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As Bob indicated, I offered to explain a little bit more about why the healthcare system “works” the way it does, especially as it relates to discounts off of charges. The information is pretty complex, so I am envisioning a series of posts that describe the situation a little more.

My personal experience is in the hospital side of the healthcare, so that will be my main focus although I'm sure these issues are similar to issues the doctors face. I will try to keep the post generally high-level, but we can also discuss details in follow up posts.

A few key definitions before I begin, in layperson terms:

“Billed Charge” – The undiscounted amount that the healthcare provider bills to the insurance company and/or the patient for services.

“Contractual Allowance” – The difference between the Billed Charge and the Contractual Rate.

“Contractual Rate” – The amount the insurance companies and providers have agreed to be paid for a specific procedure. See also: Discount.

“CPT Code” – Current Procedure Terminology – the codes used to describe (primarily) physician services.

“Discount” – The agreed upon discount off of billed charges.

“DRG” – Diagnostic Related Grouping – the number assigned for a particular diagnosis and set of treatments. DRGs have weights assigned to them based off of the complexity of the case. The higher the weight of the DRG, the larger the payment. DRGs are used for hospital stays. DRGs are the basis of payment for many insurance plans.

“EOB” – Explanation of Benefits – The form that spells out how much was charged, how much is written off to Contractual Allowances, how much the insurance company paid, and how much the patient owes.

“Outlier” – A hospital visit that exceeds certain pre-determined limits. Patients can be outliers based off of Billed Charges or length of stay, as well as less common reasons.

First, an understanding about governmental payors (Medicare and Medicaid) is important to the discussion.

Medicare is primarily for people 65 years old or older, although there are reasons for someone under 65 to be Medicare eligible.

Medicare first started as a program that would reimburse patients a set fee for a covered visit/procedure. The patient would pay for the visit and submit a claim to receive reimbursement. If the visit or procedure cost more than Medicare would reimburse, the patient was responsible for the difference.

Now, Medicare is a program that paid claims based on a Prospective Payment System (“PPS”) and the patient cannot be billed for anything above the amount Medicare specifies in its EOB, typically a per admission deductible. The PPS sets the amount that a particular service or visit will be reimbursed. The “billed” charge does not matter. The way that the healthcare provider receives payment is typically based on the CPT or DRG codes, although there are provisions for outlier reimbursement.

As an aside, and outside the scope of this post, Medicare payments to providers also take into account differences in area costs (but not well), so a doctor in NYC would receive a larger payment for the same type of visit than the one in Wheeling, WV would receive.

Medicaid is primarily for poor/low income people and is administered by each state. Medicaid also pays based on DRG and CPT codes and has a provision for outliers.

Second, an understanding of how hospitals are reimbursed is important to the discussion. Hospitals are generally reimbursed by insurance companies one of these ways:

1) Discount off Billed Charges - This is oftentimes the best payment system for hospitals. Many small insurance companies are offered a nominal discount off of services. At the hospital I worked at, we gave a flat discount off of services to several insurance companies. Most of these discounts ranged from 5% to 20% off of Billed Charges.

2) DRG Payment – Payment is determined based off a set rate for a DRG with a weight of 1 (a weight of 1 indicates an “average” case requiring “average” resources to treat), multiplied by the corresponding DRG weight. For example, a DRG with a weight of 2.3 would be worth $2300 if the set rate for a DRG of 1 is $1000.

3) Per Diems – Payment is made based off of a fixed daily rate multiplied by the length of stay.

4) Capitation – Payment is based off of a fixed fee, per member, per month, regardless of use or non-use of a healthcare provider or healthcare services.

Pros and Cons of the above reimbursements:

1) Discount off of billed services
Easy to administer.
If the discount is not too high, relatively profitable.
If the discount is too high the hospital will lose money.

2) DRG Payment
Known payment based on DRG weight and multiplier.
Can be very profitable if a patient requires fewer than “normal” resources as determined by the DRG.

If the patient is very sick or requires a lot of resources or a longer length of stay, you can lose a lot of money.
If you are in a low cost area, your payment may not cover your costs to treat the patient.

3) Per Diems
Easy to administer.
Usually does not cover even a portion of the costs of care.

4) Capitation
Easy to administer.
In a healthy population with low utilization, can be profitable

Generally is a money losing proposition.

The hospital I worked for eliminated all Per Diem and Capitation private insurance contracts, deeming them too risky. We would always prefer a discount off of Billed Charges to a payment based on DRGs, but most large insurance companies will not agree to a discount off of Billed Charges.

A few other general items of note:

1) It is, in almost every case, illegal to charge one group of people a different Billed Charge than any other group.

2) Most insurance companies require you are certified by Medicare to be offered a contract.

3) Utilization of services has been increasing dramatically.

4) New procedures and medicines are very expensive and they are being used more and more.

5) There is a lot of administration that is required in the claims submission, contracting, and collecting process.

6) Many hospitals have governmental to other payment sources (insurance, self pay, etc.) ratios of close to 1:1.

7) The majority of self-pay accounts are eventually written off without collecting a penny.

8) Denial of payment by the insurance company generally means that the hospital cannot bill the patient for the hospital stay under contract terms, or in the case of HMOs, legal terms. These accounts are also written off.

9) Many hospitals, especially not-for-profits, are struggling financially. Competition from the for-profit hospitals, especially specialty for-profit hospitals, is making the financial situation of not-for-profits worse.

Now, with that background, we can look closer into why you see large Billed Charges and big Contractual Allowances as well as the increases in healthcare premiums.

To be continued...

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