Barbara O. Wynn 

RAND Health

1200 South Hayes Street

Arlington, VA 22202-5050

MedPAC

601 New Jersey Avenue, NW

Suite 9000

Washington, DC 20001

(202) 220-3700

Fax: (202) 220-3759

www.medpac.gov

•

•

The views expressed in this report

are those of the authors.

No endorsement by MedPAC

is intended or should be inferred.

Medicare Payment

for Hospital

Outpatient Services:

A Historical Review

of Policy Options

A study conducted by RAND Health for the

Medicare Payment Advisory Commission

June 2005 • No. 05-3
Medicare Payment for 

Hospital Outpatient 

Services 

A Historical Review of Policy 

Options

BARBARA O. WYNN 

WR-267-MedPAC

June 2005 

Prepared for the Medicare Payment Advisory Commission

WORKING

P A P E R

This product is part of the RAND 

Health working paper series.

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They have been approved for

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have not been formally edited 

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RAND’s publications do not necessarily 

reflect the opinions of its research

clients and sponsors. 

is a registered trademark.
 - iii – 

PREFACE 

The Medicare prospective payment system for hospital outpatient 

services has been subject to continuing debate since it was implemented 

August 1, 2000. Policy issues include how the unit of payment is 

defined, how the payment rate is established, and how the costs of new 

technology and expensive drugs are recognized. In addition, there are 

concerns over using different payment methodologies across ambulatory 

settings and the lack of an effective mechanism to control aggregate 

Medicare expenditures for ambulatory services. This study reviews the 

alternative approaches that were considered for payment of hospital 

outpatient services when the outpatient prospective payment system was 

designed and considers their relevance today. The intended audience is 

policymakers considering refinements to the current payment system. 

This study was funded by the Medicare Payment Advisory Commission 

under Contract ACT-EE-2135. 

 - v – 

CONTENTS 

Preface..............................................................iii

Figures..............................................................vii

Tables................................................................ix

Summary................................................................x

Study Approach...................................................x

Summary of Findings and Implications............................xi

Acknowledgments.....................................................xvii

Glossary.............................................................xix

1. Background.........................................................1

Purpose of This Study............................................1

Study Approach...................................................1

Organization of this Report......................................2

2. Chronological Overview of the Development of the Outpatient 

Prospective Payment System (OPPS) .................................5

A. Development of the OPPS: From OBRA-86 to the 1995 HHS Report 

to Congress .................................................5

B. Initial Implementation of OPPS: From the BBA to the Final OPPS 

Rule .......................................................11

Balanced Budget Act of 1997 (BBA) ..........................14

Proposed Rule Implementing the OPPS ........................15

Balanced Budget Refinement Act of 1999 (BBRA) ..............17

Final Rule Implementing the OPPS ...........................17

3. Major Design Considerations for the OPPS..........................19

A. Type of Services Covered by the OPPS........................21

B. Defining the Unit of Payment................................23

Procedure Groupings ........................................25

Medical Visit Classification Logic .........................30

Packaging ..................................................32

Bundling ...................................................36

C. Establishing the Standard Payment Rate......................38

Leveling the Playing Field .................................38

Establishing Relative Weights ..............................40

D. New Technology..............................................41

Pass-through for Drugs, Devices and Biologicals ............41

Quarterly Updates to Recognize New Technology ..............44

E. Volume Controls.............................................45

4. Implications for Refining the Current OPPS........................49

Appendix A: Key Documents in OPPS Development.........................53

I. Legislative Provisions Impacting Development and 

Implementation of OPPS .....................................53

II. Major Research Reports Related to the Design of OPPS........61

III.Reports to Congress on the Design and Implementation of OPPS71

Appendix B: Materials Sent to Interviewees............................75
 - vi – 

I. Letter Sent to Potential Interviewees.......................75

II. Letter Enclosure: Medicare Hospital Outpatient System......77

Bibliography..........................................................81
 - vii – 

FIGURES 

Figure 2.1—Factors Identified by ProPAC to Evaluate Proposals for OPPS.8

Figure 2.2—Factors Identified by HHS to Evaluate Proposals for OPPS...10

Figure 3.1—Criteria Used in the April 2000 Interim Final Rule for the 

New Technology Pass-ThroughAPCs for New Technology Services ......44

 - ix – 

TABLES 

Table 2.1——Medicare Payment Methodologies for Hospital Outpatient 

Services Prior to BBA .............................................6

Table 2.2——Major Features of the OPPS: From the BBA through the April 

2000 Final Rule ..................................................12

Table 3.1——Comparison of the Number of APGs by Service Category in the 

Proposed and Final OPPS Rules ....................................30
 - x – 

SUMMARY 

The Medicare prospective payment system for hospital outpatient 

services has been subject to continuing debate since it was implemented 

August 1, 2000. Policy issues directly related to how payment is 

determined under the under the current system include: 

• The ambulatory payment classification (APC) system used to group 

procedures for payment purposes, 

• The items and services that are packaged into the APC payment, 

• The methodology used to determine the costliness of one APC 

relative to other APCs, and 

• The treatment of new technology and high cost drugs. 

In addition, there are concerns over using different payment 

methodologies across ambulatory settings and the lack of an effective 

mechanism to control aggregate Medicare expenditures for ambulatory 

services. 

The purpose of this study was to identify the alternative 

approaches that were considered for payment of hospital outpatient 

services when the outpatient prospective payment system (OPPS) was 

designed and to consider their relevance today. 

STUDY APPROACH 

The study focuses on the policy development period preceding the 

initial implementation of the OPPS. It begins with the first mandate 

for a prospective payment system for hospital outpatient services in the 

Omnibus Budget Reconciliation Act of 1986 (OBRA-86) and ends with the 

implementation of the OPPS in August 2000. A two-fold approach was 

taken to identifying the issues and policy alternatives that were 

considered during the period. First, government documents and research 

reports dating from this period were collected and reviewed. Second, 

individuals who were involved at various stages and in different roles 

in the development and implementation of the OPPS were interviewed. 
 - xi – 

SUMMARY OF FINDINGS AND IMPLICATIONS 

The rapid growth of hospital outpatient services following the 

implementation of the PPS for acute care hospital inpatient services in 

1983 led to interest in creating payment incentives to promote more 

efficient delivery of outpatient services. Most hospital outpatient 

services were paid the lesser of the hospital’s reasonable cost or 

customary charges for services furnished to Medicare beneficiaries. 

Over time, service-based payment methodologies were developed for 

certain types of services, including fee schedules for clinical 

laboratory tests and for durable medical equipment, prosthetics, 

orthotics, and supplies (DMEPOS). Payments for ambulatory surgical 

procedures and for radiology and other diagnostic tests were based on a 

blend of the hospital’s aggregate Medicare costs for these services and 

Medicare’s payments for similar services in other ambulatory settings. 

In all, there was a confusing mix of at least eight different payment 

methodologies by the time the OPPS was implemented in 2000. 

OBRA-86 spurred the development of an OPPS. The legislation 

required the Department of Health and Human Services (HHS) to develop 

and report to Congress on a fully prospective payment system for 

hospital outpatient services in two stages. The first stage was to 

focus on ambulatory surgical procedures and, to the extent practical, 

was to provide for an all-inclusive rate for the services. The second 

stage was to develop a model system for other hospital outpatient 

services. Subsequent legislation provided additional requirements for 

the full OPPS. The final statutory requirements for the OPPS were 

established by the Balanced Budget Act of 1997 (BBA) and the Balanced 

Budget Refinement Act of 1999 (BBRA). 

Reports to Congress by the HHS Secretary and the Prospective 

Payment Assessment Commission (ProPAC) articulated common policy goals 

for the OPPS.1 The overall goal was to provide incentives for the 

efficient delivery of high quality medically necessary outpatient care 

to Medicare beneficiaries. Other important attributes were whether the 

system provided similar financial incentives for care across ambulatory 

____________ 1 ProPAC was one of the predecessor agencies to the Medicare Payment 

Advisory Commission (MedPAC). 
 - xii – 

settings, administrative simplicity, predictability, limited 

opportunities for “gaming”, and incentives for controlling total program 

expenditures. 

The policy debate in the reports to Congress on the OPPS raised 

three basic issues related to defining the unit of payment: 

• Grouping. One issue was the extent to which clinically similar 

procedures should be grouped for payment purposes and the logic 

that should be used for the groupings. The advantages of 

grouping were that it created a manageable number of units of 

payment and provided a method for pricing low-volume procedures. 

Commonly cited disadvantages were that it created units of 

payment that were inconsistent with the procedure-level fee 

schedules already in use in other ambulatory settings and 

reduced procedure-level payment accuracy for higher volume 

procedures. 

• Packaging. A second issue was the extent to which ancillary 

services associated with a significant procedure should be 

packaged into a single payment for the procedure. Packaging was 

seen as a way to create incentives for efficiency. Commonly 

cited disadvantages of extensive packaging were that it was 

inconsistent with the fee schedules already in use in other 

ambulatory settings, reduced payment accuracy, and potentially 

created incentives for “gaming” by shifting the delivery of 

packaged ancillary services to other settings. 

• Bundling. The third issue was the extent to which multiple 

significant procedures related to an outpatient encounter or to 

an episode of care should be bundled into a single unit of 

payment. This issue included the question of whether services 

prescribed during an outpatient encounter but furnished in a 

non-hospital setting should be bundled into the payment. 

Bundling was seen as a way to create incentives for efficiency 

comparable to the inpatient PPS. The policy disadvantages were 

similar to those applicable to packaging. The technical policy 

issues related to developing and implementing a bundling policy 
 - xiii – 

that involved services provided over a span of time and by 

different providers made bundling a long-term policy objective. 

A prospective payment system relies on an “averaging” concept, so 

that payment may be more or less than the estimated costs of providing 

particular services, but on average it is adequate to assure access to 

high quality care. The policy decisions regarding grouping, packaging 

and bundling involved a trade-off between establishing incentives for 

efficiency through larger units of payment and payment accuracy. 

Different aspects of payment accuracy were raised in the OPPS policy 

debate: 

• One aspect relates to establishing an accurate payment rate for 

unit each of payment. Here, a major issue is the use of 

accounting costs to reflect differences in resource costs. 

Accounting costs refers to a method of determining the costs of 

outpatient services using annual cost reports filed by 

hospitals. Direct and indirect costs are allocated to each 

ancillary service department through a cost finding methodology 

and then apportioned to Medicare based on a ratio of Medicare 

charges to total charges for the ancillary service department. 

The methodology relies on accurate cost finding and on charges 

that are consistently related to costs. Other issues include: 

the use of median or mean costs to determine payment rates; the 

reliability of cost data for low-volume procedures; assigning 

ancillary procedures when multiple significant procedures are 

performed; and, combining services that were separately billed 

into a single unit of payment. 

• A second aspect relates to the amount of cost variation within 

the payment groupings. There is variation across hospitals in 

the cost of providing a particular procedure. Additional 

variation is introduced through broad procedure groupings, 

packaging of associated ancillary services with the primary 

procedure, and bundling of multiple procedures related to an 

outpatient encounter into a single payment (or bundling of all 

procedures performed over a period of time into a single per 
 - xiv – 

episode of care payment). Here, the issue is the likelihood 

that on average the payment will be accurate given the amount of 

cost variation within the grouping. Increased cost variation 

does not necessarily reduce payment accuracy at the hospitallevel unless there are systematic differences across hospitals 

in the services included in the unit of payment. However, it 

reduces service-level payment accuracy and could create 

inappropriate incentives for “gaming” by shifting higher cost 

services to alternative ambulatory settings. 

The two aspects of payment accuracy are somewhat inter-related. If 

the unit of payment is relatively large, there is more room for 

balancing inaccuracies in establishing the cost of the services covered 

by the rate than if the rate covers a small unit of payment such as an 

individual procedure. 

The HHS report to Congress on the OPPS was issued in 1995. The 

report recommended using Ambulatory Payment Group (APG)-like procedure 

groupings as the basic unit of payment (which the Health Care Financing 

Administration (HCFA) later called APCs). The groupings consisted of 

procedures that were similar clinically and with respect to resource 

costs. Four general areas were identified as requiring additional 

research: defining the unit of payment (bundling and packaging 

policies), determining how well accounting costs reflect resource costs, 

examining use of the procedure groupings in other ambulatory settings, 

and accounting for legitimate cost differences across classes of 

hospitals. The report indicated that as further research was completed 

and better data became available, the OPPS could evolve to include more 

extensive packaging of ancillary services and to cover services in other 

ambulatory settings. The report made no recommendations regarding 

mechanisms to control aggregate expenditures. 

The 1995 HHS report to Congress also raised a major concern with 

beneficiary coinsurance. The law required that beneficiaries pay 20 

percent of submitted charges for hospital outpatient services paid on a 

cost-related basis. Hospital charges substantially exceeded Medicare’s 
 - xv – 

cost-based payment amount. As a result, beneficiaries typically paid 

substantially more than 20 percent of Medicare’s payment amount. 

The beneficiary coinsurance issue created an impetus for adopting 

an OPPS as soon as possible. Adopting policies that were technically 

feasible to implement in the short-run and were unlikely to involve 

protracted policy development and debate became overriding 

considerations in the initial PPS design. Articulated policy goals that 

were deferred as implementation became the paramount concern were: 

• Creating financial incentives for the efficient use of 

ambulatory services through packaging and bundling policies; 

• Establishing consistent payment policies across ambulatory 

settings; and, 

• Controlling aggregate expenditures for hospital outpatient 

services. 

The perceived advantages and disadvantages of alternative policies 

that were considered when OPPS was initially implemented generally 

remain relevant. However, as the OPPS has evolved, concerns over the 

payment accuracy for services furnished to particular patients have been 

given precedence over creating incentives for efficient delivery of 

care. The “averaging” concept that underlies the inpatient PPS and the 

initial OPPS-construct has eroded as the OPPS payments have become 

increasingly less packaged and the procedure groupings have narrowed. 

Arguably, unpackaging further increases the importance of payment 

accuracy since there is increasingly less room within the payment to 

offset higher costs for some items and services with lower costs (or no 

usage) for others. 

Goals such as administrative simplicity and financial incentives 

for efficient use of ancillary services have been given less attention 

in the post-implementation period. At the same time, the OPPS payment 

policies increasingly resemble those for other ambulatory settings. 

Indeed, the more fee schedule-like appearance of the OPPS rates coupled 

with other developments——such as growth of ambulatory surgical center 

(ASC) services, implementation of the resource-based relative value 

scale for the practice expense component of the physician fee schedule, 
 - xvi – 

improved coding on hospital outpatient claims——suggest that progress 

might still be made on rationalizing the payment systems across 

ambulatory settings. Updating the research on differences in resource 

costs for high volume procedures across ambulatory settings should be 

considered as part of this initiative. In using accounting costs to 

set the APC relative weights, the OPPS depends on hospital charges being 

consistently related to costs. Hospital charges have been increasing 

rapidly relative to costs and there is evidence of substantial 

differences in hospital markups across hospitals and by type of 

services. Current hospital charging practices challenge more than ever 

the assumption that accounting costs accurately reflect a hospital’s 

costs for specific items and services. 

Several issues that have created extensive policy debate during the 

post-implementation stage——new technology, devices and expensive drugs——

received minimal attention in the initial PPS development. As a result, 

there is little information on alternatives that were considered for new 

technology during the OPPS design period. 

The reports produced by HHS and ProPAC during the preimplementation period envisioned that work would proceed towards the 

longer-term policy goals after the initial PPS was implemented and that 

the payment system would evolve to include more packaging and to expand 

to other ambulatory settings. However, other priorities and the 

resource demands imposed by the current system over the years, 

particularly with continuing legislative changes, interfered with 

research and policy development activities on the longer-term goals. 

When the OPPS is viewed independently, the individuals that were 

interviewed for this study seemed to believe that for the most part the 

OPPS payment system was maturing and stabilizing. However, when OPPS is 

considered within the broader context of ambulatory care payment, the 

goals of rationalizing payment methodologies across ambulatory settings 

and using financial incentives to control aggregate ambulatory 

expenditures remain important but unrealized. 
 - xvii – 

ACKNOWLEDGMENTS 

This report would not have been possible without individuals 

sharing their perspectives on the development of the initial hospital 

outpatient prospective payment system. I appreciate the willingness of 

the following individuals to participate and openly share their 

different views of the initial OPPS: Richard Averill, Thomas Ault, 

George Greenberg, Thomas Gustafson, William Kelly, Anne Marie Lynch, 

James Mathews, Henry Miller, Steven Sheingold, Deborah Williams, Janet 

Wellham, and Mark Wynn. 

The study benefited from the guidance of Chantal Wortzala, the 

initial MedPAC project officer for the study, and Rachel Schmidt, who 

assumed this role and provided insightful comments on an earlier version 

of the report. 

I would also like to thank Kathryn Khamsi for her administrative 

assistance in scheduling the interviews and preparing the report. 

 - xix – 

GLOSSARY 

Symbol Definition 

APC Ambulatory Payment Classification 

APG Ambulatory Payment Groups 

ASC Ambulatory Surgical Center 

AVG Ambulatory Visit Groups 

AWP Average Wholesale Price 

BBA Balanced Budget Act 

BBRA Balanced Budget Refinement Act 

CMHC Community Mental Health Center 

CMS Centers for Medicare and Medicaid Services 

CPT-4 Common Procedure Terminology——Version 4 

DME Durable Medical Equipment 

DMEPOS Durable Medical Equipment, Prosthetics, Orthotics, and 

Supplies 

DRG Diagnosis-related Groups 

ESRD End-stage Renal Dialysis 

HCFA Health Care Financing Administration 

HCPCS HCFA Common Procedure Coding System 

HHS Department of Health and Human Services 

HOPD Hospital Outpatient Department 

ICD-9-CM International Classification of Diseases——Version 9 

Clinical Modifications 

IOL Intraocular Lens 

MB Market Basket 

MedPAC Medicare Payment Advisory Commission 

OBRA-86 Omnibus Budget Reconciliation Act of 1986 

OPPS Outpatient Prospective Payment System 

PAC Products of Ambulatory Care 

PACS Products of Ambulatory Care and Surgery 

PAS Products of Ambulatory Surgery 

PPS Prospective Payment System 

ProPAC Prospective Payment Assessment Commission 
 - xx – 

SRG Sustainable Growth Rate 

VPS Volume Performance Standard 
- 1 - 

1. BACKGROUND 

PURPOSE OF THIS STUDY 

The Medicare prospective payment system for hospital outpatient services 

has been subject to continuing debate since it was implemented August 1, 2000. 

Policy issues directly related to how payment is determined under the under 

the current system include: 

• The Ambulatory Payment Classification (APC) system used to group 

procedures for payment purposes, 

• The items and services that are packaged into the APC payment, 

• The methodology used to determine the costliness of one APC relative 

to other APCs, and 

• The treatment of new technology and high cost drugs. 

In addition, there are concerns over using different payment 

methodologies across ambulatory settings and the lack of an effective 

mechanism to control aggregate Medicare expenditures for ambulatory services. 

The purpose of this study was to: 

• Identify the alternative approaches that were considered for payment 

of hospital outpatient services when the outpatient prospective 

payment system (OPPS) was designed. 

• Outline the strengths and weaknesses of the alternative approaches and 

consider their relevance today. 

• Identify the policy arguments used to support the final design of the 

initial outpatient PPS and consider their relevance today. 

STUDY APPROACH 

The study focus was on the policy development period preceding the 

initial implementation of the OPPS. It begins with the first mandate for a 

prospective payment system for hospital outpatient services in the Omnibus 

Budget Reconciliation Act of 1986 (OBRA-86) and ends with the implementation 

of the OPPS in August 2000. A two-fold approach was taken to identifying the 

issues and policy alternatives that were considered during this period. 

First, written materials dating from this period were collected and reviewed. 
 - 2 – 

The review covered government documents such as reports to Congress issued by 

the Prospective Payment Assessment Commission (ProPAC- one of the predecessor 

agencies to the Medicare Payment Advisory Commission) and the Secretary of 

Health and Human Services (HHS), the enabling legislation, and the proposed 

and final rules for the initial OPPS. The review also included research 

reports that investigated issues related to a new payment system for hospital 

outpatient services. Some research studies focused specifically on the design 

of the payment system. Other studies were broader examinations of differences 

across ambulatory settings in the cost of providing services or in the 

existing payment methodologies. The review concentrated on the reports that 

focused on OPPS design issues. An annotated listing of the main documents 

that were relied on in developing this report is in Appendix A. 

Second, 12 individuals were interviewed who were involved at various 

stages and in different roles in the development and implementation of the 

OPPS. The interviews started with an initial list of persons who had been 

involved from different perspectives as researchers, policy analysts and 

decision-makers, legislative analysts, and industry representatives. A 

“snowball” technique was used to identify other individuals who interviewees 

believed had key roles in bringing the initial OPPS into being. A semistructured interview process was used that concentrated on the interviewee’s 

role in the development of the outpatient PPS, the stages at which that 

involvement occurred, and the research and/or policy issues that the 

individual was involved in. Because considerable time had elapsed between the 

developmental period for the OPPS and our interviews in March 2005, the letter 

asking individuals to participate in an interview identified the areas that 

have been identified as issues and included a summary of the payment system. 

A copy of the letter sent to potential interviewees is included in Appendix B. 

None of the individuals who were contacted declined to participate; however, 

the study team was unable to contact one individual whose perspective on the 

OPPS final design would have enriched the findings. 

ORGANIZATION OF THIS REPORT 

The remainder of this report is divided into three chapters. Chapter 2 

provides a chronological overview of the development of the OPPS. It begins 

with the mandate in the Omnibus Budget Reconciliation Act of 1986 that the 

Secretary of Health and Human Services (HHS) develop a model PPS. It ends 
 - 3 – 

with a description of the policies in the final rules implementing the OPPS 

and the changes required by the Balanced Budget Refinement Act of 1999 (BBRA). 

Chapter 3 presents the study findings with respect to key design 

considerations during the development and implementation of the OPPS. Chapter 

4 summarizes the findings and discusses the implications and relevancy for 

refining the current OPPS. 

- 5 - 

2. CHRONOLOGICAL OVERVIEW OF THE DEVELOPMENT OF THE OUTPATIENT PROSPECTIVE 

PAYMENT SYSTEM (OPPS) 

A. DEVELOPMENT OF THE OPPS: FROM OBRA-86 TO THE 1995 HHS REPORT TO CONGRESS 

This section provides a chronological overview of the development of the 

OPPS. It begins with the mandate in OBRA-86 that the Secretary of HHS develop 

a model PPS for hospital outpatient services. It ends with the mandated HHS 

report to Congress that was submitted in 1995. The details of the OPPS design 

that were examined during this period are covered in the next chapter. 

The rapid growth of outpatient hospital services following the 

implementation of the PPS for acute care hospital inpatient services in 1983 

led to interest in creating payment incentives to promote more efficient 

delivery of services. The inpatient PPS created incentives for efficiency by 

making a pre-determined per discharge payment for facility services provided 

during an inpatient stay. Most hospital outpatient services were paid based 

on the lesser of the hospital’s reasonable cost or customary charges for the 

services furnished to Medicare beneficiaries. Reasonable costs were 

determined on a departmental basis by applying a ratio of Medicare charges to 

total charges for all patients to the department’s total allowed costs. The 

payment methodology provided no incentives to contain costs. Over time, 

service-based payment methodologies were developed for certain types of 

services, including fee schedules for clinical laboratory tests and for 

DMEPOS. Blended payment rates were established for ambulatory surgical 

procedures and for radiology and other diagnostic tests based on a blend of 

the hospital’s aggregate Medicare costs for these services and Medicare’s 

payment rates for similar services in other ambulatory settings. In all, 

there was a confusing mix of at least eight different payment methodologies by 

the time the OPPS was implemented in 2000 (see Table 2.1). 
 - 6 – 

Table 2.1 

Medicare Payment Methodologies for Hospital Outpatient Services Prior to 

the BBA 

Services Furnished in Hospital 

Outpatient Department (HOPD) 

Medicare Payment Amount 

ASC approved surgical procedures Lesser of 1) cost payment amount 

[reasonable cost or customary 

charges less 20% customary charges 

(not to exceed 80% reasonable cost] 

and 2) blended rate [42% cost 

payment amount and 58% ASC rate 

amount]. 

Other surgical and non-surgical 

procedures (including ambulance, 

emergency room, drugs, clinic 

visits, and physical therapy) 

Lesser of reasonable cost or 

customary charges less 20% 

customary charges (not to exceed 

80% reasonable cost) 

Renal dialysis 80% of prospective composite rate 

Radiology (facility component) and 

other diagnostic tests other than 

clinical diagnostic tests 

Lesser of 1) cost payment amount 

[reasonable cost or customary 

charges less 20% customary charges 

(not to exceed 80% reasonable cost] 

and 2) blended rate [42% cost 

payment amount and 58% physician 

fee schedule technical component 

for radiology tests; 50% cost 

payment and 50% fee schedule for 

other diagnostic tests]. 

Laboratory 100% of clinical laboratory fee 

schedule amount 

Intraocular Lenses 80% of DMEPOS fee schedule amount 

Durable Medical Equipment (DME) 80 % of DMEPOS fee schedule amount 

Note: A 10% reduction applied to payments for capital-related costs 

and a 5.8% reduction applied to other cost-based payments 

OBRA-86 spurred the development of an OPPS. The legislation 

required HHS to develop and report to Congress on a fully prospective 

payment system for hospital outpatient services in two stages: 

• The first stage was to focus on ambulatory surgical procedures. 

To the extent practicable, there was to be an all-inclusive 

payment rate that included all services commonly furnished in 

connection with ambulatory surgical procedures exclusive of 

physician services. The rates were to take into account the 

costs of performing the procedures in hospital outpatient 
 - 7 – 

departments and in ambulatory surgical centers and the extent to 

which differences in costs were justified. An interim report on 

the development of a fully prospective payment system for these 

services was due April 1, 1988 and the final report by April 1, 

1989. 

• The second stage was to develop a model system for other 

hospital outpatient services. The legislation did not elaborate 

on the considerations for the model system. The report to 

Congress on the model system was due January 1, 1991. 

Importantly, OBRA-86 also required changes in hospital billing for 

outpatient services to facilitate the development of OPPS. First, 

hospitals were required effective July 1, 1987 to begin using the Health 

Care Financing Administration (HCFA) Common Procedure Coding System 

(HCPCS) instead of the International Classification of Diseases Version 

9-Clinical Modifications (ICD-9-CM) procedure codes on outpatient 

claims. This coding system is based on the Common Procedure 

Terminology——Version 4 (CPT-4) and is used to pay for physician and 

other Part B services.2 Second, the requirement that hospitals bill for 

all services furnished during an inpatient stay was extended to 

outpatient services effective October 1, 1987. The intent was to 

associate all services furnished during an outpatient visit for purposes 

of setting OPPS rates; however, technical issues delayed implementation 

until the final OPPS rule was issued in April 2000.3

The Omnibus Budget Reconciliation Act of 1989 (OBRA-89) required 

ProPAC to issue a report examining the sources of growth in spending for 

hospital outpatient services and cost differences across ambulatory 

settings. ProPAC’s report included a set of principles that the 

____________ 

2 While this requirement established a coding system across ambulatory 

settings, hospitals billed for services by revenue center code rather than 

procedure code. An individual claim could include only the portion of the 

services provided during an encounter or services from multiple encounters. 

3 As a result, outpatient claims used to establish the initial OPPS 

payment rates did not include services that were ordered during an outpatient 

stay but performed by another entity, such as diagnostic tests provided by an 

independent laboratory or free-standing imaging center. 
 - 8 – 

Commission would use to evaluate OPPS alternatives (see Figure 2.1). 

Overall, the criteria were whether the OPPS provided incentives for the 

efficient delivery of high quality medically necessary care to Medicare 

beneficiaries. Other important attributes were whether the system 

provided similar financial incentives for care across ambulatory 

settings, administrative simplicity, predictability, and limited 

opportunities for “gaming” (ProPAC, 1990). 

Figure 2.1——Factors Identified by ProPAC to Evaluate Proposals for OPPS 

The Omnibus Budget Reconciliation Act of 1990 (OBRA-90) set out a 

range of policy issues that the HHS Secretary was to consider in 

developing the OPPS, including: the need for limits on outpatient 

expenditures, the classification system and packaging policies that 

should be used to establish the unit of service, the facility-level 

adjustments, and the appropriateness of varying payment across different 

settings. The legislation required that research reports on the OPPS 

still be submitted by January 1991 but extended the deadline for the 

1. The system should provide incentives for controlling total

expenditures. 

2. The system should maintain general access to high quality care for

Medicare beneficiaries. 

3. The system should not inhibit appropriate care or encourage

unnecessary services because of differing incentives for physicians

and hospitals. It should encourage quality care at the lowest

reasonable costs overall. 

4. The system should recognize alternative sites and changing methods of

providing care and provide similar financial incentives for this care

as well as care offered on the hospital outpatient setting. 

5. The system should recognize justifiable differences in costs of

furnishing services.

6. The system should limit the opportunity for provides to influence

payment rates through billing strategies or changes in medical record

documentation. It should promote predictability and administrative

simplicity. Finally, the system should accommodate appropriate

changing medical practice patters and new technologies. The system

should provide incentives for controlling total expenditures. 

Source: ProPAC (1990).
 - 9 – 

report to Congress on the OPPS to September 1991. ProPAC was required 

to submit analysis and comments on the proposal six months later. 

HCFA-sponsored external research for the OPPS was conducted largely 

during the period 1986-1991, and reports from various OPPS studies were 

submitted to Congress in December 1991. These studies investigated 

different approaches that might be considered in establishing the OPPS 

and examined differences in payment methodologies and costs across 

ambulatory settings. 

HCFA completed a draft report to Congress on the OPPS in 1992, but 

the report was not cleared and submitted to Congress until 1995. The 

report followed the two-stage implementation anticipated in OBRA-86. It 

recommended that the OPPS be phased in, starting with ambulatory 

surgical procedures, radiology and other diagnostic tests using an 

Ambulatory Payment Group (APG)-like classification system with limited 

packaging. The specified services were subject to the blended payment 

methodology. As a result, the data quality and packaging issues were 

less problematic for these services than for medical visits. The report 

made no recommendations regarding issues such as the extent of packaging 

and bundling procedures, classification of medical visits, outlier 

policies, or mechanisms to control aggregate expenditures. Four general 

areas were identified as requiring additional research: defining the 

unit of payment (packaging and bundling policies), determining how well 

accounting costs reflect resource costs, examining the use of APGs in 

other ambulatory settings, and accounting for legitimate cost 

differences across classes of hospitals. The report indicated that as 

further research was completed and better data became available, the 

OPPS could evolve to include more extensive packaging of ancillary 

services and to cover services in other ambulatory settings. 

The 1995 HHS report to Congress also raised a major concern with 

beneficiary coinsurance. The law required that beneficiaries pay 20 

percent of submitted charges for hospital outpatient services paid on a 

cost-related basis. HCFA found through its payment simulation models 

that hospital charges substantially exceeded Medicare’s cost-based 

payment amount. As a result, beneficiaries typically paid substantially 

more than 20 percent of Medicare’s payment amount. If the OPPS 
 - 10 – 

coinsurance amount were set at 20 percent of the prospective payment 

rate, a substantial increase in Medicare expenditures would have been 

required to maintain the total aggregate payment levels for hospital 

outpatient services. A related problem with the existing blended 

payment formula was also identified that resulted in an unintended 

increase in Medicare payments (the so-called “formula-driven” 

overpayment) (HHS, 1995). 

The 1995 HHS report included five premises that had been used to 

evaluate the alternative payment systems that were generally comparable 

to those recommended in the earlier ProPAC report (Figure 2.2). A new 

premise was that the OPPS should provide a basis for addressing the 

beneficiary coinsurance issue. The need to find an equitable solution 

to the beneficiary coinsurance problem became paramount and dwarfed 

other design considerations. The cost of correcting the beneficiary 

coinsurance problem stalled further legislative action on OPPS until the 

BBA of 1997. 

Figure 2.2——Factors Identified by HHS to Evaluate Proposals for OPPS 

1. The system should be fairly simple to understand and to administer,

preferably using a similar payment methodology for all hospital

outpatient services. 

2. The system should be fair and equitable to providers, beneficiaries,

and the Medicare program. 

3. The system should have the potential to be extended to all outpatient

providers. To the extent feasible, payments should be based on type

of services rendered, not on type of provider or supplier rendering

the services. However, in applying this “level playing field”

approach, the system must be able to recognize legitimate cost

differences among settings. 

4. Any patient classification system used to group services should be

based on clinically coherent categories and, at the same time, should

reflect resource utilization. This would limit opportunities to

“upcode” or “game” the system. 

5. The system should provide incentives to furnish services as

efficiently as possible without sacrificing the quality of care or

limiting access to care. 

Source: HHS (1995). 
 - 11 – 

ProPAC’s analysis of the 1995 HHS proposal identified three major 

concerns. First, the Commission recommended against a phased 

implementation. ProPAC argued that a phase-in: 

• Entailed implementation costs without the benefits of 

administrative simplification, 

• Created incentives to shift overhead costs to services that 

continued to be paid on a cost basis, and 

• Might make it more difficult to expand the system to other 

services in the future since there would be “winners and 

losers”. 

Second, ProPAC concluded that a prospective payment system based on 

fee-for-service payments should be accompanied by a strategy to control 

volume growth. The Commission recommended that the HHS Secretary 

explore methods that would rely on payment incentives and on 

administrative controls. Third, ProPAC recommended that beneficiary 

coinsurance be set at 20 percent of the payment rate and that savings 

from the formula-driven overpayment be used to offset the cost to 

Medicare of reducing beneficiary coinsurance. The Commission also 

recommended that the Congress require HHS to submit full specifications 

for a comprehensive OPPS as soon as possible. 

B. INITIAL IMPLEMENTATION OF OPPS: FROM THE BBA TO THE FINAL OPPS RULE 

Section 4523 of the BBA of 1997 required the establishment of a 

prospective payment system for hospital outpatient services effective 

January 1, 1999. The proposed rule was issued in September 1998. 

Subsequently, the BBRA made changes in the OPPS statutory provisions in 

response to issues that had been raised following publication of the 

proposed rule and postponed the effective date because of Y2K concerns. 

The final rule was issued in April 2000 and the new payment system was 

effective August 1, 2000. This section presents an overview of the 

basic OPPS design and the issues that were raised during the rulemaking 

process. The major characteristics of the system and how they changed 

through the legislative and rulemaking processes are summarized in Table 
 - 12 – 

2.2 and form the basis for the analysis of the alternatives discussed in 

greater detail in the next chapter. 

Table 2.2 

Major Features of the OPPS: From the BBA through the April 2000 Final 

Rule 

Feature BBA Proposed Rule BBRA Final Rule 

Services 

subject to the 

OPPS 

Services 

designated 

by the 

Secretary; 

excluded 

ambulance 

and 

therapies 

Exclude 

services 

already subject 

to a fee 

schedule or PPS 

Include 

implantable 

prosthetics 

and DME and 

tests 

associated 

with the 

implants 

Excluded 

corneal 

tissue 

acquisition 

costs 

Unit of 

Payment 

Servicebased Service-based Service-based Servicebased 

Classification 

System 

Secretary to 

develop 

groups of 

services 

that are 

comparable 

clinically 

and with 

respect to 

resource use

346 Ambulatory 

Payment 

Classification 

(APC) groups; 

121 medical 

visit groups 

based on body 

system and 

HCPCS codes 

grouped into 

three levels 

Highest median 

(or mean cost) 

for item or 

service in 

group can’t 

exceed 2x the 

lowest; 

exception for 

low-volume 

items/services 

Services 

Covered 

Bundling [Main 

provision in 

OBRA-86] 

Expanded 

physician 

assistant 

exemption to 

NPs and 

clinical 

nurse 

specialists 

Dropped earlier 

proposal that 

had required 

the hospital to 

bill for all 

diagnostic 

tests furnished 

outside the 

hospital 

ordered during 

an outpatient 

encounter 

No provision Minimal 

changes from 

proposed 

rule 

Packaging No specific 

provision 

Operating and 

recovery room, 

anesthesia, 

supplies, 

observation, 

pharmaceuticals 

other than 

chemotherapy, 

IOLs, casts and 

splints, 

corneal tissue 

acquisition 

cost, 

incidental 

procedures 

No provision 

other than 

transitional 

pass-through 

Eliminated 

packaging 

for casts 

and splints; 

corneal 

tissue; 

blood and 

blood 

products; 

items 

subject to 

the 

transitional 

pass-through
 - 13 – 

Feature BBA Proposed Rule BBRA Final Rule 

Payment Rate Relative 

Weights 

Based on 

median 

hospital 

costs for 

group 

Based on median 

costs from 

single procedure 

claims using 

cost reports 

beginning in FY 

1995 and 1995 

single procedure 

claims 

Secretary has 

authority to 

base on either 

mean or median 

hospital costs 

from most 

recent cost 

reports and 

claims 

Based on 

median costs 

from 1996 

single 

procedure 

claims using 

cost reports 

beginning in 

FY 1997 

Conversion 

Factor 

Based on 

amounts 

Medicare 

would have 

paid in 1999 

(including 

extension of 

cost 

reductions) 

Budget neutral 

to 1999 with 

cost reduction 

provisions and 

behavioral 

offset 

Eliminated cost 

reductions 

effective with 

implementation 

of PPS 

Based on 

amounts that 

Medicare 

would 

otherwise 

paid in 1999 

updated by 

MB-1 with no 

behavioral 

offset 

Standard 

facility 

Adjustments 

Wage 

adjustment 

and other 

factors 

Secretary 

finds 

necessary 

Wage adjustment 

only 

No provision No change 

Special 

Payment 

Provisions 

Other 

adjustments 

determined 

necessary 

for 

equitable 

payment 

No other 

adjustments 

No provision No change 

Outliers Authorized 

but no 

specific 

provision 

No provision Required 

budget neutral 

outlier 

payments 

capped at 2.5% 

before 2004 

and 3% 

thereafter 

Set at 2% of 

total 

payments; 

payment set 

at 75% of 

estimated 

cost in 

excess of 

2.5 times 

standard 

payment 

Type of 

hospital 

Cancer 

hospitals 

exempt 1st

year and may 

have a 

unique 

conversion 

factor 

Solicited 

comment on 

transition 

policy for 

rural hospitals

Transitional 

corridors 

through 2003 

with rural 

hospitals and 

cancer 

hospitals 

held-harmless 

Implemented 

BBRA 

provisions 
 - 14 – 

Feature BBA Proposed Rule BBRA Final Rule 

Drugs No specific 

provision 

Packaged other 

than 

chemotherapy 

Budget neutral 

transitional 

pass-through 

for 2-3 years 

capped at 2.5% 

before 2004 

and 2.0% 

thereafter for 

certain new 

drugs and 

devices. 

Implemented 

new drug 

pass-through 

on an itemby-item 

basis. 

Devices No specific 

provision 

Packaged except 

implantable 

devices paid 

under DMEPOS 

See drug 

provision 

above. 

Packaged 

implantable 

devices. 

Implemented 

new device 

pass-through 

on an itemby-item and 

packaged 

devices. 

New technology No specific 

provision 

Assign to 

existing APC 

most closely 

resembling the 

new item or 

service 

No provision 

other than for 

drugs and 

devices. 

Created new 

technology 

APCs for 

items and 

services not 

qualifying 

for 

transitional 

passthrough. 

Update 

Provisions 

Periodic 

revision 

authorized. 

Annual revision 

to wage index 

Review of all 

components not 

less than 

annually 

Implemented 

BBRA. 

Rates MB (except 

MB-1 through 

2002) 

Same as BBA. Same as BBA. Same as BBA.

Groupings and 

weights 

Periodically Revise 

groupings as 

needed; 

solicited 

comment on 

frequency of 

recalibration 

Use outside 

advisory panel 

to review 

groupings and 

weights 

Implemented 

BBRA. 

Volume Control Secretary to 

develop 

method for 

controlling 

unnecessary 

increases 

Sustainable 

growth ratelike approach 

for 2000 only 

based solely on 

OPD services 

No provision No provision 

Balanced Budget Act of 1997 (BBA) 

In laying out the overall design for the OPPS, the BBA drew on the 

1995 HHS Report to Congress. Critical features of the system needed to 

determine OPPS budget impacts were spelled out. These included policies 
 - 15 – 

related to the budget neutrality target for setting the relative weights 

and the process for phasing down beneficiary coinsurance amounts to 20 

percent of the payment over time. However, many of the specific details 

of the system were left to the Secretary’s discretion, including: the 

services that would be covered by the system, whether the unit of 

payment should be individual services or groups of services, bundling 

and packaging policies, facility adjustments and other special payment 

adjustments. The discretionary policies subsequently created the most 

policy debate and are of interest for this study. The study does not 

examine the budget baseline or coinsurance issues.4 

Proposed Rule Implementing the OPPS 

The proposed rule implementing the OPPS and the OBRA-86 bundling 

rules was published in the Federal Register in September 1998.5 The 

rule provided for grouping procedures into 346 APG-like ambulatory 

payment classification (APC) groups of services that were comparable 

clinically and with respect to resource use. Comment was explicitly 

solicited on the classifications for medical visits. The proposed APCs 

packaged services that “are recognized as contributing to the cost of 

services in an APC,” but which Medicare did not separately pay for as a 

service. Packaged items included: operating and recovery room, 

anesthesia, medical/surgical supplies, pharmaceuticals (other than 

chemotherapy drugs which had separate APCs), observation services, 

blood, intraocular lenses, casts and splints, donor tissues, and various 

incidental services such as venipuncture. The packaging policy was 

generally consistent with the packaging rules already in place for 

ambulatory surgical procedures, radiology and other diagnostic tests. 

The BBA gave the Secretary authority to designate the services 

covered by the OPPS but specifically excluded ambulance and outpatient 

therapy services. These services were to be paid under separate fee 

____________ 

4 The major budget baseline issue pertained to continuation of provisions 

reducing Medicare payments for capital and diagnostic tests for purposes of 

determining the budget neutrality target for 1999. This issue was addressed by 

the BBRA, which eliminated the cost reductions effective with the implementation 

of the OPPS. 

5 An extensive correction notice was published in June 1999.
 - 16 – 

schedules that were also established by the BBA. The proposed rule 

excluded other services paid under existing fee schedules applicable in 

all settings, e.g., clinical diagnostic laboratory services, DMEPOS, and 

End-stage Renal Dialysis (ESRD) services covered by the composite rate. 

As noted in Table 2.2, the rule was fairly straightforward in that 

there were minimal facility adjustments or special payment policies. 

The only facility adjustment was the BBA-mandated adjustment for area 

differences in hospital wage levels. The Secretary’s authority to 

provide other adjustments was not exercised. HCFA solicited comment on 

whether a transitional payment policy should be established for small 

rural hospitals that would be adversely affected by the OPPS but did not 

propose such a policy. 

With regard to volume control measures, an update in the 1999 

budget neutrality target was proposed as a CY 2000 expenditure target 

using the sustainable growth rate policy used in the physician fee 

schedule as a model. The 1999 budget neutrality target would be 

adjusted to reflect inflation, changes in the number of Medicare Part B 

fee-for- service enrollees, and an allowance for new technology. If 

actual calendar year 2000 expenditures exceeded the target, HCFA 

proposed to adjust the CY2002 conversion factor. 

A proposed rule implementing the OBRA-86 bundling provision for 

outpatient services had been published in August 1988 but had not been 

finalized. The proposal was republished as part of the OPPS proposed 

rule with one major change. The initial proposal was developed at a 

time HCFA was considering more extensive packaging under the OPPS. It 

had required that the hospital bill for any diagnostic tests performed 

outside the hospital that had been ordered during an outpatient 

encounter. This policy was dropped in the OPPS proposed rule. The 

revised policy required hospitals to bill only for services that were 

provided on the hospital premises on the same day as an outpatient 

encounter. 

The proposed rule noted that the complexity of the Y2K issues would 

preclude implementation any earlier than January 2000. The proposed 

rule originally provided for a 60-day comment period. It was extended 

four times and ultimately closed on July 30, 1999. 
 - 17 – 

Balanced Budget Refinement Act of 1999 (BBRA)

The BBRA was enacted in November 1999 after the comment period for 

the proposed rule closed. Section 201 of the BBRA contained provisions 

that affected the OPPS. There were budget neutral provisions to require 

outlier payments for services whose costs exceed a given threshold and 

to establish a temporary transitional pass-through for certain medical 

devices, drugs and biologicals. Implantable devices were explicitly 

covered under the OPPS and packaged into the APC for the associated 

procedure. The proposed rule had excluded and paid for implantable 

devices under the DMEPOS fee schedule. 

The BBRA also included provisions that affected the APC 

classification system and relative weights. The Secretary of HHS was 

given discretion to base the relative weights on either the median or 

average cost of the procedures within the APC. The amount of variation 

within a given APC was limited so that the highest cost procedure could 

not be more than two times the cost of the lowest cost procedure within 

the APC. Exceptions were allowed for low volume procedures. The 

Secretary was also required to review the groupings and relative weights 

(as well as other payment factors) annually and to consult with an 

expert outside advisory panel in doing so. The panel was authorized to 

use non-HHS data in its review. 

Another change affected payments through the transition. A 

provision applicable to all hospitals partially offset reductions in 

Medicare aggregate payments though 2003 based on each hospital’s 

payment-to-cost ratio in the base year (cost reporting periods ending in 

1996) compared to the PPS year. Cancer hospitals and rural hospitals 

with fewer than 100 beds were held harmless under the provision and paid 

at no less than the base year payment-to-cost ratio. 

Final Rule Implementing the OPPS 

A final rule with comment period implementing the OPPS was 

published in April 2000 and was initially to become effective July 1, 

2000. The comment period pertained to the provisions implementing the 

BBRA provisions. For the most part, the April 2000 rule clarified 
 - 18 – 

issues that had been raised in public comments and implemented the BBRA 

provisions. Other policy changes included: 

• Corneal acquisition costs were excluded from the OPPS and paid 

on a reasonable cost basis. 

• Packaging was no longer required for casts and splints, blood 

and blood products; and, 

• The proposal for a volume control measure was indefinitely 

deferred. 

Two additional notices followed the April 2000 notice. A July 2000 

interim final rule with comment period modified the policies for the 

transitional pass-through and delayed the effective date of the OPPS to 

August 1, 2000. A third interim rule published in November 2000 

addressed the comments on the BBRA changes and was effective January 1, 

2001. 
 - 19 – 

3. MAJOR DESIGN CONSIDERATIONS FOR THE OPPS 

This chapter focuses on alternatives that were considered during 

the development and implementation of the OPPS that relate to on-going 

issues with the payment system. These issues include: 

• How the unit of payment is defined. 

• How relative weights are established for procedure groupings. 

• How new technology and drugs are accounted for in the ratesetting process. 

• The consistency of payment for facility services across 

ambulatory settings. 

• Volume controls on Part B expenditures. 

This report does not discuss the transition payment issues. These 

policies have now expired and are no longer relevant except with respect 

to rural hospitals, where current studies are already underway. Also, 

the report does not examine issues related to outlier payments because 

they received little attention during the design of OPPS and were 

recently examined by MedPAC in its March 2004 report. 

In examining the alternative policies that were considered in 

designing the OPPS, the limitations of the data that could be used to 

establish the initial payment system should be kept in mind. 

• The sheer volume of the claims and codes that needed to be 

handled in the rate-setting process posed challenges. There 

were 80 million claims for outpatient services in 1996 (the 

claims year used to establish the rates) that matched to a cost 

report and could potentially be used to establish payment rates. 

More than 10,500 HCPCS codes were in use, of which over 5,000 

described services that the Secretary designated as covered by 

the OPPS. 

• All services associated with an outpatient encounter were not 

necessarily on a single bill. If a patient was seen in several 

departments on the same day, there might have been multiple 

claims, which could have been for treatments for the same 
 - 20 – 

condition or for different conditions. Conversely, a single 

claim could include services over multiple visits over a period 

of time and/or for multiple conditions. 

• Not all the services associated with the outpatient encounter 

may have been billed by the hospital. Services may have been 

ordered during an encounter that were performed and billed by 

another entity, such as a freestanding radiology treatment 

center. 

• There was considerable evidence of poor diagnosis and procedure 

coding practices, particularly for medical visits where the 

coding did not affect payment. Some hospitals did not 

differentiate between levels of clinic visits and used a single 

code for all visits. 

• Hospitals charged for their services by revenue centers rather 

than procedure codes. To estimate procedure costs, revenue 

center charges needed to be cross-walked into ancillary 

departments or cost centers used on the hospital cost report so 

that departmental cost-to-charge ratios could be applied. 

Charging practices for some services, including ambulance 

services (where only total charges were reported instead of base 

charges and mileage rates) and therapy services (where multiple 

procedures are typically performed during a single session) made 

developing service-based rates for these services particularly 

problematic. 

• Only single procedure bills could be used to establish relative 

weights for procedures. This is because packaged items and 

services could not be assigned to a procedure if multiple 

procedures were reported on the same bill. For example, if two 

surgical procedures were reported on the same claim and there 

were charges for an operating room, there was no basis for 

allocating the operating room charges between the two 

procedures. Of the 80 million claims that were matched with a 

cost report in establishing the initial OPPS rates, 34.6 million 

had multiple procedures and could not be used to calculate the 

median costs for the APC. After discarding about 24 million 
 - 21 – 

single procedure claims for services that were not subject to 

OPPS (e.g., laboratory service only), the final relative weights 

were based on 21.4 million single procedure claims. 

A. TYPE OF SERVICES COVERED BY THE OPPS 

Starting with the early discussions on the OPPS onward, a policy 

goal was to move payment for all hospital outpatient services from costbased reimbursement to prospectively determined rates. Prospectively 

determined rates provide an incentive to control the costs that 

reasonable cost reimbursement does not. Further, a mix of reasonable 

cost and fee schedule payments was seen as adding administrative 

complexity and creating incentives to shift overhead costs to the 

services that remained cost-reimbursed. The 1995 HHS report 

recommendation that the OPPS be phased in beginning with ambulatory 

surgical centers, radiology and other diagnostic tests was based on the 

state of research at the time the report was written rather than policy 

considerations. As research progressed and it became feasible to 

establish prospective rates for medical services, the question of 

whether certain types of services should remain on a cost-related basis 

received minimal attention. The beneficiary coinsurance issue and 

concerns that partial implementation would add administrative complexity 

and create incentives for cost-shifting provided impetus to assure all 

services were paid on a prospectively determined rate. The policy issue 

was primarily which services should be covered under the OPPS and which 

should be covered by other fee schedules. 

By the time the OPPS was implemented, prospective rates or fee 

schedules already applied to several types of services furnished by 

HOPDs, including clinical diagnostic laboratory tests, DMEPOS and, with 

the enactment of the BBA, ambulance services and outpatient therapy 

services. The issue that received some attention was whether the OPPS 

should apply to all services furnished by hospitals to outpatients or 

whether existing fee schedules should be utilized where the services 

were not packaged with an OPPS-payable service. The issue involved a 

trade-off between the administrative simplicity of having a single 

payment system for HOPD services and the long-term goal of “leveling the 
 - 22 – 

playing field” between hospitals and others who provided the same 

services. Establishing an OPPS payment for individual services that 

were already paid across ambulatory settings under an existing fee 

schedule was perceived as a step backward. The BBA explicitly excluded 

ambulance and outpatient therapy services from the OPPS and established 

new fee schedules for those services. Hospital cost data and charges 

were by revenue center and developing individual service-based rates for 

these services from cost report data was problematic. The ambulance and 

outpatient therapy services fee schedules were seen as a way to both 

establish a service-based payment for individual services and create a 

more level playing field. 

Two types of services received attention between the proposed rule 

and the final rule. 

• The proposed rule excluded implantable devices from the OPPS and 

paid for them using the DMEPOS fee schedule. The proposal was 

consistent with how the items were currently paid, statutory 

language that appeared to give the DMEPOS precedence over other 

fee schedules, and ASC payment rules. Responding to concerns that 

the DMEPOS did not account for new technology in a timely way, the 

BBRA required that implantable devices be paid under the OPPS. 

The BBRA conference report stated that the current DMEPOS fee 

schedule was not appropriate for certain implantable medical items 

such as pacemakers, defibrillators, cardiac sensors, venous 

grafts, drug pumps, stents, neurostimulators, and orthopedic 

implants as well as items that come into contact with internal 

human tissue during invasive medical procedures, but are not 

permanently implanted. 

• The proposed rule explicitly noted that there were regional 

variations in corneal acquisition costs and raised the issue of 

whether these costs should be covered by a prospective payment 

rate or reimbursed on a reasonable cost basis (as inpatient organ 

acquisition costs were). The final rule provided for payment 

based on reasonable cost to assure access was not adversely 

affected in those areas of the country with higher costs. 
 - 23 – 

B. DEFINING THE UNIT OF PAYMENT 

Much of the policy debate surrounding the OPPS has revolved around 

issues related to defining the product——or the unit of payment——that 

would be used in the system. Researchers and policymakers examined 

three basic questions: 

• Grouping. The extent to which clinically similar procedures 

should be grouped for payment purposes and the logic that should 

be used for the groupings 

• Packaging. The extent to which ancillary services associated 

with a significant procedure should be packaged into a single 

payment for the procedure 

• Bundling. The extent to which multiple significant procedures 

over a period of time should be bundled into a single unit of 

payment. 

A prospective payment system relies on an “averaging” concept, so 

that payment may be more or less than the estimated costs of providing 

particular services, but on average it is adequate to assure access to 

high quality care. The policy decisions regarding grouping, bundling, 

and packaging involved a trade-off between establishing incentives for 

efficiency through larger units of payment and payment accuracy. 

Different aspects of payment accuracy were raised in the OPPS policy 

debate: 

• One aspect related to establishing an accurate payment rate for 

unit each of payment. Here, a major issue is the use of 

accounting costs to reflect differences in resource costs. 

Accounting costs refers to a method of determining the costs of 

outpatient services using annual cost reports filed by 

hospitals. Direct and indirect costs are allocated to each 

ancillary service department through a cost finding methodology 

and then apportioned to Medicare based on a ratio of Medicare 

charges to total charges for the ancillary service department. 

The methodology relies on accurate cost finding and on charges 

that are consistently related to costs. Other issues include: 

the use of median or mean costs to determine payment rates; the 
 - 24 – 

reliability of cost data for low-volume procedures; assigning 

ancillary procedures when multiple significant procedures are 

performed; and, the combining services that were separately 

billed into a single unit of payment. 

• A second aspect relates to the amount of cost variation within 

the unit of payment (or procedure groupings). There is 

variation across hospitals in the cost of providing a particular 

procedure. Additional variation is introduced through broad 

procedure groupings, packaging of associated ancillary services 

with the primary procedure, and bundling of multiple procedures 

related to an outpatient encounter into a single payment (or 

bundling of all procedures performed over a period of time into 

a single per episode of care payment). Here, the issue is the 

likelihood that on average the payment will be accurate given 

the amount of cost variation within the grouping. Increased 

cost variation does not necessarily reduce payment accuracy at 

the hospital-level unless there are systematic differences 

across hospitals in the services included in the unit of 

payment. However, it reduces service-level payment accuracy and 

could create inappropriate incentives for “gaming” by shifting 

higher cost services to alternative ambulatory settings. 

The two aspects of payment accuracy are somewhat inter-related. If 

the unit of payment is relatively large, there is more room for 

balancing inaccuracies in establishing the cost of the services covered 

by the rate than if the rate covers a small unit of payment such as an 

individual procedure. 

The final OPPS provided for using APCs to group individual 

procedures that were similar clinically and with respect to resources 

with minimal bundling and packaging of ancillary services; namely, those 

ancillary services that were an integral part of the procedure and 

furnished on the same day in the hospital were included in the APC 

payment for the procedure. 
 - 25 – 

Procedure Groupings 

An initial assumption in designing the OPPS was that some type of 

mechanism was needed to group the procedures for purposes of setting 

prospective payment rates. It was thought that the large number of 

procedure codes that could be used by hospitals, many of which were very 

low volume, required procedure groupings. Early research on potential 

ways to group procedures examined classification systems ranging from 

the diagnosis-related groups used to pay for inpatient hospital services 

to ones that were based on resource requirements with no clinical 

considerations, such as the ASC payment groupings. The 1995 HHS report 

to Congress discussed five potential classification systems: Diagnosisrelated Groups (DRGs), Ambulatory Visit Groups (AVGs), Products of 

Ambulatory Care (PAC) and Products of Ambulatory Surgery (PAS), ASC 

payment groups, and APGs. These groups were among the systems that had 

been evaluated by the Urban Institute and Brandeis University (see 

Appendix A). The evaluation focus was on potential classification 

systems for surgical services because of the phased approach to OPPS in 

OBRA-86. Little work had been done to assess the suitability of the 

classification systems for non-surgical services before the 1995 HHS 

report to Congress was drafted. However, one of the evaluation criteria 

that HHS used was whether the system could be expanded to include other 

outpatient services. 

The DRG classification system and the AVGs, both of which had been 

developed by Yale University, were found to have problems in the 

grouping logic for ambulatory surgery. Of the three systems that were 

seen with some potential for use in the OPPS (APGs, the ASC payment 

groups, and PAS), the 1995 HHS report concluded that the APGs held the 

most promise. The APG system used approximately 300 groups of 

clinically similar significant procedures and ancillary procedures based 

on CPT-4 codes and medical visits based on ICD-9-CM diagnosis codes.6 

Unlike the DRG system, where a patient is classified into a single DRG 

during an inpatient stay, outpatients could be assigned to more than one 

APG. The perceived advantages of APGs were: 

____________ 

6 Version 2.0 of the APGs had 139 procedure, 83 medical, 58 ancillary, 2 

incidental and 8 error APGs. 
 - 26 – 

• The APGs were designed to include the full range of hospital 

outpatient services and were developed using Medicare hospital 

outpatient data. 

• The APG classification logic assigns each surgery code in a 

single group and grouped procedures based on clinical coherency 

and resource considerations, thereby eliminating the potential 

gaming created by some of the other systems. Gaming can occur 

under systems that group based solely on resource considerations 

when clinically similar procedures are assigned to different 

payment groups. 

• The groupings are flexible enough to accommodate different 

bundling and packaging decisions and to implement changes in 

those policies over time. They could also be extended to other 

ambulatory settings in the future. 

• By being clinically based, the unit of payment could also be 

used for clinical management and quality assurance. 

While the APGs took into account both clinical and resource 

considerations, the ASC payment groupings took into account only 

resource costs. There were eight payment groups (now nine) that were 

developed using $75 intervals of estimated wage-adjusted median ASC 

costs (derived from applying cost-to-charge ratios to procedure 

charges). The ASC payment groups were potentially attractive because 

the classification system was simple and already in use both to pay ASCs 

and in the blended payment methodology. Several disadvantages were 

identified: 

• The payment groups include only approved ASC procedures. The 

payment categories did not include medical visits, ancillary 

tests and services. 

• The payment groups were based on ASC cost structures and were 

not necessarily appropriate for hospital outpatient services. 

The Urban Institute study found that some procedures are more 

costly when performed in an HOPD than in an ASC while others are 

less costly. 

• The system is not clinically based. 
 - 27 – 

The Urban Institute examined ways to adapt the ASC payment 

methodology to a broader range of services. One approach assigned 

additional services to the payment groups based on their estimated 

costs. Another approach created charge-based decile payment groupings 

for ambulatory procedures based on estimated average charges. The 

researchers concluded that establishing large payment groupings based 

solely on similar estimated costs was not advisable because it would be 

easy to game the system and change groups to increase payment. This is 

because clinically similar procedures were assigned to different payment 

groups. 

The Products of Ambulatory Care (PAC) and Products of Ambulatory 

Surgery (PAS) were developed by the New York State Department of Health 

for use in its Medicaid program. The PAC was attractive because it was 

actually in use and packaged ancillary services with medical visits. 

Disadvantages were that the PAC included physician as well as facility 

services, contained groupings that were not relevant for the Medicare 

population, and did a relatively poor job of explaining cost variation 

in facility services. 

The PAS was a relatively straightforward 42-group system that 

categorized surgery into 18 surgical categories that were further 

subdivided where appropriate based on whether the procedure was 

therapeutic, diagnostic, or reconstructive. Procedures requiring 

substantially different resources could be grouped together since the 

grouping logic was based on clinical considerations only. The PAS 

classification logic and unique assignment of codes provided less 

opportunity for gaming than the ASC payment groupings. While the 1995 

HHS report suggested the PAC and PAS systems should be given 

consideration, there do not appear to have been further investigation of 

their potential use for the Medicare OPPS. Instead, analyses 

concentrated on evaluating and refining the APGs and exploring related 

packaging and bundling issues. 

As the work progressed on designing a payment system based on APGlike groupings, concerns were expressed regarding the extent to which 

procedures, particularly high volume procedures, should be grouped for 

rate-setting purposes. The arguments favoring grouping centered 
 - 28 – 

primarily on the manageability of setting rates for a large number of 

procedures, payment accuracy and price stability for low-volume 

procedures, ease of pricing new services and technologies, and face 

validity. Individual pricing revealed some aberrant cost patterns where 

procedures that should require comparable costs had substantially 

different median costs because of differences in hospital coding and 

charging practices. 

MedPAC’s March 1998 report argued against procedure groupings and 

recommended that the payment rates be based on individual services to 

help ensure consistent payments across ambulatory settings. The main 

arguments against groupings were that: 

• Payment accuracy is diminished for procedures that are more 

costly or less costly than the average cost for the procedures 

assigned to the grouping. The groupings could unfairly reward 

or penalize hospitals that systematically performed procedures 

that were below or above the average cost procedure in the 

grouping. 

• Groupings mask questionable cost data for new and low volume 

procedures. 

• Groupings impose more administrative burden than a fee schedule 

for individual services because new software and educational 

training may be required. 

• A fee schedule for individual services would make it easier to 

“level the playing field” across ambulatory sites in the future. 

Alternative approaches that were suggested for low-volume 

procedures included: 

• Price high volume procedures individually and establish prices 

for groupings of the remaining low-volume procedures; 

• Assign high volume procedures to unique payment groups and 

assign low-volume procedures that were clinically similar (in 

the same code series) to that grouping. 

In the proposed rule implementing the OPPS, HCFA proposed to use 

Ambulatory Payment Classifications (APCs). These were essentially 
 - 29 – 

Version 2 APGs with additional refinements using more current cost data 

and minimal packaging. The agency reiterated the arguments in favor of 

grouping procedures and took issue with several arguments that had been 

advanced against groupings: 

• Separate groupings for low-volume procedures would either 

require deviation from the principle of groupings based on 

clinical coherency and resource considerations or result in a 

large expansion in the number of APCs. 

• Grouping closely related services discourages the upcoding that 

occurs when clinically similar services have disparate median 

costs. 

• The APCs did not increase administrative burden because the 

grouping was made transparent to hospitals. The same relative 

weight was assigned to the multiple HCPCS codes that grouped to 

a given APC. As a result, hospitals did not need to group the 

procedure codes to the appropriate APC to determine payment. 

HCFA specifically invited comment on the decision to group 

procedures for purposes of determining the payment amount. Alternatives 

recommended by commenters included: 

• Fee schedule payments based on individual services. New codes 

could be priced based on costs of comparable services and/or 

through consulting with the Relative Value Update Committee or 

similar group. 7

• Expand the number of APCs by tightly controlling the amount of 

cost variation within an APC. 

The final regulation contained extensive changes in the APC 

classifications. Some changes were based on public comment or 

additional HCFA analyses. However, most changes were made to comply 

with the BBRA’s limit on variation within groups. The BBRA provided 

that the median cost of the highest cost procedure assigned to a 

____________ 7 The American Medical Association’s Relative Value Update Committee 

provides input to CMS on the relative values for the work component of the 

physician fee schedule. 
 - 30 – 

particular APC could not exceed two times the median cost of the lowest 

cost procedure assigned to the APC. The BBRA limit was a significant 

factor in the final APC groupings. HCFA expressed concern at the time 

that the BBRA limit may have required some unnecessary (and possibly 

ill-advised) splits in the groupings. The exception to the two times 

rule was used for 20 APGs. The exceptions were based on factors such as 

low procedure volume (less than 2 percent of claims in the APG), suspect 

or incomplete cost data, concerns about inaccurate or incomplete coding, 

or compelling clinical reasons. The changes in the number of groupings 

are shown in Table 3.1. In addition to the APC classification changes, 

there were 161 new APCs that were specific to a particular drug (or 

radio-pharmaceutical, blood product or brachytherapy seeds that were 

also eligible initially for a temporary pass-through). 

Table 3.1 

Comparison of the Number of APGs by Service Category in the Proposed and 

Final OPPS Rules 

Medical Visit Classification Logic 

As originally developed, the Version 2 APG classification logic 

used ICD-9-CM diagnosis codes to establish 80 APGs with several groups 

for each body system. The groups were designed to accommodate extensive 

packaging and became less useful in differentiating costs when HCFA 

Major APC Category Proposed Rule Final Rule

Medical Visits 120 7 

Surgical Procedures 133 149

Significant Procedures 47 79 

Ancillary Services 40 39 

Partial Hospitalization 1 1 

New Technology 0 15 

Drugs, Biologicals, Blood, etc. 4 161 

Total 345 451 
 - 31 – 

decided to use minimal packaging in the initial OPPS. The most costly 

APC was only 4.5 times more costly than the least costly APC and comingled resource-intensive and less resource-intensive encounters within 

a single APC. 

HCFA discussed three potential medical visit groupings in the 

proposed rule: the diagnosis based visit groupings, a classification 

logic based on CPT-4 codes only, and a hybrid approach that used both 

diagnosis and body system to classify medical visits. 

• An argument in favor of the diagnosis groupings was that payment 

would be based on the type of patient treated. 

• Classification based on CPT-4 codes was seen a way to 

differentiate service intensity consistent with the physician 

fee schedule. HCFA considered grouping clinic visits and 

emergency room visits separately by three intensity levels (low, 

mid-, and high-level) and creating a separate APC for critical 

care. CPT-4 groupings were used instead of individual codes 

because the data showed little cost differentiation between 

several codes. A problem in using only CPT-4 codes to construct 

relative weights was that the range of costs reflected hospital 

billing patterns and were more determined by hospital 

chargemasters than the actual resources required to treat the 

patient. Some hospitals did not differentiate for service 

intensity in their charge structure and used a single code to 

describe all medical visits. 

• The hybrid approach used a matrix of the CPT groupings and the 

body system to introduce more cost variation between the 

groupings while reducing cost variation within the groupings. 

There were 121 groupings in total. The hybrid approach was also 

seen as a way to improve diagnosis coding in HOPDs, which was 

critical for expanding packaging in the future. A concern was 

that it would make it more difficult to establish more 

consistent payments for the facility service payment for HOPD 

clinic visits and the practice expense component of physician 

office visits in the future. 
 - 32 – 

HCFA proposed using the hybrid approach but explicitly solicited on 

how medical visits should be classified. Industry commenters argued 

that none of the alternatives discussed in the proposed rule adequately 

captured differences in patient resource use and expressed concern that 

using diagnosis in the classification logic added administrative 

complexity. One CPT code——high-level emergency room visit, major signs, 

symptoms and findings——was seen as contributing to most of the cost 

differentiation using the hybrid approach. One suggestion was to use 

diagnosis in setting rates for this code but to pay for other medical 

visits based on the CPT-4 code only. In its 1999 March report, MedPAC 

noted that diagnoses at the time services are delivered are not likely 

to be a good patient-level adjustor and recommended that the Secretary 

study means of adjusting base PPS rates for patient characteristics such 

as age, frailty, co-morbidities and coexisting conditions. The 

recommendation was made in the context of rationalizing payment 

differences across ambulatory settings, but has applicability to the 

issue of establishing appropriate rates for HOPD medical visits. The 

final rule dropped the hybrid approach and implemented the groupings 

based solely on CPT-4 codes. 

Packaging 

Under the inpatient PPS, all services related to an inpatient stay 

are packaged into the per discharge unit of payment. The packaging 

creates an incentive to eliminate unnecessary services. Drawing on this 

model, the concept of packaging most services related to a given 

procedure into a single payment was identified as an OPPS policy goal 

during the developmental stage. From the outset, however, the 

feasibility of doing so was uncertain given the diversity of outpatient 

sites, variation in why patients receive HOPD care, and the high 

percentage of medical service costs associated with ancillary services. 

A concern was that there might be considerable variation in the services 

provided during an outpatient encounter. The policy options that were 

considered ranged from full packaging of all services provided during an 

outpatient encounter to minimal packing consistent with the ASC and 

physician fee schedules. Under these fee schedules, only the medical 
 - 33 – 

and surgical supplies that were an integral part of the service were 

packaged into the payment for the significant procedure. Separate 

payment was made for other ancillary services. The ASC payment rate 

also packaged the operating and recovery room services and anesthesia 

supplies that were not separately payable under the DMEPOS. 

When researchers at Urban Institute looked at this issue for 

surgical procedures, they found that almost 60 percent of outpatient 

surgery claims had charges for ancillary services that accounted on 

average for 15% of the charges. Some patterns of ancillary usage were 

identified, with respect to both the surgeries that generally involve 

laboratory or radiology procedures and the types of laboratory and 

radiology services associated with particular surgical procedures. The 

researchers concluded that any bundling of ancillary services should be 

as an add-on for particular procedures, and that more expensive and less 

routinely performed ancillary services should be reimbursed separately. 

This would reduce the likelihood of underpayment when the less common 

ancillary services are furnished. More extensive packaging would put 

hospitals at risk for medically necessary services. 

The developers of the APG system evaluated three packaging options 

in their final report on the Version 2 APGs. Medical supplies and drugs 

other than chemotherapy and incidental services were always packaged. A 

limited packaging option only packaged anesthesia services. The simple 

packaging option added simple ancillary tests. The full packaging 

option added some additional frequently performed ancillary services and 

some minor medical services. An all-inclusive packaging option was not 

examined because it put providers at risk for high-cost infrequently 

performed ancillary services. The researchers evaluated how much of the 

variation in costs was explained when using full versus limited 

packaging. Simple and full packaging explained about the same amount of 

cost variation.8 For medical claims, full packaging explained less cost 

variation than limited packaging.9 The lower amount of explained 

variation for medical claims was attributed to the combined effect of 

____________ 8 The R2

 was 0.757 for full or simple packaging vs. 0.773 for limited 

packaging. 

9 The R2 was 0.588 for full packaging vs. 0.745 for limited packaging. 
 - 34 – 

more variability in the use of ancillary services in medical encounters 

and the higher percentage of costs attributable to ancillary services. 

The researchers recommended that full packaging be used because of the 

incentives it would create for efficient use of ancillary services. The 

impact analysis indicated that there would be some redistributional 

impacts across classes of hospitals, with teaching hospitals with 

resident-to-bed ratios > 0.25 gaining 3.3% in payments relative to a 

limited packaging option. Medicare dependent small rural hospitals and 

sole community hospitals would have gained 1.8 % and 0.7% respectively, 

but rural referral centers would have lost 0.7% relative to the limited 

packaging option. 

Although packaging was attractive as an incentive for controlling 

ancillary usage, it raised a number of policy and operational issues: 

• Packaging adds administrative complexity to the payment system 

and would require more complex billing and claims processing 

systems. 

• There is less payment accuracy with packaging, particularly with 

a uniform policy that applies across all procedures and 

groupings. The alternative is a procedure-specific or APCspecific packaging policy based on clinical considerations. It 

adds additional administrative complexity to the system and is 

more prone to gaming than a uniform policy. 

• Since ambulatory services can be provided in multiple settings, 

packaging could encourage shifts in where ancillary services are 

furnished. To protect the integrity of the payment system, 

bundling policies would need to be developed to require the 

hospital to bill for services that are ordered for an outpatient 

but performed by non-hospital entities and the claims processing 

system would need to be able to identify these services. 

• Extensive packaging is inconsistent with the way services are 

paid under the ASC and physician fee schedules. 

• While packaging helps control common low-cost ancillary usage, 

hospital outpatient expenditures are heavily influenced by the 

volume of visits and the use of higher cost ancillary services. 
 - 35 – 

As responsibility for the OPPS moved from the research to the 

policy-side of HCFA, support for extensive packaging in the initial PPS 

waned. The Administration’s main focus was on getting an OPPS 

established as quickly as possible so that the beneficiary coinsurance 

issue could be addressed. When it became clear that packaging posed a 

number of policy and operational issues would need to be addressed 

before it could be implemented, there was concern that packaging might 

complicate and delay the development of a comprehensive OPPS proposal. 

Also, the hospital associations favored a simple system without any 

special software to group claims and opposed packaging beyond that 

already used in the blended rate payment methodologies. HHS was able to 

garner more support for the OPPS with minimal packaging than with more 

extensive packaging methodologies. 

The 1998 proposed rule for the implementation of the PPS proposed a 

minimal packaging policy that packaged items and services that are 

directly related and integral to performing a procedure or furnishing a 

service and are not separately payable. The packaged items included the 

use of an operating suite, procedure room or treatment room, recovery 

room or observation bed; anesthesia supplies and equipment; medical and 

surgical supplies and equipment; casting, splinting, and strapping 

services; blood and blood products; pharmaceuticals other than 

chemotherapy agents; surgical dressings; intraocular lenses; tissue 

acquisition costs, and incidental services such as venipuncture. 

In response to comments, the final rule made dropped several 

categories of packaged items and services and created new APC groups 

that allowed separate payment to be made for these services. The 

services that were not packaged in the final rule were: 

• Corneal tissue acquisition costs (separate payment for these 

acquisition costs is based on a hospital's reasonable costs 

incurred to acquire corneal tissue); 

• Blood and blood products, including anti-hemophilic agents; 

• Immunosuppressive drugs for patients following organ transplant; 

and, 
 - 36 – 

• Certain other high cost drugs that are infrequently administered 

and that were not included in the transitional pass-through 

payment provision (see discussion below). 

In developing the initial OPPS, analysis of costs for individual 

drugs was complicated by the lack of consistent data. Based on the 

Version 2 APG groupings, which had packaged all drugs other than 

chemotherapy drugs, HCFA had only required that chemotherapy drugs be 

reported using HCPCS codes and allowed hospitals to continue to bill for 

other drugs using only revenue codes. This precluded identification of 

particular drugs and their associated charges. As a result, the costs 

of individual drugs could not be isolated when the APCs were 

constructed. The proposed rule packaged all pharmaceuticals other than 

chemotherapy drugs. The final rule adopted the same policy but 

acknowledged the likelihood that the APCs might not reflect the costs of 

some very expensive, infrequently used drugs, which might put the 

hospitals that furnish them at financial risk. HCFA noted that many of 

these drugs were relatively new and would be paid for under the new 

technology pass-through established by the BBRA. 

Bundling 

For purposes of this study, the term bundling is used in 

conjunction with policies related to the span of services covered by the 

prospective rate. The bundling options range from the separate payments 

for each significant procedure or service furnished by the hospital on 

the same day to more expanded bundles involving services furnished over 

time or multiple settings. 

Various bundling alternatives were discussed during the design of 

the OPPS. Two alternatives were considered primarily as mechanisms to 

prevent “gaming” by shifting the timing or location of packaged 

ancillary services. The alternatives were not mutually exclusive and 

were seen as increasing in importance as packaging became more 

extensive. The first alternative was to establish a time window for 

packaged ancillary services. For example, the APG developers examined a 

3-day and 7-day window of time around the visit and included any 
 - 37 – 

packaged ancillaries that were furnished during this window. Expanding 

the bundle had no substantial impact on amount of variation in costs 

explained by the APGs. The percentage of APG costs accounted for by the 

packaged ancillaries increased only slightly (from 15.4% in a same day 

bundle to 16.3% in a 7-day bundle in a full packaging approach). The 

second alternative was to include packaged ancillaries ordered for a 

hospital outpatient but performed outside the hospital by a non-hospital 

entity. This alternative was considered unnecessary when the minimal 

packaging policy was adopted since all services that were an integral 

part of the procedure should have been furnished at the time the service 

was provided. 

An alternative recommended by MedPAC was intended to increase 

payment consistency across ambulatory settings. The 1999 MedPAC report 

recommended that the unit of payment be defined consistently across all 

ambulatory settings and include limited follow-up care if integral to 

the primary service. HCFA indicated that it was not adopting “limited 

follow up” visits in the final rule because of the difficulty of 

matching the costs for the follow-up services with the primary 

encounter. 

The most comprehensive alternative was to bundle all care provided 

into a single “episode of care” payment. This alternative was mentioned 

in the HHS reports to Congress as a way to provide incentives for 

efficient delivery of care comparable to the DRG payments for inpatient 

care. It was the most complex and resource intensive of the 

alternatives to analyze since it would involve multiple providers and 

require substantial database development and analysis. Creating 

episodes of care for surgical encounters (the day of surgery plus preand post- surgery windows) was suggested as more feasible than medical 

encounters and consistent with global billing policies for physician 

services (Miller and Sulvetta 1995). Other than a cataract 

demonstration that combined all pre-and post-surgical facility and 

physician services, further work was not initiated on constructing 

episodes of care. 
 - 38 – 

C. ESTABLISHING THE STANDARD PAYMENT RATE 

During the developmental stage of the OPPS, the issue of consistent 

payment methodologies and rates across ambulatory settings also received 

considerable attention. In the end, the BBA required that the OPPS 

payment parameters be based solely on hospital utilization and cost 

data. This decision was largely driven by available cost data and need 

for additional research before informed policy decisions could be made 

regarding appropriate payment differentials, if any, across ambulatory 

settings. 

The BBA required that the standard payment for a service be based a 

relative weight for the group of procedures (or procedure) multiplied by 

a conversion factor that has been adjusted for wage differentials and 

other factors needed to assure appropriate payment. The relative weight 

is a measure of the relative costliness of a group of procedures (or 

procedure) to a reference group of procedures. The BBA specified that 

the relative weights should be derived from median HOPD costs and that 

the conversion factor should result in aggregate payment levels that 

were budget neutral to aggregate payments for hospital outpatient 

services under the previous payment methodologies. 

Leveling the Playing Field 

In its 1995 report to Congress, HHS explored several alternatives 

for establishing the payment rates for the ambulatory surgical services, 

radiology and other diagnostic tests (those services that would 

initially be paid under the Secretary’s OPPS proposal). In addition to 

evaluating payments based solely on hospital costs, the report 

investigated alternatives that considered the fee schedule payment for 

facility services in other ambulatory settings: 

• The lesser of the hospital median cost for the procedures in the 

APC or a weighted average of the ASC facility fee or radiology 

technical component, as applicable; 

• A blend of the hospital cost-based and fee schedule amounts; 

and, 

• Fee schedule amounts for cataracts and plain film X-rays and 

hospital cost-based amounts for other services. 
 - 39 – 

The report recommended that the payment rates be based solely on 

hospital costs. A primary reason for the recommendation was that the 

hospital cost data were superior to the data used to set the payment 

rates for ASC facility services and the technical component of radiology 

services. After eliminating cataract surgeries, ASCs provided 1-2 

percent of the remaining ambulatory surgical procedures. The technical 

component of radiology procedures was charged-based rather than 

resource-based in 1995 and therefore was not as good a measure of cost 

as the hospital data. The report discussed potential expansion of the 

APG system to other ambulatory settings. It suggested that rates based 

solely on hospital costs were most appropriate until more information 

was available on comparative costs across ambulatory settings. There 

was an expectation was that results from studies examining differences 

in resource costs across ambulatory settings would inform future 

refinements and expansion of the OPPS. 

During the 1990’s, the Center for Health Policy Studies conducted 

several studies using resource-costing techniques to look at differences 

in the costs of selected procedures in different ambulatory settings. 

Resource costing identifies each component of a health care activity, 

the type and amount of resources used for each component, and attaches 

unit costs to each resource so that the cost of each component and the 

overall cost of the activity can be calculated. It is an expensive cost 

finding methodology, and the studies used small provider samples to 

explore the feasibility of using this methodology in the OPPS. The 

sample size limitations meant that the findings were suggestive but not 

definitive (see Appendix A). The methodology allows for actual cost 

comparisons by component (e.g., direct and indirect, salaries, drugs, 

etc.) for individual procedures independent of charging practices and is 

most feasible for high volume procedures. A major disadvantage is the 

large sample sizes needed to develop payment rates for infrequently 

performed procedures. A further limitation is that the methodology does 

not account for any differences in patient characteristics that might 

affect the resources required to perform the procedure and where it is 

performed. 
 - 40 – 

Establishing Relative Weights 

Most research on OPPS alternatives used estimated costs to 

determine the relative weights for procedure groupings. To calculate 

costs for services, only single-procedure bills were used. Claims that 

included more than one HCPCS code were excluded because it was not 

possible to specifically allocate charges or costs for packaged items 

and services to a particular procedure when more than one significant 

procedure or medical visit was billed on a claim. Costs were determined 

by applying departmental cost-to-charge ratios to the revenue center 

charges. Using charges instead of estimated costs to determine relative 

weights, as HCFA did for the DRG relative weights, was discarded as an 

alternative methodology early in the developmental stage when it was 

determined charges introduced more variation into the system and had 

distributional impacts. Researchers at 3M/HIS found that the cost-tocharge ratio in ancillary departments tended to be lower than other 

departments. Charge-based relative weights for ancillary services are 

higher than cost-based weights. They would increase payments to 

hospitals that deliver ancillary services as their primary outpatient 

services and decrease payments to hospitals whose primary services are 

clinic and emergency room visits. 

The cost-to-charge ratio methodology yielded an estimate of the 

accounting costs of providing various services. Work by the Center for 

Health Policy Studies found that hospital charges were not consistently 

related to resource costs and that lower charge procedures were more 

closely related to cost than higher charge procedures (i.e., the latter 

had higher markups). The researchers concluded that use of accounting 

cost-to-charge ratios to establish relative values would overpay 

expensive procedures and underpay inexpensive procedures. The 

researchers also found that hospitals had shifted accounting costs from 

inpatient services to outpatient services after the implementation of 

the inpatient PPS. This had implications for making comparisons across 

ambulatory settings using hospital accounting cost data. 

While relative weights based on resource costs were seen as a longterm policy goal, they were not feasible in the short-run (or in the 

long run for low-volume procedures). Reflecting current research and 
 - 41 – 

development activities related to the OPPS, the BBA required that the 

relative weights be derived from the median cost of the group of 

procedures (or procedure). The BBRA allowed the relative weights to be 

based on either median costs or mean costs. The final rule continued to 

use median costs to establish the relative weights. The cited advantage 

of using median costs was that it limited the extent to which 

infrequently performed services with suspect costs could affect the 

payment rate of an APC group. Evaluating the impact of using mean costs 

would have delayed issuing the final rule and implementation of the 

OPPS. Some commenters on the proposed rule expressed concern that the 

median failed to account for relatively high cost procedures within an 

APG and that the geometric mean would be a preferred way to account for 

these procedures. 

D. NEW TECHNOLOGY 

The issue of new technology received little attention during the 

development of the OPPS, other than a general acknowledgement that 

periodic evaluation of the APGs and recalibration of the relative 

weights would be needed to take into account new technology. The 

implications of the proposed OPPS for access to new and expensive 

technology was not explicitly addressed in the proposed policies for the 

new payment system. Appropriate payment for new technology and other 

high items has been a major issue since the implementation of the OPPS. 

Pass-through for Drugs, Devices and Biologicals 

The BBRA provided for transitional pass-through payments for 

certain drugs, pharmaceuticals, and biologicals. The proposed rule had 

packaged these items (except for cancer therapy drugs) in the APC 

payment for the service or procedure with which they were used.10 Under 

____________ 10 Under the pass-through provision, an additional payment was also to be 

made for current orphan drugs, current cancer therapy drugs, biologicals, and 

brachytherapy, and current radiopharmaceutical drugs and biological products. 

“Current” referred to those drugs and biologicals for which payment was made on 

the OPPS effective date and included the following: 1) orphan drugs; 2) cancer 

therapy drugs and biologicals, including chemotherapeutic agents, antiemetics, 

hematopoietic growth factors, colony stimulating factors, biological response 

modifiers, bisphosphonates, and a device of brachytherapy (seeds); and, 3) 

radiopharmaceutical drugs and biological products. The pass-through for these 
 - 42 – 

the pass-through provision, an additional payment was to be made new or 

innovative medical devices, drugs or biologicals whose costs are “not 

insignificant” in relation to the APC payment for the group of services 

with which they are used and were not reflected in the cost data used to 

establish the relative weights. The BBRA limited the pass-through to 2-

3 years (until the new technology would be reflected in the cost data 

used to establish the relative weights). The BBRA required that for 

drugs and biologicals, the additional payment would be the difference 

between 95 percent of average wholesale price (AWP) and the portion of 

the OPPS rate associated with the pass-through items. The additional 

payment for devices would be the difference between a hospital’s charges 

adjusted to costs and the portion of the applicable hospital outpatient 

department fee schedule amount associated with the device. Aggregate 

pass-through payments were limited to not more than 2.5 percent of total 

outpatient PPS payments through 2003, and to not more than 2.0 percent 

thereafter. A pro-rata reduction was to apply if HCFA prospectively 

determined that pass-through payments would otherwise exceed the 

aggregate cap. HCFA established interim requirements for new covered 

drugs, biologicals and devices to be eligible for the pass-through in 

the April 2000 interim final rule.11 These interim criteria, which were 

subject to comment, are summarized in Figure 3.1. In setting out its 

criteria for determining whether the cost of a new technology was 

significant, HCFA indicated an intent to reduce administrative burden by 

limiting the pass-through to those items that were significantly more 

costly and by excluding new technologies whose costs were not large 

enough relative to the APG payment amount to provide a disincentive for 

their use in the short term. Comments received during the rulemaking 

process ultimately led to policies that allowed more items to qualify 

for the pass-through payments. The most significant changes were to 

reduce the cost threshold for determining whether an items cost was “not 

insignificant” from 25 percent to 10 percent and to drop the requirement 

 

items has expired and the on-going provision for new drugs and devices is 

discussed in the body of this report. 

11 Drugs that can be self-administered are not covered under Part B of Medicare 

(with specific exemptions for certain oral chemotherapeutic agents and antiemetics, bloodclotting factors, immunosuppressives, and erythropoietin for dialysis patients).
 - 43 – 

that a device must remain with the patient when he or she is discharged 

from the HOPD. The latter change allowed pass-through payments for nonprosthetic devices that are temporarily inserted during an outpatient 

procedure (e.g., cardiac catheters and stents). Commenters recommended 

that a category-specific approach be used instead of an item-by-item 

approach to establishing eligibility for pass-through payments. They 

argued that this would allow additional payments to start as soon as the 

FDA approved a new device and lessen the competitive disadvantages for 

new devices. HCFA did not agree with this alternative. The agency 

indicated in its response that the item-by-item approach provided better 

information on the cost and use of particular new devices, permitted 

finer discrimination in the pass-through decisions, and gave new devices 

the full period for pass-through status. (The Beneficiary Improvement 

and Protection Act of 2000 subsequently required that pass-through 

eligibility be determined by categories of new devices). Some 

commenters also suggested that the more expansive definition of a device 

in the Federal Food, Drug and Cosmetic Act be used. This definition, 

which would have included some items that are treated as supplies, 

reusable items, or capital equipment by the Medicare payment systems, 

was not adopted. 

APCs for New Technology Services 

Many commenters on the 1998 proposed rule implementing the OPPS 

expressed concern about the inadequate recognition of new technology. 

The April 2000 interim final rule provided special treatment for new 

technology that did not qualify for a pass-through. The rule 

established separate APC groups to which HCFA could temporarily classify 

new technology services while it gathered additional data and gained 

pricing experience. There were 15 new technology groups with a payment 

range from about $25 in the lowest cost group to about $5,500 in the 

highest cost group. In contrast to other APC groups, the new technology 

APC groups include services that are similar only with respect to costs 

and may not be clinically similar. As with the pass-through payments, a 

qualifying new technology service would be eligible for the special 

payment for at least two years, but not more than three.
 - 44 – 

Figure 3.1——Criteria Used in the April 2000 Interim Final Rule for the 

New Technology Pass-Through 

Quarterly Updates to Recognize New Technology 

In the April 2000 rule, HCFA also stated its intention to reflect 

new technology “on an ongoing basis as expeditiously as our systems 

permit.” Due to claims processing systems requirements, however, the 

agency indicated it would make changes only at the beginning of a 

calendar quarter and projected that its process and systems requirements 

would impose a time-lag of at least six months and perhaps as long as 

nine months before a new technology was actually recognized in a payment 

change. 

• The item was not paid as an outpatient service prior to January 1, 1997(and 

therefore was not reflected in the cost data used for rate-setting).

• A cost for the drug or device was significant relative to the APC if all of 

the following criteria are met: 

(1) the expected reasonable cost of the new drug, biological, or device 

exceeds 25 percent of the applicable fee schedule amount for the 

associated service; 

(2) its expected reasonable cost exceeds the portion of the fee schedule 

amount determined to be associated with the drug, biological, or device 

by 25 percent; and 

(3) the difference between the expected reasonable cost of the item and the 

portion of the hospital outpatient department fee schedule amount 

determined to be associated with the item exceeds 10 percent of the 

applicable hospital outpatient department fee schedule amount. 

• A determination must be made that the item is reasonable and necessary for the 

diagnosis or treatment of an illness or injury or to improve the functioning 

of a malformed body member.

• In addition, a qualifying device must be an integral and subordinate part of 

the procedure performed, used for one patient only, surgically implanted or 

inserted, and remain with that patient after the patient is released from the 

hospital outpatient department. It could not be: 

(1) equipment, instruments, apparatuses, implements, or such items for 

which depreciation and financing expenses are recovered as depreciable 

assets; 

(2) materials and supplies such as sutures, clips, or customized surgical 

kits furnished incident to a service or procedure; 

(3) materials such as biologicals or synthetics that may be used to 

replace human skin. 

• The amount of the applicable fee schedule amount associated with the relevant 

drug, biological, or device would be determined on an item-by-item basis using 

hospital outpatient department claims data to the extent possible but external 
 - 45 – 

E. VOLUME CONTROLS 

A common theme among those involved with the design of the OPPS was 

that the system would not be able to control expenditure growth for 

hospital outpatient services unless the fee-for-service payment system 

were coupled with some type of volume controls. The 1995 HHS report 

discussed three ways to control volume expenditure growth but made no 

recommendation. The alternatives were: 

• Expand the volume performance standard (VPS) for physician 

services to include HOPD services. The rationale was that 

physicians rather than facilities largely drive HOPD volume. 

• Develop a VPS method that applied directly to OPD payments. The 

cited drawbacks to this approach was that it would unfairly 

penalize hospitals for physician-controlled volume and that 

setting the target would be complicated because of shifts in 

site of care. 

• Expand the physician VPS by adding a facility value for all 

ambulatory services and link it to all ambulatory facility 

payments. This approach was seen as more closely aligning 

physician and facility incentives but also potentially unfairly 

affecting certain providers for growth in other types of 

services (unless there was policy discretion in how the standard 

was applied). 

The ProPAC analysis of the HHS proposal also stressed the 

importance of controlling volume and reviewed several alternatives. The 

Commission had previously recommended including hospital outpatient 

services in the physician VPS to the same extent they would be if they 

were furnished in physician offices. (This would generally be the 

technical component of referred laboratory and radiology services under 

the HHS two-stage approach for OPPS). ProPAC recommended that HHS 

consider both methods that rely on financial incentives, such as volume 

performance standards and capitation payment, and administrative 

controls such as utilization review and practice guidelines. With 

respect to expenditure targets, ProPAC made several points but no 

recommendations: 
 - 46 – 

• The risk pool for the expenditure target could be hospitals 

only, all providers of ambulatory services, or physicians who 

order the services. Establishing an expenditure control 

specific to HOPD services might create an incentive to shift 

services to other ambulatory care settings. Putting physicians 

at risk would be a more powerful incentive. 

• The larger the risk pool, the weaker the incentives to control 

expenditures. The physician VPS was designed to provide a 

collective incentive to control volume through, for example, 

educational programs. Reductions in the size of the risk pool 

by geographic region or physician specialty had been suggested 

but raised several issues: 

o It could change the distribution of Medicare payments 

among geographic regions and could ultimately lead to 

payment rates that are increasingly unrelated to resource 

costs of producing identical services. 

o It would be difficult to set meaningful expenditure 

targets for smaller pools. 

The BBA required that the Secretary develop a method for 

controlling unnecessary increases in service and provided for an 

adjustment to the update to the conversion factor if the Secretary 

determined that the volume of services has increased beyond amounts 

established through the methodology. The 1998 proposed rule provided 

for a sustainable growth rate (SGR)-like approach for 2000 only based 

solely on OPD services that took into account inflation, changes in Part 

B fee-for-service enrollment, and an allowance for increases in service 

intensity and new technology. The rule indicated that a method for 

determining expenditure targets in the future would be proposed after 

further study. While this was deemed the most feasible approach in the 

short term, the proposed rule indicated that a more integrated approach 

that also addressed ASCs and physicians would be preferable but might 

require statutory changes. Commenters objected to the proposed volume 

control measure, arguing that it would not be a reliable way to 

distinguish the growth of necessary from unnecessary services, could 
 - 47 – 

penalize hospitals for increases attributable to technological changes 

that shift service delivery from inpatient to outpatient settings, and 

could reduce payments to an inadequate level that adversely affects 

access to care. Another objection was that expenditure caps should 

affect the physicians who order and control services instead of 

hospitals. HCFA dropped the proposal in the final rule.

 - 49 – 

4. IMPLICATIONS FOR REFINING THE CURRENT OPPS 

Many policy decisions affecting the initial design of the OPPS were 

influenced in the short run by what was feasible technically and 

acceptable to the policy process. The beneficiary coinsurance issue 

created an impetus for establishing an OPPS as soon as possible. 

Adopting policies that were technically feasible to implement in the 

short-run and which would not require protracted policy development and 

debate became overriding considerations in the initial PPS design. 

Articulated policy goals that were deferred as implementation became the 

overriding concern were: 

• Creating financial incentives for the efficient use of 

ambulatory services through extensive ancillary packaging and 

comprehensive bundling policies; 

• Establishing consistent payment policies across ambulatory 

settings; and, 

• Controlling aggregate expenditures for hospital outpatient 

services. 

The complexities of ambulatory care made progress on the 

prerequisite research and policy development for these goals problematic 

during the development of the initial OPPS. These complexities remain. 

Care is provided in multiple ambulatory settings, patients seek the same 

ancillary and medical services for different reasons, and an episode of 

care is difficult to define. Differences in patient characteristics, 

services and cost structures across ambulatory settings are still not 

well understood. 

The perceived advantages and disadvantages of alternative policies 

that were considered when OPPS was initially implemented generally 

remain relevant. However, as the OPPS has evolved, the accuracy of the 

payment rate for services furnished to particular patients has become an 

increasingly important policy objective and has overridden some of the 

other goals that were considered important when the payment system was 

implemented. The “averaging” concept that underlies the inpatient PPS 
 - 50 – 

and the initial OPPS-construct has eroded as OPPS payments have become 

increasingly less packaged and the procedure groupings have narrowed. 

Arguably, unpackaging further increases the importance of payment 

accuracy since there is increasingly less room within the payment to 

offset higher costs for some items and services with lower costs (or no 

usage) for others. As a result, goals such as administrative simplicity 

and financial incentives for efficient use of ancillary services have 

assumed less importance. At the same time, the OPPS payment policies 

increasingly resemble those for other ambulatory settings. Indeed, the 

more fee schedule-like appearance of the OPPS rates coupled with other 

developments——such as growth of ASC services, implementation of the 

resource-based practice expense component of the physician fee schedule, 

improved coding on HOPD claims——might facilitate progress on 

rationalizing the payment systems across ambulatory settings. However, 

more current research on differences in resource costs for high volume 

procedures should be considered as part of this initiative. In using 

accounting costs to set the APC relative weights, the OPPS depends on 

hospital charges being consistently related to costs. Hospital charges 

have increased rapidly relative to costs and there is evidence of 

substantial differences in hospital markups across hospitals and by type 

of service. Current hospital charging practices, which are largely 

driven by arrangements with payers, challenge more than ever the 

assumption that accounting costs accurately reflect a hospital’s costs 

for specific items and services. 

Several issues that have created considerable policy debate during 

the post-implementation stage——new technology, devices and expensive 

drugs——received minimal attention in the initial PPS development. There 

are probably several reasons for this: 

• HCPCS codes were only being used for chemotherapy drugs, which 

were known to have substantial cost variation. Other expensive 

drugs could not be readily identified and their costs evaluated. 

• Devices were paid under the DMEPOS fee schedule so issues such 

as cost variation and differential markups were not considered 

or evaluated for these items. 
 - 51 – 

The rapid technological advances that were affecting the shift of 

services to the outpatient setting and the provision of expensive new 

technology were not appreciated. As a result, the timeliness of 

recognizing high cost new technology was not an issue during the design 

phase. 

One implication is that there is little information on alternatives 

that were considered for new technology. After the proposed rule was 

issued, policy development for new technology proceeded on two tracks. 

The BBRA provided for transitional pass-through payments for high cost 

new drugs and devices. HCFA proceeded to develop the new technology 

APCs and elected to keep them in the final rule. It is not clear that 

both policies are needed. The new technology APCs (expanded to include 

services that qualify for the transitional pass-through) might be 

preferable since they involve less administrative burden by keeping all 

services on a prospectively determined rate. 

The reports produced by HHS and MedPAC envisioned that work would 

proceed towards the longer-term policy goals after the initial PPS was 

implemented. That is, the payment system would evolve to include more 

packaging and to expand to other ambulatory settings. However, other 

priorities and the resource demands imposed by the current system and 

continuing legislative changes interfered with research and policy 

development activities on the longer-term goals. When the OPPS is 

viewed independently, the individuals who were interviewed for this 

study seemed to believe that the OPPS payment system for the most part 

was maturing and stabilizing. However, when OPPS is considered within 

the broader context of ambulatory care payment, the goals of 

rationalizing the payment systems across ambulatory settings and using 

financial incentives to control aggregate ambulatory expenditures remain 

important but unrealized. 

 - 53 - 

APPENDIX A: KEY DOCUMENTS IN OPPS DEVELOPMENT 

I. LEGISLATIVE PROVISIONS IMPACTING DEVELOPMENT AND IMPLEMENTATION OF 

OPPS 

a. Omnibus Budget Reconciliation Act of 1986 (P.L. 99-509) 

Section 9343(f): Payments for Ambulatory Surgery: Development of a 

Prospective Payment Methodology for Hospital Outpatient Services

PPS for Ambulatory Surgical Procedures 

Requires a fully prospective payment system for ambulatory surgical 

procedures performed on hospital outpatients. The system to the extent 

practicable shall provide for an all-inclusive payment rate that 

encompasses payment for facility services and all medical and other 

health services, other than physician services, that are commonly 

furnished in connection with the procedure. The system shall provide for 

appropriate payment rates that take into account: 

• The costs of hospitals providing ambulatory surgical procedures; 

• The costs to Medicare (i.e., payments) for such procedures performed 

in ambulatory surgical centers (ASCs); 

• The extent to which any differences in costs are justified. 

Reports 

• Requires an interim report to Congress on the development of the 

system by April 1, 1988. 

• Requires a final report to Congress by April 1, 1989 that includes 

recommendations for implementation. 

Comprehensive OPPS 

Requires the Secretary to develop a model payment system for other 

hospital outpatient services and to submit a report to Congress by 

January 1, 1991. 
 - 54 – 

b. Omnibus Budget Reconciliation Act of 1987 

Section 4068(b): Development of a Prospective Payment Methodology 

for Hospital Outpatient Services

Amends the OBRA-86 provisions to require that the Secretary: 

• Consider whether a differential payment rate is appropriate for 

specialty hospitals; and, 

• Solicit the views of the Prospective Payment Assessment Commission in 

developing the proposals for a prospective payment system for 

hospital outpatient surgical services and for a comprehensive OPPS. 

c. Omnibus Budget Reconciliation Act of 1990 (Public Law 101-508) 

Section 4151 (b)(2): Payments for Hospital Outpatient Services: 

Development of a Proposal 

Requires the Secretary of HHS to develop a proposal to pay for 

hospital outpatient services on the basis of prospectively determined 

rates. In developing the proposal, the Secretary is to consider: 

• The need to provide for appropriate limits on increases in 

expenditures under the Medicare program; 

• The need to adjust prospectively determined rates to account for 

changes in a hospital's outpatient case mix, severity of illness of 

patients, volume of cases, and the development of new technologies 

and standards of medical practice; 

• Providing hospitals with incentives to control the costs of providing 

outpatient services; 

• The feasibility and appropriateness of including payment for 

outpatient services not currently paid on a cost-related basis under 

the Medicare program (including clinical diagnostic laboratory tests 

and dialysis services) in the system; 

• The need to increase payments under the system to hospitals that 

treat a disproportionate share of low-income patients, teaching 

hospitals, and hospitals located in geographic areas with high wages 

and wage-related costs; 
 - 55 – 

• The feasibility and appropriateness of bundling services into larger 

units, such as episodes or visits, in establishing the basic unit for 

making payments under the system; and 

• The feasibility and appropriateness of varying payments under the 

system on the basis of whether services are provided in a 

freestanding or hospital-based facility. 

Reports 

• The Administrator of the Health Care Financing Administration is 

required to submit research findings relating to prospective payments 

for hospital outpatient services to the Congress by January 1, 1991. 

• The Secretary of HHS is required to submit the OPPS proposal to 

Congress by September 1, 1991. 

• The Prospective Payment Assessment Commission is required to submit 

an analysis of and comments on the Secretary’s proposal by March 1, 

1992. 

d. Balanced Budget Act of 1997 

Section 4523: Prospective Payment System for Hospital Outpatient 

Department Services 

Establishes a prospective payment system (OPPS) for hospital 

outpatient department (HOPD) services effective January 1, 1999. The 

services included under the OPPS will be (1) OPD services designated by 

the Secretary (but not including therapy services and ambulance 

services), and (2) services covered under part B that are provided to 

hospital inpatients who have exhausted Part A benefits or are not 

entitled to Part A. 

OPPS Requirements 

• The Secretary will develop a classification system consisting of 

groups of services so that services within each group are comparable 

clinically and with respect to the use of resources. 

• The Secretary will establish relative payment weights for each group 

based on median hospital costs and estimated frequencies of 

utilization of services in 1999. 
 - 56 – 

• The Secretary will also establish a wage adjustment factor as well as 

other adjustments determined to be necessary to ensure equitable 

payments, such as outlier adjustments or adjustments for certain 

classes of hospitals. 

• The Secretary may periodically review and revise the groups, the 

relative payment weights, and the wage and other adjustments to take 

into account changes in medical practice, changes in technology, the 

addition of new services, new cost data, and other relevant 

information and factors. Such adjustments must be made in a budget 

neutral fashion 

Calculation of OPPS Fee Schedule Amounts 

• The Secretary will estimate the sum of (1) the total amount that 

would otherwise be paid by Medicare for OPD services in 1999, and (2) 

the total amount of co-payments that are estimated to be paid under 

the OPPS (see below). 

• A conversion factor will be used to convert the weights into fee 

schedule amounts. This conversion factor will be calculated in a 

manner so that the sum of the products of the fee schedule amounts 

and the frequencies equals the aggregate sum of Medicare payments and 

co-payments estimated above. 

• For each group, the OPD fee schedule amount will equal the conversion 

factor multiplied by the weight. 

• In future years, the conversion factor will be updated by the 

hospital market basket (except that for 2000-2002, the update will be 

equal to the hospital market basket reduced by 1 percentage point) 

Calculation of Co-payment Amounts 

• An "unadjusted co-payment amount" will be established for each OPD 

group based on 20 percent of the national median of the charges for 

services in the group furnished during 1996, and updated to 1999 

using the Secretary's estimate of charge growth. If the unadjusted 

co-payment amount results in an amount that is less than 20 percent 

of the OPD fee schedule amount, then the co-payment amount will be 

established to be 20 percent of the OPD fee schedule amount. 
 - 57 – 

• A pre-deductible payment percentage will be calculated for each group 

in each year. It will be equal to the ratio of (I) the OPD fee 

schedule amount minus the unadjusted co-payment amount to (II) the 

OPD fee schedule amount. 

• To determine payment for a particular group in a particular area: 

(1)The OPD fee schedule amount for the group will be adjusted by the 

wage adjustment factor and other factors determined to he 

necessary by the Secretary; 

(2)The Medicare portion of the OPD fee schedule amount will be equal 

to the adjusted OPD fee schedule amount multiplied by the predeductible payment percentage; 

(3)The amount of beneficiary co-payment will be equal to the adjusted 

OPD fee schedule amount in (1) minus the Medicare portion of the 

payment calculated in (2). 

• In each year, the unadjusted co-payment amount remains unchanged. 

The pre-deductible payment percentage and the Medicare payment, 

however, will continue to be calculated in the same manner so that 

Medicare assumes a larger portion of the total OPD fee schedule 

amount each year. 

• At the point in time when the co-payment amount for a group equals 20 

percent of the OPD fee schedule amount, the co-payment amount will be 

maintained each year at 20 percent of the fee schedule. 

• The Secretary is required to establish a procedure whereby a hospital 

could elect to reduce the co-payment amount for some or all OPD 

services to a lower amount (but not less than 20 percent of the fee 

schedule amount). 

Other Provisions 

• Volume Adjustment. The Secretary is required to develop a method for 

controlling unnecessary increases in the volume of services. If the 

Secretary determines under such a methodology that the volume of 

services has increased beyond amounts established through such 

methodology, the Secretary may adjust the update to the conversion 

factor. 
 - 58 – 

• Cancer Hospitals. The PPS for OPD services shall not apply to cancer 

hospitals until January 1, 2000. The Secretary may establish a 

separate conversion factor for their services that specifically takes 

into account the unique costs incurred by them by virtue of their 

patient population and service intensity. 

• Limitation on Review. There shall be no administrative or judicial 

review of the development of the classification system, wage 

adjustment factors, other adjustments, and volume performance 

methodologies, the calculation of base amounts, periodic adjustments, 

and the establishment of a separate conversion factor for cancer 

hospitals. 

e. Balanced Budget Refinement Act of 1999 

Section 201. Outlier Adjustment and Transitional Pass-Through for 

Certain Medical Devices, Drugs, and Biologicals.

Outlier Adjustment 

• Requires an additional payment for each covered OPD service (or 

group of services) for which a hospital's charges, adjusted to 

cost, exceed (i) a fixed multiple of the sum of the applicable fee 

schedule amount and (ii) any transitional pass-through payment and 

(iii) any such fixed dollar amount as the Secretary may establish. 

• The amount of the additional payment shall approximate the 

marginal cost of care beyond the applicable cutoff point. 

• The total additional payments may not exceed 2.5% of total 

aggregate payments for a year before 2004 and 3.0% beginning in 

2004. 

• For services furnished before 2002, the additional payments may be 

determined on a bill basis rather than for a specific group of 

services and may use an overall cost-to-charge ratio rather than 

ratios for specific hospital departments. 

Transitional Pass-Through for Additional Costs of Innovative 

Medical Devices, Drugs, and Biologicals. 
 - 59 – 

Requires an additional payment for current orphan drugs, current 

cancer therapy drugs and biologicals and brachytherapy, current 

radiopharmaceutical drugs and biological products, and new medical 

devices, drugs, and biologicals if: 

• Payment for the device, drug or biological was not being made as a 

outpatient hospital service as of December 31, 1996 and 

• The cost of the item is not insignificant. 

The payment applies for 2-3 years beginning the later of the 

effective date of the provision or the date payment is first made for 

the new medical devices, drug or biological. It shall be based the 

difference between the cost (or 95 % of the average wholesale price, in 

the case of drugs) for the service and the portion of the OPD payment 

that is associated with the service. Total aggregate payments for the 

transitional pass-through shall not exceed 2.5 percent for a year before 

2004 and 2.0 percent in 2004 and thereafter. The additional payments 

will be budget neutral and a uniform pro rata reduction is to be made if 

the estimated payments would otherwise exceed the aggregate limit. 

Inclusion of Certain Implantable Items Under System 

Requires that implantable items be included in the OPPS and 

classified to the group that includes the service to which an item 

relates. 

Classification Groups and Relative Weights 

• Authorizes the weights to be based on either median or mean hospital 

costs. 

• Limits the variation within a group so that the highest median cost 

(or mean cost) for an item or service in the group is no more than 

two times the lowest median cost (or mean cost). The Secretary may 

make exceptions in unusual cases, such as low volume items. 

• Requires consultation with an expert outside advisory panel composed 

of an appropriate selection of representatives of providers to review 

and advise the Secretary concerning the clinical integrity of the 
 - 60 – 

groups and weights. The panel may use data collected or developed by 

outside organizations in conducting the review. 

Annual Review of OPD PPS Components 

Requires review at least annually of the parameters used to 

establish the payment amounts. 

Sec. 202. Establishing a Transitional Corridor for Application of OPD 

PPS.

Sec. 203. Study and Report to Congress Regarding the Special 

Treatment of Rural and Cancer Hospitals in Prospective Payment System 

for Hospital Outpatient Department Services.
 - 61 – 

II. MAJOR RESEARCH REPORTS RELATED TO THE DESIGN OF OPPS 

a. Averill, Richard, Norbert Goldfield, Laurence Gregg, Thelma Grant 

and Boris Shafir, Design and Evaluation of a Prospective Payment 

System for Hospital Based Outpatient Care, 3M Health Information 

Systems, 1995 (HCFA Cooperative Agreement 17-C-90057/5-01). 

The study presented the results from the development of the 

Ambulatory Payment Groupings (Version 2.0) and simulation of various 

policy options. Version 2.0 had 290 APGs: 139 procedure APGs, 83 medical 

APGs (based on body system and diagnosis), 2 incidental APGs and 8 error 

APGs. The simulations examined 5 components of the payment system: 

• Basis of the payment weights. The study found that cost-based and 

charge-based weights explained the same amount of cost variation. 

However, hospital mark-ups vary considerably across hospital 

departments and that the choice of charge-based versus cost-based 

weights had distributional implications. Charge-based relative 

weights for ancillary services are higher than cost-based weights 

and would increase payments to hospitals that deliver ancillary 

services as their primary outpatient services and decrease 

payments to hospitals whose primary services are clinic and 

emergency room visits. 

• Ancillary packaging. The report found that the amount of packaging 

affected the amount of cost variation explained by the APGs . The 

report examined three packaging options that always packaged 

medical supplies and drugs other than chemotherapy and incidental 

services. 

o A limited packaging option only packaged anesthesia 

services. 

o The simple packaging option added simple ancillary tests to 

the packaging option. 

o The full packaging option added some additional frequently 

performed ancillary services and some minor medical 

services. 

An all-inclusive packaging option was not examined because it put 

providers at risk for high-cost infrequently performed ancillary 
 - 62 – 

services. Simple and full packaging explained about the same 

amount of cost variation.12 For medical claims, full packaging 

explained less cost variation than limited packaging.13 The lower 

amount of explained variation for medical claims was attributed to 

the combined effect of more variability in the use of ancillary 

services in medical encounters and the higher percentage of costs 

attributable to ancillary services. The report recommended that 

full packaging be used because of the incentives it would create 

for efficient use of ancillary services. The impact analysis 

indicated that there would be some redistribution impacts across 

classes of hospitals, with teaching hospitals with resident-to-bed 

ratios > .25 gaining 3.3% in payments relative to a limited 

packaging option. Medicare dependent small rural hospitals and 

sole community hospitals would have gained 1.8 % and .7% 

respectively, but rural referral centers would have lost .7% 

relative to the limited packaging option. 

• Outlier policy. The report examined three outlier payment options: 

no outlier set-aside, one percent of total payments set-aside for 

outliers, and a three percent set-aside. There was a small 

reduction in the amount of cost variation explained in moving from 

3% to 1% outlier payments but a large reduction for medical claims 

if outliers were eliminated entirely.14 The distributional impacts 

of the different policies across hospitals were minimal. The 

report recommended a one percent set aside. 

• Ancillary discounting. The report examined the impact of a 20 

percent discounting where there are multiple ancillaries in the 

same APG. (Discounting when there were multiple significant 

procedures was assumed throughout, i.e., the highest value 

significant procedure was paid at 100 percent and the remainder at 

50 percent). The ancillary discounting had minimal effect on the 

____________ 12 The R2

 was .757 for full or simple packaging vs. .773 for limited 

packaging. 

13 The R2 was .588 for full packaging vs. .745 for limited packaging. 

14 The R2 for the medical visit APGs was .804 , .439 and .745 using a 3%, 

1% and no outlier set aside, respectively. The R2 for all services was .823, 

.773, and .721 using a 3%, 1% and no outlier set aside, respectively. 
 - 63 – 

amount of cost variation explained by the APGs. Discounting of the 

ancillary services was not recommended because it would add 

administrative complexity with little benefit in payment accuracy. 

• Time period for bundling. The report examined same day, three day, 

and 7 day windows for packaging ancillary services. The percentage 

of APG cost from packaged ancillaries increased slightly as the 

time window expanded. The report concluded that although a broad 

time span would be desirable to preclude “gaming”, moving beyond 

same day services would impose a substantial administrative burden 

because the current billing form did not indicate the physician 

who ordered the ancillary service. 

The report also made recommendations for modifications to the claims 

(such as date of service reporting for services and requiring 

identification of the ordering physician). These were seen as important 

tools for monitoring and enabling potential expansion of the time frame 

for bundling. 

b. Sulvetta, Margaret, Lisa Dubay, Colin Flynn, John Holahan and Mark 

Miller, Prospective Payment for Medicare Outpatient Services: 

Final Report, Washington, DC: The Urban Institute, August 1992. 

The study was originally focused on outpatient surgery but was 

later expanded to encompass all hospital outpatient procedures. Other 

than the first task, which used 1985 data, 1987 claims data were used to 

investigate various issues that would need to be considered in designing 

a prospective payment system for hospital outpatient services. 

• Impact of casemix on outpatient surgery costs- Hospital case mix 

indices for outpatient surgery and other explanatory variables were 

regressed using the log of hospital costs for surgical procedures as 

the dependent variable. A surgery case mix index was highly 

significant, implying that a set of weights based on procedure codes 

could be used in a payment system. Other factors that help explain 

cost variation were wages, size (larger hospitals had lower costs 

than smaller hospitals) and specialization (hospitals that specialize 

have lower costs than hospitals that provide a wide range of 
 - 64 – 

procedures. Surgery costs were also lower in more competitive 

markets. 

• Packaging of ancillary services into surgery payment- Hospital bills 

for radiology and laboratory services were associated with high 

volume surgery procedures. Almost 60 percent of outpatient surgery 

claims had charges for ancillary services that accounted on average 

for 15% of the charges. Some patterns of ancillary usage were 

identified, both with respect to the surgeries that generally involve 

laboratory or radiology procedures and the types of radiology and the 

types of laboratory and radiology services associated with particular 

procedures. The researchers concluded that any packaging of ancillary 

services should be as an add-on for particular procedures, and that 

more expensive and less routinely performed ancillary services should 

be reimbursed separately. 

• Descriptive analysis of HOPD services- The analysis used single 

procedure code claims to look at patterns of usage, charges and 

costs. Finding that relatively few procedures drive Medicare HOPD 

spending, the researchers concluded that relatively few payment 

groups should be sufficient for an OPPS. Much of the volume and 

spending was for ancillary services, which suggested to the 

researchers that “bundling” should be considered since it offers some 

control over volume growth. Nevertheless, the researchers also found 

high variation around average costs and suggested that an outlier 

policy be considered. Rural and small hospitals had higher case-mix 

adjusted costs than other hospitals. The research also highlighted 

the issue of whether “referred” ancillary services (those services 

ordered by a community physician over which the hospital has little 

control) should be included in the OPPS and the implications that the 

site of service differential might have on where care is delivered. 

• Evaluation of alternatives for outpatient surgery- The study examined 

seven potential prospective payment classification systems for 

outpatient surgery in terms of appropriateness for the Medicare 

population, explained variance, stability, administrative complexity, 

and provider incentives: 
 - 65 – 

o Diagnosis-related Groups – 475 groups used to pay for Medicare 

inpatient hospital services based on principal and secondary 

diagnoses, surgical procedures, and age. 

o Ambulatory Visit Groups- 570 groups designed for use in 

physician offices that were formed by sorting primary 

diagnostic codes into 19 Major Ambulatory Diagnostic Categories 

which were further divided into medical clusters. 

o Products of Ambulatory Surgery- A 42-group classification 

developed by New York State for the Medicaid population that 

first classified patients into 18 major surgical categories 

which were further subdivided where appropriate based on 

whether the procedure was therapeutic, diagnostic, or 

reconstructive. 

o Ambulatory Surgical Center (ASC) payment groups- Groupings of 

procedures based on estimated costs developed by HCFA to pay 

for approved surgical procedures in ASCs. A four-group, sixgroup- and eight-group system was evaluated. 

o Ambulatory Surgical Center (ASC) methodology-ASC grouping 

methodology expanded to include all HOPD surgical procedures 

regardless of whether they were on the ASC list of approved 

procedures. 

o Charge-based decile system- Ten groups of procedures developed 

by Urban Institute using arrayed average procedure-level 

charges, which each grouping containing about 10 percent of all 

procedures. 

o Type of Service system- Developed by Urban Institute to 

classify CPT-4 services into types of service. Only the 

classification for surgical procedures was evaluated with eye 

procedures disaggregated into cataract and other eye 

procedures. 

In examining how well the potential classification systems 

explained cost or charge variation, the R-square ranged from .43 for 

the Type of Service system to .65 for the decile system. The AVGs, 

ASC methodology and charge-based decile systems performed nearly 

equally, and were superior to the remaining systems. The DRG, PAS and 
 - 66 – 

ASC were next and tightly clustered with an R-square range of .53-

.56. Each of the systems had high coefficients of variation in grouplevel charges in many of its groups, which the researchers attributed 

to charge variation at the procedure level as well as group level. 

The DRGs and AVGs were judged inferior because using diagnosis as the 

first logic for grouping does not provide unique group assignments 

for a given procedure code and were judged to have too many groups 

with low volumes of claims. The ASC payment groups were rejected 

because they contained less than half of all outpatient procedures. 

Using subjective criteria, the researchers concluded that the 

Products of Ambulatory System and the Type of Service systems held 

the most promise. They were administratively simple, held less 

opportunity for gaming than the decile or ASC methodology, 

incorporated some measure of case complexity, covered the full range 

of outpatient services, and should be transportable to other 

ambulatory settings. 

• Econometric Analysis of HOPD Services – The study developed chargebased and cost-based relative weights for high volume OPD services at 

the procedure code level and “catch-all” groupings for the remaining 

procedures. Much of the variation in average costs among hospitals 

was found to be attributable to case-mix, with no class of hospitals 

more than 6 percent above or below the national average. Using 

charges introduced more variability into the system. Small and rural 

hospitals had higher costs than other hospitals, with sole community 

hospitals 5 percent above average. Teaching was significant and 

positive for all services but disproportionate share hospitals had 

lower than average costs. 

• Comparing ASCs and HOPDs- The analysis simulated what payments would 

be if the ASC payment rates were used to pay for HOPD surgery. The 

researchers found that ASCs and HOPDs perform different types of 

surgery, that HOPDs perform a broader range of surgeries, and that 

using the ASC payment rates would reduce aggregate payments to 

hospitals by 15 percent but that there was variation by body system 

regarding which setting had lower payments and payments for low cost 

procedures would increase. 
 - 67 – 

• Evaluating APGs- Version 1.0 of the groupings developed by 3M/HIS 

were evaluated and found to effectively classify outpatient claims 

and to explain more variation that the other systems that were 

examined. The latter would be expected since there can be multiple 

APGs per claim whereas the other systems used one group per claim. 

The researchers suggested that the APCs raised three areas of 

concern:

o The complexity of the collapsing of codes through 

consolidation, packaging and discounting obscures the 

incentives to provide cost-effective care. 

o The bundles could create incentives to provide multiple 

visits. 

o Implementing the APCs for HOPD services only could create 

incentives to shift site of service. 

c. Miller, Henry, Brian Balicki, and Maureen Nuschke, Replication of 

1982 Study of Resource Costs in 25 Hospitals, Final Report, Center 

for Health Policy Studies. Contract No. DHHS-100-88-0038. April 6, 

1990. 

The study replicated an earlier resource costing study in 25 

hospitals to assess the impact that the inpatient PPS had on hospital 

costs, productivity and accounting practices. It also included a study 

of ambulatory surgery in hospitals and freestanding centers. Hospitals 

were found to overstate outpatient clinic costs at a more substantial 

rate than previously, primarily because of increased indirect cost 

allocations. The researchers concluded that differences between resource 

costs and reported accounting costs varied so greatly that a uniform 

reduction (such as the 5.8% that was later implemented for the Medicare 

program) would not result in accurate payment levels. Neither charges 

nor reported costs were seen as an appropriate way to establish 

outpatient prices. 

Hospital costs were lower than ASC costs. The researchers 

identified two reasons for this: higher productivity (staff handle more 

cases and space is used more productively) and procedure volume. The 
 - 68 – 

ASCs were operating at less than full capacity and were not able to 

achieve the same economies of scale as hospitals. 

d. Miller, Henry, William Kelly, Horen Boyagian, John McCue and JoAnna 

Burnette, Outpatient Resource Costing Final Report, Center for 

Health Policy Studies, August 7, 1995. 

The purpose of the study was to examine the feasibility of resource 

or micro-costing as a method of identifying the costs of specific health 

services in HOPD, ASCs, and physician offices. This method identifies 

the component of a health care activity, the type and amount of 

resources used for each component, and attaches unit costs to each 

resource so that the cost of each component and the overall cost of the 

activity can be calculated. High volume procedures within APGs for 

surgical, radiology, laboratory and medical visits were selected for 

study. The study involved a random sample of 35 hospitals and 32 ASCs 

and a convenience sample of 25 physicians’ offices. 

Indirect costs. The researchers found that indirect costs comprised 

a larger portion of total costs in ASCs (52%) than in HOPDs (42%). 

Indirect costs are spread over a lower volume of procedures in ASCs and 

many hospitals consider ambulatory surgery as a joint product with 

inpatient surgery and are able to realize more efficiencies with 

indirect costs. Indirect costs also had less impact on hospital 

radiology costs relative to physician offices. 

Direct costs. Little differences in direct costs between ASCs and 

HOPDs were identified for surgical procedures. There were no substantial 

differences in nursing salaries or fringe benefits. Differences in the 

costs of IOLs were identified that were due only in part to volume but 

not fully understood. The researchers concluded that there were no 

reasons why costs would vary systematically since the both perform the 

actual procedures similarly. 

Physician offices appeared to be the least costly of all settings 

but the small sample size did not provide sufficient confidence levels 

to support the conclusion for most procedures. Lower costs were 

consistently tied to the use of fewer and often lower salaried staff to 

perform supportive services. Physicians also have less equipment and 
 - 69 – 

overhead costs. Surgical procedures performed in a physician’s office 

(such as excision) were more costly when performed in an ASC or HOPD, 

which the researchers attributed to patterns of care in non- physician 

office settings, such as two nurses in the operating room and facility 

protocols for recovery from surgery. 

Volume. No consistent relationship between volume and either 

direct or indirect costs was found. 

Multiple procedures. Three combinations of surgical procedures were 

examined. The results suggested that the cost of performing a second 

surgical procedure was about 30 percent of the costs of performing it 

separately- but were not definitive given the small sample sizes. 

Hospital markups. Hospital charges did not display a consistent 

relationship to resource costs. Lower charge procedures were more 

closely related to cost than higher charge procedures (i.e., the latter 

had higher markups). The researchers conclude that use of accounting 

cost-to-charge ratios to establish relative values will overpay 

expensive procedures and underpay inexpensive procedures. 

Sample size. The small sample precluded establishing confidence 

levels for infrequently performed procedures. However, the researchers 

suggested that to have an adequate sample for these procedures a far 

larger study would be required and that modest expansions in sample size 

would not be sufficient. 

 - 71 – 

III. REPORTS TO CONGRESS ON DESIGN AND IMPLEMENTATION OF OPPS 

a. Reports submitted by the Secretary of Health and Human Services 

Interim Report to Congress: Development of Prospective Payment 

Methodology for Outpatient Hospital Surgical Services. Submitted 

by Otis R. Bowen April 1988. 

This was an interim report that summarized differences in payment 

policies for ambulatory surgical procedures between ASCs and hospital 

outpatient departments, reviewed the OBRA-86 statutory provisions 

affecting payment for ambulatory surgery, and summarized both prior and 

on-going research examining issues related to the design of a 

prospective payment system for ASC services. The on-going research 

included: 

• New York Ambulatory Care Prospective Payment Project 

• Brandeis University evaluation of Ambulatory Visit Groups and DRGs 

(both developed by Yale University) for use in an OPPS for ambulatory 

surgical services; and, 

• Urban Institute examination of cost and utilization patterns to 

inform issues such as the classification system, bundling, and 

facility adjustments. 

Goals relevant to the development of the system and the issues that 

would need to be addressed were identified, but were not analyzed in any 

depth nor were any recommendations made. 

Medicare Hospital Outpatient Prospective Payment. Submitted by Donna 

Shalala on March 17, 1995. 

The report recommended that the OPPS be implemented in two phases, 

beginning with surgery, radiology, and other diagnostic tests using APGlike procedure groupings for the patient classification system and 

hospital cost data to set the relative weights. The report indicated 

that HCFA was ready to implement the system for the recommended 

services, and as further research was conducted, the system could evolve 

to include more extensive packaging of services and all HOPD services. 
 - 72 – 

The cited advantages of the APG system was that it covered the full 

range of HOPD services, was clinically based, reflected Medicare 

resource use, and could accommodate packaging. 

The report concluded that other payment classification systems were 

flawed: 

• Diagnosis-related groups (DRGs) were developed for inpatient use and 

were inappropriate for HOPD services. 

• The ambulatory surgical center (ASC) payment groups were not 

clinically based and covered about 2,300 of the 7,000 codes that can 

be used to HOPDs. 

• The Ambulatory Visit Groups (AVGs) contained more groups than 

necessary and were subject to manipulation since a procedure code can 

be assigned to different groups based on diagnosis. 

• The medical groups in the Products of Ambulatory Care and Surgery 

system were so broadly defined so that 80 percent of HOPD medical 

visits fall into only four groupings and do not explain cost 

variation well. 

The report also suggested that a payment system based on individual 

procedure codes would be problematic because hospitals could receive 

different payment amounts for similar procedures and would have an 

incentive to upcode. In addition, it would be difficult to set accurate 

rates for low-volume procedures. 

No recommendations were made regarding the extent of packaging, 

discounting of multiple procedures, classification of medical visits, or 

outlier policies. In addition, four general areas were identified as 

requiring additional research: defining the unit of payment (packaging), 

determining how well accounting costs reflect resource costs, examining 

use of APGs in other ambulatory settings, and accounting for legitimate 

cost differences across classes of hospitals. 

The report also discussed three ways to control volume expenditure 

growth: 

• Expand the volume performance standard (VPS) for physician services 

to include HOPD services since physicians rather than facilities 

largely drive HOPD volume. 
 - 73 – 

• Develop a VPS method that applied directly to HOPD payments. The 

cited drawbacks to this approach was that it would unfairly penalize 

hospitals for physician-controlled volume and that setting the target 

would be complicated because of shifts in site of care. 

• Expand the physician VPS by adding a facility value for all 

ambulatory services and link it to all ambulatory facility payments. 

This approach was seen as more closely aligning physician and 

facility incentives but also creating the potential for unfairly 

affecting certain providers for growth in other types of services 

(unless there was policy discretion in how the standard was applied). 

In addition to making recommendations on the OPPS, the report 

called attention to the beneficiary coinsurance issue and the formuladriven overpayment for service paid on the blended payment methodology. 

b. Report Submitted by the Prospective Payment Assessment Commission 

Pettengill, Julian, Green, Tim, Kelly, Dana, Lynch, Ann-Marie and Claire 

Sharda. Analysis of the Secretary's Proposal for Medicare Payment 

for Hospital Outpatient Services, Washington, DC: Prospective 

Payment Assessment Commission, July 1995 (C-95-01). 

ProPAC’s analysis of the HHS proposal identified three major 

concerns. First, ProPAC recommended against a phased implementation, 

arguing that it entail implementation costs without the benefits of 

administrative simplification, could create incentives to shift overhead 

costs to services that continued to be paid on a cost basis, and might 

make it more difficult to expand the system to other services. Second, 

ProPAC concluded that a prospective payment system based on fee-forservice payments should be accompanied by a strategy to control volume 

growth and recommended that the Secretary explore methods that would 

rely on payment incentives. Third, the Commission recommended that 

beneficiary coinsurance be set at 20 percent of the payment rate and 

that savings from the formula-driven overpayment be used to offset the 

cost to Medicare of reducing beneficiary coinsurance. The Commission 

recommended that the Congress require HHS to submit full specifications 

for a comprehensive OPPS as soon as possible. 
 - 74 – 

The report discussed design issues and alternatives but did not 

make specific recommendations. 
 - 75 – 

APPENDIX B: MATERIALS SENT TO INTERVIEWEES 

I. LETTER SENT TO POTENTIAL INTERVIEWEES 

Dear XXX , 

MedPAC is thinking about doing some analytical work on outpatient 

PPS and has asked me to interview individuals who were involved 

development of the initial payment systems to identify the various 

issues and alternatives that were considered when outpatient PPS was 

initially developed. Would you be willing to be interviewed? I 

anticipate it will take about 1-11/2 hours. 

The objective for the interviews is to identify the alternative 

approaches that were considered for payment of hospital outpatient 

services when the outpatient PPS was designed. I will be particularly 

interested in your perceptions of the most important issues and 

alternatives that were considered between the first mandate for a 

prospective payment system for hospital outpatient services (OBRA-86) 

and the implementation of the OPPS in August 2000. As part of our 

study, we will be identifying the strengths and weaknesses of the 

alternative approaches, the policy rationale for the final design of the 

initial PPS, and the relevance of both the alternatives and the policy 

considerations today. Any input you might have on the alternatives will 

be greatly appreciated. MedPAC has also asked us to see if you might 

still have any analyses that examined alternative policies during the 

developmental period that you would be willing to share. We already 

have collected some research reports, the reports to Congress and the 

rulemaking documents. 

I’ll be interested in understanding your role in the development of 

the outpatient PPS, the stages at which your involvement occurred, and 
 - 76 – 

the research and/or policy issues that you were involved in. These 

issues might have included: 

• Scope of the payment system, i.e., which services are covered by 

the payment system 

• Unit of payment (how big a bundle) 

• Classification system used to map specific services to payment 

categories (e.g., APCs, or ASC groupings) 

• Standard payment methodology 

• Method and data for setting rates 

• Aggregate payment level 

• Special issues (e.g., drugs, devices, rural hospitals, transition 

policies) 

If you’re like me, you may be rusty on the policy issues 4-6 years 

after your involvement in the implementation of OPPS and have attached a 

Centers of Medicare and Medicaid Services (CMS)-prepared fact sheet on 

the key provisions in the OPPS final rule as a reminder. 

I’m hoping to be able to schedule an interview with you within the 

next two weeks and hope that we will be able to find a convenient time 

for you. My Administrative Assistant, Kathryn Khamsi, will be 

contacting you to set up a time. Alternatively, she can be reached at 

703-413-1100, ext. 5169 or khamsi@rand.org. 

I’m looking forward to catching up with you and “reliving” some 

Medicare payment history. 

Barbara Wynn 

Senior Health Policy Researcher 

RAND Health 
 - 77 – 

II. LETTER ENCLOSURE: MEDICARE HOSPITAL OUTPATIENT SYSTEM 

Source: http://www.cms.hhs.gov/media/press/release.asp 

Fact Sheet 

For Immediate Release: Contact: 

Saturday, April 01, 2000 

CMS Office of Public Affairs 

202-690-6145 

For questions about Medicare please call 1-800-MEDICARE or 

visit www.medicare.gov. 

A new Medicare payment system for hospital outpatient services has 

been announced in a final regulation. The system is designed to ensure 

the program and its beneficiaries pay appropriately for services and to 

encourage more efficient delivery of care. 

The final regulation discusses the Health Care Financing 

Administration's implementation of the prospective payment system (PPS) 

enacted in the Balanced Budget Act of 1997. A proposed regulation 

discussing HCFA's proposal to implement the PPS was published on Sept. 

9, 1998. The final regulation was published in the Federal Register on 

April 7, 2000. HCFA expects to implement the new payment system on July 

1, 2000. 

Outpatient PPS will save beneficiaries billions of dollars in 

coinsurance over the next several years, while assuring more accurate 

and equitable payments under Medicare. Hospitals should find the PPS 

less complicated than the current system, with more predictable 

revenues. The new payment system also will encourage hospitals to 

become more efficient, while continuing to provide quality care for 

Medicare beneficiaries. 

Background 

Medicare payment for services performed in the hospital outpatient 

setting is now primarily cost-based. Hospitals are paid under a number 

of different payment methods, including fee schedules for diagnostic 

laboratory tests, and payments based on blends of hospital costs and the 
 - 78 – 

rates paid in other ambulatory settings or physician offices for certain 

procedures. For most other services, payments are based on costs. 

On average, beneficiary coinsurance now accounts for about 50 

percent of the total payments to hospitals for outpatient services. 

Beneficiary coinsurance is based on 20 percent of the hospital's billed 

charges for the outpatient services, while Medicare's payment for the 

same services is typically based on costs. 

The Balanced Budget Act of 1997 required HCFA to replace the costbased system with the PPS, which will pay hospitals specific 

predetermined payment rates for outpatient services. The law also 

changed the way beneficiary coinsurance is determined for services under 

the PPS. 

Generally, under the new PPS, coinsurance amounts will be based on 

20 percent of the national median charge billed by hospitals for the 

service. 

The Balanced Budget Refinement Act of 1999 (BBRA) also contained a 

number of major provisions affecting the hospital outpatient PPS. These 

changes, which have been incorporated in the regulation, help ensure a 

smoother transition to the new system for hospitals and establish 

special payments for new drugs and technologies. 

Overview of the Outpatient Hospital PPS

PPS will cover all Medicare participating hospitals, except 

critical access and Indian Health Service hospitals and hospitals in 

Maryland. (Indian Health Service hospitals will be excluded only 

temporarily and will eventually be paid under the PPS). Community 

Mental Health Centers (CMHCs) that provide partial hospitalization 

services to Medicare beneficiaries will also be paid under the PPS. In 

addition, antigens, vaccines, casts and splints furnished by home health 

agencies; antigens, splints and casts furnished by hospices; and 

vaccines furnished by comprehensive outpatient rehabilitation facilities 

will be paid under the PPS. 

The new PPS will include most hospital outpatient services and 

Medicare Part B services furnished to hospital inpatients who have no 

Part A coverage. A new fee schedule is being developed for ambulance 
 - 79 – 

services, which are excluded from PPS by law. HCFA will continue to use 

fee schedules to pay for physical, occupational, and speech therapies; 

durable medical equipment; clinical diagnostic laboratory services; and 

non-implantable orthotics and prosthetics. 

The payments will be based on the ambulatory payment classification 

(APC) system, which divides all outpatient services included in the new 

payment schedule into 451 groups. The services within each group are 

clinically similar and require comparable resources. 

Each APC is assigned a relative payment weight based on the median 

cost of the services within the APC. The APC payment rates are 

initially determined on a national basis. The rates actually paid to 

hospitals in an area will vary, depending on the area's wage level. To 

adjust for wage differences across geographic areas, the labor-related 

portion of the payment rate (60 percent) will be wage adjusted, using an 

individual hospital's wage index. 

Some incidental items and services will be packaged into the APC 

payment for the services, including anesthesia, certain drugs, supplies, 

recovery room and observation services. A hospital may furnish a number 

of services to a beneficiary on the same day and receive an APC payment 

for each service. 

(However, multiple surgical procedures performed on the same day 

will be discounted. Full payment will be made for the highest paid 

procedure and 50 percent will be paid for each additional surgical 

procedure. Beneficiary coinsurance will also be discounted for multiple 

surgical procedures.) 

Effect of BBRA Amendments on the PPS

BBRA contains a number of major provisions that affect the PPS, 

which have been incorporated in the regulation including: 

• annual updating of the APC payment weights, rates, payment 

adjustments, and groups; 

• annual consultation with an expert provider advisory panel in 

the review and updating of payment groups; 

• budget-neutral outlier adjustments based on the charges, 

adjusted to costs, for all PPS services included on the 
 - 80 – 

submitted outpatient bill for services furnished before January 

1, 2002, and thereafter, based on the individual services 

billed; 

• transitional payments for the additional costs of new and 

current medical devices, drugs, and biologicals for at least 2 

years but not more than 3 years; 

• payment under the PPS for implantable devices, including durable 

medical equipment, prosthetics and those used in diagnostic 

testing; 

• transitional payments to limit providers' losses for the first 

32 years under the PPS for community mental health centers and 

most hospitals. For small rural hospitals, losses will be fully 

replaced during the first 32 years. The 10 cancer centers that 

are excluded from hospital inpatient PPS will be protected 

permanently from any reduced Medicare payments. 

• limits on beneficiary coinsurance for an individual service paid 

under the PPS to the inpatient hospital deductible. 

Because these provisions have not previously been subject to public 

comment, they will be open for comment for a 60-day period, and the 

agency may make revisions in response to comments at a later time. 

HCFA's Educational Activities

HCFA has been working on a cooperative basis with representatives 

of the hospital industry as the agency developed the detailed program 

instructions for PPS' implementation. HCFA is also planning to monitor 

the progress of hospitals as they make the changes necessary to 

implement the PPS, and HCFA will continue working closely with the 

hospital associations to address any unanticipated problems that may 

arise as implementation draws closer.
 - 81 – 

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