Prospective Payment System

In 1983, the U.S. federal government initiated a new method of payment for Medicare hospital services. The prospective payment system (PPS) created a reimbursement mechanism in which scientifically clustered diagnoses known as diagnosis-related groups (DRGs) would have predetermined compensation amounts, regardless of the hospitals' actual costs. The concept of DRGs was created by a group at Yale University in the 1970s and adopted by Medicare for the prospective payment system for hospital inpatient services. Medicare pays physicians using a modified fee-for-service system based on a resource-based relative value scale (RBRVS).

Each year the Center for Medicare and Medicaid Services (CMS, formerly the Health Care Financing Administration, or HCFA) determines hospital Medicare reimbursement based on DRGs. Since 1983, CMS has instituted a PPS for home health care, skilled nursing facilities, and outpatient care.

The PPS for hospital inpatient services has served as a model for all the other types of services that CMS currently pays through the PPS. The payment cycle can be described as follows:

• 1.
  Hospitals submit a bill for each Medicare patient they treat to their Medicare fiscal intermediary (a private insurance company that contracts with Medicare to carry out the operational functions of the Medicare program). Based on the information provided on the bill, the case is categorized into a diagnosis-related group (DRG), which determines how much payment the hospital receives. Most hospitals have software in their billing systems that optimize DRG classifications for maximum reimbursement.
• 2.
  The base payment rate is composed of a standardized amount, which is divided into amounts that are labor related and those that are not. The labor-related amount is adjusted by the hospital's local wage index. Hospitals in Alaska and Hawaii also receive an adjustment for cost of living. The base payment rate is then multiplied by the DRG relative weight to arrive at a DRG-adjusted base payment rate.
• 3.
  If the hospital cares for a disproportionate share (DPS) of low-income patients, it receives an additional amount for each case paid through the PPS, depending on the percentage of low-income patients served. The DPS factor is then applied to the DRG-adjusted base payment rate and any outlier payments received for services not meeting DRG criteria, such as catastrophic cases that generated costs outside the limits of the DRG.
• 4.
  Teaching hospitals receive a percentage add-on payment for each PPS case, depending on the ratio of residents to beds.
• 5.
  The hospital's costs for the case are evaluated to determine whether the case qualifies as an outlier. In the event that the case does meet the criteria as an outlier, an additional payment may be provided to protect the hospital from serious financial losses from unusually expensive cases. The outlier payment is added on to the DRG-adjusted base payment rate generated in the second step of the payment calculation.
• 6.
  The costs for each case are then summed to calculate the total payment due the hospital.

Several costs are excluded from PPS reimbursement. For example, direct costs of medical education for interns and residents are reimbursed to teaching hospitals based on a fixed amount per resident. In addition, bad debts from failure of patients to pay Medicare deductible and coinsurance amounts are reimbursed, but only at a rate that reasonably compensates the hospital for its costs. Finally, organ procurement costs at transplant facilities are also reimbursed separately.

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