Medicare beneficiaries receive a wide range of services in hospital outpatient departments, such as emergency room and clinic visits, diagnostic services such as x-rays, and surgical procedures. To receive Medicare payment, hospitals report the services they provided to a beneficiary on a claim form they submit to CMS along with their charge for each service. For Medicare payment purposes, an outpatient service consists of a primary service and packaged services, the additional services or items associated with that primary service. CMS assigns each primary service to an APC, which may include other similar primary services, and pays the hospital at the designated APC payment rate, adjusted for variation in local wages. A hospital can receive multiple APC payments for a single outpatient visit if more than one primary service is delivered during that visit. On outpatient claims, hospitals identify the primary services they provided using a Healthcare Common Procedure Coding System (HCPCS) code, while they identify packaged services by either specific HCPCS codes or revenue codes that represent general hospital departments or centers, such as “pharmacy,” “observation room,” or “medical social services.” In addition to claims, hospitals submit annual cost reports to CMS that state their total charges and costs for the year and the individual hospital department charges and costs. As a first step in calculating the OPPS payment rate for each APC, CMS obtains hospital charge data on each outpatient service from the latest available year of outpatient claims. It calculates each hospital’s cost for each service by multiplying the charge by a cost-to-charge ratio that is computed from the hospital’s most recent cost report, generally on an outpatient department-specific basis. In those instances when a cost-to- charge ratio does not exist for an outpatient department in a given hospital, CMS uses one from a related outpatient department or the hospital's overall cost-to-charge ratio for outpatient department services. The cost of each primary service is then combined with the costs of the related packaged services to calculate a total cost for that primary service. On single-service claims, claims with one primary service, CMS can associate packaged services with the primary service and calculate a total cost for the service (see fig. 1). However, in the case of multiple-service claims, claims with more than one primary service, packaged services and their costs listed on the claim cannot be associated with particular primary services, as the costs of a packaged service may be associated with one or a combination of primary services (see fig. 2). For this reason, CMS excluded all multiple-service claims from rate setting prior to 2003. Beginning with the 2003 payment rates, CMS identified several methods that allowed it to convert some multiple-service claims into single-service claims, and therefore include them in its rate-setting calculations. After calculating the cost of each primary service assigned to an APC for each hospital claim, CMS arrays the costs for all claims and determines the median cost. To calculate the APC’s weight relative to other APCs, CMS compares the median cost of each APC to the median cost of APC 0601, a mid-level clinic visit, which is assigned a relative weight of 1.00. For example, if the median cost of APC 0601 is $100 and the median cost of “APC A” is $50, CMS assigns APC A a relative weight of 0.50. To obtain a payment rate for each APC, CMS multiplies the relative weight by a factor that converts it to a dollar amount. In addition, CMS annually reviews and revises the services assigned to a particular APC and uses the new APC assignments and the charges from the latest available outpatient hospital claims to recalibrate the relative weights, and therefore the payment rates. New drugs and devices are eligible to receive temporary pass-through payments for 2 to 3 years, depending on when each drug and device’s eligibility began. January 1, 2003 was the first time that pass-through eligibility expired for any drugs or devices. Once pass-through eligibility for these items expires, CMS determines whether they will be considered a primary service and assigned to a separate APC or a packaged service and included with the primary services with which they are associated on a claim. On January 1, 2003, 236 drugs and on January 1, 2004, 7 drugs expired from pass-through eligibility. For those drugs expiring in 2003, CMS designated any drug with a median cost exceeding $150 (115 drugs) as a primary service, and each was assigned to its own, separately paid APC. The remaining drugs (121 drugs), those with a median cost less than $150, were designated as packaged services, that is, their costs were included with the costs of the primary service they were associated with on the claim. CMS stated that many of these latter drugs were likely present on claims with a primary service of drug administration and were therefore packaged with the services assigned to the six drug administration APCs, that is, the three chemotherapy administration and three drug injection and infusion APCs. For these packaged drugs, although hospitals had previously received two payments, one for the administration of the drug or other primary service and an additional pass-through payment for the drug itself, when eligibility expires, hospitals receive only one payment for both the administration or other primary service and the packaged drug. In 2004, all 7 drugs for which pass-through eligibility expired were designated as primary services and assigned to their own, separately paid APCs. On January 1, 2003, the devices in 95 device categories, and on January 1, 2004, the devices in 2 device categories, expired from pass-through eligibility; in both years, the devices in all device categories were designated as packaged services and their costs were included with the costs of the primary service they were associated with on the claim. Although hospitals had previously received two payments, one for the procedure associated with the device and an additional pass-through payment for the device, hospitals then received only one payment for both the procedure and its associated device. The OPPS payment rates of former pass-through, separately paid drugs were generally lower than the pass-through payment rate, but the payment rates of former pass-through drugs and devices that were packaged cannot be evaluated, as these items are not assigned a distinct payment rate. In 2003, the payment rates for the 115 of 236 former pass-through drugs that were designated as separately paid drugs almost universally decreased from the pass-through payment rates. In 2004, for all 7 former pass-through drugs were designated as separately paid drugs and the payment rates for all 7 decreased. In 2003, for the remaining 121 pass-through drugs and the devices in 95 pass-through device categories and, in 2004, the devices in 2 device categories, all of which were packaged, we cannot evaluate the payment rate changes because individual payment rates were not assigned for these items when they expired from pass-through eligibility. In 2003, about half of all drugs for which pass-through eligibility expired (115 of 236) were assigned to their own APC and paid separately. For these drugs, we determined that over 90 percent had payment rates lower than 95 percent of AWP, the pass-through payment rate; the median payment rate was 55 percent of AWP. Individual payment rates were often considerably lower than AWP, but decreases varied substantially. For example, 1 drug had a payment rate of about 7 percent of AWP, while another had a payment rate of about 94 percent of AWP. However, 10 drugs had a payment rate of more than 100 percent of AWP. In addition, payment as a percentage of AWP varied by drug source. The majority of the 113 separately paid drugs that we analyzed were sole-source (70 percent), followed by multi-source (19 percent), and generic (10 percent). Generic drugs, which were paid the highest percentage of AWP of the three categories, had a median payment rate of 74 percent of AWP, multi-source drugs had a median of 56 percent of AWP, and sole-source drugs had a median of 53 percent of AWP. In 2004, all seven drugs for which pass-through eligibility expired were assigned to separate APCs. The individual payment rate of each drug was lower than the pass-through rate of 95 percent of AWP, with a median payment rate of 69 percent of AWP. All drugs were sole-source. Although the decreases in payments for these drugs were often substantial and varied greatly across individual drugs, some level of decrease is expected when pass-through eligibility expires and payments become based on hospital costs instead of AWP, which often exceeds providers’ acquisition costs. In 2001, we reported that certain drugs purchased by individual physicians were widely available at costs from 66 to 87 percent of AWP. In 2003, the costs of 121 former pass-through drugs and devices in 95 former pass-through device categories were packaged. Because CMS combines the costs of these items with the costs of the primary services with which they are associated on each claim, a specific payment rate for each of these drugs and devices does not exist. However, to indirectly assess the payment rates of packaged drugs and devices, we reviewed the payment rates of the APCs with which CMS stated they were likely packaged. CMS stated that, in 2003, former pass-through drug costs were most likely packaged with the six drug administration APCs. The payment rates for five of the six APCs decreased in 2003, when the costs of packaged former pass-through drugs were included, compared to 2002, when the costs of these drugs were not considered in the rate-setting calculations (see table 1). We are unable to determine why the costs of these APCs decreased because fluctuations in costs for any of the primary or packaged services in these APCs, in addition to the costs of the packaged drug, could have affected the payment rates. However, we would have expected that combining the costs of up to $150 of packaged former pass-through drugs with the costs of the primary services in these APCs would have increased the 2003 payment rates for more of these APCs as more than half of them are less than $150.