Medicare Inpatient Prospective Payment System (IPPS) – 40 years later and future outlook

Nov. 13, 2023 / By Chet Stroyny

I recently learned that 2023 is the 40-year anniversary of the implementation of the Medicare hospital IPPS. I have been asked to share some reflections on this historic change to the Medicare program, what led up to it and how it has worked. Medicare was passed into law along with Medicaid in 1965. As I shared in a past blog interview, these historic programs provided insurance coverage for the elderly and disabled (after 1972) and low-income individuals who may have previously been without health insurance coverage.  

President Lyndon B. Johnson signed the Medicare and Medicaid Act, also known as the Social Security Amendments of 1965, into law in Independence, Mo., on July 30, 1965, at the Truman Presidential Library. Former President Harry S. Truman was an honored guest at the ceremony. He wanted to honor his early efforts to establish a national health insurance program. The Medicare program began July 1, 1966, and Medicaid began Jan. 1, 1966. If you have the opportunity to visit the Centers for Medicare & Medicaid Services (CMS) headquarters in Baltimore (the Federal agency who administers Medicare and Medicaid), they have pictures of the historic signing ceremony in the lobby. It is worth a visit.

A bit of background 

As with many new federal programs, Medicare and Medicaid had their growing pains. Initially, Medicare had basically two parts: Part A, hospital, nursing home and home health agency coverage, and Part B, physician medical services, some drugs, durable medical equipment (DME) and prosthetics.  

The legislation directed that Medicare Part A was to be administered by fiscal intermediaries; insurance companies like Blue Cross plans or commercial insurance companies (Travelers, Aetna and others), who had experience in the private sector insurance market. The Blue Cross Association (BCA) in Chicago was awarded the prime Part A contract and it had its local BC plans process claims in individual states. Hospitals, nursing homes and home health agencies had the option of selecting a Blue Cross plan, a commercial insurance company or sending claims directly to the Bureau of Health Insurance intermediary in Baltimore (The Division of Direct Reimbursement).  

Part B claims processing was to be administered by companies who were licensed as an insurance company (Blue Shield or commercial insurance companies). These companies were awarded and signed federal contracts at the outset of the program and were provided detailed contract specifications by the Social Security Bureau of Health Insurance (BHI) as to how they were to administer the respective programs. These insurance company entities were now considered federal contractors. 

Medicare Part A: Hospital reimbursement 

Today, I want to focus on the implementation of Medicare Part A hospital reimbursement and what led to the adoption of IPPS in 1983. Specifically, I want to focus on how hospitals used to be reimbursed and why the change occurred in 1983 when Medicare Severity Diagnostic Related Groups (MS-DRGs) were implemented. As with any health care program, the cost of the program is important, particularly for a federal insurance program like Medicare, which is financed by taxpayer dollars. The program has to be financed and rising costs were of major concern to the administration, Congress and the taxpayers they represent. 

The growth of Medicare hospital inpatient costs was significant during the period 1967 to 1983. There were 19.5 million enrollees in 1967 compared to 31.1 million in 1985. The Medicare inpatient hospital system costs grew significantly from $3 billion in 1967 (a partial year since Medicare coverage began July 1, 1966)-to $37 billion in 1982. 

The original Medicare legislation, regulations and policies reimbursed inpatient acute hospital services on a retrospective cost reimbursement basis. The Part A fiscal intermediaries were provided specific guidance on what were considered “reasonable costs” for each inpatient stay. Hospitals were reimbursed on an interim basis based on historical costs. Final reimbursement was settled when each hospital filed its final cost report to the fiscal intermediary at year end. This involved a reconciliation performed by the fiscal intermediary for “allowable costs,” with a hospital receiving additional reimbursement or having to repay an overpayment.  

The Part A fiscal intermediaries performed individual claims review as well as a “utilization review.” Hospitals could appeal claims that were disallowed. However, there was no incentive for a hospital to discharge a patient since they were being reimbursed for “costs.” I recall a personal example when my mother-in-law fractured her hip before DRGs were implemented. She was kept in the hospital for at least four weeks even though she was in good spirits and could play cards with other patients! There was no incentive to the hospital to discharge her.   

During the Reagan Administration in the 1980s, rising Medicare costs were of major concern to the administration and Congress. Medicare Part A is financed in part from a portion of the FICA taxes that workers pay into the Hospital Insurance Trust Fund. The administration and congress were very concerned about the long-term sustainability of the Medicare program, since the Fund was projected to be depleted unless something was done.  

A political fix was worked out between President Reagan and Congressman Dan Rostenkowski who chaired the House Ways and Means Committee. The policy changes were included in the Social Security Amendments of 1983. Among these were changes to coverage and other reimbursement policies which guaranteed the fiscal stability of the Medicare program. 

One of the most significant changes was to reform acute inpatient hospital reimbursement from the inefficient cost reimbursement system to the IPPS, which provides for fixed payments based on the patient’s diagnosis. Under the DRG system, hospitals were reimbursed a specific amount based on the patient’s medical diagnoses. More complex procedures received higher reimbursement. Hospitals now had an incentive to be more efficient because hospitals that were efficient earned more. Provisions were made for outlier payments for unusual medical circumstances. Patients would be discharged once they no longer needed acute care. Many discharges were to a skilled nursing facility or to a patient’s home where they could receive home health services.  

In my opinion, the DRG system caused hospitals to be more efficient and linked the financial and medical aspects of a patient’s care. It has proven to be a lifeline for the Medicare program. As Kevin Quinn noted at the 30th anniversary of DRGs, DRGs have come to define “the product of a hospital for purpose of risk adjusting and benchmarking. Medicare costs slowed and hospitals recorded record profits. The acceptance of DRG algorithms owes much to their categorical approach, clinical focus, and transparency.”  

The DRG system has proven to be sustainable and continues to this day, with a majority of Medicaid agencies adopting MS-DRGs or 3M™ All Patient Refined DRGs. To safeguard and allay concerns about premature discharges, Congress created the Peer Review Organization (PRO program) to review cases where a beneficiary felt they were discharged too soon. 

Future outlook for the hospital insurance trust fund 

The current administration and Congress are again faced with addressing the long-term sustainability of the Hospital Insurance Trust fund, as CMS’ actuaries have projected the fund will be depleted by 2032 under current law. Up until now the solution has been to “kick the can down the road” so to speak, but it will have to be addressed sooner rather than later. It will take political capital but also leadership, as was shown by the bipartisan deal struck between President Reagan and Congressman Rostenkowski. Medicare beneficiaries have a safety net due to the foresight of the researchers at Yale University and everyone who helped develop the pilot DRG program and the system which became the present MS DRG patient classification system.  

Chet Stroyny, consultant at 3M Health Information Systems.