Medicare's prospective payment system: a critical appraisal - Cost-Containment Issues, Methods, and Experiences

Health Care Financing Review, Annual, 1991 by Robert F. Coulam, Gary L. Gaumer

A final and not insignificant caveat in this literature stems from the levels of the initial payment rates. Widely conceded "overpayment" in the first year of PPS created a situation in which margins were increasing as expenses per case were dropping, due to large reductions in lengths of stay. This not only made the first year a somewhat aberrant intervention, but armed most hospitals with an unanticipated source of disposable funds, and probably altered expectations as well. Consequently, the first-year windfall may itself be an intervention that generated a stream of effects that are confounded with the incentives of PPS. Although the effects of the windfall certainly diminished over time, the years that are studied in most of the research we review are subject to the effects of the windfall and the transitory use of very restrictive updates in the next few years.

To review this research, we have divided our discussion into five substantive areas. We begin with a discussion of the financial effects of PPS on hospitals, focusing primarily on the mechanisms by which changes in expenditures and financial conditions occurred. We then examine the substantial literature on the effects of PPS on practice patterns. The next area discussed covers the financial impacts of PPS on the Medicare program and Medicare beneficiaries, followed by a look at the various potential PPS effects on the health care industry, including effects on other payers, the diffusion of new technologies, and other concerns. Finally, we review the literature on the effects of PPS on the quality of patient care, offer a series of conclusions about the effectiveness of PPS as a hospital cost-containment policy for Medicare, and suggest useful priorities for future research in this area.

Hospital finance

The central objectives of PPS were to reduce rates of increase in Medicare inpatient payments and in overall hospital cost inflation. These aims were expected to be achieved through a combination of three key elements of the PPS programs: * By the marginal incentives of a per case rate-to-rate

payment system, which put hospitals at financial risk

for inefficiency and unnecessary intensity and allowed

hospitals to retain the gains from lower costs and more

efficient operations. * By the financial stringency for higher cost hospitals of

a program that controlled rates of increase in payment

amounts and that gradually shifted hospitals from their

own cost history to national rates. * By regulatory controls on admission rates by peer

review organizations (PROs).

The foundation for this policy package was a decade of incentive ratesetting in the States (Coelen, Mennemeyer, and Kidder, 1986; Schramm et al., 1987). That experience showed that a wide range of approaches to binding revenue control was able to slow inflation rates in hospital expenses by 2-4 percentage points per year; that these effects were the result of persistent controls on inflation rates, not just one-time effects; that the per case unit of payment created strong volume effects, which made the net effects of ratesetting smaller than would have occurred if volumes had been controlled; that excluded payers shared in the financial benefits of administrative ratesetting, but also to a leaser degree than the payers for which the rates were binding; that hospital and other administrators were unable (or unwilling) to reduce rates of increase in expenses by as much as rates of increase in revenues (payments) had been reduced, thereby causing reduced margins; and (according to some evidence) that ratesetting may have had small adverse effects on patient outcomes (Shortell and Hughes, 1988; Gaumer et al., 1989). With several exceptions, this pattern of effects is similar to what we find in the literature on PPS. Indeed, in many ways the PPS literature confirms what was already known about hospital incentive payment as a cost-containment policy. We return to this point later.