Gwyn Davidson
Jim Pettersson

At a Glance 

Hospitals can prepare for APC-based systems by: 

  • Paying close attention to the modifications that state payers make to Medicare's APC policies 
  • Proactively monitoring and adjusting billing practices to be as consistent with the state payers' APC billing requirements as possible, even if the billing requirements have no effect on current payments for services 
  • Analyzing the ways in which state payer APC policies vary 
  • from Medicare to anticipate the impact of these systems on their hospitals' operations and financial condition 

Hospitals now face a second wave of payment systems based on Medicare's ambulatory payment classifications as more and more state payers piggy-back on the success of this system.

Medicare's implementation of an APC-based outpatient prospective payment system in 2000-and the adoption of this system by many private payers-has dramatically changed the way hospitals are paid for services.

Just as state payers initially were slow to adopt Medicare's inpatient diagnosis-related groups and resource-based relative value scale, they also have waited to gauge the success of Medicare's outpatient payment methodology before beginning their own implementations. To date, Medicaid agencies in Minnesota, Montana, Washington, and Wyoming have implemented APC-based systems for their fee-for-service populations. So have groups such as West Virginia's Public Employees Insurance Agency and Children's Health Insurance Program and Washington's Department of Labor & Industries and Public Employees Benefits Board. Other state agencies, such as the Medicaid program in Michigan, are not far behind. Managed care organizations that contract to provide services as part of Medicaid managed care programs also may decide to use APC-based systems.

To effectively prepare for this second wave of APC-based payment systems, hospital CFOs must proactively assess and update their hospital billing systems to record services with the detail required by APC-based systems. CFOs also must carefully analyze the ways in which state payer APC policies vary from Medicare to anticipate the impact of these systems on their hospitals' operations and financial condition.

Comparing Medicare and State Payer APCs

For state payers, implementation of an APC-based payment system allows for a greater level of consistency with Medicare's outpatient hospital payment incentives and billing requirements. It also results in payments that more closely reflect the resources associated with particular services.

Although state payers generally follow Medicare's APC methodology, payer-specific concerns and legislative or regulatory requirements result in subtle-and not-so-subtle-differences. These differences are reflected in variations in hospital payment levels.

There are a number of reasons that payment levels vary between Medicare and state payer APC systems, including differences in methods used to calculate conversion factors and the identification of relative weights. For example, Medicare uses one standard conversion factor, which is updated annually and adjusted by hospital for geographic differences. State payers, on the other hand, employ a wide variety of conversion factor strategies that range from hospital-specific conversion factors to a single, statewide conversion factor. Washington's Department of Labor and Industries, for example, uses hospital-specific conversion factors that are a blend of both hospital and statewide rates. Montana Medicaid uses a single, state-specific conversion factor for all hospitals, while Washington's Medical Assistance Administration (Medicaid) used 0.858 percent of Medicare's CY05 conversion factor, effective July 1, 2005.

Although state payers have the option of developing state-specific relative weights based on their claims experience, relative weight calculations and the periodic maintenance of relative weights are complicated and resource-intensive, and significant volumes of historical data are required to produce stable relative weight values over time for all APCs. For these and other reasons, state payers, to date, have used Medicare's APC relative weights, although Minnesota Medicaid has considered developing its own relative weights (State of Minnesota, Minnesota Health Care Program Provider Bulletin Update #79, April 9, 2001). However, hospitals should be aware of the timeline for updating relative weights in their state, as state payers do not always follow Medicare's timing for relative weight updates

Different Rules for Different Providers

The inclusion or exclusion of certain providers from APC-based payment is largely driven by state- or program-specific characteristics. For example, Medicaid agencies may rely on out-of-state border hospitals to meet federal access to care requirements for Medicaid beneficiaries living in these areas. Therefore, even though a hospital may not be located within a state, it may still be subject to that state's APC payment system.

The complexity of APC systems increases when different state payers within the same state choose to include or exclude the same provider. For example, in Washington, the state's Department of Labor and Industries and its Public Employees Benefits Board exclude out-of-state hospitals from its APC-based systems, while Washington Medicaid treats border hospitals as in-state providers for payment purposes. Some state payers follow Medicare and, as such, exclude children's hospitals and critical access hospitals from their APC-based systems. Other states take a different approach. Minnesota Medicaid, for example, includes children's hospitals in its payment system, while Wyoming Medicaid's system includes critical access hospitals. Hospitals should be aware of how their hospital type would be treated by each state payer under an APC-based payment system, as payment methodologies will vary accordingly. 

Coverage for Services Varies

Due to differences in covered populations and federal requirements, Medicare and state payers cover different services, resulting in variations in payment levels for the same service. For example, while some state payers, such as Minnesota Medicaid, do not restrict payment for certain services in an inpatient setting, others, such as Montana Medicaid, use Medicare's "inpatient only" list of services. Similarly, state payers also may vary from Medicare in the way in which they pay for outpatient hospital services that are not bundled into APCs, including clinical laboratory services. They may adopt Medicare's fee schedules, employ preexisting state fee schedules, or create new fee schedules.

Although Medicare makes outlier payments for outpatient cases that require significantly more resources than do typical cases, state payers do not always adopt this practice. This is due in part to the complexity of outlier payment calculations as well as questions raised by the Medicare Payment Advisory Commission, which advises Congress on Medicare issues, regarding the appropriateness of outlier payments and the need for such payments. Minnesota Medicaid, for example, does not make outlier payments, while the West Virginia Public Employees Insurance Agency follows Medicare's outlier calculations and guidelines. Hospitals should be aware of state payers' outlier policies and the effect that these policies may have on payment levels based on a hospital's specific mix of outpatient hospital services.

Compensation for observation services also varies between Medicare and state APC-based payment systems. Medicare allows only for a separate observation services payment when an outpatient hospital service is related to specific asthma or heart diagnoses. However, state payers may expand the list of qualifying diagnoses to take into consideration the unique attributes of their beneficiary populations-which may result in additional observation service payments. For example, Montana and Wyoming Medicaid have added diagnoses for obstetric complications, reflecting the high proportion of pregnant women in the Medicaid population. Washington Medicaid expands Medicare's policy even further by not applying Medicare's observation diagnosis list or diagnostic test requirements at all.

When expanding on Medicare's observation services policy, state payers will need to decide whether they, like Medicare, will allow only for separate observation service payment when claims with qualifying diagnoses are associated with at least eight hours of observation. For some obstetric diagnoses, for example, a typical length of stay may be less than eight hours, and using an eight-hour unit "floor" may reduce hospital payment for these services.

Unit Limitations

Medicare's APC system relies on unit billing that is consistent with procedure code definitions and Medicare's specific billing requirements. Over time, Medicare has developed different unit maximums in its APC grouping software. State payers may choose either to use these unit maximums or to rely on preestablished unit maximums that reflect their billing review experiences. Since APC payment is unit-driven, it is critical that the way hospitals bill units of service be consistent with procedure code definitions, and that patient billing staff understand the unit maximums used by both Medicare and state payers.

The Need to Assess Hospital Billing

Knowing how state payers' APC payment policies vary from Medicare's policies will help providers more accurately predict payments under new state payment systems. Regardless of the degree of variation, however, billing accurately, and in as much detail as possible-especially before APC implementation by state payers-is key.

APC-based payment relies on detailed billing. Missing or inaccurately recorded information causes claims to be returned to hospitals, which not only creates compliance and cash flow issues for providers, but also has important implications for the development of APC-based systems by state payers. State payers generally use recent historical claims data to develop payment rates for their APC-based systems, and in some cases, they must make claims processing system changes to retain all of the data fields needed for APC-modeling purposes.

The payment methodologies currently used by state payers may be less complex than Medicare's APC-based system. As a result, state payer billing requirements may not be as detailed as Medicare's requirements, and even if they are, hospitals may not follow these requirements closely if they are not tied to the current payment methodology. However, because state payers will use these historical data for rate modeling purposes, it is critical that hospitals bill for outpatient hospital services using as much detail as possible even before an APC-based system is implemented.

Planning Ahead

Hospitals should be particularly proactive in responding to state payer changes in billing requirements, as state payers will likely require hospitals to modify their billing practices in advance of their APC rate modeling and implementation. Although payment systems often evolve over time, fewer postimplementation changes will be necessary if the claims data submitted by hospitals are consistent in all respects with the state payer's billing requirements.

Gwyn Davidson is an associate director, Navigant Consulting, Inc., Health Care Practice (

Jim Pettersson is a director, Navigant Consulting, Inc., Health Care Practice (

The authors would like to thank Greta S. Tam, a 2005 summer associate at Navigant Consulting, Inc., for her research assistance.

Publication Date: Wednesday, February 01, 2006

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