Under the Medicare inpatient PPS, hospitals receive a fixed, predetermined payment for each hospital stay. The payment is based on standardized amounts that are calculated separately for hospitals in large metropolitan areas (with populations of 1 million or more) and for hospitals in smaller metropolitan and nonmetropolitan areas. The standardized amounts are the average cost of hospital stays for Medicare beneficiaries based on historical data and are updated annually for inflation. For 2001, the standardized amount for hospitals in large metropolitan areas was $4,028 and for hospitals in other areas it was $3,965. To determine a hospital’s payment for a Medicare beneficiary’s stay, the standardized amount is adjusted to account for variation in the cost of providing care to specific patients in specific locations. The labor cost adjustment accounts for geographic variation in hospitals’ labor costs, because the wages hospitals must pay employees vary significantly by area. The portion of the standardized amount (71 percent) that reflects labor-related expenses is multiplied by the area wage index. The remaining portion of the standardized amount (29 percent) is not adjusted. This part of the payment—which covers drugs, medical supplies, utilities, and other nonlabor-related expenses—is uniform nationwide because prices for these items are not perceived as varying significantly from area to area. The case-mix adjustment accounts for differences in resource requirements across types of patients. It is based on the expected care needs of the patient as measured by the diagnosis-related group (DRG) patient classification system. Additional payments are made under PPS to compensate hospitals for costs they incur in performing certain missions beyond caring for individual patients. Teaching hospitals receive additional payments from Medicare to account for costs associated with training medical residents. Hospitals that serve a disproportionate share of low-income Medicare and Medicaid patients also receive additional Medicare payments. The combination of all these adjustments and additional payments may result in widely varying per-stay payments across different types of hospitals or geographic areas. The Medicare labor cost adjustment is based on a wage index that is computed for each of 324 metropolitan and 49 statewide nonmetropolitan areas 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 average hourly wage is calculated for each area by aggregating Medicare-allowable wages for all the hospitals in the area and then dividing that sum by the corresponding staff hours. The area’s average hourly wage is then divided by the national average hourly wage to produce the area’s wage index. For example, if the average hourly wage for all hospitals in a large metropolitan area was $22.59, the wage index for that large metropolitan area would be $22.59 divided by the national average hourly wage of $21.77, for a wage index of 1.04. The wage indexes ranged from roughly 0.74 to 1.5 in 2001. As currently calculated, the wage indexes vary because of geographic differences in wages paid and also because of variation in the mix of higher- and lower- skilled workers employed in an area, termed occupational mix. An area’s average hourly wage can be higher than the national average if hospitals in an area employ more highly skilled (and thus more highly paid) workers and lower if an area’s hospitals employ more lower- skilled workers than the national average. When one area’s hospitals have a larger proportion of more skilled, higher wage staff than another area, the former’s wage index will be higher, even if wage rates in both areas for staff with the same skills, such as registered nurses, are identical. While geographic differences in wages paid affect a hospital’s labor costs but are largely beyond an individual hospital’s ability to control, the mix of occupations employed in a hospital reflects managerial decisions. The Congress, in the Medicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA), required the Secretary of Health and Human Services to collect data on hospitals’ mix of employees and their corresponding wages and calculate wage indexes beginning October 1, 2004, that are adjusted for occupational mix. (For a more detailed discussion of the impact of occupational mix variation on the wage index, see app. II.) The Medicare program uses OMB’s “metropolitan/nonmetropolitan” classification system to define its geographic areas for the labor cost adjustment. Each metropolitan statistical area (MSA) is defined as a metropolitan labor market and the residual area in each state is defined as a single, nonmetropolitan labor market. The current geographic areas will most likely change when MSA boundaries are updated in 2003 with population data from the most recent decennial census and revised standards for selecting counties for inclusion in an MSA. The Omnibus Budget Reconciliation Act of 1989 established an administrative process for geographic reclassification, in which hospitals meeting certain criteria can apply to be paid for Medicare inpatient hospital services as if they were located in another geographic area. Once reclassified, hospitals receive the higher labor cost adjustment and, where applicable, the large urban standardized amount. To reclassify, a hospital must submit an application to the MGCRB, which determines if the hospital meets the reclassification criteria (see fig. 1). The two standard criteria that individual hospitals must meet to reclassify for a higher wage index are intended to identify hospitals that have higher average wages than other hospitals in their area because they are competing for labor with hospitals in a different nearby area. 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 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 the target area. The wage criterion is satisfied if the hospital’s wages are a specified amount higher than the average in its assigned area and its wages are comparable to the average wages in the target area. Wage index reclassifications are effective for 3 years. All hospitals in an urban county can reclassify as a group if together the hospitals meet certain criteria, as described in figure 2. Rural referral centers (RRC) and sole community hospitals (SCH) can reclassify by meeting less stringent criteria. These hospitals receive special treatment from Medicare because of their role in preserving access to care for beneficiaries in specified 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 criteria to reclassify. RRCs are also exempt from the requirement that their wages be higher than the average wages in their original area. Hospitals that have lost their RRC designation can continue to reclassify under these less stringent criteria. In 1992, the first year of reclassifications, 930 hospitals were reclassified under less restrictive criteria than those currently used. More than 75 percent of these hospitals were in nonmetropolitan areas. In the following year, almost 1,200 hospitals were reclassified (of which 69 percent were in nonmetropolitan areas). For 1994, HCFA established more restrictive criteria and the number of reclassified hospitals subsequently dropped by approximately 44 percent, to 667 (see fig. 3). From 1995 to 2002, wage index reclassifications became more predominant, increasing by an average of 6 percent annually, while standardized amount reclassifications fell by almost one-quarter. For 2002, 511 nonmetropolitan hospitals and 117 metropolitan hospitals were reclassified for Medicare payment purposes. Individual hospitals have also been reclassified through legislation. Recently, the BBRA reclassified all hospitals in 7 counties (this totaled 26 hospitals) for purposes of the wage index and the standardized amount. The geographic areas that Medicare uses for the labor cost adjustment include hospitals that pay wages that may be quite different from the average wage in the entire geographic area. Hospital wages within some Medicare geographic areas—either MSAs or states’ nonmetropolitan areas—vary systematically across certain parts of the area or across types of communities. While wages paid by individual hospitals within a labor market may vary, the observed systematic variation suggests that some Medicare geographic areas include multiple labor markets. For example, the average wages of the hospitals in outlying counties of metropolitan areas usually are lower than the average wages for the entire metropolitan area’s hospitals. As a result, the labor cost adjustment for hospitals in outlying counties of metropolitan areas is based on an average wage that is often higher than the wages paid by these hospitals. In contrast, the average wages paid by hospitals in large towns (nonmetropolitan communities with between 10,000 and 49,999 people) tend to be significantly higher than the average wage of all hospitals in nonmetropolitan areas in the state. Some MSAs are very large, encompassing a diverse mix of counties. Given the broad expanse of many large MSAs, the hospitals in the different parts of an MSA may not be directly competing with each other for the same pool of employees, and the wages they pay can vary greatly. The most populous MSAs typically cover a region of several thousand square miles (see table 1). Distances between points within an MSA can exceed 100 miles. For example, the Chicago MSA includes 8 counties and 5,065 square miles, and the distance from its northernmost to southernmost point is roughly 110 miles. Hospitals in central counties of an MSA typically paid higher wages than hospitals in outlying counties. In the most populous MSAs, average central county hospital wages ranged from 7 percent higher than outlying county wages in Houston to 38 percent higher in New York in 1997. In most of these MSAs, the average wage difference between central and outlying counties ranged from 11 to 18 percent. The Washington, D.C. MSA illustrates how hospital wages in a large MSA can vary across different counties (see fig. 4). It includes hospitals located in the central city of the District of Columbia, as well as 18 counties in Maryland, Virginia, and West Virginia. Hospital wages averaged more than $23 per hour in 1997 in the District of Columbia and in most of the adjacent suburban Maryland and Virginia counties, but averaged below $20 per hour in several outlying counties. One reason MSAs are so large is because they are composed of counties, which can also be quite expansive. As with MSAs, an individual county may subsume multiple labor markets within its boundaries. As an example, San Bernardino County, California extends over 150 miles—from the city limits of San Bernardino through the Mojave Desert to the Nevada border. While most of the population is concentrated in the southwest corner of the county, which includes the city of San Bernardino, even the sparsely populated desert and mountainous portions of the county are part of the MSA. As a result, a hospital in the desert community of Joshua Tree, California, receives the same labor cost adjustment as hospitals in the city of San Bernardino 70 miles away, even though hospital wages averaged $20.84 per hour in 1997 in Joshua Tree, 13 percent less than average wages paid in San Bernardino. The Medicare program groups hospitals in nonmetropolitan areas of each state into a single geographic area for the purposes of the labor cost adjustment. Given their vast size, each statewide nonmetropolitan area is not perceived to be a single labor market, but the same labor cost adjustment is applied to hospitals in these areas. However, there are significant differences in average wages across parts of these areas. For example, for all hospitals in the nonmetropolitan area of Washington state, Medicare payments for 2001 were adjusted based on an average wage of $22.71 per hour. Yet, nonmetropolitan hospitals in the western part of the state had average wages of $24.23 per hour. Wages for nonmetropolitan hospitals in the central and eastern parts of the state, however, averaged $21.15 per hour, or 13 percent lower than hospitals in the western part of the state. Other variation in average wages across the statewide nonmetropolitan areas is associated with the 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. As a result, the Medicare labor cost adjustment may be based on average wages that are below those paid by large town hospitals and above those paid by hospitals in small towns and rural areas. For example, the 2001 labor cost adjustment for hospitals in nonmetropolitan Nebraska was based on an average hourly wage of $17.65; yet, Nebraska hospitals in large towns paid an average wage of $19.54. At the same time, small town Nebraska hospitals paid an average of $16.83 and hospitals in rural areas paid an average of $14.87, or 5 and 16 percent lower, respectively, than the area average (see table 2). In 2001, 38 percent of hospitals in large towns paid wages that were at least 5 percent higher than the average wage in their area; 16 percent paid wages that were at least 10 percent higher than the area average. While reclassification results in more appropriate labor cost adjustments for some higher wage hospitals, the reclassification criteria prevent some of them from reclassifying and exceptions to the criteria allow some lower wage hospitals to do so. In 2001, 419 hospitals, less than 10 percent of all hospitals, reclassified to receive a larger labor cost adjustment. Most of these hospitals had average wages that were above their area’s average by enough to meet the standard reclassification wage criterion. Higher wage hospitals in large towns are likelier to reclassify than higher wage hospitals in other community types because many of them are RRCs, which are exempt from the reclassification proximity criterion. Other higher wage hospitals in large towns and many higher wage hospitals in metropolitan areas, small towns, and rural areas cannot reclassify. About one-quarter of hospitals that reclassified had wages that were not high enough to satisfy the standard reclassification wage criterion. These were primarily RRCs. Generally, hospitals that reclassify but do not satisfy the standard wage criterion receive a post-reclassification labor cost adjustment that reflects average wage levels much higher than the wages they actually pay. For hospitals that meet the standard wage criterion, however, reclassification results in an adjustment that better matches their actual labor costs than did their original one. Of the 756 hospitals that paid wages sufficiently higher than their area average wage to meet the reclassification wage criteria, 310 (41 percent) were reclassified in 2001 (see table 3). Hospitals that met the wage criteria, but did not satisfy the proximity criterion, did not reclassify. Just over one- quarter of the higher wage hospitals were in large towns, yet large town hospitals made up almost half of the higher wage hospitals that reclassified. Metropolitan hospitals made up 42 percent of the higher wage hospitals, but comprised only 12 percent of the higher wage reclassified hospitals. Higher wage hospitals in large towns are likelier to reclassify than other higher wage hospitals because many are RRCs, and so are exempt from the proximity criterion. Close to half of the higher wage hospitals in small towns and rural areas reclassify. 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 nonreclassified, higher wage small town or rural hospitals that were SCHs may have opted out of the PPS to receive cost-based payments from Medicare, making reclassification irrelevant. In 2001, only 38 of the 317 metropolitan hospitals with wages that were at least 8 percent higher than the average for their area, thus satisfying the standard wage criteria, reclassified to receive a higher labor cost adjustment. Nearly two-thirds of all reclassified metropolitan hospitals were in two areas—California and the northeast. Metropolitan areas in these two regions are contiguous, so higher wage hospitals may be more likely than hospitals in other areas to satisfy the proximity criterion. In 2001, 109 (about 25 percent) of all hospitals that reclassified for the Medicare labor cost adjustment paid wages that were too low to meet the standard wage criterion for reclassification. Of these, 89 were RRCs. Roughly 42 percent of these RRCs that reclassified had wage costs below the average in their area. Some of the hospitals that were reclassified in 2001 but that did not satisfy the standard wage criterion were part of countywide reclassifications. Others had been reclassified via legislation. The relationship between a hospital’s wages and the average in its geographic area, before and after reclassification, depends on whether it was in a metropolitan or nonmetropolitan area and whether it satisfied the standard reclassification wage criterion (see table 4). Reclassification resulted in higher wage hospitals receiving a labor cost adjustment that more closely reflects the wages they actually paid. For example, prior to their reclassification, the higher wage metropolitan hospitals received a labor cost adjustment based on wages in their original area that averaged 10 percent lower than their own wages. After reclassification, the average wages paid by these hospitals did not differ from the average wages paid by the other hospitals in their area. Higher wage nonmetropolitan hospitals that reclassified joined areas with average wages about 4 percent higher than their own average wages. Before reclassification, the higher wage nonmetropolitan hospitals would have received a labor cost adjustment based on average wages that were much lower than what they actually paid. In contrast, reclassification resulted in hospitals that did not satisfy the standard wage criterion joining areas that, on average, had much higher average wages. Prior to reclassification, nonmetropolitan hospitals that did not satisfy the standard wage criterion paid wages near the average of their area. After reclassification, they received a labor cost adjustment based on wages that averaged 8 percent above their own average wages. While geographic reclassification increases the labor cost adjustment, and thus Medicare payments, to hospitals that reclassify, it does not raise total Medicare outlays because any payment increases must be offset by an across-the-board reduction to Medicare payments for all hospitals. In 2002, this budget neutrality adjustment reduced Medicare payments to nonreclassified metropolitan hospitals by about 1 percent and to nonreclassified nonmetropolitan hospitals by about 0.6 percent. If the budget neutrality adjustment were calculated and applied on a state- specific basis, the payment reductions would be different in each state. A state-specific budget neutrality adjustment would reduce payments more in some states and less in other states than the national adjustment. In states in which overall Medicare hospital payments increase more than the national average increase due to reclassification, a state-specific option would result in a bigger payment reduction. A state-specific adjustment would reduce payments less in states in which hospitals do not benefit as much from geographic reclassification as the average. Hospital payments would not be reduced in states that have no reclassified hospitals under a state-specific budget neutrality option. To meet the budget neutrality requirement, CMS annually calculates the increase in Medicare payments to reclassified hospitals. This increase is due to the use of a higher wage index or standardized amount, or both. CMS then calculates how much the standardized amount—the fixed, predetermined hospital payment—needs to be reduced so that total Medicare outlays for hospital services do not change because of reclassification. In 2002, Medicare payments to nonreclassified metropolitan hospitals were about 1 percent lower due to the budget neutrality provision than they would have been in the absence of any geographic reclassifications (see table 5). Payments to nonreclassified nonmetropolitan hospitals were about 0.6 percent lower. The effect of the budget neutrality adjustment on hospital payments varies annually depending on how much Medicare payments are increased due to hospitals being reclassified, compared to total Medicare payments to all hospitals. The budget neutrality adjustment will be higher in those years where reclassified hospitals account for a greater share of Medicare payments. A state-specific adjustment would reduce payments less than a national adjustment in states where reclassified hospitals account for a smaller share of the state’s Medicare inpatient hospital spending than the national average. For example, in Colorado, where 3 of 64 hospitals were reclassified in 2000, a state-specific budget neutrality adjustment would have reduced hospital payments by only 0.07 percent, compared to a 0.6 percent reduction under the national budget neutrality calculation. For the states that have no hospitals reclassifying, such as Nevada, there would be no budget neutrality adjustment under a state-specific approach. Conversely, a state-specific adjustment would reduce Medicare payments more than a national one in states where reclassified hospitals account for a larger share of Medicare inpatient hospital spending than the national average. In New Hampshire, for example, where a large share of the state’s hospitals was reclassified (4 of 26 hospitals) a state-specific adjustment would have reduced payments to nonreclassified hospitals by nearly 3 percent, compared to a 0.6 percent reduction under the national adjustment. Medicare’s PPS for inpatient services provides incentives to hospitals to deliver care efficiently by allowing them to keep any difference between their Medicare payments and their costs, and by making them responsible for their costs that exceed Medicare payments. To ensure that the PPS rewards efficiency rather than hospitals’ circumstances, payment adjustments are intended to account for cost differences across hospitals that are beyond the control of individual facilities. If these cost differences are not adequately accounted for by the payment adjustments, hospitals are inappropriately rewarded or put under fiscal pressure. The adjustment used to account for geographic differences in wages—the labor cost adjustment—does not adequately account for these cost differences because the geographic areas used to define labor markets are too large in many instances. As a result, refinements are needed to address systematic problems in defining hospital labor markets. Such changes could improve payment accuracy and reduce the need for geographic reclassification by grouping hospitals into areas with average wages that better match their own wages. RRCs and certain other specially designated hospitals have easier access to a higher labor cost adjustment because they are allowed to reclassify under less stringent criteria than other hospitals. These hospitals may face higher costs than other hospitals, but they do not necessarily have labor costs that are higher than the average in their geographic area. Reclassification potentially offers some financial relief to a share of these facilities, but it does not address the problem underlying their financial circumstances or assist all such facilities. Identifying the underlying cause of their higher costs is important to develop mechanisms to address their financial circumstances. To improve the adequacy of Medicare’s labor cost adjustments, we recommend that the Administrator of CMS refine the geographic areas used to more accurately reflect the labor markets in which hospitals compete for employees and the geographic variation in hospitals’ labor costs. This could include separating large towns in a state into their own labor market area and removing certain outlying counties in MSAs from the metropolitan geographic area if they exhibit wage costs that are significantly different from the rest of the metropolitan area. In its written comments on a draft of this report (see app. VI), CMS stated that it agreed with the problems we identified with the current labor market areas. CMS stated that it had conducted its own analyses of alternative approaches to defining geographic areas and consulted with hospital representatives and concluded that there is no consensus on an alternative to Medicare’s current geographic areas. CMS stated that it will consider whether changes in MSA definitions based on new census figures should be used for refining the geographic areas. CMS noted that a state- specific budget neutrality approach, which we were required to assess, would require statutory change and could make reclassifications within states highly contentious. We believe that Medicare’s current geographic areas could be refined to better reflect variation in area labor costs. While forthcoming changes to MSA definitions are important to consider in refining Medicare’s geographic areas, these changes are unlikely to improve the labor cost adjustment in most large towns. We recognize that consensus on any changes to the geographic areas would be difficult to achieve because any change would redistribute Medicare payments across hospitals so that hospital payments would increase in some areas and decrease in others. Yet, because the refinements would result in Medicare payments that better match the costs that hospitals face, they would strengthen the incentives of the PPS that encourage hospital efficiency and improve Medicare’s payment method. CMS also provided technical comments, which we incorporated as appropriate. We are sending copies of this report to the Administrator of CMS and interested congressional committees. We will also make copies available to others upon request. In addition, this report will be available at no charge on the GAO Web site at http://www.gao.gov. If you have any other questions about this report, please call me at (202) 512-7119. Jean Chung, James Mathews, Michael Rose, and Kara Sokol made key contributions to this report. To conduct this work, we recreated the 2001 labor cost adjustment for each hospital in the country prior to any reclassifications, using aggregated wage and hour data reported on 1997 Medicare hospital cost reports. We used data on reclassifications and hospital characteristics from the PPS Payment Impact Files created each year by CMS. Information on metropolitan areas, such as central and outlying counties and the criteria by which counties are included in an MSA, was obtained from the U.S. Census Bureau Web site as well as interviews with Census Bureau staff. We used RUCA codes, developed at the Washington, Wyoming, Alaska, Montana, & Idaho (WWAMI) Rural Health Research Center at the University of Washington, to examine segments of nonmetropolitan areas. We assigned 1 of 30 possible RUCA codes to each hospital based on its census tract. These 30 codes were then collapsed into 4 categories: urban, large town, small town, and rural. We calculated dollar-weighted average hourly hospital wages for each of the nonmetropolitan categories, nationally and by state, by dividing aggregate wages for all hospitals within a category by aggregate hours. We then compared the average hourly hospital wage for each nonmetropolitan subgroup within a state to the statewide nonmetropolitan average hourly wage. To evaluate the potential payment impact of applying a geographic reclassification budget-neutrality factor on a state-specific basis, we used the 2000 PPS Payment Impact File to calculate the Medicare payments to all hospitals within each state, before and after any geographic reclassifications. We then used the difference between pre- and post- reclassification payments to calculate a budget neutrality factor for each state. These budget neutrality factors were then used to estimate how payments to reclassified and nonreclassified hospitals in each state would differ under a state-specific budget neutrality adjustment, compared to the current national adjustment. In BIPA, the Congress required the Secretary of Health and Human Services to collect data on hospitals’ mix of occupations and their corresponding wages by September 30, 2003, and calculate wage indexes beginning October 1, 2004, that are adjusted to remove the effects of occupational mix on average wages. Occupational mix data for each acute care hospital will be collected and updated every 3 years. The methodology for adjusting the wage index for occupational mix will be determined after the data have been collected. Average hospital wages vary because of differences in wages paid across hospitals, but also because hospitals employ different mixes of occupations. As a result, average hospital wages are higher than the national average if the hospitals in an area employ more workers in highly skilled occupations and lower if the hospitals employ fewer workers in more highly skilled occupations. The current calculation of the Medicare wage index does not distinguish between wage differences due to geographic labor cost variation and wage differences due to geographic variation in the mix of more highly and less highly skilled occupations. Thus, Medicare’s wage indexes are too high in areas with a more highly skilled mix of hospital workers and too low in areas with a less skilled mix of hospital workers. While geographic differences in wages paid affect hospitals’ labor costs, but are beyond an individual hospital’s ability to control, occupational mix generally is within the control of a hospital. Changing the calculation of the wage index to eliminate the effect of occupational mix differences will raise the wage index for some types of hospitals and lower it for others. Wage indexes will be reduced for hospitals, such as metropolitan or teaching hospitals, that tend to hire more employees in highly skilled occupations with higher wages. Wage indexes for rural hospitals, which tend to employ a less skilled mix of employees, are likely to go up. While national data on the occupational mix of hospital employees are not available, data from California demonstrate the potential effects of changing the wage index calculation to eliminate the effects of occupational mix differences. Without adjusting for differences in occupational mix, the average hourly wage for hospitals in the Oakland MSA is 57 percent higher than the average hourly wage for nonmetropolitan California hospitals. Hospitals in the Oakland area generally employ a greater proportion of more skilled, and therefore more expensive, staff (see table 6). For example, in Oakland area hospitals, RNs account for approximately 25 percent more of the total hours worked by hospital employees than they do in nonmetropolitan California. Recalculating the wage indexes so that they reflect the same mix of workers in all areas reduces the difference between the Oakland area wages and those paid in nonmetropolitan areas to 50 percent. An occupational mix-adjusted wage index in nonmetropolitan California would be almost 4 percent higher than the current wage index calculation (see table 7). Across metropolitan areas, the change to the wage index would vary. Change in Medicare hospital payments (current law) Change in Medicare hospital payments (current law)

Summary: The Medicare program's prospective payment system (PPS) for inpatient hospital services 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 amount is based on national average costs, actual per stay payments vary widely across hospitals, primarily because of two payment adjustments in the PPS. One adjustment accounts for cost differences across patients due to their care needs and the other accounts for the substantial variation in labor costs across the country. The Medicare program's labor cost adjustment may not adequately account for geographic differences in hospital wages because of problems with the definition of labor markets. The geographic areas used by Medicare to approximate hospital labor markets often encompass large areas in which hospitals in different parts of an area or different types of communities pay widely varying wages. Geographic reclassification does not systematically address inadequacies in the way the Medicare program defines geographic areas, although it allows some, but not all, hospitals that may be in distinct labor market and pay wages above the average in their area to receive a higher labor cost adjustment. Geographic reclassification reduces payments to hospitals that do not reclassify because of the budget neutrality requirement, and the amount of this reduction would vary across hospitals under a state-specific budget neutrality approach depending on their location. In 2002, payments to metropolitan hospitals that were not reclassified were 1 percent lower and payments to nonmetropolitan hospitals that were not reclassified were 0.6 percent lower because of geographic reclassification. If the budget neutrality provision were calculated and applied within individual states instead of nationally, the adjustment would be smaller in those states in which hospitals did not benefit much from reclassification and higher in states where a higher proportion of hospitals reclassified.