Risk Management

4 common misconceptions about observation that have revenue implications 

September 28, 2023 3:18 pm

Among the many things that healthcare providers must document, few are as misunderstood and cause as much confusion as observation. Clearly, observation is often required as part of diagnosing and treating a disease or condition. The challenge for providers is that ambiguity and variability in regulatory and contract language create confusion regarding how to record observation services for the clinical record and proper payment. It therefore is imperative that clinicians understand how they should document observation so it can be appropriately billed or designated as uncompensated care.

Misconceptions that can result in reduced payment or denials

To be able to knowledgeably promote such understanding among clinicians, healthcare finance managers should be aware of four common misconceptions regarding observation services, and the often-over-looked facts that reflect the realities of such services.

Misconception 1: Observation is a status. In fact, observation is a service that requires medical necessity for the care provided, and it is not to be influenced by external factors. Outpatients receive observation services only when monitoring and testing in the hospital is clinically appropriate. The service designation does not apply to situations where patients are hospitalized without medical necessity or for convenience, which includes extending an outpatient stay because a service is not available on a weekend or because it is deemed to be too late in the day to discharge the patient. Coding and billing such services as observation services is erroneous.

To track such hours, and to enable the hospital to bill the patient if appropriate, the services should be documented under HCPCS code A9270 with revenue code 0760, with an indication that the patient is receiving custodial care.

Action steps. Hospitals should track the use of services like observation, but that lack clinical appropriateness, using the A9270 code to quantify how much unreimbursed care is provided, to avoid submitting improper claims and to determine how to minimize this practice.

Misconception 2:  A national average observation and inpatient payment rate can be used for determining payment. In fact, payment is based on factors unique to each organization and should not be solely based on national average rates.

For Medicare, many outpatient stays with observation services are paid under a comprehensive ambulatory payment classification (APC). The base payment rate in 2023 is $2,439.02, but only hospitals with a wage index of 1.0 qualify for that payment rate. As with all outpatient services, 60% of the APC is adjusted by the wage index. Thus, for example, under Medicare, a hospital in San Francisco will be paid $3,719 for observation services, whereas a hospital in Clarksdale, Mississippi, will be paid $2,132.

There is even more variability in Medicare inpatient admission payment, even for the same DRG. For a major teaching hospital in San Francisco, an admission for DRG 293, heart failure without a CC or MCC — a common diagnosis that is treated both as inpatient and outpatient with observation services — would be paid $10,654, whereas for a community hospital in Mississippi without a teaching program, the rate would be $5,506.

It is crucial to remember that in addition to payments for inpatient admissions, hospitals receive only indirect medical education, disproportionate share hospital and uncompensated care payments with inpatient admissions. They are not paid for outpatient services, which is how observation services are defined. Moreover, CMS does not make any effort to ensure hospitals receive all such additional payments that are due to them at the end of the year.

Payment for a hospital’s patients with Medicare Advantage (MA), Managed Medicaid or other non-Medicare coverage will be determined by the hospital’s contract with each payer. Although rare, there are contracts that pay for outpatient care as a percentage of charges. In such cases, a hospital may actually be paid more for a long observation stay, where the payer refuses to approve inpatient admission, than it would have received for the inpatient stay.

Action steps. Finance managers should know their organizations’ hospital-specific payment rates for every payer. They should know the difference between inpatient payment and payment for outpatient with observation services for the hospital’s most common diagnoses so they can forecast revenue appropriately and gain an upper hand in contract negotiations.

Finance managers also should talk with utilization review staff and the physician advisors who perform their peer-to-peer discussions to understand the behavior of major payers. For example, a payer might claim to use a commercial admission criteria program as its guide but then deny an inpatient admission that meets inpatient criteria but exceeds a number of days set arbitrarily under payer policy or by the payer’s medical director. Finance managers should be aware of such practices and be prepared to push back by demanding a higher payment for such patients or by prohibiting such gaming.

That said, the admission status determination must be made following the payers’ rules. Although most patients receiving outpatient care with observation services receive the exact same care as those with the same diagnosis admitted as inpatients, status cannot be chosen based on the most favorable payment.

Misconception 3: There is a national benchmark for observation rate, length of stay (LOS) and case mix index (CMI). The fact is that no two hospitals are alike. They have different payer mixes, patient populations, specialty programs and physician practice patterns, and therefore, a national benchmark does not represent a realistic, practical measure.

What one payer approves for inpatient admission one day may only warrant outpatient-with-observation services the next day when reviewed by a different nurse reviewer and medical director. Until January 2024, when the two midnight rule formally applies to MA plans, a high MA patient population invariably has a higher observation rate than does a predominantly fee-for-service Medicare population. Hospitals in areas with high numbers of medical liability suits will undoubtedly see and code more patients in their facilities as outpatients with observation services to avoid missing a rare condition, whereas hospitals in other areas would be more inclined to discharge more patients from the emergency department.

The optimal LOS and CMI also vary considerably among hospitals. Most compare their performance under each DRG with CMS’s Medicare data-based geometric mean LOS (GMLOS) for the DRG. But CMS’s method of establishing the right LOS is crude, because the GMLOS goal for a patient who has one or two major comorbidities (MCCs) will be the same as the patient with three, four or more MCCs.

Moreover, the CMI for those patients will be the same, with no adjustment made at all for the additional comorbid conditions (CCs) beyond the first one. Logically, a patient with one MCC, coded into the highest-weighted DRG for the diagnosis, cannot be expected to have the exact same LOS and medical needs as a patient with the same principal diagnosis but with three MCCs and three or four CCs that also code into that same DRG, despite its being assigned the same goal LOS and case weight.

Action steps. A hospital’s observation rate will not be excessive if every patient is placed in the right admission status based on the payer rules and proper documentation. Therefore, rather than focusing on LOS, finance managers should take three steps:

  • Ascertain how many patient days are avoidable days — i.e., where patients were hospitalized without medical necessity for hospital care.
  • Identify the patient, physician, hospital and/or payer to whom the days are attributed.
  • Work to lower the avoidable days.

Instead of looking at CMI, finance managers should compare their organizations’ CMS hierarchal condition category (HCC) risk adjustment factor scores for inpatients with those of other organizations. This score accounts for every diagnosis that is weighted in the HCC system so a patient with multiple conditions will be weighted higher than the patient with fewer or none. CMS does not provide patient-level data, but a hospital’s finance leader can perform a comparative analysis of the organization’s score and its patients’ average LOS to determine whether there may be deficiencies in its physician documentation and/or clinical documentation integrity program.

Misconception 4: An outpatient stay with observation services results in a higher out-of-pocket cost for a Medicare patient than for an inpatient admission. In reality, this situation is unlikely. The only Medicare patient who would pay more for an outpatient-with-observation-services stay than for an inpatient admission would be a patient who already paid their part A deductible for the benefit period because they had an inpatient admission within the prior 60 days. Two things should be noted regarding such an instance:

A patient’s admission status should never be chosen solely to minimize the patient’s financial obligation; the Department of Justice would likely view such an action as an inducement.

The only patient whose out-of-pocket obligation can be reliably predicted would be the Medicare beneficiary with part A and part B and no supplement, representing about 20% of the Medicare beneficiaries who have not elected a MA plan. In every other circumstance, the variables are too great to predict the patient’s cost.

With those caveats, if such a patient were admitted as an inpatient on Jan. 2, 2023, they would owe the part A deductible for 2023 of $1,600. All costs incurred during the admission would then be covered unless the stay exceeded 60 days. If that patient were placed in the hospital as outpatient with observation services, they would owe the once-yearly part B deductible for 2023 of $226 and then owe 20% of the approved payment from CMS for the stay. As noted above, that approved payment for the comprehensive APC for most observation stays could range from about $2,100 to $3,700. Thus, the patient would owe from about $650 to $970 for that stay.

Further, although the U.S. Department of Health & Human Services Office of Inspector General gave permission to hospitals to waive the cost of all self-administered drugs without concern about inducement, some hospitals still charge for them, so the patient could face additional costs.

Nonetheless, because outpatient-with-observation stays are limited to under two midnights, a patient’s medication costs would be unlikely to exceed the $600 to $900 difference between the part A deductible and the patient’s obligation as an outpatient.

Therefore, the outpatient-with-observation stay, resulting in a cost to the patient of under $1,000, will almost always result in a lower out-of-pocket obligation for the patient than the inpatient deductible of $1,600.

Action steps. Finance managers should make sure hospital staff — especially the physicians who interact with the patients at the time of the admission decision — sufficiently understand hospital payment regulations to avoid making uninformed decisions for patients about their admission status. Incorrect assumptions based on a lack of such understanding could not only be misleading to patients but also result in an improper claim and scrutiny for an anti-kickback violation.

Education and resources are imperative

These clarifications of common misconceptions around observation services also reinforce the importance of educating clinical staff around payment concerns related to choice of services, as well as coding for those services. Hospital finance leaders should not only promote such an understanding among clinicians, but also make resources available to revenue cycle staff, from registration to patient financial services, to compliantly address patient questions about the services they receive and their financial obligation for those services. 

MOON: A regulatory requirement for observation services

The Notice of Observation Treatment and Implication for Care Eligibility Act (NOTICE Act), enacted Aug. 6, 2015, requires hospitals and critical access hospitals (CAHs) to notify individuals receiving observation services as outpatients for more than 24 hours about their status and its implications. 

Under CMS’s final NOTICE Act regulation, hospitals must furnish a CMS-developed standardized notice, the Medicare Outpatient Observation Notice (MOON), to all Medicare beneficiaries who have been receiving observation services no later than 36 hours after the start of such services or upon release if it occurs sooner.a


a. CMS, “Medicare Outpatient Observation Notice (MOON),” Fact Sheet, Dec. 8, 2016.


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