Prospective Payment

Medicare's Prospective Payment System

The best-known example of case-based payment in healthcare is Medicare's prospective payment system (PPS), which was mandated by the U.S. Congress to control community hospital inpatient costs in 1983. Under this system, the Medicare program changed its mode of payment for hospital inpatient care from a retrospective cost-based system to a prospective case-based system.

After the Medicare program was established in 1965 the costs of hospital care soared. One of the major factors that led to rising costs was the retrospective cost-based payment system. Under this system, hospitals submitted their bills to Medicare after the care had been given and the costs to the hospital were known. Hospitals were then paid for the care they provided, as allowed by Medicare rules, regardless of whether the costs were high or low, excessive or appropriate. Consequently, there was little incentive for hospitals to be cost-effective.

On the other hand, the prospective case-based payment system set payment rules prior to when the care was given. By setting a fixed reimbursement level per case based on diagnosis, the PPS provided economic incentives to conserve the use of resources. Hospitals that used more resources than covered by the flat rate lost the difference. Those with costs below the rate retained the difference.

Diagnosis Related Groups

Under Medicare's PPS, the amount paid to hospitals is based on their patients' Diagnosis [Page 966]Related Groups (DRGs). Specifically, each patient is assigned into one of more than 500 DRGs, based on principal diagnosis, age, and medical complications. The DRGs aggregate patients with similar resource-consumption and hospital length-of-stay patterns. Medicare then pays the hospitals a set amount for each DRG. The government calculates the payment for each DRG based on national averages. It also modifies that amount somewhat based on local wage rates, geographic location (e.g., rural versus urban area), and whether the hospital is a teaching hospital.

Effects of Medicare's Prospective Payment System

Extensive research has been conducted to examine the impact of Medicare's PPS on hospitals and patients. This research has focused on the system's impact on average hospital length of stay, access to and quality of care, financial condition of hospitals, overall effects on costs, and hospital management.

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