William O. Cleverley

Successful hospitals know how to manage both revenue and costs to survive under a tightened Medicare reimbursement structure.


At a Glance 

The Medicare program likely faces restructuring over the long term, but payment mechanics are not expected to change over the short term. As Medicare payment continues to challenge hospitals, providers need to implement effective strategies to survive. A review of hospital Medicare inpatient and outpatient data found that providers that can manage costs and revenue will be successful.   


What's on the healthcare industry horizon in terms of Medicare payment for hospitals? Although much has changed over the past year in the political, economic, and social markets for health care, the underlying payment mechanics and long-term financial trends remain basically unchanged.

Outlook for Medicare Payment

During the 2004 presidential campaign, the two candidates presented two fairly different proposals for dealing with healthcare costs. President Bush espoused the "ownership society" approach, which would place more control and responsibility in the hands of individual consumers. Senator Kerry proposed a program that would rely more on governmental regulation and control. Both candidates were reluctant to discuss reduced benefits in an election year and instead focused more on their alternative methods for providing healthcare benefits in general and Medicare in particular.

The future of the Medicare program is, however, quickly approaching a point when serious restructuring can no longer be postponed or talked around. Practically everyone over 15 years of age realizes that Social Security and Medicare benefits are not a certainty. We have been promising greater benefits than our economy can support for many years. Yet the gravity of the numbers is sometimes lost in the face of more immediate problems of terrorism, employment, and uninsured healthcare coverage. A quote by the Social Security and Medicare boards of trustees in their 2004 Annual Report on the Status of the Social Security and Medicare Programs brings the severity of the situation into focus:

The financial outlook for the Medicare Hospital Insurance (HI) Trust Fund that pays hospital benefits has deteriorated significantly from last year, with annual cash flow deficits beginning this year and expected to grow rapidly after 2010 as baby boomers begin to retire. The growing annual cash deficits will lead to exhaustion in trust fund reserves by 2019. In addition the Medicare Supplementary Medical Insurance (SMI) Trust Fund that pays for physician services and the new prescription drug benefit will require substantial increases over time in both general revenue transfers and premium charges.

How bad is the current situation? The projected present value of required general fund transfers will be financed largely by federal income taxes. No matter how you spin this fact, $61.6 trillion will need to be transferred from the federal budget to make up the difference between benefit payments and premium shortfalls. The passage of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 with its prescription drug benefit (Part D) has added a sizable additional funding requirement. The bottom line is that without benefit reductions, substantial increases in taxes will be required if the federal government keeps its promises to provide Medicare benefits.

Medicare Program Changes

What will the federal government do to solve this impending crisis? The solutions are limited and fairly easy to understand. First, benefits might be cut. Increases in the normal retirement age have already taken place, and further increases are likely. Limiting benefits for wealthier retirees has also been discussed. Some specific program benefits may also be cut even though this strategy usually is not politically attractive. The new drug benefit may be a target as its cost becomes more clearly recognized.

Second, tax increases are also likely. Increases in the Social Security tax base as well as the actual applied rates are both possibilities.

Third, the federal government might also borrow to pay for the costs of the Medicare program. Given the extent of the current national debt and its high percentage of foreign financing, this solution might become harder to do as Medicare funding gaps widen.

Fourth, the federal government may choose to maintain the current benefit structure but reduce payments to providers. This strategy has been used often in the past, to which hospitals and physicians will attest. It is not, however, a viable long-term solution. If the federal government fails to make payments at levels that cover the long-term average cost of providing services, providers will simply opt out of the program or go out of business. Most healthcare policy analysts realize this fact and understand that short-term provider payment reductions are temporary.

From the perspective of the provider, whether hospital or medical group, the optimal operating strategy is crystal clear. To be successful, each provider needs to provide high-quality services at an efficient cost. Organizations that cannot provide value in the marketplace will fall by the wayside, just as they do in every other industry sector. While health care has some unique characteristics, it is not immune to basic economic forces.

Whatever governmental direction is in play in the future-ownership or regulation-there will be a fundamental emphasis on measurable quality of service at efficient cost. The vast majority of Medicare beneficiaries will seek their care through the traditional Medicare program. That program likely will continue to pay hospitals and other providers for Medicare services on a prospective basis. More than likely, a quantitative measure of quality will be introduced that will influence total payment. The present mode of payment for hospital services-DRG for inpatient and APC for outpatient-will probably not change for the foreseeable future. Specific minor variations may occur and have occurred, but the basic payment system will not likely change in any material way. Outlier policies, patient transfer rules, case weights, disproportionate share rules, and local coverage determinations/local medical review policies along with others may be modified, but the overall PPS should remain intact.

What Successful Hospitals Are Doing

A review of hospital data showed how and why some hospitals do better than others under Medicare. All U.S. acute care hospitals were included in the study to discover critical drivers of Medicare profits. The analysis considered inpatient and outpatient data separately.

Inpatient Medicare profit analysis. Data from filed 2002 Medicare cost reports were reviewed for all U.S. acute care hospitals, excluding critical access and sole community provider hospitals and hospitals with less than $1 million in Medicare inpatient payments. After several other minor data edits, the pool of hospitals being reviewed totaled 3,076. This data set then was divided into teaching (971 hospitals) and nonteaching (2,105 hospitals). Medicare inpatient profit was defined as total Medicare inpatient payments from Worksheet E/Part A, excluding direct graduate medical education payments. Medicare inpatient cost was defined as Line 49 from Worksheet D-1. The costs reported here do not include interns and residents. For this reason, direct graduate medical education payments were excluded from the study. Inclusion of this payment without the associated cost would overstate profitability in teaching hospitals.

From this sample of U.S. hospitals, high- and low-profit groups for the teaching and nonteaching data sets were created based upon the quartile in which they fell with respect to Medicare inpatient margin (Medicare inpatient payment less Medicare inpatient cost divided by Medicare inpatient payment). The focus was then directed at the highest and lowest quartiles for the teaching and nonteaching groups.

A comparison of the high-profit and low-profit groups showed that the results are consistent and expected, for the most part. High-profit teaching hospitals are larger and receive much greater payments for outliers, indirect medical education, and disproportionate share than do low-profit teaching hospitals. The high-profit teaching hospitals are also less costly, especially in the provision of ancillary services. Although some may look at these data and conclude that higher profit teaching hospitals have achieved their superior performance through revenue management, especially indirect medical education and disproportionate share, cost efficiency does play a large role in profit. The costs of low-profit teaching hospitals are about 9.5 percent higher than the costs of their high-profit teaching counterparts.

The data for the nonteaching hospitals are similar but with some interesting differences. First, high-profit nonteaching hospitals are slightly smaller than low-profit nonteaching hospitals, and Medicare inpatient payments represent a larger percentage of their total payments, which may explain why they pay closer attention to this segment of their business. As with high-profit teaching hospitals, high-profit nonteaching hospitals derive greater payments from outliers and disproportionate share, although the variation is not quite as large as it was for the teaching hospitals. The real profit driver, however, for nonteaching hospitals is cost. Costs in the high-profit nonteaching hospitals are 22.6 percent lower than they are in the low-profit hospitals. Differences are about equal in both nursing and ancillary areas. Apparently, the high-profit hospitals are simply more efficient in the delivery of services.

Outpatient Medicare profit analysis. Data from the 2003 hospital outpatient PPS data set were used to analyze profit drivers for Medicare outpatient services. Again, the analysis used a high-profit and low-profit subset of all acute care hospitals, removing sole community providers, hospitals with less than $1 million in Medicare outpatient payments, and children's hospitals. Facilities were not divided into teaching and nonteaching categories because payment differentials are not related to teaching status.

The high- and low-profit outpatient groups do not differ significantly with respect to size or teaching status. The high-profit outpatient group has a higher relative weight per visit, which may indicate greater complexity of service. The relative weight is the sum of APC weights plus imputed weights for fee schedule or cost-based procedures performed during the visit. It is clear, however, that Medicare outpatient profitability is almost nonexistent. Even the high-profit group lost an average of $1.81 per visit.

Payment differences are almost nonexistent between the high- and low-profit groups in the outpatient arena. When payment is adjusted for relative weight differences, the high-profit group actually receives 4.3 percent less in payment. Cost is the principal profit driver that leads to higher Medicare outpatient profit. The high-profit group has a cost structure that is 42 percent lower than for the low-profit group on a relative weight-adjusted basis.

What Lies Ahead?

Significant changes in Medicare are likely over the next 20 years as the current wave of baby boomers become Medicare beneficiaries. The nation probably will have to face critical decisions regarding both funding and benefits. More than likely some reduction in benefits coupled with an increase in funding will take place to put Medicare back on a solvent track.

No major changes in provider payment are expected in the foreseeable future, however. The present system of prospective payment for providers, especially hospitals, is expected to continue.

Successful hospitals will be those that can control their costs in increasingly tightened fiscal periods. The data shown here clearly indicate that cost control is already the critical driver of Medicare profit, especially outpatient profit.

Publication Date: Wednesday, December 01, 2004

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