Ken Perez

With the convergence of healthcare reform and the debt deal, hospitals face a difficult, decade-long challenge in maintaining positive margins in the wake of plunging Medicare payments.

At a Glance

Hospitals should begin preparing now for a decade of reductions in Medicare payment with strategies aimed at:

  • Partnering with clinical leadership  
  • Performing detailed margin analysis  
  • Engaging with service line managers and physicians  
  • Revamping care coordination  
  • Ensuring efficient operating room utilization  
  • Improving emergency department operations  

It is thrifty to prepare today for the wants of tomorrow.
-Aesop (620 to 560 BC)  

The combination of mandated reductions in Medicare payment under the Affordable Care Act, likely cuts to Medicare resulting from the recent debt deal, the rise of risk-based reimbursement, and pressure from commercial payers portends a formidable, decade-long ordeal for hospital finances. Hospitals need to formulate and implement strategies now that can help them absorb the impact of these changes and emerge from this turbulent decade as financially and operationally stronger institutions.

Six key strategies, if pursued with commitment, diligence, and forethought, will set a hospital on a course to achieve positive Medicare margins consistently despite the ongoing declines in Medicare payment. First, however, it is important to understand the circumstances affecting Medicare that bode ill for hospitals.

Current Medicare Margins

Even today, U.S. hospitals are struggling with negative Medicare margins. In 2009, U.S. hospitals generated an operating margin (loss) of 20.1 percent, on average (Healthcare Management Partners, Metrics Quarterly Report, Oct. 2010). Margins on Medicare were worse, estimated at 25 percent for U.S. hospitals, on average, in 2009 and projected to reach 27 percent in 2011 (Medicare Payment Advisory Commission, Report to the Congress: Medicare Payment Policy, March 2011). According to the American Hospital Association (AHA), 61 percent of hospitals lose money on Medicare (Fragile State of Hospital Finances, 2009 AHA survey data).

Market Basket Updates: Reductions and Productivity Adjustments

On an annual basis, the Centers for Medicare & Medicaid Services (CMS) updates its payments and cost limits, issuing market basket updates to reflect input price inflation facing providers in the provision of medical services. The Affordable Care Act mandates negative adjustments to CMS's market basket update for the inpatient prospective payment system (IPPS), specifying annual percentage reductions for FY10 through FY19.

Exhibit 1


Exhibit 2


In addition, section 3401 of the act mandates to-be-determined productivity adjustments for FY12 through FY20 and beyond. In general, the productivity adjustments are to be equal to the 10-year moving average of changes in annual economywide private nonfarm business multifactor productivity. The final rule for the FY12 IPPS, issued by CMS on Aug. 1, 2011-and published in the Aug. 18, 2011, Federal Register -sets the FY12 productivity adjustment at -1.0 percent.

The mandated reductions to the market basket update and the productivity adjustments total $112.6 billion in Medicare savings (that is, reduced payments to hospitals) for FY10-FY19 (Foster, R.S., CMS, "Estimated Financial Effects of the 'Patient Protection and Affordable Care Act,'" April 22, 2010). Although these changes may be seen as favorable from a CMS budgetary-control perspective, they will obviously place greater financial pressure on hospitals.

Adjustments for Documentation and Coding Improvements

The Medicare Payment Advisory Commission (MedPAC) proposed adjusting payments to account for documentation and coding improvements as a way to offset payment increases (or "overpayments") that occurred during the two-year transition, beginning in 2008, from diagnosis-related groups (DRGs) to Medicare severity-adjusted DRGs (MS-DRGs). The coding refinements inherent in MS-DRGs had also resulted in refined payments, allowing more dollars for "sicker" patients with supporting documentation. Although documentation and coding improvements allowed hospitals to measure patient severity more accurately, these improvements also led to an increase in reported case mix under MS-DRGs-and higher payments to hospitals-even though patients' levels of illness and resource needs did not differ from previous years. These payment increases were not allowed because, by law, the transition to the MS-DRG system was not supposed to result in an increase or decrease in Medicare payments. So it was determined that payment adjustments were needed to recoup the higher payments. The approach that CMS has devised to address both recoupment of overpayments and prospective adjustments is described in the FY12 IPPS final rule.

Recoupments. CMS and MedPAC estimated that documentation and coding improvements increased payments from CMS to hospitals by 5.8 percent in 2008 and 2009. In FY11, CMS applied half of this adjustment, or 2.9 percent, as a one-time recoupment that will be restored in FY12 via a +2.9 percent adjustment. CMS also applied a new 2.9 percent cut in FY12 to recoup the remaining half of the 5.8 percent. For FY12, the 12.9 percent adjustment to remove the FY11 recoupment cancels out the 2.9 percent FY12 recoupment. (The FY12 recoupment is also a one-time, or temporary, cut that will be restored in FY13.)

Prospective documentation and coding cut. CMS has decided to make a prospective documentation and coding cut to permanently remove increased payments from the system. CMS has indicated that a total prospective cut of 5.4 percent is needed. Through FY11, CMS had applied cuts totaling 1.5 percent, so a cut of 3.9 percent remains necessary. CMS has decided to apply slightly more than 50 percent of this cut-2.0 percent-in FY12, and may apply the remaining 1.9 percent in FY13 and/or subsequent years.

Calculation of the FY12 IPPS Market Basket Update

At 1,509 pages, CMS's final rule for the FY12 IPPS is considerably longer and more "generous" to hospitals than the proposed rule issued on May 5, 2011. CMS sets the IPPS market basket update for FY12 at 3.0 percent. The 0.1 percent reduction mandated by the Affordable Care Act and the productivity adjustment downward another 1.0 percent reduces the IPPS market basket update to 1.9 percent. Factoring in a final documentation and coding improvement prospective cut of 2.0 percent and a 1.1 percent increase in response to litigation against the Department of Health and Human Services (to restore rural floor budget neutrality adjustments for FY07 and FY08) yields a net payment increase of 1.0 percent for FY12.

Although the net change for the IPPS from FY11 to FY12 is positive, hospitals will still face financial pressures. The intent of the market basket update is to offset increases in hospital input prices, so in theory, its effect should be margin-neutral. However, as has been noted, there are adjustments to the market basket update, and if the sum of them is negative, added pressure is placed on hospitals to maintain margins. For FY12, the adjustments total -2.0 percent.

All hospitals-whether they be currently profitable with the Medicare portion of their business (and statistics indicate that there are few such organizations), breaking even, or losing money-should understand, monitor, and take steps to mitigate the adverse effects of the reductions to Medicare payment in the future. Consider, for example, the added financial pressure placed on a 300-bed hospital with $250 million in revenue in FY11 because of the final IPPS rule for FY12. Let's assume that the effects of hospital input price inflation offset the unadjusted market basket update, that the hospital experiences no volume growth in FY12 (for the sake of simplicity), and that Medicare accounts for 40 percent of the hospital's total revenue (i.e., $100 million). Because the adjustments to the market basket update for FY12 total -2.0 percent, as previously mentioned, this hospital would need to reduce costs by $2 million in FY12 to maintain Medicare margins at the level they were in FY11.

Exhibit 3


The Budget Control Act of 2011: The Specter of Additional Cuts to Medicare

Passed by the House of Representatives on Aug. 1, 2011, by a vote of 269-161 and by the Senate the following day by a vote of 74-26, the Budget Control Act of 2011 was signed into law by President Barack Obama on Aug. 2, 2011, as Public Law 112-25. The 74-page law has generally been referred to as the "debt deal."

The debt deal creates and tasks a 12-member joint committee of Congress (the so-called "Super Committee") to produce proposed legislation by Nov. 23, 2011, that would reduce the deficit by at least $1.5 trillion over 10 years. Each chamber of Congress would consider the proposal of the joint committee on an up-or-down basis without any amendments by Dec. 23, 2011. The debt deal sets up a new sequestration process to cut spending across the board and ensure that any debt limit increase is met with greater spending cuts if the joint committee members fail to agree upon and produce a proposal with at least $1.2 trillion in spending cuts.

If the committee fails to produce such a proposal, then President Obama may request up to $1.2 trillion for a debt limit increase. Assuming the President is able to increase the debt limit by $1.2 trillion (contingent upon congressional approval), across-the-board spending cuts would result that would equal the difference between $1.2 trillion and the deficit reduction (if any) enacted as a result of the joint committee and subsequent approval by both chambers of Congress. (See "Summary of the Revised Budget Control Act of 2011," Fact Sheet,, Aug. 1, 2011.)

The across-the-board spending cuts would apply to FY13-FY21, and to both mandatory and discretionary programs. The final agreement specifies that total reductions would be split equally between two categories of expense: defense discretionary and non-defense discretionary plus covered entitlements. The across-the-board cuts would apply to Medicare, although the cut to Medicare is capped at 2 percent, which would reportedly save $126 billion and be limited to cuts to provider payments (American Association of Preferred Provider Organizations, "Debt Deal Includes Trigger for Medicare Spending Cuts to Providers," Health Policy Report, Aug. 5, 2011). Social Security, veterans' benefits, civilian and military retirement, and all low-income subsidies including Medicaid and "welfare" programs (e.g., food stamps) would be exempt, as would net interest payments.

How large a cut could the joint committee conceivably propose for Medicare? As a preliminary analytical exercise, if one assumes that Medicare will bear its proportional share of the cuts, $150 billion to $200 billion in cuts to Medicare could be expected over the 10 years. If one further assumes that the cuts will be accomplished by reduced payments to providers, with no reduction to benefits (currently a more politically popular approach), and that the IPPS would bear its proportional share of the cuts, the IPPS would be cut by $50 billion to $65 billion over the 10 years. The IPPS cuts would translate into a cut of $1.5 million to $1.9 million per hospital per year, which would be equivalent to a 2.3 to 2.9 percent average annual reduction to the IPPS.

What would be the combined, cumulative impact of the debt-deal-driven cuts and the aforementioned reductions to the IPPS market basket update mandated by the Affordable Care Act? For the 10-year period of FY12 to FY21, payments to hospitals under the IPPS would be sliced by $162 billion to $177 billion, translating into a $5 million payment decline, on average, for an average-sized IPPS-participating hospital (i.e., with about 210 beds) per year, compared with payment levels before healthcare reform.

As for possible non-IPPS cuts, Washington, D.C.-based law firm Patton Boggs comments:

All deficit reduction proposals to date should be considered on the table, particularly those that have been scored and would produce significant savings, including cuts to graduate medical education programs, home health providers, labs, rural hospitals, Medigap and Medicaid reform measures, just to name a few. Healthcare reform and new programs created by the Affordable Care Act are also vulnerable, including delivery system pilots and demos and support to the newly established health insurance exchanges, adding additional pressure to states already in fiscal crisis. (Patton Boggs L.L.P., Capital Thinking Updates,, Aug. 4, 2011.)

Furthermore, the credit rating agency Standard & Poor's (S&P) is pressuring the federal government to follow through on near-term budget cuts and implement a credible long-term deficit reduction plan. On Aug. 5, 2011, S&P took the unprecedented step of lowering the United States' AAA rating to AA+. In its statement about the downgrade, S&P said that it is issuing a negative outlook, which means that there is a chance it will lower the rating again within the next two years. S&P said such a downgrade, to AA, would occur if the agency sees smaller reductions in spending than Congress and the administration have agreed to make, higher interest rates, or new fiscal pressures during this period (Martin Crutsinger, "S&P downgrades U.S. credit rating from AAA,", Aug. 5, 2011).

Additional Forces Affecting Hospital Finances

Philosophically aligned with the broad pay-for-performance movement, the healthcare delivery reforms described in the Affordable Care Act pertaining to value-based purchasing, hospital readmissions, and healthcare-acquired conditions tie financial carrots and sticks to quality performance. By 2016, 6 percent of a hospital's IPPS payment will be at risk, placing greater pressure on hospitals to excel from a quality standpoint, despite steadily declining funding from Medicare.

In the past, hospitals have sought to offset downward pressures on Medicare reimbursement by simply shifting costs to commercial payers. This recourse will no longer be available, however, as commercial payers, themselves facing financial challenges, will increasingly prove unable and unwilling to offset pressure on government payment rates, placing greater pressure on hospitals to contain costs (Morgan Stanley, "Reimbursement Pressure to Spur M&A and Cost Control," Healthcare Facilities, July 8, 2011).

Strategies to Offset the Reductions in Medicare Reimbursement

What should hospitals do to mitigate these significant threats to revenue? Although it goes without saying that hospitals should continue to strive for continued gains in administrative efficiency, the sheer magnitude of the financial challenges posed by these potent forces dictates that hospitals should focus attention immediately on improving the efficiency and effectiveness of their core activity: the process and delivery of care.

Hospitals should begin by implementing the following six strategies, which reflect best practices that have been clearly shown to help hospitals reduce costs and create efficiencies. An additional advantage of these strategies is that each one-if pursued with focus and commitment-can be fully implemented within six months.

Partner with clinical leadership. Clearly, given the need for improved, more cost-effective care delivery, the hospital's senior finance executive should start by meeting with the chief medical officer and others on the clinical leadership team to forge or reinforce a financial-clinical partnership. At the meeting, the CFO should:

  • Provide an assessment of the current financial condition of the hospital
  • Explain the impending increased financial pressures and their likely impact on the organization
  • Solicit the support and assistance of the clinical leadership team

Perform detailed margin analysis. The finance department should identify low-margin MS-DRGs for which payment is significantly lower than actual cost, and ensure that cost-saving strategies are targeted at these MS-DRGs. The finance department also should analyze MS-DRG/service line margins down to the physician and patient level to determine the areas of profitability and loss, looking at direct cost contribution margin. The analysis should focus, in particular, on the five MS-DRGs/service lines with the highest volumes, the five with the highest profitability, and the five with the greatest losses, with an in-depth review to ascertain the reasons for profit or loss. A few months after this initial analysis is completed, the hospital should establish a process of ongoing margin analysis and review by a team of service line managers and physicians as well as the hospital's senior management team.

Engage with service line managers and physicians. Finance should take the lead in assembling a clinical performance improvement action team (CPIAT) composed of service line managers and physicians. At the outset, using data analytics provided by finance, the CPIAT should focus on identifying and achieving performance improvements in the following areas:

  • Supply utilization
  • Length of stay
  • Drug costs
  • Readmissions within 30 days of discharge
  • Ancillary testing usage

Finance also should:

  • Review and analyze reasons for Medicare and Medicaid clinical denials, and take appropriate steps to address their causes
  • Establish a clinical documentation improvement program for special care areas and the surgical floors
  • Emphasize to physicians the necessity of accurate and complete coding needs, since the process is driven by physician input

Physician scorecards (statistically valid, case mix-adjusted) should be established to measure quality and cost at the physician level against the hospital's targets for supply utilization, length of stay, drug costs, and other resources utilized, based on the work of the CPIAT. The scorecards also should be used to benchmark physician performance against the performance of peers and national norms for quality and efficiency. Physicians identified as delivering low-cost, high-quality care should be recognized and used as role models for best practices.

Financial-clinical grand rounds should be initiated to review various cases of costs, care, and outcomes and to incorporate lessons learned into the organization's standards of care.

Revamp care coordination. The hospital's clinical leadership should evaluate and improve care coordination policies. Avoidable readmissions can be reduced by improving the discharge planning process. For example, the hospital should use checklists and auditing to ensure that the following items are always verified with the patient at discharge:

  • Medications and how to take them
  • Follow-up appointments
  • The identity of the primary caregiver at home
  • Diet and exercise parameters
  • Need for home healthcare visits
  • Notifications (when to call one's physician)

Other important steps and considerations include:

  • Ensuring that every discharge summary is sent to the primary care physician
  • Establishing or connecting with a local or regional health information exchange to enhance care coordination, prevent duplicative tests, and reduce costs
  • Understanding how attending physicians are using consultants and the potential impact on costs and bed days

Ensure efficient operating room (OR) utilization. To optimize OR utilization, hospitals need to take specific steps to decrease scheduling gaps and delays, reduce costs, and enhance care delivery. Improved scheduling (that aligns surgeons and surgeries), method changes, standardized processes, and operational reporting are just a few of the means for accomplishing these ends.

The hospital also can benefit from using analytics to identify variances in operating time and OR room turnover time by procedure and operating physician, thereby facilitating process improvement conversations with OR staff and physicians. Such an analysis also can help to identify the root causes of delays in surgery start times and post-anesthesia care unit (PACU) admissions. Another benefit is the identification of top performers to enable best-practice sharing.

Improve emergency department (ED) operations. Much has been written in recent years about the space and staffing challenges faced by EDs. Data analysis and review of ED supply and drug utilization, ancillary testing, and inappropriate usage can help improve ED operations and reduce costs.

A Clear Threat-and an Opportunity

Medicare accounts for a large portion of revenue for the vast majority of U.S. hospitals. In general, hospital operating margins are at breakeven, and margins on Medicare are worse. The payment reductions required under the Affordable Care Act and the adjustments to the IPPS to account for documentation and coding improvements are multifaceted, complex, and material, and will constitute a significant threat to hospital finances for many years. Add to this mix the further cuts to Medicare that are likely as a result of the debt deal, the trend toward more risk-based reimbursement, and pressure from commercial payers, and the outlook for hospitals looks exceedingly grim.

Yet hospitals can seize an important opportunity to achieve financial gains large enough to offset the reductions in Medicare payment if they meet these challenges with strategies, such as those discussed here, that target a hospital's largest and most core activity: the process and delivery of care. Moreover, as hospitals use these strategies to improve the general care delivery model, their efforts will not only improve performance under Medicare, but also benefit the hospital's non-Medicare business, further improving revenue and efficiency, and ensuring the long-term success of the whole organization.

Ken Perez is senior vice president and director of healthcare policy, MedeAnalytics, Inc., Emeryville, Calif. (

Publication Date: Monday, October 03, 2011

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