Medicare's Prospective Payment System at Age Eight: Mature Success or Midlife Crisis?
| Publication year | 1991 |
| Citation | Vol. 14 No. 03 |
The enactment of Medicare's Prospective Payment System (PPS) for hospitals in 1983(fn1) was accompanied by extraordinary hoopla and rhetoric, if not by prolonged Congressional deliberation or even by committee hearings. PPS constituted an extraordinary change in the method by which the government paid some $40 billion annually to the nation's hospitals for the provision of inpatient care to 28 million Medicare beneficiaries. Such a huge change of direction might have been expected to be the focus of considerable attention, at least among those with a professional interest in hospital matters, but PPS was depicted in even grander terms. Proposed near the highwater mark of the Reagan Revolution in domestic policy, PPS was depicted as a critical step in the "deregulation" of American hospitals, as a major initiative in establishing "marketplace competition" in the health care industry, and as a sophisticated application of the principle of using incentives rather than "command and control" regulation to make public policy more consonant with microeconomic theory.(fn2)
In keeping with this "marketplace" model, Reagan's Department of Health and Human Services and Office of Management and Budget conceived of PPS as a largely self-maintaining system that would pay hospitals a uniform national rate, adjusted only for differences in local wage rates and the effects of teaching programs, for each of 467 Diagnosis-Related Groups (DRGs). There would be no appeals process and no exceptions process. Some of PPS's more extreme ideological enthusiasts suggested that once the system was fully implemented there would not even be a need to collect cost data from hospitals. Each year, the Secretary of Health and Human Services would update payment rates for inflation, while continuing to refine the classification process that assigned cases to DRGs. And that would be that.(fn3)
Under such a system, it was argued, hospitals would have an extremely powerful incentive to control their costs, since those able to deliver care for less than the uniform rate would be able to keep all the savings, while those whose costs exceeded the rates would be at risk of financial catastrophe. Of course, in such a market, a considerable number of hospitals might be expected to fail-perhaps as many as a third, according to one Administration official.(fn4) That was just the expected price to be paid for the replacement of the inherent evils of cost-based reimbursement with a more economically rational system such as PPS.
PPS is now approaching its eighth birthday. It is widely viewed as a success, credited for both a transformation of the hospital industry and the saving of many billions of dollars. These credited savings have, not inconsequentially, postponed the date at which the Hospital Insurance Trust Fund is projected to be insolvent.(fn5) Early fears that such a system of cost controls would lead to serious impairments in the quality of care provided to Medicare beneficiaries appear to have been disproved, as have anxieties that widespread hospital closings and resource scarcity would impair access to needed services for beneficiaries.
Despite these apparent successes, there may be less to PPS than meets the eye. PPS may have constrained Medicare expenditures, but over the last five years real hospital costs have been rising at rates close to the pre-PPS pattern. Even the savings from the early years of PPS may have been at least partially the result of forces largely external to PPS. At the same time, contrary to all expectations, America's hospitals have experienced unprecedented prosperity during the first eight years of PPS. Somewhat more hospitals may have closed during that time than might otherwise have been expected, but the numbers are still not terribly large. And the verdict may still be out on some of the quality issues.
As discussion of more systemic reform of the nation's health care system gains more attention, this may be a good time to take stock of what PPS has and has not accomplished and what lessons it may hold for future policy, both for hospital payment and for government financing of health care. It is also likely that over the next several years, as the pressures surrounding PPS intensify for reasons that will be discussed below, the basic rationale and structure of the system will be increasingly debated, whether or not more general reform also takes place.
What follows is necessarily a rather selective (for reasons of brevity and reader tolerance) and even subjective attempt to summarize the experience under PPS to date and to suggest some lessons that might be drawn from that experience for the future reform of PPS itself and of payment systems generally. No attempt will be made here to be comprehensive, to explain all the technical details of an inherently and increasingly complex system, nor even to systematically survey the rapidly growing body of literature. But the few issues and themes that clearly stand out will be the focus of most of this paper. The paper begins with a review of the aggregate data on PPS's performance since its inception, looking at the effects both on the payor, Medicare, and the payees, the nation's hospitals. It will then consider some of the distributional patterns of benefits and losses potentially concealed by those aggregate figures. The issues of quality and access and the related impacts of the system on health care generally will then be quickly considered. This will be followed by a more evaluative consideration of the major strengths and weaknesses of PPS and a consideration of future directions for the program.
I. What Really Happened
In order to understand both the context in which PPS was enacted and the way in which it has evolved, two basic issues must be understood. First, PPS was born from the intellectual discrediting of cost-based reimbursement for hospital and other health care services. The enactment of PPS in 1983 culminated a five-year political process that effectively began when the hospital industry, seeking to defeat, President Carter's cost containment legislation in 1978 and 1979, undertook a "Voluntary Effort" to control the rate of hospital cost growth. This Carter Administration proposal followed relatively traditional price-control principles which, it must be noted, had worked in the past, both in the Nixon Economic Stabilization Program and in a number of states. But after a brief hiatus at the outset of the "Voluntary Effort," hospital costs proceeded to grow at even higher rates, partly-but only partly-because of record levels of inflation in the economy as a whole. By 1982 and 1983, therefore, an extremely embarrassed hospital industry recognized that some form of limit on payments was inevitable and tried to cut the best deal it could with an angry Congress.(fn6) By early 1983, DRG-based hospital payments had been successfully in place in New Jersey for three years.(fn7) However, there was neither a broad base of experience nor a well-developed conceptual underpinning for any system of hospital payment in the United States other than the cost reimbursement or rate-setting models which were energetically rejected in the deregulatory climate of the time. Thus, what PPS had going for it, politically and rhetorically, was that it was clearly not cost-based reimbursement and ostensibly not rate-setting either. Just about everything else had to be made up as policymakers went along.
Second, PPS was established within the framework of the budgetary strictures of the early Reagan Administration and within the rules of the then-new Budget Reform process and the subsequent procedures of Gramm-Rudman. To my mind, the greatest innovation in the Administration proposal that became PPS was the assignment to the Secretary of HHS of real budgetary control over Part A of the Medicare program. Once the system was up and running, the Secretary would provide an annual update factor for the DRG rates, and that (more or less) would be that.(fn8) If improvements in medical recordkeeping or development of new technologies required changes in the DRGs themselves, those too would be implemented on a budget-neutral basis.
The flip side of this budgetary coin, however, was that budget estimates and targets were to be derived from "current services" estimates, which were projections of expenditures under existing Medicare law in the absence of policy change. But the Medicare system being replaced was cost-based and in the midst of the greatest year-to-year increases in its history, due partly to inflation in the economy as a whole. In order to get PPS started by establishing rates for federal fiscal year (FY) 1984, the rules said that one began with a projection based on FY 1981 and 1982 data, the most recent data then available, of what Medicare would otherwise be paying hospitals under cost-based reimbursement. Thus, the initial PPS rates were based on the very high inflationary expectations of a period of unprecedented cost growth.
The estimates of what Medicare would otherwise have been paying in FY 1984, which became the base for the first year's PPS rates, were further inflated by some technical errors on the part of the relatively junior staff making...
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