William O. Cleverley and James O. Cleverley

Preparing for future payment policies and practices will require a balancing act involving a broad range of revenue-enhancing strategies.

Hospital executives believe that poor payment is the primary obstacle facing hospitals today, according to a recent Cap-Gemini/Ernst & Young report.a As executives strive to improve the financial standing of their organizations, many wonder what payment policies and practices will become prevalent in the future, and what payment strategies will be critical to enhancing hospital revenue. Although there is no crystal ball in health care, a look at recent trends and influences can provide some answers.

Hospital Market Structure and Driving Forces

Payment or pricing in any industry is largely determined by the underlying market structure. The hospital industry is no exception. Such factors as number of buyers and sellers, barriers to entry, price elasticity, and technology shape the ability of hospital providers to recover their costs and earn reasonable levels of profit.

Regional nature of services. Although mergers, acquisitions, and the creation of large health systems have changed organizational structure, health care is still primarily delivered at the local level. Regionalized care has a profound impact on market structure, and most hospital executives recognize its importance in pricing and payment issues. Market share has been a critical factor in most studies of organization profitability. Although hospital size does not necessarily correlate to success, dominance in the identified market is a key competitive advantage.

Public and private payers. Unlike many other U.S. industries, health care has a limited number of buyers. Most Americans are purchasers of health services, but the majority of health expenditures are made by a limited number of large public or private payers. Medicare and Medicaid represent the bulk of public payment, while private health insurance comprises the largest source of private payment.

Public dollars represent the largest source of payment for hospital services, 58 percent in 2001. It is interesting to note, however, the relative decline in percentage terms since 1998, the year after the Balanced Budget Act was implemented. Projections by CMS in a January 2003 report on national healthcare expenditures forecast stabilization in the public expenditure share until 2010, when the projected level of public financing will be 57 percent.

Medicare alone accounts for 30 percent of all hospital expenditures. For the vast majority of community hospitals, the Medicare percentage is even larger and will likely increase when the first wave of baby boomers turn 65 in 2011. The added fiscal pressure on the Medicare trust funds will have dramatic effects upon hospital and healthcare financing in the United States. Possible responses of the federal government include raising taxes, increasing beneficiary payments for wealthier beneficiaries, reducing benefits, and constraining provider payments. None of these moves will be popular. However, Medicare financing has never been based upon actuarially sound principles, and the day of reckoning is coming.

In the end, although public source payments to hospitals will increase, the relationship of payment to cost will almost certainly be reduced in the years ahead for both Medicare and Medicaid.

Just as public payment is dominated by Medicare and Medicaid, private payment in health care is dominated across the country by a small number of private health plans. CMS reported that the nation's 10 largest managed care firms provide coverage for two-thirds of all managed care enrollees.b This market concentration was created by a wave of managed care mergers and acquisitions in the 1990s-more than 275 merger and acquisition transactions between 1994 and 1999.c The result, of course, is fewer plans for hospitals and employers to negotiate with for health services.

Recent headlines have documented the burden many employers face with regard to escalating healthcare expenses. A fourth consecutive year of double-digit percentage increases in health expenses has prompted many employers to cut costs by shifting a greater portion of expenses to employees and changing covered benefit services.d 

The impact of this cost-shifting to employees has been a continued rise in the number of uninsured. The number of uninsured rose 5.8 percent between 2001 and 2002 and, for 2002, is at 43.6 million Americans. That figure represents 15.2 percent of the U.S. population.e Contributing to the increase has been a decline in the number of people covered by employer-based insurance, possibly because more younger workers are opting out of employer-based coverage because of higher employee contributions. This market dynamic could result in portions of hospital charges being paid by the patient, or some elective hospital procedures being delayed or forgone by patients. Some health policy analysts have already linked current declines in hospital volumes to the declining economy and reduced insurance coverage.

Although hospital mergers and acquisitions increased dramatically during the late 1990s, they have slowed significantly in recent years. The number of hospitals involved in mergers dropped from 323 in 1996 to 101 in 2002-a 69 percent decline.f The merger and acquisition activity left fewer independent facilities and more multihospital health systems, resulting in a few large players controlling many of the largest metropolitan areas in the United States. In many U.S. metropolitan areas, it is common for the vast majority of hospital revenue to be controlled by three hospital systems. This gives these hospital systems added negotiating leverage with large health payers. Additional merger movement on the hospital side is likely to create antitrust scrutiny that may prevent additional consolidation.

Price elasticity. Health care is a highly valued service in our society. Through periods of above-average inflation, consumers still have been relatively willing to incur personal health expenses. Although sustained hyperinflation would be detrimental to the market, consumers have shown that the healthcare market is somewhat inelastic. Limited resources often mean consumers must make choices between options. Recently, this was evident during United Auto Workers contract negotiations with Big Three automakers, in which workers sacrificed wage increases to maintain generous health benefits.g 

Price inelasticity for hospital services helps both providers and health plans achieve prices that may enable a fuller recovery of total costs-including costs not paid for by Medicare, Medicaid, and the large uninsured population. It also seems clear that future prices for hospital and health services will in some way be linked to quality. Some price differential will be accorded to those providers that can substantiate claims of above-average quality.

Shift to outpatient care. The percentage of total gross charges accounted for by outpatient activity was about 35 percent in 2002, up from 32.5 percent in 1997, according to our Medicare cost report database. This percentage probably would be much higher in smaller hospitals, where outpatient revenue is typically larger. Current and foreseeable trends in pharmaceuticals, genomic patterning, imaging enhancements, and a variety of other developments will continue to shift more of the hospital's core business to the ambulatory arena. Some even predict that many hospitals will close as more patient treatment shifts to physician or other clinic settings.

The shift to outpatient care will continue, but don't write off the hospital industry yet. Much of the new technology may be costly and require heavy investment in both human and physical capital. Hospitals are and have always been natural sites for the location of these services. However, hospitals will need to become much more concerned about payment in the outpatient arena, where the bulk of their services most likely will be delivered. In addition, hospital executives should recognize sources of competition other than hospitals.

Barriers to entry. Across the country, states have been waging battles to protect existing hospital market share. The decision by some states to remove certificate-of-need legislation that regulated the building of new healthcare facilities has paved the way for increased competition in many markets. New specialty hospitals threaten to draw profitable business from existing hospitals. Although many state legislatures are responding to this dynamic, the long-term impact is unclear.

Healthcare Payment

Payment mechanisms in health care are perhaps more complex than those of any other U.S. industry. Medicare payment provisions alone require dedicated staffs within hospitals to ensure compliance and billing accuracy. Many private health plan contracts are equally complex. The merits of universal healthcare coverage in the United States are currently being debated, but it is not clear whether universal coverage would imply a single payment system or some other form of payment arrangement. Hospital financial executives must, therefore, master the myriad rules, regulations, and payment provisions that define ultimate levels of revenue.

Framework. Although confusing at times, a basic framework for payment calculation can be simply stated as follows:

Total Payment = Enrollees X Utilization X Price

The price component can be the most difficult to determine.

The ideal arrangement for payers is to pay providers a fixed fee per enrollee-i.e., capitation. This method effectively shifts both utilization and price risk to providers. Conversely, providers would like to see payment based upon billed charges, thereby shifting both utilization and price risk to the payer.

Medicare. No hospital payer has a greater impact than Medicare, which accounts for 40 to 60 percent of total revenue in most adult short-stay U.S. hospitals. Since 1983, Medicare has paid most hospitals on a prospective basis for inpatient services, using a DRG methodology. In 2000, Medicare introduced APCs, effectively putting payment for outpatient services on a prospective basis. We expect these two Medicare payment methods to change little in the years ahead. The lesson is simple: coding and billing are, and will continue to be, critical to accurate payment from Medicare.

Medicare payment methods also affect other payers. For example, in the years ahead, many plans will likely shift to payment methods that originated with Medicare, such as APCs.

Private insurance. Most contracts pay hospitals on a fixed-fee basis, either per diem or case-related, for inpatient services. Many of these contracts have outlier thresholds that provide additional payment on a charge-related basis when the thresholds are exceeded.

We have noted a movement toward more percentage-of-charge payment methods for inpatient care, usually combined with price increase limits. Outpatient payment is much more likely to be on a percentage-of-charge basis, especially for nonsurgical procedures. We have noted a slight movement toward additional percentage-of-charge arrangements in the outpatient arena, as well.

Strategies for Revenue Enhancement

The picture painted of present and expected hospital payment need not be doom-and-gloom. One thing appears certain: well-managed, progressive-thinking organizations will succeed, and those with less creativity and innovation will either fail or be acquired.

Below are a few especially important strategies for hospitals as they deal with payment issues in the future.

Negotiate more favorable contract terms with payers. Ideally, this means setting payment terms that cover both the cost of doing business with that payer and deficiencies from government and uninsured patients. Anything less than these terms indicates that you will likely be eating into your capital reserves and creating enormous financial hardships for the organization.

A percentage-of-charge methodology for both inpatient and outpatient services makes the most sense. It should also simplify contract administration by removing some of the complex carve-outs, outliers, and other provisions. It is reasonable for the health plan to expect an annual price limitation restriction similar to the provision in many current contracts, but it is not reasonable to have that limit related to medical care inflation. The price restriction should be related to a price index that is based upon hospital charges, not net payments.

Ensure accurate payment. Frequently, payment is less than indicated by contract terms, even in hospitals that have sophisticated contract management systems in place. Many contracts are very complex, and their details may not be accurately reflected in contract management systems. Annual audits of claims payments by an outside party may help hospital executives identify the scope and magnitude of potential payment issues.

Improve coding and billing practices. Much present-day hospital payment is linked to accurate coding and billing. For example, failing to code respiratory failure as the principal diagnosis on a Medicare patient placed on a ventilator may mean a loss of $13,000 if the case is categorized as DRG 127, rather than DRG 475. The importance of accurate coding and billing cannot be overstated.

Examine pricing policies. Setting prices that do not cover the hospital's full "reasonable" costs, including a capital allowance, results only in shifting the economic burden of health care to the next generation of patients. In establishing price levels, healthcare financial managers should recognize similar hospitals with different payer mix should have different pricing. For example, hospitals with heavy percentages of Medicaid and uninsured patients must have higher prices to recover losses on those segments of business, unless there is some form of public or tax support to subsidize the payment/cost difference. In short, your overall price structure should be based on principle, not on public pressure.

A wide range of factors will have an impact on payment for hospitals and healthcare systems in the future. But an emphasis on revenue-enhancing strategies such as accuracy in coding, awareness of nonhospital competition, appropriate pricing, and astute contract management can help hospitals gain and maintain firm financial footing. Stay tuned.

William O. Cleverley, PhD, is president, Cleverley & Associates, Worthington, Ohio, and a member of HFMA's Central Ohio Chapter.

James O. Cleverley is a graduate student at The Ohio State University, Columbus.

Questions or comments about this article may be sent to William Cleverley at bcleverley@cleverleyassociates.com


a. "Top Hospital Executives Identify Leading Trends," PR Newswire, May 2002.

b. Trends & Indicators in the Changing Health Care Marketplace, 2002-Chartbook, Baltimore: CMS.

c. "Consolidations Running Rampant among Managed Care Companies." Health Industry Today, August 1999.

d. Fuhrmans, Vanessa, "Health-Care Costs to Rise in 2004." Wall Street Journal, September 29, 2003, p. A6.

e. Schaefer, Sara, and McGinley, Laurie, "Number of Americans without Health Coverage Rises, " Wall Street Journal, September 30, 2003, p. B1.

f. "U.S. Hospital Mergers Hit Record High in '97," BBI Newsletter, June 1998; and "Hospital M&A Activity Falls in 2002," hfm, May, 2003.

g. Hawkins Jr., Lee, and Freeman, Sholnn, "UAW Gives Priority to Health Care," Wall Street Journal, September 17, 2003.

Publication Date: Monday, December 01, 2003

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