Assessing the FY 1989 change in Medicare PPS outlier policy - fiscal year; prospective payment system

Health Care Financing Review, Winter, 1992 by Grace M. Carter, Donna O. Farley

Introduction

Under Medicare PPS, the price paid by the Health Care Financing Administration (HCFA) for a Medicare patient's hospital stay is proportional to the weight assigned to the diagnosis-related group (DRG) of the stay. The payment is intended to cover the cost of care for a typical patient in the DRG at an efficient hospital. Because costs of care vary for individual cases, hospitals are expected to make money on some patients and lose money on others so that, on average, payments equal costs. This system puts hospitals at financial risk; they will lose money if they are inefficient or if they are just unlucky and receive patients who require costlier care than average.

PPS also provides additional payments to outlier cases, which are cases that have extremely long lengths of stay or extremely high costs relative to typical cases in their DRG. The purposes of outlier payments are to reduce financial risk to hospitals and financial incentives to under serve extremely high-cost or longstaying patients. Financial risk arises from random factors - any hospital may receive more than its share of costly cases just by chance. In addition, some hospitals may consistently receive patients who are costlier than average for their DRG. Although other parts of PPS, including the continuous refinement of DRGs and special payments for special categories of hospitals (teaching, disproportionate share, sole community providers, and rural referral centers), are intended to address systematic differences across hospitals in costs, outlier payments may also help alleviate remaining differences between a hospital's expected payment per case and the cost of efficiently treating that group of cases.

HCFA implemented changes to its outlier policy effective November 1, 1989. In this article, we report our assessment of the effects of those changes. We compare the outlier policies in effect during FYs 1989 and 1988 with respect to the financial protection they afford to hospitals and the distribution of outlier payments among high-cost cases, patient groups, and hospital groups; and we evaluate two aspects of the response of hospitals to outlier policy.

Outlier policy

There are two kinds of outliers: day outliers, which are cases that remain in the hospital longer than a day threshold, and cost outliers, which are cases whose charges exceed a cost threshold after adjustment to an estimate of cost. The values of the thresholds depend on DRG, but they are set so that only a small proportion of cases qualify for these outlier payments.

It was the original intent of policymakers that the amount of the outlier payment for a particular case approximate the marginal costs incurred after the case exceeds its threshold. This would provide an incentive to care appropriately for these unusual cases without providing an incentive to provide unnecessary care. The marginal costs are estimated as a fraction of total costs called "the marginal cost factor."(1)

For cases that exceed the day outlier threshold, the day outlier payment formula is based on an approximation to the average Federal payment for a day in the same DRG at the same hospital. For each day beyond the outlier threshold, the formula adds to the DRG payment the marginal cost factor times the estimated daily Federal payment. The daily payment is an approximation because it is calculated by taking the case payment for the DRG and dividing it by the geometric mean length of stay (LOS) rather than dividing it by the arithmetic mean LOS.

The cost outlier payment formula uses ratios of cost to charges from the most recent settled cost report for each hospital. The charges for each potential cost outlier case are multiplied by these ratios and adjusted by payment factors to get an estimate of the standardized operating cost of the case. The cost outlier payment formula pays the marginal cost factor times the difference between the sum of these standardized costs for the case and the cost outlier threshold.

In the original implementation of the PPS, the marginal cost factor was set at 0.6. When a case exceeded both the day and the cost outlier thresholds, it was paid at the day outlier rate.

The way outlier payments are calculated was changed for discharges occurring on or after November 1, 1988, with the intent to reduce hospitals' financial risk by increasing payment for the most costly cases. The changes were:

* Cases that exceed both day and cost outlier thresholds now receive payment according to whichever formula provides the greater payment amount.

* The marginal factor for cost outliers, excluding burn cases, was changed from 0.60 to 0.75. (The marginal cost factor for both day and cost outliers in burn DRGs was set at 0.9 on April 1, 1988).(2)

* A hospital-specific cost-to-charge ratio is now used to standardize charges to an estimate of costs when calculating the cost outlier formula. Previously, a single number, 0.66, was used as an estimate of the cost-to-charge ratio for all hospitals.