The Pricing of U.S. Hospital Services: Chaos Behind A Veil of Secrecy

Uwe E. Reinhardt


Health Affairs. 2006;25(1):57-69. 

In This Article

How Hospitals Set Their Prices, and How They are Paid

Overarching the U.S. hospital payment system is each individual hospital's "chargemaster." The data shown in Exhibit 1, for example, were taken from the chargemasters of the hospitals featured in the exhibit. A hospital's chargemaster is a lengthy list of the hospital's prices for every single procedure performed in the hospital and for every supply item used during those procedures. A sample chargemaster posted on the Web site of California's state government, for example, contains close to 20,000 items.[7]

Traditionally, each U.S. hospital has had its own chargemaster, but through the Health Insurance Portability and Accountability Act (HIPAA) of 1996, Congress has sought to impose a standard national format on that nomenclature, a process that is yet to be completed.[8] Hospitals update their chargemasters at least annually but often more frequently. Typically, a hospital will submit, for all of its patients, detailed bills based on its chargemaster, even to patients covered by Medicare. An advantage of these bills is that at least in principle, patients can check whether all of the supplies and services listed on the bill were actually delivered. A disadvantage, for hospitals, is that these bills are very lengthy and add up to large totals that do not bear any systematic relationship to the amounts third-party payers actually pay them for the listed services. As noted earlier, these actual payments tend to be less than half of the amounts that originally were billed. Hospitals do not follow a common practice in updating their chargemasters. Some hospitals might simply raise every price in the list by the same percentage once a year. Others might update prices for particular items or procedures separately, by different percentages, which makes it difficult to know by what overall percentage a hospital has increased its prices. These updates sometimes occur more than once a year. In general, the process appears to be ad hoc, without any external constraints—the "madness" alluded to by McGowan.[9]

With the exception of California, which now requires hospitals to make their chargemasters public, hospitals are not required to post their chargemasters for public view. It may be just as well. If the sample chargemaster posted by California's state government is any guide, prospective patients would be hard put to make sense of these price lists.

An individual hospital might be paid by a dozen or more distinct third-party payers, each with its own distinct set of rules for and levels of payment, which are negotiated separately with each private insurer once a year. Medicare and Medicaid have their own extensive rules for paying hospitals. Relative to hospitals paid under the much simpler national health insurance schemes in other countries, the contracting and billing departments of U.S. hospitals therefore are huge enterprises, often requiring large cadres of highly skilled workers backed up by sophisticated computer systems that can simulate the revenue implications of the individual contract negotiations. Furthermore, because violations of contracts with the government programs can trigger severe civil or criminal penalties, hospital billing departments are strictly monitored and supervised by sizable internal control operations.

U.S. hospitals now receive abut 31 percent of their net revenues from Medicare. About 88 percent of Medicare's total payments to hospitals directly for patient care is for inpatient services; the remainder goes for outpatient services.[10]

For inpatient services, Medicare pays hospitals flat fees per hospital case, according to a schedule of close to 600 distinct diagnosis-related groups (DRGs). The system assigns relative payment weights to each DRG. To arrive at the actual payment for a particular DRG in a given year, that DRG's relative payment weight is multiplied by that year's monetary conversion factor (the "base payment amount," in dollars). That payment is then further adjusted for regional variations in the cost of labor and of other hospital inputs, and for other local factors that might affect a hospital's cost of producing care.[11] To accommodate complex cases whose resource use greatly exceeds that foreseen in the closest DRG, the system provides for "outlier" payments that, in principle, are set to reflect the hospital's estimated cost of providing the additional supplies and services used.

The DRG weights used in this system were originally based on the relative average costliness of cases in DRGs in the early 1980s. They have been recalibrated regularly on the basis of average standardized, billed charges for all cases falling into each DRG in the most recent Medicare file.[12] Congress updates the monetary conversion factor annually, to reflect changes in technology, practice patterns, and economywide market conditions—for example, in the so-called market-basket price index of hospital inputs (such as energy) affecting hospitals in all regions.

The DRG system, which is, in essence, a system of centrally administered prices, has had its critics in the United States over the years. None other than Tom Scully, the Medicare administrator during President George W. Bush's first term, has disparaged Medicare as a "dumb price fixer."[13] Ironically, that very system was originally put into place by none other than the staunchly market-oriented Ronald Reagan. In any event, since it was first introduced in 1983, the DRG system has had a number of imitators abroad, notably in Australia and Germany.

For outpatient services, Medicare originally reimbursed hospitals retrospectively for allowable, incurred costs, for which beneficiaries were required to make copayments. By 1997 these copayments had come to equal about 50 percent of total Medicare payments to hospitals for outpatient care.[14] In the Balanced Budget Act (BBA) of 1997, Congress mandated Medicare to replace that inherently inflationary, retrospective, full-cost reimbursement system with a prospective fee schedule, whose basic payment unit is either a service or a particular procedure. This schedule went into effect in 2000.

In developing the new fee schedule, Medicare bundled—as much as is sensible—entire sets of supplies and services associated with each major procedure into one lump-sum fee for that procedure. These procedure categories are classified into some 600 distinct groups, each of which contains major procedures that "are clinically similar and use comparable amounts of resources."[15] The grouping was made according to an ambulatory payment classification (APC) scheme developed through health services research. These APCs are still evolving, as Medicare gains experience with them and as new technology emerges.

As in the DRG system, the dollar amount paid hospitals for a particular APC is determined by multiplying the relative cost weight of that APC (based on median costs for that APC) by a monetary conversion factor. Further adjustments are made for regional variations in input costs, especially wages, and other factors thought to affect hospital outpatient costs. Once again, there is a provision for outlier payments. There is also provision for pass-through payments covering costly new technology (such as drugs) going into particular treatments.

The Medicare payment system is highly complex, in part because government payment systems must observe rules of fairness, strict accountability to taxpayers, and other social goals not imposed on private payers. Critics of the system sometimes overlook the fact that these requirements pose administrative challenges not shared by private enterprise. However, the myriad of distinct payment systems for U.S. private insurers are very complex as well, by international standards, and often still based on paper claims.

Medicaid now accounts for about 17 percent of total national spending on hospital care.[16] Payment methods vary from state to state, but two methods dominate for inpatient payments: flat fees per DRG or flat per diem payments.[17] The DRG payments are unilaterally set by the state governments, usually as a percentage of Medicare DRGs. For outpatient services, the most common approach traditionally has been what is called "cost reimbursement," or fee schedules set by the state governments. Many states, however, are considering switching to the APC system pioneered by Medicare.[18]

As Allen Dobson and his colleagues show elsewhere in this volume, on average, for the nation as a whole, Medicaid's payments to hospitals fall well short of fully allocated costs, even after the separate disproportionate-share hospital (DSH) subsidies paid by the federal government and the states to hospitals with disproportionately large loads of uninsured or Medicaid patients are accounted for.[19] That shortfall must be covered by other payers—mainly private insurers.

Hospitals receive roughly one-third of their net revenues from private health insurers, which pay hospitals on the basis either of steeply discounted charges (with discounts in excess of 50 percent), negotiated per diems, or flat charges per entire episode (DRGs). Usually an insurer pays most claims on one base (for example, per diems), although an insurer may pay some hospitals on other bases as well.

Discounted charges tend to be used by smaller insurance companies for inpatient services. They are used by all insurers for outpatient services, although insurers often bundle all of the services going into a major procedure (such as a laparoscopic cholecystectomy) into one code, just as Medicare and Medicaid do with the APC system. Case-based payments are each insurer's own adaptation of the Medicare DRGs. Usually the insurers will use the Medicare DRG groupings, but each will assign its own relative weights to the individual DRGs.

Whatever an insurer's base for paying hospitals might be, the dollar level of payments is negotiated annually between each insurer and each hospital. Under a DRG system, for example, the item to be negotiated is the monetary conversion factor for the year and, possibly, some of the DRG weights. These actual dollar payments have traditionally been kept as strict, proprietary trade secrets by both the hospitals and the insurers. Recently Aetna announced that it will make public the actual payment rates it has negotiated with physicians in the Cincinnati area.[20] That this small, tentative step toward transparency made national news speaks volumes about the state of price-transparency in U.S. health care. It remains to be seen whether that first step will trigger a larger industrywide move toward removing, at long last, the veil that has been draped for so long over the actual prices paid in the U.S. health system.

Until recently, only uninsured, self-paying U.S. patients have been billed the full charges listed in hospitals' inflated chargemasters, usually on the argument that the Medicare rules required it.[21] This is how even uninsured middle-class U.S. patients could find themselves paying off over many years a hospital bill of, say, $30,000 for a procedure that Medicaid would have reimbursed at only $6,000 and commercial insurers somewhere in between.[22]

Because uninsured patients often are members of low-income families, many of them ultimately paid only a fraction of the vastly inflated charges they were originally billed by the hospital, but only after intensive and morally troubling collection efforts by the hospital.[23] After a series of searing exposes of these collection efforts in the press—notably by staff reporter Lucette Lagnado of the Wall Street Journal—Congress held hearings on these practices.[24] Partly under pressure from consumers and lawmakers and partly on their own volition, many hospitals now have means-tested discounts off their chargemasters for uninsured patients, which bring the prices charged the uninsured closer to those paid by commercial insurers or even below.[25] Some very poor patients, of course, have received hospital care free of charge all along, on a purely charitable basis.

Traditionally, both the structure of hospitals' chargemasters and the prices they contained varied from hospital to hospital, and they did not match the diverse nomenclatures used by insurance carriers to describe hospital services. The resulting chaos brought forth new business ventures, such as WebMD, as clearinghouses.[26] Their proprietary software was designed to translate invoices expressed in a hospital's nomenclature into the different nomenclature used by the relevant insurer.

To eliminate this chaos, and the persistence of paper claims it begot, in 1996 Congress passed HIPAA, whose "administrative simplification" provisions sought to impose a uniform format and data content on all U.S. health care transactions, to ease electronic transactions among all payers and providers. In the meantime, the health industry has made strides toward that goal. As of this writing, however, full "HIPAA compliance" with complete, direct, two-way information exchanges between providers and payers has not yet been attained in the United States; insurers are the main laggards.[27] This failure to attain uniform coding standards throughout the industry provides a continued reason for the clearinghouse industry to stay in business.[28] It also adds to the health system's administrative overhead.