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1 The Balanced Budget Act Of 1997: Will Hospitals Take A Hit On Their PPS Margins? Despite major savings on Medicare, prospective payments under the new budget will still be sufficient to cover inpatient costs. by Stuart Gu terman On 5 A u g u s t President Bill Clinton signed into law the Balanced Budget Act of 1997 (BBA), which reduced federal spending $127 billion over a five-year period from 1998 through The Medicare program alone accounted for $112 billion in savings over this period; this represents a 9.1 percent reduction in total program spending and a decrease in the annual growth rate from 8.8 percent to 5.6 percent. Payments for inpatient hospital services under Medicare s prospective payment system (PPS) amounted to almost one-third of the total Medicare payments anticipated prior to the BBA, and reductions in PPS operating and capital payments comprise about the same proportion of estimated savings. There was much debate among policymakers over the size of these reductions and the effects they would have on the hospitals that receive the payments. This paper describes some of the most important BBA provisions related to PPS payments and the potential impact of the provisions on payments and costs. This analysis does not predict the financial performance of the hospital industry in today s rapidly changing marketplace. Rather, it looks at the BBA s PPS payment reductions in the context of the current level of PPS payments, the level to which payments would have grown in the absence of legislation, and the trend toward reduced cost growth over the past several years. PPS PROVISIONS The BBA contains a number of provisions that affect PPS payments. These provisions account for about $32 billion in savings over the five-year budget period (Exhibit 1). Some of these provisions affect both the level of PPS payments and their distribution across hospitals, and others affect only one or the other. n OPERATING UPDATE. More than onehalf of the savings generated by the BBA results from changes in the update applied to PPS operating payments each year. The PPS update is the factor by which the basic payment rates under PPS are increased to reflect expected inflation in the input prices faced by hospitals, as measured by the PPS hospital market basket index. From 1986 through 1996 the PPS update was set (by Congress) at an average of 2.1 percentage points below the forecasted market basket increase in each 159 Stuart Guterman is a deputy director of the Medicare Payment Advisory Commission (MedPAC), which was formed in October 1997 as a combination of the Prospective Payment Assessment Commission (ProPAC) and the Physician Payment Review Commission (PPRC). He had been at ProPAC since 1988 and a deputy director since Previously, he was a researcher at the Health Care Financing Administration. H E A L T H A F F A I R S ~ J a n u a r y / F e b r u a r y

2 EXHIBIT 1 Prospective Payment System (PPS) Provisions In The Balanced Budget Act Of 1997 Provision PPS operating update a PPS capital payments a IME payments a DSH payments a Outlier payments a Certain hospital discharges to postacute care Small rural Medicare-dependent hospitals Reclassification for DSH payments Rural referral centers Floor on area wage index Base payment rate for Puerto Rico Hemophilia pass-through Special provisions for hospitals with certain characteristics Estimated savings (billions) $ Total 31.9 SOURCE: Congressional Budget Office, August NOTES: IME is indirect medical education. DSH is disproportionate-share hospital. Several other provisions that affect payments to PPS hospitals but are not reflected in the calculation of PPS inpatient margins are not included in this list. These include the reduction in Medicare payments for beneficiaries bad debts, which is not considered in the calculation of PPS margins, and the addition of payments for Medicare+Choice enrollees treated at PPS hospitals, which are not considered PPS payments. a Included in analysis of payment policy effects. 160 year. In 1997, before Congress agreed on new legislation, the PPS update was set at 0.5 percentage points below the forecasted increase, as required by the legislation in place at the time. Had no legislation been passed this year, the PPS update would have been set equal to the forecasted market basket increase for 1998 through 2002; instead, the BBA set the update at an average of 1.7 percentage points below market basket comparable to the increases over the previous decade. 2 n CAPITAL PAYMENTS. Another major provision is a reduction in the PPS payment rate for inpatient capital costs. This change eliminates the large increase in capital payments that occurred in 1996, when a requirement (in effect since 1992) that capital payment rates be set so that payments would equal 90 percent of aggregate anticipated capital costs expired. n IME AND DSH ADJUSTMENTS. The BBA also modified the levels of the indirect medical education (IME) payments for teaching hospitals and the disproportionate-share hospital (DSH) payments for facilities that treat a large number of indigent patients. Both IME and DSH payments are concentrated among a relatively small number of hospitals. The BBA reduced the IME adjustment by 29 percent over the next four years. 3 DSH payments were lowered by 5 percent over the next five years. 4 Because many teaching hospitals also receive DSH payments and many disproportionate-share hospitals also have teaching programs, these BBA provisions may hit some hospitals particularly hard. n OUTLIER PAYMENTS. Outlier payments are made under PPS for cases that are exceptionally expensive relative to the payment rate the hospital receives. The amount of additional payment is determined by comparing the estimated cost for the case to a cost threshold. Before the BBA, the estimated cost of each case at teaching or disproportionateshare hospitals was adjusted downward to reflect the additional payments that these hospitals already received under PPS; if the case still exceeded the outlier threshold, the hospital would receive an outlier payment with an IME or a DSH adjustment. As a result of the H E A L T H A F F A I R S ~ V o l u m e 1 7, N u m b e r 1

3 initial cost adjustment, however, many very expensive cases at teaching and disproportionate-share hospitals would fail to qualify for outlier payments at all. The BBA eliminated the IME and DSH adjustments to outlier payments, resulting in further reduced PPS payments to these hospitals. Subsequently, the Health Care Financing Administration (HCFA) eliminated the cost adjustment and revised the threshold to reflect IME and DSH payments. As a result, the losses borne by teaching and disproportionate-share hospitals before qualifying for outlier payment are comparable in dollar terms to those borne by other hospitals, and more of their cases will qualify for outlier payments. 5 METHODS FOR ESTIMATING THE BBA S IMPACT Using a fairly simple model of PPS payments and costs, we attempted to simulate the potential impact of the BBA s provisions over the period covered by the legislation. There were several key components to the model. First, the base time period was 1995, the date of the latest available Medicare Cost Report data on PPS payments and costs. In that year the PPS inpatient margin, which is an indicator of PPS operating and capital payments relative to the corresponding costs, was 10 percent (Exhibit 2). 6 This was the highest margin in a decade and represented a remarkable turnaround from 2.4 percent only four years earlier. The reason for this turnaround is clear from an examination of the trends in PPS payments and costs (Exhibit 3). The high PPS margins in the early years resulted from large increases in operating payments in the first two years of PPS (capital did not come under PPS until 1992) and considerably slower cost growth in the first year than in the succeeding years. Between 1984 and 1991, PPS payments per case rose at an annual rate of 6.4 percent 2.5 percentage points faster than the Consumer Price Index (CPI) but PPS costs per case jumped 9.1 percent per year. Between 1991 and 1995, PPS payments per case had decelerated to 4.2 percent per year (1.3 percentage points faster than the CPI), but PPS costs per case rose at an annual rate of only 1 percent (1.9 percentage points slower than the CPI). In fact, PPS costs per case actually declined in 1994 and again in Clearly, cost growth is a key factor in recent hospital finan- 161 H E A L T H A F F A I R S ~ J a n u a r y / F e b r u a r y

4 162 cial performance and in modeling the impact of payment policy changes. The next step was to extrapolate costs and payments from 1995 to 1997 (the year before implementation of the BBA). Data from the American Hospital Association s National Hospital Panel Survey, released monthly with a relatively short time lag, indicated that the trend toward slower growth in hospital costs per case that began in the early 1990s was continuing through These data were used to project PPS inpatient costs per case forward to 1997, at the relatively conservative rate of 2 percent per year or one percentage point below market basket. That rate is about three percentage points higher than the most recent documented trend in PPS costs per case. Payments were based on the known PPS updates for 1996 and 1997, along with the Prospective Payment Assessment Commission s (ProPAC s) assumptions about changes in the Medicare case-mix index. These rates were applied to 1995 costs and payments for each hospital for which 1995 data were available. 8 Payment growth was then estimated, given the provisions that would have been in effect under previous legislation. These include a PPS operating update equal to the market basket index, for which forecasts through the period of analysis were available; a PPS capital update of about two percentage points less than the operating update in each year, arbitrarily chosen to approximate the recent trend in PPS capital updates; and no change in any other aspect of PPS payment. These provisions were applied separately as they pertained to basic, outlier, IME, DSH, and capital payments in 1997, with each component derived from the extrapolation of total PPS payments and the estimates produced by the ProPAC PPS payment model. All assumptions were applied on a per case basis, to reflect the payment system. Finally, the BBA provisions were incorporated into the analysis. The PPS operating update was applied to operating payments in each year. The capital payment reduction and the reductions in the IME and DSH adjustments were applied in terms of percentage changes from the previous baseline. Estimates of the impact of the outlier payment changes were based on the ProPAC PPS payment H E A L T H A F F A I R S ~ V o l u m e 1 7, N u m b e r 1

5 model. Both the baseline and BBA margins were calculated for each hospital group based on two alternative assumptions about cost growth one equal to the market basket increase in each year and one equal to market basket minus one percentage point. 9 RESULTS n OVERALL IMPACT. As might be expected, the BBA has a substantial impact on estimated PPS margins (Exhibit 4). The aggregate PPS margin for all hospitals a comparison of all PPS payments and all PPS costs is 8.9 percentage points lower when the provisions of the BBA are incorporated into the analysis than under the baseline assumptions. However, the baseline PPS margin is based on extremely unrealistic provisions that, one might argue, were never meant to be implemented. Under these provisions, and assuming cost per case growth at market basket minus one percentage point, the PPS margin would be 24.2 percent by The large decrease represented by the BBA, therefore, only reduces the PPS margin to 15.3 percent by 2002 still the highest in history. n HOSPITAL GROUPS. The distribution of the impact across hospital groups is swamped by the very high PPS margins across the board (Exhibit 5). In 1995 major teaching hospitals (hospitals with at least twenty-five residents per 100 beds) had the highest PPS margin of any group 10.5 percentage points above the aggregate for all hospitals, 11.2 percentage points higher than the PPS margin for other teaching hospitals, and 14.5 percentage points more than nonteaching hospitals. These distinctions would have become less meaningful by 2002 under the baseline provisions, because the PPS margin for each of these groups was estimated to exceed 20 percent. With the reductions under the BBA, the margins at major teaching hospitals still are estimated to be 12.2 percentage points above nonteaching hospitals, but all three teaching status groups would have PPS margins in double figures. The pattern is similar when hospitals are grouped by other characteristics. n PAYMENTS AND TOTAL REVENUES. The PPS operating update and the capital payment reduction will affect all hospitals 163 H E A L T H A F F A I R S ~ J a n u a r y / F e b r u a r y

6 164 equally as a proportion of their PPS or capital payments, but different groups of hospitals have different relative shares of operating and capital payments. 10 The IME and DSH cuts affect the hospitals that receive those payment adjustments. The outlier payment changes also are distributed unevenly across hospitals. The combined impact of these provisions is not surprising (Exhibit 6). The provisions cut overall PPS payments by 10.6 percent below the baseline payment level. With the exception of the major teaching group, which is expected to have a larger-than-average reduction, and the rural and rural disproportionateshare groups, which bear smaller-than-average burdens, all of the effects are within 0.5 percentage points. The increase in PPS payments relative to costs under the baseline assumptions would more than offset the BBA reductions, however. As a result, almost every hospital group would have a more favorable PPS payment situation in 2002 than they had in The net effect on PPS payments ranges from 0.1 percent for major teaching hospitals to 2.4 percent for rural hospitals. The PPS changes by themselves therefore would not have an unfavorable effect on total revenues. For all hospitals, these changes account for a 0.3 percent increase in total revenues the product of the 1.3 percent increase in PPS payments relative to costs and the 28.4 percent share of total revenues accounted for by PPS payments. The net effect by hospital group varies according to the impact of the PPS provisions and each group s PPS payments as a share of total revenues, and ranges from zero for major teaching hospitals to 0.6 percent for rural hospitals. H E A L T H A F F A I R S ~ V o l u m e 1 7, N u m b e r 1

7 EXHIBIT 6 Impact Of The Balanced Budget Act Of 1997 (BBA) On Prospective Payment System (PPS) Payment In 2002 Hospital group Baseline change in PPS payments BBA impact on PPS payments Net impact on PPS payments PPS payments as share of total revenues Net impact on total revenues All hospitals % 10.6% 1.3% 28.4% 0.3% Large urban Other urban Rural Major teaching Other teaching Nonteaching DSH: large urban DSH: other urban DSH: rural Non-DSH SOURCE: Prospective Payment Assessment Commission (ProPAC) estimates. NOTES: DSH is disproportionate-share hospital. Several important changes that would affect PPS payments are not reflected above. These include changes in the definition of transfer cases under PPS, changes in the rules governing PPS capital exceptions payments, provisions that increase payments to some rural hospitals, and other provisions affecting hospitals in specific locations or circumstances. In addition, other changes that may affect medicare payments to PPS hospitals are not reflected above, such as changes in payment for hospital outpatient services, direct graduate medical education (GME) payments, payments to teaching hospitals that treat Medicare+Choice patients, and payments to other providers that may be owned by hospitals and therefore affect their total margins DISCUSSION We have attempted here to indicate the potential effects of the PPS payment provisions of the BBA on PPS inpatient margins. Although the PPS margin does not indicate the overall financial status of the hospital industry or individual hospitals, it is commonly viewed as the single best indicator of the adequacy of payments under PPS, because it provides a direct comparison of those payments and the costs to which they correspond. Moreover, because PPS replaced a cost-based reimbursement system, the PPS margin also allows us to compare payments under the current system with what payments would have been under the old system. These results are heavily dependent upon assumptions about hospital cost increases during However, even if hospital inpatient costs per discharge grow at a rate equal to the PPS hospital market basket index which is percent above the rate observed in 1994 and 1995 the PPS margin would be back over 10 percent by PPS payments would well exceed costs for the vast majority of hospitals. Drawing conclusions about the BBA s impact on hospitals overall financial status is much more difficult, because it depends on a variety of rapidly evolving factors, including other Medicare payment policies, Medicaid payment changes, the growth of uncompensated care, and developments in private insurance. Nonetheless, the most recent data indicate that, at least over the past several years, the industry has managed to improve the balance of revenues and expenses in the face of strong pressure from private payers. Although slightly more than 20 percent of all hospitals had negative total margins in 1995, this figure was lower than in any year since PPS began in Although other changes may exert increasing pressure on hospitals continued viability, this analysis indicates that the PPS provisions in the BBA do not reduce Medicare s ability to more than cover the costs of inpatient hospital services. H E A L T H A F F A I R S ~ J a n u a r y / F e b r u a r y

8 166 NOTES 1. This figure represents a reduction in federal spending relative to spending anticipated under existing legislation. It reflects a $160 billion reduction in estimated federal outlays and $33 billion in new spending. These and all other budget estimates in this paper are from the Congressional Budget Office. 2. This probably is the best indication of the unrealistic nature of the baseline provisions. Congress regardless of which party is in the majority historically has set provisions in law that it intends to revisit when new legislation is developed. These provisions such as a PPS update equal to the market basket increase allow future Congresses to claim easy savings by restoring payment parameters to more realistic levels. The high PPS updates for 1997 and beyond were set in the Omnibus Budget Reconciliation Act of 1993 by the Democratic 103d Congress, and the BBA similarly sets the PPS updates equal to the market basket increase for 2003 and beyond. 3. The BBA also limited the number of residents that each hospital could count in determining its IME adjustment and provided an incentive payment for hospitals that agree to reduce the number of residents they train. Neither of these provisions is reflected in the analysis described in this paper. 4. The BBA also requires the secretary of health and human services to develop and report on a new DSH payment formula by August This might have a substantial impact on the distribution of PPS payments, but since its form is not known, it is omitted from this analysis. 5. Although the actions taken by the Health Care Financing Administration were not part of the BBA, they are directly related to the BBA provision and are reflected in the analysis of the effects of the act. 6. The PPS inpatient margin is equal to the difference between PPS inpatient (operating plus capital) payments and costs, divided by PPS payments. 7. More recent data from the same source indicate that the trend has continued at least through the first half of Although the data clearly indicate that neither cost nor payment growth is uniform across hospitals or even groups of hospitals, the changing environment in which hospitals operate makes it impossible to reliably project their past cost history into the future on an individual basis. The recent trend toward slower cost growth, however, is remarkably widespread, so the results of this analysis probably present a reasonable picture of the impact of the payment changes in the BBA. 9. For ease of presentation, the results presented below focus on the market basket minus one percentage point scenario. 10. Until 2001 the reduction in capital payments actually will affect individual hospitals only to the extent that they are paid under the fully prospective method. Some hospitals, however, are paid partially on the basis of their new capital costs (that is, costs associated with capital projects that were being planned before or while the PPS for capital was implemented, but are not reflected in the hospital s base-year costs) and so are less affected by the reduction. By 2002, however, capital payments for all hospitals will be based on the prospectively determined federal payment rate. H E A L T H A F F A I R S ~ V o l u m e 1 7, N u m b e r 1