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A recent example of how costs can be driven up by increased third-party coverage is Medicare's chronic renal disease program authorized by the Social Security Amendments of 1972. In FY 1974, the cost to the Medicare program for patients with chronic renal disease was $250 million. Three years later, the cost of the program has doubled to more than half a billion dollars in FY 1977. Estimates of future costs are $1.5 billion by 1981.

D. Reimbursement Methods

The methods by which providers of health care--specifically hospitals and physicians--are reimbursed for their services have a significant impact on the cost of such services. This is because the reimbursement methods for these health care providers contain few incentives which encourage cost control or efficiency.

1. Hospital Reimbursement.

Hospitals are reimbursed according to either the costs they incur in delivering patient care or the prices or charges they assign for different units of service they supply to patients. The predominant method of reimbursement, used by Medicare, Medicaid, and most Blue Cross plans, is cost-based reimbursement. Cost reimbursement involves determinations, in accordance with established principles, of the actual costs incurred by the hospital in providing patient care. Payments are made at periodic intervals based on estimated operating costs with retroactive adjustments made for each accounting period.

This retrospective cost-based reimbursement mechanism has come under increasing criticism in recent years and has been cited as one of the contributors to the inflation in health care costs. Specifically, this method of paying for hospital care is viewed as inflationary because: (a) it fails to set effective limits on the costs to be reimbursed; and (b) because it fails to offer incentives for efficient performance or, alternatively, to create disincentives for inefficient operation. In effect, retrospective cost reimbursement virtually guarantees payment for costs, thus relieving the hospital from pressures to contain costs. Moreover, cost-based reimbursement may actually provide disincentives for efficiency since the less a hospital spends, the less reimbursement it will receive from the third-party payor.

Charge-based reimbursement similarly provides few incentives for cost control. Reimbursement by third-party payors (some Blue Cross plans and most commercial insurers) takes many forms. Plans may reimburse on the basis of "billed charges," without making any special effort to determine that they are reasonable. In other cases, reimbursement is based on charges which the hospital must demonstrate, through budget review by the third party, are cost-related. Another approach bases payment on "negotiated charges," in which the third-party payor may examine not only the hospital's budget but its management efficiency and effectiveness in arriving at a negotiated charge rate.

Under all of these methods of charge-based reimbursement,

there is great freedom and latitude granted the hospitals. Pricing policies within a hospital are based on target revenue levels, and frequently the charges for certain services may be entirely unrelated to the costs associated with the production of those services. Cost increases are easily countered by changes in the hospital's charge structure. There is little pressure on the hospital to economize or to resist cost increases in its operation.

The increase in national health expenditures for hospital care is shown in the following table. Not only have aggregate expenditures increased, especially since the mid-sixties when Medicare and Medicaid began, but also hospital care as a percentage of total health expenditures has increased.


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Source: Gibson, Robert M., and Mueller, Marjorie Smith.


Health Expenditures, Fiscal Year 1976." Social Security Bul-
letin, Vol. 40, No. 4, April, 1977.


Physician Reimbursement. There are a number of ways physicians are paid for their services. Although some physicians are paid salaries, e.g. many of those employed by governments, the great majority bill for their services on a fee-for-service basis. Fee-for-service means that the physician bills a charge for each service that he renders. A physician may take a number of considerations into account in setting his fees. These include such factors as the amounts charged by other physicians in the area, the net income he wishes to generate, his qualifications and experience, his expenses, and the time required to perform


a given procedure and its complexity.

Critics of fee-for-service argue that it provides the physician with an incentive to provide excessive or even unnecessary services (visits, procedures, tests, etc.) since the more services he provides, the more he will be paid.

Third-party payors usually pay a physician's billed charge in full if the charge: does not exceed the billing physician's usual fee, does not exceed the amount that is customarily billed for the service by other physicians in the area, and if it is otherwise reasonable. Health benefit plans that set allowable fees in this manner are called "UCR" (i.e., usual, customary, and reasonable) plans. Today, the major national Blue Shield accounts and many of the plans offered at the local level have adopted the UCR method of setting allowable fees. Commercial insurance company UCR plans vary depending on company policy. Generally the commercial companies do not screen claims against the billing physician's usual fees. An allowance is usually made in full if the billed fee does not exceed the level prevailing in the area. Medicare also reimburses according to the UCR approach, but the cutoff point for determining "prevailing charge" is somewhat below the 75th percentile. On the average, Medicare allows only about 80 percent of billed charges. Under the Medicaid program, most States pay physicians according to fee levels set lower than those of the Medicare program.

A second major problem area concerns hospital-based physicians who bill for their participation in services which involve a large institutional input. For example, a clinical laboratory test is ordinarily carried out by a hospital technician using hospital equipment on hospital premises. The technician works under the general supervision of a physician (i.e. a pathologist) who, while not directly involved in the individual tests, is responsible for the operation of the laboratory. The physician may work only part-time, depending in part on the size of the hospital and the availability of Ph.D. scientists to share in the supervision of the laboratory. In the case of a small hospital, the physician may work in the laboratory only a few days a month. Since the amount of physician input can vary so greatly from hospital to hospital, it is not possible to judge the reasonableness of his charges for laboratory tests by comparing them to the fees charged by other pathologists. Moreover, even if two pathologists had identical fee schedules and worked the same number of hours, one could receive a much higher income than the other depending on the number of tests performed.

Hospital-based physicians are, in some cases, paid more than other physicians. However, because of these different variables, third parties have not been able to develop easily administered techniques for judging the reasonableness of the bills they receive for the services of hospital-based physicians where the physician serves largely as a supervisor of hospital personnel.

Another method of payment--capitation--has attracted public attention in recent years because of the increased interest in prepayment group practice and HMO's. Under this method, physician groups are paid on a flat rate by the insuring organization for the care of each patient

for whom they assume responsibility.

The physicians providing the services are then paid by the HMO by salary or on a modified fee-for-service basis, depending on the type of HMO. In most HMO's, incentives are built into the capitation to encourage cost control. For example, if costs are less than anticipated, the savings may be returned to the physician group to be distributed among its members or, if an individual physician has contracted with the HMO to provide care, he may receive a percentage of the savings. Thus there is positive incentive to control costs, since the savings may be distributed back to the physicians.

The following table shows national health expenditures for physicians' services. Although physicians' services as a percentage of total national expenditures has declined, the expenditures for such services have increased rapidly since Medicare and Medicaid began in the mid-sixties.


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Health Expenditures, Fiscal Year 1976." Social Security Bulletin, Vol. 40, No. 4, April, 1977.

E. Pluralism in the Health Care Industry

The great variety in the types of health care facilities, programs and payment mechanisms in this country makes it difficult to develop a single coherent health care policy or to agree on any single plan of action to control rising health care costs. There are a multitude of providers such as hospitals, physicians practicing various specialties,

other kinds of practitioners, nursing homes, extended care facilities and other nursing care institutions, and community health centers. These are operated by private nonprofit organizations, the Federal Government (Veterans' Administration, Department of Defense), State and local governments, and by private enterprise. Many of the bills are paid by the individual patient out of his own pocket. Programs which pay for the costs of medical care vary from the Federal Government's Medicare and Medicaid programs, to Blue Cross and Blue Shield programs, to private health insurance. Some believe that the degree of fragmentation in the health care area poses a substantial barrier to any unified, concerted effort to contain health costs.

F. Personal Health Habits--Environmental Factors

Some important factors contributing to expenditures for health care services are the personal health habits, environmental factors and other problems which contribute to "bad health." While the incidence of such induced diseases may not necessarily have increased over time, the effects of controllable habits and environmental circumstances leading to "bad health" are significant. Unhealthy lifestyles and habits leading to poor health include smoking, the abuse of alcohol and other drugs, improper nutrition, lack of exercise, and failure to have children innoculated. Environmental factors include air and water pollution, work hazards, automobile accidents, and accidents in the home.


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