The Effect of the Medicare Prospective Payment System

Abstract

In 1965, the enabling legislation for the Medicare program mandated that hospitals be reimbursed for the reasonable costs they incurred in providing services to Medicare beneficiaries. During the first 15 years of the program, hospital payments (which make up about 71 % of all Medicare payments) increased at an annual rate of approximately 15.4% (94). Most of the increase in payments was due to the increasing costs of providing hospital services. The federal policy of retrospective cost reimbursement was an important factor contributing to that explosion in hospital costs (56, 61, 96). In response to the increase in program costs, in 1982 Congress passed the Tax Equity and Fiscal Responsibility Act (TEFRA), which made major changes in Medicare's hospital reimbursement policy. The two most impor­ tant features of this change were (a) a limit was placed on the allowable (reimburseable) rate of increase in the cost per hospital discharge, and (b) the concept of case-mix was incorporated into the reimbursement system. The following year, the Congress passed the Social Security Reform Act, which established a prospective payment system for hospitals under the Medicare program (PPS). The basic features of PPS are as follows: