Medicare Hospital Payments: Refinements Needed to Better Account 
for Geographic Differences in Wages (30-SEP-02, GAO-02-963).	 
                                                                 
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.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-963 					        
    ACCNO:   A05195						        
  TITLE:     Medicare Hospital Payments: Refinements Needed to Better 
Account for Geographic Differences in Wages			 
     DATE:   09/30/2002 
  SUBJECT:   Comparative analysis				 
	     Compensation					 
	     Health care cost control				 
	     Health care costs					 
	     Hospitals						 
	     Labor costs					 
	     Managed health care				 
	     Salary increases					 
	     Medicare Program					 
	     Medicare Prospective Payment System		 

                                                                 
Medicare Hospital Payments: Refinements Needed to Better Account 
for Geographic Differences in Wages (30-SEP-02, GAO-02-963).	 
                                                                 
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.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-963 					        
    ACCNO:   A05195						        
  TITLE:     Medicare Hospital Payments: Refinements Needed to Better 
Account for Geographic Differences in Wages			 
     DATE:   09/30/2002 
  SUBJECT:   Comparative analysis				 
	     Compensation					 
	     Health care cost control				 
	     Health care costs					 
	     Hospitals						 
	     Labor costs					 
	     Managed health care				 
	     Salary increases					 
	     Medicare Program					 
	     Medicare Prospective Payment System		 

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GAO-02-963

Report to Congressional Committees

United States General Accounting Office

GAO

September 2002 MEDICARE HOSPITAL PAYMENTS

Refinements Needed to Better Account for Geographic Differences in Wages

GAO- 02- 963

Page i GAO- 02- 963 Medicare Hospital Wage Variation Letter 1 Results in
Brief 3 Background 5 Medicare Labor Cost Adjustment Does Not Adequately
Account for

Wage Differences within Certain Areas 11 Through Reclassification, Some
Hospitals Receive a More Appropriate Labor Cost Adjustment 16 Budget
Neutrality Adjustments Are Relatively Modest, but Would Vary under a
State- Specific Option 20 Conclusions 22 Recommendations for Executive
Action 23 Agency Comments and Our Evaluation 23 Appendix I Scope and
Methodology 26

Appendix II The Effect of Accounting for Occupational Mix on the Wage
Index 27

Appendix III Average Hospital Wages in Outlying and Central Counties of
Metropolitan Areas, by State, Fiscal Year 1997 30

Appendix IV Average Hospital Wages across Community Types in
Nonmetropolitan Areas, by State, Fiscal Year 1997 31

Appendix V Effect of the Current and a State- Specific Budget Neutrality
Option on Hospital Payments, by State, Fiscal Year 2000 33 Contents

Page ii GAO- 02- 963 Medicare Hospital Wage Variation Appendix VI Comments
from the Centers for Medicare &

Medicaid Services 35

Tables

Table 1: Hospital Wage Variation in the Most Populous Metropolitan
Statistical Areas, Fiscal Year 1997 13 Table 2: Average Hospital Wages
across Nonmetropolitan Areas in

Selected States, Fiscal Year 1997 16 Table 3: Reclassified Hospitals by
Wage Level and Community Type, Fiscal Year 2001 18 Table 4: Area Average
Wage Compared to Hospital Wage, before and after Reclassification, Fiscal
Year 2001 20 Table 5: Effect of the Geographic Reclassification Budget
Neutrality Requirement on Medicare Inpatient Hospital Payments, by
Metropolitan and Nonmetropolitan Status, Fiscal Years 1995 through 2002 21
Table 6: Hospital Wages, Adjusted for Mix of Occupations, Oakland

MSA and Nonmetropolitan California, Fiscal Year 1998 28 Table 7: Effect of
an Occupational Mix Adjustment on Average Area Wages in California, Fiscal
Year 1998 29 Figures

Figure 1: Geographic Reclassification Criteria, Wage Index
Reclassification for Individual Hospitals 9 Figure 2: Geographic
Reclassification Criteria for all Hospitals in

an Urban County 9 Figure 3: Hospitals Reclassified for Medicare Payment,
Fiscal Years 1993- 2002 11 Figure 4: Hospital Wages by County, Washington,
D. C. Metropolitan Statistical Area, Fiscal Year 1997 14

Page iii GAO- 02- 963 Medicare Hospital Wage Variation Abbreviations

BBRA Medicare, Medicaid, and SCHIP Balanced Budget Refinement Act of 1999
BIPA Medicare, Medicaid, and SCHIP Benefits Improvement and

Protection Act of 2000 CMS Centers for Medicare & Medicaid Services DRG
diagnosis- related group HCFA Health Care Financing Administration MGCRB
Medicare Geographic Classification Review Board

MSA metropolitan statistical area OBRA Omnibus Budget Reconciliation Act
OMB Office of Management and Budget PPS prospective payment system RN
registered nurse

RRC rural referral center RUCA rural urban commuting area SCH sole
community hospital SCHIP State Children*s Health Insurance Program

Page 1 GAO- 02- 963 Medicare Hospital Wage Variation September 30, 2002
Congressional Committees

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 fixed
amount is adjusted for these two sources of cost differences because they
are largely beyond any individual hospital*s ability to control. The labor
cost adjustment is based on a wage index calculated for

specified geographic areas across the country. The wage index reflects how
average hospital wages in each geographic area compare to average hospital
wages nationally. 1 The geographic areas are intended to represent

the separate labor markets in which hospitals compete for employees. Each
metropolitan area, as defined by the Office of Management and Budget
(OMB), is considered a single labor market, and all areas outside of
metropolitan areas in each state are treated as a single labor market. All
hospitals within a given geographic area receive the same labor cost
adjustment. Thus, Medicare*s payment to a hospital in an area with lower
wages is below the national average payment and the payment to a hospital
in a higher wage area is above the national average. In general, hospitals
in nonmetropolitan areas have lower wages than those in metropolitan areas
and therefore have a lower wage index and receive lower Medicare payments.
Conversely, hospitals in metropolitan areas

tend to pay higher wages than hospitals in nonmetropolitan areas and
receive higher Medicare payments.

The labor cost adjustment has been criticized for failing to appropriately
adjust payments to reflect the average wages that some hospitals pay. Some
hospitals indicate that the wages they must pay are higher than the

1 The hospital wage index reflects total employee compensation, including
hospital spending for employee wages and benefits.

United States General Accounting Office Washington, DC 20548

Page 2 GAO- 02- 963 Medicare Hospital Wage Variation average wages in
their assigned geographic area because they must compete for employees
with hospitals in nearby, higher wage areas. To

address these concerns, the Congress in 1989 established an administrative
process for geographic reclassification, which allows hospitals that meet
criteria concerning their average wages and proximity to a higher wage
paying area to reclassify. 2 A reclassified hospital is paid based on the
Medicare labor cost adjustment of the higher wage area. In addition,
certain specially designated rural hospitals can reclassify to a higher
wage area by meeting less stringent criteria. The Congress required that
the reclassification policy be budget neutral, that is, not change total
Medicare outlays, so the increased payments to reclassified hospitals are

offset by an across- the- board reduction in payments to other hospitals.
In the Medicare, Medicaid, and SCHIP Balanced Budget Refinement Act of
1999 (BBRA), 3 the Congress directed us to evaluate Medicare*s labor cost
adjustment policies. In consultation with the committees of jurisdiction,
we have examined (1) whether Medicare*s labor cost adjustment accounts
appropriately for geographic variation in average wages, (2) the extent to
which reclassification addresses potential problems with Medicare*s labor

cost adjustment, and (3) the effect of the budget neutrality adjustment on
hospitals that do not reclassify, including the impact of altering the
budget neutrality adjustment so that payment increases to reclassified
hospitals in

a state would be funded by payment reductions to hospitals within the same
state, rather than across all hospitals nationwide, as is done now.

To address these issues, we used 1997 Medicare hospital cost reports (the
comprehensive financial document that hospitals submit annually to receive
payment from Medicare) to analyze hospital wage data, because 1997 wage
data were used to calculate the 2001 wage indexes. 4 We also analyzed more
recent Medicare hospital cost report data, PPS Payment Impact Files, and
wage data in California Hospital Annual Disclosure Reports submitted to
the California Office of Statewide Health Planning and Development. We
also interviewed officials at the Centers for

2 Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101- 239, sec.
6003( h), 103 Stat. 2106, 2154 (classified to 42 U. S. C. sec. 1395ww( d)
(Supp. I 1989)). 3 Pub. L. No. 106- 113, Appendix F, sec. 410, 113 Stat.
1501A- 321, 376.

4 Annual numbers throughout this report refer to fiscal years unless
otherwise noted.

Page 3 GAO- 02- 963 Medicare Hospital Wage Variation Medicare & Medicaid
Services (CMS); 5 the Medicare Geographic Classification Review Board
(MGCRB), which reviews and approves

reclassification applications; and representatives of some hospitals that
have been reclassified. We did our work in accordance with generally
accepted government auditing standards from January 2000 through September
2002. A detailed discussion of our scope and methodology is in appendix I.

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
may pay widely varying wages. The patterns of wage variation indicate that
some of the geographic areas combine multiple labor markets. Hospitals in
some outlying counties of metropolitan areas pay average wages that are
lower than the average wage paid in the entire area, yet the labor cost
adjustment to their Medicare payments is based on the entire area*s
average and reflects the higher wages of hospitals in the central
counties. In nonmetropolitan areas, hospitals in large towns (with
populations of 10,000 to 49,999 people) typically pay higher wages than
hospitals in small towns and rural communities. Yet, the labor cost
adjustment for large town hospitals is based on the average wage of all
nonmetropolitan hospitals in their state. As a result, Medicare*s labor
cost adjustment for large town hospitals often reflects a lower average
wage than if the adjustment were based on the average wages they pay.

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 a distinct labor market
and pay wages above the average in their area to receive a higher labor
cost adjustment. Hospitals in large towns that pay wages that are so much
higher than the average in their area that they satisfy the
reclassification wage criterion are likelier than such higher wage
hospitals in other community types to reclassify. This is because many
hospitals in large towns are specially designated rural hospitals that can
reclassify without

5 On July 1, 2001, the agency that administers the Medicare program was
renamed from the Health Care Financing Administration (HCFA) to CMS. This
report refers to the agency as HCFA when discussing actions taken before
the name change and as CMS when discussing actions taken after the name
change. Results in Brief

Page 4 GAO- 02- 963 Medicare Hospital Wage Variation satisfying the
proximity criterion that they be near an area with a higher labor cost
adjustment. Metropolitan hospitals with wages that are higher

than their area average are less likely to reclassify because they must
satisfy the proximity criterion and few are near another metropolitan area
with a higher labor cost adjustment. Conversely, a number of hospitals
reclassify, even though the wages they pay are not significantly higher
than the average in their geographic area. Hospitals that reclassify
without satisfying the wage criterion receive a labor cost adjustment that
is based on average wages that are higher than what they actually pay.
Reclassified hospitals that satisfy the wage criterion tend to receive a
labor cost

adjustment that more closely reflects the wages they actually pay than
their labor cost adjustment prior to reclassification.

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 about 1 percent
lower and payments to nonmetropolitan hospitals that were not reclassified
were about 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. For example, our analysis indicates that a
statespecific adjustment in 2000 would have reduced payments to hospitals
that did not reclassify by almost 3 percent in New Hampshire, where 4 out
of

its 26 hospitals reclassified, and hospitals in Nevada would not have had
their payments changed because no hospitals in that state reclassified.

We recommend that the Administrator of CMS improve the adequacy of the
Medicare labor cost adjustment by refining the definitions of Medicare
geographic areas to more accurately reflect hospital labor markets. In
written comments to a draft of this report, CMS agreed that there are
problems with Medicare*s current definitions of geographic areas and it
stated that there is no consensus on how to improve the definitions.

Page 5 GAO- 02- 963 Medicare Hospital Wage Variation 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. 6 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.
7 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. 8 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. 9 6 This discussion pertains to Medicare*s payments
for hospital operating costs; Medicare*s payments for hospital capital
costs are not included.

7 For example, wages for registered nurses (RN) in Seattle were 18 percent
above the national average in 1999, while wages for RNs in nonmetropolitan
Alabama were 16 percent below the national average. 8 Hospitals in Alaska
and Hawaii also receive cost- of- living adjustments for the nonlabor
portion of the standardized amount. 9 There are approximately 500 DRGs,
each of which is intended to distinguish patients with similar clinical
conditions who receive similar treatments. Each DRG is assigned a relative
weight, which compares its costliness to the average for all DRGs, and is
used to adjust the standardized amount. For example, Medicare*s payment to
a hospital to treat a Medicare beneficiary with a respiratory infection
with complications is nearly twice that for a beneficiary with a kidney
and urinary tract infection with complications. Background

Page 6 GAO- 02- 963 Medicare Hospital Wage Variation 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. 10 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. 11
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

10 New Jersey, Rhode Island, and Washington, D. C. do not have any
nonmetropolitan areas, and therefore do not have a statewide
nonmetropolitan wage index. Numbers include Puerto Rico*s six urban and
one rural geographic areas.

11 Calculations for the 2001 Medicare wage index were based on 1997
Medicare hospital cost report data. The fiscal intermediaries who contract
with CMS to process Medicare claims review the wage data reported by
hospitals on the cost reports. The fiscal intermediaries apply basic
checks as directed by CMS, flagging any wage data that fall outside of
specific parameters. When aberrant data are found, the fiscal
intermediaries require hospitals to either provide documentation to
support their reported wage data, or to correct

inaccuracies. Among the 4 fiscal intermediaries we contacted, none tracked
the frequency of aberrant data, but they did not perceive that inaccurate
wage reporting by hospitals was a major problem. Wage Index

Page 7 GAO- 02- 963 Medicare Hospital Wage Variation thus more highly
paid) workers and lower if an area*s hospitals employ more lower- skilled
workers than the national average. 12 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), 13 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. 14 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. 15 12 To the
extent that certain hospitals hire more workers in higher- skilled
occupations

because they treat patients needing more complex care than other
hospitals, the payment adjustment that reflects patient care needs, made
through the DRG system, is intended to account for the resulting higher
costs. 13 Pub. L. No. 106- 554, Appendix F, sec. 304, 114 Stat. 2763A-
463, 494 (classified to 42 U. S. C.

sec. 1395ww( d)( 3)( E) (2000)). 14 MSAs are groups of counties containing
a core of at least 50, 000 people, together with adjacent areas having a
high degree of economic and social integration with that core. OMB defines
the central county or counties of an MSA as those containing the largest
city or urbanized area. An outlying county or counties qualify for
inclusion in a metropolitan area based on the amount of commuting to the
central counties and other specified measures of metropolitan character.

15 New standards for whether to include an outlying county in an MSA will
be applied to 2000 census data. Previously, the standards were based on
population density in the outlying county and the amount of commuting to
central counties. The new standards exclude population density as a
criterion and apply a single standard of commuting levels. Labor Market
Areas

Page 8 GAO- 02- 963 Medicare Hospital Wage Variation 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. 16 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. 17 16 Initially, geographic
reclassification only applied to hospital inpatient PPS payments.

However, in establishing the PPS for hospital outpatient services, the
Balanced Budget Act of 1997 directed the Secretary of Health and Human
Services to develop a method of adjusting outpatient PPS payments to
account for variation in wages (Pub. L. No. 105- 33, sec. 4523, 111 Stat.
251, 445 (classified to 42 U. S. C. sec. 13951 (Supp. IV 1998))). The
Secretary subsequently determined that outpatient PPS payments would be
subject to the

inpatient hospital labor cost adjustment, including the effects of
geographic reclassifications. As a result, reclassified hospitals receive
a higher labor cost adjustment to both inpatient and outpatient payments.
17 A hospital may also reclassify to receive the higher standardized
amount. It must satisfy

the proximity criterion and its costs must be significantly greater than
its current payment. This type of reclassification has declined and is not
the focus of our analyses. Geographic

Reclassification

Page 9 GAO- 02- 963 Medicare Hospital Wage Variation Figure 1: Geographic
Reclassification Criteria, Wage Index Reclassification for Individual
Hospitals

Source: 42 CFR 412.230 (2001).

All hospitals in an urban county can reclassify as a group if together the
hospitals meet certain criteria, as described in figure 2.

Figure 2: Geographic Reclassification Criteria for all Hospitals in an
Urban County

Source: 42 CFR 412.234 (2001).

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

Page 10 GAO- 02- 963 Medicare Hospital Wage Variation 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. 18 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. 19 18 SCHs may elect to be paid based on their own
costs or the applicable PPS payment

amount. SCHs electing payments under the PPS may qualify to be
reclassified. See U. S. General Accounting Office, Medicare*s Rural
Hospital Payment Policies,

GAO/ HEHS- 00- 174R, (Washington, D. C.: Sept. 15, 2000) for more detail
on rural hospital designations. 19 Sec. 152, 113 Stat. 1501A- 334. Under a
statutory provision on the length of wage index

reclassifications, these hospitals were effectively reclassified for a 3-
year period. See BIPA, Sec. 304, 114 Stat. 2763A- 494. Another example of
legislatively reclassified hospitals is found in the so- called *Lugar
hospital* designation, enacted in 1987. Certain rural counties are deemed
urban if they are adjacent to urban areas and they conform to certain
criteria based on residents* commuting patterns and population density as
defined by OMB. See

Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100- 203, sec.
4005( a), 101 Stat. 1330, 1330- 47 (classified to 42 U. S. C. sec. 1395
ww( d)( 8) (1988)). Hospitals in these counties receive Medicare payments
based on the standardized amount and the wage index

of the adjacent urban area. The number of Lugar hospitals stayed
relatively constant through 2001, with 27 hospitals in 22 counties
affected by this provision. Updates to the criteria for determining
metropolitan character resulted in an increase in the number of Lugar
hospitals to 41 in 31 counties in 2002. As long as OMB deems the county
urban, Lugar hospitals located in the county will continue to receive
Medicare payments as urban

hospitals.

Page 11 GAO- 02- 963 Medicare Hospital Wage Variation Figure 3: Hospitals
Reclassified for Medicare Payment, Fiscal Years 1993- 2002

Source: PPS Payment Impact Files, fiscal years 1993- 2002.

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 Medicare Labor Cost Adjustment Does Not

Adequately Account for Wage Differences within Certain Areas

Page 12 GAO- 02- 963 Medicare Hospital Wage Variation 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. 20 20 See appendix III
for a comparison of wages in outlying and central counties in

metropolitan areas for all states. Medicare Metropolitan

Geographic Areas May Encompass Multiple Labor Markets with Varying Average
Wages

Page 13 GAO- 02- 963 Medicare Hospital Wage Variation Table 1: Hospital
Wage Variation in the Most Populous Metropolitan Statistical Areas, Fiscal
Year 1997 Average hourly hospital wage within

MSA MSA Counties Square miles Hospitals Central

counties Outlying counties All counties in MSA

Range of hospital wages

within MSA a

Los Angeles- Long Beach, CA 1 4,060 104 $26.12 N/ A $26.12 $20.09 - 29.84
New York, NY 8 1,141 74 31.93 $23.15 31.86 24.84 - 35.80 Chicago, IL 9
5,065 84 24.30 20.77 24.27 20.17 - 26.56 Philadelphia, PA- NJ 9 3,856 62
23.82 23.15 23.81 19.72 - 26.46 Washington, DC- MD- VA- WV 18 6,465 40
23.70 20.14 23.41 19.66 - 25.72 Detroit, MI 6 3,896 48 22.92 20.57 22.88
18.90 - 24.50 Houston, TX 6 5,921 43 21.23 19.83 21.19 16.75 - 23.18
Atlanta, GA 20 6,126 42 22.40 19.66 21.98 18.36 - 23.97 Boston, MA- NH N/
A b 7,384 76 N/ A N/ A 24.30 19.88 - 26.17 Dallas, TX 8 6,186 36 21.75
18.98 21.58 18.85 - 24.80

Note: N/ A means not applicable. a The range excludes wages that are in
the top 10 percent and the bottom 10 percent of the

distribution of wages reported in the MSA. b The Boston MSA is comprised
of cities and towns rather than counties.

Source: GAO analysis of 1997 hospital wages used in construction of the
2001 wage index, as reported in Medicare hospital cost reports and county-
level data from the US Census Bureau (http:// www. census. gov/
population/ estimates/ metro- city/ 99mfips. txt) downloaded June, 2002
and the National Association of Counties. 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.

Page 14 GAO- 02- 963 Medicare Hospital Wage Variation Figure 4: Hospital
Wages by County, Washington, D. C. Metropolitan Statistical Area, Fiscal
Year 1997

Source: GAO analysis of 1997 hospital wages used in construction of 2001
wage index, as reported in Medicare hospital cost reports.

Page 15 GAO- 02- 963 Medicare Hospital Wage Variation 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
Some Medicare

Nonmetropolitan Geographic Areas Encompass Multiple Community Types with
Varying Wages

Page 16 GAO- 02- 963 Medicare Hospital Wage Variation area; 16 percent
paid wages that were at least 10 percent higher than the area average. 21
Table 2: Average Hospital Wages across Nonmetropolitan Areas in Selected
States, Fiscal Year 1997

Number of hospitals Average hourly wage for nonmetropolitan subgroups
Large town Small town Rural area

Statewide nonmetropolitan

average hourly wage Large town Small town Rural area

Nebraska 11 32 32 $17.65 $19.54 $16.83 $14.87 Iowa 15 54 24 17.48 18.81
16.74 15.38 Arizona 6 8 2 18.11 19.14 17.00 16.59 Georgia 23 44 18 18.13
18.88 16.61 17.37 Washington 17 8 15 22.71 23.51 21.72 19.19

Note: Large towns have a population of 10,000 to 49, 999, small towns a
population of 2,500 to 9,999, and rural areas have populations under
2,500.

Source: GAO analysis of 1997 hospital wages used in construction of 2001
wage index, as reported in Medicare hospital cost reports.

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. 22
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

21 See appendix IV for average wages across community types for all
states. 22 To qualify for reclassification through the MGCRB application
process, metropolitan hospitals must meet the standard wage criterion that
their average wages are at least 8 percent higher than the average in
their area and nonmetropolitan hospitals must have

average wages that are at least 6 percent higher than the average in their
area, unless they are RRCs. However, RRCs must pay wages that are at least
82 percent of the average in the target area. Through

Reclassification, Some Hospitals Receive a More Appropriate Labor Cost
Adjustment

Page 17 GAO- 02- 963 Medicare Hospital Wage Variation 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 onequarter 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. Not All Higher Wage

Hospitals Can Reclassify

Page 18 GAO- 02- 963 Medicare Hospital Wage Variation Table 3:
Reclassified Hospitals by Wage Level and Community Type, Fiscal Year 2001

Nonmetropolitan Metropolitan Large

town Small town Rural All

Higher wage hospitals Total 317 203 168 68 756 Reclassified 38 149 92 31
310 Percent reclassified 12% 73% 55% 46% 41%

Non- higher wage hospitals Total 2,407 386 819 478 4,090 Reclassified 11
75 21 2 109 Percent reclassified .5% 19% 3% .4% 3%

Note: Higher wage hospitals are those that have wages high enough relative
to other hospitals in their geographic area to meet the standard
reclassification criterion, which for metropolitan hospitals is average
wages at least 8 percent higher than the average in their geographic area,
and for

nonmetropolitan hospitals is average wages at least 6 percent higher than
the average in their area. Large town, small town, and rural areas were
defined using rural urban commuting area (RUCA) codes rather than location
in a Medicare nonmetropolitan geographic area. Some nonmetropolitan
hospitals were defined by RUCA codes as being urban based on their high
levels of commuting to urban areas.

Source: GAO analysis of 1997 hospital wages used in construction of 2001
wage index, as reported in Medicare hospital cost reports and 2001 PPS
Payment Impact File. Analysis excludes hospitals reclassified through
legislation, hospitals that receive only a standardized amount
reclassification,

hospitals with missing wage data, and nonmetropolitan hospitals that were
defined by RUCA codes as urban.

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. 23 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

23 Only about 11 percent of SCHs reclassified in 2001. It can be more
financially advantageous for them to be exempt from the PPS and have their
payments based on their actual costs.

Page 19 GAO- 02- 963 Medicare Hospital Wage Variation were in two areas*
California and the northeast. 24 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.
25 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 24 The northeast region includes New York, New Jersey,
Pennsylvania, and Connecticut.

25 Additional Medicare payments for teaching activities and providing a
disproportionate share of care to the poor may compensate certain higher
wage metropolitan hospitals for their higher labor costs. Certain
Hospitals Can

Reclassify without Meeting the Standard Wage Criterion

Reclassified Hospitals That Did Not Satisfy the Standard Wage Criterion
Likely Receive a Labor Cost Adjustment Higher than the Wages They Pay

Page 20 GAO- 02- 963 Medicare Hospital Wage Variation their area. After
reclassification, they received a labor cost adjustment based on wages
that averaged 8 percent above their own average wages.

Table 4: Area Average Wage Compared to Hospital Wage, before and after
Reclassification, Fiscal Year 2001

Difference between area average wage and hospital- specific wage

Category of hospital Before

reclassification (percent)

After reclassification

(percent) Metropolitan

Reclassified * higher wage -10% 0% Nonreclassified * higher wage 7 N/ A

Nonmetropolitan Reclassified * higher wage 9 4 Reclassified * non- higher
wage -1 8 Nonreclassified * higher wage -4 N/ A

Note: N/ A means not applicable. Higher wage hospitals are those that have
wages high enough relative to other hospitals in their geographic area to
meet the reclassification criterion, which for metropolitan hospitals is
average wages at least 8 percent higher than the average in their
geographic area, and for nonmetropolitan hospitals is average wages at
least 6 percent higher than the average in their area. Non- higher wage
hospitals are those that cannot satisfy the reclassification wage
criterion.

Source: GAO analysis of 1997 hospital wages used in construction of 2001
wage index, as reported in Medicare hospital cost reports and 2001 PPS
Payment Impact File. Analysis excludes hospitals reclassified through
legislation, hospitals that receive only a standardized amount
reclassification, and

hospitals with missing wage data. 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
statespecific 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 Budget Neutrality

Adjustments Are Relatively Modest, but Would Vary under a State- Specific
Option

Page 21 GAO- 02- 963 Medicare Hospital Wage Variation 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. Table 5: Effect of the Geographic
Reclassification Budget Neutrality Requirement

on Medicare Inpatient Hospital Payments, by Metropolitan and
Nonmetropolitan Status, Fiscal Years 1995 through 2002

Percent change in per stay payments 1995 1996 1997 1998 1999 2000 2001
2002 Metropolitan Reclassified 2.4 2.6 3.3 3.2 4. 8 4.1 5. 4 4.2

Nonreclassified -0.6 -0.6 -0. 6 -0.5 -0.6 -0.6 -0.7 -1.0

Nonmetropolitan Reclassified 7.4 7.4 8.6 8.7 7. 0 6.5 5.9 5. 5
Nonreclassified -0.4 -0.4 -0. 4 -0.4 -0.4 -0.4 -0.5 -0.6 Source: Impact
Analysis Tables from final PPS rules, published in the Federal Register,
1995- 2001.

Budget Neutrality Adjustment Calculated to Offset Payment Increases to
Reclassified Hospitals

Page 22 GAO- 02- 963 Medicare Hospital Wage Variation 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. 26 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. 27 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. 26 We used 2000 data for this analysis because they were the
most recent, complete data available. 27 See appendix V for more
information on state- specific budget neutrality. Effect of State-
Specific

Budget Neutrality Adjustment Would Depend on Benefits of Reclassification
for State*s Hospitals

Conclusions

Page 23 GAO- 02- 963 Medicare Hospital Wage Variation 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 statespecific
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
Recommendations for

Executive Action Agency Comments and Our Evaluation

Page 24 GAO- 02- 963 Medicare Hospital Wage Variation 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.

Laura A. Dummit Director, Health Care* Medicare Payment Issues

Page 25 GAO- 02- 963 Medicare Hospital Wage Variation List of Committees
The Honorable Max Baucus Chairman

The Honorable Charles E. Grassley, Jr. Ranking Minority Member Committee
on Finance United States Senate

The Honorable Bill Thomas Chairman The Honorable Charles B. Rangel Ranking
Minority Member Committee on Ways and Means House of Representatives

The Honorable W. J. *Billy* Tauzin Chairman The Honorable John D. Dingell
Ranking Minority Member Committee on Energy and Commerce House of
Representatives

Appendix I: Scope and Methodology Page 26 GAO- 02- 963 Medicare Hospital
Wage Variation 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
postreclassification 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. Appendix I: Scope and Methodology

Appendix II: The Effect of Accounting for Occupational Mix on the Wage
Index

Page 27 GAO- 02- 963 Medicare Hospital Wage Variation 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 Appendix
II: The Effect of Accounting for

Occupational Mix on the Wage Index

Appendix II: The Effect of Accounting for Occupational Mix on the Wage
Index

Page 28 GAO- 02- 963 Medicare Hospital Wage Variation occupational mix
differences. 1 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. Table 6: Hospital Wages, Adjusted for Mix of Occupations,
Oakland MSA and Nonmetropolitan California, Fiscal Year 1998

Average hourly wage Occupational mixadjusted

average hourly wage

Oakland MSA $36.73 $36.30 Nonmetropolitan areas $23.40 $24.27 Percent
difference 57.0% 49.6%

Source: GAO analysis of wage data from 1998 California Hospital Annual
Disclosure Reports. Area average hourly wages shown here differ from those
used in calculating Medicare payments, which are based on wages reported
in Medicare hospital cost reports.

1 To evaluate the effects of adjusting the hospital wage index after
removing the effects of occupational mix, we obtained occupation- specific
hospital wage and staff hour data from the 1998 California Hospital Annual
Disclosure Reports submitted to the California Office of Statewide Health
Planning and Development. We calculated average hourly wages and average
share of hours contributed for each reported occupational category. Wages
and hours that were associated with expenses that are not covered by
Medicare, such as research, were excluded. Using these data, we calculated
an unadjusted average hourly wage and an occupational- mix adjusted
average hourly wage with the mix of occupation

hours held constant for each geographic area. The difference between the
two averages is the effect of occupational mix. Our results are only
suggestive of the magnitude and direction of changes when CMS modifies its
wage index calculation method. CMS has identified the occupational
categories for which it will collect wage data, but has not yet determined
the methodology for using these data in calculating the wage index.

Appendix II: The Effect of Accounting for Occupational Mix on the Wage
Index

Page 29 GAO- 02- 963 Medicare Hospital Wage Variation Table 7: Effect of
an Occupational Mix Adjustment on Average Area Wages in California, Fiscal
Year 1998 California areas

Percent difference between average wages calculated with and without an

occupational mix adjustment

Nonmetropolitan California 3.7% Bakersfield 3.7% Chico- Paradise 3.7%
Fresno 2.8% Los Angeles- Long Beach -0.6% Merced 3.7% Modesto 4.8% Oakland
-1.2% Orange County -1.5% Redding 0.1% Riverside- San Bernardino 0.0%
Sacramento 2.6% Salinas 2.8% San Diego -3.7% San Francisco 0.7% San Jose
-0.9% San Luis Obispo- Atascadero- Paso- Robles 1.2% Santa Barbara- Santa
Maria- Lompoc -1.0% Santa Cruz- Watsonville -2.2% Santa Rosa -3.1%
Stockton- Lodi 3.1% Vallejo- Fairfield- Napa -1.8% Ventura 0.3% Visalia-
Tulare- Porterville 3.7% Yolo -3.2% Yuba City -1.5%

Source: GAO analysis of wage data from 1998 California Hospital Annual
Disclosure Reports.

Appendix III: Average Hospital Wages in Outlying and Central Counties of
Metropolitan Areas, by State, Fiscal Year 1997

Page 30 GAO- 02- 963 Medicare Hospital Wage Variation State Average
percent difference

between outlying and central county wages a State

Average percent difference between outlying and central

county wages a

Alabama -8 Montana N/ A Alaska N/ A Nebraska -12 Arizona -17 Nevada -26
Arkansas -6 New Hampshire N/ A California -13 New Jersey -11 Colorado N/ A
New Mexico 11 Connecticut -7 New York -14 Delaware -29 North Carolina -12
District of Columbia N/ A North Dakota -1 Florida -8 Ohio -10 Georgia -19
Oklahoma -17 Hawaii N/ A Oregon 2 Idaho -10 Pennsylvania -10 Illinois -1
Rhode Island N/ A Indiana -5 South Carolina -5 Iowa -2 South Dakota -23
Kansas -17 Tennessee -11 Kentucky -13 Texas -7 Louisiana -9 Utah N/ A
Maine N/ A Vermont N/ A Maryland -12 Virginia -14 Massachusetts -2
Washington -6 Michigan -7 West Virginia -6 Minnesota -11 Wisconsin -12
Mississippi 6 Wyoming N/ A Missouri -15 Note: N/ A means not applicable.

a We averaged the percentage difference between outlying and central
county wages within each MSA across all MSAs within each state. Then, we
averaged the difference within each MSA across all MSAs that had outlying
counties within a state. The percentage difference represents the amount
by which outlying county wages are greater or less than central county
wages, so a negative number

indicates lower wages in outlying counties. These comparisons were not
possible in the MSAs that do not have any outlying counties, in the states
that have no MSAs with outlying counties, or in the states that have only
outlying counties of MSAs with central counties in bordering states.
Source: GAO analysis of 1997 hospital wages used in construction of the
2001 wage index, as reported in Medicare hospital cost reports.

Appendix III: Average Hospital Wages in Outlying and Central Counties of
Metropolitan Areas, by State, Fiscal Year 1997

Appendix IV: Average Hospital Wages across Community Types in
Nonmetropolitan Areas, by State, Fiscal Year 1997

Page 31 GAO- 02- 963 Medicare Hospital Wage Variation Number of hospitals
Percent difference from nonmetropolitan average wage

State Large town Small town Rural Average hourly

wage, all nonmetropolitan

hospitals Large town hospitals Small town

hospitals Rural hospitals

Alabama 17 26 10 $16.30 2% -1% -12% Alaska 3 8 2 26.98 -5% 2% -3% Arizona
6 8 2 18.11 6% -6% -8% Arkansas 16 33 7 16.21 6% -4% -18% California 14 19
7 21.47 -4% 4% -3% Colorado 3 20 12 19.52 9% 1% -20% Connecticut 1 1 0
25.50 -1% 1% N/ A Delaware 0 2 0 19.75 N/ A 0% N/ A District of Columbia
N/ A N/ A N/ A N/ A N/ A N/ A N/ A Florida 6 17 4 19.42 0% -2% 2% Georgia
23 44 18 18.13 4% -8% -4% Hawaii 5 4 4 24.07 -2% 3% 20% Idaho 7 16 8 18.89
2% -2% -9% Illinois 26 40 5 17.77 4% -9% -7% Indiana 18 25 2 18.73 2% -4%
8% Iowa 15 54 24 17.48 8% -4% -12% Kansas 22 30 39 16.56 5% -4% -10%
Kentucky 15 35 21 17.27 3% -3% 1% Louisiana 13 23 10 16.72 2% -3% -1%
Maine 2 13 7 19.08 4% -2% 1% Maryland 4 3 1 18.83 0% 0% 0% Massachusetts 1
1 1 24.39 -4% 20% 6% Michigan 15 20 23 19.57 5% 0% -11% Minnesota 19 35 38
19.33 2% 1% -8% Mississippi 27 35 17 16.31 3% -4% -10% Missouri 20 23 17
16.76 4% -7% -6% Montana 6 16 16 18.91 8% -4% -16% Nebraska 11 32 32 17.65
11% -5% -16% Nevada 2 5 3 20.10 5% -5% -11% New Hampshire 6 3 4 21.43 2%
0% -12% New Jersey N/ A N/ A N/ A N/ A N/ A N/ A N/ A New Mexico 14 6 3
18.50 0% -2% 18% New York 12 18 4 18.50 4% -5% -4% North Carolina 20 25 13
18.38 4% -3% -11% North Dakota 6 6 26 16.80 6% -3% -7% Ohio 30 19 2 18.88
2% -4% -25% Oklahoma 17 39 14 16.31 5% -6% -13% Oregon 17 12 3 22.06 0% 2%
-2%

Appendix IV: Average Hospital Wages across Community Types in
Nonmetropolitan Areas, by State, Fiscal Year 1997

Appendix IV: Average Hospital Wages across Community Types in
Nonmetropolitan Areas, by State, Fiscal Year 1997

Page 32 GAO- 02- 963 Medicare Hospital Wage Variation Number of hospitals
Percent difference from nonmetropolitan average wage

State Large town Small town Rural Average hourly

wage, all nonmetropolitan

hospitals Large town hospitals Small town

hospitals Rural hospitals

Pennsylvania 11 26 6 18.67 1% 0% -3% Rhode Island N/ A N/ A N/ A N/ A N/ A
N/ A N/ A South Carolina 9 18 0 18.22 3% -3% N/ A South Dakota 8 8 21
16.48 4% -3% -10% Tennessee 19 32 14 17.06 4% -3% -7% Texas 46 83 35 16.33
4% -6% -1% Utah 4 9 7 19.67 3% -4% -6% Vermont 2 6 4 20.19 8% -3% -6%
Virginia 8 20 9 17.83 4% -2% -6% Washington 17 8 15 22.71 3% -4% -16% West
Virginia 9 15 9 17.92 4% -1% -18% Wisconsin 12 34 21 19.33 3% -3% -2%
Wyoming 5 12 6 19.19 2% 1% -12%

Note: N/ A means not applicable. Source: GAO analysis of 1997 hospital
wages used in the construction of the 2001 wage index, as reported in
Medicare hospital cost reports. Large town, small town, and rural areas
were defined using RUCA codes rather than location in a Medicare
nonmetropolitan geographic area. As a result, 45 hospitals that receive
the nonmetropolitan labor cost adjustment were excluded from this
analysis. Two states and the District of Columbia have no nonmetropolitan
areas.

Appendix V: Effect of the Current and a StateSpecific Budget Neutrality
Option on Hospital Payments, by State, Fiscal Year 2000

Page 33 GAO- 02- 963 Medicare Hospital Wage Variation Change in Medicare
hospital payments Under national budget

neutrality adjustment (current law) Under state- specific budget

neutrality option State Total

hospitals Reclassified hospitals Reclassified

hospitals Nonreclassified hospitals Reclassified

hospitals Nonreclassified hospitals

Alabama 109 10 6.3% -0.6% 6.4% -0.5% Alaska 16 1 0. 0% 0. 0% 0.0% 0.0%
Arizona 61 2 7. 9% -0.6% 8.4% -0.2% Arkansas 78 18 7.3% -0.6% 6.3% -1.6%
California 405 19 6.6% -0.8% 7.0% -0.4% Colorado 64 3 5. 8% -0.6% 6.4%
-0.1% Connecticut 33 6 7. 5% -0.6% 7.1% -1.0% Delaware 5 2 6.5% -0.6% 5.6%
-1.5% District of Columbia 10 0 N/ A -0.6% N/ A 0.0% Florida 193 10 2.2%
-0.5% 2.6% -0.2% Georgia 160 22 10.6% -0.6% 9.7% -1.5% Hawaii 22 1 4. 2%
-0.6% 4.9% 0.0% Idaho 43 8 4. 9% -0.5% 4.0% -1.3% Illinois 196 22 6.1%
-0.6% 6.4% -0.3% Indiana 112 23 5.0% -0.6% 4.7% -0.9% Iowa 117 8 8. 1%
-0.4% 7.3% -1.2% Kansas 113 10 10.5% -0.6% 9.5% -1.5% Kentucky 101 20 6.4%
-0.5% 5.4% -1.5% Louisiana 128 11 8.0% -0.5% 8.0% -0.4% Maine 37 1 6. 0%
-0.6% 6.2% -0.4% Maryland N/ A N/ A N/ A N/ A N/ A N/ A Massachusetts 80 2
1. 6% -0.6% 2.1% -0.1% Michigan 156 16 4.2% -0.6% 4.6% -0.3% Minnesota 137
14 7.4% -0.6% 7.6% -0.4% Mississippi 99 19 6.9% -0.8% 5.5% -2.1% Missouri
121 13 7.3% -0.6% 7.2% -0.8% Montana 43 4 13.4% -0.6% 12.1% -1.7% Nebraska
87 9 11.3% -0.6% 9.9% -1.9% Nevada 26 0 N/ A -0.6% N/ A 0.0% New Hampshire
26 4 9. 3% -0.6% 6.8% -2.9% New Jersey 84 26 7.6% -2.4% 6.9% -3.0% New
Mexico 34 1 11.6% -0.6% 11.6% -0.5% New York 216 16 5.5% -0.6% 6.0% -0.2%
North Carolina 121 20 6.8% -0.6% 6.4% -1.0% North Dakota 46 10 2.6% -0.3%
2.4% -0.6% Ohio 170 31 5.9% -0.8% 5.7% -0.9% Oklahoma 113 12 8.1% -0.6%
7.6% -1.0% Oregon 60 9 4. 1% -0.4% 3.9% -0.6%

Appendix V: Effect of the Current and a StateSpecific Budget Neutrality
Option on Hospital Payments, by State, Fiscal Year 2000

Appendix V: Effect of the Current and a StateSpecific Budget Neutrality
Option on Hospital Payments, by State, Fiscal Year 2000

Page 34 GAO- 02- 963 Medicare Hospital Wage Variation Change in Medicare
hospital payments Under national budget

neutrality adjustment (current law) Under state- specific budget

neutrality option State Total

hospitals Reclassified hospitals Reclassified

hospitals Nonreclassified hospitals Reclassified

hospitals Nonreclassified hospitals

Pennsylvania 200 13 6.6% -0.8% 6.9% -0.5% Rhode Island 11 2 9. 0% -0.6%
9.2% -0.4% South Carolina 61 10 4.4% -0.6% 4.6% -0.5% South Dakota 47 3 8.
3% -0.6% 7.7% -1.2% Tennessee 123 12 13.2% -0.6% 13.2% -0.6% Texas 376 39
11.6% -0.6% 11.7% -0.6% Utah 40 7 13.1% -0.6% 12.3% -1.3% Vermont 14 2 3.
3% -0.6% 3.5% -0.4% Virginia 92 6 5. 5% -0.6% 5.9% -0.2% Washington 86 5
0. 4% -0.6% 0.9% -0.1% West Virginia 50 7 10.8% -0.6% 8.5% -2.6% Wisconsin
125 13 4.3% -0.6% 4.3% -0.5% Wyoming 24 1 9. 7% -0.5% 9.6% -0.5%

National total 6.8% -0.7% 6.5% -0.6%

Note: N/ A means not applicable. Hospitals in Maryland are not paid by
Medicare under the PPS, so they were excluded from this analysis. Source:
GAO analysis of data from 2000 Medicare hospital cost reports and the
fiscal year 2000 PPS Payment Impact File from the CMS.

Appendix VI: Comments from the Centers for Medicare & Medicaid Services
Page 35 GAO- 02- 963 Medicare Hospital Wage Variation Appendix VI:
Comments from the Centers for Medicare & Medicaid Services

Appendix VI: Comments from the Centers for Medicare & Medicaid Services
Page 36 GAO- 02- 963 Medicare Hospital Wage Variation (201034)

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