Medicare Hospital and Physician Payments: Geographic Cost Adjustments Important to Preserve Beneficiary Access to Services
Published: 2002-07-23T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony discusses Medicare program payment adjustments to hospitals and physicians that account for geographic differences in costs.
section_title: What GAO Found
paragraphs: Because Medicare's hospital and physician payment systems are based on national rates, these geographic cost adjustments are essential to account for costs beyond providers' control and to ensure that beneficiaries have adequate access to services. If these adjustments are not adequate, this could affect providers' financial stability and their ability or willingness to continue serving Medicare patients. Medicare's payments to hospitals vary with the average wages paid in a hospital's labor market. Yet, some hospitals believe that the labor cost adjustment applied does not reflect the average wage in their labor market area. Medicare's labor cost adjustment does not adequately account for geographic differences in hospital wages in some areas because a single adjustment is applied to all hospitals in an area, even though it may encompass multiple labor markets or different types of communities within which hospitals pay significantly different average wages. Geographic reclassification addresses some inequities in Medicare's labor cost adjustments by allowing some hospitals that pay wages enough above the average in their area to receive higher labor cost adjustments. However, some hospitals can reclassify even though they pay wages that are comparable to the average in their area. To help ensure that beneficiaries in all parts of the country have access to services, Medicare adjusts its physician fee schedule on the basis of indexes designed to reflect cost differences among 92 geographic areas. The adjustment is designed to help ensure that the fees paid appropriately reflect the cost of living and operating a practice in that area.

section_title: Letter
paragraphs: I am pleased to be here today as you discuss how the Medicare program  adjusts payments to hospitals and physicians to account for geographic  differences in costs. Because Medicare’s hospital and physician payment  systems are based on national rates, these geographic cost adjustments  are essential to account for costs beyond providers’ control and to ensure  that beneficiaries have adequate access to services. If these adjustments  are not adequate, Medicare could financially reward or penalize providers  due only to where they are located. Over time, this could affect some  providers’ financial stability and their ability or willingness to continue  serving Medicare patients.
Some providers contend that Medicare’s geographic cost adjustments are  inadequate. Medicare’s payments to hospitals are intended to vary with the  average wages paid in a hospital’s labor market. Yet, some hospitals  believe that the labor cost adjustment applied to their payments does not  reflect the average wage they face in their labor market area. Hospitals  that meet certain criteria can qualify to have their payments increased  through Medicare’s reclassification process. But concerns remain about  the geographic variation in payments to hospitals and disparities in  hospital financial performance under Medicare’s hospital payment system.  Similarly, physicians have raised concerns about the appropriateness of  Medicare’s geographic adjustment to their fees.
My comments today are based on our forthcoming report on the Medicare  program’s labor cost adjustment for hospital services and our preliminary  work on the program’s physician payment adjustment. I will focus on (1)  how Medicare determines the labor cost adjustment for hospitals in an  area; (2) whether Medicare’s labor cost adjustment accounts appropriately  for geographic variation in wages paid by hospitals; (3) the extent to which  geographic reclassification addresses potential problems with Medicare’s  labor cost adjustment for hospitals; and (4) how Medicare determines  geographic adjustments to physician fees. My comments are based  primarily on our analysis of hospital Medicare cost report data and other  information, including that compiled by the Centers for Medicare and  Medicaid Services, the agency within the Department of Health and  Human Services that oversees the Medicare program.
In summary, Medicare’s labor cost adjustment does not adequately  account for geographic differences in hospital wages in some areas  because a single adjustment is applied to all hospitals in an area even  though the area may encompass multiple labor markets or different types  of communities within which hospitals pay significantly different average  wages. Geographic reclassification addresses some inequities in  Medicare’s labor cost adjustments by allowing some hospitals that pay  wages enough above the average in their area to receive a higher labor  cost adjustment. At the same time, however, some hospitals can reclassify  even though they pay wages that are comparable to the average in their  area. To help ensure that beneficiaries in all parts of the country have  access to services, Medicare adjustments its physician fee schedule based  on indexes designed to reflect cost differences among 92 geographic areas.  The adjustment is designed to help ensure that the fees paid in a  geographic area appropriately reflect the cost of living in that area and the  costs of operating a practice. We are beginning an analysis of the  methodology and data that Medicare uses to make the adjustment to  determine whether it appropriately reflects underlying costs and, if not,  whether beneficiary access to physician services has been impaired in  certain areas.
subsections: section_title: A Hospital’s Labor Cost Adjustment Is Based On Average Wages Paid in a Geographic Area
paragraphs: Medicare’s prospective payment system (PPS) provides incentives for  hospitals to operate efficiently by paying them a predetermined, fixed  amount for each inpatient hospital stay, regardless of the actual costs  incurred in providing the care. Although the fixed, or standardized,  amount is based on national average costs, actual hospital payments vary  widely across hospitals, primarily because of two payment adjustments in  PPS. There is an adjustment that accounts for cost differences across  patients due to their care needs, and a labor cost adjustment that accounts  for the substantial variation in average hospital wages across the country.  The fixed amount is adjusted for these two sources of cost differences  because they are largely beyond any individual hospital’s ability to control.
The Medicare labor cost adjustment for a geographic area is based on a  wage index that is computed using data that hospitals submit to Medicare.  The wage index for an area is the ratio of the average hourly hospital wage  in the area compared to the national average hourly hospital wage. The  wage indexes ranged from roughly 0.74 to 1.5 in 2001. Only the portion of  the hospital payment that reflects labor-related expenses (71 percent) is  multiplied by the wage index. The rest of the payment, which covers  drugs, medical supplies and certain other non-labor-related expenses, is  uniform nationwide because prices for these items are not perceived as  varying significantly from area to area.
The geographic area for which a wage index is calculated is supposed to  represent an area where hospitals pay relatively uniform wages. If it does  not, the hospitals in the area may receive a labor cost adjustment that is  higher or lower than the wages paid in their area would justify.
The Medicare program uses the Office of Management and Budget’s  (OMB) “metropolitan/non-metropolitan” classification system to define the  geographic areas used for the labor cost adjustment. Medicare calculates  labor cost adjustments for 324 metropolitan areas and 49 “statewide” non- metropolitan areas. Medicare specifies an OMB metropolitan statistical  area (MSA) as a distinct region within which wages are assumed to be  relatively uniform. Medicare specifies the rest of a state—all the non-MSA  counties—as a single, non-metropolitan area in which hospitals are  assumed to face similar average wages. These non-metropolitan areas can  be quite large and not contiguous (see fig. 1).
section_title: Labor Cost Adjustment Does Not Adequately Account for Wage Differences Within Certain Areas
paragraphs: The variation in hospital wages within some Medicare geographic areas –  MSAs or the non-metropolitan areas in a state—is systematic across  different parts of these areas. While wages paid by hospitals are expected  to vary within a labor market, such systematic variation suggests that  some Medicare geographic areas include multiple labor markets within  which hospitals pay different average wages. For example, average  hospital wages in outlying counties of MSAs tend to be lower than average  hospital wages in central counties. Average wages in non-metropolitan  large towns tend to be higher than in other non-metropolitan areas within  a state. Because the labor cost adjustment does not take this kind of  systematic variation into account, the adjustment sometimes does not  appropriately reflect the average wages that hospitals pay.
subsections: section_title: Medicare Metropolitan Geographic Areas May Encompass Multiple Labor Markets With Varying Average Wages
paragraphs: Because an MSA may extend over several thousand square miles, the  hospitals within an MSA may not be competing with each other for the  same pool of employees. Therefore, these hospitals may need to pay  varying wages to attract workers. The Washington, D.C. MSA illustrates  how hospital wages in a large MSA can vary across different counties (see  fig. 2). It includes hospitals located in the central city of the District of  Columbia and in 18 counties in Maryland, Virginia, and West Virginia.  Hospital wages averaged $23.70 per hour in fiscal year 1997 in the District  of Columbia and in most adjacent suburban Maryland and Virginia  counties, but averaged $20.14 per hour in the outlying counties. Yet, the  labor cost adjustment for hospitals within this MSA is based on an average  wage of $23.41 per hour and is the same for hospitals within all its  counties.
Hospitals in central counties of an MSA typically pay higher wages than  hospitals in outlying counties. Central county hospital wages ranged from  7 percent higher than outlying county hospital wages in Houston to 38  percent higher in New York City in fiscal year 1997. In most of the MSAs  with the highest population, the difference was from 11 to 18 percent in  fiscal year 1997.
section_title: Some Medicare Non- metropolitan Geographic Areas Encompass Multiple Community Types with Varying Wages
paragraphs: Medicare uses the same labor cost adjustment for all hospitals in the non- metropolitan areas of a state. The adjustment would be adequate for all  hospitals in these sometimes vast areas if the hospitals paid similar  average wages. However, we found wage variation across non- metropolitan areas that appears to be systematically related to type of  community. In three-quarters of all states, the average wages paid by  hospitals in large towns are higher than those paid by hospitals in small  towns or rural areas. About 38 percent of hospitals in large towns paid  wages that were at least 5 percent higher than the average wage in their  area, and 16 percent paid wages that were at least 10 percent higher than  the area average.
As a result, the Medicare labor cost adjustment for non-metropolitan areas  may be based on average wages that are lower than wages paid by large  town hospitals and based on average wages that are higher than wages  paid by hospitals in small towns and rural areas. For example, the fiscal  year 2001 labor cost adjustment for non-metropolitan Nebraska was based  on an average hourly wage of $17.65. Yet, Nebraska hospitals in large  towns had an average wage that year that was 11 percent higher; small  town Nebraska hospitals had an average wage that was 5 percent lower;  and hospitals in rural areas of the state had an average wage that was 16  percent lower.
section_title: Through Reclassification, Some Hospitals Receive a More Appropriate Labor Cost Adjustment
paragraphs: The administrative process for geographic reclassification allows hospitals  meeting certain criteria to be paid for Medicare inpatient hospital services  as if they were located in another geographic area with a higher labor cost  adjustment.  The first criterion concerns the hospital’s proximity to the  higher-wage “target” area. The proximity requirement is satisfied if the  hospital is within a specified number of miles of the target area (15 miles  for a metropolitan hospital and 35 miles for a non-metropolitan hospital)  or if at least half of the hospital’s employees reside in the target area. The  second criterion pertains to the hospital’s wages relative to the average  wages in its assigned area and in the target area. This criterion is satisfied  if the hospital’s wages are a specified amount higher than the average in its  assigned area and if its wages are comparable to the average wages in the  target area.
Rural referral centers (RRC) and sole community hospitals (SCH) can be  reclassified by meeting less stringent criteria. These hospitals receive  special treatment from Medicare because of their role in preserving access  to care for beneficiaries in certain areas. RRCs are relatively large rural  hospitals providing an array of services and treating patients from a wide  geographic area. SCHs are small hospitals isolated from other hospitals by  location, weather, or travel conditions. RRCs and SCHs do not have to  meet the proximity requirement to reclassify. RRCs are also exempt from  the requirement that their wages be higher than those of the average  wages in their original market.
subsections: section_title: Not All Higher-Wage Hospitals Can Be Reclassified
paragraphs: Of the 756 hospitals that paid wages high enough to qualify for  reclassification, only 310, or 41 percent, were reclassified in fiscal year  2001. More than one-quarter of these higher-wage hospitals were in large  towns, and 73 percent of them were reclassified. Higher-wage hospitals in  large towns are likelier to be reclassified than other higher-wage hospitals  because many are RRCs, which are exempt from the reclassification  proximity criterion.
In contrast to the nearly three-quarters of large town higher-wage hospitals  that reclassified in fiscal year 2001, about half of higher-wage hospitals in  small towns and rural areas were reclassified. Almost 39 percent of the  reclassified higher-wage small town and rural hospitals were exempt from  the proximity criterion because they were RRCs or SCHs. Some non- reclassified, higher-wage small town or rural hospitals that were SCHs  may have opted out of PPS to receive cost-based payments from Medicare,  making reclassification irrelevant.
Moreover, even though metropolitan area higher-wage hospitals made up  42 percent of the higher-wage hospitals, only 12 percent of them were  reclassified in fiscal year 2001—a percentage far lower than that for  higher-wage hospitals in other areas. Reclassified metropolitan hospitals  paid wages that were about 10 percent above the average wage in their  former area; those average wages are equal to the average wage in the new  areas to which these hospitals were reclassified in fiscal year 2001.
The likely reason that so few metropolitan higher-wage hospitals were  reclassified is that few are close enough to a higher-wage MSA to meet the  proximity criterion. More than two-thirds of the metropolitan hospital  reclassifications in fiscal year 2001 were concentrated in two areas— California and a region that includes parts of New York, Connecticut, New  Jersey and Pennsylvania—where metropolitan areas are close enough to  each other that more higher-wage hospitals in these areas may be able to  meet the reclassification proximity requirement.
section_title: Certain Hospitals Can Be Reclassified Without Meeting Wage Criterion
paragraphs: While reclassification is designed to increase payments to hospitals paying  wages significantly above the average for their area, certain provisions  allow some hospitals that pay lower wages to reclassify. For example, an  additional 116 hospitals were reclassified for a higher wage index in fiscal  year 2001, even though they paid wages that were too low to meet the  wage criterion. Prior to reclassification, these non-metropolitan hospitals  had average wages that were close to the area average. With  reclassification, these hospitals were assigned to areas with a labor cost  adjustment based on wages that averaged 8 percent higher than their own.
Of the 116 hospitals that reclassified for a higher wage index in fiscal year  2001, but failed to meet the wage criterion, 89 were RRCs (see table 1).  About 42 percent of these had wage costs below their statewide non- metropolitan average. The other hospitals that reclassified, but did not pay  wages that met the wage criterion, include those that were part of county- wide reclassifications and those reclassified through legislation.
section_title: Physician Fees Are Adjusted for Cost-of- Living, Practice Expense and Malpractice Premium Differences
paragraphs: Medicare’s physician fee schedule, which specifies the amount that  Medicare will pay for each physician service, includes an adjustment to  help ensure that the fees paid in a geographic area appropriately reflect  the cost of living in that area and the costs associated with the operation  of a practice. This geographic adjustment is a critical component of the  physician payment system. An adjustment that is too low can impair  beneficiary access to physician services, while one that is too high adds  unnecessary financial burdens to Medicare. Although much attention in  recent months has focused on the method used to annually update the  physician fee schedule, concerns have also been voiced about the  appropriateness of the geographic adjustments. H.R. 4954, the Medicare  Modernization and Prescription Drug Act of 2002, would require us to  evaluate the methodology and data that Medicare uses to geographically  adjust physician payments. We are beginning an analysis of the  methodology and the available data to determine whether Medicare’s  geographic adjustment appropriately reflects underlying costs and  whether beneficiary access to physician services has changed in certain  areas.
In adjusting 2002 fees for physician services, Medicare has delineated 92  separate geographic areas. In some instances, these areas consist of an  entire state. For example, physician fees are uniform across Connecticut.  In other cases, a large city or group of cities within a state is classified into  one geographic area and the rest of the state is classified into another.  Maryland illustrates this case: Baltimore and surrounding counties are  classified into one geographic area, and the rest of Maryland is classified  as another. Finally, some large metropolitan areas, such as New York City  and its suburban counties, are split into multiple geographic areas.
Medicare’s geographic adjustments for physician fees are based on  indexes that are designed to reflect cost differences among the 92 areas.  There are three separate indexes, known as geographic practice cost  indexes (GPCI), that correspond to the three components that comprise  Medicare’s payment for a specific service: (1) the work component,  reflecting the amount of physician time, skill, and intensity; (2) the  practice expense component, reflecting expenses, such as office rents and  employee wages; and (3) the malpractice insurance component, reflecting  the cost of personal liability insurance premiums. The overall geographic  adjustment for each service is a weighted average of the three GPCIs  where the weights represent the relative importance of the components  for that service. Across all physician services in 1999, the average weights  were approximately 55 percent for the work component, 42 percent for  the practice expense component, and 3 percent for the malpractice  insurance component.
The GPCIs are calculated from a variety of data sources. The work GPCI is  based on a sample of median hourly earnings of workers in six  professional categories. Physician earnings are not used because some  physicians derive much of their income from Medicare payments, and an  index based on physician earnings would be affected by Medicare’s  existing geographic adjustments. The work GPCI is a weighted average of  the median earnings of these professions in the area and their median  earnings nationwide. If the work GPCI was based solely on the median  earnings in each area, physician payments would likely increase in large  metropolitan areas and decrease in rural areas. The practice expense GPCI  is based on wage data for various classes of workers, office rent estimates,  and other information. The malpractice insurance GPCI is based on  average premiums for personal liability insurance.
Concerns have been raised that the current geographic adjustments for  physician fees do not appropriately reflect the underlying geographic  variation in physicians’ costs and that, as a result, beneficiary access to  services may be impaired in certain areas. Unfortunately, information on  physicians’ willingness to see Medicare patients is dated—although it does  not indicate access problems. Data from the 1990s show that virtually all  physicians were treating Medicare beneficiaries and, if they were  accepting new patients, accepted those covered by Medicare. A 1999  survey conducted by the Medicare Payment Advisory Commission  (MedPAC) from that year found that 93 percent of physicians who had  been accepting new patients were continuing to do so. It is unclear  whether the situation has deteriorated since 1999. MedPAC is updating its  survey, and the new results may shed light on this issue. However,  MedPAC’s survey results may not be able to identify access problems if  they occur only in certain areas. As I said in my testimony before this  Subcommittee in February, it is important to identify beneficiary access  problems quickly and take appropriate action when warranted. As part of  the work we are beginning on access to physician care, we will examine  Medicare claims data to get the most up-to-date picture possible of access  by area, by specialty, and for new versus established patients.
section_title: Concluding Observations
paragraphs: Medicare’s PPS for inpatient services provides incentives to hospitals to  deliver care efficiently by allowing them to keep Medicare payment  amounts that exceed their costs, while making hospitals responsible for  costs that exceed their Medicare payments. To ensure that PPS rewards  hospitals because they are efficient, rather than because they operate in  favorable circumstances, payment adjustments are made to account for  cost differences across hospitals that are beyond any individual hospital’s  control. If these payment adjustments do not adequately account for cost  differences, hospitals are inappropriately rewarded or face undue fiscal  pressure. The adjustment used to account for wage differences—the labor  cost adjustment—does not do so adequately because many of the  geographic areas that Medicare uses to define labor markets are too large.
Geographic reclassification provides relief to some hospitals that pay  wages that are higher than the average in their area. Yet, other hospitals  paying higher wages cannot be reclassified. Still other hospitals get a  higher labor cost adjustment than is warranted by the wages they pay, and  many are in rural areas and may be facing financial problems. Their labor  cost adjustment, however, is not necessarily the cause of these problems.  Therefore, reclassification may not be the most effective mechanism to  address the financial pressure faced by these rural hospitals.