A U G U S T 1 9 9 9

R E P O R T T O T H E C O N G R E S S

Teaching Hospitals

Rethinking Medicare’s

Payment Policies for

Graduate Medical Education

and Teaching Hospitals

1730 K Street, NW • Suite 800 • Washington, DC 20006

(202) 653-7220 • Fax: (202) 653-7238 • www.medpac.gov
Re t hi n ki n g M e di c a re’s Pa y m en t Po l i c ie s f o r G M E a n d Te a c hi n g H os pi t a l s • Au g u s t 199 9

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Term expires April 2000

Peter Kemper, Ph.D.

Center for Studying

Health System Change

Washington, DC

Judith Lave, Ph.D.

University of Pittsburgh

Pittsburgh, PA

D. Ted Lewers, M.D.

Private practice of medicine

Easton, MD

Hugh W. Long, Ph.D., J.D.

Tulane Medical Center

New Orleans, LA

William A. MacBain

MacBain & MacBain, LLC

Ithaca, NY

Gerald M. Shea

AFL-CIO

Washington, DC

Commission members

Gail R. Wilensky, Ph.D., Chair

Project HOPE

Center for Health Affairs

Bethesda, MD

Joseph P. Newhouse, Ph.D., Vice chair

Harvard University

Boston, MA

Term expires April 2001

Spencer Johnson

Michigan Health and Hospital

Association

Lansing, MI

Woodrow A. Myers Jr., M.D.

Ford Motor Company

Dearborn, MI

Joseph P. Newhouse, Ph.D.

Alice Rosenblatt, F.S.A, M.A.A.A.

Wellpoint Health Networks

Thousand Oaks, CA

John W. Rowe, M.D.

Mount Sinai School of Medicine

Mount Sinai-NYU Medical Center

and Health System

New York, NY

Gail R. Wilensky, Ph.D.

Term expires April 2002

Beatrice S. Braun, M.D.

AARP

Spring Hill, FL

Floyd D. Loop, M.D.

The Cleveland Clinic Foundation

Cleveland, OH

Janet G. Newport

PacifiCare Health Systems

Santa Ana, CA

Carol Raphael

Visiting Nurse Service of New York

New York, NY

Mary K. Wakefield, Ph.D.

College of Nursing and Health Science

George Mason University

Fairfax, VA

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Analysts

Stephanie Bernell, Ph.D.

Louisa A. Buatti, M.H.S.

Andrew L. Cosgrove, M.P.P.

David V. Glass, M.S.

Janet C. Goldberg, M.P.H.

Timothy F. Greene, M.B.A.

Craig K. Lisk, M.S.

Stephanie Maxwell, Ph.D.

Susan Philip, M.P.P.

Nancy Ray, M.S.

Deborah Walter, M.P.A.

Susanne Weinrauch, M.D., M.P.A.

Judy A. Xanthopoulos, Ph.D.

Daniel Zabinski, Ph.D.

Commission staff

Murray N. Ross, Ph.D.

Executive director

Lu Zawistowich, Sc.D.

Deputy director

Jennifer Jenson, M.P.H., M.P.P.

Special assistant to the executive director

Helaine I. Fingold, J.D.

General counsel

Research directors

Jack Ashby, M.H.A.

Elizabeth Docteur, M.S.

Scott Harrison, Ph.D.

Kevin J. Hayes, Ph.D.

Julian H. Pettengill, M.A.

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Administrative support

Wylene Carlyle

Diane E. Ellison

Plinie (Ann) Johnson

Molly Ryan

Cynthia Wilson

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The Balanced Budget Act of 1997 (BBA) required the Medicare Payment Advisory Commission

to examine the need for changes in federal policy affecting graduate medical education (GME),

Medicare’s payments to teaching hospitals, and federal health care workforce issues. (See legislative

language from the BBA in the appendix.) This report fulfills MedPAC’s mandate and provides a

foundation for future work by the Commission.

The BBA required MedPAC to consult with outside experts in completing this study. The

Commission has taken this requirement seriously and gratefully acknowledges the comments and

insights of countless individuals and organizations. We have discussed issues related to GME at almost

every meeting since MedPAC was created, always providing opportunities for interested groups to

comment on the Commission’s discussions. Last year, we convened a panel of outside policy experts to

help identify key issues for consideration. We asked more than 200 organizations and individuals to share

their ideas and concerns about GME and related policies, and in the course of this process received

letters offering comments and suggestions for policy changes from more than 50 different groups. Both

Commissioners and staff have had many in-person meetings and telephone conversations with interested

parties to discuss the report and related issues.

In addition to discussing Medicare’s role in supporting graduate medical education, teaching

hospitals, and their interrelated missions, the Commission has also considered numerous healthcare

workforce issues in its public meetings, including physician and resident supply, specialty mix, and

geographic distribution; international medical school graduates (IMGs); and Medicare’s current support

for nursing and allied health professions training programs. We also explored the extent of medical

schools’ dependence on service-generated income and the implications of this dependence for the future

of these institutions.

Most of the Commission’s energy focused on how Medicare payment policies for graduate

medical education and teaching hospitals should be changed. Our discussion led to the six

recommendations included in this report that encourage policymakers to rethink Medicare’s payment

policies for graduate medical education, teaching hospitals, and related items in the context of

Medicare’s primary role: improving access to care for Medicare beneficiaries.

Preface

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Executive summary

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Executive summary

The Medicare Payment Advisory Commission (MedPAC) believes that policymakers should reorient

their thinking about Medicare’s payments for graduate medical education. Specifically, we believe that

payments to teaching hospitals for the direct costs of operating approved medical residency programs

should be viewed as payments for patient care, not as payments for training. Consistent with this belief,

the Commission recommends that Medicare’s two payments to teaching hospitals that are currently

labeled as medical education should be combined into one payment that better accounts for the higher

costs of the enhanced patient care those hospitals provide to Medicare beneficiaries.

An appropriately designed payment adjustment for enhanced patient care, together with certain technical

refinements in Medicare’s payments to hospitals, would help ensure access to the services teaching

hospitals provide while simultaneously encouraging teaching hospitals to provide services efficiently.

Our recommendation is not intended to achieve budgetary savings, but to focus Medicare’s payments

more appropriately. Because the Commission recognizes that changing current payment methods would

have a significant impact on payments to individual hospitals, we recommend that these changes be

phased in over several years. MedPAC will analyze the potential effects and policy issues of

implementing a payment adjustment for enhanced patient care for our March 2000 report to the

Congress.

This report describes the analytic principles that underlie the Commission’s thinking and presents

recommendations that lay out a conceptual framework for refining Medicare payments. Although much

of the discussion focuses on payments to teaching hospitals for inpatient services, the principles outlined

here apply to other teaching settings where higher payments may be justified on the basis of enhanced

patient care being provided.

Medicare’s goals

Medicare was enacted to improve access to health care services by reducing the financial burden faced

by aged (and later disabled) people seeking medical care. In pursuit of this goal, the program seeks to

ensure access for its beneficiaries to high quality, medically necessary care in an appropriate setting.

Consequently, MedPAC believes that Medicare’s payments should:

• induce providers to supply care efficiently,

• account for differences in the intensity and complexity of care provided,

• recognize the value of enhanced patient care provided in teaching hospitals and other settings where

residents and other health professionals train when the added value of patient care justifies its higher

costs, and

• not intentionally distort the supply of physicians and other health professionals.

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What is Medicare buying from teaching hospitals?

Teaching hospitals incur two types of costs associated with operating approved graduate medical

education programs. Direct costs comprise stipends paid to residents for the services they provide and

other assigned program expenses such as salaries of supervising faculty. So-called indirect costs reflect

the higher costs per case observed in teaching hospitals that cannot be allocated specifically to residency

programs. Compared with other hospitals, teaching hospitals treat patients with more complex

conditions and provide patient care that is more intensive and technologically sophisticated.

Medicare has recognized teaching hospitals’ higher costs since the program began. Initially, no

distinction was made between direct medical education costs and other costs of inpatient care. However,

when policymakers were considering how to set limits on cost reimbursement—and later move to a

prospective payment system (PPS)—they had to decide whether and how to account for Medicare’s

share of teaching hospitals’ higher costs. They elected to pay the direct costs of graduate medical

education separately and to pay the indirect costs incurred by teaching hospitals through a percentage

add-on to base PPS rates.

MedPAC has concluded that the distinction between direct and indirect costs is an accounting artifact

that should not continue to guide Medicare’s payments to teaching hospitals or to other providers.

Payments for the indirect costs associated with residency programs have been viewed as payments for

patient care since the inception of the prospective payment system. We believe that the direct costs

attributed to graduate medical education programs also reflect patient care, and that Medicare’s payments

for such costs should be viewed in this manner and not as payment for training.

Reclassifying residents’ stipends as payment for patient care is straightforward because residents provide

care as they learn. In addition, economic theory suggests that the costs teaching hospitals record for

faculty salaries and residency program overhead are also for patient care. These costs substitute for the

additional wages hospitals would otherwise need to pay residents to provide care if they were not also

furnishing them with graduate medical education. Residents are willing to accept lower wages because

the skills they acquire while providing care allows them to earn more in the future or achieve greater job

satisfaction.

What should Medicare buy from teaching hospitals?

The Commission believes that the value of the enhanced patient care provided to Medicare beneficiaries

in teaching hospitals justifies the costs of providing it. Accordingly, Medicare should adjust the

payments it makes to teaching hospitals to reflect the higher costs of this care. In addition, the

Commission believes that similar payment adjustments should also be developed for other settings where

residents or other health professionals train when the added value of patient care justifies their higher

costs.

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How should Medicare pay for patient care in teaching hospitals?

Operationally, developing a payment adjustment for enhanced patient care in hospitals would entail

replacing Medicare’s current separate payments for direct and indirect graduate medical education costs

with a single adjustment to its diagnosis-related group (DRG) payments for inpatient services.

Concurrent with this change, MedPAC believes that several technical refinements should be made to

make DRG payments and the enhanced patient care adjustment better match expected costs of inpatient

care in all hospitals and to reduce teaching hospitals’ incentives to train an excessive number of

residents.

The Commission does not anticipate that implementing these policies would substantially alter aggregate

program payments, although it would significantly affect Medicare’s payments to individual hospitals. We

therefore recommend that changes be phased in over several years and plan to make specific

recommendations on how such changes should be implemented in our March 2000 report.

Medicare’s current policy links hospitals’ payments to the number of residents they employ and has the

unintended consequence of increasing the supply of physicians. The changes that MedPAC is

recommending would likely reduce—but not eliminate—hospitals’ incentives to train more residents than

they would otherwise.

How should Medicare pay for patient care in other teaching settings?

The principle that Medicare should recognize the value of enhanced inpatient care provided in teaching

hospitals should be extended to other settings where residents and other health professionals train when

two conditions are met. First, the cost of care is higher than that furnished in otherwise comparable

settings; and second, beneficiaries receive enhanced care that justifies the higher costs.

Developing an adjustment for care provided in the outpatient department of teaching hospitals, while

difficult to do in the near term, would help make Medicare’s payments more closely match the expected

costs of care in inpatient and outpatient settings. While conceptually appropriate, developing enhanced

patient care adjustments for care provided outside the hospital setting is likely to be an ambitious task.

Medicare and federal workforce policy

The Commission recognizes that Medicare’s payment policies influence both providers’ decisions about

what kinds of staff to hire in providing care and the decisions of people seeking careers as health

professionals. For example, Medicare policies with respect to coverage and payment for services used

predominantly by Medicare beneficiaries will influence the number of people who choose geriatric

medicine and other fields that serve primarily aged or disabled people.

However, consistent with the Commission’s position that Medicare’s primary purpose is ensuring

beneficiary access to care, MedPAC does not advocate using Medicare payment policy as a primary tool

for affecting the overall supply, specialty mix, and distribution of health care professionals. Instead, the

Commission believes that specific targeted programs may be a more appropriate vehicle for achieving

these workforce goals.

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Table of contents

Commission members .....................................................................................iii

Commission staff ............................................................................................. v

Preface............................................................................................................. vii

Executive summary ......................................................................................... ix

Rethinking Medicare’s Payment Policies for Graduate Medical Education

and Teaching Hospitals ....................................................................................1

Medicare’s goals ................................................................................................................................ 3

What is Medicare buying from teaching hospitals? ...........................................................................4

What should Medicare buy from teaching hospitals? ........................................................................8

How should Medicare pay for patient care in teaching hospitals? .........................................................9

How should Medicare pay for patient care in other teaching settings? ............................................ 13

Medicare and federal health workforce policy ..................................................................................14

Future work ........................................................................................................................................ 15

Appendix ......................................................................................................... 19

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Rethinking Medicare’s

Payment Policies for

Graduate Medical Education

and Teaching Hospitals

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R E C O M M E N D A T I O N S

1 Medicare should pay more for patient care in teaching settings when the

enhanced value of that care justifies its higher costs.

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2 The Congress and the Secretary should improve the diagnosis related groups to

reflect more accurately the relationship between illness severity and the cost of

inpatient care, thereby making Medicare payments more consistent with

efficient providers’ costs.

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3 The Congress should revise Medicare’s payments to recognize the higher value

of patient care services provided in teaching hospitals through an enhanced

patient care adjustment.

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4 The Congress should phase in the payment adjustment for enhanced patient

care and any related policies that substantially change payments to individual

providers.

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5 The Congress and the Secretary should develop payment adjustments for

enhanced patient care in all settings where residents and other health care

professionals train when the added value of patient care justifies its higher

costs.

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6 Federal policies intended to affect the number, specialty mix, and geographic

distribution of health care professionals should be implemented through specific

targeted programs rather than through Medicare.
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Under the Balanced Budget Act of 1997 (BBA), the Congress required the Medicare Payment

Advisory Commission (MedPAC) to examine the need for changes in Medicare’s payment policies and

other federal policies that affect graduate medical education (GME), payments to teaching hospitals, and

other health care workforce training (see the Appendix for the legislative language). This request was

motivated by several concerns reflecting the different perspectives of important stakeholders. One was

whether Medicare, given its uncertain financial prospects, should continue to pay for graduate medical

education programs that were seen as primarily benefitting physicians who are expected to earn high

incomes in later private practice. Another concern was the appropriateness of wide variation in

Medicare’s payments to teaching hospitals. A third concern was the perception that supporting GME

programs through Medicare’s hospital payment policies was distorting teaching hospitals’ decisions

about the number and specialty mix of physicians to train and about the appropriate sites for training.

These concerns were further heightened by widespread uncertainty in the teaching hospital community

about private insurers’ future payment policies. Many were pessimistic that insurers operating in

increasingly competitive markets would continue to support teaching hospitals’ GME programs, applied

research, and other specialized activities by paying more than these providers’ costs for the patient care

services furnished to their enrollees.

This report develops a conceptual framework that MedPAC believes policymakers should use in

rethinking Medicare’s payment policies for graduate medical education and teaching hospitals. The

Commission’s framework ultimately derives from Medicare’s goals. But it also considers the value of

the enhanced patient care beneficiaries receive in teaching hospitals and other settings that conduct

health professions training, and who bears the costs of general training, such as that provided in

residency programs. Based on these considerations, the Commissinon has crafted six recommendations

that should guide the development of refinements in Medicare’s payments to teaching hospitals and to

providers in other settings where residents and other health professionals train. Although these

recommendations indicate the broad direction for policy change, they do not specify fully detailed

policies that could be adopted immediately. MedPAC will continue to develop and examine the

operational changes needed to implement these policies with the goal of making specific

recommendations in its March 2000 report to the Congress on Medicare payment policy.

Medicare’s goals

Medicare was enacted to improve access to care by reducing the financial burden faced by elderly (and

later disabled) people in obtaining medically necessary services. Accordingly, Medicare’s principal goal

is to ensure that its beneficiaries have access to high quality care in the most appropriate clinical setting.

At the same time, program policies must balance the interests of the providers who furnish care and the

beneficiaries and taxpayers who finance that care.

To ensure access to care in the most appropriate setting, Medicare’s payment policies must encourage

providers to supply high quality services to its beneficiaries and to produce those services efficiently. To

accomplish these objectives, the program’s payment rates must be consistent with efficient providers’

costs of producing appropriate care. This means that the payment rates must approximate efficient

providers’ costs and also account for predictable differences in unit costs that arise from clinically

appropriate variations in service complexity and intensity. In addition, Medicare’s payments should

neither encourage nor discourage providers’ use of particular types of resources in producing care.

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These principles help to ensure that Medicare’s limited funds are used effectively and that providers’

payments enable them to furnish services that are of value to program beneficiaries.

What is Medicare buying from teaching hospitals?

Teaching hospitals—facilities that operate approved residency training programs—generally incur higher

expenses than hospitals without teaching programs. Medicare’s hospital payment policies have always

recognized the program’s share of these higher costs by making additional payments to teaching

facilities. In fiscal year 1999, these additional payments are projected to account for $6.2 billion in

program spending (CBO).

Given the goals and objectives identified earlier, Medicare’s additional payments to teaching hospitals

have raised questions about what the program is buying and whether the value of what it is buying is

worth the added costs. Past thinking about these questions has been anchored in the cost accounting

framework underlying Medicare’s original cost reimbursement method for paying facility providers.

That framework suggests that although teaching hospitals produce multiple products, such as graduate

training for resident physicians, training for other health professionals, applied research, and patient care,

the costs generated by these activities can be separated accurately.

The cost accounting view of what Medicare is buying

For more than 15 years, Medicare paid hospitals and other facility providers, such as hospital outpatient

departments and skilled nursing facilities, according to the program’s share of their incurred allowable

costs. Cost reimbursement was implemented through a set of cost accounting rules that providers

applied in filing annual cost reports at the end of their fiscal years. These rules enabled Medicare to:

• identify categories of allowable and non-allowable expenses,

• allocate allowable overhead costs (such as housekeeping and administrative expenses) among a

facility’s patient care and other activities,

• separate costs for inpatient care from those for outpatient care or other services, and,

• determine the share of the provider’s expenses the program would pay for each activity.

Segregating each provider’s costs for various activities—such as residency training programs, other

training, and research—from those for patient care was necessary under cost reimbursement. Costs

associated with some activities (research or consumer advertising, for example) were not allowable for

reimbursement because they were not considered necessary or sufficiently related to the production of

patient care. The Congress, however, explicitly allowed hospitals’ costs for operating training programs

for residents and other health professionals based on the belief that “... these activities enhance the

quality of care in an institution...” (House Report 213, 89th Congress).

Costs for different activities also were segregated because the basis for determining Medicare’s share of

costs could differ depending on the nature of the activity. For instance, Medicare’s share of a

provider’s costs for radiology services was based on its share of the facility’s total radiology service

charges. Medicare’s share of residency program costs, however, was based on how residents’ time

was allocated among the hospital’s activities and the program’s share of the facility’s charges in each

activity.

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Although they were accounted for separately, Medicare initially made no payment distinction between

hospital costs that were directly attributed to operating approved training programs (residents’ stipends,

compensation for teaching faculty and program administrative staff, and allocated facility overhead) and

other costs for patient care (those for nursing care or medical supplies, for example). In the mid-1970s,

however, policymakers began to consider how to set limits on the amount of allowable costs that would

be reimbursed. Consequently, they had to decide whether, and how, to account for teaching hospitals’

higher costs.

Initially, only routine patient care costs per patient day (expenses for room, board, and routine nursing

care) were subject to the new reimbursement limits. Following the logic of the cost accounting

framework, the Health Care Financing Administration (HCFA) eventually decided that direct costs for

training programs represented costs of education rather than routine care. As a result, HCFA excluded

costs for approved training programs (those for residents and for other health professions) from the

reimbursement limits and Medicare continued to pay its share of these costs as before.

But excluding the direct costs of training programs accounted for only part of the higher per diem costs

incurred by teaching hospitals. Further analysis showed that the presence of residency training

programs was associated with an increase in providers’ per diem routine patient care costs, and that the

size of the increase was strongly associated with the intensity of the facility’s resident training activity as

measured by its number of residents per bed. In response to these findings, HCFA adopted an

adjustment, called the indirect medical education (IME) adjustment, which raised the reimbursement

limits for teaching hospitals depending on their resident to bed ratios.

The Congress codified these policies in law, paying separately for the direct costs of approved training

programs and requiring HCFA to apply a revised IME adjustment, when it expanded Medicare’s

routine per diem reimbursement limits to cover operating costs per discharge in the Tax Equity and

Fiscal Responsibility Act of 1982. These policies were reaffirmed when the Congress adopted the

hospital inpatient prospective payment system (PPS) in the Social Security Amendments of 1983.

Although the Congress subsequently decided to pay for teaching hospitals’ direct costs of approved

residency training programs based on prospectively determined per resident amounts, these payments

were still viewed as covering Medicare’s share of the costs of physician training. By contrast, the IME

adjustment was always seen as providing teaching hospitals with additional payments to cover the higher

inpatient care costs associated with the greater complexity and intensity of the services they furnished.

Policymakers understood that the IME adjustment was needed for two reasons. One was that teaching

hospitals tend to offer a broader array of technologically sophisticated services than other hospitals; thus

some patients in these facilities would receive complex and costly services unavailable elsewhere. A

related reason was that teaching hospitals tend to attract patients with greater severity of illness who

require more complex and costly treatment, but the case-mix adjustment based on diagnosis related

groups (and thus the payment rates under Medicare’s inpatient PPS) did not fully capture these severity

differences or their impact on patient care costs.

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What is Medicare really buying?

MedPAC has concluded that the distinction between the direct and indirect costs of training

programs is artificial and incompatible with the pressures providers face in competitive markets. In

the analytic framework of economics, the direct and indirect costs associated with training

programs are indistinguishable; both represent costs of providing patient care. Therefore, the

distinction between these costs is not a valid guide for making payments to hospitals (or other

providers offering health professions training programs) that face competitive markets for patient

care and the resources they purchase to produce that care.

Medicare’s current payment policies for teaching hospitals

Medicare’s current payment policies for teaching hospitals still reflect the cost accounting

distinction between the direct costs of resident training programs and the indirect or

added patient care costs associated with teaching intensity as measured by the facility’s

resident to bed ratio. In fiscal year 1999, Medicare’s payments for hospitals’ direct costs of GME

programs are expected to amount to $2.2 billion, and those for indirect costs related to GME

programs will account for $3.7 billion. In addition, Medicare will pay $300 million for hospitals’

incurred costs of operating approved training programs for other health professionals, such as

nurses and various types of technicians.

Payments for direct costs of residency training programs

Medicare pays for its share of hospitals’ direct GME costs based on prospectively determined,

hospital-specific per resident amounts. A hospital’s direct GME payment primarily reflects the

product of three components. The first is the hospital’s direct GME costs per resident in 1984,

updated for inflation to the current year. The second component is the hospital’s current number of

full-time-equivalent (FTE) residents. The third component is Medicare’s share of the hospital’s

inpatient days.

Hospitals’ resident counts are subject to several rules. A facility may count residents training both

in and outside of the hospital as long as it pays substantially all of the training costs (including

residents’ stipends and benefits and faculty supervisory costs). However, residents training

beyond their period of initial residency (the smaller of the minimum period required for board

eligibility in a specialty or five years) are counted as only 0.5 FTEs. To discourage further growth

in the number of residents, the BBA placed a cap on the number of residents a hospital could

count for determining GME payments.

Hospitals’ payment amounts also depend on their mix of residents’ specialties. Payments are

about 6 percent higher for residents in primary care (family practice, general internal medicine,

general pediatrics, and obstetrics and gynecology) and other selected specialties (geriatrics, public

health and preventive medicine), compared with those in other specialties.

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In competitive markets, a rational firm will not pay for the cost of general training such as residency

training (Becker 1975, Feldman and Yoder 1980). Once trained, residents and other health

professionals can use their acquired skills to gain employment elsewhere at a salary commensurate with

their new skill level. Because the provider that furnishes general training has no way of capturing a

return on its investment, it has no financial incentive to pay for training costs.

Instead, residents bear the cost of training by providing patient care and other services in conjunction

with their training that are of value to the institution where they train, while accepting compensation for

the services they provide that is lower than they might otherwise be able to earn given their skill level.1

Residents and other trainees are willing to bear the cost of their training because it increases their future

earning potential and job satisfaction.

Medicare’s current payment policies for teaching hospitals

Payments for indirect costs of medical education programs

Medicare pays for its share of the indirect costs associated with hospitals’ resident training

activities by applying a percentage add-on to each teaching facility’s per discharge payments under

the hospital inpatient prospective payment system (PPS). Under PPS, each hospital is paid a fixed

rate per Medicare discharge to cover its operating costs. A separate payment, determined in a

similar way, is made for a hospital’s capital costs. These per discharge payment rates are adjusted

to reflect the relative level of local prices for labor and capital in the hospital’s area and to reflect

the relative costliness of cases in the diagnosis related group (DRG) to which each patient is

assigned. The adjusted payment rates are the hospital’s basic DRG operating and capital

payments. In addition, a hospital may receive operating and capital outlier payments for any cases

that are exceptionally costly relative to other cases in the same DRG.

A teaching hospital’s operating IME payments are determined as a percentage add-on to its basic

DRG operating payments. The add-on percentage is based on the hospital’s ratio of residents to

its beds. A similar add-on to PPS capital payments is determined by the ratio of residents to

occupied beds. For fiscal year 1999, the IME adjustment for PPS operating payments is set at

approximately 6.5 percent for every 10 percentage point increment in the ratio of residents to

hospital beds.1 Consequently, one-half of all teaching hospitals receive an adjustment through their

operating payments of 6.7 percent or more; 10 percent receive adjustments of more than 29

percent. For capital payments, it is set at about 2.9 percent for every 10 percentage point

increment in the ratio of residents to occupied beds. ■

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1 The IME adjustment for PPS operating payments was set at 7.7 percent for every 10 percentage point increment in

the ratio of residents to hospital beds prior to the passage of the Balanced Budget Act of 1997. The BBA lowered the

adjustment to 7.0 percent for fiscal year 1998, 6.5 percent for fiscal year 1999, 6.0 percent for fiscal year 2000,

and 5.5 percent for fiscal year 2001 and beyond. As is the case for direct GME payments, the number of residents a

hospital can count in its IME payment formula is capped.

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1 Because they have extensive training in the life sciences, residents have a broad array of alternative employment

opportunities other than providing clinical services.
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Residents earn a stipend because they provide patient care and perform other services that are of value

to the hospital. Other things being equal, this stipend reflects the value of the services residents furnish

minus the cost of their training. The direct cost of their training is reflected in the remaining direct GME

expenses for faculty supervision, administrative staff, and facility overhead. In principle then, the direct

GME costs that hospitals report on their Medicare cost reports represent the net value of the patient

care services residents provide. The same logic applies to the direct costs of other health professions

training programs, such as those for nurses.

The premise that residents bear the costs of their own training implies that the distinction between direct

and indirect GME costs is not economically meaningful. Direct costs are, in effect, patient care costs.

Since residents bear the cost of their training, Medicare is paying not for training costs but rather for

patient care. The services provided by residents and other trainees are just one part of the enhanced

patient care furnished in teaching hospitals.

What should Medicare buy from teaching hospitals?

The Commission believes that the value of the enhanced patient care in teaching hospitals justifies the

higher cost of providing it. Consistent with its goal of ensuring beneficiaries’ access to medically

necessary care in the most appropriate clinical setting, Medicare should adjust its payments to teaching

hospitals to reflect the higher cost of the care they furnish.

RECOMMENDATION 1

8

Medicare should pay more for patient care in teaching settings when the enhanced

value of that care justifies its higher costs.

The higher patient care costs observed in teaching hospitals reflect a number of factors that are likely to

strengthen the clinical care Medicare beneficiaries and other patients receive. Compared with other

hospitals, teaching facilities tend to undertake more applied clinical research aimed at developing and

testing new diagnostic and therapeutic technologies, such as imaging methods, drugs and devices, and

surgical procedures. They also tend to hire a more costly mix of staff, including teaching faculty and

technical specialists needed to provide advanced training, research, and patient care. Consequently,

teaching facilities generally offer a broader and more technically sophisticated array of services, attract

patients who are more acutely ill, and furnish care that is more complex and costly, than do other

hospitals.

Graduate medical education and other training activities also tend to enhance the care provided to

beneficiaries in other ways. The team approach to care strengthens clinical decisionmaking and

provides additional oversight of care quality. Moreover, in teaching settings residents are readily

available to assess and respond to changes in patient status.

Medicare has traditionally paid for the enhanced patient care available to its beneficiaries in teaching

hospitals, although partly under the label of medical education. MedPAC recommends that Medicare

continue to pay for this care when the benefits exceed the additional cost.
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How should Medicare pay for patient care in teaching hospitals?

As discussed earlier, one of Medicare’s primary goals is to ensure beneficiaries’ access to care. To do

this, Medicare payments must approximate efficient providers’ patient care costs, reflecting differences

in cost that arise from differences in patient complexity and in the complexity and intensity of the care

provided.

To better capture cost differences, Medicare payment policies should be changed in two ways. First, to

recognize the higher acuity level of patients in teaching hospitals, Medicare’s case-mix measurement

methods must account more fully for differences in illness severity among patients. Second, to reflect

more accurately the enhanced value of services teaching hospitals furnish,Medicare’s IME adjustment

and direct GME payment should be combined into a single payment adjustment that would be applied

to the per case payment rates under PPS. In addition, to reduce the potential influence on hospitals’

demand for residents of the resident to bed ratios in current GME payments, the enhanced patient care

adjustment would ideally be based on some other proxy measure that does not involve counting

residents.

Improving case-mix measurement to account for differences in illness severity

Medicare’s capacity to set accurate payment rates under the hospital inpatient prospective payment

system depends critically on the effectiveness of its case-mix measurement methods. The current casemix measure is based on two components. One is the diagnosis related groups (DRG) patient

classification system, which defines about 500 distinct patient categories. The other is a set of relative

weights for all DRGs, which measures the expected relative costliness of a typical patient in each

category compared with the average cost for all patients.

On average, beneficiaries treated in teaching hospitals are sicker than those seen at other hospitals.

However, the current DRGs and relative weights do not fully capture differences in expected patient

care costs that arise from differences in the severity of illness among patients. The current IME

adjustment partly reflects higher costs in teaching hospitals that are due to unmeasured differences in the

illness severity of their patients.

RECOMMENDATION 2

9

The Congress and the Secretary should improve the diagnosis related groups to

reflect more accurately the relationship between illness severity and the cost of

inpatient care, thereby making Medicare payments more consistent with efficient

providers’ costs.

To improve the accuracy of Medicare’s inpatient case-mix measurement methods, the Congress and the

Secretary should examine three policy changes. The first is refining DRG definitions to reflect illness

severity more accurately by expanding the number of patient categories to account more fully for how

coexisting conditions and complications affect the cost of care.
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The other two policy changes would make DRG weights better reflect the relative costliness of cases

across DRGs. The first of these changes would alter the method for calculating weights to account

better for differences in the markups hospitals apply in setting charges. Cases in high-cost DRGs tend

to be concentrated in hospitals with high costs and high markups, while cases in low-cost DRGs are

concentrated in hospitals with low costs and relatively low markups. As a result, relative weights—

which are now based on national average charges per case in each DRG—tend to overstate the

expected costliness of high-cost DRGs and understate that for low-cost DRGs. MedPAC anticipates

that a technical change in the method used to calculate the DRG weights would reduce these errors.

The second improvement would involve financing outlier payments for extremely costly cases based on

the prevalence of such payments in each DRG, instead of reducing payments in all DRGs by a flat

percentage as currently required. Outlier cases and payments are relatively concentrated in high-cost

DRGs, but DRG weights are calculated based on national average charges per case in each DRG,

without accounting for differences in outlier spending. As a result, the weights in high-cost DRGs tend

to be overstated. MedPAC anticipates that financing outlier payments on a DRG-specific basis would

make relative weights measure more accurately the expected relative costliness of typical patients in

each category.

Other things being equal, these improvements in case-mix measurement would make PPS payments

reflect more accurately efficient hospitals’ costs. They would also redistribute payments among

hospitals. Consequently, a phase-in period probably would be desirable to cushion the effects of these

policies.

Further, although HCFA has authority to make changes in the DRG definitions and weights, the method

of financing outlier cases is set in law. In addition, previous refinements to the DRGs have led to

changes in hospitals’ coding practices that often substantially increased measured case mix and PPS

payments, but HCFA does not now have authority to offset the anticipated impact of coding changes

when adopting refinements such as those suggested here. The Commission will consider these issues

further as it begins to develop specific recommendations later this year.

Recognizing the enhanced value of patient care services in teaching hospitals

Compared with other hospitals, teaching hospitals’ higher costs in part reflect differences in the

complexity and intensity of services they furnish. As indicated earlier, MedPAC believes that the value

of the enhanced patient care furnished by teaching hospitals justifies their higher costs.

RECOMMENDATION 3

10

The Congress should revise Medicare’s payments to recognize the higher value of

patient care services provided in teaching hospitals through an enhanced patient

care adjustment.
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MedPAC envisions an enhanced patient care (EPC) adjustment that would combine Medicare’s current

additional payments to teaching hospitals into a single adjustment to PPS payments for patient care.2

This adjustment would help to ensure beneficiaries’ access to care in teaching hospitals by making

Medicare’s payments reflect the added cost of the services these facilities provide. Teaching hospitals

would continue to face financial incentives to produce care efficiently because payments still would be

tied to bundles of services represented by the refined DRGs.

In principle, creating a single adjustment would involve two steps. First, direct GME costs would be

added to other inpatient care costs to get a better measure of the actual costs of care per discharge.

Second, the relationship between the revised measure of inpatient costs per discharge and some

measure of teaching hospitals’ patient care enhancements (such as residents per bed) would be

estimated.

In practice, however, integrating direct GME costs into patient care payments through an EPC

adjustment raises several difficult issues. One is the question of which direct GME costs should be

incorporated into hospitals’ costs per discharge. Another issue concerns which measures and methods

should be used in estimating the proposed EPC adjustment. A third issue concerns the impact this

policy change may have on Medicare’s overall payments to hospitals for inpatient care. Finally,

policymakers need to consider how an EPC adjustment should be implemented for teaching hospitals

(or inpatient units) that are exempt from PPS.

What GME costs should be included? In combining direct GME costs with teaching hospitals’

other inpatient care costs, should policymakers include teaching hospitals’ current direct GME costs or

their current direct GME payments? Using the most recent direct GME cost data for determining the

EPC adjustment would allow payments to reflect the current relationship between teaching intensity (or

some other proxy measure) and inpatient costs per case. If the relationship were based on current

payments, the adjustment would reflect hospitals’ direct per resident costs from 1984 updated for

inflation plus the effect of the resident weighting factors on payments. Using current GME costs might

increase aggregate Medicare payments to hospitals because Medicare’s share of these costs

substantially exceeds its aggregate GME payments.

A second issue is what to do about direct GME costs related to the time residents spend in other

settings, such as outpatient care units. The direct GME costs teaching hospitals report on their

Medicare cost reports reflect the full accounting costs borne by the hospital for its approved GME

programs. Some of these costs, however, reflect the time residents spend in hospital outpatient

departments and other ambulatory settings. How costs related to other settings are treated would affect

the estimated EPC adjustment, and it might also affect hospitals’ incentives regarding allocation of

residents among settings. A similar issue arises about whether to include the portion of residents’ time

spent in other settings in hospitals’ resident counts. Whether or not analogous EPC adjustments would

be implemented in making payments for services in those other settings would also be an important

consideration in deciding these issues.

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2 The EPC adjustment, like the current IME adjustment, would be applied as a percentage add-on to hospitals’ base DRG

payment rates. Consequently, EPC payments would automatically reflect adjustments, such as that for local labor price levels,

built into the DRG payment rates.
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What measures and methods should be used? Estimating an EPC adjustment raises a number

of important technical issues. One issue concerns what measure can or should be used to represent the

extent of the patient care enhancements available at each teaching hospital. In its current IME

adjustments for operating and capital payments, Medicare relies on proxy measures that are based on

the number of residents (ratios of residents to beds and residents to occupied beds, respectively). With

currently available tools, enhanced patient care cannot be directly measured. The virtue of the current

teaching intensity measures is that they appear to capture or explain a plausible portion of the variability

in teaching hospitals’ costs. But the disadvantage is that hospitals receive higher payments if they have

more residents, creating incentives to employ more residents than they otherwise would. Ideally, other

proxy measures could be developed that would capture the enhanced value of patient care provided by

teaching hospitals without using the count of residents. Accordingly, the Commission will search for

reasonable alternatives.

Developing an EPC adjustment also will raise a variety of other issues regarding data and technical

methods. The Commission anticipates that some refinements in methods—such as using more recent

data and adopting some technical improvements in the statistical methods— likely will result in better

estimates of the relationship between resident intensity and hospital costs per case.

What impact should the EPC adjustment have on aggregate payments to teaching

hospitals? Another issue is whether an EPC adjustment should be implemented in a budget-neutral

manner. The level of the new enhanced patient care adjustment should reflect as closely as possible the

efficient cost of providing care in teaching hospitals. Whether this means higher or lower payments to

teaching hospitals depends on how policymakers resolve the issues just raised.

How should an enhanced patient care adjustment be implemented for PPS-exempt

facilities? The preceding discussion has focused on PPS inpatient payments, but many residents train

in hospitals and units that are not subject to Medicare’s inpatient PPS. Excluded hospitals and units are

paid under provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The TEFRA

payment system does not have an IME adjustment, although payments are based on hospital-specific

rates, subject to rate of increase limits. Like PPS hospitals, these hospitals receive separate direct

GME payments. To incorporate direct costs into inpatient rates for this set of providers, the base target

amounts would need to be revised to include inpatient GME costs as a part of inpatient operating costs.

Should the enhanced patient care adjustment be reflected

in payments to Medicare+Choice plans?

Under current law, Medicare’s payments for direct GME and indirect medical education are gradually

being removed from the base used to calculate payment rates for Medicare+Choice plans. Instead,

payments will be made directly to teaching hospitals when they provide care to Medicare+Choice

enrollees. We recognize that our recommendation to develop an enhanced patient care adjustment

raises a number of issues concerning treatment of this adjustment for the purpose of paying

Medicare+Choice plans. These issues are complex and will be the subject of future discussions by the

Commission.

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Phasing in payment policy changes

The policy changes the Commission is recommending are not intended to produce large increases or

decreases in Medicare spending. The main focus of these recommendations is to help improve the

accuracy of overall Medicare payment policy. Creating a new enhanced patient care adjustment,

however, and making other improvements to Medicare payment policies potentially would redistribute a

substantial amount of Medicare revenues across providers. Hospitals that had high per resident

payment amounts for direct medical education costs, for instance, could see a decrease in payments,

while those with low per resident payments could see an increase. But these effects may be muted by

the other changes MedPAC proposes.

RECOMMENDATION 5

RECOMMENDATION 4

13

The Congress should phase in the payment adjustment for enhanced patient care

and any related policies that substantially change payments to individual

providers.

A sharp change in Medicare payments has the potential for placing some hospitals under unnecessary

financial stress, which could hurt beneficiary access to needed services. Phasing in these changes would

help to cushion some of the financial impact of these policies. Transition mechanisms have been an

important part of many Medicare payment policy changes. When the inpatient PPS was first

implemented, there was a three-year phase-in from hospital-specific rates to national rates. The

transition to PPS for inpatient capital payments has taken place over 10 years.

The appropriate time period and type of transition mechanism will depend on the estimated impact of

potential policy changes on providers and beneficiaries. For its March 2000 report, the Commission

will be conducting analyses to help identify an appropriate transition mechanism and phase-in period.

How should Medicare pay for patient care in other teaching settings?

The principles discussed previously need not be confined to the inpatient setting or to physician training.

As with inpatient care, patient care costs may be higher in other settings where teaching takes place

because a different set of services is being produced. These settings may treat a more acute patient mix,

offer a broader scope of services, provide more intensive treatment, or employ a more costly mix of

staff. Care may also be enhanced by the presence of other types of health professional training

programs.

The Congress and the Secretary should develop payment adjustments for enhanced

patient care in all settings where residents and other health care professionals train

when the added value of patient care justifies its higher costs.
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Recognizing the potential contribution of residents and other trainees to patient care services in other

settings would improve the consistency of Medicare’s payment policies across settings, giving providers

incentives to use the most appropriate setting for patient care and training. The same criteria that

MedPAC applies to inpatient care would have to be met before an enhanced patient care adjustment

were made. First, the cost of efficiently provided care must be higher. Second, the care being provided

must be considered more valuable.

Where these criteria would be met is an empirical question that will need further examination. To

develop enhanced patient care adjustments for other settings, costs historically included in direct GME

payments would have to be allocated to the settings in which trainees furnished services. For example,

resident salary expenses related to the time spent providing patient care in the hospital outpatient

department should be classified as hospital outpatient costs. In addition, appropriate proxies for the

extent to which patient care is enhanced would have to be developed for the facilities that participate in

residency training. While the data necessary to develop an enhanced patient care adjustment for

hospital outpatient services may be available, the data necessary for determining whether adjustments

are needed in other settings currently are not.

The Commission believes that the presence of non-physician health professional training programs in a

facility may also contribute to enhancing the care provided to Medicare beneficiaries in hospitals and

other settings. However, there are virtually no data showing which providers train specific health

professionals. A first step would be to identify providers that participate in these activities. Then we

can determine whether these providers have higher patient care costs and whether they provide

enhanced patient care that might warrant adjusting payment rates.

Medicare and federal health workforce policy

A well-trained supply of physicians and other health care professionals is essential to providing quality

care for Medicare beneficiaries. This raises the question of what role the Medicare program should

play in ensuring that this supply is available. The Commission has concluded that although Medicare

spending for health care services influences the health workforce in many ways, payment policy is too

blunt an instrument to rely on to achieve specific workforce goals.

RECOMMENDATION 6

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Federal policies intended to affect the number, specialty mix, and geographic

distribution of health care professionals should be implemented through specific

targeted programs rather than through Medicare payment policies.
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As the single largest payer for health care services, Medicare necessarily influences the market for health

professionals. By covering aged and disabled people who previously had limited ability to pay for

health care, Medicare greatly increased demand for the services of health care professionals. Medicare

affects not only the overall demand for health professionals, but also their specialty mix and geographic

distribution. Indeed, Medicare spending for health care services probably has a greater influence on the

size and composition of the health workforce than any of the targeted payment policies intended to

influence the workforce directly.

In general, markets correctly interpret the signals Medicare sends through its payment policies. By

providing a steady source of revenue, the program encourages training in specialties associated with

treating the illnesses of aged and disabled people. Where Medicare does not pay for services generally

associated with a particular specialty, it may discourage training. For example, although several studies

have indicated an inadequate supply of geriatricians, the number of geriatric training slots exceeds the

number of people who choose to enter the specialty (Reuben). This may reflect a lack of payment for

services such as palliative care and comprehensive geriatric assessment. Thus, Medicare’s payments for

specific services need to be considered in light of how they affect the supply of such services.

As with other career decisions, people deciding to enter a health profession weigh the benefits—in

terms of the income, prestige, and job satisfaction they expect to attain—against the costs of acquiring

the necessary training. By giving beneficiaries resources to buy health services, Medicare increases the

incomes of health professionals and in so doing makes the cost of professional training a better

investment. This benefit for health professionals helps ensure access to care consistent with Medicare’s

purpose.

Nonetheless, several reasons suggest that Medicare and the market do not always produce the supply

and distribution of health care professionals that society desires. First, as is true for other professions,

people seeking careers that require extensive training may not have the financial resources to acquire

that training. Second, the time required to obtain training may mean that the supply of particular

specialties lags the demand, while other specialties are in oversupply. Finally, the demand for health

care professionals in isolated rural areas or high-poverty areas may not be adequate to support

minimum basic services.

Medicare is not well-suited to addressing these concerns. Where the issue is access to extended

training, education grants or loans may be a more effective means of improving access. Where the issue

is the supply of health professionals at a particular time or in a particular place, programs that address

health workforce specifically may provide better tools and broader vision to help ensure an acceptable

mix of health professionals for both Medicare beneficiaries and the general population.

Future work

Over the coming year, MedPAC will begin to flesh out this set of recommendations. With an eye to

ensuring beneficiary access to the enhanced patient care that teaching settings provide, the Commission

will examine payment refinements aimed at measuring more accurately the cost of patient care in

teaching settings.

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For inpatient hospital payments, we will begin by analyzing the impact of refining the DRGs and their

relative weights, and moving to DRG-specific outlier financing. Then, we will examine the effect of

replacing the current direct GME and IME payments with an enhanced patient care adjustment. This

enhanced patient care adjustment will be developed to reflect the relationship between teaching activity

(or other proxy measures) and hospitals’ patient care costs, including both reported direct medical

education costs and other patient care costs.

The Commission will also begin to evaluate the need to adjust Medicare payments to account for the

enhanced value of care in other settings where physicians train. In addition, we will consider whether

differences in patient care associated with other health professionals’ training programs justify similar

payment adjustments.■

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References

Becker GS. Human capital: a theoretical and empirical analysis, with special reference to education,

second edition. Chicago, The University of Chicago Press. 1975.

Bradley T, Congressional Budget Office. Personal communication. Washington (DC). July 1999.

Feldman RD, Yoder SG. A theoretical analysis of GME financing in Hadley J, Urban Institute, editor,

Medical education financing: policy analyses and options for the 1980’s. New York, PRODIST. 1980.

Reuben DB, Beck JC. Training physicians to care for older Americans: progress, obstacles, and future

directions. Washington (DC), National Academy Press. 1994.

U.S. House of Representatives. House report No. 213, 89th Congress, 1st session. 1965.

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Appendix

The Balanced Budget Act of 1997 (BBA) required the Medicare Payment Advisory Commission to

examine federal policy affecting graduate medical education (GME), Medicare’s payments to teaching

hospitals, and federal workforce issues. Following is the legislative language from the BBA.

SEC. 4629. RECOMMENDATIONS ON LONG-TERM POLICIES REGARDING TEACHING

HOSPITALS AND GRADUATE MEDICAL EDUCATION.

 (a) IN GENERAL.—The Medicare Payment Advisory Commission (established under section 1805 of the

Social Security Act and in this section referred to as the “Commission”) shall examine and develop

recommendations on whether and to what extent medicare payment policies and other Federal policies

regarding teaching hospitals and graduate medical education should be changed. Such recommendations shall

include recommendations regarding each of the following:

 (1) Possible methodologies for making payments for graduate medical education and the selection of entities

to receive such payments. Matters considered under this paragraph shall include —

 (A) issues regarding children’s hospitals and approved medical residency training programs in pediatrics,

and

 (B) whether and to what extent payments are being made (or should be made) for training in the nursing and

other allied health professions.

 (2) Federal policies regarding international medical graduates.

 (3) The dependence of schools of medicine on service-generated income.

 (4) Whether and to what extent the needs of the United States regarding the supply of physicians, in the

aggregate and in different specialties, will change during the 10-year period beginning on October 1, 1997,

and whether and to what extent any such changes will have significant financial effects on teaching hospitals.

 (5) Methods for promoting an appropriate number, mix, and geographical distribution of health

professionals.

 (b) CONSULTATION.—In conducting the study under subsection (a), the Commission shall consult with the

Council on Graduate Medical Education and individuals with expertise in the area of graduate medical

education, including —

 (1) deans from allopathic and osteopathic schools of medicine;

 (2) chief executive officers (or equivalent administrative heads) from academic health centers, integrated

health care systems, approved medical residency training programs, and teaching hospitals that sponsor

approved medical residency training programs;

 (3) chairs of departments or divisions from allopathic and osteopathic schools of medicine, schools of

dentistry, and approved medical residency training programs in oral surgery;

 (4) individuals with leadership experience from representative fields of non-physician health professionals;

 (5) individuals with substantial experience in the study of issues regarding the composition of the health care

workforce of the United States; and

 (6) individuals with expertise in health care payment policies.

 (c) REPORT.—Not later than 2 years after the date of the enactment of this Act, the Commission shall

submit to the Congress a report providing its recommendations under this section and the reasons and

justifications for such recommendations.

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