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THEME SET-UP: Big sky’s revenue sourCes

C H A P T E R 3

PAYING FOR HEALTH SERVICES

Big Sky Dermatology Specialists is a small group practice in Jackson, Wyoming. The city is located in the scenic Jackson Hole Valley and is a major gateway to the Grand Teton and Yellowstone National Parks. In addition, it is home to the world’s largest ball of barbed wire. (It is amazing what you learn when studying healthcare finance!)

Jen Latimer, a recent graduate of Idaho State University’s healthcare administration program, was just hired to be Big Sky’s practice manager. One of her first tasks was to review the group’s payer mix. (Payer mix is a listing of the individuals and organizations that pay for a provider’s services, along with each payer’s percentage of revenues.) After all, revenues are the first step (of many) needed to ensure the financial success of any business.

To understand Big Sky’s revenues more thoroughly, Jen focused on two questions. First, who are the payers? In other words, where does Big Sky’s revenue come from? Second, what methods do the payers use to determine the payment amount? By gaining an appreciation of the group’s revenues, Jen believed she could accurately judge the financial riskiness of the practice. Furthermore, she would

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C o p y r i g h t 2 0 1 8 . G a t e w a y t o H e a l t h c a r e M a n a g e m e n t .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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be able to identify possible steps toward increasing the practice’s revenues and reduce the riskiness associated with those revenues.

By the end of the chapter, you will have a better understanding of healthcare-provider revenue sources and how the specific payment method influences provider behavior. Spe- cifically, you, like Jen, will know more about how these issues affect Big Sky.

After studying this chapter, you will be able to do the following:

➤ List the key features of insurance.

➤ Describe the major types of third-party payers.

➤ Discuss, in general terms, the reimbursement methods used by third-party

payers, and the associated incentives and risks for providers.

➤ Explain how clinical and procedural coding affects reimbursement.

➤ Define the specific reimbursement methods used by Medicare.

➤ Describe the key features of healthcare reform.

LEARNING OBjECTIvES

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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 5 1

3.1 INTRODUCTION In most industries, the consumer of the product or service (1) has a choice among many suppliers, (2) can distinguish the quality of competing goods or services, (3) makes a (pre- sumably) rational decision regarding the purchase on the basis of quality and price, and (4) pays for the full cost of the purchase.

The provision of healthcare services does not follow this general model, as healthcare is delivered under unique circumstances. First, often only a few individuals or organizations provide a particular service. Second, judging the quality of competing providers is difficult, if not impossible. Third, the decision (or at least recommendation) on which provider to use for a particular service typically is not made by the consumer but rather by a physician or some other clinician. Fourth, the bulk of the payment to the provider is not normally made by the user (the patient) but by an insurer. Finally, for most individuals, the purchase of health insurance is paid for (or heavily subsidized) by employers or government agencies, so many patients are insulated from the true cost of healthcare services.

This highly unusual marketplace significantly influences the supply of and demand for healthcare services. To gain a better understanding of the unique payment mechanisms involved, we must examine the healthcare reimbursement system.

3.2 BASIC INSURANCE CONCEPTS Because insurance is the cornerstone of healthcare reimbursement, an appreciation of basic insurance concepts will help you better understand the marketplace for healthcare services.

A SIMPLE ILLUSTRATION

Assume that no health insurance exists and that you face only two medical outcomes in the coming year:

Outcome Probability Cost Stay healthy 0.99 $ 0 Get sick 0.01 50,000 1.00

What is your expected healthcare cost (in the statistical sense) for the coming year? To find the answer—$500—multiply the cost of each outcome by its probability of occur- rence and then sum the products:

Expected cost = (Probability of outcome 1 × Cost of outcome 1) + (Probability of outcome 2 × Cost of outcome 2)

= (0.99 × $0) + (0.01 × $50,000) = $0 + $500 = $500.

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Now, assume that everyone else faces the same medical outcomes and hence faces the same odds and costs associated with healthcare. Fur- thermore, assume that you, and everyone else, make $60,000 a year. With this salary, you can easily afford the $500 expected healthcare cost. The problem, however, is that no one’s actual cost will be $500. If you stay healthy, your cost will be zero; if you get sick, your cost will be $50,000, and this amount could force you, and most people who get sick, into personal bankruptcy, which is a ruin- ous event. (Do not forget that you have to pay all of your living expenses out of your $60,000 annual income in addition to any healthcare costs.)

Now, suppose an insurance policy that pays all of your healthcare costs for the coming year is available for $600.Would you take the policy, even though it costs $100 more than your “expected” healthcare costs?

Most people would, and do. Because individuals are risk averse (see “Critical Concept: Risk Aversion”), they are willing to pay $100 more than their expected benefit to eliminate the risk of financial ruin. In effect, policyholders are passing the costs associated with the risk of getting sick to the insurer who, as you will see, is spreading those costs over a large number of subscribers.

Would an insurer be willing to offer the policy for $600? If the insurer could sell enough policies, it would know its revenues and costs with some precision. For example, if the insurer sold a million policies, it would collect 1,000,000 × $600 = $600 million in health insurance premiums; pay out roughly 1,000,000 × $500 = $500 million in claims; and have about $100 million to cover administrative costs. It could provide a reserve in case claims are greater than predicted and make a profit. By writing a large number of policies, the financial risk inherent in medical costs can be spread over a large number of people, reducing the risk for the insurance company (and for each individual).

BASIC CHARACTERISTICS OF INSURANCE

The simple example discussed earlier illustrates why individuals seek health insurance and why insurance companies are formed to provide such insurance. Next, we will dig a little deeper into insurance basics.

Insurance typically has four distinct characteristics:

1. Pooling of losses. The pooling (sharing) of losses is the heart of insurance. Pooling means that losses are spread over a large group of individuals so that

Pooling

The spreading of

losses over a large

group of individuals (or

organizations).

CRITICAL CONCEPT Risk Aversion

Risk aversion is the tendency of individuals and businesses to

dislike financial risk. Risk-averse individuals and businesses

are motivated to use insurance and other techniques to protect

against risk. For example, a favorite tool to control risk is di-

versification, which in the context of revenues means lowering

risk by having different sources of income. By not depending

on one source—say, Medicare patients—a provider can reduce

the uncertainty (riskiness) of its revenue stream. Insurance

is another way to limit risk. Individuals buy insurance on the

houses they own to limit the consequences of calamitous

events, such as fires or hurricanes.

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C h a p t e r 3 : P a y i n g f o r H e a l t h S e r v i c e s 5 3

each individual realizes the average loss of the pool rather than the actual loss incurred. In addition, pooling involves the grouping of a large number of homogeneous exposure units (people or things having the same risk characteristics). Thus, pooling implies (a) the sharing of losses by the entire group and (b) the prediction of future losses with some accuracy based on the law of large numbers. (The law of large numbers implies that predicting outcomes is easier when many identical trials are involved. For example, if a coin is flipped only once, you do not know whether the results will be heads or tails. However, if the coin is flipped 1,000 times, the result will be very close to 500 heads and 500 tails. In other words, you cannot predict the results of a single toss with any confidence, but you can predict the aggregate results if you have a large pool of tosses.)

2. Payment only for random losses. A random loss is unforeseen and occurs as a result of chance. Insurance is based on the premise that payments are made only for losses that are random. We discuss the moral hazard problem, in which losses are not random, in a later section.

3. Risk transfer. An insurance plan almost always involves risk transfer. The sole exception to the element of risk transfer is self-insurance, whereby an individual or a business does not buy insurance. (Self-insurance is discussed in a later section.) Risk transfer means that the risk is shifted from the insured to the insurer, which typically is in a better financial position to pay the loss than is the insured because of the premiums collected. In addition, because of the law of large numbers, the insurance company is better able to predict its losses.

4. Indemnification. Indemnification is the reimbursement of the insured if a loss occurs. In the context of health insurance, indemnification occurs when the insurer pays, in whole or in part, the insured or the provider for the expenses related to an insured’s illness or injury.

In summary, we applied these four characteristics to our insurance example: (1) The losses are pooled across a million individuals, (2) the losses on each individual are random (unpredictable), (3) the risk of loss is passed to the insurance company, and (4) the insur- ance company pays for any losses.

REAL-WORLD PROBLEMS

Insurance works fine when the four basic characteristics are present. However, if any of these characteristics is violated, problems arise. The two most common problems are adverse selection and moral hazard.

Random loss

An unpredictable

loss, such as one that

results from a fire or

hurricane.

Risk transfer

The passing of risk

from one individual or

business to another

(usually an insurer).

Indemnification

The agreement to pay

for losses incurred by

another party.

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Adverse Selection

Adverse selection occurs because those individu- als and businesses likely to incur losses are more inclined to purchase insurance than are those less likely to incur losses (see “Critical Concept: Adverse Selection”). For example, an otherwise healthy individual without insurance who needs a costly surgical procedure is more apt to get health insurance if she can afford it, whereas an identi- cal individual without the threat of surgery is less likely. Similarly, consider the health insurance

purchase likelihood of a 20-year-old versus that of a 65-year-old. All else the same, the older individual, with much greater health risk because of age, will probably obtain insur- ance. (Individuals aged 65 or older consume, on average, more than three times the dollar amount of healthcare services that younger individuals do.)

If the tendency toward adverse selection goes unchecked, a disproportionate num- ber of sick people, or those most likely to become sick, will seek health insurance, causing the insurer to experience higher-than-expected claims. This increase in claims will trigger a premium increase, which worsens the problem, because healthier members of the plan will either pursue cheaper rates from another company (if available) or forgo insurance.

One way health insurers attempt to control adverse selection is by instituting underwriting provisions. Thus, smokers may be charged a higher premium than nonsmokers. Another way is by including preexisting condition clauses in contracts, although this strategy was disallowed by the passage of the Affordable Care Act in 2010. (A preexisting condition is a physical or mental condition of the insured individual that existed before the issuance of the policy.) A typical clause might state that preexisting conditions are not covered until the policy has been in force for some period—say, one or two years. Preexisting conditions present a true problem for the health insurance field because an important characteristic of insurance is randomness. If an individual has a preexisting condition, the insurer no longer bears random risk but rather assumes the role of payer for the treatment of a known condition.

Because insurers tend to avoid paying large predictable claims, the US Congress passed the Health Insurance Portability and Accountability Act (HIPAA) in 1996. Among other actions, HIPAA set national standards, which could be modified within limits by the states, regarding what provisions could be included in health insurance policies. For example, under a group health policy—say, one that covers employees of a furniture manu- facturer—coverage to individuals cannot be denied or limited, and employees cannot be required to pay more in premiums if they suffer from poor health.

HIPAA also limited insurers’ ability to impose preexisting condition clauses and how long they could delay before beginning coverage. It allowed time credit for preexisting condi- tions under one plan to be counted tow

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