Implementing fixed-fee provisions would not remove the factors that drive price increases, nor would it reduce administrative hassles or decrease risk.
Healthcare figures to be a primary issue in the 2020 elections, with much of the focus on costs — especially hospital costs. A common concern among users of hospital services is the apparent lack of correlation between hospital charges and payment.
Although some hospital managed care executives have suggested replacing percent-of-charge (POC) contract provisions with fixed-fee payment as a solution, these proposals are based on three myths regarding the POC payment methodology relative to fixed-fee payment.
A closer look at each myth reveals that such a payment change could be problematic for the industry. A better solution is within reach, however: An indexed rate limit in POC contracts that would allow hospitals to lower charges without experiencing reductions in payments.
Sidebar: A closer look at healthcare payment models
Myth #1: Replacing POC provisions with fixed fees will remove the need to increase prices
Many managed care executives believe that replacing POC provisions with fee schedules will enable them to lower their current prices or at least restrain price increases. But consider this pricing formula:
REQUIRED PRICE = [AVERAGE COST + (REQUIRED MARGIN + LOSS ON FIXED-FEE CONTRACTS)] / [POC VOLUME × (1-AVERAGE DISCOUNT %)]
As the formula shows, the required price that any hospital must set is based on several factors.
1. Actual prices must be set at levels that exceed actual costs.
2. Hospitals, like any business, must generate a profit margin to replace their physical assets and to service debt obligations.
3. Losses on fixed-fee payment plans (stemming from fee schedules that are less than cost) must be shifted to patients who are covered by POC provisions. There would be a gain rather than a loss if actual payment exceeded incurred cost, but that outcome is unlikely given the large losses that usually result from government payment plans.
4. As POC volume shrinks, the resulting price must be increased.
Let’s use a case example to help isolate the key factors. Assume we have a POC provision that makes payment for emergency department (ED) claims at 50% of billed charges, and we want to replace that provision with a fee schedule that pays $1,000 for levels 1 and 2 emergency claims, $1,600 for level 3 claims, $4,500 for level 4 claims and $6,000 for level 5 claims. Will this change permit us to reduce our ED charges?
The answer is yes, but only if the fixed-fee payments exceed the current POC payment. If the fee schedule payment is less than the POC payment, that loss would have to be shifted to the now smaller base of POC patients, which would result in a higher required price. Negotiating a fixed-fee replacement for a POC payment makes no sense financially unless there is a significant increase in payment. Managed care payers seem unlikely to agree to increase their payment beyond current levels, meaning a reduction in charges would be improbable.
Some might argue that removing the POC provision will help reduce patient responsibility amounts. Since collectability on those amounts is not likely to be 100%, this reduction could represent a financial advantage to the hospital.
Upon examination, however, this scenario is suspect. Using the ED example, assume current pricing for a level 1 claim is $2,000. At the current 50% payment provision, expected payment would be $1,000. If the claim includes a 20% copayment provision, the patient would pay $200 based on allowed charges of $1,000, and the managed care plan would pay $800. Meanwhile, moving from the POC payment to the $1,000 fixed payment for the level 1 emergency claim would still require a 20% copayment of $200.
Even though the initial payment change might be net revenue neutral, the longer-term effect figures to be an increase in the hospital’s prices. To understand this from a mathematical perspective, review the pricing formula again. Given recent trends, government payments can be expected to erode over time. Although some of the loss will be picked up by commercial fixed-fee payments, a sizable portion will not.
That shortfall will require an even larger shift to POC plans, resulting in even larger increases in prices. With fixed payment terms in place, and an income target that is essential to preserving the financial viability of the institution, hospitals must either implement draconian cost reductions or increase prices to the smaller block of POC patients.
Empirical data indicates an association between lower percentages of POC payment and higher prices. We pulled data from about 300 hospitals in 2018. These were all prospective payment hospitals, with critical access hospitals and specialty hospitals excluded.
We determined the percentage of revenue derived from POC contracts and then divided the hospitals into quartiles using that metric. Using 2018 Healthcare Cost Report Information System (HCRIS) data and 2017 Medicare claims data, we then computed the average values for three measures of pricing: mark-up ratios, average charge per Medicare discharge adjusted for case mix, and average charge per Medicare visit adjusted for ambulatory payment classification relative weight. Those values are presented in the exhibit below.
The key finding: hospitals with higher percentages of revenue derived from POC provisions have significantly lower markups and lower prices. The variances are substantial and amount to a 75% to 85% difference between the highest and lowest POC quartile.