Pricing Medicare's diagnosis-related groups: charges versus estimated costs

Health Care Financing Review, Fall, 1989 by Kurt F. Price

Price Medicare's diagnosis-related groups: Charges versus estimated costs

Introduction

Medicare currently pays for hospital inpatient care based on prospectively set prices for each of 474 diagnosis-related groups (DRG's). The DRG prices represent the relative costliness of inpatient hospital services provided to Medicare beneficiaries. Since the implementation of this prospective payment system (PPS), the DRG prices have been based on both estimated costs and charges. Prices were originally based on estimated costs using cost data from 1981. In the third year of PPS, however, the DRG prices were recalibrated on the basis of charges alone, because sufficiently recent cost data were not yet available.

Timely availability of cost data has greatly improved since the first recalibration in 1986. Now that more recent cost data are available, should DRG process, one again, be based on estimated costs? Or should they continue to be based on charges alone? These questions raise two very different issues: First, are cost-based prices more accurate than prices based on charges alone? Second, does it really matter? Are the two sets of prices very different? In this article, the arguments related to the first issue are discussed, and empirical evidence regarding the second is presented.

Strong arguments can be made for both the charge-based and the cost-based methodologies. On the one hand, charges may reflect many factors other than hospitals' estimated costs, such as hospitals' revenue maximization strategies. These factors should not be reflected in PPS payments. On the other hand, the current Medicare method of estimating costs may distort estimates of true cost. Unfortunately, there are no data representing true Medicare costs available to test these two methods. Determining which approach more accurately measures relative costliness involves subjective judgment.

There are data, however, to evaluate the differences between the two pricing methods. The study reported here compares DRG prices based on charges alone with prices calculated from estimated costs. The results show that the two approaches produce much larger differences in DRG prices than previously reported (Cotterill, Bobula, and Connerton, 1986; Prospective Payment Assessment Commission, 1985). Further, the results suggest that PPS payments would be significantly redistributed if DRG prices were, once again, based on estimated costs. These findings highlight the need to better understand the effects of hospital charge-setting practices and Medicare cost-finding methods on DRG prices.

Background

PPS establishes fixed prices for inpatient hospital care in the form of relative weights for each of 474 DRG's. (The actual number of DRG's has varied since the implementation of the prospective payment system. For fiscal year 1989, prices have been established for 474 DRG's.) To calculate payments, the assigned DRG weight is multiplied by a standardized payment amount and adjusted for the hospital's area wages, teaching status, and percent of poor patients. The two alternative methods for calculating DRG weights and the implications of using each approach are discussed in the remainder of this section.

Medicare methods for calculating weights

There are basically two methods for estimating relative DRG weights. The first approach uses charge information from the hospital bill. The Health Care Financing Administration (HCFA) has implemented these charge-based weights for fiscal years 1986-89. The second method adjusts these charges using cost information obtained from the Medicare Cost Report (MCR).

Under the cost-based approach, routine and special care costs are estimated by multiplying routine and special care lengths of stay (LOS) by the respective per diem costs derived from the MCR. Ancillary costs are estimated by multiplying departmental charges by the corresponding ratio of cost-to-charge (RCC), which is also derived from the MCR. (A more detailed description of the cost-based methodology is provided in the section of this article on data and methods.)

The DRG weights are recalculated annually by HCFA, using the most recent data available. This process is formally referred to as recalibration. The purpose of recalibration is to create an entirely new set of DRG weights. The establishment of new DRG weights potentially redistributes payments among DRG's as well as among hospitals. The recalibration process is revenue neutral, however, and aggregate PPS payments remain unchanged.

Recalibration is necessary to maintain weights that accurately reflect the relative costliness of inpatient care across DRG's as medical practice patterns and relative use of hospital resources change over time. Practice pattern changes may include adding or dropping services, substituting more or less costly services, and shifting care to other settings (e.g., outpatient).

HCFA computed the original DRG weights using the cost-based methodology with 1981 patient-level data, adjusted using per diem costs and cost-to-charge ratios from the 1981 MCR's. The first recalibration of the weights was completed for fiscal year 1986 using fiscal year 1984 patient billing data. Because up-to-date cost report information was not available at the time, HCFA developed these new weights based on charges alone.