outpatient acute care hospitals in 2000 (SUNY, 2001; CMS, 2006c). Physicians are reimbursed according to the Medicare Physician Fee Schedule. The new systems set payments for various services (or bundles of services) in advance of their delivery. Thus, providers know how much they will be paid before they treat their patients and can better plan their care and resource use.

Fees and payment rates of Medicare’s prospective payment systems are set administratively to cover CMS’s estimate of the average cost of providing a service, plus a small margin. In some instances, the payment does not cover the provider’s costs; in other cases, the payment is more than sufficient. In some situations in which costs far exceed payments, Medicare provides additional “outlier payments” that cover a portion of the excess costs. Under most of Medicare’s prospective payment systems, payments are adjusted for geographic differences in labor and other costs. In general, prospective payment encourages providers to keep the costs of services below the payment amount and creates incentives to treat those with the least severe and complex conditions in any particular diagnosis, service, or risk category.

As noted above, the unit for which payments are made may be a bundle that encompasses all of the inputs necessary to provide a stay in an institution or perform a procedure, or it may be a discrete, narrowly defined item, test, or service. Under most of the payment systems, unless Congress intervenes, rates are automatically adjusted upward each year based on indexes of anticipated price increases. A major exception is the Medicare Physician Fee Schedule update, which is governed by the sustainable growth rate (SGR). This formula limits the growth in per beneficiary Medicare Physician Fee Schedule expenditures to the growth in per capita gross domestic product. Because the volume and average intensity of services paid for under the Medicare Physician Fee Schedule have been growing very rapidly, application of the SGR formula has resulted in negative updates for physicians in recent years. With the exception of 2002, Congress has acted to avert these reductions (U.S. GAO, 2005). CMS projects that the SGR will impose annual negative updates of more than 4 percent each year during 2007–2011, which may affect physicians’ willingness to consider performance-related payment changes and incentives (MedPAC, 2006).

Appendix A presents more detailed descriptions of payment systems and their incentives for in- and outpatient hospital care, skilled nursing facilities, home health care, outpatient dialysis services, physicians, and Medicare Advantage plans. The discussion there is intended to give a broad overview of payment methodologies, not a detailed picture of all the complexities of each method, to provide a context for the consideration of payment incentives. Table 2-1 presents an overall picture of spending in the Medicare program by provider setting.

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