HOPSITALS: Is there a built in profit in DRGs?

I got this random question and I didn’t know the answer, so I’m doing an “ask the audience” hoping that some geek smart on Medicare is reading.

Is there a pre-defined profit margin built into DRG payments when they are set? Obviously some DRGs are profitable and other less so, but does CMS set a defined rate for “profit” or “margin” within DRGs?

Please put your thoughts in the comments.

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5 replies »

  1. Has anyone heard about possible changes in the FY07 proposed Medicare inpatient rule, i.e. rebasing DRGs on costs instead of the current system of charges?

  2. Medicare payment rates are not intended to provide a profit margin, even though MedPac monitors hospital margins to assess payment adequacy. The goal of the inpatient and outpatient prospective payment systems is to reimburse hospitals for costs incurred in caring for Medicare patients. Since reimbursing hospitals retrospectively provided no incentive to control costs, Congress and CMS have developed systems designed to pre-determined rates based on the data reported by all participating hospitals on their cost reports. The inpatient DRG payment rates (not the weights) are based on average costs for providing inpatient care, and the outpatient APC rates are based on median costs for providing outpatient care. Ratios of cost to charge are established for each service area in the hospital (inpatient routine, ICU, ancillary services) and these ratios are then applied to Medicare charges to arrive at the Medicare portion of each hospital’s costs.
    There is a large body of regulation and law that determines which costs are included in the cost of providing patient care and which are not. For example, Medicare does not allow hospitals to include the cost of marketing and advertising, beyond the costs necessary to inform the community of its services (i.e., things like yellow page ads are ok, but billboards promoting the hospital are not). That’s why some people argue that Medicare costs aren’t “true” costs. They don’t include a lot of the expenses hospitals incur in the normal course of business, but they do include most of the costs directly related to providing patient care.
    It’s a fairly crude approach to cost accounting that has received its share of criticism, but no one seems to have devised a better methodology.

  3. Charges are never reflective of actual costs, except perhaps occasionally, by accident. This “Ratio of Cost to Charges” methodology imputes costs to cases through fantasy charges. It truly is amazing. Even more amazing, some hospitals try to manage internal operations by using RCC.
    The regression analysis takes costs from the cost report and charges both into account. There is a tie to overall costs, but what share of the overall costs is said to be associated with a particular case is allocated through charges.
    But Malay is quite right: there is no guarantee that the hospital makes money on a single case, a single DRG, all Medicare reimbursements, or at all. If they do not manage their costs about as well as the norm, they are more of less guaranteed to lose money with respect to Medicare.
    What is the “norm” takes into account region, hospital size, whether it is a teaching hospital, and other factors. So the game is not in theory rigged.

  4. A pre-defined margin would imply a “Cost-Plus” payment contract in which CMS would pay the hospital actual cost plus a margin or profit.
    The DRG system is a prospective payment system (PPS), it sets payments before any service is delivered and does not use the actual cost incurred by the hospital (except in the case where the charges are excessively high). Therefore, CMS cannot set a margin because they do not know how much the service will actually cost the hospital to deliver.
    The reason for using a PPS is to shift some of the risk for treating patients to the hospital. There can be no built in margin because each case is different. The goal is to manage each episode as well as possible to create a profitable payment.
    DRG weights are calculated through regression analysis of hospital charges. Since charges are not always reflective of actual cost, some DRGs become more profitable than others. CMS re-weights DRGs periodically to counteract these effects.
    Following the payment all the way through, the DRG weight is multiplied by a base payment which includes the standardized amount (labor and non-labor portion) and adjustments for wage index, graduate medical education, disproportionate share, etc.
    The standardized amount was originally set by hospital cost data from 1981 and gets an annual update factor from Congress based on inflation and cost-efficiency.

  5. As best I can tell, the answer to the question you pose is “no”.
    In the instructions for FORM HCFA-2552-92, you can see a methodology for computing something like “total equity capital employed” and then according to titles V and XIX, there is an allowable return on equity. In this sense, and with respect to that portion of their operations that takes care of Medicare patients, healthcare providers are regulated with respect to the return on equity measures as utilities (telephone, power, etc) are.
    So under this definition of “profit” (return on equity), then “profit” figures in to the Medicare cost reports, which eventually get used to compute at least the base for DRG reimbursements, which are then arbitrarily chopped by congress in order to balance the budget on the backs of providers rather than constituients who might vote them out of office. How very small-d democratic!
    Apparently, the base reimbursements imputed to the 450-odd DRGs are calculated through a regression technique based on case-mix and the medicare cost report. So there is no “profit” calculated per DRG, although they presumably make a return on equity on their overall case mix. Make sense?
    I’ll see what else I can find out.