under the Medicare Advantage program.

The largest opportunity for payers is the implementation DRGs and APCs for their commercial contracts.  Because many payers continue to use percent of charge arrangements to pay for hospital services, introducing Prospective Payment methods can lead to immediate reductions in claim liabilities, improve clinical information flow from bills, and create a structure designed to ensure manageable growth in spending over time.  While the commercial use of DRGs is limited primarily by market factors, APCs present significantly greater challenges because of the complexities of the system.

One important advantage of Prospective Payment is the fact that code-based reimbursement creates incentives for more accurate coding and billing.  PPS results in better information about what payers are purchasing and this information can be used, in turn, for network development, medical management, and contracting.

Still, the benefits and opportunities of Prospective Payment systems are becoming increasingly clear to the healthcare industry, and will continue to drive the adaptation of DRGs and APCs to commercial populations.  Both payers and providers will benefit from the more appropriate and efficient alignment of risk that Prospective Payment brings.  The specific methods used – and the extent to which such methods are used directly as the basis for contracting rather than indirectly for the calculation of contractual rates – will depend largely upon market forces and the extent to which payers and providers sharing an understanding and commitment to the principles of Prospective Payment.

Kurt Price, M.S., is Vice President of Reimbursement Management, and Dean Farley, Ph.D., is Vice President of Healthcare Policy and Analysis for HSS, Inc. (www.hssweb.com)

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