United States Government Accountability Office

GAO Report to Congressional Committees

MEDICARE

CMS’s Proposed 

Approach to Set 

Hospital Inpatient 

Payments Appears 

Promising 

July 2006 

 

GAO-06-880 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

July 2006

MEDICARE

CMS’s Proposed Approach to Set 

Hospital Inpatient Payments Appears 

Promising 

Highlights of GAO-06-880, a report to 

congressional committees 

Under Medicare’s inpatient

prospective payment system 

(IPPS), hospitals generally receive

fixed payments for hospital stays

based on diagnosis-related groups 

(DRG), a system that classifies 

stays by patient diagnosis and 

procedures. CMS is required to at 

least annually update DRG 

payments to address changes in the 

cost of inpatient care. CMS uses

charge-based weights to update 

these payments. Cost-based

weights are used to set payments in

the outpatient prospective payment 

system (OPPS). The Medicare

Prescription Drug, Improvement,

and Modernization Act of 2003 

required GAO to study IPPS 

payments in relation to costs. 

During the course of GAO’s work, 

CMS proposed a new cost-based 

method for determining DRG

weights. This report (1) examines 

the applicability of CMS’s costbased method—used for the 

OPPS—to weight DRGs in the IPPS

and (2) evaluates whether CMS’s 

proposed approach is an 

improvement over its OPPS

method for setting cost-based

weights. Using fiscal year 2002 cost

reports and claims from 2001, 2002, 

and 2003 to examine the 

applicability of the OPPS method, 

GAO estimated costs for 1,025 IPPS 

hospitals whose Medicare cost 

reports most consistently reflected 

the total charges and number of 

Medicare stays that these hospitals 

reported on their claims. To

evaluate CMS’s proposed approach,

GAO analyzed fiscal year 2003 cost

reports and 2003 claims for 3,558 

hospitals. 

If the OPPS method were applied to the IPPS, it could undermine the 

objective of better aligning DRG payment weights with actual costs. GAO 

estimated costs for 1,025 hospitals using CMS’s cost-based OPPS weighting 

method to determine its applicability for weighting inpatient DRGs, and 

found that, for all but one of the 1,025 hospitals, GAO’s application of CMS’s 

OPPS method resulted in cost estimates for inpatient accommodation 

services that on average were 72 percent less than what the hospitals 

reported on their Medicare cost reports for these services. For 57 percent of 

the hospitals, GAO’s application of CMS’s OPPS method resulted in cost 

estimates for inpatient ancillary services that on average were 8 percent 

more than what the hospitals reported on their Medicare cost reports. For 

22 percent of the hospitals, the application of CMS’s OPPS method resulted 

in cost estimates for inpatient ancillary services that were on average 

6 percent less than what the hospitals reported on their Medicare cost 

reports. These differences occur because the current OPPS weighting 

method does not address the variation in how hospitals allocate charges and 

costs in reporting Medicare services. 

GAO found that CMS’s proposed new approach to set payment weights for 

DRGs appears promising, and may result in improvements in setting costbased weights compared with the OPPS method. CMS’s proposed approach 

relies on grouping charges into 10 broad service groups, and converting 

those charges to cost-based weights by using national-average cost-to-charge

ratios (CCR) that are derived from hospital data submitted to CMS. Use of 

national-average CCRs ameliorates the effects that variations in hospital 

charge and cost allocation decisions can have on DRG weights. GAO’s 

analysis, using 2003 claims data and fiscal year 2003 cost report data for 

3,558 IPPS hospitals, suggests that 6 of the service groups, which constitute 

a majority of Medicare inpatient charges, appear promising. GAO also found 

that wide ranges in the CCRs for 2 of the groups, the therapeutic services 

and operating room groups, raise concerns about their ability to better align 

payment with costs for those services. GAO did not have enough specific 

information to determine whether the remaining 2 groups are likely to 

capture the relevant cost-to-charge relationship for services in those groups. 

In commenting on a draft of this report, CMS stated that it was pleased with 

GAO’s findings. CMS also stated that it could not comment further because it 

is currently considering public comments in developing the fiscal year 2007

final rule for the IPPS payment rates. Hospital association reviewers agreed

that cost estimation problems can result because of hospital reporting 

variation. However, they noted that because hospital reporting variation still 

affects the data CMS is proposing to use to set DRG weights, they were 

concerned with GAO’s assessment that the CMS approach is promising. GAO 

believes the approach appears promising, in particular, because CMS 

proposes to use national-average CCRs to reduce the impact of individual 

hospital reporting practices. 

www.gao.gov/cgi-bin/getrpt?GAO-06-880.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact A. Bruce 

Steinwald, (202) 512-7101 or 

steinwald@gao.gov. 
Contents 

Letter 1

Results in Brief 5

Background 6

Applying the OPPS Weighting Method to IPPS Could Undermine 

the Objective of Better Aligning DRG Payment Weights with 

Costs 12

CMS’s Proposed Cost-Based Approach for IPPS May Result in 

Improvements over the OPPS Cost-Based Method 14 

Concluding Observations 20 

Agency and External Reviewer Comments and Our Evaluation 20 

Appendix I Scope and Methodology 24 

Appendix II Comments from the Centers for Medicare & 

Medicaid Services 28 

Appendix III GAO Contact and Staff Acknowledgments 29 

Tables 

Table 1: Hospital Information Included on Claims and Medicare 

Cost Reports Submitted to CMS 8 

Table 2: CMS’s Proposed Service Groups 16 

Table 3: Proposed Therapeutic Services Group: Cost Centers and 

CCRs 19 

Figure 

Figure 1: How Hospitals Can Allocate Charges from Revenue

Centers to Cost Centers and the Effect on CMS’s Cost 

Estimates 11

Page i GAO-06-880 Medicare Hospital Inpatient Payments
Abbreviations 

AAMC Association of American Medical Colleges 

AHA American Hospital Association 

APC ambulatory payment classification 

CCR cost-to-charge ratio 

CMS Centers for Medicare & Medicaid Services 

COPD chronic obstructive pulmonary disease 

DRG diagnosis-related groups

HCRIS Healthcare Cost Reporting Information System 

HHS Department of Health and Human Services 

ICD-9-CM International Classification of Diseases, 9th Revision, 

 Clinical Modification 

IPPS inpatient prospective payment system 

MedPAC Medicare Payment Advisory Commission 

MEDPAR Medicare Provider Analysis and Review 

MMA Medicare Prescription Drug, Improvement, and 

 Modernization Act of 2003 

OPPS outpatient prospective payment system 

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Page ii GAO-06-880 Medicare Hospital Inpatient Payments
United States Government Accountability Office

Washington, DC 20548 

July 28, 2006

Congressional Committees 

At $119.4 billion, spending for hospital inpatient services accounted for 

over a third of total Medicare spending in fiscal year 2005. Most of these 

dollars were spent on care provided to Medicare beneficiaries by the 

approximately 4,000 acute care hospitals that bill Medicare under its 

inpatient prospective payment system (IPPS). Under this payment system, 

a hospital generally receives a fixed, predetermined payment amount for a 

hospital stay.1

 IPPS rates are based on diagnosis-related groups (DRG), a 

system that classifies inpatient stays by patient diagnosis and the 

procedures they receive. Each DRG has a numeric weight, which signifies 

the average costliness of stays assigned to that DRG relative to the average 

costliness of other inpatient stays. The Centers for Medicare & Medicaid 

Services (CMS) in the Department of Health and Human Services (HHS) is 

required by statute to update DRG weights at least annually to address the 

changes in the cost of inpatient care. As a result of the DRG updates, 

changes occur annually in the payments hospitals receive for inpatient 

stays. 

Because CMS does not have a direct measure of the cost of a hospital stay, 

it uses the charge information hospitals include on their Medicare claims 

to adjust the DRG weights. The weights that are developed from charge 

data are referred to as charge-based weights. Health policy analysts have

had long-standing concerns about the use of charge data to set DRG 

weights.2

 They contend that charges are not a good proxy for costs, in 

large part, because of the variation in hospitals’ charge-setting practices. 

 1

Throughout this report, we use the term stay to represent a patient’s hospitalization, which 

CMS and hospitals refer to as a discharge for data-reporting purposes. 

2

See Medicare Payment Advisory Commission (MedPAC), Report to the Congress: 

Variation and Innovation in Medicare (Washington, D.C.: June 2003); MedPAC, Report to 

the Congress: Physician-Owned Specialty Hospitals (Washington, D.C.: March 2005).

MedPAC advises the Congress on issues affecting the Medicare program. See also J. 

Newhouse, et al., “Predicting Hospital Accounting Costs,” Health Care Financing Review, 

vol. 11, no. 1 (1989); and Kurt F. Price, “Pricing Medicare’s Diagnosis Related Groups: 

Charges versus Estimated Costs,” Health Care Financing Review, vol. 11, no. 1 (1989). 

Page 1 GAO-06-880 Medicare Hospital Inpatient Payments
A hospital sets a charge for a service that is generally above the cost of the 

service. The difference between the charge and cost is referred to as a 

mark-up. Not all services are marked up by the same percentage; mark-ups

for services may be influenced by several factors, including level of 

competition in the local market, service utilization, and insurers’ 

purchasing arrangements. If all services were marked up over costs by an 

identical percentage, charges would represent the relative costliness of 

services perfectly. However, because variations in mark-up percentages 

vary across services and across hospitals, weights based on charges can 

overvalue some services and undervalue others and compromise the 

accuracy of DRG payment amounts. 

Recognizing the problem involved in using charges to determine DRG 

weights, the Medicare Payment Advisory Commission (MedPAC) 

recommended in 2005 that CMS use a cost-based rather than charge-based 

method to weight the DRGs in the IPPS.3

 A cost-based method entails 

estimating the costs of hospital services for each DRG. Basing weights on 

cost estimates is intended to better align payments with hospitals’ costs 

compared with the current charge-based method. 

CMS currently uses cost-based weights to determine relative costliness for 

outpatient services provided to Medicare beneficiaries under its hospital 

outpatient prospective payment system (OPPS).4

 However, in its notice of 

proposed rulemaking for the fiscal year 2006 IPPS rates, CMS noted that, 

without further analysis, it was uncertain whether using the current OPPS 

cost estimation method would better align payments with costs for 

inpatient DRGs.5

The Medicare Prescription Drug, Improvement, and Modernization Act of 

2003 (MMA) required us to conduct a study of the appropriateness of 

Medicare’s IPPS payments in relation to costs.6

 In light of MedPAC’s 

recommendation that CMS adopt a cost-based weighting method, we 

evaluated CMS’s concern about using the OPPS cost-based method to set 

DRG weights. During the course of our work, CMS published a notice of

 3

MedPAC, Report to the Congress: Physician-Owned Specialty Hospitals (Washington 

D.C.: March 2005). 

4

See 42 U.S.C. § 1395l(t)(2)(C). 

5

70 Fed. Reg. 23,306, 23,455 (May 4, 2005). 

6

Pub. L. No. 108-173, § 501(c), 117 Stat. 2066, 2290. 

Page 2 GAO-06-880 Medicare Hospital Inpatient Payments
proposed rulemaking describing its intent to use a new cost-based 

approach to adjust the DRG weights beginning in fiscal year 2007.7

 We 

discussed these developments with the committees of jurisdiction, and 

this report examines (1) the applicability of CMS’s cost-based method—

used to set weights in OPPS—to weight DRGs in the IPPS and (2) whether 

CMS’s proposed approach for the IPPS is an improvement over its OPPS 

method for setting cost-based weights. 

To examine the applicability of CMS’s OPPS cost-based method to weight

DRGs in the IPPS, we reviewed CMS instructions to hospitals on billing 

Medicare for services provided, and CMS instructions to hospitals for 

filing Medicare cost reports—these cost reports are submitted annually to

CMS by hospitals and contain aggregate information on charges for 

services and the actual costs of providing those services to all patients, as 

well as information on total charges and estimates of costs for services 

provided to Medicare beneficiaries. We used the Medicare Provider 

Analysis and Review (MEDPAR)—a CMS database that compiles and 

maintains hospitals’ Medicare claims—to analyze hospital claims. For 

3,660 hospitals paid under Medicare IPPS in fiscal year 2002, we compared 

Medicare cost reports and claims for services delivered. We identified 

1,025 IPPS hospitals whose Medicare cost reports most consistently 

reflected the total charges and number of Medicare stays that these 

hospitals reported on their claims.8

 Using each hospital’s fiscal year 2002

claims and Medicare cost report data for the 1,025 hospitals, we applied 

the OPPS cost estimation method to estimate Medicare costs for each 

hospital separately. CMS uses a single method to match cost information 

from the cost reports to charge information from the claims, and applies 

this method uniformly to all hospitals to estimate costs. Costs are 

estimated by using hospital-specific cost-to-charge ratios (CCR) derived 

from each hospital’s respective Medicare cost report. A CCR is a ratio that 

describes the cost and charge relationship for similar services, such as 

pharmacy or laboratory, or for all services provided in a hospital. Similar 

to CMS, we developed a single method to match costs to charges, applied

this method uniformly to all hospitals, and used hospital-specific CCRs to 

 7

71 Fed. Reg. 23,996, 24,006-24,011 (April 25, 2006). By August 1, 2006, after evaluating 

comments on its notice of proposed rulemaking, CMS expects to publish a final rule

describing its decision on the use of cost-based weights.

8

We excluded hospitals from our analysis if the total Medicare charges and number of stays 

from their cost reports and claims data did not match within .3 percent.

Page 3 GAO-06-880 Medicare Hospital Inpatient Payments
estimate a hospital’s costs.9

 For each hospital, we aggregated cost 

estimates for accommodation and ancillary services separately.10 We then 

compared these aggregate estimates to what each hospital reported as its 

total Medicare costs for these services for fiscal year 2002 to determine the 

extent to which our cost estimates matched what each hospital reported 

on its Medicare cost report. We interviewed representatives from CMS, 

and fiscal intermediaries (claims administration contractors for CMS that 

process hospital claims). In addition, we spoke with representatives of the 

American Hospital Association (AHA) and the Association of American 

Medical Colleges (AAMC) about general hospital IPPS issues in October 

2004. Our results are not generalizable to hospitals whose total charges 

and hospital stays from their Medicare cost reports and claims data did not

match within .3 percent in fiscal year 2002. 

To address whether CMS’s proposed approach for the IPPS is an 

improvement over its OPPS method of setting cost-based weights, we first 

identified potential problems in applying the OPPS method to the IPPS. If 

our cost estimates did not match what hospitals reported on their cost 

reports, we compared how charges were categorized on the claims relative 

to how they were categorized on the cost report. On the basis of this 

analysis, we then determined whether CMS’s proposed approach would 

better capture measures of cost. In particular, CMS’s approach entails 

grouping charges from hospitals’ claims into 10 broad service groups.11

CMS uses these service groups as a basis to create cost-based weights by 

using national-average CCRs to eliminate charge mark-ups for each service 

group. In examining the proposed approach, we reviewed CMS’s April 

2006 notice of proposed rulemaking and analyzed 2003 Medicare claims 

and fiscal year 2003 Medicare cost reports for 3,558 IPPS hospitals to 

evaluate the national-average CCRs.12 We determined the data to be 

 9

Because the data sources that CMS uses to set payment rates are different for the IPPS 

and OPPS and because certain IPPS services are not provided in the OPPS, we needed to

develop a mapping method to match cost information from the cost report to IPPS charge 

information from the claims. For more detail on our mapping method, see our scope and

methodology in app. I. 

10Accommodation services include room and board and nursing services. Ancillary services 

include all other services associated with an inpatient stay, for example, drugs and 

diagnostic services. 

11The 10 proposed service groups are routine, intensive, drugs, supplies & equipment,

therapeutic services, operating room, cardiology, laboratory, radiology, and other services. 

12We did not examine the extent to which the OPPS method measures relative costliness 

for outpatient services. 

Page 4 GAO-06-880 Medicare Hospital Inpatient Payments
sufficiently reliable for the purposes of this report. (For more detail on our 

scope and methodology, see app. I.) We performed this work from June 

2004 through July 2006 in accordance with generally accepted government 

auditing standards. 

If the OPPS method were applied to the IPPS, it could undermine the 

objective of better aligning DRG payment weights with costs. When we 

estimated fiscal year 2002 costs using CMS’s cost-based OPPS weighting 

method to determine its applicability for weighting inpatient DRGs, we 

found that, for all but one of the 1,025 hospitals in our analysis, our 

application of CMS’s OPPS method resulted in cost estimates for inpatient

accommodation services that on average were 72 percent less than what 

the hospitals reported on their Medicare cost reports for these services. 

For 57 percent of the hospitals, our application of CMS’s OPPS method 

resulted in cost estimates for inpatient ancillary services that on average 

were 8 percent more than what the hospitals reported on their Medicare 

cost reports.13 For 22 percent of the hospitals, our application of CMS’s 

OPPS method resulted in cost estimates for inpatient ancillary services 

that were on average 6 percent less than what the hospitals reported on 

their Medicare cost reports. These differences resulted from our 

application of CMS’s single approach to mapping hospital-specific cost 

center CCRs to revenue center charges. Cost differences result because 

this method does not address the variation in how hospitals allocate their 

charges and costs. 

Results in Brief 

CMS is proposing a new cost-based approach to set payment weights for 

inpatient DRGs that appears promising, and may result in improvements in 

setting cost-based weights compared with the OPPS method. The proposal 

involves grouping charges into 10 broad service groups. The charges for 

each of the 10 service groups are converted to cost-based weights by using 

national-average CCRs that correspond to each of the service groups. This 

approach ameliorates the problems we observed with the OPPS method 

because the approach does not require the application of hospital-specific 

CCRs. When CMS applies hospital-specific CCRs to match charges to costs 

for all hospitals, it may not capture the relevant cost-to-charge 

 13The 8 percent is based on estimates from 1,020 hospitals. This estimate excludes ancillary 

cost estimates for 5 hospitals from our sample of 1,025 because they were extreme outliers. 

When we included data from these hospitals in our aggregate cost estimates, the resulting 

ancillary cost estimates for the 1,025 were overestimated on average by 222 percent

relative to what all the hospitals reported. 

Page 5 GAO-06-880 Medicare Hospital Inpatient Payments
relationships for services. Using national-average CCRs in the proposed 

approach is intended to reduce the impact that variations in hospital 

charge and cost allocation decisions can have on the DRG weights. Six of 

the service groups, which constitute a majority of Medicare inpatient 

charges, appear promising because their CCRs are relatively consistent 

with one another within a service group and are likely to capture the 

relevant cost-to-charge relationship for the services included in these 

groups. An additional 2 groups contain cost center CCRs that range widely

within their respective groups and, therefore, raise concerns about their 

ability to better align payment with costs for services in those groups. 

While the remaining 2 groups also include cost center CCRs that vary 

widely, due to the limitations of the MEDPAR data, we did not have 

enough specific information to determine whether the 2 remaining service 

groups are likely to capture the relevant cost-to-charge relationship for the 

services included in those groups. 

In commenting on a draft of this report, CMS stated that it was pleased 

with our findings. CMS also stated that it could not comment further 

because it is currently considering public comments in developing the 

fiscal year 2007 final rule for the IPPS payment rates. Hospital association 

reviewers agreed that cost estimation problems can result because of 

hospital reporting variation. However, they noted that because hospital 

reporting variation still affects the data CMS is proposing to use to set 

DRG weights, they were concerned with our assessment that the CMS 

approach is promising. We believe the approach appears promising, in 

particular, because CMS proposes to use national-average CCRs to reduce 

the impact of individual hospital reporting practices. 

To set payment weights for inpatient and outpatient services, CMS has two 

sources of data: claims, which are bills hospitals submit to CMS upon a 

Medicare beneficiary’s discharge to receive payment for inpatient and 

outpatient services rendered to Medicare beneficiaries, and Medicare cost 

reports, which are statements that hospitals submit annually to CMS 

identifying, by service category, the charges and costs for services 

rendered to all patients, not just Medicare beneficiaries. Charge-based 

weights, derived from claims data, are used to measure the relative 

costliness of stays assigned to DRGs in the hospital inpatient setting. Costbased weights, derived from claims and Medicare cost report information, 

are used to measure the relative costliness of ambulatory payment 

classification (APC) groups in the outpatient setting. APCs in the OPPS are 

analogous to DRGs in the IPPS. 

Background 

Page 6 GAO-06-880 Medicare Hospital Inpatient Payments
Hospitals submit claims upon a beneficiary’s discharge to CMS identifying 

charges for services delivered to a Medicare beneficiary. These charges 

are billed by categories of service—for example, anesthesiology, 

cardiology, radiology—and these categories are referred to as revenue

centers. A revenue center represents a revenue-generating department or 

unit within a hospital. By associating a revenue center with each service 

billed on a claim, a hospital can track its charges for services associated 

with that department. 

Claims and Medicare Cost 

Reports Are the Data 

Sources Available to Set 

Payment Weights for IPPS 

and OPPS Services 

In addition to keeping track of its charges for services by department or 

unit, a hospital tracks the costs associated with these departments. 

Hospitals submit this information annually to CMS on their Medicare cost 

reports. These reports contain hospitals’ actual total costs and costs by 

department for all patients. The costs are reported in broad categories 

called cost centers. Similar to revenue centers, pharmacy, supplies, 

cardiology, and emergency room are also examples of cost centers, based 

on departments common to many hospitals. 

CMS requires hospitals to report total charge and cost data for all patients

by cost center. Although CMS does not require a one-to-one match 

between cost centers and revenue centers, it requires that a hospital report 

its list of revenue centers that are contained in each of its cost centers. 

Neither the cost nor the charge data reported in cost centers are broken 

down by individual items and services delivered by hospital stay, or DRG. 

Revenue center charges are accumulated from all claims for all patients 

and reported in total in associated cost centers on the Medicare cost 

report. The relationship between revenue centers and cost centers is 

subject to individual hospital discretion in how they accumulate charges 

and costs and is therefore variable across hospitals. Table 1 describes the 

information included on claims and on Medicare cost reports. 

Page 7 GAO-06-880 Medicare Hospital Inpatient Payments
Table 1: Hospital Information Included on Claims and Medicare Cost Reports Submitted to CMS 

Information ClaimsaMedicare cost report

b

Charges Lists charges for each service provided Includes hospital’s total charges and charges aggregated by cost 

center for (1) all patients and (2) Medicare beneficiaries 

Costs None Includes hospital’s total costs aggregated by cost center for all 

patients and hospital’s estimates of the share of costs accounted

for by Medicare beneficiaries

Categories of services Revenue centers Cost centers 

Submitted to CMS Upon a beneficiary’s discharge Annually 

Source: GAO analysis of information contained on claims and Medicare cost reports. 

a

A claim contains billed charges for services provided during an inpatient stay. 

b

A Medicare cost report contains an annual summary of a hospital’s total costs and charges. 

Hospitals vary in the number of cost centers and revenue centers they use,

and their decisions in allocating costs and charges to cost centers are 

driven typically by the hospitals’ own internal accounting systems and 

organizational structure. For example, if a hospital does not have a 

separate department for anesthesia services, it may allocate its charges for 

anesthesia to the Medicare cost report’s cost center for operating room. 

Though hospitals report their total charges and total costs for all patients, 

as well as total costs and charges by cost center, they do not separately 

track the costs of services delivered by payer source. However, in 

reporting to CMS, each hospital must include in its Medicare cost report 

total charges for all patients, total charges for Medicare beneficiaries, and 

an estimate of the share of the hospital’s costs for services delivered to 

Medicare beneficiaries, in total and by cost center. 

Charge-Based Weights Are 

Used to Measure Relative 

Costliness of Inpatient 

DRGs 

To determine the costliness of one inpatient DRG compared with others, 

CMS uses charge data from claims. Generally, the charges on a claim are 

for accommodation and ancillary services. Accommodation services 

include room and board and nursing services. These services are classified

as either routine or intensive care, based on the level of intensity of the 

nursing services required. Ancillary services include all other services 

Page 8 GAO-06-880 Medicare Hospital Inpatient Payments
associated with an inpatient stay; for example, drugs and diagnostic 

services.14

Charges for accommodation and ancillary services have been used to 

weight DRGs since 1986. In general, the average charge for each DRG is 

divided by the average charge for all DRGs to produce a weight. The 

resulting weights are multiplied by a base payment rate to determine 

payment for each DRG.15

Charges have long been considered a problem in setting relative weights 

for inpatient hospital services because the method assumes a consistent 

relationship between the charge set for an item or service and its cost to 

the hospital. A recent MedPAC-sponsored report on hospitals’ chargesetting practices attributes the wide variation in the relationship between

costs and charges to hospital-specific factors—such as mission, location,

and payer mix—and charge mark-up decisions.16

Cost-Based Weights Are 

Used to Measure Relative 

Costliness of Outpatient 

APCs 

Unlike IPPS, which uses charges to set payment weights for DRGs, CMS 

uses cost-based weights in the OPPS to measure the costliness of one APC 

relative to the others. Because neither the claims nor the Medicare cost 

reports include the costs for individual items or services, these costs must 

be estimated by CMS in order to calculate payment weights. As a first step, 

CMS obtains hospital charge data on each outpatient service from the 

claims. It calculates each hospital’s cost for each service by multiplying 

the charge amount for each service by the CCR that is computed from 

each hospital’s cost report, generally on a cost center-specific basis. The 

application of a CCR to a charge is designed to remove the mark-up from

each charge in order to identify the cost of the item or service. For 

example, to estimate the cost of a radiology service, CMS multiplies the 

charge associated with a hospital’s radiology revenue center on each claim 

by the radiology cost center CCR for that hospital. CMS uses these 

estimated costs to develop payment weights for each APC. 

 14Payment for physician services is not included in the DRG payment to hospitals. 

Physicians are paid by Medicare under a separate fee schedule. 

15The base payment rate is a standardized amount, which is divided into labor and 

nonlabor-related shares. 

16The Lewin Group, A Study of Hospital Charge Setting Practices (Falls Church, Va.:

2005). 

Page 9 GAO-06-880 Medicare Hospital Inpatient Payments
Hospitals vary in how they allocate revenue center charges to cost centers 

on their Medicare cost reports. When estimating costs for purposes of 

weighting APCs, however, CMS uses its own system of mapping the 

hospitals’ revenue center charges to cost center CCRs in order to convert 

the charges to an estimate of cost. This can be problematic since hospitals 

may allocate their revenue centers to cost centers in a different manner 

from CMS. For example, as illustrated in figure 1, some hospitals allocate 

charges from the same revenue center to separate cost centers; others 

allocate charges from several revenue centers to a single cost center. 

CMS’s use of a single method in mapping charges to costs and then 

applying that method across all hospitals for purposes of cost estimation 

does not recognize the differences in hospital allocation decisions when 

estimating costs. As a result, some service costs are systematically 

overestimated and some are underestimated. 

Page 10 GAO-06-880 Medicare Hospital Inpatient Payments
Figure 1: How Hospitals Can Allocate Charges from Revenue Centers to Cost Centers and the Effect on CMS’s Cost 

Estimates 

Source: GAO. 

Hospital B allocates charges for three revenue centers to one cost center

Hospital B’s claim for a beneficiary

Revenue Charge 

centers amounts

Anesthesia $500

Operating room services $1,000

Supplies $500

Hospital B’s annual cost report

Cost Aggregate CCRs

centers charges

Anesthesia $0 N/A 

Operating room services $2,000 .33a

Supplies $0 N/A 

CMS’s estimation of Hospital B’s cost

Cost Charge CCRs Estimated

centers amounts costs

Anesthesia $500 x .40 = $200

Operating room services $1,000 x .33a = $330

Supplies $500 x .40 = $200

CMS uses the hospital’s 

overall ancillary CCR (.40) to 

estimate the cost of services 

without associated CCRs.

Hospital A allocates ancillary charges for three revenue centers to three separate cost centers

Hospital A’s claim for a beneficiary

Revenue Charge 

centers amounts

Anesthesia $500

Operating room services $1,000

Supplies $500

Hospital A’s annual cost report

Cost Aggregate CCRs

centers charges

Anesthesia $500 .17

Operating room services $1,000 .40

Supplies $500 .34 

CMS’s estimation of Hospital A’s cost

Cost Charge CCRs Estimated

centers amounts costs

Anesthesia $500 x .17 = $85

Operating room services $1,000 x .42 = $420

Supplies $500 x .34 = $170

CMS uses the hospital’s 

reported CCRs from each 

ancillary service cost 

center to estimate cost.

Note: For illustrative purposes, these hospitals’ total charges reflect charges for only one patient. 

Hospitals’ Medicare cost reports would normally contain all charges for all services delivered during a 

fiscal year. 

a

The CCR computed for Hospital B’s operating room services is a weighted average reflecting the 

costs and charges for all three of the services reported on the Medicare cost report. 

Page 11 GAO-06-880 Medicare Hospital Inpatient Payments
The services represented in figure 1 are ancillary services typical to many 

hospitals. Hospital A reports charges in all three cost centers, and reports 

CCRs for these cost centers. Hospital B does not use separate cost centers

for anesthesia and supplies; therefore, it does not report any charges in its 

cost centers for anesthesia and supplies. As a result, Hospital B does not 

report CCRs for these services specifically. To estimate the cost for these 

services without an associated CCR, the current OPPS cost-based 

weighting method uses, or defaults to, the hospital’s overall ancillary 

CCR—which is the ratio of a hospital’s total ancillary costs to its total 

ancillary charges. Therefore, in the case of Hospital B, CMS’s single 

mapping approach defaults to Hospital B’s overall ancillary CCR to 

estimate a cost for its anesthesia and supply charges. To the extent that 

the hospital’s overall ancillary CCR is an inaccurate measure of the costto-charge relationship for those services, the costs of those services will be 

overestimated or underestimated. If these cost estimates are used to set 

relative weights, payment amounts for the services can be inappropriate.

CMS asserts that the application of CCRs to Medicare charges is a 

fundamental principle of cost reimbursement and has been in effect for 

many years. Because CMS does not have any other financial information 

from hospitals except each hospital’s claims and Medicare cost report, it 

views the use of CCRs as the most straightforward way to estimate costs 

from charges.17

When we used CMS’s cost-based OPPS weighting method to determine its 

applicability for weighting inpatient DRGs, we found that, for the majority 

of hospitals in our analysis, our estimates of aggregate costs for Medicare 

stays were on average more than what the hospitals reported on their cost

reports for ancillary services. In addition, our estimates for 

accommodation services were on average less than what the hospitals 

reported on their cost reports for the Medicare services associated with 

these stays. These differences resulted from CMS’s single approach to 

mapping hospital-specific cost center CCRs to revenue center charges. 

Cost differences result because the CMS method does not address the 

variations in how hospitals allocate charges and costs. Using such cost 

estimates to set DRG weights in the IPPS would undermine the goal of 

better aligning payment with costs. 

Applying the OPPS 

Weighting Method to 

IPPS Could 

Undermine the 

Objective of Better 

Aligning DRG 

Payment Weights with 

Costs 

 17See 70 Fed. Reg. at 23,455 (May 4, 2005). 

Page 12 GAO-06-880 Medicare Hospital Inpatient Payments
We estimated costs using the OPPS method for each hospital stay and 

aggregated the accommodation and ancillary cost estimates for each of the 

1,025 hospitals in our analysis. We compared our aggregate 

accommodation and ancillary cost estimates to the accommodation and 

ancillary costs each hospital reported on its Medicare cost report. For all 

but one of the hospitals in our analysis, our application of CMS’s OPPS 

method resulted in cost estimates for inpatient accommodation services 

that were on average 72 percent less than what the hospitals reported on 

their Medicare cost reports for these services. For 57 percent of the 

hospitals, our application of CMS’s OPPS method resulted in cost 

estimates for inpatient ancillary services that were on average 8 percent 

more than what the hospitals reported on their Medicare cost reports.18

For 22 percent of the hospitals, our application of CMS’s OPPS method 

resulted in cost estimates for inpatient ancillary services that were on 

average 6 percent less than what the hospitals reported on their Medicare

cost reports. 

The differences between our aggregate estimates using the OPPS method 

and hospitals reported costs indicate that a single approach to mapping 

cost center CCRs to revenue center charges is problematic because CCRs 

are applied to certain charges that do not capture the cost-to-charge 

relationship for those charges. For example, approximately 18 percent of 

the hospitals in our analysis did not allocate their charges for anesthesia 

services to their Medicare cost report’s anesthesia cost center and thus did

not report a CCR for that cost center.19 In applying the CMS OPPS method 

to estimate the cost of anesthesia services for these hospitals, we 

multiplied each hospital’s anesthesia charge included on the hospital’s 

claims by each hospital’s overall ancillary CCR. Although we could not 

measure the precise effect of using a default CCR for these services, our 

information on average CCRs was instructive. That is, the average overall 

ancillary CCR for the 1,025 hospitals in our analysis was .34 and for the 

hospitals that reported costs and charges in the anesthesia cost center, the 

 18The 8 percent is based on estimates from 1,020 hospitals. This estimate excludes ancillary 

cost estimates for 5 hospitals from our sample of 1,025 because they were extreme outliers. 

When we included data from these hospitals in our aggregate cost estimates, the resulting 

ancillary cost estimates for the 1,025 were overestimated on average by 222 percent

relative to what all the hospitals reported. 

19This hospital allocation practice—billing for services and allocating the charges to a

different cost center service type—occurred to varying degrees for all ancillary cost 

centers. 

Page 13 GAO-06-880 Medicare Hospital Inpatient Payments
average anesthesia CCR was .16.20 The difference between the two CCRs 

suggests that using each hospital’s overall ancillary CCRs to estimate its 

anesthesia costs produced an estimate that, on average, overvalued these

services at the individual hospital level and contributed to the differences 

between the aggregated ancillary cost estimates we calculated and what 

hospitals reported to CMS as their ancillary costs. The extent of the 

problem for cost estimation depends upon the frequency with which the 

overall ancillary CCR is used in place of a specific cost center CCR. 

Cost estimation problems can also result when hospitals report two 

distinct service types, with different mark-ups, in one cost center. 

Specifically, about 9 percent of the hospitals in our analysis reported 

charges for intensive care services in a cost center other than intensive 

care. For example, some of these hospitals may have reported intensive 

care charges with routine service charges in the routine cost center. In 

fiscal year 2002, hospitals’ average CCR for intensive care services for the

1,025 hospitals in our analysis was .81 compared with the average CCR for 

routine services of .96. Such combining into one cost center results in a 

weighted average CCR that may undervalue routine services and overvalue 

intensive care services. These estimates can systematically influence 

DRGs that have a disproportionate amount of either intensive care or 

routine services. 

CMS is proposing an approach to set payment weights for inpatient DRGs 

that appears promising, and may result in improvements in setting costbased weights compared with the OPPS method. The proposal involves 

grouping charges into 10 broad service groups. The charges for each of the 

10 service groups are converted to cost-based weights by using nationalaverage CCRs that correspond to each of the service groups. This 

approach ameliorates the problems we observed with the OPPS method 

because it does not require the application of hospital-specific CCRs, 

which, using CMS’s single method to match charges to cost, may not 

capture the relevant cost-to-charge relationships for services. Using 

national-average CCRs is intended to reduce the impact that variations in 

CMS’s Proposed CostBased Approach for 

IPPS May Result in 

Improvements over 

the OPPS Cost-Based 

Method 

 20The average mark-up for overall ancillary services was 194 percent of the cost, and for 

anesthesia services the average mark-up was 525 percent. These mark-ups were in addition

to the cost and result in a charge that is almost three times and six times the cost of 

services for all ancillary and anesthesia services, respectively. For example, a hospital’s 

cost for an anesthesia service was $16. The hospital applied a mark-up of $84, which is 

525 percent of $16, resulting in a charge of $100. 

Page 14 GAO-06-880 Medicare Hospital Inpatient Payments
hospital charge and cost allocation decisions can have on the DRG 

weights. Six of the service groups, which constitute a majority of Medicare 

inpatient charges, appear promising because their CCRs are relatively 

consistent within a service group and are likely to capture the relevant 

cost-to-charge relationship for the services included in these groups. An 

additional 2 groups contain cost center CCRs that range widely within 

their respective groups and, therefore, raise concerns about their ability to

better align payment with costs for services in those groups. Finally, due 

to the limitations of the MEDPAR data, we did not have enough 

information to determine whether the 2 remaining service groups are 

likely to capture the relevant cost-to-charge relationship for the services 

included in those groups. 

National-Average CCRs 

Intended to Reduce Impact 

on IPPS Weights of 

Variation in Hospital 

Charge and Cost 

Allocation Decisions 

Under its proposed approach for the IPPS, CMS takes several steps to 

create cost-based weights for each DRG. The approach entails grouping 

charges from hospital’s claims into 10 broad service groups.21 (See table 2.)

CMS uses these service groups as a basis to create charge-based weights 

by standardizing the charges in each group to remove differences due to 

hospital-specific characteristics. To standardize the charges, CMS 

calculates an average charge for each hospital for each of the 10 proposed 

service groups. CMS then divides each individual hospital’s charge for 

each service by that hospital’s average charge for the service group. 

Ultimately, these standardized charges for all hospitals are aggregated by 

DRG and the average charge for each DRG is divided by the nationalaverage charge for all cases. This yields 10 standardized, national chargebased weights that correspond to each service group for each DRG. In 

order to convert these charge-based weights to cost-based weights, charge

mark-ups must be removed. To accomplish this, CMS calculates 10 

national-average CCRs for each of the 10 broad service groups using 

hospitals’ Medicare cost report data. CMS then uses these CCRs to convert 

the national charge-based weights to cost-based weights.22 The 10 costbased weights for each DRG are summed to produce one final weight for 

each DRG. 

 21In this report, we use the term service group to describe CMS’s proposed groups. In its

Federal Register notice, CMS refers to these groups as cost centers. 

22It is possible that a particular DRG may have a zero value for one or more of the 10

service groups. This can occur if hospitals do not provide particular services as part of a

DRG. 

Page 15 GAO-06-880 Medicare Hospital Inpatient Payments
Table 2: CMS’s Proposed Service Groups 

CMS’s proposed service 

group 

Revenue centers from claims used to

calculate relative charge weightsa

Cost centers from Medicare cost report used to

calculate national-average CCRs 

Routine Private room

Semi-private room 

Ward

Adults & pediatrics 

Intensive Intensive care

Coronary care 

Intensive care unit 

Coronary care unit 

Burn intensive care unit 

Surgical intensive care unit 

Other special care unit 

Drugs Pharmacy Drugs charged to patients 

Intravenous therapy 

Supplies & Equipment Medical/surgical supply 

Durable medical equipment 

Used durable medical equipment 

Medical supplies charged to patients 

Durable medical equipment rented 

Durable medical equipment sold 

Therapeutic Services Physical therapy 

Occupational therapy 

Speech therapy

Inhalation therapy 

Physical therapy 

Occupational therapy 

Speech pathology 

Respiratory therapy 

Operating Room Operating room

Anesthesia 

Operating room

Recovery room

Delivery and labor room 

Anesthesiology 

Cardiology Cardiology Electrocardiology

Electroencephalography 

Laboratory Laboratory Laboratory

Provider-based physician clinical laboratory service 

Radiology Radiology

Magnetic resonance imaging (MRI) 

Lithotripsy 

Radiology-diagnostic 

Radiology-therapeutic 

Radioisotope 

Other Services Ambulance 

Blood 

Blood administration 

Outpatient services 

Emergency room

Clinic visit 

End-stage renal disease (ESRD) 

Other services

Ambulance 

Whole blood and packed red blood cells 

Blood storing, processing, and transporting

Other outpatient services 

Ambulatory surgical center (Non-distinct part)

Emergency 

Clinic 

Home program dialysis 

Renal dialysis

Other ancillary

Source: GAO analysis and 71 Fed. Reg. 23,996, 24,009-24,010 (April 25, 2006). 

a

Data for the revenue centers are from the CMS MEDPAR file. MEDPAR pools revenue centers into 

broad revenue center categories and reports total charges by these categories. The revenue centers 

from MEDPAR are not a one-to-one match with cost centers from the Medicare cost reports. 

Page 16 GAO-06-880 Medicare Hospital Inpatient Payments
The proposed approach, which entails using national-average CCRs rather 

than individual hospital CCRs, is intended to reduce the impact that 

variations in hospital charge and cost allocation decisions can have on

DRG weights. Specifically, the national-average CCRs, in conjunction with 

standardized charge-based weights, are more likely than the OPPS method 

that entails using hospital-specific CCRs to capture the relevant cost-tocharge relationships for the services in each group. In principle, the 

national-average CCRs are applied to a group of services with similar 

charge mark-ups. Similarly, the national-average CCRs will be influenced

by the most commonly used hospital allocation practices among hospitals 

and are, therefore, less likely to be influenced by atypical hospital 

allocation practices. Furthermore, because a national-average CCR is 

established for each service group, the proposed approach eliminates the 

need to use, or default to, a hospital’s overall CCR when a particular cost 

center CCR is not reported. For these reasons, CMS’s proposed approach 

to establishing cost-based weights for the purpose of better aligning 

payments with costs for DRGs appears promising. 

Service Group Approach 

Appears Promising but 

Some Concerns Exist 

Because CMS’s broad service group approach is integral to improved 

payment accuracy, and because CMS is currently considering refinements 

to the service groups for the fiscal year 2007 IPPS payments, we examined 

the 10 proposed service groups and their associated national-average 

CCRs.23 For 6 of the proposed service groups, which constitute a majority 

of Medicare inpatient charges, the national-average CCRs appear 

promising, and are likely to capture the relevant cost-to-charge 

relationships for the services included in these groups. An additional 

2 groups contain cost center CCRs that range widely within their 

respective groups, and therefore, raise concerns about their ability to 

better align payment with costs for services in those groups. Due to the 

limitations of the MEDPAR data, we did not have enough information to 

determine whether the 2 remaining service groups are likely to capture the 

relevant cost-to-charge relationship for the services included in the 

groups. 

 23CMS’s proposed service groups are based on its analysis of cost report and claims data. 

Each group includes revenue center charges that, in total for the group, represent at least 

5 percent of all Medicare charges for inpatient hospital services. The groups also include 

cost centers that, CMS asserts, are consistent with general hospital accounting definitions.

To analyze the cost centers within the service groups, we used fiscal year 2003 Medicare 

cost report data for 3,558 hospitals paid under the IPPS in order to conform to the same 

time period as the analysis CMS conducted for its April 2006 notice of proposed 

rulemaking. 

Page 17 GAO-06-880 Medicare Hospital Inpatient Payments
Six of the groups, which constitute approximately 63 percent of total 

Medicare inpatient charges in 2003, appear promising since they either 

contain cost center CCRs that are relatively consistent with one another 

within a group, or contain individual cost center CCRs that vary from the 

national-average CCRs, but the charges associated with those services 

constitute a small percentage of total Medicare inpatient charges. For 

example, one of these six groups—radiology—includes three cost center 

CCRs that are relatively consistent with the radiology national-average 

CCR, with a range of 7 percentage points between the highest and lowest 

CCR for these three cost centers. This grouping produces a nationalaverage CCR that will not be unduly influenced by any one cost center 

CCR included in the average. The other service groups that appear 

promising include cardiology, routine, drugs, supplies & equipment, and 

other services.24

While six of the service groups that constitute a majority of Medicare 

inpatient charges appear promising, two other groups, therapeutic 

services and operating room, raise concerns because they contain cost 

center CCRs that vary widely and involve services that can be linked to 

high-volume DRGs. The national-average CCR for these service groups 

may not capture the appropriate cost-to-charge relationships for certain 

services in those groups and could undermine the goal of better aligning 

payments with costs for those services. Table 3 illustrates this problem for 

one of the groups, therapeutic services, where the difference between the 

lowest and highest cost center CCR is 26 percentage points. The cost 

center CCR for respiratory therapy is substantially lower than the other 

cost center CCRs included in this group.25 Respiratory therapy is used to 

treat respiratory diseases classified under DRG 088—chronic obstructive 

pulmonary disease (COPD)26—Medicare’s fourth most frequently billed 

DRG. In 2003, hospitals billed Medicare approximately $1.4 billion for 

respiratory therapy services provided under DRG 088. This amount 

accounted for 17 percent of the total ancillary service charges and 

11 percent of the total charges for DRG 088, which were $12 billion. The 

 24The supplies & equipment and other services groups include cost center CCRs that range 

widely from the national-average CCR for their groups; however, the charges associated 

with those services constitute approximately 1 percent of total Medicare charges and, 

therefore, are not likely to have an impact on the DRG weights that include those services. 

25Respiratory therapy is also referred to as inhalation therapy. 

26COPD refers to chronic lung disorders that result in blocked air flow in the lungs. The two 

main COPD disorders are emphysema and chronic bronchitis, the most common causes of

respiratory failure. 

Page 18 GAO-06-880 Medicare Hospital Inpatient Payments
other therapy services in the group accounted for approximately 1 percent 

of the DRG’s total charges. 

Table 3: Proposed Therapeutic Services Group: Cost Centers and CCRs 

Cost centers included in the 

therapeutic services group 

GAO-calculated cost 

center CCRs 

CMS-proposed nationalaverage CCR for 

therapeutic services group

Physical therapy .52 

Occupational therapy .44 

Speech pathology .53

Respiratory therapy .27 

.35 

Source: GAO analysis based on fiscal year 2003 Medicare cost report data and 71 Fed. Reg. 24,021 (April 25, 2006). 

Our analysis of hospitals’ fiscal year 2003 Medicare cost report data 

showed that, on average, for the 3,558 hospitals paid under the IPPS that 

we reviewed, the CCR for respiratory therapy is .27. The use of the 

national-average CCR would result in a weight that would undervalue 

physical, occupational, and speech therapy services. Conversely, the use 

of the national-average CCR in this instance would result in an estimate 

that overvalues respiratory therapy services. Because these services 

account for 17 percent of all ancillary charges for DRG 088, the application 

of the national-average CCR will result in a weight that would be based on 

an overstated cost estimate. This is a problem because the overstated cost 

estimate for this service is a significant portion of a high-volume DRG. 

Similarly, the operating room service group may not capture the 

appropriate cost-to-charge relationships for certain services. The services

contained within this group can be linked to DRGs that involve surgery, 

and those DRGs constitute almost half of the number of IPPS DRGs. The 

group contains CCRs for operating room and anesthesia, which are .38 and 

.17, respectively. CMS’s proposed national-average CCR for this service 

group is .37. The use of the national-average CCR would result in a weight 

that would overvalue anesthesia services. In its comment on the CMS 

proposed approach, MedPAC noted problems with the therapeutic 

services and the operating room service groups.27

 27MedPAC correspondence to CMS, June 12, 2006. 

Page 19 GAO-06-880 Medicare Hospital Inpatient Payments
Finally, the remaining two groups—intensive and laboratory—include cost 

center CCRs that also vary widely. However, using the MEDPAR data that

CMS uses to construct the IPPS rates, we could not assess the charges 

associated with those services because they cannot be separately 

identified. Without such information, we could not determine the volume 

of specific services provided under these groups and, therefore, we could

not assess the potential impact on the DRG weights. 

Policy analysts have for decades suggested that replacing charge-based 

with cost-based weights would improve the accuracy of the weights to 

measure relative costliness for hospital inpatient DRGs. Our findings 

suggest that the CMS approach of using national-average CCRs to develop

cost-based weights for inpatient DRGs appears promising because it 

addresses the concerns associated with charges that are currently used to

weight DRGs. The proposed approach improves the OPPS method of 

estimating costs because the OPPS uses a single method to map hospitalspecific CCRs to charges. That method does not reflect the effects that 

variation in hospital charge and cost allocation decisions can have on the 

DRG weights. 

The national-average CCRs for the service groups are critical to the goal of

better aligning payments with costs for DRGs. As CMS is considering 

refining its service group categories, we note that two of the groups, 

therapeutic services and operating room, contain cost center CCRs that 

range widely and raise concerns about its ability to better align payment 

with costs for services in those groups. This issue notwithstanding, we 

found that most of the proposed service groups, which represent a 

majority of the Medicare inpatient charges, are likely to capture the 

relevant cost-to-charge relationship for the services included in these 

groups. 

We received written comments on a draft of this report from CMS (see 

app. II). We also received oral comments from representatives from two 

hospital associations, the AHA and the AAMC. 

In commenting on a draft of this report, CMS stated that it was pleased 

with our findings. CMS also stated that it could not comment further 

because it is currently considering public comments in developing the 

fiscal year 2007 final rule for the IPPS payment rates. 

Concluding 

Observations 

Agency and External 

Reviewer Comments 

and Our Evaluation 

CMS Comments 

Page 20 GAO-06-880 Medicare Hospital Inpatient Payments
Representatives from both AHA and AAMC acknowledged the problems 

inherent in matching charges from claims to cost information on hospitals’ 

cost reports due to the differences in the ways in which hospitals report 

these data. The AHA representatives specifically noted that the problems 

with cost estimation due to hospital reporting variation we describe in this

report parallels what AHA has found in its own analysis. AHA 

representatives also agreed that the differences in which hospitals allocate 

their charges and costs, and the cost estimates that result, could 

potentially affect DRG relative weights. 

Hospital Association 

Comments and Our 

Evaluation 

AHA representatives stated, however, that we should more prominently 

discuss the issues of using cost report data to set the relative weights. 

Specifically, they stated that we should better emphasize that CMS’s 

proposed national-average CCRs are based on cost report data that could 

still present problems as a result of hospital reporting variation. 

As we stated in the draft report, the only data sources available to CMS to 

set the DRG weights are hospital Medicare cost report and claims. 

Medicare cost report data reflect hospital reporting variation because CMS 

allows hospitals the flexibility to report charges and costs in a manner that 

is consistent with each hospital’s accounting system and organizational 

structure. Our conclusion that the proposed approach appears promising 

is based on our assessment that, given that cost report and claims are the 

only data available, CMS’s approach in using these data to set DRG 

weights, that is, using national-average CCRs with standardized chargebased weights, can ameliorate the effects of differences in hospital 

reporting. 

Representatives from both organizations also were concerned about the 

overall message of the report that the CMS approach appears promising. 

The AHA representatives stated that although the proposed approach 

could address some issues associated with using cost report data, they 

also noted that we did not test the validity of the proposed approach. The 

AAMC representatives also questioned our overall message given some of 

the concerns we noted in the report with the national service groups. In 

particular, AAMC stated that although we found that the service groups 

accounting for 63 percent of total inpatient charges appear promising, they 

believed that the remaining 37 percent was a substantial percentage. 

Testing the validity of CMS’s proposed approach was beyond the scope of

our work. However, we believe that the report presents a balanced view of 

the CMS approach, given our findings on hospital reporting variation and 

its effects on cost estimation. As noted in the draft report, we found that 

Page 21 GAO-06-880 Medicare Hospital Inpatient Payments
6 of the 10 service groups that represent 63 percent of Medicare inpatient 

charges are promising because the cost center CCRs within each service 

group are relatively consistent. As a result, the proposed national-average 

CCRs for these 6 groups are likely to capture the relevant cost-to-charge 

relationships for the services within these groups. However, we also noted

in the draft report that we have concerns about the ability of 2 of the 

service groups to better align payment with costs, and that we did not have 

enough information to evaluate the 2 remaining service groups. 

Additionally, we received technical comments from the two associations, 

which we incorporated as appropriate. 

We are sending a copy of this report to the Administrator of CMS. We will 

also provide copies to others on request. The report is available online at

no charge on GAO’s Web site at http://www.gao.gov. 

If you or your staff have any questions, please contact me at (202) 512-7101

or steinwalda@gao.gov. Contact points for our Offices of Congressional 

Relations and Public Affairs may be found on the last page of this report. 

GAO staff who made major contributions to this report are listed in 

appendix III. 

A. Bruce Steinwald 

Director, Health Care 

Page 22 GAO-06-880 Medicare Hospital Inpatient Payments
List of Committees 

The Honorable Charles E. Grassley 

Chairman 

The Honorable Max Baucus 

Ranking Minority Member 

Committee on Finance 

United States Senate 

The Honorable William M. Thomas 

Chairman 

The Honorable Charles B. Rangel 

Ranking Minority Member 

Committee on Ways and Means 

House of Representatives 

The Honorable Nancy Johnson 

Chairman 

The Honorable Pete Stark 

Ranking Minority Member 

Subcommittee on Health

Committee on Ways and Means 

House of Representatives 

Page 23 GAO-06-880 Medicare Hospital Inpatient Payments
Appendix I: Scope and Methodology 

Page 24 GAO-06-880

Appendix I: Scope and Methodology 

This appendix identifies data sources used for our analyses and 

summarizes our methods. 

We used data from Medicare Provider Analysis and Review (MEDPAR)—

the Centers for Medicare & Medicaid Services’ (CMS) database for 

compiling and maintaining hospitals’ Medicare claims—from 2001, 2002, 

and 2003. A MEDPAR record represents one distinct stay, and contains 

patient and hospital identifiers and diagnosis and procedure codes based

on the International Classification of Diseases, 9th Revision, Clinical 

Modification (ICD-9-CM). CMS uses MEDPAR for rate-setting purposes 

under the inpatient hospital prospective payment system (IPPS). 

Data Sources 

We also used fiscal year 2002 and 2003 hospital Medicare cost report data 

that individual hospitals are required to submit annually to Medicare as 

compiled in CMS’s Healthcare Cost Reporting Information System 

(HCRIS) database. HCRIS is constructed by CMS based on the Medicare 

cost reports submitted to the fiscal intermediaries. Each hospital defines 

its own fiscal year—the only requirement is that the beginning date of the

hospital fiscal year must fall within the federal fiscal year (October 1 

through September 30). There is a time lag of up to 2 years before the data

are complete for all hospitals. 

Hospitals report total costs and total charges by cost center on their 

Medicare cost reports. They have the discretion to use as many or as few 

cost centers on the cost report as they choose. Beyond the more general

cost centers, hospitals have the ability to report more detailed information, 

referred to as subscripts, for specific services. For example, a hospital may 

report data for the cardiology cost center, and additional data for a 

subscript of cardiology, called cardiac catheterization. In the HCRIS 

database, the cost center data reflect the sum of the subscripted data. This

level of detail is similar to the manner in which service-level data are 

available in the MEDPAR file. 

To assess the reliability of the MEDPAR and HCRIS data, we reviewed 

existing documentation related to the data quality control procedures and 

electronically tested the data to identify obvious problems with accuracy.

We determined that the data were sufficiently reliable for the purposes of 

this report. Further, because we chose to estimate costs using only those 

hospitals that most consistently reported charges and stays between their

claims and their Medicare cost report, we could then assess the validity of

our cost estimates relative to the aggregate Medicare costs these hospitals

reported on their Medicare cost reports. Because our cost estimation 

Medicare Hospital Inpatient Payments
Appendix I: Scope and Methodology 

analysis was conducted on a subset of hospitals in fiscal year 2002, the 

results are not generalizable to the hospitals in fiscal year 2002 whose total 

charges and number of stays from their Medicare cost reports and claims 

did not match within .3 percent. 

To examine the applicability of CMS’s current cost-based method used to 

set weights in the outpatient prospective payment system (OPPS) to 

weight diagnosis-related groups (DRG) in the inpatient prospective 

payment system (IPPS), we first identified 3,660 short-term, acute 

hospitals that were paid under IPPS and submitted fiscal year 2002 data to

CMS. A hospital’s fiscal year 2002 could start anytime from October 1, 

2001, through September 30, 2002. As a result, the cost reports contain 

charges and estimated costs for services provided to Medicare 

beneficiaries in 2001, 2002, and 2003. For this reason, we used MEDPAR 

and Medicare cost reports to match claims from 2001, 2002 and 2003 to 

each hospital’s fiscal year 2002 Medicare cost report. Using approximately 

12 million MEDPAR records and HCRIS data from 3,660 hospitals, we 

aggregated charges and stays from the MEDPAR claims file for each 

hospital in our universe. We compared the aggregate charges and stays 

from MEDPAR with the charges and number of stays reported on each 

hospital’s Medicare cost report. We used fiscal year 2002 data because 

these were the most recent, complete Medicare cost report data available

when we began our analysis in October 2004. 

Methods 

From this analysis, we identified 1,025 hospitals whose Medicare cost 

report charges and number of stays matched within .3 percent. We looked

at the distribution of hospitals matching aggregate charges and stays 

ranging from .1 percent to 1 percent as reported in Medicare cost reports 

and claims. We chose .3 percent (1,025 hospitals), because it represented 

over a quarter of the total IPPS hospitals and included at least 25 hospitals

for each hospital type (e.g., teaching, urban, for-profit). The 1,025 hospitals 

have a distribution across types of hospitals similar to the population of 

IPPS hospitals. We assumed these 1,025 hospitals had the most consistent 

cost information available to perform our cost analysis. 

To estimate costs for inpatient services for each of the 1,025 hospitals, we 

applied the cost estimation method that CMS uses in the outpatient 

hospital setting; that is, we used individual cost center CCRs based on 

each hospital’s Medicare cost report data to convert charges to costs. 

Similar to what CMS does for estimating costs for outpatient services, we 

developed a mapping method to match revenue centers to cost centers to 

determine which CCR to use to estimate costs for the 1,025 hospitals 

Page 25 GAO-06-880 Medicare Hospital Inpatient Payments
Appendix I: Scope and Methodology 

included in our analysis. For example, we mapped the radiology revenue 

center charges to the radiology cost center. In cases where revenue 

centers and cost centers did not directly correspond, we used the 

hospital’s overall ancillary CCR to estimate costs, with the following 

exceptions. If a hospital billed for speech, occupational or physical 

therapy charges, but did not include a matching cost center on its cost 

report for those services, we used another therapy cost center CCR to 

estimate costs. For example, if a hospital billed for physical therapy but 

did not have a matching cost center, we used the speech therapy cost 

center CCR. In addition, if a hospital’s cost report did not include a DME 

cost center but the claims showed DME revenue center charges, we 

applied the hospital’s overall supply CCR to estimate costs. 

We multiplied the cost center CCR from the hospital Medicare cost report 

to each charge for each claim. Subsequently, for each of the 1,025 

hospitals we summed our cost estimates for accommodation and ancillary

services separately and then compared these aggregate cost estimates to 

what hospitals reported as their costs for these services on their Medicare 

cost reports. From this analysis, we calculated the percentage of hospitals

where our estimates were, on average, either more or less than what the 

hospitals reported for ancillary and accommodation services separately.

After comparing our cost estimates to what the hospitals reported on their 

Medicare cost report, we examined hospital reporting methods, that is, we 

identified the cost centers to which hospitals reported their charges and

compared these charges to how hospitals reported these services on their 

claims. For example, while a hospital may record $1,500 in physical 

therapy charges on its claims, it may record these physical therapy charges

in the occupational therapy cost center on its cost report. This practice is 

in keeping with the discretion CMS affords hospitals in how they 

accumulate and report charges and costs. 

To examine whether CMS’s proposed approach for the IPPS is an 

improvement over its OPPS method for setting cost-based weights, we 

estimated costs for fiscal year 2002 using the OPPS method, and reviewed

CMS’s April 2006 notice of proposed rulemaking.1 In particular, we 

identified potential problems in applying the OPPS cost-based method to 

the IPPS and determined whether CMS’s proposed approach would 

ameliorate those problems. We evaluated CMS’s proposal to use national-

 1

We did not examine the extent to which the OPPS method measures relative costliness for 

outpatient services. 

Page 26 GAO-06-880 Medicare Hospital Inpatient Payments
Appendix I: Scope and Methodology 

average CCRs to derive cost-based weights. We used data from 3,558 

hospitals paid under the IPPS that submitted a fiscal year 2003 Medicare 

cost report. We used fiscal year 2003 Medicare cost reports in order to 

conform to the same time period as the analysis CMS conducted for its 

April 2006 notice of proposed rulemaking. We calculated CCRs for each of 

the cost centers that are included in CMS’s 10 proposed service groups.2

We determined whether the service groups appear promising based on the 

extent to which cost center CCRs contained within each group varied. 

Additionally, using 2003 claims data, we analyzed the proportion of service 

group charges to determine whether the service groups appear promising 

in capturing cost-to-charge relationships for the respective services in 

each group.

 2

The 10 proposed service groups are routine, intensive, drugs, supplies & equipment, 

therapeutic services, operating room, cardiology, laboratory, radiology, and other services.

Page 27 GAO-06-880 Medicare Hospital Inpatient Payments
Appendix II: Comments from the Centers for Medicare & Medicaid Services Appendix II: Comments from the Centers for 

Medicare & Medicaid Services 

Page 28 GAO-06-880 Medicare Hospital Inpatient Payments
Appendix III: GAO

A

 Contact and Staff 

cknowledgments 

Page 29 GAO-06-880

Appendix III: GAO Contact and Staff 

Acknowledgments 

GAO Contact A. Bruce Steinwald, (202) 512-7101 or steinwalda@gao.gov 

In addition to the contact above, Maria Martino, Assistant Director, 

Shamonda Braithwaite, Melanie Anne Egorin, Hannah Fein, Nora Hoban, 

Julian Klazkin, Daniel Lee, and Eric Wedum made key contributions to this 

report. 

Medicare Hospital Inpatient Payments

Acknowledgments 

(290379) 
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