The Issue

With the increasing participation of healthcare providers in accountable care organizations (ACOs) under the Medicare ACO demonstration and in similar arrangements with commercial payers, the trend toward population-based health care appears to have gathered significant momentum. And with this trend, the healthcare industry is essentially again adopting capitation as a primary method of payment. This trend applies not only to Medicare payment but also to commercial payment as private insurers follow Medicare's lead. For hospitals and most other providers, it will require a fundamental change in organizational business models and attention to many new factors, including financial incentives, terminology, metrics, and management paradigms.

Because the move from fee-for-service to population-based health care will be gradual, these providers will need to deal with conflicting incentives throughout the transition period, and probably indefinitely. Failure to understand and manage these conflicting incentives was a primary cause of the failures of capitation during the 1990s. In the present healthcare climate, however, providers that cannot adapt may end up being the casualties rather than the payment methodology.


Under a population-based healthcare model, a specific patient population is assigned in some way to an entity that functions as the contracting organization, which will receive capitated payment for the services delivered to the population's members. It also is essential that the contracting organization be capable of functioning under the capitated payment methodology, which means there must be some way to associate the specific population with the entity, and only that entity, for specific types of service.

The basic premise of the population health model is that payment is based on the delivery, or potential delivery, of care to a specific large set of individuals identified as being members of the population that the provider serves. This population includes not only the provider's patients (i.e., those individuals who are actively seeking medical care from the provider), but also healthy individuals who are not actively seeking care. Defining this population is not a straightforward matter: Although members is the commonly used term for the individuals composing the population, these individuals may not be actual members of any specific group, and may even be unaware that they belong to the specific capitated population.

Understanding the details of how members are assigned to the population is important to a contracting organization because those members represent the underlying volume of that organization's business.

In addition, capitation works well only when it involves a single capitated entity providing a specific type of service to patients. Primary care physicians are capitated only for primary care services, for example. It would not work, on the other hand, for two physical therapy providers to be capitated for the same patient population, because patients could choose to receive services from only one of the providers, which would leave the more-often-selected provider undercompensated and the other overcompensated.

Capitation also poses problems with certain provider types-for example, in those instances where members typically expect to have a choice of provider. A hospital could be capitated for
certain services, for example, only if all members were required to use that hospital for all the covered hospital services.

Typically, therefore, organizations delivering population-based health services and receiving capitation payments are organized to include a wide range of providers such that the members have the freedom to choose providers as allowed by their type of insurance.

Action Steps for Providers

The steps to success under a population-based healthcare payment system revolve around three primary areas of concern.

Understanding the interrelationships between the financial statements of the providers under the population-based system and the contracting organization in terms of revenue, expense, and assets and liabilities. Unlike in a fee-for-service payment system, revenue under a population-based model is based on the size of the covered population, without regard for the services provided, as well as on the payment rate per member per month (PMPM).

Understanding expenses for a contracting organization requires a conscious effort to separate that organization from the providers that constitute it. This separation is particularly important when the contracting organization is itself a provider, such as in a hospital-sponsored physician-hospital organization. The distinction is important because payments (i.e., revenue) to providers are an expense to the contracting organization. And because most providers are paid on a fee-for-service basis, utilization of their services creates a cost to the contracting organization.
This is the most critical paradigm shift for hospital leaders. Under fee-for-service payment, increases in utilization are good; they generally increase hospital revenue. But under capitated payment, those increases in hospital revenue are generally countered by corresponding increases in expenses to the contracting organization.

Developing entirely new metrics based on members rather than patients. Although the typical "per patient day" and "per admission" metrics will still have their place in hospital management, the primary metrics for a contracting organization are denominated by member months.

Member months are computed by counting the number of members assigned to the contracting organization in each month of the metric. And the number of member months in the year is computed by summing the number of members in each of the 12 months. Thus, a critical metric for a contracting organization is "amount paid PMPM" which refers to total payments to all providers during a specific period (which need not be a month), divided by the number of member months in that period. This amount can be stratified by different cost categories-for
example as "inpatient cost PMPM."

Adjusting for risk by quantifying the relative costs of the particular population based on its medical and demographic conditions. A "risk adjustment" is typically used to adjust capitation payment rates to account for differences between the populations that provided the bases for computing payment rates and the populations to which the rates are applied. For example, if a contracting organization had a higher-than-average percentage of diabetic patients, its risk-adjustment factors should reflect that difference.

Risk factors are helpful to contracting organizations in several ways. First, when comparing PMPM costs with the associated risk factors, organizations should find a rough correlation between the patient's cost and their associated risk factor. It is intuitive that the extreme values of cost and risk factors should bear some relationship to each other, simply because sick patients are generally costly. High costs but low risk scores for a patient may indicate inappropriate or unnecessary treatment for relatively uncomplicated patient, whereas higher risk scores accompanied by low costs may indicate a patient with critical medical conditions who is being undertreated.

In addition, the risk-scoring process itself identifies patients having the most common chronic conditions, such as diabetes, chronic obstructive pulmonary disease, and asthma. Identifying these patients and targeting them for special treatment is a key component of any population-based health system. Analytics that incorporate risk scores are critical for population health management.

The financial incentives, metrics, and accounting components associated with population-based health care differ significantly from those of traditional healthcare systems that are based on fee-for-service payment. Leaders of organizations pursing capitated strategies should grasp the underlying differences between these components and apply them in managing their organizations. 

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Publication Date: Sunday, July 01, 2012

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