AHM Health Plan Finance and Risk Management: Provider Reimbursement Methods

Provider Reimbursement Methods

Course Goals and Objectives
After completing this lesson you should be able to

Discuss the advantages and disadvantages of traditional, salary, fee-for-service, and

discounted fee-for-service provider reimbursement methods
Explain how utilization risk is distributed in each of the provider reimbursement
methods
Define churning, upcoding, and unbundling and recognize which provider
reimbursement systems are designed to solve these problems
Explain the purpose of using the relative value scale and resource-based relative value
scale systems
Define global fees, withholds, risk pools, and bonuses and explain how they are used
by health plans to motivate providers to manage overutilization
Discuss the methods that health plans use to reimburse hospitals

Although laws and regulations influence the structure of provider reimbursement contracts in
health plans, laws and regulations are by no means the only influence on these contracts.
Provider contracts in managed care have also evolved over time in response to market forces.
Market forces include the presence of competitors in the market, the level of demand for
healthcare services, and the availability (or level of supply) of those services. Market forces, in
turn, are driven by the goals of the various parties involved in healthcare: the people who
receive the care, the providers of the care, the entities that pay for the care, and the entities that
manage the delivery of that care. In the long run, each of these must interact with the others to
attain its goals.
Within this context, the managed healthcare market has generated many different ways of
balancing the cost of healthcare with access to care and the comprehensiveness of health
benefits. Ultimately, variety in healthcare plans is a response to the demands of plan members
and sponsors. Not all sponsors and plan members demand the same level of
comprehensiveness; consequently, different groups of consumers will find different plans
attractive. All other factors being equal, however, plan sponsors and members prefer to pay the
lowest possible price for the healthcare benefits they receive, and the market will tend to reward
health plans and providers who can achieve the same long-term goal: cost efficiency in
delivering quality healthcare.
Not all provider reimbursement methods are equally efficient in aligning all of the short-term
goals of the participants with this long-term goal of cost efficiency. When the short-term financial
goals of the participants are in conflict with this longterm goal, health plans face various
inefficiencies that can ultimately lead to higher costs and lower quality care.
Because different healthcare consumers have different needs, however, there is no one
reimbursement system that works most efficiently for all providers and types of health plans in

all health plans. Each reimbursement system has strengths and weaknesses. Health plans
arose as a system for aligning the financial goals of the participants, with each type of
reimbursement method implicitly addressing the weaknesses of other methods. This lesson
describes common types of provider reimbursement methods in health plans and outlines the
advantages and disadvantages of each type.
Provider Reimbursement Methods
The rapid growth and dynamic market conditions within the health plan industry have caused
the development of a large number of provider reimbursement methods. New variations on
these methods are developed (or mandated by regulatory bodies) each year. Generally,
physician reimbursement in health plans is typically based on one of the following methods:

Salary
Per treatment or per service fee schedule (commonly known as fee-for-service)
Per plan-member rate (that is, the provider is paid a certain amount for every plan
member during a defined period)
Percent-of-premium schedule (the health plan pays providers a percentage of all the
premiums received in exchange for covering plan members, and providers agree to
provide all necessary medical treatment for those plan members)

In this lesson, we discuss a number of health plan reimbursement methods both in terms of
these categories, and in terms of how these methods divide financial and utilization risks
between providers and health plans. We begin by outlining how physicians and hospitals were
traditionally paid before managed care, because the weaknesses of traditional physician
reimbursement led to rising healthcare costs. These rising costs led to a market response:
health plans. Health plans are, in this sense, a response to some of the inefficiencies of
traditional medicines financial structures, including physician reimbursement.
Traditional Provider Reimbursement
Before health plans became widely established, provider reimbursement typically involved an
individual patient paying an individual provider after the provider rendered healthcare services.
Typically, patients with health insurance first had to pay their providers, and then submit a claim
to the insurer. If the insurer denied the claim, the responsibility for paying for the care remained
with the patient. Although this traditional method of payment allowed individuals who sought
healthcare considerable freedom of choice in physicians and treatment options, it also
presented several financial disadvantages.
Financial Disadvantages of Traditional Physician Reimbursement
From a financial point of view, traditional physician reimbursement is subject to three types of
disadvantages. First, this reimbursement method concentrates, rather than spreads, the
financial risk for a patient and that patients physician when the patient faces a serious illness,
particularly in cases where the patient either has no insurance or is underinsured. By
concentrating risk, this method, in effect, concentrates the costs of healthcare. In other words,
an underinsured individual who had a serious illness often faced a choice of either receiving
inadequate care or suffering severe financial hardship in paying for treatment.

Providers themselves risked not getting paid for their services. Providers under this
reimbursement system also faced a potential ethical and financial dilemma. These physicians
had to decide either to provide (1) different levels of treatment, based not on the seriousness of
the illness, but on the wealth of the patients with the illnesses, or (2) the same level of treatment
to all patients, but charge different rates to different patients for the same treatment.

Second, traditional physician reimbursement fails to reward physicians who attempt to contain
healthcare costs, even in cases where the patient has adequate indemnity insurance. Thus,
healthcare costs tend to increase relatively rapidly under this system. As long as a patient can
afford additional care, a physician is financially rewarded for providing more and more services,
even if the costs of those services outweigh their benefits. Most patients do not have the
expertise to judge the benefit of a treatment in relation to the cost of the treatment, so patients
who can afford extra services are motivated to purchase the services to be on the safe side. In
the long run, those patients may pay for and undergo treatments or tests that are unnecessary.
In addition, such choices increase the total cost of healthcare in the economy and cause the
resources within the healthcare system as a whole to be allocated inefficiently.

Third, traditional provider reimbursement often involves operational inefficiencies. To provide the
best possible care, a physician must stay current with professional advances in medicine. At the
same time, a physician would have to perform or manage all administrative and marketing
functions of the practice. Few physicians do all of these things equally well, so the practices of
even skilled physicians are subject to administrative inefficiencies that can result in either
increased costs to patients or decreased profit for the physicians. Physicians who practice alone
or in small clinics also may have difficulty achieving economies of scale in their administrative
and fixed costs, which drives up the cost of providing each treatment.

Health plans seek to avoid these three problems through the use of managed care techniques.
The structure of provider reimbursement methods in health plans involves a large number of
complex details, particularly with respect to determining a fair rate of reimbursement, given that
the exact level of care required by a population of plan members cannot be known in advance.
However, the methods themselves are easier to understand if you keep in mind that each
method addresses some or all of the three problems that we have just discussed. To solve
these problems, provider reimbursement methods seek to align the long-term goal of financial
efficiency with the short-term financial goals of those involved in the healthcare system. In most
cases, managed care achieves at least part of the realignment of participants goals through the
use of strategies that redistribute risk among the participants in healthcare plans.
Salary Reimbursement Method
Under a salary reimbursement method, or budget method, providers are paid an agreed-upon
salary in exchange for providing healthcare services. Such a system requires an administrative
entity to pay the salaries. Staff model HMOs, many government healthcare facilities, and some
hospitals use salaries as a way of paying physicians.

Compared to traditional physician reimbursement, the salary system automatically carries with it
several potential benefits. First, it separates some of the administrative functions of healthcare
from the practice of medicine, at least to the extent that the physicians and other providers do
not have to perform all of the business functions necessary in private practice. These
administrative functions can be done efficiently for a large number of providers at once, thus
lowering the administrative cost per plan member and achieving economies of scale.
Also, salaries eliminate much of the financial incentive providers might otherwise have to
perform services that are not medically necessary. In other words, because the physician is not
being paid on a per-treatment basis, simply performing more services will not financially benefit
the physician. In addition, because provider reimbursement is a sizable portion of a health
plans total costs, salaries help to stabilize expenses for the health plan or other entity
employing the providers, and at the same time stabilizes the income of the providers.
Cost stabilization is often a feature of prospective reimbursement, which is any system that
pays providers at a predetermined rate in advance of the providers supplying treatments or
services. A salary is a prospective reimbursement method, as are many of the health plan
reimbursement methods we will discuss. Traditional provider reimbursement and other forms of
paying providers per treatment are not prospective. Many prospective reimbursement methods
tend to give providers incentives to avoid overutilization, because under these types of
prospective reimbursement providers are typically not paid more simply for providing more
services.

A salary system also has some disadvantages. Although cost stabilization prevents
unexpectedly high reimbursement costs, it may also hinder cost reduction. Unless the salary
system is augmented with another type of incentive plan, providers who work efficiently and
effectively are not necessarily paid more than those who do not. Some providers under a salary
system may feel motivated to do less work, because the incentive system itself provides no
motivation to work harder. Therefore, positive levels of quality, productivity, and resource
utilization have to be encouraged in other ways.
One method of doing so is to create a salary range for providers, so that all provider-employees
are paid at least a minimum amount, and can earn up to a maximum amount by being more
productive or efficient. Similarly, providers or groups of providers can be given a bonus in
addition to their salaries after a profitable period. In this way the providers employer encourages
high productivity and efficient practices by returning some of the income and cost savings to the
providers who are successful in achieving desirable results. Such incentive methods can also
be administratively complex. They must be designed carefully so that providers are not simply
paid more to do more, but are paid more to work more effectively.
For example, an incentive program that measures the level of a physicians workload by
counting the number of diagnostic tests the physician orders is encouraging the physician to
order diagnostic tests, which may or may not indicate that the physician is practicing more
effective medicine. Both salary and nonsalary reimbursement systems can share this problem.
Often, the problem is addressed in part by having physician review panels analyze the
effectiveness of treatments rendered by individual physicians.

Under a straight salary system, providers accept some service risk. Service risk is the risk that
plan members will demand more services from the physician than had been anticipated when
the salary schedule was designed.
For the most part, however, the risk in a salary system rests with the entity paying the providers.
Providers avoid the risk that their incomes will fluctuate, and they avoid many of the business
and financial risks they would face as independent practitioners. Furthermore, they avoid the
risk that unexpectedly high utilization rates will drive costs above the income generated by the
health plans premiums. The providers employer, whether a health plan, a governmental entity,
or a hospital, in effect accepts the risk that, in the short term, costs will exceed cash flows. Like
any other business entity, the health plan or other healthcare employer will still be obligated to
pay provider salaries for as long as the employer is operating. Similarly, if plan premiums or
membership levels fall below the plans targets, the health plan or other employer must, at least
in the short term, continue meeting the same labor costs.
The health plan that operates a salary system also faces an increase in risk of liability in many
jurisdictions: as employees, the physicians are the agents of the health plan. Because an
employer is typically seen as having greater control over the actions of its employees than it
would have over the actions of independent contractors, a health plan that employs physicians
may face greater liability for its physician-employees acts of negligence.
Fee-for-Service Reimbursement Methods
In fee-for-service (FFS) reimbursement methods, providers are paid per treatment or per
service that they provide. After providing a given service or treatment, the provider bills the plan
for that treatment. Typically, FFS payment agreements contain a no-balance-billing clause. No
balance billing means that the physician agrees to accept the payment made by the health
plan as full payment for the service and will not bill the plan member for that service. No balance
billing is also often used in combination with reimbursement systems other than FFS. No
balance billing is attractive to plan members and plan sponsors because it reduces the
possibility they will face unexpected healthcare costs. Instead, their healthcare costs are defined
through premiums, copayments, and other elements that are specified in the contract offered by
the health plan.
One of the benefits of FFS reimbursement is that it is relatively easy to initiate, especially in
markets where health plan penetration is low. Using FFS can allow an health plan to acquire a
large panel of providers, which allows plan members considerable freedom to choose their
personal physicians or other providers. This freedom is highly valued by a sizable portion of the
population. Especially in markets where a health plan is attempting to establish itself, the health
plan will appear more attractive to potential plan members if becoming a member does not
require them to switch doctors. We discuss the disadvantages of FFS in the next section.
In a fee-for-service (FFS) reimbursement method, providers are paid per treatment or per
service that they provide. One typical benefit of FFS reimbursement is that it:
is highly effective in preventing excessive services that take the form of churning,
unbundling, and upcoding
provides physicians who attempt to control costs with a higher rate of compensation than
is provided to physicians who make the effort to control costs
is relatively easy to initiate, especially in markets where managed care penetration is low

guards against the practice of defensive medicine

Answer: C
Discounted Fee-for-Service
One of the first methods developed to control the costs of traditional provider reimbursement
was to determine what the usual, customary, and reasonable (UCR) fees were for each type of
treatment, then negotiate with providers to pay a discount on the UCR fee. Although UCRs were
developed by indemnity insurers, a discount on standard fees is also used by health plans. In
discounted fee-for-service (discounted FFS) reimbursement methods, the health plan
reimburses the provider on a per-treatment basis at a level below the providers usual charge for
that service. Variations on this basic arrangement are common today.
The advantage for the health plan under discounted FFS reimbursement is that the fees are
discounted. The discounted FFS concept can also be coupled with a fee schedule. Under fee
schedules, the health plan determines a maximum value for each procedure or treatment, and
pays the provider the lesser of the providers requested fee or the maximum value. Fee
schedules offer the advantage of allowing the health plan to develop uniform fees for the same
service delivered by different providers.

Providers are willing to accept a discounted or negotiated fee that is less than their usual fee
because doing so allows them access to the health plan plan membersthat is, a larger
customer base. Even providers who are not seeking to expand their plan member bases may
join panels to avoid losing plan members that they already have. Finally, unlike salary
reimbursement systems, providers who supply more services under FFS automatically receive
higher reimbursement, thus removing any motivation the provider might have to provide too few
services.
From the health plans point of view, the main disadvantage with FFS reimbursement methods
is that, while physicians are financially rewarded for providing more services, there is no
guarantee that more services necessarily translate into better plan member care in all cases.
Although the number of physicians or other providers who engage in fraud by supplying
excessive services is relatively small, physicians or other providers who are rewarded for
supplying more services will tend to supply them. For this reason, an FFS reimbursement
system will encourage providers to bill more services, leading to greater healthcare costs.
Both FFS and discounted FFS systems may fail to prevent excessive servicesand therefore
excessive costswhen those excessive services take one of three forms: churning, upcoding,
and unbundling. Churning involves a physician or other providers either seeing a plan member
more often than is necessary, or providing more treatments and tests than are necessary.
Churning ultimately adds to the costs of the plan and therefore increases the cost of healthcare
coverage to the plan member and the employer (or other payor). A plan member therefore has
motivation to avoid churning, but may not have the knowledge necessary to tell whether or not a
treatment or return office visit is necessary. Thus, churning almost always has to be prevented
by the health plans management practices. Health plans often do so by tracking claims

frequency by treatment code and by individual providers. When some treatments appear to be
billed at greater-than-expected rates, the cause can be investigated.

Upcoding is the practice of a providers billing for a procedure that pays more than the
procedure actually performed by the provider.1 The tendency to upcode can result in code
creep, which is the condition of frequently billing for more lucrative services than those actually
performed. If upcoding becomes common within an health plans health plan, the health plans
costs can rise significantly.
Unbundling is the practice of a providers billing for multiple components of a service that were
previously included in a single fee, when the total reimbursement for the multiple component
services would be higher than the single fee. Many health plans use claims software that can
recognize unbundling and will automatically rebundle the component services. Like churning,
upcoding and unbundling are essentially impossible for the plan member to detect and may be
difficult for employers or other payors to detect as well. Therefore, health plans seek to prevent
practices such as churning, upcoding, and unbundling through quality control and cost control
management functions.
Another motivating factor in some cases of overutilization involves the risk of malpractice liability
that physicians face. The risk of being found guilty of malpractice is a pure risk for a physician
it is a loss without possibility of gain. The presence of pure risk motivates those who face it to try
to avoid that risk. Some providers will be motivated by malpractice liability risk to practice
defensive medicine. Defensive medicine is an attempt to minimize malpractice risk by
supplying extra services, such as multiple diagnostic tests, even if those services are not likely
to benefit the plan member. As payment methods, neither FFS nor discounted FFS guard
against the practice of defensive medicine.
Discounted FFS and FFS reimbursement methods also are subject to another disadvantage
that we discussed under traditional reimbursement methods. Providers who are compensated
under these systems and who attempt to control costs may find themselves paid less than
physicians who make little effort to control costs. Thus, the health plan can in some cases find
itself compensating inefficient providers at a higher rate than it compensates efficient providers.
Relative Value Scale
Under any FFS system, a health plan will be motivated for administrative and financial reasons
to develop uniform fees to reimburse all providers who perform the same service. An important
method of determining uniform fee reimbursement is the use of relative value scales (RVS).
Under a relative value scale (RVS) system, a health plan assigns weighted values to each
medical procedure or service performed by a provider based on the cost and intensity of that
service. Each type of procedure is given a code number.
For example, an appendectomy would have a different code from a tonsillectomy, and an
appendectomy without complications of a peritonitis infection would have a different code from
an appendectomy performed on a plan member with severe peritonitis. Usually, RVS code
numbers are based on the current procedural terminology (CPT) codes, which were developed
by and are updated annually by the American Medical Association. To determine the actual
payment (in dollars) to a provider who performs a service defined by a CPT code, the weighted

value of the code is multiplied by a money multiplier. In practice, RVS codes have tended to
reward procedural services, such as surgical procedures, more than cognitive services, such as
office visits or research done by a physician on a plan members condition.
To address the potential imbalance in the RVS payments for procedural versus cognitive
services, a variation of the RVS system was developed. The resource-based relative value
scale (RBRVS) system is a means of determining provider reimbursement that attempts to take
into account all resources that providers use in providing care to plan members, including
procedural, educational, mental, and financial resources. 2 The Centers for Medicare and
Medicaid Services (CMS) requires the use of RBRVS for Medicare billing. This requirement has
encouraged the use of RBRVS as a uniform billing methodology, even outside Medicare
markets.
Both RBRVS and RVS share with UCR fees an administrative advantage when used as part of
an FFS reimbursement system. Because physicians using these systems bill for their services
according to precise codes, tracking treatment rates is much easier and more exact for the
health plans quality and cost management functions. The use of RBRVS also provides a
coherent starting point for fair compensation to various providers who may be providing different
types of services. Therefore, RBRVS can be useful to a health plan that is developing
reimbursement schedules for various types of providers in a comprehensive health plan.

One disadvantage that RBRVS shares with other FFS systems is that RBRVS rewards
providers for rendering more services, but does not put them at financial risk for overutilization.
The health plan retains overutilization risk under a reimbursement system that uses RBRVS in
the absence of any other incentive system. Consequently, the health plan must manage the risk
of overutilization either through a separate incentive system that motivates providers to control
costs, or through administrative measures, such as clinical practice guidelines, that seek to
manage provider behavior. The health plan must also establish safeguards to minimize
upcoding under RBRVS systems.
Global Fees
Another method of provider reimbursement uses global fees. A global fee is a single fee that
the provider is given for all services associated with an entire course of treatment given to a
plan member. For example, global fees are common in obstetrics. The global fee would be
payment for prenatal visits, the delivery itself, and a defined period of post-delivery care. Global
fees also can be set up for non-emergency surgical procedures, or certain types of office visits
where the service or treatment is well defined. Thus, the provider or providers (for example, a
hospital in the case of surgeries) must manage the costs of the components of a plan members
course of treatment, because the cost of these components cannot be billed separately to the
health plan.
A global fee therefore transfers some of the risk for overutilization of care from the health plan to
the providers. In doing so, a global fee rewards providers who deliver costeffective care. Global
fee systems do not completely eliminate all motivation a provider may have to engage in
churning, because the provider is still being paid according to the number of treatments
performed. However, global fees do eliminate unbundling and upcoding within specific
treatments, because the single global fee covers the entire course of treatment.

Global fees can be more administratively complicated to develop initially than straightforward
FFS systems, particularly when global fees provide compensation to more than one provider.
For example, if a global fee is paid for an appendectomy, then a fair method must be devised for
dividing that fee among the surgeon, anesthesiologist, and other providers involved in that
treatment. Global fees for physician services or for individual providers, however, are similar to
bundling. To operate efficiently, global fees require that a health plan have a claims system that
recognizes the component services contained within the global fee, so that the health plan will
not pay both the global fee and make individual payments for the same component services
billed under individual codes.
The global fees themselves must reflect how difficult and time-consuming each course of
treatment is relative to other courses of treatment. The health plan and the provider, as parties
to the reimbursement contract, will have fewer conflicts if the global fee for a given treatment is
fair that is, neither excessively high nor too low to cover the costs the provider incurs in
providing the treatment. Ideally, the global fee system balances the reimbursement for each
treatment with the relative reimbursement for other treatments. This balance is important in
terms of managing utilization, because if the global fee for one procedure is financially more
attractive than the fee for a second procedure, then the fee system may inadvertently
encourage upcoding.

Global fees expose providers to the risk that the cost of treatment for some plan members may
exceed the global fee. Under such conditions, a provider may be reluctant to provide additional
services. Consequently, a system must be in place to assure that plan members receive
appropriate care. Two commonly used systems are quality management on the part of the
health plan, and various forms of insurance or contractual elements that protect the provider
against financial losses in cases that require exceptionally expensive treatment. We discuss
these forms of insurance and contractual elements in more detail in future lessons.
In the long-run, a global fee system, like any other provider reimbursement system, works best if
it aligns the financial goals of the providers with the financial goals of the health plan, employer,
and plan member. The financial goals must also be aligned with the central goal of providing
excellent care. Some characteristics of provider reimbursement systems that help achieve these
alignments are listed in Figure 3B-1.

Dr. Martin Cassini is an obstetrician who is under contract with the Bellerby Health Plan.
Bellerby compensates Dr. Cassini for each obstetrical patient he sees in the form of a single
amount that covers the costs of prenatal visits, the delivery itself, and post-delivery care . This
information indicates that Dr. Cassini is compensated under the provider reimbursement method
known as a:
global fee
relative value scale
unbundling
discounted fee-for-service
Provider Incentive Methods: Withholds, Risk Pools, and Bonuses

Withholds, risk pools, and bonuses are all means of motivating providers to manage costs by
making a portion of their reimbursement dependent on how well the providers and the health
plan manage costs. In all three methods, an assumed or budgeted cost is developed, and a
portion of the providers income is subject to enhancement (or loss), depending on whether
costs are held below the budgeted amount during a specific period.
Withholds
In a withhold arrangement, a percentage of the providers reimbursement is not paid to the
providers until the end of a financial period; claims that exceed the budgeted costs for care
during that period are charged against the withheld funds, and after such claims are paid, the
remaining money in the withhold is distributed to the providers. If providers hold costs below the
amount budgeted for that period, then the entire amount of money in the withhold is usually
distributed to them. If the cost overruns exceed the withhold, then the deficits are usually the
responsibility of the health plan. Withholds usually range from 10% to 20% of total provider
reimbursement for the period.
Risk Pools
A risk pool is an arrangement in which a fund is created at the beginning of a financial period,
any claims approved for payment are paid out of that fund during the period, and at the end of
the period, any remaining risk pool funds are paid to providers. If costs exceed the funded risk
pool, the providers and the health plan pay the deficit according to percentages agreed upon at
the beginning of the contract period.
Dr. Jacob Winburne is compensated by the Honor Health Plan under an arrangement in which
Honor establishes at the beginning of a financial period a fund from which claims approved for
payment are paid. At the end of the given period, any funds remaining are paid out to providers.
This information indicates that the arrangement between Dr. Winburne and Honor includes a
provider incentive known as a:
risk pool, and any deficit in the fund at the end of the period would be the sole
responsibility of Honor
risk pool, and any deficit in the fund at the end of the period would be paid by both
Dr. Winburne and Honor according to percentages agreed upon at the beginning of
the contract period
withhold, and any deficit in the fund at the end of the period would be the sole
responsibility of Honor
withhold, and any deficit in the fund at the end of the period would be paid by both Dr.
Winburne and Honor according to percentages agreed upon at the beginning of the
contract period
Bonus Arrangements
Bonus arrangements, which pay providers over and above their usual reimbursement at the
end of a financial period, are based on the performance of the health plan as a whole, a group
of providers within the plan, or an individual provider. Bonuses provide financial incentives to
providers to minimize unnecessary costs. Bonuses may be based on a percentage of a
providers reimbursement or a percentage of the savings experienced by the health plan.
Bonuses based on savings achieved by the plan as a whole have the advantage of being

somewhat easier to administer, but, in such cases, the achievement of savings and the bonus
for each provider will be based partly on events outside the providers control.
Under a bonus reimbursement arrangement, the providers are not at financial risk to make up
any deficit experienced by the plan. Beyond the possibility of losing their bonus, providers are
not at risk when the plan faces deficits. As we noted previously, providers in a risk pool
arrangement are usually responsible for sharing a plan deficit even if the deficit is greater than
the funded risk pool.
The central motivation for forming risk pools, withholds, and bonus arrangements is to transfer
some of the financial risk associated with overutilization to providers, who at least partly control
utilization rates. In this way, providers are motivated to control utilization by managing it
themselves.
Hospital Reimbursement Methods
Hospitals are an important player in provider reimbursement systems. Often an health plan will
reimburse hospitals using one reimbursement method, and the providers associated with the
hospital will be paid using a different method. Also, a single hospital may be reimbursed under
several different payment systems, which will vary from health plan to health plan, health plan to
health plan1, and from private plans to government plans such as Medicare and Medicaid.
Before continuing our discussion of hospital reimbursement methods, refer to Figure 3B-2,
which provides definitions for some key terms used in hospital reimbursement.
Straight Charges
The simplest (albeit least desirable) payment mechanism in healthcare is straight charges,
under which a hospital submits its claim in full to a health plan and the plan pays the bill. It is
also obviously the most expensive, after the option of no contract at all. This is a fallback
position to be agreed to only in the event that the health plan is unable to obtain any form of
discount at all, but it is still desirable to have a contract with a no-balance-billing clause in it for
purposes of reserve requirements and licensure.
Straight Discount on Charges
Another possible arrangement with hospitals is a straight discount on charges, under which a
hospital submits its claim to a health plan in full, and the plan discounts it by the agreed-to
percentage and then pays the claim. The hospital accepts this payment as payment in full. The
amount of discount that can be obtained will depend on the factors discussed above. This type
of arrangement is not infrequent in markets with low levels of health plan penetration but is
uncommon in markets with high levels of health plans.
Sliding Scale Discount on Charges
Sliding scale discounts are an option, particularly in markets with low health plan penetration but
some level of competitiveness among hospitals. Under a sliding scale discount on charges,
the percentage discount on a hospitals bill is reflective of the hospitals total volume of
admissions and outpatient procedures. Deciding whether to combine these two categories or
deal with them separately is not as important as making sure that the parties deal with them

both. With the rapidly climbing cost of outpatient procedures, savings from reduction of inpatient
utilization could be negated by an unanticipated overrun in outpatient charges.
An example of a sliding scale is a 20% reduction in charges for 0 to 200 total bed days per year
with incremental increases in the discount up to a maximum percentage. An interim percentage
discount is usually negotiated, and the parties reconcile at the end of the year based on the final
total volume.
How a health plan tracks the discount is also negotiable. A health plan may vary the discount on
a month-to-month basis rather than yearly. Alternatively, the health plan may track total bed
days, number of admissions, or whole dollars spent. Whatever the health plan finally agrees to
should be a clearly defined and measurable objective.
The last issue to look at in a sliding scale is timeliness of payment. It is likely that the hospital
will demand a clause in the contract spelling out the health plans requirement to process claims
in a timely manner, usually 30 days or sooner. In some cases a health plan may negotiate a
sliding scale, or a modifier to the main sliding scale, that applies a further reduction based on
the plans ability to turn a clean claim around quickly. For example, the health plan may
negotiate an additional 4% discount for paying a clean claim within 14 days of receipt.
Conversely, the hospital may demand a penalty for clean claims that are not processed within
30 days.
Straight Per-Diem Charges
Unlike straight charges, a negotiated straight per-diem charge is a single charge for a day in
the hospital, regardless of any actual charges or costs incurred. In this most common type of
arrangement, a health plan negotiates a per-diem rate with the hospital and pays that rate
without adjustments. For example, the plan will pay $800 for each day regardless of the actual
cost of the service.
Hospital administrators are sometimes reluctant to add days in the intensive care unit or
obstetrics to the base per diem unless there is a sufficient volume of regular medical-surgical
cases to make the ultimate cost predictable. In a small health plan, or in one that is not limiting
the number of participating hospitals, the hospital administrator is concerned that the hospital
will be used for expensive cases at a low per diem while competitors are used for less costly
cases. In such cases, a good option is to negotiate multiple sets of perdiem charges based on
service typefor example, medical-surgical, obstetrics, intensive care, neonatal intensive care,
rehabilitation, and so forthor a combination of per diems and a flat case rate (explained later)
for obstetrics.
The key to making a per diem work is predictability. If the health plan and the hospital can
accurately predict the number and mix of cases, then they can accurately calculate a per diem.
The per diem is simply an estimate of the charges or costs for an average day in that hospital,
minus the level of discount.
A theoretical disadvantage of the per diem approach, however, is that the per diem must be paid
even if the billed charges are less than the per diem rate. For example, if the health plan has a
per-diem arrangement that pays $800 per day for medical admissions, and the total allowable
charges (billed charges less charges for noncovered items provided during the admission) for a

5-day admission are $3,300, the hospital is reimbursed $4,000 for the admission ($800 per day
5 days).
This is acceptable as long as the average per diem represents an acceptable discount, but it
has been anecdotally reported that some large, self-insured accounts have demanded the
lesser of the charges or the per diems for each casethat is, laying off the upper end of the risk
but harvesting the reward. Such demands are to be avoided because they corrupt the integrity
of the perdiem calculation.
A health plan may also negotiate to reimburse the hospital for expensive surgical implants
provided at the hospitals actual cost of the implant. Such reimbursement would be limited to a
defined list of implants, such as cochlear implants, where the cost to the hospital for the implant
is far greater than is recoverable under the per diem or outpatient arrangement.
Cascade Hospital has negotiated with the McBee Health Plan a straight per-diem rate of $1,000
per day for medical admissions. One of McBees plan members was admitted to Cascade for 10
days. Total billed charges equaled $10,000, of which $2,000 were for noncovered items. This
information indicates that, for this admission, the amount that McBee was obligated to
reimburse Cascade was:
$0
$8,000
$10,000
$12,000
Answer: C
Sliding Scale Per-Diem Charges
Like the sliding scale discount on charges discussed above, the sliding scale per diem charge is
also based on total volume. Under sliding scale per-diem charges, a health plan negotiates
an interim per diem that it will pay for each day in the hospital; depending on the total number of
bed days in the year, the plan will either pay a lump sum settlement at the end of the year or
withhold an amount from the final payment for the year to adjust for an additional reduction in
the per diem from an increase in total bed days. It may be preferable to make an arrangement
whereby on a quarterly or semiannual basis the plan will adjust the interim per diem so as to
reduce any disparities caused by unexpected changes in utilization patterns.
Differential by Day in Hospital
Charging according to differential by day in hospital refers to the fact that most
hospitalizations are more expensive on the first day. For example, the first day for surgical
cases includes operating suite costs and operating surgical team costs. This type of
reimbursement method is generally combined with a per-diem approach, but the first day is paid
at a higher rate, such as $1,000, and each subsequent day is $600.

Diagnosis-Related Groups
As with Medicare, a common reimbursement methodology is by diagnosis-related group (DRG),
which is a statistical system of classifying inpatient stays into groups for the purpose of
payment. There are publications of DRG categories, criteria, outliers, and trim pointsthat is,
the cost or length of stay that causes the DRG payment to be supplemented or supplanted by
another payment mechanismto enable a health plan to negotiate a payment mechanism for
DRGs based on Medicare rates or, in some cases, state regulated rates. First, though, the plan
needs to assess whether it will be to its benefit.
If it is the plans intention to reduce unnecessary utilization, there will not necessarily be
concomitant savings if it uses straight DRGs. If the payment is fixed on the basis of diagnosis,
any reduction in days will go to the hospital and not to the plan. Furthermore, unless the health
plan is prepared to perform careful audits of the hospitals DRG coding, it may experience code
creep. On the other hand, DRGs do serve to share risk with the hospital, thus making the
hospital an active partner in controlling utilization and making plan expenses more manageable.
Generally, DRGs are better suited to plans with loose controls than plans that tightly manage
utilization. Insight 3A-2 explains a Medicare demonostration program, combining DRG payment
with incentive, or bonus payments for quality.
Insight 3A-2
THE PREMIER HOSPITAL
SUPERIOR QUALITY CARE

QUALITY INCENTIVE

DEMONSTRATION:

REWARDING

Overview
The Premier Hospital Quality Incentive Demonstration is part of the CMS Hospital Quality
Initiative, originally launched in 2003 by the Centers for Medicare & Medicaid Services (CMS)
and the Department of Health and Human Services (HHS). The Premier Hospital Quality
Incentive Demonstration, a three-year project launched with Premier Inc., a nationwide
organization of not-for-profit hospitals, will recognize and provide financial rewards to hospitals
that demonstrate high quality performance in a number of areas of acute care.
CMS is pursuing a vision to improve the quality of health care by expanding the information
available about quality of care and through direct incentives to reward the delivery of superior
quality care. Through the Premier Hospital Quality Incentive Demonstration, CMS aims to see a
significant improvement in the quality of inpatient care by awarding bonus payments to hospitals
for high quality in several clinical areas, and by reporting extensive quality data on the CMS web
site.
Quality of Care Measures
Under the demonstration, top performing hospitals will receive bonuses based on their
performance on evidence-based quality measures for inpatients with: heart attack, heart failure,
pneumonia, coronary artery bypass graft, and hip and knee replacements. The quality
measures proposed for the demonstration have an extensive record of validation through
research, and are based on work by the Quality Improvement Organizations (QIOs), the Joint
Commission on Accreditation of Healthcare Organizations (JCAHO), the Agency for Healthcare
Research and Quality (AHRQ), the National Quality Forum (NQF), the Premier system and
other CMS collaborators.

Hospital Scores Hospitals will be scored on the quality measures related to each condition
measured in the demonstration. Composite quality scores will be calculated annually for each
demonstration hospital by rolling-up individual measures into an overall quality score for each
clinical condition. CMS will categorize the distribution of hospital quality scores into deciles to
identify top performers for each condition.
Financial Awards
CMS will identify hospitals in the demonstration with the highest clinical quality performance for
each of the five clinical areas. Hospitals in the top 20% of quality for those clinical areas will be
given a financial payment as a reward for the quality of their care. Hospitals in the top decile of
hospitals for a given diagnosis will be provided a 2% bonus of their Medicare payments for the
measured condition, while hospitals in the second decile will be paid a 1% bonus. The cost of
the bonuses to Medicare will be about $7 million a year, or $21 million over three years.
Improvement Over Baseline
In year three, hospitals that do not achieve performance improvements above demonstration
baseline will have adjusted payments. The demonstration baseline will be clinical thresholds set
at the year one cut-off scores for the lower 9th and 10th decile hospitals. Hospitals will receive
1% lower DRG payment for clinical conditions that score below the 9th decile baseline level and
2% less if they score below the 10th decile baseline level.
Adapted from: Premier Hospital Quality Incentive Demonstration, Fact Sheet. Centers for
Medicare & Medicaid Services, Washington, DC February, 2004.
Service-Related Case Rates
Similar to DRGs, service-related case rates are a cruder reimbursement mechanism. Under
service-related case rates, various service types are defined and the hospital receives a flat
per admission reimbursement for whatever type of service to which the patient is admittedfor
example, all surgical admissions cost $6,100. Service types include medicine, surgery, intensive
care, neonatal intensive care, psychiatry, and obstetrics. If services are mixed, a prorated
payment, such as 50% of surgical and 50% of intensive care, may be made.
Case Rates and Package Pricing
Whatever mechanism a plan uses for hospital reimbursement, it may still need to address
certain categories of procedures and negotiate special rates. Case rates are rates that are
established on a case by case basis. The most common of these is obstetrics. It is common to
negotiate a flat rate for a normal vaginal delivery and a flat rate for a Caesarean section or a
blended rate for both. In the case of blended case rates, the expected reimbursement for each
type of delivery is multiplied by the expected (or desired) percentage of utilization.
For example, a case rate for vaginal delivery is $2,000, and a case rate for Caesarean section is
$2,600. If expected utilization is 80% for vaginal delivery and 20% for Caesarean section, then
the case rate is $2,120 ($2,000 0.8 = $1,600; $2,600 0.2 = $520; $1,600 + $520 = $2,120).
With the recent legislative activity regarding minimum length of stay for obstetrics, flat case
rates, regardless of either length of stay or Caesarean section versus vaginal delivery, are
clearly the preferred method of reimbursement, other than capitation.

Although common, case rates are certainly not necessary if the per diem is all-inclusive, but a
health plan will want to use them if it has negotiated a discount on charges. This is because the
delivery suite or operating room is substantially more costly to operate than a regular hospital
room. For example, a health plan may negotiate a flat rate of $2,100 per delivery. The downside
of this arrangement is that the health plan achieves no added savings from decreased length of
stay. The upside is that it makes the hospital a much more active partner in controlling
utilization.
Another area for which a health plan would typically negotiate flat rates is specialty procedures
at tertiary hospitals for medical procedures such as coronary artery bypass surgery or heart
transplants. These procedures, although relatively infrequent, are tremendously costly.
A broader variation is package pricing or bundled case rates. Package pricing or bundled case
rate refers to an all-inclusive rate paid for both institutional and professional services. A health
plan negotiates a flat rate for a procedure, such as coronary artery bypass surgery, and that rate
is used to pay all parties who provide services connected with that procedure, including
preadmission and post-discharge care. Bundled case rates are not uncommon in teaching
facilities where there is a facility practice plan that works closely with the hospital.
Reimbursement Methods for Ancillary Service Providers
One of the primary means by which health plans have achieved greater financial efficiency than
traditional medicine is through economies of scale. For health plans, this typically involves
developing a network of providers, including individual physicians and hospitals. health plans
seeking to provide comprehensive health plans must also contract with a variety of providers for
ancillary services. Ancillary services is an umbrella term for a variety of healthcare services
outside of surgery, primary care, and most hospital treatment, and typically these services are
provided by non-physicians. Many ancillary services are diagnostic: laboratory tests, radiology,
and magnetic resonance imaging are all examples of services often considered ancillary by
health plans. Similarly, many kinds of physical and behavior therapy, dialysis, home health care,
and even pharmacy services are considered ancillary services.
One characteristic of most ancillary services that has important contractual and financial
implications for a health plan is that few plan members seek these services without first being
referred to the ancillary provider by a physician. For this reason, the utilization rates for ancillary
services are partly controlled by physician behavior. Consequently, utilization rates and the
costs that a health plan experiences for ancillary providers depend on the type of network the
health plan manages, and the reimbursement methods it uses for its physicians and hospitals.
An important feature of health plans that have large health plans is that these plans develop
significant data over time concerning quality outcomes by type and intensity of treatments,
including ancillary services. Thus, these health plans are able to provide physicians with
indicators for determining whether a referral to ancillary services should be made in a given
case. The health plans case managers may also help control utilization and maximize quality of
care by consulting with physicians and ancillary providers at the beginning of a case to
determine the appropriate frequency and intensity of use of ancillary services.
Reimbursement methods for ancillary service providers tend to fall into the same general
categories as those we have already discussed for physicians and hospitals: FFS, discounted
FFS, case rates, per diems, and capitation are all used. Within the limits of the utilization

controls mentioned above, these reimbursement systems distribute utilization risk between the
contracting parties much as the same reimbursement methods distribute risk between
physicians and health plans.
Reimbursement methods for ancillary services may also be influenced by the structure of the
health plan that negotiates the contract with the ancillary service providers. A closed panel plan,
for instance, may operate the ancillary service itself. A closed panel plan, as well as many open
panel plans, may also contract for services with the ancillary service providers or provider
groups.

As we have seen, in choosing methods of provider reimbursement for PCPs, specialists,

hospitals, and ancillary service providers, health plans and the providers themselves must
consider a number of factors, including the

Type of providers
Type of service being performed by the providers
Degree to which transferring utilization risk to the providers is possible and desirable

Different methods of reimbursement have different implications in terms of who is responsible

for controlling utilization risk and who is responsible for controlling a significant source of
financial costs that a health plan incurs. Capitation, which is already an important
reimbursement method for many physicians and hospitals, is becoming more common in
ancillary service provider contracts. We discuss capitation in the next lesson.