Medicare: CMS's Proposed Approach to Set Hospital Inpatient	 
Payment Appears Promising (28-JUL-06, GAO-06-880).		 
                                                                 
Under Medicare's inpatientprospective payment system (IPPS),	 
hospitals generally receive fixed payments for hospital stays	 
based on diagnosis-related groups (DRG), a system that classifies
stays by patient diagnosis and procedures. CMS is required to at 
least annually update DRG payments to address changes in the cost
of inpatient care. CMS uses charge-based weights to update these 
payments. Cost-based weights are used to set payments in the	 
outpatient prospective payment system (OPPS). The Medicare	 
Prescription Drug, Improvement, and Modernization Act of 2003	 
required GAO to study IPPS payments in relation to costs. During 
the course of GAO's work, CMS proposed a new cost-based method	 
for determining DRG weights. This report (1) examines the	 
applicability of CMS's cost-based method--used for the OPPS--to  
weight DRGs in the IPPS and (2) evaluates whether CMS's proposed 
approach is an improvement over its OPPS method for setting	 
cost-based weights. Using fiscal year 2002 cost reports and	 
claims from 2001, 2002, and 2003 to examine the applicability of 
the OPPS method, GAO estimated costs for 1,025 IPPS hospitals	 
whose Medicare cost reports most consistently reflected the total
charges and number of Medicare stays that these hospitals	 
reported on their claims. To evaluate CMS's proposed approach,	 
GAO analyzed fiscal year 2003 cost reports and 2003 claims for	 
3,558 hospitals.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-880 					        
    ACCNO:   A57640						        
  TITLE:     Medicare: CMS's Proposed Approach to Set Hospital	      
Inpatient Payment Appears Promising				 
     DATE:   07/28/2006 
  SUBJECT:   Cost analysis					 
	     Health care cost control				 
	     Health care costs					 
	     Hospital care services				 
	     Hospitals						 
	     Medical services rates				 
	     Medicare						 
	     Policy evaluation					 
	     Strategic planning 				 
	     CMS Medicare Hospital Inpatient			 
	     Prospective Payment System 			 
                                                                 

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GAO-06-880

     

     * Results in Brief
     * Background
          * Claims and Medicare Cost Reports Are the Data Sources Availa
          * Charge-Based Weights Are Used to Measure Relative Costliness
          * Cost-Based Weights Are Used to Measure Relative Costliness o
     * Applying the OPPS Weighting Method to IPPS Could Undermine t
     * CMS's Proposed Cost-Based Approach for IPPS May Result in Im
          * National-Average CCRs Intended to Reduce Impact on IPPS Weig
          * Service Group Approach Appears Promising but Some Concerns E
     * Concluding Observations
     * Agency and External Reviewer Comments and Our Evaluation
          * CMS Comments
          * Hospital Association Comments and Our Evaluation
     * Data Sources
     * Methods
     * GAO Contact
     * Acknowledgments
     * GAO's Mission
     * Obtaining Copies of GAO Reports and Testimony
          * Order by Mail or Phone
     * To Report Fraud, Waste, and Abuse in Federal Programs
     * Congressional Relations
     * Public Affairs

Report to Congressional Committees

United States Government Accountability Office

GAO

July 2006

MEDICARE

CMS's Proposed Approach to Set Hospital Inpatient Payments Appears
Promising

GAO-06-880

Contents

Letter 1

Results in Brief 5
Background 6
Applying the OPPS Weighting Method to IPPS Could Undermine the Objective
of Better Aligning DRG Payment Weights with Costs 12
CMS's Proposed Cost-Based Approach for IPPS May Result in Improvements
over the OPPS Cost-Based Method 14
Concluding Observations 20
Agency and External Reviewer Comments and Our Evaluation 20
Appendix I Scope and Methodology 24
Appendix II Comments from the Centers for Medicare & Medicaid Services 28
Appendix III GAO Contact and Staff Acknowledgments 29

Tables

Table 1: Hospital Information Included on Claims and Medicare Cost Reports
Submitted to CMS 8
Table 2: CMS's Proposed Service Groups 16
Table 3: Proposed Therapeutic Services Group: Cost Centers and CCRs 19

Figure

Figure 1: How Hospitals Can Allocate Charges from Revenue Centers to Cost
Centers and the Effect on CMS's Cost Estimates 11

Abbreviations

AAMC Association of American Medical Colleges AHA American Hospital
Association APC ambulatory payment classification CCR cost-to-charge ratio
CMS Centers for Medicare & Medicaid Services COPD chronic obstructive
pulmonary disease DRG diagnosis-related groups HCRIS Healthcare Cost
Reporting Information System HHS Department of Health and Human Services
ICD-9-CM International Classification of Diseases, 9th Revision, Clinical
Modification IPPS inpatient prospective payment system MedPAC Medicare
Payment Advisory Commission MEDPAR Medicare Provider Analysis and Review
MMA Medicare Prescription Drug, Improvement, and Modernization Act of 2003
OPPS outpatient prospective payment system

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United States Government Accountability Office

Washington, DC 20548

July 28, 2006

Congressional Committees

At $119.4 billion, spending for hospital inpatient services accounted for
over a third of total Medicare spending in fiscal year 2005. Most of these
dollars were spent on care provided to Medicare beneficiaries by the
approximately 4,000 acute care hospitals that bill Medicare under its
inpatient prospective payment system (IPPS). Under this payment system, a
hospital generally receives a fixed, predetermined payment amount for a
hospital stay.1 IPPS rates are based on diagnosis-related groups (DRG), a
system that classifies inpatient stays by patient diagnosis and the
procedures they receive. Each DRG has a numeric weight, which signifies
the average costliness of stays assigned to that DRG relative to the
average costliness of other inpatient stays. The Centers for Medicare &
Medicaid Services (CMS) in the Department of Health and Human Services
(HHS) is required by statute to update DRG weights at least annually to
address the changes in the cost of inpatient care. As a result of the DRG
updates, changes occur annually in the payments hospitals receive for
inpatient stays.

Because CMS does not have a direct measure of the cost of a hospital stay,
it uses the charge information hospitals include on their Medicare claims
to adjust the DRG weights. The weights that are developed from charge data
are referred to as charge-based weights. Health policy analysts have had
long-standing concerns about the use of charge data to set DRG weights.2
They contend that charges are not a good proxy for costs, in large part,
because of the variation in hospitals' charge-setting practices.

1Throughout this report, we use the term stay to represent a patient's
hospitalization, which CMS and hospitals refer to as a discharge for
data-reporting purposes.

2See Medicare Payment Advisory Commission (MedPAC), Report to the
Congress: Variation and Innovation in Medicare (Washington, D.C.: June
2003); MedPAC, Report to the Congress: Physician-Owned Specialty Hospitals
(Washington, D.C.: March 2005). MedPAC advises the Congress on issues
affecting the Medicare program. See also J. Newhouse, et al., "Predicting
Hospital Accounting Costs," Health Care Financing Review, vol. 11, no. 1
(1989); and Kurt F. Price, "Pricing Medicare's Diagnosis Related Groups:
Charges versus Estimated Costs," Health Care Financing Review, vol. 11,
no. 1 (1989).

A hospital sets a charge for a service that is generally above the cost of
the service. The difference between the charge and cost is referred to as
a mark-up. Not all services are marked up by the same percentage; mark-ups
for services may be influenced by several factors, including level of
competition in the local market, service utilization, and insurers'
purchasing arrangements. If all services were marked up over costs by an
identical percentage, charges would represent the relative costliness of
services perfectly. However, because variations in mark-up percentages
vary across services and across hospitals, weights based on charges can
overvalue some services and undervalue others and compromise the accuracy
of DRG payment amounts.

Recognizing the problem involved in using charges to determine DRG
weights, the Medicare Payment Advisory Commission (MedPAC) recommended in
2005 that CMS use a cost-based rather than charge-based method to weight
the DRGs in the IPPS.3 A cost-based method entails estimating the costs of
hospital services for each DRG. Basing weights on cost estimates is
intended to better align payments with hospitals' costs compared with the
current charge-based method.

CMS currently uses cost-based weights to determine relative costliness for
outpatient services provided to Medicare beneficiaries under its hospital
outpatient prospective payment system (OPPS).4 However, in its notice of
proposed rulemaking for the fiscal year 2006 IPPS rates, CMS noted that,
without further analysis, it was uncertain whether using the current OPPS
cost estimation method would better align payments with costs for
inpatient DRGs.5

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003
(MMA) required us to conduct a study of the appropriateness of Medicare's
IPPS payments in relation to costs.6 In light of MedPAC's recommendation
that CMS adopt a cost-based weighting method, we evaluated CMS's concern
about using the OPPS cost-based method to set DRG weights. During the
course of our work, CMS published a notice of proposed rulemaking
describing its intent to use a new cost-based approach to adjust the DRG
weights beginning in fiscal year 2007.7 We discussed these developments
with the committees of jurisdiction, and this report examines (1) the
applicability of CMS's cost-based method-used to set weights in OPPS-to
weight DRGs in the IPPS and (2) whether CMS's proposed approach for the
IPPS is an improvement over its OPPS method for setting cost-based
weights.

3MedPAC, Report to the Congress: Physician-Owned Specialty Hospitals
(Washington D.C.: March 2005).

4See 42 U.S.C. S: 1395l(t)(2)(C).

570 Fed. Reg. 23,306, 23,455 (May 4, 2005).

6Pub. L. No. 108-173, S: 501(c), 117 Stat. 2066, 2290.

To examine the applicability of CMS's OPPS cost-based method to weight
DRGs in the IPPS, we reviewed CMS instructions to hospitals on billing
Medicare for services provided, and CMS instructions to hospitals for
filing Medicare cost reports-these cost reports are submitted annually to
CMS by hospitals and contain aggregate information on charges for services
and the actual costs of providing those services to all patients, as well
as information on total charges and estimates of costs for services
provided to Medicare beneficiaries. We used the Medicare Provider Analysis
and Review (MEDPAR)-a CMS database that compiles and maintains hospitals'
Medicare claims-to analyze hospital claims. For 3,660 hospitals paid under
Medicare IPPS in fiscal year 2002, we compared Medicare cost reports and
claims for services delivered. We identified 1,025 IPPS hospitals whose
Medicare cost reports most consistently reflected the total charges and
number of Medicare stays that these hospitals reported on their claims.8
Using each hospital's fiscal year 2002 claims and Medicare cost report
data for the 1,025 hospitals, we applied the OPPS cost estimation method
to estimate Medicare costs for each hospital separately. CMS uses a single
method to match cost information from the cost reports to charge
information from the claims, and applies this method uniformly to all
hospitals to estimate costs. Costs are estimated by using
hospital-specific cost-to-charge ratios (CCR) derived from each hospital's
respective Medicare cost report. A CCR is a ratio that describes the cost
and charge relationship for similar services, such as pharmacy or
laboratory, or for all services provided in a hospital. Similar to CMS, we
developed a single method to match costs to charges, applied this method
uniformly to all hospitals, and used hospital-specific CCRs to estimate a
hospital's costs.9 For each hospital, we aggregated cost estimates for
accommodation and ancillary services separately.10 We then compared these
aggregate estimates to what each hospital reported as its total Medicare
costs for these services for fiscal year 2002 to determine the extent to
which our cost estimates matched what each hospital reported on its
Medicare cost report. We interviewed representatives from CMS, and fiscal
intermediaries (claims administration contractors for CMS that process
hospital claims). In addition, we spoke with representatives of the
American Hospital Association (AHA) and the Association of American
Medical Colleges (AAMC) about general hospital IPPS issues in October
2004. Our results are not generalizable to hospitals whose total charges
and hospital stays from their Medicare cost reports and claims data did
not match within .3 percent in fiscal year 2002.

771 Fed. Reg. 23,996, 24,006-24,011 (April 25, 2006). By August 1, 2006,
after evaluating comments on its notice of proposed rulemaking, CMS
expects to publish a final rule describing its decision on the use of
cost-based weights.

8We excluded hospitals from our analysis if the total Medicare charges and
number of stays from their cost reports and claims data did not match
within .3 percent.

To address whether CMS's proposed approach for the IPPS is an improvement
over its OPPS method of setting cost-based weights, we first identified
potential problems in applying the OPPS method to the IPPS. If our cost
estimates did not match what hospitals reported on their cost reports, we
compared how charges were categorized on the claims relative to how they
were categorized on the cost report. On the basis of this analysis, we
then determined whether CMS's proposed approach would better capture
measures of cost. In particular, CMS's approach entails grouping charges
from hospitals' claims into 10 broad service groups.11 CMS uses these
service groups as a basis to create cost-based weights by using
national-average CCRs to eliminate charge mark-ups for each service group.
In examining the proposed approach, we reviewed CMS's April 2006 notice of
proposed rulemaking and analyzed 2003 Medicare claims and fiscal year 2003
Medicare cost reports for 3,558 IPPS hospitals to evaluate the
national-average CCRs.12 We determined the data to be sufficiently
reliable for the purposes of this report. (For more detail on our scope
and methodology, see app. I.) We performed this work from June 2004
through July 2006 in accordance with generally accepted government
auditing standards.

9Because the data sources that CMS uses to set payment rates are different
for the IPPS and OPPS and because certain IPPS services are not provided
in the OPPS, we needed to develop a mapping method to match cost
information from the cost report to IPPS charge information from the
claims. For more detail on our mapping method, see our scope and
methodology in app. I.

10Accommodation services include room and board and nursing services.
Ancillary services include all other services associated with an inpatient
stay, for example, drugs and diagnostic services.

11The 10 proposed service groups are routine, intensive, drugs, supplies &
equipment, therapeutic services, operating room, cardiology, laboratory,
radiology, and other services.

12We did not examine the extent to which the OPPS method measures relative
costliness for outpatient services.

                                Results in Brief

If the OPPS method were applied to the IPPS, it could undermine the
objective of better aligning DRG payment weights with costs. When we
estimated fiscal year 2002 costs using CMS's cost-based OPPS weighting
method to determine its applicability for weighting inpatient DRGs, we
found that, for all but one of the 1,025 hospitals in our analysis, our
application of CMS's OPPS method resulted in cost estimates for inpatient
accommodation services that on average were 72 percent less than what the
hospitals reported on their Medicare cost reports for these services. For
57 percent of the hospitals, our application of CMS's OPPS method resulted
in cost estimates for inpatient ancillary services that on average were 8
percent more than what the hospitals reported on their Medicare cost
reports.13 For 22 percent of the hospitals, our application of CMS's OPPS
method resulted in cost estimates for inpatient ancillary services that
were on average 6 percent less than what the hospitals reported on their
Medicare cost reports. These differences resulted from our application of
CMS's single approach to mapping hospital-specific cost center CCRs to
revenue center charges. Cost differences result because this method does
not address the variation in how hospitals allocate their charges and
costs.

CMS is proposing a new cost-based approach to set payment weights for
inpatient DRGs that appears promising, and may result in improvements in
setting cost-based weights compared with the OPPS method. The proposal
involves grouping charges into 10 broad service groups. The charges for
each of the 10 service groups are converted to cost-based weights by using
national-average CCRs that correspond to each of the service groups. This
approach ameliorates the problems we observed with the OPPS method because
the approach does not require the application of hospital-specific CCRs.
When CMS applies hospital-specific CCRs to match charges to costs for all
hospitals, it may not capture the relevant cost-to-charge relationships
for services. Using national-average CCRs in the proposed approach is
intended to reduce the impact that variations in hospital charge and cost
allocation decisions can have on the DRG weights. Six of the service
groups, which constitute a majority of Medicare inpatient charges, appear
promising because their CCRs are relatively consistent with one another
within a service group and are likely to capture the relevant
cost-to-charge relationship for the services included in these groups. An
additional 2 groups contain cost center CCRs that range widely within
their respective groups and, therefore, raise concerns about their ability
to better align payment with costs for services in those groups. While the
remaining 2 groups also include cost center CCRs that vary widely, due to
the limitations of the MEDPAR data, we did not have enough specific
information to determine whether the 2 remaining service groups are likely
to capture the relevant cost-to-charge relationship for the services
included in those groups.

13The 8 percent is based on estimates from 1,020 hospitals. This estimate
excludes ancillary cost estimates for 5 hospitals from our sample of 1,025
because they were extreme outliers. When we included data from these
hospitals in our aggregate cost estimates, the resulting ancillary cost
estimates for the 1,025 were overestimated on average by 222 percent
relative to what all the hospitals reported.

In commenting on a draft of this report, CMS stated that it was pleased
with our findings. CMS also stated that it could not comment further
because it is currently considering public comments in developing the
fiscal year 2007 final rule for the IPPS payment rates. Hospital
association reviewers agreed that cost estimation problems can result
because of hospital reporting variation. However, they noted that because
hospital reporting variation still affects the data CMS is proposing to
use to set DRG weights, they were concerned with our assessment that the
CMS approach is promising. We believe the approach appears promising, in
particular, because CMS proposes to use national-average CCRs to reduce
the impact of individual hospital reporting practices.

                                   Background

To set payment weights for inpatient and outpatient services, CMS has two
sources of data: claims, which are bills hospitals submit to CMS upon a
Medicare beneficiary's discharge to receive payment for inpatient and
outpatient services rendered to Medicare beneficiaries, and Medicare cost
reports, which are statements that hospitals submit annually to CMS
identifying, by service category, the charges and costs for services
rendered to all patients, not just Medicare beneficiaries. Charge-based
weights, derived from claims data, are used to measure the relative
costliness of stays assigned to DRGs in the hospital inpatient setting.
Cost-based weights, derived from claims and Medicare cost report
information, are used to measure the relative costliness of ambulatory
payment classification (APC) groups in the outpatient setting. APCs in the
OPPS are analogous to DRGs in the IPPS.

Claims and Medicare Cost Reports Are the Data Sources Available to Set Payment
Weights for IPPS and OPPS Services

Hospitals submit claims upon a beneficiary's discharge to CMS identifying
charges for services delivered to a Medicare beneficiary. These charges
are billed by categories of service-for example, anesthesiology,
cardiology, radiology-and these categories are referred to as revenue
centers. A revenue center represents a revenue-generating department or
unit within a hospital. By associating a revenue center with each service
billed on a claim, a hospital can track its charges for services
associated with that department.

In addition to keeping track of its charges for services by department or
unit, a hospital tracks the costs associated with these departments.
Hospitals submit this information annually to CMS on their Medicare cost
reports. These reports contain hospitals' actual total costs and costs by
department for all patients. The costs are reported in broad categories
called cost centers. Similar to revenue centers, pharmacy, supplies,
cardiology, and emergency room are also examples of cost centers, based on
departments common to many hospitals.

CMS requires hospitals to report total charge and cost data for all
patients by cost center. Although CMS does not require a one-to-one match
between cost centers and revenue centers, it requires that a hospital
report its list of revenue centers that are contained in each of its cost
centers. Neither the cost nor the charge data reported in cost centers are
broken down by individual items and services delivered by hospital stay,
or DRG. Revenue center charges are accumulated from all claims for all
patients and reported in total in associated cost centers on the Medicare
cost report. The relationship between revenue centers and cost centers is
subject to individual hospital discretion in how they accumulate charges
and costs and is therefore variable across hospitals. Table 1 describes
the information included on claims and on Medicare cost reports.

Table 1: Hospital Information Included on Claims and Medicare Cost Reports
Submitted to CMS

Information      Claimsa                Medicare cost reportb              
Charges          Lists charges for each Includes hospital's total charges  
                    service provided       and charges aggregated by cost     
                                           center for (1) all patients and    
                                           (2) Medicare beneficiaries         
Costs            None                   Includes hospital's total costs    
                                           aggregated by cost center for all  
                                           patients and hospital's estimates  
                                           of the share of costs accounted    
                                           for by Medicare beneficiaries      
Categories of    Revenue centers        Cost centers                       
services                                
Submitted to CMS Upon a beneficiary's   Annually                           
                    discharge              

Source: GAO analysis of information contained on claims and Medicare cost
reports.

aA claim contains billed charges for services provided during an inpatient
stay.

bA Medicare cost report contains an annual summary of a hospital's total
costs and charges.

Hospitals vary in the number of cost centers and revenue centers they use,
and their decisions in allocating costs and charges to cost centers are
driven typically by the hospitals' own internal accounting systems and
organizational structure. For example, if a hospital does not have a
separate department for anesthesia services, it may allocate its charges
for anesthesia to the Medicare cost report's cost center for operating
room.

Though hospitals report their total charges and total costs for all
patients, as well as total costs and charges by cost center, they do not
separately track the costs of services delivered by payer source. However,
in reporting to CMS, each hospital must include in its Medicare cost
report total charges for all patients, total charges for Medicare
beneficiaries, and an estimate of the share of the hospital's costs for
services delivered to Medicare beneficiaries, in total and by cost center.

Charge-Based Weights Are Used to Measure Relative Costliness of Inpatient DRGs

To determine the costliness of one inpatient DRG compared with others, CMS
uses charge data from claims. Generally, the charges on a claim are for
accommodation and ancillary services. Accommodation services include room
and board and nursing services. These services are classified as either
routine or intensive care, based on the level of intensity of the nursing
services required. Ancillary services include all other services
associated with an inpatient stay; for example, drugs and diagnostic
services.14

Charges for accommodation and ancillary services have been used to weight
DRGs since 1986. In general, the average charge for each DRG is divided by
the average charge for all DRGs to produce a weight. The resulting weights
are multiplied by a base payment rate to determine payment for each DRG.15

Charges have long been considered a problem in setting relative weights
for inpatient hospital services because the method assumes a consistent
relationship between the charge set for an item or service and its cost to
the hospital. A recent MedPAC-sponsored report on hospitals'
charge-setting practices attributes the wide variation in the relationship
between costs and charges to hospital-specific factors-such as mission,
location, and payer mix-and charge mark-up decisions.16

Cost-Based Weights Are Used to Measure Relative Costliness of Outpatient APCs

Unlike IPPS, which uses charges to set payment weights for DRGs, CMS uses
cost-based weights in the OPPS to measure the costliness of one APC
relative to the others. Because neither the claims nor the Medicare cost
reports include the costs for individual items or services, these costs
must be estimated by CMS in order to calculate payment weights. As a first
step, CMS obtains hospital charge data on each outpatient service from the
claims. It calculates each hospital's cost for each service by multiplying
the charge amount for each service by the CCR that is computed from each
hospital's cost report, generally on a cost center-specific basis. The
application of a CCR to a charge is designed to remove the mark-up from
each charge in order to identify the cost of the item or service. For
example, to estimate the cost of a radiology service, CMS multiplies the
charge associated with a hospital's radiology revenue center on each claim
by the radiology cost center CCR for that hospital. CMS uses these
estimated costs to develop payment weights for each APC.

14Payment for physician services is not included in the DRG payment to
hospitals. Physicians are paid by Medicare under a separate fee schedule.

15The base payment rate is a standardized amount, which is divided into
labor and nonlabor-related shares.

16The Lewin Group, A Study of Hospital Charge Setting Practices (Falls
Church, Va.: 2005).

Hospitals vary in how they allocate revenue center charges to cost centers
on their Medicare cost reports. When estimating costs for purposes of
weighting APCs, however, CMS uses its own system of mapping the hospitals'
revenue center charges to cost center CCRs in order to convert the charges
to an estimate of cost. This can be problematic since hospitals may
allocate their revenue centers to cost centers in a different manner from
CMS. For example, as illustrated in figure 1, some hospitals allocate
charges from the same revenue center to separate cost centers; others
allocate charges from several revenue centers to a single cost center.
CMS's use of a single method in mapping charges to costs and then applying
that method across all hospitals for purposes of cost estimation does not
recognize the differences in hospital allocation decisions when estimating
costs. As a result, some service costs are systematically overestimated
and some are underestimated.

Figure 1: How Hospitals Can Allocate Charges from Revenue Centers to Cost
Centers and the Effect on CMS's Cost Estimates

Note: For illustrative purposes, these hospitals' total charges reflect
charges for only one patient. Hospitals' Medicare cost reports would
normally contain all charges for all services delivered during a fiscal
year.

aThe CCR computed for Hospital B's operating room services is a weighted
average reflecting the costs and charges for all three of the services
reported on the Medicare cost report.

The services represented in figure 1 are ancillary services typical to
many hospitals. Hospital A reports charges in all three cost centers, and
reports CCRs for these cost centers. Hospital B does not use separate cost
centers for anesthesia and supplies; therefore, it does not report any
charges in its cost centers for anesthesia and supplies. As a result,
Hospital B does not report CCRs for these services specifically. To
estimate the cost for these services without an associated CCR, the
current OPPS cost-based weighting method uses, or defaults to, the
hospital's overall ancillary CCR-which is the ratio of a hospital's total
ancillary costs to its total ancillary charges. Therefore, in the case of
Hospital B, CMS's single mapping approach defaults to Hospital B's overall
ancillary CCR to estimate a cost for its anesthesia and supply charges. To
the extent that the hospital's overall ancillary CCR is an inaccurate
measure of the cost-to-charge relationship for those services, the costs
of those services will be overestimated or underestimated. If these cost
estimates are used to set relative weights, payment amounts for the
services can be inappropriate.

CMS asserts that the application of CCRs to Medicare charges is a
fundamental principle of cost reimbursement and has been in effect for
many years. Because CMS does not have any other financial information from
hospitals except each hospital's claims and Medicare cost report, it views
the use of CCRs as the most straightforward way to estimate costs from
charges.17

  Applying the OPPS Weighting Method to IPPS Could Undermine the Objective of
                 Better Aligning DRG Payment Weights with Costs

When we used CMS's cost-based OPPS weighting method to determine its
applicability for weighting inpatient DRGs, we found that, for the
majority of hospitals in our analysis, our estimates of aggregate costs
for Medicare stays were on average more than what the hospitals reported
on their cost reports for ancillary services. In addition, our estimates
for accommodation services were on average less than what the hospitals
reported on their cost reports for the Medicare services associated with
these stays. These differences resulted from CMS's single approach to
mapping hospital-specific cost center CCRs to revenue center charges. Cost
differences result because the CMS method does not address the variations
in how hospitals allocate charges and costs. Using such cost estimates to
set DRG weights in the IPPS would undermine the goal of better aligning
payment with costs.

17See 70 Fed. Reg. at 23,455 (May 4, 2005).

We estimated costs using the OPPS method for each hospital stay and
aggregated the accommodation and ancillary cost estimates for each of the
1,025 hospitals in our analysis. We compared our aggregate accommodation
and ancillary cost estimates to the accommodation and ancillary costs each
hospital reported on its Medicare cost report. For all but one of the
hospitals in our analysis, our application of CMS's OPPS method resulted
in cost estimates for inpatient accommodation services that were on
average 72 percent less than what the hospitals reported on their Medicare
cost reports for these services. For 57 percent of the hospitals, our
application of CMS's OPPS method resulted in cost estimates for inpatient
ancillary services that were on average 8 percent more than what the
hospitals reported on their Medicare cost reports.18 For 22 percent of the
hospitals, our application of CMS's OPPS method resulted in cost estimates
for inpatient ancillary services that were on average 6 percent less than
what the hospitals reported on their Medicare cost reports.

The differences between our aggregate estimates using the OPPS method and
hospitals reported costs indicate that a single approach to mapping cost
center CCRs to revenue center charges is problematic because CCRs are
applied to certain charges that do not capture the cost-to-charge
relationship for those charges. For example, approximately 18 percent of
the hospitals in our analysis did not allocate their charges for
anesthesia services to their Medicare cost report's anesthesia cost center
and thus did not report a CCR for that cost center.19 In applying the CMS
OPPS method to estimate the cost of anesthesia services for these
hospitals, we multiplied each hospital's anesthesia charge included on the
hospital's claims by each hospital's overall ancillary CCR. Although we
could not measure the precise effect of using a default CCR for these
services, our information on average CCRs was instructive. That is, the
average overall ancillary CCR for the 1,025 hospitals in our analysis was
.34 and for the hospitals that reported costs and charges in the
anesthesia cost center, the average anesthesia CCR was .16.20 The
difference between the two CCRs suggests that using each hospital's
overall ancillary CCRs to estimate its anesthesia costs produced an
estimate that, on average, overvalued these services at the individual
hospital level and contributed to the differences between the aggregated
ancillary cost estimates we calculated and what hospitals reported to CMS
as their ancillary costs. The extent of the problem for cost estimation
depends upon the frequency with which the overall ancillary CCR is used in
place of a specific cost center CCR.

18The 8 percent is based on estimates from 1,020 hospitals. This estimate
excludes ancillary cost estimates for 5 hospitals from our sample of 1,025
because they were extreme outliers. When we included data from these
hospitals in our aggregate cost estimates, the resulting ancillary cost
estimates for the 1,025 were overestimated on average by 222 percent
relative to what all the hospitals reported.

19This hospital allocation practice-billing for services and allocating
the charges to a different cost center service type-occurred to varying
degrees for all ancillary cost centers.

Cost estimation problems can also result when hospitals report two
distinct service types, with different mark-ups, in one cost center.
Specifically, about 9 percent of the hospitals in our analysis reported
charges for intensive care services in a cost center other than intensive
care. For example, some of these hospitals may have reported intensive
care charges with routine service charges in the routine cost center. In
fiscal year 2002, hospitals' average CCR for intensive care services for
the 1,025 hospitals in our analysis was .81 compared with the average CCR
for routine services of .96. Such combining into one cost center results
in a weighted average CCR that may undervalue routine services and
overvalue intensive care services. These estimates can systematically
influence DRGs that have a disproportionate amount of either intensive
care or routine services.

CMS's Proposed Cost-Based Approach for IPPS May Result in Improvements over the
                             OPPS Cost-Based Method

CMS is proposing an approach to set payment weights for inpatient DRGs
that appears promising, and may result in improvements in setting
cost-based weights compared with the OPPS method. The proposal involves
grouping charges into 10 broad service groups. The charges for each of the
10 service groups are converted to cost-based weights by using
national-average CCRs that correspond to each of the service groups. This
approach ameliorates the problems we observed with the OPPS method because
it does not require the application of hospital-specific CCRs, which,
using CMS's single method to match charges to cost, may not capture the
relevant cost-to-charge relationships for services. Using national-average
CCRs is intended to reduce the impact that variations in hospital charge
and cost allocation decisions can have on the DRG weights. Six of the
service groups, which constitute a majority of Medicare inpatient charges,
appear promising because their CCRs are relatively consistent within a
service group and are likely to capture the relevant cost-to-charge
relationship for the services included in these groups. An additional 2
groups contain cost center CCRs that range widely within their respective
groups and, therefore, raise concerns about their ability to better align
payment with costs for services in those groups. Finally, due to the
limitations of the MEDPAR data, we did not have enough information to
determine whether the 2 remaining service groups are likely to capture the
relevant cost-to-charge relationship for the services included in those
groups.

20The average mark-up for overall ancillary services was 194 percent of
the cost, and for anesthesia services the average mark-up was 525 percent.
These mark-ups were in addition to the cost and result in a charge that is
almost three times and six times the cost of services for all ancillary
and anesthesia services, respectively. For example, a hospital's cost for
an anesthesia service was $16. The hospital applied a mark-up of $84,
which is 525 percent of $16, resulting in a charge of $100.

National-Average CCRs Intended to Reduce Impact on IPPS Weights of Variation in
Hospital Charge and Cost Allocation Decisions

Under its proposed approach for the IPPS, CMS takes several steps to
create cost-based weights for each DRG. The approach entails grouping
charges from hospital's claims into 10 broad service groups.21 (See table
2.) CMS uses these service groups as a basis to create charge-based
weights by standardizing the charges in each group to remove differences
due to hospital-specific characteristics. To standardize the charges, CMS
calculates an average charge for each hospital for each of the 10 proposed
service groups. CMS then divides each individual hospital's charge for
each service by that hospital's average charge for the service group.
Ultimately, these standardized charges for all hospitals are aggregated by
DRG and the average charge for each DRG is divided by the national-average
charge for all cases. This yields 10 standardized, national charge-based
weights that correspond to each service group for each DRG. In order to
convert these charge-based weights to cost-based weights, charge mark-ups
must be removed. To accomplish this, CMS calculates 10 national-average
CCRs for each of the 10 broad service groups using hospitals' Medicare
cost report data. CMS then uses these CCRs to convert the national
charge-based weights to cost-based weights.22 The 10 cost-based weights
for each DRG are summed to produce one final weight for each DRG.

21In this report, we use the term service group to describe CMS's proposed
groups. In its Federal Register notice, CMS refers to these groups as cost
centers.

22It is possible that a particular DRG may have a zero value for one or
more of the 10 service groups. This can occur if hospitals do not provide
particular services as part of a DRG.

Table 2: CMS's Proposed Service Groups

                  Revenue centers from                                        
                  claims used to          Cost centers from Medicare cost     
CMS's proposed calculate relative      report used to calculate            
service group  charge weightsa         national-average CCRs
Routine        Private room            Adults & pediatrics                 
                  Semi-private room Ward  
Intensive      Intensive care Coronary Intensive care unit Coronary care   
                  care                    unit Burn intensive care unit       
                                          Surgical intensive care unit Other  
                                          special care unit                   
Drugs          Pharmacy                Drugs charged to patients           
                                          Intravenous therapy                 
Supplies &     Medical/surgical supply Medical supplies charged to         
Equipment      Durable medical         patients Durable medical equipment  
                  equipment Used durable  rented Durable medical equipment    
                  medical equipment       sold                                
Therapeutic    Physical therapy        Physical therapy Occupational       
Services       Occupational therapy    therapy Speech pathology            
                  Speech therapy          Respiratory therapy                 
                  Inhalation therapy      
Operating Room Operating room          Operating room Recovery room        
                  Anesthesia              Delivery and labor room             
                                          Anesthesiology                      
Cardiology     Cardiology              Electrocardiology                   
                                          Electroencephalography              
Laboratory     Laboratory              Laboratory Provider-based physician 
                                          clinical laboratory service         
Radiology      Radiology Magnetic      Radiology-diagnostic                
                  resonance imaging (MRI) Radiology-therapeutic Radioisotope  
                  Lithotripsy             
Other Services Ambulance Blood Blood   Ambulance Whole blood and packed    
                  administration          red blood cells Blood storing,      
                  Outpatient services     processing, and transporting Other  
                  Emergency room Clinic   outpatient services Ambulatory      
                  visit End-stage renal   surgical center (Non-distinct part) 
                  disease (ESRD) Other    Emergency Clinic Home program       
                  services                dialysis Renal dialysis Other       
                                          ancillary                           

Source: GAO analysis and 71 Fed. Reg. 23,996, 24,009-24,010 (April 25,
2006).

aData for the revenue centers are from the CMS MEDPAR file. MEDPAR pools
revenue centers into broad revenue center categories and reports total
charges by these categories. The revenue centers from MEDPAR are not a
one-to-one match with cost centers from the Medicare cost reports.

The proposed approach, which entails using national-average CCRs rather
than individual hospital CCRs, is intended to reduce the impact that
variations in hospital charge and cost allocation decisions can have on
DRG weights. Specifically, the national-average CCRs, in conjunction with
standardized charge-based weights, are more likely than the OPPS method
that entails using hospital-specific CCRs to capture the relevant
cost-to-charge relationships for the services in each group. In principle,
the national-average CCRs are applied to a group of services with similar
charge mark-ups. Similarly, the national-average CCRs will be influenced
by the most commonly used hospital allocation practices among hospitals
and are, therefore, less likely to be influenced by atypical hospital
allocation practices. Furthermore, because a national-average CCR is
established for each service group, the proposed approach eliminates the
need to use, or default to, a hospital's overall CCR when a particular
cost center CCR is not reported. For these reasons, CMS's proposed
approach to establishing cost-based weights for the purpose of better
aligning payments with costs for DRGs appears promising.

Service Group Approach Appears Promising but Some Concerns Exist

Because CMS's broad service group approach is integral to improved payment
accuracy, and because CMS is currently considering refinements to the
service groups for the fiscal year 2007 IPPS payments, we examined the 10
proposed service groups and their associated national-average CCRs.23 For
6 of the proposed service groups, which constitute a majority of Medicare
inpatient charges, the national-average CCRs appear promising, and are
likely to capture the relevant cost-to-charge relationships for the
services included in these groups. An additional 2 groups contain cost
center CCRs that range widely within their respective groups, and
therefore, raise concerns about their ability to better align payment with
costs for services in those groups. Due to the limitations of the MEDPAR
data, we did not have enough information to determine whether the 2
remaining service groups are likely to capture the relevant cost-to-charge
relationship for the services included in the groups.

23CMS's proposed service groups are based on its analysis of cost report
and claims data. Each group includes revenue center charges that, in total
for the group, represent at least 5 percent of all Medicare charges for
inpatient hospital services. The groups also include cost centers that,
CMS asserts, are consistent with general hospital accounting definitions.
To analyze the cost centers within the service groups, we used fiscal year
2003 Medicare cost report data for 3,558 hospitals paid under the IPPS in
order to conform to the same time period as the analysis CMS conducted for
its April 2006 notice of proposed rulemaking.

Six of the groups, which constitute approximately 63 percent of total
Medicare inpatient charges in 2003, appear promising since they either
contain cost center CCRs that are relatively consistent with one another
within a group, or contain individual cost center CCRs that vary from the
national-average CCRs, but the charges associated with those services
constitute a small percentage of total Medicare inpatient charges. For
example, one of these six groups-radiology-includes three cost center CCRs
that are relatively consistent with the radiology national-average CCR,
with a range of 7 percentage points between the highest and lowest CCR for
these three cost centers. This grouping produces a national-average CCR
that will not be unduly influenced by any one cost center CCR included in
the average. The other service groups that appear promising include
cardiology, routine, drugs, supplies & equipment, and other services.24

While six of the service groups that constitute a majority of Medicare
inpatient charges appear promising, two other groups, therapeutic services
and operating room, raise concerns because they contain cost center CCRs
that vary widely and involve services that can be linked to high-volume
DRGs. The national-average CCR for these service groups may not capture
the appropriate cost-to-charge relationships for certain services in those
groups and could undermine the goal of better aligning payments with costs
for those services. Table 3 illustrates this problem for one of the
groups, therapeutic services, where the difference between the lowest and
highest cost center CCR is 26 percentage points. The cost center CCR for
respiratory therapy is substantially lower than the other cost center CCRs
included in this group.25 Respiratory therapy is used to treat respiratory
diseases classified under DRG 088-chronic obstructive pulmonary disease
(COPD)26-Medicare's fourth most frequently billed DRG. In 2003, hospitals
billed Medicare approximately $1.4 billion for respiratory therapy
services provided under DRG 088. This amount accounted for 17 percent of
the total ancillary service charges and 11 percent of the total charges
for DRG 088, which were $12 billion. The other therapy services in the
group accounted for approximately 1 percent of the DRG's total charges.

24The supplies & equipment and other services groups include cost center
CCRs that range widely from the national-average CCR for their groups;
however, the charges associated with those services constitute
approximately 1 percent of total Medicare charges and, therefore, are not
likely to have an impact on the DRG weights that include those services.

25Respiratory therapy is also referred to as inhalation therapy.

26COPD refers to chronic lung disorders that result in blocked air flow in
the lungs. The two main COPD disorders are emphysema and chronic
bronchitis, the most common causes of respiratory failure.

Cost centers included                        CMS-proposed national-average 
in the therapeutic    GAO-calculated cost     CCR for therapeutic services 
services group                center CCRs                            group 
Physical therapy                      .52                                  
Occupational therapy                  .44               .35
Speech pathology                      .53 
Respiratory therapy                   .27 

Table 3: Proposed Therapeutic Services Group: Cost Centers and CCRs

Source: GAO analysis based on fiscal year 2003 Medicare cost report data
and 71 Fed. Reg. 24,021 (April 25, 2006).

Our analysis of hospitals' fiscal year 2003 Medicare cost report data
showed that, on average, for the 3,558 hospitals paid under the IPPS that
we reviewed, the CCR for respiratory therapy is .27. The use of the
national-average CCR would result in a weight that would undervalue
physical, occupational, and speech therapy services. Conversely, the use
of the national-average CCR in this instance would result in an estimate
that overvalues respiratory therapy services. Because these services
account for 17 percent of all ancillary charges for DRG 088, the
application of the national-average CCR will result in a weight that would
be based on an overstated cost estimate. This is a problem because the
overstated cost estimate for this service is a significant portion of a
high-volume DRG.

Similarly, the operating room service group may not capture the
appropriate cost-to-charge relationships for certain services. The
services contained within this group can be linked to DRGs that involve
surgery, and those DRGs constitute almost half of the number of IPPS DRGs.
The group contains CCRs for operating room and anesthesia, which are .38
and .17, respectively. CMS's proposed national-average CCR for this
service group is .37. The use of the national-average CCR would result in
a weight that would overvalue anesthesia services. In its comment on the
CMS proposed approach, MedPAC noted problems with the therapeutic services
and the operating room service groups.27

27MedPAC correspondence to CMS, June 12, 2006.

Finally, the remaining two groups-intensive and laboratory-include cost
center CCRs that also vary widely. However, using the MEDPAR data that CMS
uses to construct the IPPS rates, we could not assess the charges
associated with those services because they cannot be separately
identified. Without such information, we could not determine the volume of
specific services provided under these groups and, therefore, we could not
assess the potential impact on the DRG weights.

                            Concluding Observations

Policy analysts have for decades suggested that replacing charge-based
with cost-based weights would improve the accuracy of the weights to
measure relative costliness for hospital inpatient DRGs. Our findings
suggest that the CMS approach of using national-average CCRs to develop
cost-based weights for inpatient DRGs appears promising because it
addresses the concerns associated with charges that are currently used to
weight DRGs. The proposed approach improves the OPPS method of estimating
costs because the OPPS uses a single method to map hospital-specific CCRs
to charges. That method does not reflect the effects that variation in
hospital charge and cost allocation decisions can have on the DRG weights.

The national-average CCRs for the service groups are critical to the goal
of better aligning payments with costs for DRGs. As CMS is considering
refining its service group categories, we note that two of the groups,
therapeutic services and operating room, contain cost center CCRs that
range widely and raise concerns about its ability to better align payment
with costs for services in those groups. This issue notwithstanding, we
found that most of the proposed service groups, which represent a majority
of the Medicare inpatient charges, are likely to capture the relevant
cost-to-charge relationship for the services included in these groups.

            Agency and External Reviewer Comments and Our Evaluation

We received written comments on a draft of this report from CMS (see app.
II). We also received oral comments from representatives from two hospital
associations, the AHA and the AAMC.

CMS Comments

In commenting on a draft of this report, CMS stated that it was pleased
with our findings. CMS also stated that it could not comment further
because it is currently considering public comments in developing the
fiscal year 2007 final rule for the IPPS payment rates.

Hospital Association Comments and Our Evaluation

Representatives from both AHA and AAMC acknowledged the problems inherent
in matching charges from claims to cost information on hospitals' cost
reports due to the differences in the ways in which hospitals report these
data. The AHA representatives specifically noted that the problems with
cost estimation due to hospital reporting variation we describe in this
report parallels what AHA has found in its own analysis. AHA
representatives also agreed that the differences in which hospitals
allocate their charges and costs, and the cost estimates that result,
could potentially affect DRG relative weights.

AHA representatives stated, however, that we should more prominently
discuss the issues of using cost report data to set the relative weights.
Specifically, they stated that we should better emphasize that CMS's
proposed national-average CCRs are based on cost report data that could
still present problems as a result of hospital reporting variation.

As we stated in the draft report, the only data sources available to CMS
to set the DRG weights are hospital Medicare cost report and claims.
Medicare cost report data reflect hospital reporting variation because CMS
allows hospitals the flexibility to report charges and costs in a manner
that is consistent with each hospital's accounting system and
organizational structure. Our conclusion that the proposed approach
appears promising is based on our assessment that, given that cost report
and claims are the only data available, CMS's approach in using these data
to set DRG weights, that is, using national-average CCRs with standardized
charge-based weights, can ameliorate the effects of differences in
hospital reporting.

Representatives from both organizations also were concerned about the
overall message of the report that the CMS approach appears promising. The
AHA representatives stated that although the proposed approach could
address some issues associated with using cost report data, they also
noted that we did not test the validity of the proposed approach. The AAMC
representatives also questioned our overall message given some of the
concerns we noted in the report with the national service groups. In
particular, AAMC stated that although we found that the service groups
accounting for 63 percent of total inpatient charges appear promising,
they believed that the remaining 37 percent was a substantial percentage.

Testing the validity of CMS's proposed approach was beyond the scope of
our work. However, we believe that the report presents a balanced view of
the CMS approach, given our findings on hospital reporting variation and
its effects on cost estimation. As noted in the draft report, we found
that 6 of the 10 service groups that represent 63 percent of Medicare
inpatient charges are promising because the cost center CCRs within each
service group are relatively consistent. As a result, the proposed
national-average CCRs for these 6 groups are likely to capture the
relevant cost-to-charge relationships for the services within these
groups. However, we also noted in the draft report that we have concerns
about the ability of 2 of the service groups to better align payment with
costs, and that we did not have enough information to evaluate the 2
remaining service groups.

Additionally, we received technical comments from the two associations,
which we incorporated as appropriate.

We are sending a copy of this report to the Administrator of CMS. We will
also provide copies to others on request. The report is available online
at no charge on GAO's Web site at http://www.gao.gov .

If you or your staff have any questions, please contact me at (202)
512-7101 or [email protected] . Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this report. GAO staff who made major contributions to this report are
listed in appendix III.

A. Bruce Steinwald Director, Health Care

List of Committees

The Honorable Charles E. Grassley Chairman The Honorable Max Baucus
Ranking Minority Member Committee on Finance United States Senate

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

The Honorable Nancy Johnson Chairman The Honorable Pete Stark Ranking
Minority Member Subcommittee on Health Committee on Ways and Means House
of Representatives

Appendix I: Scope and Methodology

This appendix identifies data sources used for our analyses and summarizes
our methods.

                                  Data Sources

We used data from Medicare Provider Analysis and Review (MEDPAR)-the
Centers for Medicare & Medicaid Services' (CMS) database for compiling and
maintaining hospitals' Medicare claims-from 2001, 2002, and 2003. A MEDPAR
record represents one distinct stay, and contains patient and hospital
identifiers and diagnosis and procedure codes based on the International
Classification of Diseases, 9th Revision, Clinical Modification
(ICD-9-CM). CMS uses MEDPAR for rate-setting purposes under the inpatient
hospital prospective payment system (IPPS).

We also used fiscal year 2002 and 2003 hospital Medicare cost report data
that individual hospitals are required to submit annually to Medicare as
compiled in CMS's Healthcare Cost Reporting Information System (HCRIS)
database. HCRIS is constructed by CMS based on the Medicare cost reports
submitted to the fiscal intermediaries. Each hospital defines its own
fiscal year-the only requirement is that the beginning date of the
hospital fiscal year must fall within the federal fiscal year (October 1
through September 30). There is a time lag of up to 2 years before the
data are complete for all hospitals.

Hospitals report total costs and total charges by cost center on their
Medicare cost reports. They have the discretion to use as many or as few
cost centers on the cost report as they choose. Beyond the more general
cost centers, hospitals have the ability to report more detailed
information, referred to as subscripts, for specific services. For
example, a hospital may report data for the cardiology cost center, and
additional data for a subscript of cardiology, called cardiac
catheterization. In the HCRIS database, the cost center data reflect the
sum of the subscripted data. This level of detail is similar to the manner
in which service-level data are available in the MEDPAR file.

To assess the reliability of the MEDPAR and HCRIS data, we reviewed
existing documentation related to the data quality control procedures and
electronically tested the data to identify obvious problems with accuracy.
We determined that the data were sufficiently reliable for the purposes of
this report. Further, because we chose to estimate costs using only those
hospitals that most consistently reported charges and stays between their
claims and their Medicare cost report, we could then assess the validity
of our cost estimates relative to the aggregate Medicare costs these
hospitals reported on their Medicare cost reports. Because our cost
estimation analysis was conducted on a subset of hospitals in fiscal year
2002, the results are not generalizable to the hospitals in fiscal year
2002 whose total charges and number of stays from their Medicare cost
reports and claims did not match within .3 percent.

                                    Methods

To examine the applicability of CMS's current cost-based method used to
set weights in the outpatient prospective payment system (OPPS) to weight
diagnosis-related groups (DRG) in the inpatient prospective payment system
(IPPS), we first identified 3,660 short-term, acute hospitals that were
paid under IPPS and submitted fiscal year 2002 data to CMS. A hospital's
fiscal year 2002 could start anytime from October 1, 2001, through
September 30, 2002. As a result, the cost reports contain charges and
estimated costs for services provided to Medicare beneficiaries in 2001,
2002, and 2003. For this reason, we used MEDPAR and Medicare cost reports
to match claims from 2001, 2002 and 2003 to each hospital's fiscal year
2002 Medicare cost report. Using approximately 12 million MEDPAR records
and HCRIS data from 3,660 hospitals, we aggregated charges and stays from
the MEDPAR claims file for each hospital in our universe. We compared the
aggregate charges and stays from MEDPAR with the charges and number of
stays reported on each hospital's Medicare cost report. We used fiscal
year 2002 data because these were the most recent, complete Medicare cost
report data available when we began our analysis in October 2004.

From this analysis, we identified 1,025 hospitals whose Medicare cost
report charges and number of stays matched within .3 percent. We looked at
the distribution of hospitals matching aggregate charges and stays ranging
from .1 percent to 1 percent as reported in Medicare cost reports and
claims. We chose .3 percent (1,025 hospitals), because it represented over
a quarter of the total IPPS hospitals and included at least 25 hospitals
for each hospital type (e.g., teaching, urban, for-profit). The 1,025
hospitals have a distribution across types of hospitals similar to the
population of IPPS hospitals. We assumed these 1,025 hospitals had the
most consistent cost information available to perform our cost analysis.

To estimate costs for inpatient services for each of the 1,025 hospitals,
we applied the cost estimation method that CMS uses in the outpatient
hospital setting; that is, we used individual cost center CCRs based on
each hospital's Medicare cost report data to convert charges to costs.
Similar to what CMS does for estimating costs for outpatient services, we
developed a mapping method to match revenue centers to cost centers to
determine which CCR to use to estimate costs for the 1,025 hospitals
included in our analysis. For example, we mapped the radiology revenue
center charges to the radiology cost center. In cases where revenue
centers and cost centers did not directly correspond, we used the
hospital's overall ancillary CCR to estimate costs, with the following
exceptions. If a hospital billed for speech, occupational or physical
therapy charges, but did not include a matching cost center on its cost
report for those services, we used another therapy cost center CCR to
estimate costs. For example, if a hospital billed for physical therapy but
did not have a matching cost center, we used the speech therapy cost
center CCR. In addition, if a hospital's cost report did not include a DME
cost center but the claims showed DME revenue center charges, we applied
the hospital's overall supply CCR to estimate costs.

We multiplied the cost center CCR from the hospital Medicare cost report
to each charge for each claim. Subsequently, for each of the 1,025
hospitals we summed our cost estimates for accommodation and ancillary
services separately and then compared these aggregate cost estimates to
what hospitals reported as their costs for these services on their
Medicare cost reports. From this analysis, we calculated the percentage of
hospitals where our estimates were, on average, either more or less than
what the hospitals reported for ancillary and accommodation services
separately. After comparing our cost estimates to what the hospitals
reported on their Medicare cost report, we examined hospital reporting
methods, that is, we identified the cost centers to which hospitals
reported their charges and compared these charges to how hospitals
reported these services on their claims. For example, while a hospital may
record $1,500 in physical therapy charges on its claims, it may record
these physical therapy charges in the occupational therapy cost center on
its cost report. This practice is in keeping with the discretion CMS
affords hospitals in how they accumulate and report charges and costs.

To examine whether CMS's proposed approach for the IPPS is an improvement
over its OPPS method for setting cost-based weights, we estimated costs
for fiscal year 2002 using the OPPS method, and reviewed CMS's April 2006
notice of proposed rulemaking.1 In particular, we identified potential
problems in applying the OPPS cost-based method to the IPPS and determined
whether CMS's proposed approach would ameliorate those problems. We
evaluated CMS's proposal to use national-average CCRs to derive cost-based
weights. We used data from 3,558 hospitals paid under the IPPS that
submitted a fiscal year 2003 Medicare cost report. We used fiscal year
2003 Medicare cost reports in order to conform to the same time period as
the analysis CMS conducted for its April 2006 notice of proposed
rulemaking. We calculated CCRs for each of the cost centers that are
included in CMS's 10 proposed service groups.2 We determined whether the
service groups appear promising based on the extent to which cost center
CCRs contained within each group varied. Additionally, using 2003 claims
data, we analyzed the proportion of service group charges to determine
whether the service groups appear promising in capturing cost-to-charge
relationships for the respective services in each group.

1We did not examine the extent to which the OPPS method measures relative
costliness for outpatient services.

2The 10 proposed service groups are routine, intensive, drugs, supplies &
equipment, therapeutic services, operating room, cardiology, laboratory,
radiology, and other services.

Appendix II: Comments from the Centers for Medicare & Medicaid Services
Appendix II: Comments from the Centers for Medicare & Medicaid Services

Appendix III: GAOA Appendix III: GAO Contact and Staff Acknowledgments

                                  GAO Contact

A. Bruce Steinwald, (202) 512-7101 or [email protected]

                                Acknowledgments

In addition to the contact above, Maria Martino, Assistant Director,
Shamonda Braithwaite, Melanie Anne Egorin, Hannah Fein, Nora Hoban, Julian
Klazkin, Daniel Lee, and Eric Wedum made key contributions to this report.

(290379)

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Highlights of GAO-06-880 , a report to congressional committees

July 2006

MEDICARE

CMS's Proposed Approach to Set Hospital Inpatient Payments Appears
Promising

Under Medicare's inpatient

prospective payment system (IPPS), hospitals generally receive fixed
payments for hospital stays based on diagnosis-related groups (DRG), a
system that classifies stays by patient diagnosis and procedures. CMS is
required to at least annually update DRG payments to address changes in
the cost of inpatient care. CMS uses charge-based weights to update these
payments. Cost-based weights are used to set payments in the outpatient
prospective payment system (OPPS). The Medicare Prescription Drug,
Improvement, and Modernization Act of 2003 required GAO to study IPPS
payments in relation to costs. During the course of GAO's work, CMS
proposed a new cost-based method for determining DRG weights. This report
(1) examines the applicability of CMS's cost-based method-used for the
OPPS-to weight DRGs in the IPPS and (2) evaluates whether CMS's proposed
approach is an improvement over its OPPS method for setting cost-based
weights. Using fiscal year 2002 cost reports and claims from 2001, 2002,
and 2003 to examine the applicability of the OPPS method, GAO estimated
costs for 1,025 IPPS hospitals whose Medicare cost reports most
consistently reflected the total charges and number of Medicare stays that
these hospitals reported on their claims. To evaluate CMS's proposed
approach, GAO analyzed fiscal year 2003 cost reports and 2003 claims for
3,558 hospitals.

If the OPPS method were applied to the IPPS, it could undermine the
objective of better aligning DRG payment weights with actual costs. GAO
estimated costs for 1,025 hospitals using CMS's cost-based OPPS weighting
method to determine its applicability for weighting inpatient DRGs,  and
found that, for all but one of the 1,025 hospitals, GAO's application of
CMS's OPPS method resulted in cost estimates for inpatient accommodation
services that on average were 72 percent less than what the hospitals
reported on their Medicare cost reports for these services. For 57 percent
of the hospitals, GAO's application of CMS's OPPS method resulted in cost
estimates for inpatient ancillary services that on average were 8 percent
more than what the hospitals reported on their Medicare cost reports. For
22 percent of the hospitals, the application of CMS's OPPS method resulted
in cost estimates for inpatient ancillary services that were on average 6
percent less than what the hospitals reported on their Medicare cost
reports. These differences occur because the current OPPS weighting method
does not address the variation in how hospitals allocate charges and costs
in reporting Medicare services.

GAO found that CMS's proposed new approach to set payment weights for DRGs
appears promising, and may result in improvements in setting cost-based
weights compared with the OPPS method. CMS's proposed approach relies on
grouping charges into 10 broad service groups, and converting those
charges to cost-based weights by using national-average cost-to-charge
ratios (CCR) that are derived from hospital data submitted to CMS. Use of
national-average CCRs ameliorates the effects that variations in hospital
charge and cost allocation decisions can have on DRG weights. GAO's
analysis, using 2003 claims data and fiscal year 2003 cost report data for
3,558 IPPS hospitals, suggests that 6 of the service groups, which
constitute a majority of Medicare inpatient charges, appear promising. GAO
also found that wide ranges in the CCRs for 2 of the groups, the
therapeutic services and operating room groups, raise concerns about their
ability to better align payment with costs for those services. GAO did not
have enough specific information to determine whether the remaining 2
groups are likely to capture the relevant cost-to-charge relationship for
services in those groups.

In commenting on a draft of this report, CMS stated that it was pleased
with GAO's findings. CMS also stated that it could not comment further
because it is currently considering public comments in developing the
fiscal year 2007 final rule for the IPPS payment rates. Hospital
association reviewers agreed that cost estimation problems can result
because of hospital reporting variation. However, they noted that because
hospital reporting variation still affects the data CMS is proposing to
use to set DRG weights, they were concerned with GAO's assessment that the
CMS approach is promising. GAO believes the approach appears promising, in
particular, because CMS proposes to use national-average CCRs to reduce
the impact of individual hospital reporting practices.
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