At a Glance  

  • Today's pure production-based compensation and incentive models are lagging behind new, third-party, "value based" payment models, such as shared savings, bundled payments, and pay for performance.
  • Financial executives are struggling with the emerging disconnects between new, external payment models and traditional methods providers use to distribute funds internally.
  • To begin to align internal payment models with emerging third-party payment models, providers should inventory the misaligned incentives within their own organizations, engage their physicians and payers in a dialogue on what needs to be paid and how, and learn from past mistakes.
  • No perfect payment distribution model exists. Rather, providers should choose a best-fit model based on their market position, culture, and readiness for change.
  • Ultimately, finance executives should take the lead in aligning their organization's internal and external payment models.

Providers should take the lead to align their organization's internal and external payment models with the basic tenets of payment reform.

Providers of all sizes are exploring a variety of new third-party payment models with public and private payers. These models have significant implications not just for providers' revenue streams, but also for how they structure physician compensation and incentives.

Mindful of this proliferation of new payment models, providers will need to be much more assertive and selective about how and what they want to be paid by CMS and commercial payers. The days of automatic 6 to 8 percent commercial rate increases are numbered.

Likewise, providers will need to be more deliberate about how they move beyond traditional compensation and incentive formulas that reward only physician production and tenure. For example, providers will need to explore new models that specify minimum performance standards, penalize noncompliance with standards, and reward results related to service, access, satisfaction, and efficiency improvements.

They also should ask a number of internal and external payment design questions:

  • What are the organization's ultimate performance-improvement metrics and goals, by service, provider, group, and population?
  • Where do current incentives get in the way of these goals?
  • What is the base salary target for physicians (e.g., 80 percent of the market median)?
  • What is the maximum upside bonus versus downside risk potential (e.g., 0 to 25 percent of market median salary)?
  • How should internal and external payment models align so that income isn't simply redistributed to politically powerful stakeholders, but instead results in improved patient quality, service, and affordability?
  • What direct investments will be made in infrastructure, data, and care management to improve practice efficiency (e.g., $100,000/physician)?
  • What are the bonus distribution percentages (e.g., 67 percent to primary care, 33 percent to specialists)?

This new mindset is a far cry from the current purely production-based compensation and incentive practices summarized in Exhibit 1.

Finance, managed care, clinical improvement, and physician executives will play pivotal roles in aligning their third-party contract terms with internal compensation, bonus, and loss distribution models. Unfortunately, there is no instruction manual or tool to automatically align external and internal payment models.

So to assist finance, managed care, clinical improvement, and physician executives in their journey, we tackle three of the more common questions we observe as providers transition from a volume-based payment system to a value-based payment system:

  • What problems are arising with compensation and incentive models as third-party managed care contracts become more performance-based?
  • What types of internal and external payment alignment models are working and where?
  • What are some early lessons learned from organizations on the cutting edge of new payment models?

External and Internal Payment Models: Emerging Problems

At least three tangible problems are emerging with internal compensation and incentive models as third-party contracts become more performance-based: insufficient funding sources, inadequate incentive levels, and a focus that considers compensation before patient concerns.

Insufficient funding sources. Many of the nation's largest health systems and hospitals are compensating physicians at above-market rates. These large systems have been able to pay above-market rates because they have negotiated above-market commercial payment rates with private payers. But as payers and regulators begin to reduce unit payment on high-margin imaging, procedural, and lab services and scrutinize hospital directorship and management fees to physicians, the funding sources for physician compensation and incentives are expected to stagnate, if not decrease. Consequently, hospitals and physicians should acknowledge the potential for fewer dollars and the need to evolve their approach to compensation and incentives.

Inadequate incentive levels. How much incentive is enough to change hospital and physician behavior? Historically, researchers have reported that physicians experienced less conflict of interest when less than 10 percent of their incomes was at risk of not materializing. When more than 20 percent of physician incomes was at risk, the conflict of interest was greater. In between 10 and 20 percent, experience was mixed (Pearson, S.D., Sabin, J.E., and Emmanuel, E.J., "Ethical Guidelines for Physician Compensation Based on Capitation," New England Journal of Medicine, Sept. 3, 1998). Recent research shows that a small percentage (generally 0 to 5 percent) of physician incomes is at risk for quality and service performance under most providers' current internal compensation and incentive arrangements. However, the same research indicates most large health systems envision that 10 to 20 percent of physician incentives will be at risk in the future. So in addition to acknowledging the compensation funding gap, providers need to rethink how much incentive will be necessary to influence behavior change in their organization. For one recent multispecialty group, a $20,000 to $30,000 annual bonus potential for each primary care physician, coupled with a payer-direct investment in physician practice variation reports and a case manager, was critical to achieving that organization's goals.

Exhibit 1


Focus that considers compensation before patient concerns. Patients' interests can become secondary issues during controversial, politically charged managed care, compensation, and incentive alignment negotiations. Consequently, pure production-based compensation and incentive models (e.g., ones paid on relative value units the physician produces) still thrive today, that reward any volume, regardless of whether care is necessary or avoidable and regardless of the impact on patient out-of-pocket cost sharing. Providers can make matters worse by negotiating the greatest payment increases on services they expect to generate the most volume growth, regardless of whether such growth is clinically necessary. Furthermore, most incentive and bonus dollars are typically distributed to hospitals and physicians, not to patients. Only a few organizations surveyed transparently invest a portion of their bonuses in programs that improve future access, efficiency, and service. Consequently, underlying performance improvements may not be sustained, costs escalate after small decreases, and patients foot a larger percentage of their ever increasing bills.

So mindful of emerging third-party payment models and their inherent disconnects, providers need to devise a strategy to align their internal compensation, incentive, and investment models with emerging, value-based contracting terms. Unfortunately, many providers are opting for a standard approach to resolve a short-term emergency without a thoughtful analysis of market competitors, immediate priorities, and long-term goals. Considerable caution and time are necessary as providers attempt to align their internal compensation, incentive, and investment models with emerging third-party payment models.

Payment Alignment Models: 3 Examples

There are several internal/external payment alignment models worth considering, but the three described here represent the more common models. Hospitals and health systems should choose the model that works best for them given their competitors, market position (e.g., size, specialization), and readiness for change.

Payment alignment model 1. The "let's own it all" payment alignment model is a rare breed. Few providers own their own multispecialty physician practice and health plan, but the ones that do control their cash flow, referral channels, and underlying risks. Provider-led integrated delivery systems with a relentless focus on reducing avoidable unit costs and utilization within specific patient populations use simple and elegant compensation and incentive models.

Their incentives are rooted in ongoing analytics that track avoidable costs (e.g., excessive, risk-adjusted drug or procedural spend) by specific primary care physicians, specialists, and patients. Their compensation and incentive models are managed centrally and tied closely to the organization's go-to-market strategy (e.g., reward top-performing physicians who improve access and grow underserved segments). Their models link directly to their long-term operating and capital budget as well, so that compensation, incentive, and risk pools are properly funded. Finally, the close-knit culture of these organizations permits them to penalize and/or eliminate underperforming providers who are not achieving minimum performance standards.

Payment alignment model 2. In this model, a single, large provider partners with a large payer to implement third-party payment terms, including pay for performance, bundles, and partial capitation arrangements. About half of the arrangements are designed to grow patients/membership at competitors' expense (e.g., expand into a new geography or patient population with a branded health plan and physician group). Where a payer and provider can jointly enter a new market with a higher quality, lower cost product that doesn't simply shift more costs to patients, the payer, providers, employers, and patients can win.

All parties can win because new volume growth can fund deep compensation and incentive pools that can (for a time) make up for lackluster improvements in underlying overuse and misuse of resources. Over time, though, the new volume potential will decrease. If payers and providers fail to reinvest savings from "low-hanging fruit" (e.g., reductions in excessive emergency department [ED] use or high brand-name prescription use) early in their arrangement, cost savings and compensation and bonus pools evaporate quickly. So ignoring the need to invest some of the bonus up front becomes a major problem for these types of arrangements.

Payment alignment model 3. In this model, several independent providers partner with each other to design a high-performing network, payment model, and payment distribution model in conjunction with a large payer. The independent providers tend to operate in highly fragmented markets, where a series of smaller hospitals, physician groups, and independent practice associations can come together only through a full merger or acquisition. These models have the most complexity by design, because they rely on a series of management contracts that cover medical management, analytic services, facility rental, and other activities. Despite their inherent complexity, they are also vehicles payers desire to begin to integrate and align historically fragmented parties to improve performance that independent parties cannot achieve on their own.

One common evolution path is for providers (rather than payers) to initiate the creation of these high-performing networks. Then the networks contract with one or two payers and provide medical management services to specific payer subpopulations in return for a PMPM fee, fee schedule bonus (e.g., 10 percent), and/or direct investment (e.g., in health information exchange technology, which allows disparate providers to track referral and utilization patterns). Over time, these high-performing networks become strategic assets for payers that cultivate them. In return, providers benefit from a payer-funded, shared savings pool and/or volume steerage away from competitors that do not participate in the high-performance network. In these models in particular, the payment alignment model requires a stable, physician-led governing body across disparate providers to practice by fundamental performance and payment principles (e.g., evolve into risk, build in early wins, raise the bar). The actual payment distribution formulas vary, but tend to reward primary care rather heavily at first. Over time, the payment distribution and investment approach focuses on rewarding reductions in excessive specialty and hospital utilization through the use of the highest performing providers.

Exhibit 2


The exhibit above summarizes key similarities and differences among the three payment alignment models profiled here.

Payment Alignment Models: Early Lessons Learned

The three payment alignment models underscore a few key takeaways for health systems as they design internal and external payment models that achieve the Institute for Healthcare Improvement's Triple Aim goals of improving population health, enhancing the patient experience, and reducing costs in an increasingly competitive environment.

Strategic foundation. The health systems should ensure that the payment alignment model supports its broader competitive strategy. The best payment models are not the ones with the most sophisticated math formulas. Nor are the best payment models the ones that drive the highest compensation levels to providers. The best payment models align internal incentives with what the market values, and in so doing drive both top-line and bottom-line improvements, as well as overall population health. Top-line improvements come from several sources, including preferential unit payment increases, shared savings, bonuses, and selective steerage/volume gains, particularly from historically underserved areas. Bottom-line improvements come from reductions in avoidable input unit costs (e.g., paying too much for particular supplies) and avoidable resource consumption/waste (e.g., excessive imaging and lab services associated with ED services). Health systems should not be enticed by large one-time-only bonus pools or cash infusions that reward the organization for nothing in particular.

Data-driven design. Health systems should demand detailed claims data from payers and partner with them to perform analytics. They should benchmark unit payment, utilization, and input costs by patient population, not just by hospital or physician practice. Credibility and trust with participating physicians should be built by using fair market valuation techniques to benchmark and establish internal and external payments. Furthermore, payers should be wary of designing payment models that lavishly reward individual physicians with bonuses in the high five to low six figures for simply reducing bed days and/or admissions, but not improving underlying health conditions.

Get the right team behind a deliberate change management plan. The most successful payment alignment models are being designed by integrated teams consisting of finance, clinical improvement, and physician practice staff. These staff members understand the underlying financial, clinical, and operational barriers at their organizations and are well positioned to provide input into a three- to five-year change management plan, which incorporates:

  • Updates to the health system's strategic capital plan to reflect market payment and compensation rates, as well as future performance-improvement initiatives required to maintain current margins
  • A road map that outlines which incentives and investments need to change to drive performance
  • A list of "early wins," including patient- centered medical homes, high-performance managed care networks, individualized patient care plans, and cost-effective risk adjustment techniques

Finance Should Lead

All the talk about payment reform, payment reductions, bundling, and shared savings strikes a profoundly personal note when these changes translate into compensation and incentive changes. Providers will need to be much more deliberate in how they align their external managed care contracting approaches and internal compensation and incentive approaches. This article provides a few key insights into what is working and what is not working today. Ultimately, no perfect model exists. Rather, finance executives will need to take a lead role in aligning their organization's external and internal payment models.

Michael E. Nugent, CHFP, is a managing director, provider and payer strategy practice, Navigant Consulting, Inc., Chicago, and a member of HFMA's First Illinois Chapter.


Emerging Performance-Based Payment Models 

Both the Centers for Medicare & Medicaid Services (CMS), with the issuance of the Medicare Bundled Payments for Care Improvement Initiative, and commercial payers are exploring performance-based payment models that involve, to a great extent, bundled payments.

Commercial Payers

Among the emerging payment models used with commercial payers, such as Blue Cross and Blue Shield plans, are:

  • Advanced pay-for-performance models that tie providers' pay raises and bonuses to achieving efficiency goals
  • Bundled facility and professional payment models for acute inpatient care
  • Bundled payment models for care of chronic conditions across the inpatient and outpatient spectrum

Advanced "pay-for-performance" models. In these models, payers tie providers' future pay raises and/or bonuses to performance metrics. These metrics have been evolving beyond traditional process metrics (e.g., vaccination rates) to efficiency-oriented metrics (e.g., generic prescribing rate, readmission rate, and expected versus actual expenditures), which all but guarantee some reduction in utilization and/or unit cost for the payer. If providers fail to achieve the negotiated performance improvements, they will leave money on the table. It's not uncommon for providers to leave up to 50 percent of the bonus potential on the table, depending on the metrics they negotiate with payers.

Facility and professional bundled payment for acute inpatient services, including hearts, hips, knees, and backs. Providers are expending significant effort to design inpatient payment bundles in response to requests from CMS and commercial payers. These bundles combine hospital and physician reimbursement into one payment to cover services within some time span before and/or after the admission. Hospitals use these bundles to attract physician referrals by sharing cost savings (e.g., supply standardization savings) and utilization savings (e.g., reductions in unnecessary days or steerage of patients to lower cost sites of care) with physicians who use the hospital the most. But hospitals are struggling with whether and how to align their physician compensation and incentive programs with these new bundled payment options.

Bundled payment for chronic conditions. Payers and providers are also exploring bundled payment for chronic conditions, such as diabetes and asthma. These payer-provider payment arrangements typically cover cross-continuum, care management services for specific, high-cost chronically ill populations. Examples include a $40 to $50 per patient per month (PMPM) case management fee for primary care services and nurse care management services, plus additional fee-for-service payments for comprehensive, periodic check-ups. Providers are looking for ways to integrate these payments into their compensation and incentive plans.

Medicare Bundled Payments for Care Improvement Initiative

The four payment models announced by CMS in August only accelerate providers' interest in bundling, because these payment arrangements permit hospitals that CMS selects to share savings with employed and/or affiliated physicians.

Model 1. Hospitals commit to a 2 to 3 percent inpatient facility, across-the-board discount in all diagnosis-related groups (DRGs) for the opportunity to share unit cost and utilization savings with their physicians, who continue to be paid on a traditional fee-for-service schedule.

Model 2. Hospitals agree to a 2 to 3 percent inpatient facility discount tied to specific DRGs (e.g., cardiac) and follow-up care within a 30-, 60-, or 90-day window postdischarge.

Model 3. Providers agree to a small discount for postacute care only, associated with specific DRGs, to help drive delivery innovations postdischarge where savings potential is significant.
Model 4. Hospitals and physicians jointly agree to a prospective, 3 percent or greater discount rate off current rates for select DRGs. The contracting hospital receives a check from CMS and distributes the fees among participating physicians in accordance with performance-based criteria.

Publication Date: Tuesday, November 01, 2011

Login Required

If you are an existing member, please log in below. Username and password are required.



Forgot User Name?
Forgot Password?

If you are not an HFMA member and would like to access portions of our content for 30 days, please fill out the following.

First Name:

Last Name:


   Become an HFMA member instead