REPORT TO THE CONGRESS

Rural Payment Provisions

in the Medicare Prescription 

Drug, Improvement, and 

Modernization Act of 2003

DECEMBER 2006
601 New Jersey Avenue, NW • Suite 9000 • Washington, DC 20001

(202) 220-3700 • Fax: (202) 220-3759 • www.medpac.gov

REPORT TO THE CONGRESS

Rural Payment Provisions

in the Medicare Prescription 

Drug, Improvement, and 

Modernization Act of 2003

DECEMBER 2006

Executive summary

Rural payment provisions in the MMA | December 2006 v

Executive summary

In the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA), 

the Congress mandated that MedPAC study the effect of certain MMA provisions on hospital 

payments, capital expenditures, and overall costs. The provisions focus on rural hospitals, 

but the effect is not limited to them; in fi scal year 2006, the MMA provisions are estimated 

to result in $377 million in additional prospective payment system (PPS) payments to rural 

hospitals (2.3 percent increase) and $774 million in additional payments to urban hospitals (0.7 

percent increase). In addition to increasing PPS payments, the MMA expanded opportunities 

for hospitals to convert to critical access hospital (CAH) status and receive cost-based 

reimbursement. 

We examine the following provisions of the MMA in this report:

• Equalized standardized amount (MMA section 401). This provision increases the 

standardized amount paid to rural and small urban hospitals to the amount large urban 

providers receive. It increases Medicare spending by approximately $571 million per year.

• Lowered labor share (section 403). This provision lowers the labor share (hospitals’ labor 

costs as a share of total costs) for hospitals with a wage index less than 1.0, from 69.7 

percent to 62 percent. It increases spending by about $314 million per year.

• Increased cap on rural disproportionate share (section 402). This provision enhances 

disproportionate share (DSH) payments for rural hospitals and urban hospitals with fewer 

than 100 beds. The cap on DSH payments rises from 5.25 percent to 12 percent of inpatient 

payments for these hospitals. The provision increases spending by approximately $223 

million per year.

• Adjustment for low volume (section 406). This provision increases inpatient payments for 

isolated low-volume hospitals (affects fewer than fi ve hospitals). It increases spending by 

less than $1 million per year. Few low-volume hospitals qualify primarily because most 

small rural hospitals have converted to CAH status.

• Adjustment for out-commuting (section 505). For three years starting in fi scal year 2005, 

this provision increases the wage index for hospitals located in counties where a large 

number of employees commute to a higher wage county. It increases spending by $44 

million per year.

• Revised market basket weights (section 404). This provision revises the weights (including 

the labor share) used in the hospital market basket more frequently. It has no material effect 

on payments.
vi Rural payment provisions in the MMA | December 2006

• Extended outpatient hold-harmless payments (section 411). This provision extends the 

outpatient hold-harmless provision for small rural and sole community hospitals (SCHs) for 

two years. The current extension increases spending by roughly $50 million per year. 

• Provided for cost-based laboratory payments (section 416). For cost report years starting 

between July 1, 2004, and June 30, 2006, hospitals with fewer than 50 beds that are located 

in qualifi ed rural areas (those with population density in the lower 25 percent) received 

cost-based laboratory payments. This provision increases spending by roughly $9 million in 

2006. 

• Changed CAH limitations (section 405). This provision increases CAH payment rates 

from 100 percent to 101 percent of costs, allows CAHs to use all 25 beds for acute care, 

and permits distinct part psychiatric and rehabilitation units. However, starting in 2006, all 

new CAH converters must be 15 miles by secondary road or 35 miles by primary road from 

the nearest hospital. Although the average CAH conversion increases Medicare payments 

by about $1 million, we have not estimated a specifi c number of conversions caused by the 

MMA.

Estimating the effect of these provisions on Medicare payments is relatively straightforward. 

However, evaluating their effect on capital expenditures and overall costs is diffi cult. Past 

experience suggests that increases in hospital revenue will be followed by increases in hospital 

expenditures (MedPAC 2005). However, the time lag is such that it is too soon to determine 

the magnitude of any change given that most MMA provisions only took effect in late 2004. In 

addition, the magnitude of any change in costs is likely to be small for most hospitals. 

When the provision extending hold-harmless payments expires at the end of 2008, it may be 

time to refi ne the outpatient payment system to account for factors leading to the poor outpatient 

fi nancial performance of small hospitals. One possibility is to have a low-volume adjustment 

to offset the effect of low patient volumes on costs per unit of service. Currently, small rural 

hospitals benefi t from hold-harmless payments and SCHs benefi t from a 7.1 percent add-on to 

their outpatient payments; however, neither of these payment adjustments effectively targets 

isolated hospitals that have high costs because they lack economies of scale. 
Rural payment provisions in the 

Medicare Prescription Drug, 

Improvement, and Modernization 

Act of 2003

Rural payment provisions in the MMA | December 2006 3

Legislative mandate and background

The Congress mandated that MedPAC study the effect of certain “rural hospital payment 

adjustments” in the Medicare Prescription Drug, Improvement, and Modernization Act of 

2003 (MMA). We are required to “analyze the effect on total payments, growth in costs, capital 

spending, and such other payment effects” of eight MMA changes to the prospective payment 

system (PPS) by December 2006. We were also required to submit an interim report on the effect 

of changes to critical access hospital (CAH) payments in 2005. Our June 2005 Report to the 

Congress (MedPAC 2005) includes the interim report. 

This report completes our mandated work. We fi rst present the effect of eight MMA provisions 

on Medicare inpatient and outpatient payments to traditional (non-CAH) hospitals. Second, 

we summarize the MMA changes to CAH payment policies that were discussed in our interim 

report. Third, we examine the effects of higher payments on hospital costs. 

The provisions of the MMA continue two payment policy trends that have increased rural 

hospital payment rates in recent years. The fi rst trend is an expansion of opportunities for rural 

hospitals to receive cost-based payments from Medicare. The second trend is an increase in 

rural PPS payment rates so that they are closer to urban payment rates. The Balanced Budget 

Act of 1997 (BBA); Balanced Budget Refi nement Act of 1999 (BBRA); Medicare, Medicaid, 

and SCHIP Benefi ts Improvement and Protection Act of 2000; and the MMA have expanded 

opportunities for rural hospitals to receive cost-based payments for Medicare services. 

As the patchwork of policies designed to increase opportunities for cost-based reimbursement 

has expanded, the number of hospitals receiving payments based on current or historical costs 

has increased. Hospitals can increase inpatient payments by becoming a CAH (roughly 1,280 

hospitals), sole community hospital (SCH) (414 hospitals), or small rural Medicare-dependent 

hospital (MDH) (133 hospitals).1

 CAHs receive 101 percent of costs, whereas SCHs receive a 

prospective payment rate based on the greater of their historical costs trended forward or current 

PPS rates. MDHs receive a prospective payment rate based on a blend of current PPS rates and 

their historical costs. Of the approximately 2,273 rural hospitals operating in 2006, only 446 were 

not eligible for payments based on their current or historical costs. These 446 hospitals represent 

only 20 percent of rural hospitals, but they tend to be larger than CAHs and MDHs and received 

roughly 39 percent of rural inpatient payments (Figure 1, p. 4). 

In addition to special inpatient payments, some rural hospitals also receive special outpatient 

payments. CAHs receive 101 percent of costs for outpatient services, SCHs receive a 7.1 percent 

add-on to outpatient PPS payments (funded by a reduction in payments to all other hospitals), 

and rural hospitals with no more than 100 beds (other than SCHs) still receive a form of costbased reimbursement (hold-harmless payments) for outpatient services. Under the hold-harmless 

policy, which is set to expire in 2008, hospitals receive the greater of payments under the 

outpatient PPS or an estimate of the cost-based payments under the system that preceded the 

outpatient PPS.
4 Rural payment provisions in the MMA | December 2006

Rural and urban impacts of MMA PPS changes 

Before the MMA was passed, many rural hospitals received inpatient payments based on current 

or historical costs instead of traditional PPS payments. Thus, the MMA changes in inpatient 

prospective payment rates affected only a minority of rural hospitals. Because almost all urban 

providers are paid PPS rates and tend to have more admissions, the “rural hospital payment 

adjustments” actually directed more new dollars to urban than to rural hospitals (Table 1). 

However, rural hospitals’ payments increased by a larger percentage (2.3 percent) than urban 

hospital payments (0.7 percent). The effects of each change to inpatient payment rates are 

described below.

Equalized standardized amount 

Differences in cost experiences led the Congress to enact separate rates for hospitals in large 

urban, other urban, and rural areas from 1988 through 1994. Legislation equalized the rural and 

other urban standardized amounts for fi scal year 1995.2 However, hospitals in large urban areas 

still received a standardized operating amount 1.6 percent higher than that provided to hospitals 

in rural and small urban areas through 2003. The MMA permanently equalized the standardized 

amount for Medicare inpatient prospective payment services. The equalization increased overall 

Figure 1

Share of hospitals and inpatient payments by rural hospital type

Note: CAH (critical access hospital), SCH (sole community hospital), MDH (Medicare-dependent hospital), PPS (prospective payment system). Payments 

are simulated using 2004 Medicare claims and 2006 Medicare payment policies. Post-acute swing-bed payments are excluded. Standard PPS 

refers to hospitals paid under the traditional PPS payment rates and includes rural referral centers.

Source: MedPAC analysis of cost report and impact fi les from CMS.

CAH 

56%

SCH

18%

MDH 

6%

Standard PPS 

20%

CAH 

17%

SCH

38%

MDH 

6%

Standard PPS 

39%

Share of rural hospitals Share of inpatient payments
Rural payment provisions in the MMA | December 2006 5

rural hospital payments by less than 1 percent (on average) because SCHs and MDHs have 

the option of being paid based on their historical cost of providing services. A large share of 

increased payments went to hospitals in small urban areas because they are more likely to receive 

traditional PPS rates (as opposed to a cost-based rate) and tend to be larger.

Lowered labor share 

Hospital operating payments are adjusted for regional differences in reported wage rates. Since 

the start of the inpatient PPS, CMS has used cost accounting data to set the “labor share,” which 

is the share of hospital costs that CMS estimates is related to local wage rates. CMS recently 

analyzed data on hospital purchases of labor, supplies, and other inputs and concluded that 69.7 

percent of hospital costs can be directly or indirectly attributed to labor costs.3 In computing 

payments to hospitals, the labor share is multiplied by the wage index, which refl ects the relative 

wage rates in different markets. In a move that increases payments to hospitals in low-wage 

Table 1

Estimated increase in 2006 payments due to MMA provisions

Rural effect Urban effect

MMA provision

Increase in 

payments 

(in millions)

Percent change 

in payments

Increase in 

payments 

(in millions)

Percent change 

in payments

Inpatient changes

Equalized standardized amount $87 0.7% $484 0.5%

Lowered labor share 64 0.5 250 0.3

Increased rural DSH cap 177 1.4 46 0.1

Adjusted for low volume <1 0.0 0 0.0

Adjusted for out-commuting 10 0.1 34 0.0

Market-basket weights 0 0.0 0 0.0

Outpatient changes

Extended hold harmless* 50 1.5 0 0.0

Provided cost-based lab 9 0.2 0 0.0

Total increase in inpatient and 

outpatient payments 377 2.3 774 0.7

Note: MMA (Medicare Prescription Drug, Improvement, and Modernization Act of 2003), DSH (disproportionate share).

 *The hold-harmless provision does not apply to sole community hospitals (SCHs); they receive a 7.1 percent increase in outpatient payments via a 

separate provision in the MMA. The result is roughly a $90 million increase in payments to SCHs. The SCH provision is budget neutral, so outpatient 

payment rates to other hospitals are reduced by roughly 0.4 percent. Note that the total is not additive due to the interaction of different policies. 

Source: MedPAC analysis of Medicare cost report data and the Provider Statistical and Reimbursement System (PS&R) reports from fi scal intermediaries. 
6 Rural payment provisions in the MMA | December 2006

areas, the MMA allows hospitals with a wage index less than 1.0 to use a 62 percent labor 

share. Therefore, in areas with a wage index less than 1.0, 62 percent of operating payments 

are adjusted (decreased) to refl ect lower-than-average labor costs. In areas with a wage index 

greater than 1.0, 69.7 percent of operating payments are adjusted (increased) to refl ect higherthan-average labor costs. Empirical estimates of the average labor share across the nation vary 

somewhat depending on the methodology used. However, no empirical studies support the 

assumption that hospitals in low-wage areas tend to use less labor than those in areas where labor 

is more expensive. The net effect of allowing a 62 percent labor share for hospitals in low-wage 

areas is to increase payments to hospitals in low-wage index areas (both rural and urban) by $314 

million per year.

Rural payments increased by roughly 0.5 percent and urban payments increased by roughly 0.3 

percent due to the labor share provision. The increase is not budget neutral. However, in dollar 

terms, most of the $314 million in increased payments goes to urban areas. The urban benefi t 

is large relative to the rural benefi t for several reasons. First, urban hospitals tend to be larger. 

Second, many urban areas have a wage index below 1.0. Third, many rural hospitals do not receive 

traditional prospective payment rates and this change affects only inpatient PPS payments. 

Increased cap on rural disproportionate share 

The rural disproportionate share (DSH) adjustment was enacted in 1986 because of the belief 

that poor patients are more costly to care for than middle- and upper-income patients (CBO 

1990). In recent years, some have viewed DSH payments as a subsidy for uncompensated care 

for the uninsured and underinsured rather than the differential in the cost of treating low-income 

and other Medicare benefi ciaries.

Prior to the MMA, rural hospitals with 500 or more beds and urban hospitals with more than 

100 beds did not have a DSH payment cap, but smaller hospitals had DSH payments capped at 

5.25 percent of operating payments. The MMA increased the cap on DSH payments to smaller 

hospitals from 5.25 percent to 12 percent of inpatient operating payments. In 2006, we estimate 

that raising the cap to 12 percent will increase annual payments to rural hospitals by $177 million 

dollars. The benefi ts are concentrated in hospitals with large shares of Medicaid patients and lowincome Medicare patients.

Adjustment for inpatient low volume

In our June 2001 Report to the Congress, MedPAC recommended a graduated increase in 

inpatient payments per case for isolated rural hospitals. The objective was to help hospitals that 

inevitably lacked economies of scale because they serve an area with low population density. 

The MMA enacted a low-volume adjustment for hospitals with fewer than 800 discharges per 

year that are more than 25 miles from the nearest hospital. However, the MMA let the Secretary 

determine the amount of that adjustment. Based on its analysis of hospital costs, CMS concluded 

that the adjustment should only be above zero for hospitals with 200 or fewer discharges. As 
Rural payment provisions in the MMA | December 2006 7

a result, CMS estimates that only two hospitals will benefi t from the adjustment in 2007. The 

impact of the provision on payments is less than $1 million.

Even if the Congress had relaxed the distance requirement and allowed the low-volume 

adjustment to reach 800 discharges (as MedPAC recommended), very few hospitals would benefi t. 

Thirty-fi ve rural hospitals had fewer than 800 discharges and were more than 15 miles from a 

competitor in 2004. The reason so few would benefi t from an inpatient low-volume adjustment is 

that most small rural hospitals with low volumes of inpatients have converted to CAH status. Even 

among the 35 rural hospitals that could qualify for a revised inpatient low-volume adjustment, 

many are SCHs and may choose a hospital-specifi c rate (that is, a cost-based rate) over a PPS rate 

with a low-volume adjustment. 

Adjustment for out-commuting

Starting in fi scal year 2005, hospitals located in counties where a large number of hospital 

workers commute to a higher wage county receive an increased wage index. In fi scal year 2006, 

CMS expected 251 hospitals to receive this out-commuting payment adjustment. The adjustment 

is proportional to the share of employees who commute from the hospital’s county to a hospital 

in a county with a higher wage index. It has a small effect on inpatient payments.

Revised market basket weights

The MMA requires more frequent revisions in the market basket weight computations (including 

estimation of the labor share) used in the hospital market basket. The market basket is a weighted 

sum of the different inputs used by hospitals. Over time, the effect of price changes for a specifi c 

hospital input can carry more or less weight in the market basket. For example, if hospitals 

increase pharmaceutical use, the market basket may change so that price changes to prescription 

drugs represent 6 percent rather than 5 percent of the market basket. To account for these 

variances over time, CMS has historically revised market basket weights about every fi ve years. 

The MMA requires CMS to revise the market basket computations more frequently. In response, 

CMS proposed revising them every four years. The payment rates are still updated every year, 

but the weights that go into estimating input cost infl ation are revised every four years rather than 

every fi ve years. The changes in the weights are expected to be small and have no material effect 

on payments. 

Individual outpatient changes 

The BBA provided for the implementation of prospective payments for hospital outpatient 

services starting in August 2000. The BBRA implemented transitional corridor payments that 

helped soften the effects on hospitals that would experience payment reductions. For most 

hospitals, transitional corridor payments made up part of the difference between the payments 

they would have received under the previous, partially cost-based system and the payments under 

the outpatient PPS. However, some hospitals—cancer hospitals, children’s hospitals, and rural 
8 Rural payment provisions in the MMA | December 2006

hospitals with 100 or fewer beds—were held harmless by the transitional corridor payments. 

They received the greater of their outpatient PPS payments or an estimate of the payments they 

would have received under the partially cost-based system (which were often less than full costs).

Extended hold-harmless payments 

Although cancer and children’s hospitals have permanent hold-harmless status, the BBRA slated 

the eligibility for hold-harmless payments for rural hospitals to expire on December 31, 2003. 

However, in 2003 the MMA extended hold-harmless eligibility for small rural hospitals for 

calendar years 2004 and 2005. In addition, the MMA provided hold-harmless eligibility for 2004 

and 2005 to all SCHs in rural areas. The Defi cit Reduction Act of 2005 provides for small, rural 

hospitals (that are not SCHs) to receive nearly full hold-harmless payments from 2006 through 

2008. These hospitals will receive 95 percent of full hold-harmless payments in 2006, 90 percent 

in 2007, and 85 percent in 2008. 

The partial hold-harmless payments provided small rural hospitals with about $50 million in 

additional revenue in 2006. It is not clear whether these hold-harmless payments in 2007 and 

2008 will be higher or lower than they were in 2006. On the one hand, eligible hospitals will 

receive a smaller percentage of the full hold-harmless payments in 2007 and 2008, which would 

decrease the payments. On the other hand, more hospitals may be eligible for hold-harmless 

payments in 2007 and 2008 if their costs increase faster than Medicare payments, which would 

increase total hold-harmless payments.4

Provided for cost-based laboratory payments

Medicare pays for most clinical diagnostic laboratory tests performed by hospitals—excluding 

those for inpatients—under a fee schedule. Section 416 of the MMA provides a temporary 

exemption from the clinical laboratory fee schedule (CLFS) for “qualifi ed rural hospitals” to 

have their clinical laboratory services paid on the basis of costs, rather than the CLFS, from July 

1, 2004, through June 30, 2006. A qualifi ed rural hospital has fewer than 50 beds and is located 

in a qualifi ed rural area—that is, one of those areas with the lowest population densities that 

comprise 25 percent of the rural population. 

Qualifi ed rural hospitals are relatively small and few in number (about 130). We estimate that 

this provision increased Medicare program spending by roughly $70,000 per hospital or $9 

million per year for all qualifying hospitals. We estimated the difference between fee-schedule 

laboratory payments and cost-based laboratory payments with data from the fi scal intermediaries’ 

Provider Statistical and Reimbursement System (PS&R). We examined PS&R reports from a 

sample of 33 of the 130 qualifi ed rural hospitals. The 33 hospitals in our sample make up about 

25 percent of the qualifying rural hospitals. Therefore, we estimated total payments under the 

Medicare laboratory fee schedule and under a cost-based system for all qualifying rural hospitals 

by multiplying by 4 the estimates for the 33 hospitals in our sample. Although the sample was 

selected based on availability of data and was not randomly drawn, we believe it is a large enough 

share of the population to reasonably represent the population of 130 hospitals.
Rural payment provisions in the MMA | December 2006 9

Changed SCH outpatient payments

The MMA required CMS to investigate whether rural hospitals incur a greater cost per service 

under the outpatient PPS than their urban counterparts. If CMS found a discrepancy in costs 

between rural and urban hospitals, the MMA required it to adjust payments to rural hospitals to 

offset their higher costs.

CMS’s analysis revealed that SCHs located in rural areas have higher unit costs than other 

hospitals. Beginning in 2006, CMS is adjusting upward by 7.1 percent payments to rural SCHs 

for all outpatient PPS services, excluding drugs and devices that are paid under the pass-through 

policy. 

The 7.1 percent SCH add-on payment is budget neutral; therefore, the approximately $90 million 

in special payments that rural SCHs receive are offset by a $90 million reduction in Medicare 

payments to all hospitals, equivalent to a 0.4 percent reduction in the base rate for Medicare 

outpatient payments. 

Addressing higher costs at lower volume hospitals

We analyzed the factors that affect hospitals’ costs per outpatient service and found that the 

volume of outpatient services is a strong driver of cost per service; cost per unit of outpatient 

service declines as the volume of outpatient services increases. Moreover, the rate of decrease 

is greatest at the lowest volumes (Appendix B of this report presents regression results and 

MedPAC’s March 2006 Report to the Congress provides a general discussion of low-volume 

adjustments). Currently, SCHs benefi t from a 7.1 percent add-on to their outpatient payments 

and small (non-SCH) hospitals benefi t from hold-harmless payments; however, neither of these 

adjustments effectively targets isolated hospitals with high costs because they lack economies 

of scale. An outpatient low-volume adjustment could be instituted to replace the current holdharmless payments and the SCH add-on. The low-volume adjustment could be part of a broader 

effort to more completely refi ne the outpatient payment system, which is seven years old. The 

regression results shown in Appendix B of this report suggest that further analysis is needed to 

evaluate whether outpatient services with a higher payment weight are more profi table than less 

complex outpatient services. A more complete refi nement of outpatient payments may be needed 

if changes in payment weights have not appropriately matched changes in the costs of delivering 

different outpatient services. 

To implement an outpatient low-volume adjustment, policymakers would have to set the 

threshold where low-volume payments would begin (e.g., at the mean volume). In addition, 

to avoid paying a low-volume adjustment to hospitals in close proximity to each other, the 

adjustment could be limited to hospitals that are a minimum distance from all other hospitals 

(e.g., 15 road miles). 

A low-volume adjustment would narrow the range of fi nancial performance among rural 

hospitals. This adjustment (for illustration, using a threshold of 125,000 services and a 15-mile 

distance requirement) could be implemented when the hold-harmless provisions expire in 2009 

and when funds from the SCH provision are redirected to the base payment rate. Assuming these 
10 Rural payment provisions in the MMA | December 2006

changes in policy, 2004 margins for rural hospitals would range from a high of –2.4 for overall 

margins (–13.8 percent outpatient/2.0 percent inpatient) for small rural (non-SCH) hospitals with 

low outpatient volume to a low of –7.6 percent overall margins (–16.3 percent outpatient/–3.2 

percent inpatient) for small rural (non-SCH) hospitals without low outpatient volume. SCH 

hospitals’ margins would fall within this range.

MMA changes to CAH limitations

The MMA increased CAH payments from 100 percent of costs to 101 percent of costs and 

instituted four key changes to the CAH program: 

• allowing up to 25 CAH beds to be used for acute inpatient care;

• allowing 10-bed distinct part inpatient psychiatric units;

• allowing 10-bed distinct part inpatient rehabilitation units; and

• starting in 2006, requiring that all new CAHs be 35 miles by primary road or 15 miles by 

secondary road from the nearest hospital (before the MMA, states could waive the distance 

requirement).5

 

We provide a more complete background discussion of CAHs in our June 2005 Report to the 

Congress. 

Allowing 25 acute-care patients 

Prior to the MMA, CAHs were limited to 25 beds but could only have 15 acute-care patients. The 

MMA allowed the hospitals to use all 25 beds for acute care. As we discussed in our June 2005 

report, this provision may have resulted in some rural hospitals with a census regularly between 

15 and 25 beds converting to CAH status that otherwise would not have converted. The provision 

may have resulted in roughly 100 additional CAH conversions. In our June 2005 report, we 

estimated that CAH payments would be roughly $1 million more than PPS rates for the average 

CAH, primarily due to increased post-acute swing-bed, outpatient, and laboratory payments. 

Additional conversions result in increased Medicare payments to these hospitals.

Allowing existing CAHs to expand their acute inpatient census from a maximum of 15 to 25 

should not materially affect Medicare payments to hospitals that had converted to CAH status 

before passage of the MMA. Whereas cost-based payments to CAHs for outpatient and postacute swing-bed care tend to be substantially higher than PPS rates, cost-based payments for 

acute inpatient care are often close to PPS rates. In addition, adding volume to existing CAHs is 

likely to reduce costs per discharge because of economies of scale. Therefore, allowing CAHs to 

increase the number of acute inpatients should not signifi cantly affect Medicare costs other than 

through an indirect effect on the number of converting hospitals. 
Rural payment provisions in the MMA | December 2006 11

Allowing distinct part psychiatric and rehabilitation units 

Prior to the MMA, CAHs could not have distinct part units in addition to their 15 acute-care 

beds. The MMA allows CAHs to have rehabilitation and psychiatric units with up to 10 beds 

each in addition to 25 acute-care beds. The distinct part units are paid prospective rates. As 

of June 2006, only 6 of the 1,283 CAHs had distinct part rehabilitation units, whereas 67 had 

distinct part psychiatric units. Most of the 67 hospitals had distinct part psychiatric units when 

they converted to CAH status. Only 10 added psychiatric units after they converted to CAH 

status, and 57 converted to CAH status while operating a distinct part psychiatric facility (CMS 

2006). 

Allowing CAHs to add distinct part units appears to have resulted in at least 10 additional 

distinct part units in rural areas—a potential benefi t for areas that often have a shortage of mental 

health services (IOM 2005). It is not known whether adding and retaining inpatient capacity 

in these small communities helps recruit mental health professionals to these areas. The cost 

of the provision depends on how many of the 57 CAHs that had psychiatric units when they 

converted would not have converted if the provision had not been enacted. As stated earlier, CAH 

conversions are estimated to cost Medicare $1 million per conversion per year. 

Firming the 15/35-mile rule

The most signifi cant change to the CAH program is the removal of a state’s ability to waive the 

requirement that CAHs be at least 35 miles from another hospital by primary road or 15 miles 

by secondary road. Existing CAHs will be grandfathered into the program. Most current CAHs 

are 10 to 25 miles from the nearest hospital and do not meet the distance requirement; they were 

allowed CAH status under state authority to waive the distance requirement.

Because most hospitals that qualify for CAH status converted by January 1, 2006, the number of 

CAH conversions slowed to a handful in 2006. It is diffi cult to predict what savings will result 

from requiring rural hospitals to be more than 35 miles from the nearest competitor; however, a 

considerable number of conversions that otherwise would have occurred may be prevented. The 

provision not only will prevent new CAHs from being built close to existing hospitals but also 

will prevent suburban hospitals from converting to CAH status as they age and lose market share 

to competitors.6

 

Post-acute stays in swing beds 

Medicare created the swing-bed program to allow hospitals with excess capacity to use beds 

for post-acute care when other sources of post-acute care are not available.7

 CAHs receive 

higher Medicare payments for post-acute care in swing beds than other hospitals receive under 

prospective payment rates, and they have a fi nancial incentive to increase the use of empty swing 

beds for post-acute care. Increasing occupancy reduces average costs per day at the hospital, 

resulting in higher profi ts on private-payer acute-care patients. Although the fi nancial incentives 

exist for swing-bed use, and fi nancial consultants have been explaining these benefi ts to hospital 

executives, the rate of increase in swing-bed use through 2004 has been fairly modest. Among 

our sample of 574 CAHs that converted by 2002, swing-bed days increased by 5 percent, a mean 
12 Rural payment provisions in the MMA | December 2006

increase of 32 days per year from 2003 to 2004. Other analyses show that the increase in swingbed use through 2003 was modest (Dalton 2006). A survey of CAHs in 2004 indicated that 4 

percent added swing-bed services and 11 percent signifi cantly expanded swing-bed use, but more 

than 80 percent stated they had not changed their level of swing-bed services through 2004 (Flex 

Monitoring Team 2004). 

One area of swing-bed use that should be monitored is the transfer of post-acute patients from 

larger PPS hospitals to CAH swing beds. For certain diagnosis related groups discharged to skilled 

nursing facilities (SNFs), the transfer policy reduces PPS payments when a transfer patient’s PPS 

length of stay is more than one day shorter than the geometric mean length of stay. Although PPS 

payments are reduced for short-stay patients discharged to SNFs, they are not reduced for shortstay patients discharged to swing beds. Larger hospitals have a fi nancial incentive to discharge their 

short-stay patients to CAH swing beds because the transfer policy does not apply. Because of the 

large hospitals’ fi nancial incentive to discharge patients as soon as possible and the CAHs’ fi nancial 

incentive to take post-acute patients, it is important to monitor transfers to confi rm that patients are 

being transferred to CAH swing beds no earlier than is in the best interest of the patient. The text 

box describes how swing-bed costs for post-acute patients are calculated. 

Swing-bed cost accounting rules result in higher post-acute payments

Since 2001, CMS has used a new method to calculate payments for routine services provided 

to post-acute swing-bed patients (HCFA 2001). Before the Medicare, Medicaid, and SCHIP 

Benefi ts Improvement and Protection Act of 2000, Medicare paid critical access hospitals 

(CAHs) a fi xed payment for the costs associated with routine care for post-acute patients 

in swing beds. This fi xed payment equaled the average cost of routine care for post-acute 

patients in freestanding skilled nursing facilities (SNFs). Under the new method, CMS 

pays for routine care based on hospitals’ reported costs, averaged over acute and skilled 

nursing patients. To calculate the cost of a post-acute patient’s routine care, CMS divides the 

hospitals’ total inpatient routine costs (after carving out nursing-facility-type Medicaid days) 

by the sum of acute and post-acute days to obtain an estimated routine cost per day. Because 

hospitals’ routine costs per day exceed freestanding SNFs’ routine costs per day, this change 

in payment method signifi cantly increases payments for post-acute swing-bed patients. 

Compared with the old payment method, the new one decreases payments for acute care. 

The changes refl ect a shift in cost allocation from acute to post-acute care. To compute the 

routine costs allocated to acute patients, CMS starts with total inpatient routine costs and 

then “carves out” nursing-facility-type Medicaid payments. CMS then evenly allocates the 

remaining routine costs to acute and post-acute patients. Because costs allocated to postacute payments increase under the new method, the costs remaining to be allocated to acute 

patients decrease. Although CAHs receive roughly $1,000 in Medicare payments for every 

post-acute day, the reduction in costs allocated to acute patients offsets some of that gain. 

For the marginal post-acute day, the net increase in Medicare payments may be only $400 or 

$500 instead of the full $1,000. Net revenue per post-acute day of $400 or $500 is $100 to 

$200 more than SNF payment rates of roughly $300 per day. Rural payment provisions in the MMA | December 2006 13

How do increased payments affect capital expenditures and overall costs? 

Both the method (e.g., cost-based reimbursement) and the level of payment can affect cost 

growth. In the early 1990s, hospital costs declined because of incentives associated with the 

introduction of the PPS and because of fi nancial pressure managed care companies placed 

on hospitals (Chalkley and Malcomson 2000, Gaskin and Hadley 1997). Complementing the 

academic literature, the trade press is replete with case studies of hospitals that reduced costs 

when faced with fi nancial pressure (Guyon 2003, McGinnis et al. 2005). 

In recent years, rural hospitals have tended to receive larger increases in Medicare inpatient 

payments per case than urban hospitals, averaging an additional 2 percent per year from 2000 

through 2004. The largest increase, 6.7 percent from 2003 to 2004, was partially due to the MMA 

provisions discussed in this report. Although costs have increased rapidly at rural hospitals, they 

have increased just as rapidly at urban hospitals that received smaller increases in Medicare 

payment rates (Table 2). Cost growth in urban hospitals may be infl uenced by increasing 

consolidation of hospitals in urban areas, which may have led to higher private-payer profi t 

margins that could be used to fund cost growth. 

Overall, rural and urban hospitals appear to have faced roughly equal pressure to constrain costs 

through 2004. Although Medicare payments increased faster among rural than among urban 

hospitals, non-Medicare margins increased faster among urban hospitals. The net result is that 

Table 2

Medicare PPS inpatient payment growth and cost growth

2000–2001 2001–2002 2002–2003 2003–2004

Mean 

change

Medicare payment growth 

per discharge

Rural hospitals 4.4% 4.5% 3.1% 6.7% 4.7%

Urban hospitals 2.8 3.3 1.5 3.0 2.7

Medicare cost growth per discharge

Rural hospitals 4.7 8.0 5.5 6.5 6.2

Urban hospitals 5.0 8.1 6.3 5.8 6.3

Total (all payer) margin growth

Rural hospitals –0.5 –0.6 0.4 0.7 0.0

Urban hospitals –0.2 0.1 0.8 –0.2 0.1

Note: PPS (prospective payment system). Changes in payments can be lower or higher than the annual update due to changes in Medicare payment 

rules, coding, and case mix. 

Source: MedPAC analysis of cost report data from CMS.
14 Rural payment provisions in the MMA | December 2006

total margins (all payers) among rural and urban hospitals have almost equal cumulative changes 

over the four years ending in fi scal year 2004. Given equal changes in total margins over those 

four years and a 5 percent total margin among rural hospitals versus a 4.2 percent total margin 

among urban hospitals in 2004, it is not surprising that we do not see a material difference in the 

rates of cost growth. 

The question for this study is whether increased Medicare payment rates will affect capital 

expenditures and overall costs. Most MMA payment increases did not start affecting hospitals 

until partway through 2004 and may not affect capital expenditures until 2006 if it takes a 

hospital a year to change its capital expenditure plans. Once 2006 data become available, we 

could test whether the hospitals that received the largest increases in payments (10 percent or 

more) increased their capital expenditures and overall costs faster than other hospitals. However, 

for hospitals that received a 1 or 2 percent increase in payments because of the PPS provisions, 

the effect on capital expenditures and overall costs probably will be too small to detect. 

Effect of CAH conversions on capital expenditures and overall costs

When CAHs shift from fi xed prospective payment rates to cost-based payments, their incentive 

to constrain costs is reduced and capital expenditures become fi nancially more attractive. The 

inpatient PPS was implemented in the early 1980s to provide a greater incentive for hospitals 

to control costs than they had under cost-based reimbursement. The literature from the 1980s 

generally indicates that the introduction of PPS eventually reduced cost growth among acutecare hospitals (Long et al. 1987, Feder et al. 1987). Now that CAHs have moved back to costbased reimbursement 20 years later, there is a concern about increased costs. In our June 2005 

CAH chapter, we reported modestly higher growth in cost after conversion for CAHs than for 

comparable hospitals through 2003. 

Although CAHs still have some incentive to control costs, it is easier for CAHs than for 

PPS hospitals to fund increases in the cost of care, all else being equal. When a PPS hospital 

purchases additional labor or equipment, the hospital must pay for it with cash fl ow from 

existing sources or through increased patient volume. In contrast, when a CAH purchases 

additional labor or equipment, its Medicare payment per unit of service increases, assuming 

volume does not change. For example, one hospital administrator informed us that his 

patient mix is roughly 50 percent Medicare, so when he considered remodeling his outpatient 

department the analysis assumed that increased Medicare payments would pay 50 percent of the 

cost—even without a change in patient volume. 

CAHs tend to operate in older facilities with signifi cant needs for capital improvements. In a 

2004 survey of 474 CAHs conducted by a team from the University of Minnesota, University of 

North Carolina, and University of Southern Maine, 42 percent of the respondents reported they 

had pursued a capital loan at some point between 2001 and 2004 (Flex Monitoring Team 2005). 

Roughly 9 in 10 loan applicants were successful. Although some CAHs still have weak fi nancial 

performance, most have access to capital, and we should expect increases in capital expenditures 

as CAHs replace and update their aging facilities. 
Rural payment provisions in the MMA | December 2006 15

Some observers may view increased capital spending at aging CAHs as a positive development 

but may also be concerned that capital spending is not targeted to hospitals that are critical 

for patients’ access to care. There is signifi cant diversity among the locations of CAHs with 

aging facilities. Some CAHs are isolated rural hospitals and others have competitors within 15 

miles. Given that cost-based reimbursement is available to all types of CAHs, we should expect 

increases in capital spending at all types of CAHs. 

The increased capital expenditures have started to be refl ected in Medicare cost report data. In 

MedPAC’s sample of 574 CAHs that had converted to CAH status by 2002, aggregate capital 

expenditures for the group increased by 8 percent from 2003 to 2004, compared with an 

aggregate increase of 5 percent for a group of hospitals that had not converted to CAH status 

by 2004.8 The 3 percent difference in the rate of capital expenditure growth is statistically 

signifi cant but is modest in magnitude, representing less than $50,000 in additional capital costs 

(e.g., depreciation and interest expense) per CAH per year. Given that the Flex Monitoring Team 

estimated that CAHs needed to make more than $2 million in additional capital expenditures on 

average, we should expect increasing capital expenditures to drive further increases in reported 

interest and depreciation expenses. 

Do CAHs have a competitive advantage over their neighbors?

Some non-CAH hospitals that compete with CAHs have expressed concern that they cannot 

afford to pay the same wages as CAHs because they receive lower payment rates. As time goes 

on, they may also think they are at a disadvantage when it comes to capital improvement projects. 

As with any cost-based reimbursement system, the risk exists that the provider may purchase 

services from related entities, which can lead to increased Medicare payments for CAHs and 

enhanced competitive advantages over their neighbors. Therefore, it will be important for CMS 

to monitor CAHs to ensure that reported costs are reasonable and that transactions with related 

entities have negotiated rates that refl ect the best price available to the CAH, as required by 

current cost-reporting regulations. 

Can networking solve economy-of-scale problems?

The CAH program requires CAHs to network with at least one larger support hospital. In some 

cases, the relationship with the support hospital primarily consists of an agreement whereby the 

larger facility accepts transfers from the CAH. In other cases, the CAH and the support hospital 

share common ownership and are highly integrated. Many CAHs also network with other 

small hospitals. To encourage networks, the federal Offi ce of Rural Health Policy offers grant 

programs for small rural health care organizations to create networks or other partnerships with 

other health care organizations. Some networks have accomplished specifi c objectives such as 

providing joint credentialing or joint quality improvement programs, but that should not be seen 

as the solution for all the diffi culties that accompany CAHs’ lack of scale. The most extensive 

studies of rural hospitals’ organizational strategies, such as joining systems and networks, did not 

fi nd any “direct, easily observable linkages between network participation and the balance sheets 
16 Rural payment provisions in the MMA | December 2006

of participating hospitals” (Mick et al. 1995, Moscovice et al. 1995). There are some examples of 

fi nancially successful hospitals in networks, but there are also examples of fi nancially successful 

independent, small-town hospitals (Stensland and Millet 2002). 

Encouraging innovation and efficiency

Rural patients may benefi t from some hospital mergers. CAHs with fewer than 500 admissions 

tend to have small medical staffs and are less likely to have certain benefi cial services such as 

an on-site pharmacist. In contrast, higher volume CAHs serving larger areas tend to have more 

resources. For example, MedPAC staff visited a 25-bed CAH with more than 1,000 admissions 

that serves a large area with seven satellite clinics in surrounding towns. By serving a wide area 

(more than 30 miles in all directions) the hospital has the economies of scale to support 2 fulltime pharmacists, an electronic medical record that links all 7 clinics to the hospital, 2 full-time 

paramedics, a full-time radiologist, and more than 10 board-certifi ed physicians who travel to the 

7 clinics. The physician staff indicated that the ability to have local colleagues and to see a certain 

volume of patients in the hospital were both important factors in their ability to provide quality 

care. Mergers of smaller CAHs into larger CAHs may result in more resources for rural patients.

CMS limits CAHs’ ability to build facilities in new locations. To maintain its CAH status, a CAH 

must remain in its current location or at least continue to serve the same patient base if it changes 

location. Before merging, CAHs may want assurances from CMS that the merged facility will 

be able to keep the CAH designation. Therefore, CMS may want to clarify that two hospitals 

can move or merge and build a hospital in a new location as long as the new hospital acts as a 

replacement facility for the two merging facilities. In addition, we will also be monitoring rural 

providers to determine whether any CAHs are choosing not to merge because of concern that the 

merged facility could not meet the region’s needs, given the 25-bed limit for CAHs. Because of 

the potential benefi ts of consolidation, allowing merging CAHs to exceed the 25-bed limit for a 

number of years after the merger of two neighboring CAHs may be benefi cial. The mergers of 

CAHs are just one way for rural health care delivery systems to change in response to changes 

in medical technology and in rural demographics. We should be willing to shift the location of 

where care is delivered as well as how it is delivered if those changes will improve the quality of 

care rural patients receive. Rural payment provisions in the MMA | December 2006 17

Centers for Medicare & Medicaid Services, Department of Health and Human Services. 2006. 

List of critical access hospitals and their attributes. October.

Chalkley, M., and J. Malcomson. 2000. Government purchasing of health services. In Handbook 

of Health Economics. New York: Elsevier North Holland. 

Congressional Budget Office. 1990. Medicare’s disproportionate share adjustment for hospitals. 

Washington, DC: CBO.

Dalton, K. 2006. Participation in skilled nursing and swing-bed care in rural hospitals following 

conversion to cost-based reimbursement. Paper presented at the 2006 Academy Health annual 

research meeting, June 26.

Feder, J., J. Hadley, and S. Zuckerman. 1987. How did Medicare’s prospective payment system 

affect hospitals? New England Journal of Medicine 317, no. 14 (October): 867–873.

Flex Monitoring Team. 2005. The availability and use of capital by critical access hospitals. 

March. 

Flex Monitoring Team. 2004. 2004 CAH survey: National data. August. 

Gaskin, D., and J. Hadley. 1997. The impact of HMO penetration on the rate of hospital cost 

inflation, 1985–1993. Inquiry 34, no. 3: 205–216.

Guyon, R. 2003. Caritas Norwood Hospital: Back from the brink. Healthcare Financial 

Management (July): 38–44.

Health Care Financing Administration, Centers for Medicare & Medicaid Services, Department 

of Health and Human Services. 2001. Exemption of critical access hospital swing beds from 

skilled nursing facility prospective payment system. Program Memorandum Transmittal, no. 

A–01–09. January 16.

Institute of Medicine. 2005. Quality through collaboration: The future of rural health.

Washington, DC: National Academies Press.

Long, M. J., J. D. Chesney, R. P. Ament, et al. 1987. The effect of PPS on hospital product and 

productivity. Medical Care 25, no. 6 (June): 528–538.

McGinnis, M., E. Stark, and K. O’Leesky. 2005. Supply and conquer. Healthcare Financial 

Management (March): 82–86. 

Medicare Payment Advisory Commission. 2006. Report to the Congress: Medicare Payment 

Policy. Washington, DC: MedPAC.

References
18 Rural payment provisions in the MMA | December 2006

Medicare Payment Advisory Commission. 2005. Report to the Congress: Issues in a Modernized 

Medicare Program. Washington, DC: MedPAC. 

Mick, S., L. Morlock, D. Salkever, et al. 1995. Horizontal and vertical integration-diversification 

in rural hospitals: A national study of strategic activity, 1983–1988. Journal of Rural Health 9: 

99–119. 

Moscovice, I., J. Christianson, J. Johnson, et al. 1995. Building Rural Hospital Networks. Ann 

Arbor, MI: Health Administration Press.

Stensland, J., and M. Millet. 2002. The variance of rural small-town hospitals’ financial 

performance. Bethesda, MD: Project Hope.
Rural payment provisions in the MMA | December 2006 19

Endnotes

1. On average, CAH inpatient payments have increased because of conversion to CAH status. 

However, there are a significant number of CAHs that faced a decline in inpatient payments 

after conversion. These hospitals usually converted to CAH status to obtain increased 

payments for outpatient services and for post-acute care in swing beds. Counts of special 

classifications for hospitals are from the final inpatient payment rule issued August 1, 

2006, and correspondence with CMS during the summer of 2006.

2. Medicare sets per-discharge base rates (standard operating amounts) for the operating 

costs an efficient facility is expected to incur in furnishing covered inpatient services. The 

payment rate is adjusted for the complexity of the diagnosis related groups and area wage 

rates. Operating payments pay for labor and supply costs; a separate capital payment is 

designed to pay for the cost of depreciation, interest, rent, and property-related insurance 

and taxes. For fiscal year 2006, the operating base rate was $4,731.

3. Others have used regression analysis to estimate the share of hospital costs that are related 

to the wage index, but those estimates often vary depending on the functional form of 

regression. CMS concluded that the regression results were too unstable to use and chose to 

use the cost accounting approach. 

4. CMS determines hold-harmless payments as the greater of hospital payments under the 

outpatient PPS or the cost-based system that preceded it. The cost-based payments are 

calculated as the product of current costs and a historical payment-to-cost ratio. Therefore, 

the growth in hospital costs can affect whether a hospital will receive hold-harmless 

payments in the future.

5. Technically, a state had to replace the distance requirement with its own “necessary 

provider” criteria. However, the states used very broad criteria so that most (and often all) 

of the states’ small rural hospitals qualified for necessary provider status. The criteria did 

not have to be closely related to access to care. For example, some states gave necessary 

provider status to all rural hospitals in counties with an above-average percentage of people 

over the age of 65. One state declared hospitals “necessary providers” based on several 

considerations, such as having low occupancy because they were in an area with local 

competition. CMS believed the Congress intended to give states almost complete control 

over this issue and therefore did not challenge “necessary provider” criteria even in the few 

cases in which those criteria allowed CAHs to exist in the same town as another hospital.

6. Technically, a hospital must be in a rural area to be a CAH. However, a hospital that the 

state designated as rural for any purpose would be considered rural when determining CAH 

eligibility. Therefore, although CAHs are not located in the core of large urban areas, some 

are located in suburban areas within metropolitan statistical areas. 
20 Rural payment provisions in the MMA | December 2006

7. Swing beds can be used for acute or post-acute care. Most CAH beds are swing beds.

8. When hospitals convert to CAH status they often start to expense purchases of lower cost 

items (costing less than $5,000) rather than record the items as assets on their books and 

depreciate them. For example, a hospital could expense 10 beds that cost $4,000 each rather 

than capitalize those items and depreciate them. Hospitals expense the items rather than 

depreciate them so that Medicare will reimburse them in the current year rather than over 

the life of the item. The net effect is that our estimates of increases in converting hospitals’ 

depreciation expense and capital expenses may be understated because of this change in 

hospitals’ policies about what assets are capitalized and what assets are expensed. 
A APPENDIX

Mandate for report

Rural payment provisions in the MMA | December 2006 23

Mandate for report

Medicare Prescription Drug, Improvement, and Modernization Act of 2003, 

Section 433

(a) IN GENERAL—The Medicare Payment Advisory Commission shall conduct a study of the 

impact of sections 401 through 406, 411, 416, and 505. The Commission shall analyze the effect 

on total payments, growth in costs, capital spending, and such other payment effects under those 

sections.

(b) REPORTS—

(1) INTERIM REPORT—Not later than 18 months after the date of the enactment of this Act, 

the Commission shall submit to Congress an interim report on the matters studied under 

subsection (a) with respect only to changes to the critical access hospital provisions under 

section 405.

(2) FINAL REPORT—Not later than 3 years after the date of the enactment of this Act, 

the Commission shall submit to Congress a fi nal report on all matters studied under 

subsection (a).

B APPENDIX

Regression analysis

Rural payment provisions in the MMA | December 2006 27

Regression analysis

We used regression analysis to estimate the relationship between hospital cost per service under 

the outpatient prospective payment system (PPS) and total volume of outpatient services. In 

theory, cost per service should decline as the number of services increases.

The unit of observation in our regression is the hospital. The dependent variable is hospital 

cost per outpatient PPS service, adjusted for geographic differences in the price of inputs. We 

measured input prices with the hospital wage indexes that CMS uses to adjust outpatient PPS 

payments for geographic differences. The explanatory variables include the number of outpatient 

services furnished to all patients (not just Medicare benefi ciaries), a service-mix index that 

measures the complexity of services hospitals provide, and a number of 0/1 variables that refl ect 

hospital characteristics that could affect costs in the outpatient department. We used natural logs 

of the dependent variable, volume of outpatient services, and the service-mix index. All variables 

used in our analysis are from 2004 claims, Cost Report, or Provider of Service fi les.

Graphic analysis showed that the relationship between outpatient cost per service and volume 

of service is nonlinear. As volume increases, outpatient cost per service decreases at a fast rate 

at low volumes and a slow rate at high volumes (Figure B-1, p. 28). Natural log transformations 

often create linear relationships when the relationship between untransformed variables is 

nonlinear. We examined natural log versions of cost per service and volume and found the 

relationship is still nonlinear. In response, we used a spline function on the log-transformed 

variables. The spline function groups hospitals by volume of services and estimates a distinct 

relationship between cost per service and volume for each group. We chose the spline function 

because it fi ts the data reasonably well and is easier to apply as a payment policy tool than 

alternatives such as a quadratic function. Our spline function collects hospitals into these three 

groups:

• fewer than 25,000 outpatient services,

• at least 25,000 services but fewer than 225,000 services, and

• at least 225,000 services.

For each group, we estimated the relationship between volume and cost per service.

Results from our regression analysis verify our graphic analysis: cost per service declines at a 

faster rate among low-volume than among high-volume hospitals (Table B-1, p. 29). Among 

hospitals that provide fewer than 25,000 services, a 10 percent increase in volume results in a 

1.2 percent decrease in cost per service. Among hospitals that provide at least 25,000 but fewer 

than 225,000 services, a 10 percent increase in volume results in a 0.8 percent decrease in cost 

per service. Finally, among hospitals that provide at least 225,000 services, the decrease in cost 

per service caused by increases in volume is not statistically different from 0. Although hospitals 

benefi t from economies of scale all the way up to roughly 225,000 units of service, we propose 
28 Rural payment provisions in the MMA | December 2006

Figure B-1

Outpatient cost per service decreases as volume increases

Note: Number of outpatient services refl ects services provided to all patients, not just Medicare benefi ciaries.

Source: MedPAC analysis of 2003 and 2004 outpatient claims fi les, 2004 Cost Report fi le, and 2004 Provider of Services fi le from CMS. Cost per service relative to the mean

1.0

0.8

0.6

0.4

0.2

0.0

–0.2

0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 200,000 160,000 180,000

Number of outpatient services
Rural payment provisions in the MMA | December 2006 29

Table B-1

Cost per outpatient service declines as outpatient volume increases

Variable Coeffi cient t-statistic

Constant 5.85 21.36

Volume of outpatient services

<25k −0.12* −4.49

25k–225k −0.08* −8.59

>225k −0.01 −0.56

Service complexity mix 0.77* 45.06

Outpatient surgery in hospital 0.01 1.02

Government hospital 0.00 −0.46

For-profi t hospital −0.08* −5.75

Medical residents per discharge equivalent

Second quintile 0.06* 2.06

Third quintile 0.04 1.49

Fourth quintile 0.09* 3.19

Fifth quintile 0.04 1.78

Occupancy rate

Second quintile −0.01 −0.59

Third quintile 0.01 0.36

Fourth quintile −0.01 −0.55

Fifth quintile 0.04* 2.19

Percent of outpatient services in ER

Second quintile −0.04* −3.28

Third quintile −0.10* −6.68

Fourth quintile −0.13* −8.89

Fifth quintile −0.17* −10.04

Market share

Second quintile −0.03* −2.36

Third quintile −0.01 −0.82

Fourth quintile 0.00 −0.04

Fifth quintile 0.01 0.41

Percent of inpatient days that are Medicaid

Second quintile −0.01 −0.87

Third quintile 0.01 0.49

Fourth quintile 0.00 −0.28

Fifth quintile 0.00 −0.13

Note: ER (emergency room). The dependent variable is costs per service under the outpatient prospective payment system, adjusted for geographic 

differences in cost of inputs. The dependent variable, volume, and service mix are natural logarithms. All other variables are 0/1 dummy 

variables. Discharge equivalent = Discharges + (outpatient charges)/((inpatient charges)/discharges)). For residents per discharge equivalent, 

occupancy rate, percent of outpatient services that are ER services, market share, and percent of inpatient days that are Medicaid benefi ciaries, 

we divided hospitals into quintiles. For each of these variables, we used the fi rst quintile as the point of comparison. 

R-squared = 0.60. N = 2,808.

 * Signifi cant at 5 percent level

Source: MedPAC analysis of 2003 and 2004 outpatient claims fi les, 2004 Medicare Cost Report fi le, and 2004 Provider of Services fi le from CMS.

More about MedPAC

Rural payment provisions in the MMA | December 2006 33

Commission members

Glenn M. Hackbarth, J.D., chairman

Bend, OR

Robert D. Reischauer, Ph.D., vice chairman

The Urban Institute

Washington, DC

Term expires April 2008

Nancy-Ann DeParle, J.D.

JPMorgan Partners

Washington, DC

David F. Durenberger, J.D.

National Institute of Health Policy

University of St. Thomas

Minneapolis, MN

Jennie Chin Hansen, R.N., 

M.S.N., F.A.A.N.

AARP

San Francisco, CA

Nancy M. Kane, D.B.A.

Harvard School of Public Health

Boston, MA

Nicholas J. Wolter, M.D.

Billings Clinic

Billings, MT

Term expires April 2009

Mitra Behroozi, J.D.

1199SEIU Benefit and Pension Funds

New York, NY

Karen R. Borman, M.D.

University of Mississippi 

Medical Center

Jackson, MS

Ronald D. Castellanos, M.D.

Southwest Florida 

Urologic Associates

Ft. Myers, FL

Glenn M. Hackbarth, J.D.

Douglas Holtz-Eakin, Ph.D.

Maurice R. Greenberg Center 

for Geoeconomic Studies

Council on Foreign Relations

Washington, DC

Robert D. Reischauer, Ph.D.

Term expires April 2007

John M. Bertko, F.S.A., 

M.A.A.A.

Humana Inc.

Louisville, KY

Sheila P. Burke, M.P.A.,

R.N., F.A.A.N.

Smithsonian Institution

Washington, DC

Francis J. Crosson, M.D.

The Permanente Federation, LLC

Oakland, CA

Arnold Milstein, M.D., 

M.P.H.

Pacific Business Group on Health

San Francisco, CA

Ralph W. Muller, M.A.

University of Pennsylvania

Health System

Philadelphia, PA

William J. Scanlon, Ph.D.

Health policy consultant

Oak Hill, VA
34 Rural payment provisions in the MMA | December 2006

Commission staff

Mark E. Miller, Ph.D.

Executive director

Sarah Thomas, M.S.

Deputy director

Analytic staff

Jack Ashby, M.H.A.

Cristina Boccuti, M.P.P.

Niall Brennan, M.P.P.

Sharon Bee Cheng, M.S.

Evan Christman, M.P.Aff.

David V. Glass, M.S.

Timothy F. Greene, M.B.A.

Scott Harrison, Ph.D.

Kevin J. Hayes, Ph.D.

Sally Kaplan, Ph.D.

Kathryn Linehan, M.P.H.

Craig K. Lisk, M.S.

Anne Mutti, M.P.A.

Jennifer Podulka, M.P.Aff.

Nancy Ray, M.S.

Rachel Schmidt, Ph.D.

Joan Sokolovsky, Ph.D.

Jeffrey Stensland, Ph.D.

Ariel Winter, M.P.P.

Daniel Zabinski, Ph.D.

Research assistants

Sarah Friedman

Megan Moore

Special assistant to the 

executive director

Annissa McDonald

Administrative staff

Reda H. Broadnax, B.S., 

 Executive officer

Wylene Carlyle

Diane E. Ellison

Timothy Gulley

Tina Jennings, MTESL

Plinie (Ann) Johnson

Jason McMahon

Cynthia Wilson

Staff consultants

Carol Carter, Ph.D.

Dana K. Kelley, M.P.A.

Julian Pettengill

Carlos Zarabozo, A.B.
601 New Jersey Avenue, NW • Suite 9000 • Washington, DC 20001

(202) 220-3700 • Fax: (202) 220-3759 • www.medpac.gov