Value Based Payment

Value-Based Payment and Commercial Healthcare Insurers: Getting Paid for Doing What’s Right

October 2, 2017 11:15 am

Many healthcare providers that have embraced a value-based payment strategy face a risk from continuing to operate under payment contracts that may actually penalize them for delivering improved value.

In response to the quality initiatives promulgated by the Centers for Medicare & Medicaid Services (CMS), hospitals and health systems have been adopting clinical and operating models conducive to value-based payment that are transforming the way healthcare organizations are paid. CMS’s activities around value-based payment are reflected in initiatives such as the Hospital-Acquired Condition Reduction Program, the Hospital Readmissions Reduction Program, and Hospital Value-Based Purchasing Program. Meanwhile, many commercial payment methods have remained stagnant or have undergone a much slower process of change. Although some may still debate whether the healthcare industry has reached the tipping point between fee-for-service (FFS) and value-based payments, the effects of the transformation are expanding broadly, with the result that many traditional commercial contracting methods can easily become more of a liability than an asset.

In the past, commercial managed care contracts served hospitals well, primarily because they were driven by volume, with the FFS model dominating the healthcare payment landscape. Indeed, the legacy of FFS models, which reward volume and intensity of service, can be seen in many commercial contracts that continue to be ingrained in the financial fabric of most healthcare organizations.

Meanwhile, the shift to value-based care has been underway for some time. And although many insurance companies have negotiated value-based contracts with providers that replicate aspects of CMS’s value-focused initiatives, the results of the ongoing shift in payment focus on the commercial side have been far from universally felt among healthcare organizations. Vestiges of contract language not conducive to a value-based payment model may continue to exist in the commercial managed care contracts under which many healthcare providers have operated for years, escaping the notice of these providers. It behooves all providers to revisit their contracts to ensure their contracts are up to date and reflect the inherent goals of value-based payment and that the provider receives the full payment to which it is entitled.

In value-based models, physicians and hospitals are paid for achieving what the Institute for Healthcare Improvement has described as the Triple-Aim: improving quality and patient satisfaction while reducing or maintaining cost. Unfortunately, as these same providers seek to do the right things by driving down costs and improving outcomes, they may not be aware that they are being penalized for their efforts under provisions in their commercial managed care contracts.

Liability or Asset?

Given the accelerated rate of the market’s transformation, healthcare organizations are starting to feel the painful financial drawbacks under traditional FFS models that are tied to outdated commercial managed care contracts. For example, although it may seem counterintuitive, hospitals can be financially penalized for discharging patients to home sooner because existing commercial FFS managed care contracts are not designed to recognize the reduction in length of stay (LOS).

Of course, some healthcare organizations have good reason to hold on to FFS models as long as possible. On average, commercial FFS contracts tend to pay about 1.4 to 2.3 times the Medicare payment rates for similar services, whereas the governmental payer mix is growing primarily due to an aging population that will continue to push margins into a downward spiral. a This creates added pressure for margin preservation within provider commercial contracts.

Meanwhile, despite hospitals’ movement toward a value-based operating model in response to CMS-driven initiatives, managed care contracts drafted years ago tend not to acknowledge hospital efforts to improve quality of care at a lower cost. Thus, driving utilization down while improving quality of care to avoid substantial financial penalties could lead to a substantial loss of payment where older FFS managed care contracts are still in place.

Case Example: Reconciling Payment Incentives

How can a fee-for-service commercial managed care contract negatively affect an organization’s bottom line? The experiences of one Southern health system provide a case example of such an impact. With over $2 billion in net revenue and with more than 15,000 staff employees and 1,500 beds, and 50,000 inpatient admissions systemwide, this health system is nationally recognized for its excellence in quality and patient safety. Its efforts to adopt a value focus were prompted by a recognition of the ongoing transition of the U.S. healthcare system toward value-based care, as reflected in CMS initiatives.

Yet even as it engaged in these efforts, it was not fully aware of the impact that its new value focus was having on its commercial managed care payments. The health system may have earned a reputation for excellence in providing high-quality care, but it suffered a negative financial impact because of a disconnect between its operating model being newly focused on value and the persistence of more traditional FFS language within its commercial contracts.

On average, the health system’s commercial payer contracts were 12 years old, with only very minor modifications having been made in the form of exhibits added to the original contract for annual adjustments (e.g., simply updating the outpatient discount rate for a commercial payer contract by 0.6 percent based on the current discount payment rate for outpatient services, annual inflation adjustment, and hospital aggregate increase to the charge description master).

Two types of language within the health systems contracts persisted through all of these changes, however: stop-loss coupled with first-dollar language, and lesser-of language.

Stop-loss and first-dollar contract language. The presence of such language in the health system’s contract underscores how just a few words, or the lack of them, can have a huge impact on payment levels. A stop-loss clause is intended to limit the loss a provider would experience for outlier cases with a high-dollar charge, where the LOS is substantially higher than the national or regional average. Under the stop-loss provision, a hospital sometimes can receive an alternate form of payment (percentage of charge or per diem) for cases over a certain charge threshold, as defined by first-dollar language within the provision, indicating that once a stop-loss threshold has been met, the alternative method of payment is applied.

In our health system’s case, the contract included first-dollar language that applied to the entire claim, thereby causing the health system to see its payment limited as it sought to manage utilization for highly weighted DRGs. b Understanding such language and its impact is becoming increasingly important with the shift in payer mix and an emphasis on reducing utilization. When a stop-loss clause includes first-dollar language, providers have more exposure for highly weighted DRGs for which they are seeking to manage utilization.

The impact of the first-dollar language for the health system is perhaps best illustrated by a comparison of its effect on payment for cases involving MS-DRG 3 with the effect of an incremental payment approach to the stop-loss threshold. c For FY17, MS-DRG 3 has a relative weight of 17.9495, with a base rate of $11,242 and average LOS of about 32 days, amounting to a DRG-based payment rate of $201,788. d (Note that in our examples discussed below, the health system’s charge per day for this MS-DRG is set at $10,866 for FY17 to eliminate this element as a variable in the analysis.)

The health system’s contract specified that the stop-loss threshold was $176,893 of charges, and the first-dollar language in the contract then specified that, upon meeting the threshold, the health system’s payment would be 55 percent of billed charges on the entire claim. The use of incremental-to-threshold or second-dollar contract language is an alternative to this stop-loss approach that can be more favorable to the provider, where the provider is paid a percentage of billed charges on every dollar exceeding the stop-loss threshold. For illustrative purposes, let’s assume that percentage also is 55 percent of the charges in question.

The exhibits below demonstrate how the specific language can have a substantial impact on payment levels for providers.

Stop-Loss Clause Example Comparing Payment Under a First-Dollar

Stop-Loss Clause Example Demonstrating Impact of Managing LOS and Utilization

Provision Compared With an Incremental-to-Threshold

Provision Pact

The first exhibit shows that our case study health system’s payment under its first-dollar contract provision would actually be less than the case rate MS-DRG payment (i.e., $347,712 x 55 percent of charges = $191,242, which is $10,546 less than the DRG case rate payment of $201,788 that the health system otherwise would have received).

Meanwhile, a stop-loss clause including incremental-to-threshold contract language where the health system would have been paid 55 percent of billed charges on every dollar exceeding the stop-loss threshold would have amounted to an increase in payment of $69,055 above the full MS-DRG payment, as calculated below:

$347,712 – $176,893 = $170,819

$170,819 X 55 percent of charges = $93,950

$176,893 + $93,950 = $270,843

Historically, the negative impact resulting from the health system’s first-dollar contract language might not have been noticed in an FFS environment. After all, the payment level was not significantly reduced in this instance. However, as hospitals manage utilization to the appropriate level of care, such stop-loss language does not protect hospitals that effectively manage LOS.

The second exhibit demonstrates that a stop-loss clause with first-dollar language such as that included in our case study health system’s contract becomes a limiting factor when LOS is being appropriately managed.

The exhibit demonstrates how the health system might have been protected by such contract language under FFS, where the LOS exceeded the average for the MS-DRG (i.e., 55 percent of the higher charges for a 34-day LOS [$369,444] amounts to $203,194, which is $1,406 higher than the $201,788 case rate for the MS-DRG).

Under value-based payment, however, where the health system is successful in reducing LOS, the adverse impact of such contract language becomes clear. The exhibit shows how the health system’s charges for a reduced LOS of 25 days would have amounted to $271,650 (i.e., $10,866 x 25), and because that amount exceeds the stop-loss threshold, the provision regarding 55 percent of total payment would apply. The resulting payment of $149,407 would constitute a loss of $52,381 relative to the $201,788 case rate.

In short, high LOS had masked the true exposure the health system faced under value-based payment as a result of the stop-loss language in its contract—particularly with respect to the highly weighted MS-DRGs, where payment levels clearly would have been higher without the presence of the stop-loss clauses. Given that LOS is decreasing and providers are managing cost in a new value-based operating model, the impact of such provisions is magnified, and providers should examine their contracts to assess their own levels of exposure to such language.

Lesser-of language. Our case-study health system also was experiencing an adverse financial impact from lesser-of language within its contract instead of being rewarded for providing a higher quality of care and keeping patients out of the hospital. (Such language states that the provider will be paid either the reimbursable rate or total billed charges, whichever is less.)

Lesser-of Clause Example Showing DRG-Based Contracted Payment Versus Total Charge

The exhibit above shows how a lesser-of clause might affect payment for an MS-DRG 3 case where the focus on managing LOS resulted in a LOS of less than nine days, resulting in a charge of $57,000. Under the lesser-of clause, the insurer would pay the lesser rate, for a loss to the health system of $144,788 on the DRG-based care rate for such a case.

Mathematically speaking, the health system would have had to raise the room rates astronomically or keep patients longer in the hospital to incur the charges necessary to achieve higher levels of payment. This example shows how, under a lesser-of clause, a greatly reduced LOS could produce a scenario where the total charge, in falling far short of the case rate payment, ends up being the amount paid—at a considerable financial disadvantage to the organization.

Solutions: Three Steps

These examples of potential challenges and payment pitfalls that may be hidden in existing contracts underscore the need for deliberate and immediate action on the part of healthcare providers to address such problems. To this end, providers should take the following three steps, which can help them position themselves for sustainable long-term success and lay the groundwork for maximizing the benefits that are achievable in a value-based environment.

Perform a market and competitive assessment. With the transformational changes in the market, an initial assessment is critical to reassess and update the status of significant agreements. Ensuring a payment contract is financially sound requires a thorough understanding of the current managed care market and competitive landscape, and an awareness of the subtle terms in the contract that can affect profitability.

The results of this assessment can help an organization develop its managed care contracting strategy, analyze existing contracts, identify risks and pitfalls, negotiate recommended changes, and enter value-based arrangements as appropriate.

The information also can contribute to transparency around pricing that is market-specific and that accounts for competitive and payer conditions. Attention to price transparency will continue to become more imperative as high-deductible health plans proliferate and patients increasingly purchase health care more like consumers.

Create a strategic contracting matrix. Moving toward value-based contracting with commercial payers begins with an evaluation of an organization’s current revenue portfolio. A first step is to create a matrix of current insurers, including high-level attributes that reflect disconnects, gaps, and variances among the major insurers in a provider organization’s system. Such attributes might include the presence of stop-loss and lesser-of clauses and language around ambulatory case rates and percentage-of-charge rates in contracts focused on value-based purchasing. Understanding the potential financial impact of such language on an organization’s current utilization of services can be revealing.

The goal of such a contract matrix is to understand the current state and to identify opportunities for improvement that can be addressed during contract negotiations. Often, a provider can have a variety of contracts that are quite dissimilar from each other. Creating and maintaining a contract matrix provides a single source for visibility into and understanding of the differences among the various contracts, and helps identify areas of exposure to some of the disconnects from adjusting operational and clinical initiatives.

Clean up and align the charge description master (CDM). Moving to a value-based contracting platform requires providers to be flexible and agile in making pricing adjustments. Achieving such flexibility and agility requires a clean CDM that exhibits consistency and reflects the organization’s current pricing strategy. Many current CDMs reflect pricing from an FFS ecosystem. Adjusting to reflect a value-based payment perspective may prove daunting if the CDM has not been revisited for an extended period. In addition to requiring substantial time and resources, a one-time CDM clean-up may not be possible due to current contract limitations but may, instead, require several iterative steps. Given the magnitude and effort of such a clean-up process, it should not be delayed.

The extent to which an organization can accurately assess its gaps and opportunities for improved payment depends heavily on its having a clean CDM. The presence of unused or outdated charge items, different charge rates for the same charge item, and blank charges all can lead to inaccuracies within an organization’s attempt at performing a value-based analysis. Focused efforts to address the CDM can allow an organization to more appropriately align its charge structure with various rates and competitive forces in its markets while reducing margin compression from limiting contract language.

Successful implementation of these three key steps can help organizations to move forward with a clear vision and purpose by acquiring the transformational agility to quickly adapt their strategies to rapid movement from volume to value. Once a provider organization does begin to move into value-based arrangements, it behooves the organization to move into similar arrangements with all its health plan partners to ensure they do not unfairly benefit from the provider’s value-focused accomplishments in managing cost and improving the quality of care.

It also should be understood that the steps outlined here constitute only the start, and that to achieve a sustainable future, it also will be necessary to focus on longer-term solutions that address critical areas such as value-based contracting, data analytics, and population health programs. To succeed in any future value-based and potentially risk-bearing contracts, organizations must ensure that their IT infrastructures, clinical maturity, and related processes match their advancing revenue portfolio.

Ryan Gillis is a manager, DHG Healthcare, Atlanta.

Paul Yun is a senior consultant, DHG Healthcare, Atlanta.


a. Proebsting, D., Why Hospital Cost Shifting is No Longer a Viable Strategy , Milliman Healthcare Reform Briefing Paper, Milliman, Inc., 2010.  

b. See CMS, FY 2017 Final Rule and Correction Notice Tables, Table 5: List of Medicare Severity Diagnosis-Related Groups (MS-DRGs), Relative Weighting Factors, and Geometric and Arithmetic Mean Length of Stay—FY 2017.

c. MS-DRG 3 = ECMO OR TRACH W MV 96+ HRS OR PDX EXC FACE, MOUTH & NECK W MAJ O.R. (Extracorporeal membrane oxygenation or tracheostomy with mechanical ventilation 96+ hours or principal diagnosis except face, mouth, and neck with major operating room procedure)

d. This amount is the DRG current case rate payment for the health system’s commercial payer contract, which is determined by multiplying the DRG base rate (i.e., $11,242) by the current DRG relative weight (i.e., 17.9495 per FY17 Final Rule) = $201,788 


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