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). 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. 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. 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. 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. 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. 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.