2
Background and Environmental Trends

This chapter provides background on the clinical laboratory industry and analyzes trends in the health care environment that have affected the cost of providing clinical laboratory services, the quality of those services, and beneficiary access to care. An understanding of these factors, in addition to an appreciation of anticipated trends in laboratory technology (discussed in greater detail in Chapter 3) is necessary to design a forward-thinking, effective Medicare outpatient clinical laboratory payment system and anticipate its likely effects.1

A cautionary note is necessary at the beginning of this chapter. Reliable descriptive data on the clinical laboratory industry are extremely limited, and any picture the committee attempts to paint will be frustratingly hazy.2 There are a number of factors that influence the quality of available data. First, no single industry association or public agency oversees all aspects of this industry, and there is no unique census Standard Industrial Classification (SIC) business code

1  

Much of the research for this chapter draws on work conducted by CHPS Consulting (Center for Health Policy Studies) Columbia, Maryland, for the Institute of Medicine (IOM).

2  

Multiple statistics citing the Health Care Financing Administration (HCFA) as the data source often did not match, perhaps because HCFA produces volumes of data that are continuously updated, making the time and specific definitions of data elements critical to understanding what the data represent. Many HCFA data come from ongoing program operations developed to serve claims processing needs rather than policy research interests; thus, different analysts may manipulate the raw data somewhat differently resulting in numbers that vary slightly.



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Medicare Laboratory Payment Policy: Now and in the Future 2 Background and Environmental Trends This chapter provides background on the clinical laboratory industry and analyzes trends in the health care environment that have affected the cost of providing clinical laboratory services, the quality of those services, and beneficiary access to care. An understanding of these factors, in addition to an appreciation of anticipated trends in laboratory technology (discussed in greater detail in Chapter 3) is necessary to design a forward-thinking, effective Medicare outpatient clinical laboratory payment system and anticipate its likely effects.1 A cautionary note is necessary at the beginning of this chapter. Reliable descriptive data on the clinical laboratory industry are extremely limited, and any picture the committee attempts to paint will be frustratingly hazy.2 There are a number of factors that influence the quality of available data. First, no single industry association or public agency oversees all aspects of this industry, and there is no unique census Standard Industrial Classification (SIC) business code 1   Much of the research for this chapter draws on work conducted by CHPS Consulting (Center for Health Policy Studies) Columbia, Maryland, for the Institute of Medicine (IOM). 2   Multiple statistics citing the Health Care Financing Administration (HCFA) as the data source often did not match, perhaps because HCFA produces volumes of data that are continuously updated, making the time and specific definitions of data elements critical to understanding what the data represent. Many HCFA data come from ongoing program operations developed to serve claims processing needs rather than policy research interests; thus, different analysts may manipulate the raw data somewhat differently resulting in numbers that vary slightly.

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Medicare Laboratory Payment Policy: Now and in the Future for clinical laboratory services; therefore, there are no standard data sources or common definitions used for data that are collected. Second, large companies and hospitals often provide other laboratory services in addition to clinical laboratory testing, and these services may be included in aggregate data for laboratory testing.3 Finally, laboratory services are only a small segment of a hospital’s or physician’s business and often are not calculated or are reported separately. Where necessary, this chapter cites several data sources when there is no obvious “right” one. The general direction of the trends described in this chapter is more important than the exact values of various figures. BACKGROUND ON THE CLINICAL LABORATORY INDUSTRY The clinical laboratory industry is very diverse. Understanding the different types of laboratories, their markets, and the types of services they provide is critical because each has an effect on the cost and quality of laboratory services, as well as beneficiary access to care. This section discusses the number, types, and geographic distribution of laboratories; testing volume; revenue distribution by type of laboratory; and an analysis of the trends in spending for laboratory services in relation to other health care services. It concludes with an analysis of the financial strength of the industry. Sites of Service In 1999, 170,102 laboratories conducted 5.7 billion laboratory tests for both inpatients and outpatients in the United States (Tables 2.1 and 2.2). There are three main types of laboratories that provide clinical laboratory services: hospital-based, independent, and physician office laboratories (POLs). Hospital-based laboratories: Hospital-based laboratories conduct more tests than all other types of laboratories combined. They serve primarily the inpatient and outpatient testing needs of their hospital but may also conduct tests for patients not seen at their hospital, typically called “outreach testing.” In 1999, 8,560 hospital-based laboratories (Table 2.1) conducted almost 3 billion laboratory tests (Table 2.2). There are many more hospital-based laboratories than there are hospitals in the U.S. because some hospitals operate more than one laboratory. Independent laboratories run some hospital-based laboratories. Independent laboratories: Independent laboratories conduct tests for physicians, hospitals, and other health care providers. These laboratories tend to be regional in nature, with single companies operating multiple laboratory fa- 3   For example, data on revenue may include revenue from testing related to life insurance and testing for drugs of abuse.

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Medicare Laboratory Payment Policy: Now and in the Future TABLE 2.1 Number of Laboratories by Type of Facility; 1999-Early 2000 Type of Facility Number of Laboratories Percentage of Total Hospital laboratories 8,560 5 Independent laboratories 4,936 3 Physician office laboratories 105,089 62 Other 51,517 30 Total 170,102     SOURCE: Health Care Financing Administration, 2000a. TABLE 2.2 Test Volume by Type of Facility; 1999-Early 2000 Type of Facility Volume (millions) Percentage of Total Hospital laboratories 2,958.2 52 Independent laboratories 1,514.2 26 Physician office laboratories 656.4 11 Other 597.1 10 Total 5,725.9   NOTE: Volume figures include both inpatient and outpatient tests performed for all public and private sector payers. SOURCE: Health Care Financing Administration, 2000a. cilities. In 1999, 4,936 independent laboratories (Table 2.1) conducted almost 1.5 billion laboratory tests in the United States (26 percent) (Table 2.2). The number of independent laboratories is somewhat misleading because independent laboratories underwent rapid corporate consolidation during the 1990s, resulting in two large national and many other smaller independent laboratories.4 Multiple laboratories that may be counted separately are actually part of one corporate entity. Physician office laboratories: POLs generally conduct relatively simple or moderately complex tests to provide immediate, on-site results to physicians. At 105,089, there are far more POLs than other types of laboratories (Table 2.1). While many POLs conduct only the most simple laboratory tests and have very 4   Quest Diagnostics Inc. recently took over SmithKline Beecham’s clinical laboratory business to form the largest independent laboratory. Its closest competitor is LabCorp.

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Medicare Laboratory Payment Policy: Now and in the Future low test volume, others may serve large group practices and provide a range of tests at volumes comparable to those of independent laboratories. Other laboratories: The remaining laboratories include testing facilities at end-stage renal disease (ESRD) centers, home health agencies, nursing homes, and other sites. Although these “other laboratories” account for slightly more than 30 percent of all laboratory facilities (Table 2.1), they conduct only 10 percent of all laboratory tests (Table 2.2) and are often not paid out of the Medicare outpatient laboratory benefit. Trends in numbers of laboratories and testing volume broken down by more specific type of service provider are presented in Appendix D. Since some types of tests are complex or require special expertise, they may be sent from one laboratory to another. Laboratories that conduct tests for other laboratories are called “reference” laboratories. Reference laboratories are usually large and may be independent or hospital based. Some tests are so uncommon, complex, expensive, and dependent on specialized interpretation skill that they are labeled “esoteric.” Some tests previously considered esoteric, such as polymerase chain reaction (PCR) testing for HIV, have become so common that the esoteric label no longer applies. Laboratories that specialize in esoteric testing are usually affiliated with a university or research institution but may be independent. Geographic Distribution Clinical laboratories in the United States are geographically distributed much like the population. According to a 1995 summary report of the Clinical Laboratory Improvement Advisory Committee of the Centers for Disease Control and Prevention (CDC), Texas and California have the greatest number of laboratories, while Midwestern and rural New England states have the lowest concentration (CDC, 1995). Size and Distribution of the Market The clinical laboratory industry is a $30 billion to $35 billion industry5 (Dyckman and Cassidy, 2000; Klipp, 2000; Merrill Lynch, 1999) representing approximately 3.5 percent of the $1.0 trillion in total personal health care expenditures in the United States in 1998. Based on recent pricing trends, CHPS Consulting estimates that expenditures on laboratory tests in 1999 are expected to be 3–6 percent higher than for 1998 (Dyckman and Cassidy, 2000). Because hospitals are paid for inpatient care based largely on per-case and per diem payment methodologies, rather than on a fee-for-service (FFS) basis, payments for laboratory services provided in the inpatient setting are included within 5   This includes both inpatient and outpatient testing services.

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Medicare Laboratory Payment Policy: Now and in the Future FIGURE 2.1 Laboratory industry revenue by segment, 1999. SOURCE: Klipp (2000). payments for more broadly defined services. This is explained further in the discussion of environmental trends below. Not surprisingly, hospital-based laboratories, which have the highest test volume, also have the largest market share in terms of revenue. Industry sources put the hospital-based market share at 63 percent for 1999. This is an increase from the estimated 57 percent share it held in 1993 (Figure 2.1). Independent laboratories hold about 26 percent of the market share, while “other” laboratories account for only 3 percent. Although POLs represent about 11 percent of test volume, they receive only 8 percent of the revenue because they tend to perform simpler, less expensive tests. Trends in Expenditures for Laboratory Services The early 1980s was a period of significant health care inflation, and during that time, clinical laboratories benefited from favorable payment policies. Beginning with implementation of the inpatient prospective payment system (PPS) in the mid-1980s, and with the growth of managed care in the late 1980s and 1990s, changes to both governmental and nongovernmental payment systems helped rein in health care spending and bring health care inflation back into the single digits. Expenditures for laboratory services have been particularly affected by efforts to control health care costs. While the rate of growth in national health expenditures has slowed, actual expenditures for most categories of health care spending have continued to increase even when controlling for inflation (Figure 2.2). In contrast, expenditures for laboratory services provided in all settings have declined steadily; expenditures in 1998 were more than 10 percent lower than in 1993 (Klipp, 2000). Figure 2.3 tracks the trends in health expenditures for the five years from 1993 to 1998 for total personal health care, laboratory, hospital, and physician services.

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Medicare Laboratory Payment Policy: Now and in the Future FIGURE 2.2 Personal health care expenditures as a percentage of Gross Domestic Product: 1960–2008. SOURCE: Health Care Financing Administration, data from the Office of Strategic Planning and the Office of National Health Statistics. Financial Strength of the Laboratory Industry The committee searched for direct evidence of the financial health of the clinical laboratory industry, but found little because most segments of the industry are not required to report financial information. POLs and outpatient hospital laboratories are not independent businesses, but integrated parts of physicians’ practices and hospitals, respectively. Also, many commercial independent laboratories, particularly relatively small laboratories, are not publicly held corporations and have no obligation to report financial data publicly. To assess the financial health of the industry, therefore, the committee reviewed a number of finance industry reports as well as recent market studies that provide some information on the commercial laboratory industry’s profitability, mostly for the largest laboratory firms (Donaldson, 1993; Lehman Brothers, 1993; Merrill Lynch, 1999; Smith Barney Research, 1990). The committee supplemented this information with indirect evidence of industry financial health, such as changes in number, volume, and market share of the different segments. The committee found virtually no direct information on the financial performance of POLs; however, the number of POLs continues to grow, indicating that there is some incentive to provide these services. Because of incentives re-

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Medicare Laboratory Payment Policy: Now and in the Future FIGURE 2.3 Trends in expenditures for health care services, 1993–1998. SOURCE: Laboratory data: CHPS Consulting analysis of information in Klipp (2000); other health services: Levit et. al. (2000). lated to efficiency and convenience, physicians may provide laboratory services regardless of their independent profitability. The committee also found no direct data to assess the financial well being of hospital-based laboratories. Hospital-based laboratories’ share of the total market grew during the 1990s, despite payment reductions and the aggressiveness of managed care contracting. Most, if not all, of this growth has been in the provision of laboratory services in the hospital’s outpatient department and for providers outside the hospital (outreach testing). The growth in outreach testing can be attributed to diametrically opposed circumstances. Growth may suggest that, as a group, hospital-based laboratories are profitable. On the other hand, it could be a response to market changes that threaten the financial viability of hospitals, including global shifts from inpatient to outpatient care. In this case, growth may reflect an attempt by hospitals to spread fixed costs across an increased volume of services. Available data do not reflect the experience of hospital laboratories after implementation of the Balanced Budget Act of 1997 (BBA), which changed inpatient payment and mandated a new payment methodology for outpatient services. The new prospective payment system for outpatient hospital services does not include laboratory services, but could affect the general financial status of hospitals. Changes mandated by the 1999 Balanced Budget Refinement Act (BBRA) for the new outpatient PPS is expected to lessen the negative projected financial effect on hospitals (Guterman, 2000).

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Medicare Laboratory Payment Policy: Now and in the Future Environmental factors during the 1990s, particularly reductions in Medicare fees and growth in managed care among both public and private payers, had a significant effect on the profitability of the independent laboratory sector (Hoerger et al., 1996). By 1995, all of the laboratory industry’s leading firms were either experiencing losses or sharply declining profits. According to Klipp (2000), in 1996, the top three independent laboratories had a combined net loss of $792 million on $4.58 billion of revenue. Industry reports suggest that independent laboratories are again becoming profitable. Profit margins improved during the past two years, at least among the major laboratory firms, partly as a result of improved pricing for managed care business. The three largest laboratory firms were marginally profitable in 1998, with an average profit margin of 2.6 percent. In the first half of 1999, after Quest Diagnostics acquired SmithKline Beecham laboratories, the average profit margin for the two largest laboratories, Quest Diagnostics and LabCorp, was 1.2 percent (Klipp, 2000). Stock values for both increased substantially in the first half of 2000. Analysts predict that these companies will be able to streamline production and negotiate better rates for supplies. The committee found no direct financial information on the smaller independent laboratories, which mostly compete in local markets. MEDICARE PART B CLINICAL LABORATORY TRENDS Medicare is the largest single purchaser of clinical laboratory services. This section describes Medicare as a segment of the outpatient clinical laboratory market. Medicare Part B Spending Laboratory services paid for under the Medicare Part B clinical laboratory fee schedule represent a relatively small component of the annual Medicare budget—about 1.6 percent; however, they constitute a significant portion of the market for the laboratory industry, and Medicare’s policies appear to influence the behavior of other payers. According to industry estimates, Medicare pays approximately 29 percent of the nation’s laboratory bill when inpatient testing, FFS outpatient testing, and managed care are included (Figure 2.4). The Medicare Part B fee schedule for outpatient laboratory services accounts for approximately one-third of what Medicare spends for laboratory services (Gustafson, 2000). The Health Care Financing Administration (HCFA) reports that Medicare Part B spending for clinical laboratory services fell from $3.8 billion in 1992 to

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Medicare Laboratory Payment Policy: Now and in the Future FIGURE 2.4 Laboratory industry payer mix by percentage of revenue, 1999. $3.6 billion in 1998, with a compound annual growth rate of −1.1 percent (Table 2.3) (Gustafson, 2000). Over the same period, total annual Medicare spending grew from $141 billion to $231 billion; a compound annual growth rate of 8.5 percent (Gustafson, 2000). Clinical laboratory spending as a percentage of total Medicare spending over time is presented in Figure 2.5. Payments for laboratory services per Medicare beneficiary in the FFS program declined during the mid 1990s, but, based on projections, have recently begun to rise (Table 2.4). The Office of the Actuary at HCFA projects that recent growth will continue. Estimates provided by HCFA show that in 1998, Medicare paid facilities (outpatient-hospital laboratories plus ESRD clinics, nursing homes, home health, and other laboratories) $1,489 million, independent laboratories $1,336 million, and POLs $752 million (Figure 2.6).6 6   Medicare does not collect data on its laboratory expenditures by site of service; instead, annual expenditure data are collected based on whether the claim was processed by a Medicare carrier (which processes claims from POLs and independent laboratories) or by a fiscal intermediary (which processes all hospital claims and most other laboratory claims). Any data describing Medicare Part B market share for POLs versus independent laboratories are estimated by subtracting claims that have a physician provider number on them.

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Medicare Laboratory Payment Policy: Now and in the Future TABLE 2.3 Part B Clinical Laboratory Spending by   Calendar Year ($ millions) CAGR, 1992–1998 (%) Type of Laboratory 1992 1995 1998 Independent 1,761 1,871 1,336 −4.5 POL 1,101 936 752 −6.2 Facilitya 967 1,378 1,489 +7.5 Total 3,829 4,185 3,577 −1.1 NOTE: CAGR = compound annual growth rate. aIncludes Part B payments to hospitals, nursing homes, home health agencies, and other laboratories paid by fiscal intermediaries. SOURCE: Gustafson, 2000. FIGURE 2.5 Part B spending on clinical laboratory services as a percentage of total Medicare spending, 1992–1998. NOTE: Percentages are for total Part B spending on clinical laboratory services, including hospital outpatient/outreach services. SOURCE: Health Care Financing Administration. Trend data show that the Medicare Part B market share for facilities is growing (Figure 2.7).7 HCFA’s Office of the Actuary projects that this trend will continue. It projects that by 2001, 45 percent of expenditures for services on the clinical laboratory fee schedule will go to the facilities described above, and 55 7   There is some variation in trend data that may be the result of how various sites of service are defined and whether “other laboratories” are included within the outpatient hospital segment.

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Medicare Laboratory Payment Policy: Now and in the Future FIGURE 2.6 Medicare Part B spending (in millions)* by laboratory type, 1998. Includes carrier and FI data for the laboratory fee schedule and some physician services such as pathology. **Includes outpatient hospital, ESRD, nursing homes, home health, and other laboratory services paid for by FIs. SOURCE: Health Care Financing Administration. percent will go to independent and physician office laboratories (Steiner and Root, 1999). Although the Medicare Part B fee schedule for clinical laboratory services covers approximately 1,100 different test codes, which reflect an even greater number of tests,8 the top 10 test codes account for 24 percent and the top 200 account for more than half of Part B laboratory expenditures (Gustafson, 2000).9 ENVIRONMENTAL TRENDS Various environmental trends during the past two decades have put pressure on the clinical laboratory industry to cut costs and improve quality. This section reviews government regulatory efforts to improve quality, protect workers, and reduce waste and abuse. It also reviews cost-control efforts undertaken by both 8   Up from 881 codes in 1994. 9   The fee schedule for each CPT code for each carrier region and the national limitation amount is available on the Internet at http://www.hcfa.gov/stats/cpt/clfdown.htm.

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Medicare Laboratory Payment Policy: Now and in the Future CLIA’s Impact on Quality Data indicate sharp increases in both PT performance and CLIA laboratory registration rates from 1995 to 1996. CLIA requires PT for 86 tests or analytes.18 Data show that in 1996, 87.4 percent of the scores from enrolled laboratories demonstrated no failures on PT19, compared to 69.4 percent in 1995 (HCFA, 2000b). PT results from previously unregulated laboratories, particularly POLs, are most likely to be unacceptable (MMWR, 1996; Stull et al., 1998). The data also indicate that 93.2 percent of the laboratories required to be enrolled in PT were actually enrolled in 1996, compared to 89.6 percent in 1995. HCFA’s target for fiscal year (FY) 1999 was that 90 percent of the scores for all 86 analytes requiring PT reported from all laboratories enrolled in PT should contain no failures and that 95 percent of all eligible laboratories would be participating. Occupational Safety and Health Administration Occupational Safety and Health Administration (OSHA) regulations protect the safety of workers, but also increase the cost of providing laboratory services. They touch almost every aspect of the provision of laboratory services. For instance, to minimize the transmission of infectious disease, health care workers and laboratory personnel are required to wear personal protective equipment (PPE) and to dispose of needles and other contaminated materials in specific ways. OSHA may require the use of “safety needles” in the future. Health care facilities, including physician offices, are required to have an occupational expo 18   This list of 86 analytes is made up largely of commonly performed diagnostic tests whose results are important in health care treatment decisions. Each laboratory performs PT on the regulated analytes that are a part of its specific test menu. There are other tests performed by laboratories, regulated under CLIA, for which PT is not required. Some of these tests are laboratory examinations and procedures that are so simple and accurate there is almost no likelihood of producing erroneous results. There are other tests for which PT is not yet available or may not yet be required by CLIA regulations. Some laboratories voluntarily participate in any PT that is available, even if not yet required under CLIA regulations. If no PT is available, laboratories are still supposed to take steps to validate their procedures. Tests for which PT is required may be added as CDC and HCFA update CLIA regulations (HCFA, 1998). PT does not evaluate errors made during the preanalytic or postanalytic phase of testing. 19   Each laboratory is given 5 samples for each analyte. This is called a testing event. In most cases, the laboratory must obtain a satisfactory score on 4 out of 5 of these samples (80 percent). Some analytes such as blood type and Rh require 100 percent accuracy. A laboratory that is within the satisfactory range for all analytes is said to have no failures. Some analytes have fixed criteria to determine whether the laboratory was within a satisfactory range. For instance, on a serum cholesterol test, the laboratory is permitted to be within +/−10 percent of the actual value. Other types of analytes are graded on a bell-shaped curve. The criteria for a satisfactory value for each analyte are outlined in 42CFR493 subpart H 493.821 of the CLIA regulations.

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Medicare Laboratory Payment Policy: Now and in the Future sure control plan. Contaminated waste, including leftover specimen samples, must be disposed of in a way that is more costly than disposal of regular trash. In addition, the transportation of certain human tissues and body fluids requires special packaging to protect the handler.20 Each laboratory is required to develop a chemical hygiene plan which addresses the specific hazards found in its location and its approach to them (OSHA, 2000). Laboratories must also be equipped with proper ventilation to ensure safe air quality within the building (OSHA, 1999). There are few data on the cost of compliance with OSHA regulations for the laboratory industry; however, tighter regulatory control usually means an increased financial and administrative burden. This burden has likely affected hospital-based, independent, and physician office laboratories and has implications for the cost of providing laboratory services. MINIMIZING FRAUD, WASTE, AND ABUSE The administration and Congress have tried to ensure that public funds are not wasted or abused by limiting physicians’ ability to refer patients to a laboratory in which they have a financial interest, by aggressively investigating certain billing practices, and by denying payment for Medicare claims that are not deemed medically necessary. Stark Amendments The Ethics in Patient Referral Act (1998), commonly referred to as the Stark Amendments,21 prohibits physicians from referring patients to laboratories and other designated health services in which they or their immediate family members have a financial interest.22 It also attaches civil penalties to entities receiving these inappropriate referrals if they bill Medicare or Medicaid. The main purpose of the law is to reduce the overuse of health care services that can occur when physicians have a financial incentive to refer patients for laboratory services. A previous Institute Of Medicine (IOM) report showed that physicians order more laboratory tests when they profit from laboratory services (Gray, 1986). Implementation of the Stark Amendments has been controversial (Committee urges final rule on Stark self-referral law revisions, 1999). Because Stark II was so broad, Congress added a number of exemptions to the rule that allow physicians to operate in-office laboratories and permit referrals made within certain types of “group practices” (Kalb, 1999). Several of the law’s re- 20   New CDC and Department of Transportation requirements may be imposed on packaging of diagnostic specimens. 21   Named after the legislation’s sponsor, Representative F.Pete Stark. 22   The original legislation, or Stark I, enacted in 1989, restricted self-referral to laboratories. Stark II, enacted in 1993, expanded the statute to include 10 additional “designated health services.”

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Medicare Laboratory Payment Policy: Now and in the Future quirements, however, raise concerns for physicians. For example, one of the requirements is that the physician or another member of the group must directly supervise the laboratory test. Direct supervision is more stringent than CLIA requirements because it means that the prescribing physician (or another physician member of the group) must be on site and immediately available during testing. There is anecdotal evidence that many laboratories are not aware of this requirement and, therefore, are not complying with its provisions. This is important because “the Stark laws contain no express requirement of intent; a physician can violate them even if he or she does not have any improper goal or purpose” (Kalb, 1999). The Stark regulations also created a situation where independent physicians could no longer share laboratory facilities. Before these regulations, laboratories were commonly shared by independent practitioners to minimize expenses and provide a wider range of services than would be possible for a solo physician. Physicians must now either divest or form bona fide group practices to comply with the regulation. In response to widespread confusion and public comment, HCFA attempted to clarify Stark II in a proposed rule (Proposed Rule, 1998). Because there was so much controversy and public comment in reaction to the proposed rule, the final rule has not been issued. HCFA is expected to issue a final rule later this year (Graziano, 2000). Several members of Congress have introduced legislation to bring the supervision requirement more in line with CLIA, but Congress has not acted on these proposals. OIG Investigations Spurred by concern during the last decade that laboratories were improperly billing the federal government, the OIG has conducted several major investigations that have resulted in significant settlements against providers of clinical laboratory services. These settlements have amounted to almost $1 billion dollars in recoveries, fines, and penalties (Grob, 2000). The OIG asserted that some laboratories were charging individually for tests that should have been billed as a panel at a lower rate (unbundling), using diagnosis codes that were never provided by a physician, providing kickbacks to physicians for patient referrals, double billing, and billing for unordered tests and tests that were not medically necessary (Grob, 2000). As a result of these cases, some laboratories not only paid large fines, but also signed agreements with the OIG called Corporate Integrity Agreements. The OIG has developed model compliance plans designed to assist clinical laboratories in developing internal controls that help prevent fraud, abuse, and waste (OIG, 2000).

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Medicare Laboratory Payment Policy: Now and in the Future Medical Necessity Review In addition to retrospective reviews conducted by the OIG, Medicare contractors routinely review claims for certain tests against local medical criteria regarding the appropriateness of performing a particular test on a particular patient. This review is called local medical review policy (LMRP). Claims for laboratory tests that do not have a diagnosis code that is deemed to justify performance of the test may be denied even though the laboratory has no control over tests ordered by physicians. Contractors may also target certain providers, who have a history of inappropriate billing, for routine review. Laboratory representatives testified that judgments regarding the medical appropriateness of laboratory tests, which are based solely on the presence or absence of particular International Classification of Diseases, Ninth Revision (ICD-9) diagnosis codes provided by the ordering physician, result in many inappropriate denials and a large administrative burden. The committee found a high rate of denials for some laboratory claims (Appendix E), but it was unable to determine what proportion of all outpatient laboratory claims were denied based on medical necessity criteria. HCFA data from 1998 showed that 12.3 percent of all POL claims were denied, but only 2.5 percent were denied because they were deemed medically unnecessary. Appeals of denied claims are often expensive and time consuming. They also require participation of the physician who has little incentive to follow through. As a result, laboratory representatives testified that the current approach to assessment of medical necessity is misguided and results in an unfair financial burden on clinical laboratories. PAYMENT TRENDS Medicare payment trends for both inpatient and outpatient services, as well as some shift to capitated payments by both public and private payers, have squeezed the profit margins of the laboratory industry and limited the industry’s ability to shift costs from payer to payer and test to test. Medicare Shift to Prospective Payment Systems A 1983 revision in Medicare payment policy for inpatient hospital services radically altered financial incentives for hospital laboratory services. Specifically, Medicare shifted from a reasonable cost reimbursement to a per-case approach based on diagnosis-related groups (DRGs).23 The prospectively set payment amount was based on adjusted average historical costs and covers all services provided during the patient’s stay. As a result, some cases may cost the hospital more than the Medicare payment, whereas other cases cost less. The system is designed to give hospitals an incentive to manage care more effi- 23   Other third-party payers may pay on a per diem basis or negotiated rates.

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Medicare Laboratory Payment Policy: Now and in the Future ciently. Because of this change in payment policy, inpatient hospital laboratory testing became a cost center for Medicare patients rather than a profit center. The new payment policy thus created an incentive to reduce the number of tests ordered for hospital inpatients and to shift inpatient care to the outpatient setting. The 1997 BBA mandated a change in the Medicare payment methodology for outpatient hospital services. Beginning in 2000, payments for outpatient services were also to be based on prospectively determined rates for bundled services. Clinical laboratory services provided under the clinical laboratory fee schedule are excluded from this change in payment methodology; however, significant payment policy changes were made in the way independent laboratories will be paid for pathology services. If a test is performed by an independent laboratory for a hospital outpatient department, the laboratory must bill the hospital for the technical component.24 The hospital recoups what it pays the laboratory in the bundled payment amount it receives for the outpatient service. Previously, the laboratory was able to bill Medicare directly for the technical component (College of American Pathologists, 2000). Implementation of this billing requirement was recently delayed due to an intense lobbying effort by independent laboratories and the College of American Pathologists. Any major change in payment policy has the potential to affect the financial stability of the provider organization (in this case, hospitals) and to alter payment incentive structures for the provision of care. Growth of Managed Care The growth in managed care for both public and private payers has resulted in reduced revenue for the clinical laboratory industry.25 Managed care organizations are typically defined as any third-party payer that uses cost-control or utilization-control mechanisms to direct the use of health care services. Almost all third-party payers now use managed care techniques to control costs. These techniques have reduced payments to laboratories and limited their ability to offset the cost of uncompensated services for patients who are uninsured, have limited coverage, or have coverage with particularly low payment rates.26 24   The PPRC (1995) defines “technical component” as the part of a relative value or fee for a diagnostic test or therapeutic procedure that represents the cost of performing the service excluding the physician’s work. The “professional component” is defined as the part of a relative value or fee that represents the cost of a physician’s interpretation of a diagnostic test or treatment planning for a therapeutic procedure. Under this policy change, the independent laboratory is still permitted to bill Medicare directly for the professional component. 25   According to a 1998 report by Interstudy, enrollment in the most aggressive type of managed care plan, health maintenance organizations, more than doubled, from 33.3 million to 81.3 million members, from 1990 to 1999. 26   Medicaid payment rates are typically lower than those of other third-party payers.

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Medicare Laboratory Payment Policy: Now and in the Future Because of their ability to negotiate volume discounts, managed care organizations commonly pay significantly lower fees than other payers for laboratory services. In addition, many managed care plans pay laboratories on a capitated basis (Hoerger et al., 1996). Under a capitated payment arrangement, a laboratory is paid a fixed amount per member per month to provide all or a specified range of laboratory services for an enrolled population. Unlike the situation in which physicians or health maintenance organizations (HMOs) receive capitated payments for provision of care to patients, independent laboratories have little control over the volume or type of laboratory tests that are ordered and covered by the capitation rate. Capitation of laboratory services first began in the mid-1990s and by the end of 1998 accounted for 20–25 percent of testing volume at the three largest national independent laboratories (Klipp, 2000). Driven in large part by their fear of losing market share, some hospitals and independent laboratories aggressively cut prices in bids for managed care contracts. Many laboratories bid below their costs in order to win capitated managed care contracts in the hope that physicians in the managed care plans would also use their services for non-managed care patients; however, there is little evidence that these “pull-through” expectations have been met (Hoerger et al., 1996; Klipp, 2000). Managed care organizations generally prefer to contract with fewer laboratories that can provide services across larger geographic areas. The independent national and regional laboratories, therefore, were better positioned to provide services under capitated contracts, giving them an advantage over hospital-based laboratories; however, because of poorly negotiated managed care contracts, increased market share did not result in increased revenue for independent laboratories. In fact, according to Washington G-2 Reports, (Klipp, 2000) independent laboratories saw testing revenue drop from $10.4 billion to $8.1 billion, between 1993 and 1999, a decrease of 22 percent. This decline was due in part to poorly negotiated managed care contracts. There appears to be a recent trend among independent laboratories to “walk away” from unprofitable managed care contracts. Laboratories may simply have learned from their mistakes, or mergers and acquisitions among the independent laboratories, discussed in more detail in the next section, may have given the largest laboratory companies the strength to pass up unfavorably priced contracts. Chief executive officers of the top independent laboratories have stated that they are beginning to focus less on volume and more on profitability (Klipp, 2000). In addition, it appears as though the growth in managed care may be slowing. The Lewin Group (2000) reports that consumers are shifting to more flexible plans; there is a growing backlash against managed care that has resulted in legislatively imposed coverage mandates, which in turn have reduced HMO profits. A recent survey from the American Association of Health Plans reports that many third-party payers are dropping their contracts to provide Medicare+Choice plans, Medicare’s version of managed care (Morgan, 2000).

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Medicare Laboratory Payment Policy: Now and in the Future RESPONSE FROM THE INDUSTRY TO ENVIRONMENTAL TRENDS The clinical laboratory industry has become very competitive despite the high degree of consolidation that has occurred in the independent laboratory sector. Changes in Medicare payment methodology, cuts in payment rates by Medicare and other payers, and the growth of managed care contracting have caused some laboratories, particularly hospital-based laboratories, to look to new markets in order to maintain profitability. These changes also have led to consolidation in both the independent and the hospital-based segments of the laboratory industry. In addition, hospital-based laboratories and independent laboratories have become engaged in head-to-head competition for market share as they strive to achieve levels of efficiency and critical mass that will allow them to compete effectively for outpatient, physician, and managed care business. Market Consolidation and Network Development Market consolidation has radically changed the face of the independent laboratory sector. In 1990, no single laboratory company had a major market share; rather, the eight largest companies accounted for 47 percent of the nationwide independent laboratory market (Hoerger et al., 1996). By 1999, two companies, Quest Diagnostics and LabCorp, largely through mergers and acquisitions, accounted for 61 percent of the testing conducted by independent laboratories (Klipp, 2000). Some experts have raised concerns about the level of concentration in two national independent laboratories and the implications of that for industry competition. In the 1990s, laboratory consolidation was viewed as conferring an advantage for negotiating managed care contracts. Although two companies now dominate the independent laboratory market with an estimated 61 percent of total test volume, that is only 16 percent of the total clinical laboratory market share, including hospital-based and physicians’ office laboratories. Hospitals also have responded to the changing health care marketplace by forming regional laboratory networks with other hospitals and independent laboratories. This consolidation began in earnest in the mid-1990s with the formation of integrated delivery systems. Networks have taken different approaches to how they consolidate their laboratories (including intralaboratory, interlaboratory, intrahospital, and interhospital consolidation), but they also have tried to reduce costs by increasing operational efficiencies (Farwell, 1995). Some in the industry believe that hospital-based laboratories have an advantage over independent laboratories in the current environment (Steiner and Root, 1999). Hospitals are better situated than most commercial laboratories to provide STAT (literally, at once) testing and same-day test results. At the same time, commercial laboratories may be better positioned, in terms of the types of testing they do, to incorporate newer, more complex tests.

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Medicare Laboratory Payment Policy: Now and in the Future TABLE 2.6 Hospital Laboratory Outpatient-Outreach Test Volume as a Percentage of Total Hospital Testing, Selected Years Staffed Acute Care Beds 1987 1991 1993 1996 1998 150–300 25.8 30.6 38.0 40.9 42.8 >300 23.2 26.9 31.6 37.2 35.0   SOURCE: Klipp, 2000. Growth of Hospital-Based Laboratory Outreach Programs During the 1990s, because of changes in inpatient payment policy (described above), hospitals shifted a great deal of inpatient services to the outpatient setting. To make up for the inpatient volume that was lost to nonhospital laboratories providing tests to outpatients, hospitals have developed outreach programs to bring testing into their laboratories from physicians outside the hospital. Since the early 1990s, the average number of inpatient tests per discharge has declined, while outpatient test volume has grown as a percentage of total hospital-based testing. Table 2.6 presents outpatient and outreach volume as a percentage of total hospital-based testing since 1987. Change has been most significant in the 150- to 300-bed hospitals, with outpatient and outreach volume as a percentage of total hospital testing increasing almost 66 percent from 1987 to 1998. For hospitals with more than 300 beds, the increase over the same period was almost 51 percent. While volume has been growing, revenue per outreach test has been shrinking. Washington G-2 Reports (Klipp, 2000) estimates that from 1994 to 1999, revenue per outreach test decreased from $16.50 to $11.50, a decline of more than 30 percent. Hospitals in areas of high managed care penetration have seen outreach test revenue decline even further, to less than $10 per test. SUMMARY The laboratory industry is composed of hospital-based, independent, and physician office laboratories. The industry appears to be both resilient and vulnerable to environmental trends. For instance, after being hit hard by global trends toward managed care and cost containment, the two largest independent laboratories not only have survived, but are rebounding. Hospital-based laboratories have been able to increase their outpatient and outreach business in response to declines in inpatient business. The numbers of POLs initially declined in response to federal regulatory policies designed to improve the quality of laboratory testing but are now increasing, partially in response to an increase in the number of waived tests available. Overall, test volume is up, but revenue per test and aggregate Medicare Part B spending for outpatient laboratory services are down.

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Medicare Laboratory Payment Policy: Now and in the Future Many factors have affected the cost of providing laboratory services. New regulatory requirements have increased the cost of doing business; however, the industry has also found ways to reduce costs through consolidation that provides economies of scale. Demand for laboratory services is likely to grow as the population ages and innovation makes new tests possible. In many laboratories, innovative technologies and increased regulatory requirements have reduced the length of time it takes for the physician to receive laboratory test results and have improved quality and patient convenience. Improved quality has been demonstrated through proficiency testing. An increase in the number of waived tests has made it easier for patients to undergo testing during a visit to the doctor. In addition to being more convenient for patients, testing closer to the physician leads to faster turnaround time that may speed diagnosis and treatment. Environmental trends, particularly payment trends, have the potential to affect beneficiary access to laboratory testing. Coding, coverage, and payment problems, such as delays in assigning codes to new technology and the current approach to determining medical necessity that leads to inappropriate denials, could create barriers to beneficiary access to care. REFERENCES Auxter, S. 1999. Are physician office laboratories making a comeback? Clinical Laboratory News, March. Binns, H.J., S.LeBailly, and H.G.Gardner. 1998. The physicians’ office laboratory: 1988 and 1996 survey of Illinois pediatricians. Pediatric Practice Research Group [see comments]. Arch Pediatr Adolesc Med 152, No. 6:585–592. Comment in: Arch Pediatr Adolesc Med 1998; 152, No. 12:1248–1249. Bogdanich, W. November 2, 1987a. Lax laboratories: The Pap test misses much cervical cancer through labs’ errors. Wall Street Journal. Bogdanich, W. December 29, 1987b. Physicians’ carelessness with Pap tests is cited in procedure’s high volume failure rate. Wall Street Journal. Boone, D.J. 1992. Literature review of research related to the Clinical Laboratory Improvement Amendments of 1988 [see comments]. Arch Pathol Lab Med 116, No. 7: 681–693. Comment in: Arch Pathol Lab Med 1992; 116, No. 7:679–680. Born, P.H., and S.L.Thran. 1998. The influence of CLIA ‘88 on physician office laboratories. J Fam Pract 46, No. 4:319–327. Centers for Disease Control and Prevention (CDC) 1995. Clinical Laboratory Improvement Committee Summary Report. Atlanta, GA: CDC. CDC. 2000. CLIA Waived Test List. Web page accessed August 3, 2000. Available at http://www.phppo.cdc.gov/dls/clia/waived.asp. Chapin, K., and E.J.Baron. 1995. Impact of CLIA 88 on the clinical microbiology laboratory. Diagn Microbiol Infect Dis 23, No. 1–2:35–43. College of American Pathologists. 2000. Hospital Outpatient PPS Information for Pathologists. Web page accessed August 4, 2000. Available at http://www.cap.org/html/advocacy/capdocs/pps.html. Committee urges final rule on Stark self-referral law revisions. June 7, 1999. AMA News.

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