When the Medicare program for hospitals was authorized in 1965 it originally reflected the structure of the traditional indemnity insurance models that it was based on, and was also required to reimburse hospitals on a “reasonable cost” basis.

This payment model criticized by many who believe that it rewarded volume of care, thereby creating financial incentives for unnecessary care, and did not control medical costs, which were quickly escalating Indeed, during the period from 1966-1982, the Medicare program experienced rapid cost growth, averaging close to 19 percent per year.

In 1983, to counter the high cost and volume growth within the Medicare system, the Health Care Financing Authority (HCFA, which in 2001 was renamed the Centers for Medicare & Medicaid Services, or CMS) used authority granted it by Congress to implement a “prospective payment system,” for inpatient and care, under which hospitals would receive payment for services in the form of a payment bundle, the value of which was established on a nationwide cost of care for each service, and adjusted for geographic variation in the cost of labor. This system became the inpatient prospective payment system (IPPS). In 1997 the agency received authority to create an outpatient prospective payment system (OPPS) outpatient services on or after January 1, 2000. Both systems pay for hospital services in bundles which were originally intended to reflect the cost of care for an “efficient” provider. The payment bundle for the IPPS is referred to as the Diagnosis-Related Group (DRG) payment, and the Ambulatory Payment Classification (APC) payment in the OPPS.

Both of these prospective payments contain various enhancements for additional costs. Hospitals which treat a disproportionate share of low-income and governmentally-covered patients are given a disproportionate share (DSH) adjustment to their payment, hospitals with teaching programs are given an adjustment for graduate medical education (GME), and individual cases are given enhancements over their basic computed DRG amount based on the presence of a qualifying comorbidity or complication (CC). For individual cases with costs that greatly exceed the DRG amount, Medicare will pay an additional payment called an “outlier” payment.

In subsequent years, HCFA/CMS has instituted prospective payment systems for most other institutional providers, including inpatient psychiatric hospitals, skilled nursing facilities, ambulatory surgery centers, inpatient rehabilitation facilities, and long term care hospitals.