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Hospital payment in the United States: An overview and discussion of current policy issues

Payment policy in the United States since the introduction of the Medicare Program for the elderly and disabled populations in the 1960s has been evolving from providing little incentive for hospitals to contain costs to its current form, which creates an enormous incentive for cost containment. The Diagnosis Related Group (DRG) system implemented by Medicare for hospital payment in 1983 is viewed favorably in terms of slowing cost escalation of inpatient care, while maintaining quality and access. DRG payments are not fully prospective, in that payments depend on procedures and outlier payments. Medicare spending on hospitals has grown significantly more slowly than spending on other types of services. Implementation has required periodic adjustments with refinements for new technologies, capital costs, and teaching. The main problems with DRG payments are their incentives to contain costs can be too strong, there are incentives for selection, and they may encourage substitution of outpatient for inpatient care without facilitating care management. Two alternatives to DRG payments to hospitals are a Mixed Payment System and Capitation. Under a mixed system hospitals are paid partially prospectively and partially on the basis of actual costs. This has certain desirable incentive properties in bringing prices more in line with marginal costs without setting them to zero as they are in a fully prospective system. With capitation, payments to providers are made monthly that reflect expected, not actual costs. They have been adopted as an alternative prospective payment mechanism by the Medicare and by many private insurers. Because payments are independent of whether any health services are actually provided, capitated payments create superior incentives for agents to manage all forms of medical care. Risk adjustment is necessary in order to create appropriate incentives for providers to enroll and treat all types of patients without encouraging selection. Although a variety of risk adjustment formulas are used in the United States, the most widely used rely on diagnostic information from medical claims to adjust payments. The US Medicare program started using one such system, based on Diagnostic Cost Groups (DCGs) in 2000 to pay its managed care plans.