Medicare Hospital Payments: Refinements Needed to Better Account for Geographic Differences in Wages

GAO-02-963 Published: Sep 30, 2002. Publicly Released: Sep 30, 2002.
Jump To:
Skip to Highlights

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.

Skip to Recommendations


Recommendations for Executive Action

Agency Affected Recommendation Status
Centers for Medicare & Medicaid Services To improve the adequacy of Medicare's labor cost adjustments, the Administrator of the Centers for Medicare and Medicaid Services should refine the geographic areas used to more accurately reflect the labor markets in which hospitals compete for employees and the geographic variation in hospitals' labor costs. This could include separating large towns in a state into their own labor market area and removing certain outlying counties in metropolitan statistical areas from the metropolitan geographic area if they exhibit wage costs that are significantly different from the rest of the metropolitan area.
Closed – Not Implemented
In 2003, OMB announced new standards for defining metropolitan and rural areas that recognized a new area category called Micropolitan areas, comprised of smaller cities and towns with a population count of between 10,000 and 50,000. The category of micropolitan area was considered but rejected by CMS for use in defining labor market areas for inpatient hospital reimbursement by Medicare. In its preamble to the FY 2005 final rule on inpatient hospital reimbursement, CMS explained that adding the micropolitan area definition would significantly impact the payments to many hospitals (both positively and negatively) in Micropolitan as well as other areas. According to their analysis, more hospitals would be negatively than positively affected. In addition, the new definitions would result in many metropolitan and Micropolitan areas having only one hospital in its area, which could lead to potential instability in the rates from year to year.

Full Report