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I also have with me Ms. Karen Davis, Deputy Assistant Secretary of HEW for Health in the office of the Assistant Secretary for Planning and Evaluation.

Senator TALMADGE. I am delighted to have both of them before the committee.

Secretary CALIFANO. We believe that the structure presently contemplated is an appropriate first step in the development of a sound HCFA organization, and that it will be fully consistent with the intent of your health care financing proposal. At this time, it is essential that we continue to have flexibility to adapt organizational structure to the programmatic needs that emerge from practical, day-to-day experience. We do not, therefore, believe that legislation establishing HCFA is necessary to achieve the desirable goals of consolidating medicare and medicaid administration.

Mr. Chairman, there is another problem identified in the proposed legislation that the administration views as being of the greatest urgency-the methods by which hospitals are reimbursed for services. provided to medicare and medicaid beneficiaries and the skyrocketing increases in hospital costs that are caused, in substantial part, by present reimbursement methods.

I would like to devote much of my remaining testimony to this fundamental issue because it is a matter of signal importance and because the President has proposed legislation, the Hospital Cost Containment Act of 1977, which also addresses the problem.

As you noted when introducing S. 1470, the administration bill is a stopgap, transitional measure that complements the long-term structural reform contained in the Medicare-Medicaid Administrative and Reimbursement Act.

As this subcommittee knows well, the medicare and medicaid programs presently reimburse hospitals for reasonable costs incurred in providing services to program beneficiaries. This retrospective payment method has proven to be highly inflationary, because reimbursement simply covers rising hospital costs, however unnecessary or wasteful those costs may be. By reimbursing hospitals for most incurred costs, this method provides virtually no incentives for efficiency.

As this subcommittee also knows well, this method of reimbursement-which also applies in other health programs has contributed to rampaging inflation in the hospital industry, which constitutes 40 percent of health care costs. If we take no action now, total health expenditures will double between 1975 and 1980; hospital costs paid by medicare and medicaid will double even sooner; total hospital spending could reach $220 billion by 1986; and the share of the Federal budget that goes to hospitals will rise steeply above the present 9 cents of every dollar.

Mr. Chairman and members, we must either take some fairly stringent action or find the way to pick up the tab through increased taxes on the American taxpayers.

Section 2 of S. 1470 would establish a prospective reimbursement system for hospitals participating in medicare and medicaid. In essence, this is accomplished by classifying hospitals according to bed size and type and by establishing prospective limits on per diem. routine operating costs for hospitals in that group.

We believe that the concepts underlying section 2 of the proposed legislation are sound and another testament to this subcommittee's foresight. Reimbursement of hospitals must be shifted from retrospective to prospective; prospective limits on hospital costs should be based on different types of hospitals; and these limits should encourage efficiency and penalize inefficiency. These concepts, as the President has stated, must clearly be part of meaningful reform.

But, although we support the concepts underlying section 2 hospital reimbursement requirements, let me share with you some of the difficulties we have with that provision as presently drafted.

First, the provision applies only to medicare and medicaid payments, which constitute about one-third of hospital spending nationwide. Holding down medicare and medicaid payments alone could simply encourage hospitals to refuse these patients, to provide such patients with second-class care, or to transfer their costs to other payors.

Mr. Chairman, I was delighted to notice in your opening statement that you would consider extending coverage to all hospitals. In Colorado, for example, where the State imposed limits solely on medicaid, other hospital costs in that State rose by 40 percent. So if you do not cover it all, there will be a balloon-it is like putting your hand on one part of a pillow and watching the rest of it blow out.

Second, we do not yet have adequate data or methodologies to classify hospitals according to relevant cost-based characteristics-and such a classification is, of course, necessary for a sound, long-run prospective reimbursement system.

Although section 2 significantly improves on the present method of classifying, hospitals-which is required under section 223 of the Social Security Amendments of 1972-by using local wage base data as an important variable, we simply do not have such data at present for most localities in the United States.

I do not know how long it will take to get such data. I know that most of the data changes we made in the mid-60's were requested from the Bureau of Labor Statistics and the Commerce Department. They were not in effect for several years..

A sound classification should take into account not just bed size and types of hospitals, as proposed in the bill, but also the types of patients in hospitals of equivalent size and type. Obviously, a 200-bed, short-term general hospital with a large fraction of obstetrical patients will have different costs than a 200-bed short-term general hospital. with a large fraction of cardiac patients. Unfortunately, we presently lack the methodology to classify hospitals by types of patient-that is, by the type of diagnostic patient case mix.

Similarly, the bill proposes that "teaching" hospitals constitute one of three types of hospitals-along with short-term general and speciality hospitals. Again, we presently lack an agreed-upon methodology for determining whether, and to what extent, an institution is a "teaching hospital."

We do not believe that these are insurmountable barriers to a sound prospective reimbursement classification system, and we look forward to working with you to develop such a system. But these difficulties are real obstacles in the short term.

Third, and related to the point immediately above, section 2 covers only about 35-40 percent of present hospital costs and does not include such critical expenditures as capital costs, education and training costs, malpractice insurance expenses, energy costs, and so-called ancillary costs-for example, the costs for expensive operating rooms or high-priced X-ray machines. Hospitals may be able to circumvent section 2's restraint on a limited proportion of their costs by shifting costs to other, uncovered areas-for example, ancillary costs or by increasing the lengths of patient stays.

I was delighted, again, to notice in your opening statement a flexibility to extend the coverage of this legislation should we, or others, be able to convince the subcommittee that that is an important thing to do.

Senator TALMADGE. We would be delighted to have your recommendations in that regard, Mr. Secretary.

Secretary CALIFANO. Thank you, sir.

Fourth, we seriously question whether a specific classification system should be actually written into a statute. Even when we are able to devise an adequate classification system for prospective hospital reimbursement, we will be continually refining our data and methodologies. Flexibility should be built into the statute to allow for improvements without additional legislation.

Fifth, section 2 does not place a limit on actual increase in hospital costs over time but instead bases its limits on the average costs for types of hospitals. Thus, if all hospitals increase their costs substantially from one year to the next, this provision would permit reimbursement to rise accordingly.

The skyrocketing, 15-percent-a-year increase in hospital costs would continue interminably.

Finally, section 2, while pointing the way toward sensible changes in reimbursement techniques, will not, in our judgment, effectively control costs in the immediate future. Indeed, our preliminary, relatively conservative estimates indicate that section 2 could cost up to $50 million more in fiscal year 1978-even if it could be fully implemented than the present cost-limiting provisions already in law. Not only could section 2 add as much as $50 million to President Carter's fiscal year 1978 budget, but its costs appear to increase with time to approximately $55 million in fiscal year 1979, $64 million in fiscal year 1980, and $75 million in fiscal year 1981.

If modifications could be devised to meet the difficulties discussed above, however, then we would expect substantial long-term savings from section 2.

I might note, Mr. Chairman, in view of your opening statement, the professional actuaries who did the analysis included a factor for the effect of incentives. I will submit for the record all of their detailed work, because I think it would be helpful for your experts to look at what our professional people have done.

Senator TALMADGE. We would be pleased if you would submit that data, Mr. Secretary.

Secretary CALIFANO. Thank you, Mr. Chairman.

[The following was subsequently supplied for the record:]

Note to the files.

JUNE 3, 1977. Subject: Summary of selected Talmadge bill (S. 1470) provisions and cost estimates for HI.

Following is a brief description of the provisions of S. 1470 which are expected to have a significant impact on HI, the expected financial impact of such provisions, and the principal assumptions underlying these estimates.



A uniform system of accounting and cost reporting would be established, and hospitals would be classified by bed size, type of care, etc. Routine operating costs (i.e., costs other than capital and related costs, education and training costs, intern-resident-physician costs, heating and cooling energy costs, malpracitce insurance costs, and ancillary service costs) would be reimbursed on the following basis:

(a) An "adjusted per diem payment rate for routine operating costs" would be established for each classification cell, based on average routine operating costs for the cell and adjusted for price increase.

(b) A hospital which has actual routine operating costs greater than or equal to this rate would receive its actual costs, subject to a maximum of 120 percent of the greater of (1) the rate for its cell and (2) the rate for the cell in the nearest bed-size category.

(c) A hospital which has actual routine operating costs less than the "adjusted payment rate" would receive its actual costs plus the lesser of (1) 50 percent of difference between actual costs and the payment rate and (2) 5 percent of the payment rate.

Certain other adjustments and exclusions are identified in the bill.

This section of the bill would be fully effective for hospital fiscal years beginning with fiscal year 1981. The following estimates illustrate the impact of this section without regard to the implementation schedule, based on a fully implemented, full-year, incurred basis:

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The above estimates, both for Section 223 and Section 2 of S. 1470, were based on distributions of Medicare hospital routine cost per day amounts by bed size, metropolitan-nonmetropolitan, and other classifications. Specific recognition was given to (1) the types of costs excluded from coverage and the various exception or adjustment provisions under S. 1470 and (2) the exception categories under Section 223. The net result is a reduction in average hospital reimbursement levels of 0.5 percent under S. 1470 (a reduction of 1.2 percent due to the upper limit, partially offset by a cost of 0.7 percent due to the incentive provision) versus 0.7 percent under Section 223. Although the 120 percent limit under Section 2 is more stringent than the present limitation under Section 223, the "incentive" provision offsets a part of this higher level of savings; this results in lower total savings than under Section 223.


Capital and increased operating costs associated with the approved closing or conversion of underutilized bed capacity or services would be recognized as reasonable costs for reimbursement purposes.

This section of the bill would be effective upon enactment, with applications for approval to be accepted beginning with January 1, 1978, but with a maximum of 50 approvals to be granted prior to January 1, 1981. The following estimates illustrate the full impact of this section, without regard to the 50-hospital limit:

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These estimates were based on a distribution from a 500-hospital sample of the number of hospitals, the number of hospital beds, and the amount of hospital expenses by occupancy rate. A target minimum occupancy rate, for purposes of this section, was assumed to be 70 to 75 percent; a reduction in the supply of beds nationally of about 5 percent would result if all hospitals were raised to this level by reducing the number of beds maintained. Partial or full closing was assumed to be practicable in settings accounting for 1⁄4 to 1⁄2 of these beds, on a dollar-weighted basis (i.e., reflecting the fact that the bulk of the hospitals with the lowest occupancy rates tend to be smaller hospitals with relatively low levels of cost, where closing tends to be less feasible). The marginal savings between (1) maintaining an empty bed and (2) ceasing to maintain such a bed but recognizing certain residual costs was assumed to average 20-30 percent, based on the hospital expense categories that could be reduced or eliminated. The net result is a potential level of savings of about 0.5 percent, under full implementatation and full participation by the hospital sector.

SECTION 46-RATE OF RETURN ON EQUITY FOR PROPRIETARY HOSPITALS The rate of return on equity recognized by the program would be increased from 12 times to 2 times the current interest rate on trust fund assets.

The section of the bill would be effective upon enactment, applicable to hospital fiscal years beginning after the month of enactment. The following estimates illustrate the full impact of this section:

Fiscal year:





Cost impact








These estimates were derived from data collected from a sample of Medicare cost reports for proprietary hospitals and from data published by the American Hospital Association on investor-owned short-term hospitals.




Based on a National Center for Health Statistics survey and SMI program experience, it is projected, that there will be 7 physician visits per SMI enrollee during fiscal year 1978. 251⁄2 million SMI enrollees are projected for fiscal year 1978. Approximately 55 percent of SMI claims are submitted on an assignment basis. Therefore if $1 is to be paid for each visit paid under assignment, the cost would be $30 million for the three months that the provision would be effective in fiscal year 1978 and $115 million during the full year, fiscal year 1979.


Allowing new physicians in scarcity areas to establish their customary charge levels at the 75th percentile rather than the 50th percentile would add about 20 percent to present law reimbursement levels to those new physicians. This estimate is based on data from a survey of customary charges in Arkansas. From "The Supply of Health Manpower," it was estimated that 12 percent of new physicians (1700 in fiscal year 1978) would be working in scarcity areas. The new

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