Payment Mechanisms

Payment mechanisms are the methods by which healthcare providers are reimbursed for the goods and services they provide. Payment mechanisms include those made by the patient, or first-party payments; health insurer, or third-party payments; and those payments that are assumed by the healthcare provider, or second-party payments. Each payment mechanism has inherent economic incentives that affect utilization.

Third-Party Payment Mechanisms
Third-party payers (i.e., insurance companies, managed-care organizations, and the government) use a number of mechanisms to pay healthcare providers for the cost of services delivered to their insured patients. Both public payers (e.g., Medicare and Medicaid) and private payers (e.g., Blue Cross and Blue Shield and other insurance plans) have similar types of payment mechanisms available. These payment mechanisms include fee-for-service, fee schedule, per diem, per stay, and capitation payments. Often, a payer uses multiple payment mechanisms within a particular insurance productExport. Read more ... ». For example, physician outpatient care may be reimbursed using a fee schedule and hospital inpatient care may be reimbursed on a per-stay basis.

Fee-for-Service
A fee-for-service payment mechanism reimburses healthcare providers on a per-unit basis or for each service provided. The fee may be based on the actual charges (i.e., the amount charged by the provider) or based on a schedule that lists the dollar amount to be reimbursed for each service. Under fee-for-service payment mechanisms, providers have the economic incentive to provide more services than necessary to increase revenue, since they are paid per unit. When fee-for-service payments are based on actual charges rather than a predetermined fee schedule, providers can also increase revenue by increasing their charges.

Fee Schedules
Fee schedules are a particular type of fee-forservice payment mechanism that establishes either a maximum amount or actual amount of reimbursement for a particular service. If the fee schedule were used to establish maximum fees, the provider would receive the lesser of the amount charged and the predetermined amount in the fee schedule. In practice, providers almost always charge more than the fee schedule amount to ensure receipt of the full amount established in the fee schedule. Providers have the incentive to provide more services than necessary as a means of increasing revenue, but they have no influence on the amount reimbursed per service as long as their fees are set above the fee schedule amount.

The most common fee schedule in the United StatesVolume-Outcome Relationship. Read more ... » is the National Physician Fee Schedule Relative Value System, which Medicare uses to reimburse physicians for services provided to Medicare beneficiaries. The system is based on the Resource-Based Relative Value Scale (RBRVS), which was developed by William Hsiao and his associates at Harvard UniversityNewhouse, Joseph P.. Read more ... ». Specifically, this fee schedule establishes relative value units for each Current Procedural Terminology (CPT) and Healthcare Common Procedure Coding System (HCPCS) code, and it then converts the relative value units to a dollar amount of reimbursement using a conversion factor that is revised annually. Many third-party payers use this system as the basis for determining their physician fee schedules by modifying the conversion factor that translates relative value units to dollars of reimbursement.

Per Diem
Per diem is a payment mechanism that reimburses healthcare providers per day of stay and establishes a set fee per day. Per diem is most commonly used by third-party payers for acute, longterm, skilled nursing and psychiatric hospital stays. Providers have the incentive to keep patients in the facility longer than necessary to increase reimbursement, but they have no influence on the price paid per day.

Per Stay
Third-party payers may also use payment mechanisms that make one payment for each episode of care, such as a hospitalization stay. Per stay payments solve the incentive problem inherent in per diem payments of treating patients for longer durations of time than necessary, since a flat payment per episode is made. Providers do have an incentive, however, to increase the number of times a patient is admitted to increase reimbursement.

Medicare’s prospective payment system (PPSPatient Dumping. Read more ... ») is a payment mechanism that reimburses services on a fixed amount per episode of care for some types of services, such as acute inpatient hospital stays and home health careVolume-Outcome Relationship. Read more ... », while it uses per diem payments for other services, such as skilled nursing care. Acute-care hospitals are reimbursed for each inpatient case based on the Diagnosis Related Group (DRGThompson, John Devereaux. Read more ... ») assigned to the case, with one payment for each hospital stay. DRGs were developed by John D. Thompson and Robert B. Fetter at Yale UniversityMcNerney, Walter J.. Read more ... ». Specifically, the total payment includes a base DRG payment component plus adjustments if the hospital has a high proportion of low-income patients or is a teaching hospital or if the case is an outlier in terms of being a high-cost case. Home health careHome Health Care. Read more ... » is reimbursed based on 60-day episodes of care, with a base payment plus adjustments for factors such as case-mix (i.e., severity of illness, clinical condition, and services required).

Capitation
Capitation is a payment mechanism that reimburses a physician, medical group practice, or hospital a fixed amount per patient for a fixed period of time. Often capitation payments are paid for each insured member assigned to a provider for each month, or a per-member per-month (PMPMCapitation. Read more ... ») capitation payment. Capitation payments cover a predetermined set of services provided within the defined time period and may include primary and specialty-care physician services, other outpatient services, diagnostic and laboratory tests, and hospital stays. The provider assumes the risk of the healthcare costs for the defined population of patients, and therefore, has the incentive to provide efficient care.

First-Party Payment Mechanisms
Healthcare providers also receive payments directly from patients. Self-pay is a first-party payment mechanism and includes situations in which the patient is the only payer and those in which the patient is responsible for a portion of the payment with a third party responsible for a balance of the payment.

Self-Pay
Self-pay is the patient’s out-of-pocket payment obligation. Self-pay as a payment mechanism includes two types of patients—those with no source of health insuranceTax Subsidy of Employer-Sponsored Health Insurance. Read more ... » coverage who are responsible for the entire fee (i.e., uninsured self-pay), and those with a third-party source of health insurance coverageCrowd-Out. Read more ... » who must pay a portion of the fee out of pocket (i.e., insured self-pay). Payments for uninsured self-pay patients have historically been based on hospital or provider charges with no negotiated price discounts. Many hospitals have been criticized for charging patients with the least financial means the most for care, and many are revising their policies for uninsured self-pay patients.

Payments for insured self-pay patients are based on the negotiated rates established between the third-party payer and healthcare provider. Insured self-pay payment mechanisms include three main types of demand-side cost sharing, namely deductibles, coinsurance, and copayments. A deductible is the amount that an insured individual must pay out of pocket before the insurer will start to reimburse the providers for services, and the individual usually must pay the deductible each year. From an insurance perspective, coinsurance is a general term that refers to the amount of a medical bill that the insured individual is responsible for out of pocket, which could be stated as a percentage of the total amount billed or as a flat dollar amount. In healthcare, coinsurance is commonly used to refer specifically to the proportion of the negotiated medical fees that the insured individual is responsible for (e.g., 20% coinsurance), with the insurer paying the remaining proportion of the fees. A copayment refers to the flat dollar amount of the negotiated medical fees that the insured individual must pay (e.g., $20 copayment), with the insurer paying the remaining dollar amount of the fees. The dollar amount paid out of pocket with coinsurance may vary for each visit, but the dollar amount for a copayment remains constant.

These demand-side payment mechanisms may work together in a single episode of care. For example, suppose an individual has health insurance coverage with a $500 deductible and a 20% coinsurance once the deductible is met. At the beginning of the year, the individual receives an MRI scan. This individual’s out-of-pocket expenses would be $540 ($500 deductible + $40 coinsurance (20% × $200)), while the insurer’s portion would be $160 ($700 – $540). Instead, if the individual has a $500 deductible with a $20 copayment, the individual’s out-of-pocket expense would be $520, while the insurer would pay $180.

Provider Internal Payment Mechanisms
Hospitals, physicians, and other healthcare providers do not collect payments from all patients—either because of a decision to provide services as charity care to a patient without the financial resources to pay or because of a failure to collect payment from the patient or third-party payer. Both charity care and bad debt are classified as uncompensated care.

Charity Care
For patients without the income (or assets, in some cases) to pay for needed services, healthcare providers may render the care as charity care. Charity care includes services that are provided but for which the provider does not expect a payment. The provider does not bill the patient or insurer nor does the provider pursue collection of payment from an external source.

Bad Debt
Bad debt includes payments that are expected to be collected but are not collected from either the patient or a third-party payer. Providers attempt to collect these payments but are ultimately unsuccessful. Bad debt is an expense to providers.

Future ImplicationsRegulation. Read more ... »
Healthcare payment mechanisms have become increasingly diverse and complex over time. Patients undergoing the same procedure at the same hospital often use different payment mechanisms, or combination of payment mechanisms, and pay different amounts for the same services.

Even with healthcare reforms that would expand coverage to the currently uninsured population, the U.S. healthcare system is likely to continue relying on multiple sources of coverage, which will further fuel the complex web of payment mechanisms. While nations with a single-payer system have inherently simplified payment mechanisms, many nations may consider an increase in the individual’s out-of-pocket responsibilities to control their own spiraling healthcare costs.

The largest change in the United States is likely to occur with respect to the balance of payments made by the individual compared with the insurer. Consumer-driven health plans are increasing the individual patient’s cost-sharing obligations as a mechanism to control costs. This shift is likely to precipitate a change in how hospitals, physicians, and other healthcare providers collect first-party payments. While copayments for outpatient visits are routinely collected at the time of service, deductibles and coinsurance amounts for hospitalizations are more likely to be billed retrospectively. These payments are often collected after treatment because providers often cannot ex ante calculate the cost of treatment. As the size of first-party payments increases from hundreds to thousands of dollars, providers will have a greater incentive to collect them up front to guarantee payment. At face value, this change seems relatively minute; however, it could also lead to an increase in the number of potential patients denied services until they can make payment, to prevent a surge in bad debt.

Tricia J. Johnson and Michael Morgenstern

See also Capitation; Charity Care; Diagnosis Related Groups (DRGs); Fee-for-Service; Healthcare Financial Management; Prospective Payment; Resource-Based Relative Value Scale (RBRVS); Uncompensated Healthcare

Further Readings
Baron, Richard J., and Christine K. Cassel. “21st-Century Primary CarePrimary Care. Read more ... »: New Physician Roles Need New Payment Models,” Journal of the American Medical Association 299(13): 1595–97, April 2, 2008.
Davis, Karen. “Making Payment Reform in the U.S. Healthcare System Possible.” Medscape General Medicine 9(4): 63, 2007.
Davis, Karen, and Stuart Guterman. “Rewarding Excellence and Efficiency in Medicare Payments,” Milbank QuarterlyStructure-Process-Outcome Quality Measures. Read more ... » 85(3): 449–68, September 2007.
Newhouse, Joseph P. “Medicare’s Challenges in Paying Providers,” Health Care Financing Review 27(2): 35–44, Winter 2005–2006.

Web Sites
American Hospital Association (AHA): http://www.aha.org
American Medical Association (AMA): http://www.ama-assn.org
Centers for Medicare and Medicaid ServicesCenters for Medicare and Medicaid Services. Read more ... » (CMSNational Association of State Medicaid Directors. Read more ... »): http://www.cms.hhsCenters for Medicare and Medicaid Services. Read more ... ».gov
Healthcare Financial Management Association (HFMA): http://www.hfma.org
Medicare Payment Advisory Commission (MedPAC): http://www.medpac.gov