The growing financial burden from high commercial prices for medical services is fueling calls for reform. Private insurers already rely on Medicare’s coding architecture to adjudicate most claims, but they frequently provide large percentage add-ons to appease their affiliated networks. For instance, as documented in a series of recent studies, private insurers pay an average of as much as 231 percent of Medicare’s rates for inpatient hospital stays. Advocates for tighter price regulation see a ready opportunity to lower costs by extending the reach of Medicare’s limits to the private sector.
There is no question that capping commercial prices at an arbitrary percentage of Medicare, such as 150 percent, would lower overall costs, at least initially. Insurance premiums would fall, as would cost-sharing charges. If nothing else changed, the value to working-age households would outweigh the revenue losses for a health sector badly in need of more rigorous cost discipline.
But there are considerations beyond the convenience of using existing Medicare rules to regulate pricing throughout the health system. Relying almost exclusively on the government’s payment rules to control costs invites several questions: Are the data and methods underlying these regulations sound, and do they incentivize the right kind of care for patients, both now and in the future? Further, are there realistic alternatives that might deliver better results?
A review of the government’s current payment system catalog suggests room for improvement. The attraction is that Medicare’s rates, irrespective of how they have been derived, provide a level of control over pricing that is mostly non-existent in today’s highly compromised private market. But that is not the same thing as saying Medicare’s pricing rules -- built on a vast and entrenched fee-for-service coding and bill-paying system -- encourage efficiency, innovation, and high-value care.
Further, there is also one outlier model within Medicare that might be useful for stimulating new thinking about what is possible across more health care services.
Replacing ‘Cost-Plus’
Medicare did not always have its current reputation as a tightfisted payer. Indeed, today’s rules are a direct consequence of the program’s early history of ineffective cost control.
At enactment, Congress required the federal agency administering the program—originally the Social Security Administration and later the Health Care Financing Administration (which was eventually renamed the Centers for Medicare and Medicaid Services [CMS])—to operate as a passive purchaser, not a heavy-handed regulator. Hospitals and physicians tallied up their costs, and the government covered them, with some extra thrown in for acceptable “margins.” Few questions were asked.
Not surprisingly, this arrangement worked well for the industry but not taxpayers. From 1967 to 1980, Medicare spending per beneficiary grew at an average annual rate of 13 percent. Cost escalation was so rapid that by the late 1970s a political consensus had formed that something had to give.
In the early 1980s, Congress began a two-decade journey to jettison cost-plus reimbursement in favor of formula-based payments, which use cost reports and other sources for determining input expenses to calculate a fair “average” payment for itemized services. In most cases, the new systems were written so that the payments would be known by providers in advance of delivering care—that is, prospectively. Thus, the expenses incurred for individual patients became mostly irrelevant to what providers would be paid.
A major breakthrough came with congressional approval of the prospective payment system (PPS) for inpatient hospital care in 1983. The law’s successful and rapid implementation, and its acceptance as a relevant model for private insurers, encouraged policymakers to take up payment reforms for many other provider categories (see exhibit 1).
Exhibit 1. Partial List of CMS payment systems
Source: MedPAC 2023
Coding And Billing Drive Take-Up
An important source of CMS’s power is the fee-for-service coding systems that are the foundations for the various payment reforms enacted since 1983. In a complex and fragmented delivery system, insurers need a method for rapidly examining and adjudicating tens of millions of claims for payment. When Medicare built the infrastructure that allowed private insurers to drop cost-plus reimbursement, the entire industry moved swiftly to follow the government’s lead.
It was an understandable move. Building a claims and payment processing system for thousands of differing care scenarios is an expensive proposition. Hospitals, doctors, and the various other entities and clinicians seeking Medicare reimbursement had little choice but to gradually adopt the government’s standards. However, once they built systems incorporating Medicare rules, they were not eager to also build wholly separate systems for other payers. Additionally, private insurers did not want to invest the substantial capital required to separate themselves from the Medicare fee-for-service model.
The end result is that CMS’s rates and codes have become the industry standards for payment. Private insurers are free to modify their payment contracts in any way they find useful, but nearly all use Medicare’s current coding and payment systems act as their starting points. Selective modifications are then offered that cost private insurers far less to build and manage than it would cost them to build an entirely new model.
The convenience and lower costs of building upon Medicare’s rules affect the design of Medicare Advantage (MA) plans, too, even as these optional coverage arrangements have reached enrollment parity with the traditional program. They have the flexibility under current rules to pay their affiliated providers on terms that differ from Medicare’s fee-for-service paradigm, but their usual approach is to accept Medicare’s coding systems as the starting point for payment with targeted modifications. Often, this means agreeing to pay a percentage add-on to Medicare’s rates, possibly with new conditions to prevent clinically questionable uses of certain services and to steer patients toward preferred providers.
It is an indication of the momentum behind Medicare’s payment rules that MA plans tend to use them as their launch points for payment. While large in total enrollment, none of the players in the MA market have the leverage to force terms onto the entire provider community in the way that Medicare can through its regulatory reach.
A Lumbering Regulator
Once in place, the series of payment reforms approved by Congress transformed HCFA (now CMS) into the regulatory powerhouse it is today. This is exactly what hospitals and doctors feared would occur when the program was launched.
The agency’s regular cadence of payment rule updates is now a year-round, must-watch enterprise. To keep up, the multi-trillion-dollar industry that CMS oversees (and directly and indirectly finances) employs an army of lawyers and lobbyists to comb through the rules and communicate publicly and privately with agency officials. The overall goal is to prevent surprises and secure terms that are as favorable as possible to stakeholder bottom lines.
The usual metric used to validate this state of affairs is continued access to care for beneficiaries with costs that are more under control than in the private market. The congressional agency tasked with monitoring the rules and suggesting changes—the Medicare Payment Advisory Commission (MedPAC)—regularly issues reports confirming the basic value of CMS’s rulemaking philosophy.
Of course, conjuring a persuasive and plausible counterfactual is difficult. Because of Medicare’s size—on average about one third of the market—most providers have only two realistic options: accept and work with the government’s rules, no matter how adverse the financial terms, or exit the market entirely. Not surprisingly, most choose to stay and then attempt to find ways to maximize their revenue while accepting what they cannot change.
While there is some logic and reasoning behind much of what CMS requires, the agency cannot escape certain tendencies that are typical when public authorities oversee complex sectors of the economy:
Stasis
The federal regulatory process is cumbersome and slow and exhibits substantial inertia. What already exists tends to continue unless loud and powerful voices go to Congress and demand change.
Part of the reason modifications tend to be incremental is that federal law governing the administrative process was written to protect the public from arbitrary rulemaking that could disrupt businesses and livelihoods. Federal agencies must provide notice of their planned changes, allow time for public input, respond to valid criticisms, and marshal supporting evidence before implementing disruptive changes. Falling short on any of these standards invites costly lawsuits.
Consequently, there are modifications every year to the major payment systems, but they tend to build gradually on what exists and are small compared to the vast architecture that lies beneath them. The government is also reluctant to pull back on its powers because of the awareness that reversing course and retaking control will be difficult. Thus, it is rare for payment rules to relax previously imposed requirements. The trend is toward the gradual accretion of power by CMS, not its dissipation.
Old And Questionable Data
Redetermining payments with new data is expensive, as the affected industries must collect what the government needs to update its formulas. It also invites controversy because—if the anticipated changes must be budget neutral, as is usually the case—there will be winners and losers, and the potential losers typically will activate their supporters in Congress to take up their cause. Because government agencies have strong self-preservation impulses, they tend to avoid conflicts that are not strictly necessary to fulfill their missions. For CMS, that means sticking with old data and methods as long as possible.
As an example, the starting point for the PPS for inpatient hospital care is a standardized per diem rate that has been indexed and modified continuously for four decades but nonetheless has its origins in 1981 cost data, which were used as the foundation for the first payment calculations.
For physician fees, the American Medical Association and its affiliated membership societies play an outsized role in maintaining the relative weights that are used to set fees for the various services provided by the members. The normal tool for determining the time and effort required for these services is a survey questionnaire sent to participating physicians. As documented by the Government Accountability Office, this approach suffers from exceptionally small sample sizes, poor response rates, and biased submissions.
The base rate for paying skilled nursing facilities is similarly suspect. Currently, it is tied to a sample of just 205 nursing homes dating back to 2006-2007. CMS sponsored an evaluation in these facilities of the time it took for staff to perform various services for patients and then constructed its prospective payment system based on the results. The final rule implementing the changes, which affects the entire industry, took more than a decade to implement.
Opacity
Each of the payment constructs administered by CMS is amended at regular (usually annual) intervals. Over many years and often decades, even such an incremental process can lead to substantial new layers of compliance. The overall effect is a system of rules characterized by complexity and heavy administrative processes.
One indication of this tendency toward impenetrability is the length of the annual payment rules, as published in the Federal Register. For instance, for the fiscal year that began on October 1, the new rule for hospital inpatient care is just short of 800 pages, with three columns of text for most of the published pages. The physician fee schedule and skilled nursing facilities rules for 2024 run 1227 and 147 pages, respectively.
Incumbency Privilege
As is observed in other heavily regulated industries, the expectation in Congress and within the industry is that CMS will administer payments in a manner that will be tight budgetarily but without jeopardizing the financial viability of large segments of the provider community. In other words, payments will be high enough to keep the doors open. This unstated premise means that the rules are constructed to meet the expectations of the existing provider community and not new entrants. Indeed, because of the complexity and start-up costs associated with compliance, it is exceptionally difficult and expensive for wholly new enterprises to enter these markets.
Prices From Suppliers
Medicare’s purchase prices for some durable medical equipment (DME) items offer a notable exception to the normal pattern. Instead of CMS calculating rates based on an administrative formula, the DME suppliers state their prices in a bidding process that is then used to determine what the government will pay.
CMS began paying for some DME based on competitive pricing in 2011, with subsequent rounds of bidding expanding the list of covered products and updating the reimbursement amounts. About half of all items included in Medicare’s DME coverage have had their fees determined at some point by the competitive pricing rules over the past decade, with the rest still paid pursuant to the terms of a fee schedule originally constructed based on the history of cost-plus charges from the suppliers.
Competitive bidding has delivered notable and consistent savings since 2011, with the program experiencing large and persistent reductions in the prices paid for the products covered by the new system. According to a study cited by MedPAC, the reduction in pricing from competitive bidding is expected to deliver $42 billion in total savings over a decade, including $17 billion in reduced out-of-pocket costs for Medicare beneficiaries. Exhibit 2 shows the effects of bidding on total DME spending and makes clear that requiring suppliers to specify their prices in a competitive market worked as planned to lower the cost burden for the program and its beneficiaries.
Exhibit 2. DME spending growth before and after competitive bidding
Source: Medicare Trustees Reports (2023 [pg. 143], 2018 [pg. 137], 2010 [pg. 179])
When Demand Is Price Sensitive
The dominant regulatory model employed by CMS today has become so entrenched and accepted by policymakers and the industry that it is rare for discussion to occur about potential alternative orientations. Indeed, as noted, the prevailing policy discussion currently is about extending Medicare’s regulatory reach further into the commercial market.
But one can imagine different possibilities. Indeed, it is not wishful thinking to seek absolute declines in prices for some services, not just stability, based on alternative models that would disrupt current market expectations. In particular, it is conceivable that, instead of relying exclusively on CMS to calculate what prices will be fair and reasonable, the providers of services could stipulate what prices they would like to charge—but only if the market were structured in a way that allowed for ready comparisons with competitors, and consequences based on the results.
To this end, reliance on bidding will only work when the demand for the services is price sensitive. In the case of DME, the consumer is the government, and the rules state that lower price offers are more likely to secure the government’s business.
For other services covered by Medicare, it would be more difficult, but not impossible, to rely on pricing from those providing the services. An essential requirement would be standardization of what is being priced to eliminate uncertainly around which suppliers are offering the lowest prices for the same set of clinical services.
For many (but not all) non-DME coverage, the beneficiaries, not the government, choose where to get care. Consequently, beneficiaries would be stepping into the role of price-sensitive consumers. That would have to be done carefully to ensure the bidding produces only savings and not higher costs.
There are several possibilities for beginning to test what would work:
High-Volume Imaging And Lab Services
Some categories of Medicare-covered services are similar to DME in that what is provided to patients is sufficiently replicable to lend itself to a bidding system. Lab services and medical imaging have accepted industry standards that should allow for apples-to-apples price comparisons even recognizing that quality and innovation cannot be sacrificed in exchange for maximizing cost reduction for the government.
High-Volume Surgical Procedures
CMS has been implementing a series of bundled payment initiatives over the past decade, including for total joint replacements, which emphasize pricing for all required services needed to complete the intervention. A redesigned initiative could establish standardized bundles for several high-volume interventions and then solicit bids in each market. With standardized bundles, patients would know precisely which goods and services would be included in bundle, allowing them to easily compare prices across the available options.
On the provider side, acceptable bids would have to be below the pricing that would occur under the current administered pricing models or clearly demonstrate superior quality for a higher price per procedure coupled with fewer complications and lower use of other services. Further, in order for the beneficiaries to have an incentive to migrate to lower-priced options, they would have to receive a share of the savings.
The bundle definitions now used by CMS could be the starting point for initiating a bidding model, but these terms could be modified over time to become broader. This would open up more opportunities for the participating providers and health systems to reengineer their care protocols and processes to reduce expenses while improving patient outcomes.
A bidding model also could be a first step toward bundles established around patient conditions (e.g., osteoarthritis), where a single, risk-adjusted price based on the bids could cover the care needed to improve patient health. This method would accommodate considerations around the potential complications associated with various options (whether surgical or not) into patient care decisions.
Primary And Chronic Care Management
Currently, physicians providing primary care to, and managing chronic diseases for, Medicare patients send claims to Medicare for each service they provide. As an alternative, these physicians could be paid a risk-adjusted monthly fee in return for a commitment to provide a defined set of services to the patients who select them. For instance, participating practices could be asked to submit a bid for the monthly charge they would request to cover a certain number of in-person visits, routine tests, and video and audio communication.
Beneficiaries could select any primary care or chronic care management practice that they find attractive, but they would pay more or less based on the submitted monthly charge bids from the practices. Further, unlike the current ACO models, beneficiaries would pay higher cost-sharing if they elected to receive services covered by this initiative from providers not included in their initial designations. The initiative also differs from MA in that the beneficiary would select only a provider for routine primary and care management services and not a full network for all of their potential health care needs.
Eliminating payment claims for the tens of millions of services submitted by primary care physicians would dramatically reduce the administrative burden on doctors’ offices, the government, and patients.
These reforms would be embedded within traditional Medicare, but the objective would be to set new pricing terms that would lower costs for private coverage, too. As with the current payment rules, if Medicare incorporated price comparisons into its reimbursement models, and the results were positive, there is not much doubt that the private sector would move in this direction, too. The effect would be to amplify the potential for genuine price competition to occur throughout the industry, and for the savings to multiply.
The Goal Is Value
The power of Medicare’s payment rules is not in dispute. The formulas the government uses have become the accepted norms for the industry. Hospitals, physician practices, and other providers of health-related services build their business plans around them.
Some proponents of Medicare’s existing processes would like to take the next step toward an all-payer system based on the government’s rulemaking power. Costs in the private sector would come down, at least for a time, but this approach would lock in place today’s inefficiencies and mediocrity.
It is not fanciful to believe better is possible. Market pricing, while challenging, would reward efficiency, productivity improvement, and value-enhancing innovation. These are the key ingredients for breakthrough improvements and should not be written off as unachievable.
Authors’ Note
David Bernstein reports personal fees from: 1) Harvard Business School; 2) National Academy of Medicine; 3) The Heritage Foundation; 4) Mass General Brigham – Population Health Management; 5) Children’s Orthopaedic Surgical Foundation (COSF); 6) CapaDev (value-based health care consulting firm); 7) Value In Health (value-based health care “think tank” in the Kingdom of Saudi Arabia). He also reports support for attending meetings and/or travel from PROMIS Health Organization (PHO) and grants from: 1) AOFAS (American Orthopaedic Foot & Ankle Society); 2) AFSH (American Foundation for Surgery of the Hand); 3) CSRS (Cervical Spine Research Society). He reports editorial roles, including: 1) Associate Editor at Clinical Orthopaedics and Related Research; 2) Social Media Editor at Spine; 3) Editorial Board Member at Journal of Orthopaedic Experience & Innovation
James Capretta serves on the Advisory Board of the National Institute for Health Care Management Foundation.
