A USFC research team published a study about disparities in the cost of healthcare. While I do completely appreciate that prices for healthcare are out of control and vary widely, no one has yet explained why costs can vary so widely between hospitals. Accordingly, this article is intended to fill in that gap. Clearly, I cannot be certain about all of the cause,s but I want to bring attention to the fact that there is much more to hospital charges than many people understand.
As a general rule, hospitals are paid by insurance companies in one of two ways depending on the hospitals’ contract with the insurance. The first is called “per diem” (per day) and the second is DRG (diagnosis related group). Per Diem contracts are generally associated with commercial insurance companies, whereas DRG billing is how payers such as Medicare pay a hospital.
In per diem billing, or billing to commercial insurance companies, the hospital is paid a flat fee for each day that a patient is in the hospital. The amount that the insurance pays depends on the patient’s acuity – how sick a patient is and what level of treatment that patient will require. This is usually linked directly to a location in the hospital. For example, a patient in a standard hospital bed (usually called “med/surg” referring to medical / surgical) will be paid less than a sicker patient in the ICU (intensive care unit). Each acuity level has a flat payment rate for each day a patient is in the hospital.
To make sure that hospitals are not upgrading patients unnecessarily to the higher paying acuity levels, the hospital must call the insurance every day to update the insurance about the patient’s condition. If the insurance does not agree with the patient’s acuity designation based on clinical facts, the insurance will refuse payment for every day with which they do not agree. Basically, hospitals have to fight hard to get payment and expensive clinical resources (nurses in case management) have to be dedicated to a daily insurance contact for every patient.
Here, you should start seeing a trend. First, the hospital is taking care of a patient. That costs money in salaries for the staff, equipment, etc. Next, the hospital has to pay even more money to staff a department of nurses who work to meet insurance requirements. Hmmm…I wonder why healthcare costs are high?
Then there is DRG billing, which refers to diagnosis related groups and is the form of payment used by Medicare and Medicaid primarily (though there are some commercial insurances who use it, too). Perhaps you have heard the term “perspective payment system”. If you didn’t know what that is – DRG is part of the perspective payment system. A DRG is a 3-digit code that looks like this – 123.
In DRG billing, patients are assigned to a diagnosis related group or a grouping of patients with related diagnosis. Each DRG has a value called a relative weight which is determined by the Federal Government and published in the Federal Register. This weight looks like this, for example – 0.623 – and each DRG has its own relative weight, an approximation of the resource consumption and costs associated with treating a patient belonging to that DRG.
That said, each hospital is given its own base payment rate. This is a dollar figure that is determined by Medicare/Medicaid and is influenced by many factors such as the size of the hospital’s low income population, whether other hospitals are nearby or far away, and so on. Every hospital has its own distinct base payment rate calculated according to many, many factors.
This is a very important fact.
For example, a base payment rate may be $3,000. To calculate the costs and payment for the patient, the relative weight is multiplied by the base payment. Using the numbers above, that gives us 0.632 x $3,000 = $1,896, which will be paid for the entire hospitalization.
In this example (which is using completely random numbers) a patient admitted to the hospital and assigned to DRG 123 will receive a flat payment rate of $1,896 regardless of actual resource consumption. The DRG method assumes that hospitals will be cost conscious and assign resources carefully as to make the most profit for each patient. To make sure that the hospitals don’t incorrectly assign patients to DRGs that have a higher weight to secure a higher payment, Medicare performs retrospective audits that require massive hospital staff resources to accommodate. These audits are called RAC audits.
So, in DRG billing the important fact here is that EVERY hospital has a different base payment rate and hospitals in different geographic locations may also have different relative weights. So, let’s compare how this concept applies to different hospitals and see what happens with charges (the numbers are completely fake for example purposes only).
Hospital A in New York City services an appendectomy
The hospital’s base rate is $5,333
The total payment: $12,447,22
Hospital B in Fargo, N.D. services an appendectomy
The relative weight may be 0.876
The hospital’s base rate is $2,756
The total payment: $2,414.25
The difference between NYC and North Dakota: $10,032.97
Do you see how this translates to different payment amounts to different hospitals and accordingly different charge amounts to accommodate those payments?
Here’s another important fact. Regardless of the amount a hospital charges –the insurance allowed amount is final! If the hospital charges more than the insurance allows – the hospital must adjust (write off) the remainder. If you think about it, the charges that many people complain about really don’t matter for people with insurance, because the payment and the patient responsibility is set by the insurance company’s allowed amount – not the hospital charges.
We must consider that it is generally the insurance companies that are driving hospital charges for both insured and uninsured patients, as hospitals abide by their insurance contracts and meet insurance requirements.
One last fact to know is that this post is a gross oversimplification of hospital-insurance contracts and payment schedules. There are many more factors that can increase hospital charges such as patients with complications or major complications and outliers. Still, I feel that this oversimplification does the job of showing the reader that we need to slow down and consider how complex the system is before accusing hospitals of wrong-doing based on charge amounts.
In a nutshell, hospital costs are largely driven by health insurance companies.