Medicare Prospective Payment System

In 1983, in response to rapidly rising costs associated with retrospective cost-based reimbursement, Congress established the Medicare Prospective Payment System (PPS) to pay for inpatient services. In important respects, the PPS is analogous to an experience-rated insurance scheme with mandatory reinsurance. In exchange for assuming financial risk for caring for a patient during a hospital stay, the provider receives a prospectively determined payment. This payment may be thought of as an experience rated "premium," determined on the basis of patient diagnosis at discharge, based on Diagnosis Related Groups (DRGs) and selected provider and geographic characteristics. Providers are also eligible for retrospective "outlier" payments based on the actual costs of caring for unusually costly patients. These retrospective payments may be thought of as a form of reinsurance in which 1) participation is mandatory (i.e., opting out of reinsurance provisions is not an option); and 2) there is an implicit premium imposed on providers through a downward adjustment in PPS-based payments to finance outlier payments.

The underlying notion in the PPS is that, by placing providers at financial risk for the cost of the services they provide incentives can be created to increase efficiency across the board. Two related problems exist with this approach. First, providers may respond strategically to financial risk in addition to or in lieu of attempting to increase efficiency, for example, by manipulating quality and/or denying access to care for unprofitable patients. Second, providers' exposure to risk may vary for reasons beyond their control. Thus, there may be systematic differences in providers' expected costs of treating patients due to differences in input costs or inter-DRG case mix. Providers' costs may also vary because of nonsystematic (random) fluctuations in the treatment needs of patients within DRGs.

Outlier payments have been justified on the grounds that they mitigate incentives for providers to avoid unusually costly patients or to forego appropriate treatments, and that they systematically redistribute revenues to providers who face a greater risk of treating high-cost patients (ProPAC 1997). However, even with outlier payments and other existing adjustments, an important public policy issue remains: Can current PPS rules can be modified to make the distribution of financial risk more equitable and/or efficient? In the face Of concerns regarding fairness and strategic behavior, two major types of modifications have been proposed in PPS payment rules to redistribute providers' exposure to financial risk. The first is refinements in experience rating; for instance, in DRG categories or in adjustments to payments on the basis of provider.

The second is refinements and/or expansion of mandatory reinsurance provisions; for example, through use of "mixed" payment systems increasing the retrospective component of payments. Both refinements in experience rating and in reinsurance provisions can simultaneously alter providers' exposure to financial risk associated with systematic and nonsystematic variations in costs. Efforts to evaluate the financial risk implications of proposed modifications have typically examined the impact on the mean and variance of patient profitability. Changes in expected profits provide a direct monetary measure of changes in systematic financial risk associated with alternative proposals. The mean and variance of profits do not, however, provide a comparable measure of either the impact on nonsystematic (random) risk or on the total risk faced by a provider in a given period (i.e., the combined financial risk associated with systematic and nonsystematic variations). In addition, it is important to consider implications of random variations for provider as well as patient-level profitability. This is because the provider, rather than the patient, is often the relevant unit for analysis. The impact of random variations at the provider level will depend not only on the degree of variation at the patient level, but also on total volume at the provider level; as the number of discharges increases, financial risk associated with random variations will approach zero.

Serious concerns about the rising costs of health care have led to numerous proposals for reform. Many of these recommendations (e.g., capitated payments, managed care systems) focus on cost containment strategies that constrain growth through the prospective reimbursement for specific services. Consequently, they represent a form of price control designed to reduce revenues of health care providers. While the cost reducing benefits of these price controls have been promoted to the public, little attention has been paid to the negative consequences, particularly the effect on capital accumulation in the health care industry. The impact of price controls on hospitals' ability to raise capital is an important issue. Gray notes, that the move of the industry toward managed care and large, integrated health care systems has put a premium on those organizations having access to capital. However, just as rent controls have led to a reduction in the investment in rental properties, price controls on hospital services would be expected to lead to reduced investment in the industry as well. In addition, hospitals traditionally have required access to both long-term and short-term capital to upgrade technology, support new capital improvements, and maintain the existing physical plant. Thus, corporate hospitals need to issue new stock and/or accumulate retained earnings to generate needed equity capital for such future needs. Lastly, both corporate and not-for-profit (NFP) hospitals have relied heavily in the past, and most likely will rely in the future, on the bond market for their capital needs.

Regulatory experience with price controls in the health care industry is limited; however, Congress enacted over a decade ago the Tax Equity and Fiscal Responsibility Act (TEFRA) that established target rates per case for each hospital. The diagnosis-related group-based (DRG) Medicare Prospective Payment System (PPS), enacted one year later, set price controls on Medicare hospital reimbursements. Although these events have generated considerable research, the focus of most studies has been limited to the effect of PPS on hospital utilization patterns or expenditures. Few studies have focused on the effect on capital markets in the hospital sector.

Background

Rapid growth in Medicare expenditures from rising medical care costs prompted Congress to pass TEFRA, signaling the end of retrospective cost reimbursement from Medicare and unrestricted growth in the hospital industry. TEFRA constrained rates of increase in Medicare payments to hospitals by setting target rates per case based on an inflation factor applied to the hospital's base-year (1981) cost. Also, as part of this legislation, Congress required that a proposal for a prospective payment system for Medicare be presented by the Secretary of Health and Human Services (HHS) by the end of the year (1982). Unlike TEFRA, the proposed system would offer significant cost-reducing incentives for hospitals by establishing rates based on averages per case among hospitals.

After the December PPS proposal, Congressional response was immediate. In less than three months, both the House and Senate passed PPS legislation as part of the Social Security Amendment of 1983. The President signed the bill one month later. See Table 1 for a synopsis of Congressional actions. The objective of PPS was to slow the growth in hospitals' costs while providing access to quality health services for Medicare beneficiaries. Under PPS, payments are made at predetermined fixed rates, representing the average cost nationally of treating a Medicare patient according to the patient's classification into one of more than 470 DRGs.

Beginning October 1, 1983, the implementation of PPS was to take place over a three-year period; however, in 1986, this was extended one additional year. To ease the pain of implementation, this phase-in allowed a declining proportion of the total PPS rate to be based on each hospital's historical costs. Medicare payments for capital costs and medical education were excluded along with certain hospitals, such as psychiatric, rehabilitation, children's, and long-term care. By excluding capital costs from PPS, capital payments continued to be paid on an allowable-cost basis, but this policy generated much debate and uncertainty throughout implementation of the law.

Thus, PPS legislation and its implementation occurred over a long period with three specific events: the passage of TEFRA (September 3, 1982); the enactment of PPS (March 25, 1983); and, the promulgation of PPS regulations (October 7, 1983). While the phase-in of PPS was to take place over an extended period, much of the rule promulgation had occurred by the end of 1985, and the direction that PPS was taking the Medicare reimbursement system was readily apparent. Consequently, the period of analysis in this paper runs from January 1982 through December 1985. The period is sufficiently long to capture the full effect of PPS legislation yet sufficiently parsimonious to limit the number of other confounding events.

Previous Research - Market Effects of PPS

Previous work has analyzed the reaction of the stock market to PPS legislation. However, these studies focus primarily on the impact of the passage of PPS immediately around the event and do not address the capital acquisition issue. This paper's focus on the effect of PPS over time differentiates it from earlier market-evaluation.
Folland and Kleiman employ an X-inefficiency model suggesting that price regulation increases the cost of non pecuniary benefits, thereby, reducing their use. Using daily return data, they find a significant positive market response for a four-stock portfolio around the passage of PPS. Since not all firms had significant abnormal returns around that date, Folland and Kleiman (1990, p 64.) ". . . conclude overall that the market did not respond decisively to the DRG legislation." Their results provide only weak support for their hypothesis that these hospitals were not cost efficient. Moreover, it is difficult from their results to reach a definitive answer to the question of how PPS affected hospital systems' ability to generate capital.

Jacobson also used daily return data but tested portfolios that contained not only direct providers of health care but also distributors of hospital equipment, hospital supplies, and manufacturers of medical equipment. She did not find significant abnormal returns for any of the event dates tested, including March 25, the day the Senate approved the conference report. Her results suggest that the impact of PPS on capital generation by hospitals was neutral, yet Folland and Kleiman show significantly positive residuals around March 25. Jacobson's insignificant results appear to be due to the inclusion of a much more diverse group of firms in her portfolio while the portfolios used in this study and Folland and Kleiman contain only acute-care hospital firms.

While Jacobson and Folland and Kleiman focus on returns, Asper and Hassan focus on the change in riskiness for publicly traded hospital stocks due to the passage of PPS. They test for changes in risk by comparing betas for periods before and after the passage of PPS. Their results show a decrease in systematic risk after passage of PPS, but they find changes in risk for some control industries as well.

They conclude that while the acute-care hospital portfolio became less risky after PPS, the decrease in risk may not have been unique to health care. However, Asper and Hassan use monthly return data and are forced to use very long periods to generate sufficient observations. Their estimating equation covers January 1976 to August 1982, while the post period covers August 1983 to December 1988. These long periods could easily contaminate the data by including many other events that affect returns. Health care reform is a continuous time-dependent process; therefore, the episode of reform needs to be analyzed thoroughly over the full period if there is to be an accurate understanding of the effect on the market and capital accumulation in the health care industry. The next section describes the methodology used.