Medicare payment policies for technical pathology services have changed over the years as new payment systems for hospital and physician services have been implemented and modified. Beginning with the implementation of the hospital inpatient PPS on October 1, 1983, through the implementation of the Medicare physician fee schedule (MPFS) on January 1, 1992, and the outpatient PPS on August 1, 2000, payment for technical pathology services changed as fixed, predetermined payment replaced reasonable cost or charge-based reimbursement for Medicare services. Under the inpatient PPS, each inpatient stay is classifed into a diagnosis- related group (DRG) based primarily on the patient’s condition. Each DRG has a payment weight assigned to it that reflects the relative cost of inpatient treatment for a patient in that group compared with that for the average Medicare inpatient. Included in the costs of each DRG are nonphysician services provided to inpatients by the hospital and its outside suppliers. A hospital receives a DRG payment from Medicare and a deductible amount from a beneficiary for each inpatient benefit period.Each year, the DRG weights are recalibrated to account for changes in resource use, and the payment rate is adjusted by an update factor to account for changes in market conditions, practice patterns, and technology. Medicare separately pays physicians, including pathologists, and certain other professionals for the direct services they provide to inpatients. When developing the inpatient PPS in the early 1980s, HCFA determined that technical pathology services outsourced to laboratories were an integral part of the professional services provided by the laboratories’ pathologists, not separate nonphysician services. Based on that determination, the payment for technical pathology services provided by laboratories was included in the larger payment to the laboratories and not included in the PPS payments. In 1992, HCFA implemented the MPFS, which created distinct payments for the professional and technical components of most diagnostic services, including pathology services. Although the MPFS included a distinct payment to laboratories for technical pathology services, HCFA did not revise its policy to prohibit laboratories from continuing to receive the separate Medicare payment for outsourced technical pathology services provided to inpatients. Under the MPFS, beneficiaries are responsible for a copayment equal to 20 percent of the payment for physician services, including technical pathology services. Thus, inpatient beneficiaries whose technical pathology services were outsourced by a hospital to a laboratory that received direct payment from Medicare were responsible for a copayment, while other inpatients were not. On July 22, 1999, HCFA proposed ending Medicare payments under the MPFS to laboratories for technical pathology services provided to hospital inpatients on or after January 1, 2000. Under the proposal, laboratories, like suppliers of other nonphysician services, would have to seek payment from hospitals for technical pathology services provided to hospital inpatients. HCFA’s rationale for its proposed rule was that payment for technical pathology services provided to beneficiaries was already included in the inpatient PPS. When implementing the inpatient PPS, HCFA established separate payment rates for rural and urban hospitals based on data from hospitals’ cost reports submitted to the agency. Hospitals that performed their own technical pathology services included such costs in their cost reports, while hospitals outsourcing these services did not. According to HCFA, urban hospitals generally performed such services, and in part, their higher rates reflected that. Consequently, in HCFA’s view, when the separate rural rate was eliminated in 1995 and rural hospitals began receiving the higher rate paid to most urban hospitals, the cost of technical pathology services was included in that payment. Thus, HCFA concluded that when a laboratory received payment from Medicare for technical pathology services provided to a hospital inpatient, Medicare was paying twice for the same service—once to the hospital as part of the PPS payment and once to the laboratory through the MPFS. A second reason HCFA cited to support its proposed rule was concern that hospital outsourcing arrangements with laboratories to provide technical pathology services would proliferate if hospitals realized these arrangements would reduce their costs without any reduction in their inpatient PPS payments. After considering comments from the hospital industry and laboratories, which stated, in part, that they would need additional time to renegotiate their agreements, in the final rule, HCFA delayed implementation of the policy until January 1, 2001. In December 2000, the Congress enacted provisions in BIPA that stated that laboratories furnishing technical pathology services to hospital patients under agreements with hospitals as of the publication date of the HCFA proposed rule could continue to receive payment directly from Medicare for these services until January 1, 2003. Because the outpatient PPS was implemented in August 2000, the provisions applied to services provided to outpatients as well as inpatients. The outpatient PPS pays hospitals a predetermined amount per service similar to a fee schedule. All services paid under the outpatient PPS, including technical pathology services, are classified into groups called ambulatory payment classifications (APC). Like inpatient DRGs, the relative weights of the APCs are adjusted annually by recalibration and the payment rates by an update factor to account for changes in resource use, technology, practice cost, and service delivery. When the outpatient PPS was implemented, beneficiary copayments for a service were generally 20 percent of the hospitals’ median charges for that service in 1996, updated to 1999. Therefore, the beneficiary cost-sharing obligation as a percentage of APC payment rates varies by service. Because the median charges were often higher than the APC payment rates implemented with the outpatient PPS, beneficiary copayments were frequently as high or higher than 50 percent of the total APC payment amount. The Balanced Budget Act of 1997 established a mechanism to gradually decrease the cost-sharing percentages for all APCs to 20 percent over time. The copayments that beneficiaries are responsible for paying under the outpatient PPS for technical pathology services that are furnished directly by hospitals are roughly comparable to the copayments that beneficiaries are responsible for paying laboratories under the MPFS when services are outsourced. The outpatient PPS payment rates for technical pathology services are significantly lower than the corresponding MPFS payment rates, but outpatient PPS copayments represent a higher percentage of the payment for technical pathology services than MPFS copayments. If the BIPA provisions are not reinstated and CMS terminates direct payments to laboratories, hospitals would have to negotiate payment amounts with laboratories to pay them directly for services delivered to inpatient and outpatient beneficiaries or begin to supply these services themselves. While the hospitals would not experience any direct adjustments to their inpatient DRG payments, over time, hospital costs of paying laboratories for technical pathology services would be reflected in the DRG weights, as the annual recalibration accounts for changes in the costs of delivering services. For services delivered to outpatients, hospitals would bill Medicare under the outpatient PPS for technical pathology services and, therefore, would recover additional revenue even if they continued to outsource these services to laboratories. Inpatient beneficiaries of hospitals that outsource technical pathology services would no longer be responsible for additional copayments to the laboratories. Outpatient beneficiaries would no longer be responsible for copayments to laboratories under the MPFS, but instead would be responsible for copayments to the hospitals where they received their services under the outpatient PPS. CAHs, which as of March 2003 constituted 15 percent of all hospitals and 31 percent of rural hospitals, would not be affected by the termination of direct laboratory payments. CAHs are not paid under the inpatient and outpatient PPS, but instead are paid based on their reasonable costs of providing services. Currently, CAHs receive no payment from Medicare for technical pathology services outsourced to laboratories that directly bill Medicare because CAHs incur no costs in the delivery of those services. If direct laboratory payments are terminated, CAHs would be reimbursed by Medicare for their costs of paying laboratories to perform technical pathology services, and outpatient beneficiaries who currently are responsible for paying 20 percent of the payment for their technical pathology services to the laboratories under the MPFS would instead be responsible for paying 20 percent of the CAHs’ customary charges. See table 1 for a description of Medicare payments to outsourcing PPS hospitals and CAHs, and table 2 for a description of beneficiary cost- sharing obligations at outsourcing PPS hospitals and CAHs, under current policy and if direct payment to laboratories is terminated. We estimate that in 2001, 4,773 PPS hospitals and CAHs, representing 95 percent of all such facilities, outsourced at least some technical pathology services to laboratories that received direct payment from Medicare for those services (see table 3). However, most hospitals outsourced a small number of these services to laboratories. In 2001, approximately 1.4 million technical pathology services were outsourced, and the median number of outsourced services per hospital was 81. Approximately 68 percent of all hospitals outsourced 200 or fewer technical pathology services, and only 6 percent outsourced more than 1,000 services. Outsourcing hospitals consisted of 2,428 urban PPS facilities and 1,651 rural PPS facilities, representing 95 percent and 97 percent of urban and rural PPS hospitals in 2001, respectively, and 694 CAHs. Among hospitals outsourcing technical pathology services, urban hospitals, including CAHs, outsourced a median of 97 services and 64 percent of all services, and rural hospitals, including CAHs, outsourced a median of 61 services and 36 percent of all services. Almost twice as many services were delivered to outpatient beneficiaries compared to inpatient beneficiaries, as outpatient services accounted for approximately 64 percent of all outsourced services. If laboratories had not received direct payment for services for hospital patients, we estimate that Medicare spending would have been $42 million less in 2001, with $18 million and $24 million in savings for inpatient and outpatient services, respectively, and overall beneficiary cost sharing would have been reduced by $2 million.