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How does Medicare pay providers in traditional Medicare?

Medicare relies on a number of different approaches when calculating payments to each provider for services they deliver to beneficiaries in traditional Medicare.

Current payment systems in traditional Medicare have evolved over the last several decades, but have maintained a fee-for-service payment structure for most types of providers. In many cases, private insurers have modeled their payment systems on traditional Medicare, including those used for hospitals and physicians. Building on Medicare payment reforms included in the Affordable Care Act and new approaches being tested and launched by the CMS Innovation Center, the Secretary of Health and Human Services recently announced a set of explicit targets to be met in the coming years that would tie an increasing share of traditional Medicare payments to provider performance on quality and spending.1

About two-thirds of Medicare’s benefit spending is on services delivered by providers in traditional Medicare.

Out of $597 billion in total benefit spending in 2014, Medicare paid $376 billion (63%) for benefits delivered by health care providers in traditional Medicare.2 These providers include hospitals (for both inpatient and outpatient services), physicians, skilled nursing facilities, home health agencies, inpatient rehabilitation facilities, hospice agencies, long-term care hospitals, outpatient dialysis facilities, ambulatory surgical centers, inpatient psychiatric facilities, durable medical equipment suppliers, ambulance providers, and laboratories. In general, Medicare pays each of these providers separately, using payment rates and systems that are specific to each type of provider. The remaining share of Medicare benefit payments (37%) went to private plans under Part C (the Medicare Advantage program; 26%) and Part D (the Medicare drug benefit; 11%). These private plans are responsible for paying providers or pharmacies on behalf of their Medicare enrollees. (See What is Medicare Advantage? and What is the Medicare Part D prescription drug benefit? for additional information on how Medicare pays Medicare Advantage and Part D plans.) The Budget Control Act of 2011 put in place a 2 percent across-the-board cut (known as “sequestration”) in Medicare payment to plans and providers beginning in 2013.

For most payment systems in traditional Medicare, Medicare determines a base rate for a specified unit of service, and then makes adjustments based on patients’ clinical severity, selected policies, and geographic market area differences.

Medicare uses prospective payment systems for most of its providers in traditional Medicare. In general, these systems require that Medicare pre-determine a base payment rate for a given unit of service (e.g., a hospital stay, an episode of care, a particular service). Then, based on certain variables, such as the provider’s geographic location and the complexity of the patient receiving the service, Medicare adjusts its payment for each unit of service provided (see Appendix 4: Medicare Payments to Providers). For most payment systems, Medicare updates payment rates annually to account for inflation adjustments. The main features of hospital, physician, outpatient, and skilled nursing facility payment systems (altogether accounting for almost three-quarters of spending in traditional Medicare) are described below:

  • Inpatient hospitals (acute care): Medicare pays hospitals per beneficiary discharge, using the Inpatient Prospective Payment System. The base rate for each discharge corresponds to one of over 700 different categories of diagnoses—called Diagnosis Related Groups (DRGs)—that are further adjusted for patient severity. DRGs that are likely to incur more intense levels of care and/or longer lengths of stay are assigned higher payments. Medicare’s payments to hospitals also account for a portion of hospitals’ capital and operating expenses. Some hospitals receive added payments, such as teaching hospitals and hospitals with higher shares of low-income beneficiaries. Recent Medicare policies also reduce payments to some hospitals, including hospitals that have relatively higher Medicare readmission rates following previous hospitalizations for certain conditions.
  • Physicians and other health professionals: Medicare reimburses physicians and other health professionals (e.g., nurse practitioners) based on a fee-schedule for over 7,000 services. Payment rates for these services are determined based on the relative, average costs of providing each to a Medicare patient, and then adjusted to account for other provider expenses, including malpractice insurance and office-based practice costs. This system, known as the Resource-Based Relative Value Update Scale (RBRVS), has been in place since 1992. Increases to Medicare’s payments include bonuses to those practicing in designated shortage areas. In general, health professionals who are not physicians but bill Medicare independently (e.g., nurse practitioners) receive a 15 percent reduction in payment.

Under current law, Medicare’s physician fee-schedule payments are subject to a formula, called the Sustainable Growth Rate (SGR) system, enacted in 1987 as a tool to control spending. For more than a decade this formula has called for cuts in physician payments, reaching as high as 24 percent. To prevent these cuts in physician payments from occurring, policymakers have overridden the SGR 17 times, as of 2014. Policymakers in both the House and the Senate agreed on a bipartisan proposal to repeal the SGR and replace it with a long-term approach for setting physician fees (H.R. 4015/S.2000), but disagreement on how the federal government would cover the cost of this proposal has so far prevented its enactment.

  • Hospital outpatient departments: Medicare pays hospitals for ambulatory services provided in outpatient departments, based on the classification of each service into more than 750 categories with similar expected costs. Final determination of Medicare payments for outpatient department services is complex and incorporates both individual service payments and payments “packaged” with other services, partial hospitalization payments, as well as numerous exceptions. Hospitals may receive additional payments for certain outpatient department services, such as specified drugs and devices; unusually costly (outlier) services; and adjustments for some rural hospitals and cancer hospitals.
  • Skilled Nursing Facilities (SNFs): SNFs are freestanding or hospital-based facilities that provide post-acute inpatient nursing or rehabilitation services. Medicare pays SNFs one of 66 pre-determined daily rates (categorized as Resource Utilization Groups (RUGs) for each patient, based on patients’ expected level of nursing and therapy needs. SNF payments incorporate operating and capital costs for providing care to Medicare patients, and an added daily payment from Medicare for care provided to beneficiaries with AIDS.
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