	Background

Under the Medicare inpatient PPS, hospitals receive a fixed,  predetermined payment for each hospital stay. The  combination of all these adjustments and additional payments may result  in widely varying per-stay payments across different types of hospitals or  geographic areas. Medicare Labor Cost Adjustment Does Not Adequately Account for Wage Differences within Certain Areas

The geographic areas that Medicare uses for the labor cost adjustment  include hospitals that pay wages that may be quite different from the  average wage in the entire geographic area. Other variation in average wages across the statewide nonmetropolitan  areas is associated with the type of community. Some of the hospitals that were reclassified in  2001 but that did not satisfy the standard wage criterion were part of  countywide reclassifications. Budget Neutrality Adjustments Are Relatively Modest, but Would Vary under a State-Specific Option

While geographic reclassification increases the labor cost adjustment, and  thus Medicare payments, to hospitals that reclassify, it does not raise total  Medicare outlays because any payment increases must be offset by an  across-the-board reduction to Medicare payments for all hospitals. If the  budget neutrality adjustment were calculated and applied on a state- specific basis, the payment reductions would be different in each state. A state-specific adjustment  would reduce payments less in states in which hospitals do not benefit as  much from geographic reclassification as the average. In 2002, Medicare payments to nonreclassified metropolitan hospitals  were about 1 percent lower due to the budget neutrality provision than  they would have been in the absence of any geographic reclassifications  (see table 5). Payments to nonreclassified nonmetropolitan hospitals were  about 0.6 percent lower. Effect of State-Specific Budget Neutrality Adjustment Would Depend on Benefits of Reclassification for State’s Hospitals

A state-specific adjustment would reduce payments less than a national  adjustment in states where reclassified hospitals account for a smaller  share of the state’s Medicare inpatient hospital spending than the national  average. Conclusions

Medicare’s PPS for inpatient services provides incentives to hospitals to  deliver care efficiently by allowing them to keep any difference between  their Medicare payments and their costs, and by making them responsible  for their costs that exceed Medicare payments. The adjustment  used to account for geographic differences in wages—the labor cost  adjustment—does not adequately account for these cost differences  because the geographic areas used to define labor markets are too large in  many instances. As a result, refinements are needed to address systematic  problems in defining hospital labor markets.
What GAO Found

The Medicare program's prospective payment system (PPS) for inpatient hospital services provides incentives for hospitals to operate efficiently by paying them a predetermined, fixed amount for each inpatient hospital stay regardless of the actual costs incurred in providing the care. Although the fixed amount is based on national average costs, actual per stay payments vary widely across hospitals, primarily because of two payment adjustments in the PPS. One adjustment accounts for cost differences across patients due to their care needs and the other accounts for the substantial variation in labor costs across the country. The Medicare program's labor cost adjustment may not adequately account for geographic differences in hospital wages because of problems with the definition of labor markets. The geographic areas used by Medicare to approximate hospital labor markets often encompass large areas in which hospitals in different parts of an area or different types of communities pay widely varying wages. Geographic reclassification does not systematically address inadequacies in the way the Medicare program defines geographic areas, although it allows some, but not all, hospitals that may be in distinct labor market and pay wages above the average in their area to receive a higher labor cost adjustment. Geographic reclassification reduces payments to hospitals that do not reclassify because of the budget neutrality requirement, and the amount of this reduction would vary across hospitals under a state-specific budget neutrality approach depending on their location. In 2002, payments to metropolitan hospitals that were not reclassified were 1 percent lower and payments to nonmetropolitan hospitals that were not reclassified were 0.6 percent lower because of geographic reclassification. If the budget neutrality provision were calculated and applied within individual states instead of nationally, the adjustment would be smaller in those states in which hospitals did not benefit much from reclassification and higher in states where a higher proportion of hospitals reclassified.