Introducing competition and price transparency into the Medicare payment system

November 1st, 2017 / By Richard Averill, MS, Richard Fuller, MS

Would an Amazon-like price shopping experience for individual healthcare services help control healthcare costs? Price transparency is frequently cited as a possible strategy for reducing the cost of healthcare because it would allow consumers to shop for individual healthcare services based on price and thereby foster price competition. If patients are given meaningful, easily understood prices for individual healthcare services, will they choose providers based on price? If patients are informed consumers, balancing the quality of care with the cost of care, will price transparency prove to be an effective cost control strategy? The Medicare Inpatient Prospective Payment System (IPPS) can offer a means of testing and answering these questions.

In today’s health insurance market, price transparency induces enrollees to join or switch health plans in large part based on relative premium levels. It is much less clear, however, whether price transparency at the point of use level (e.g., selection of a hospital for elective surgery) can be effective. Price shopping at the point of use requires a transparent price for each unit of service along with the willingness of patients to use prices to both shop across providers and to select a provider based on relative price. Real unit of service price transparency in healthcare is a difficult challenge requiring:

  • Identification of comparable units of service, which often requires bundling or unbundling of services
  • Adjustments for the patient’s clinical condition since the same service may cost more in a sicker patient (cholecystectomy for a patient with multiple chronic diseases, for example)
  • Prices available in advance so patients can shop
  • Safeguards against price collusion and/or coordination in the commercial insurance market to avoid potential antitrust issues

There is no strong evidence that price at the individual unit service level (as opposed to the insurance premium level) is a strong factor in patient selection of a provider. A belief that “it costs more so the quality must be better” is a difficult bias to overcome. Despite this lack of evidence, there have been bills introduced in Congress such as H.R.5547 the ‘‘Health Care Price Transparency Promotion Act of 2016,’’ which focused on price transparency for hospital charges. One of the bill’s requirements was that research be done on the types of price information that would be useful to consumers for “making decisions about where, when and from whom to receive care.” Except for hospital stays, most healthcare services are reported using Current Procedural Terminology (CPT) codes, which are used to determine payment. There are 10,170 CPT codes and each CPT code can have up to four modifiers, essentially creating a limitless number of unique CPT code-modifier combinations. Requiring and disseminating transparent prices from every physician, hospital, ambulatory surgery center, imaging center, etc. for every CPT code-modifier combination would be an enormously complex task.

Before attempting to create complex price transparency requirements, there should be a comprehensive test of whether patients can be induced to price shop.  The Medicare DRG based Inpatient Prospective Payment System (IPPS) provides an ideal system to test whether consumers (Medicare beneficiaries) will take price as expressed in the form of a discount into consideration when selecting a hospital. The Medicare IPPS uses inpatient discharges categorized by Diagnosis Related Groups (DRGs) as the basic unit of payment. Based on the patient’s diagnosis, procedures, age, and sex, the DRGs assign each patient to a single, mutually exclusive and clinically coherent group of patients who are expected to consume similar amounts and types of hospital resources. A single prospective price for all services rendered during the hospitalization (similar to a market price in that it is exogenous and fixed) is established for each DRG thereby creating the financial incentive for hospitals to provide care efficiently. As noted in the 1982 HHS Report to Congress establishing the Medicare IPPS, the objective of IPPS was “to set a reasonable price for a known product” (Schweiker, 1982).   

Since actual treatment costs of patients in a DRG vary across hospitals and significant economies of scale exist (i.e. beds need to be filled), the opportunity for price competition among hospitals exists. DRG prices could be in part competitively established by allowing hospitals to discount the standard DRG price. To be effective these discounts need to provide a benefit to both the hospital (e.g., an increase in patient volume) and to the beneficiary (e.g., lower deductible). The 1982 HHS IPPS Report to Congress recognized that some form of competitive pricing should be considered in IPPS.

“Competitive bidding is not an approach that can be implemented quickly. . . However, this price setting mechanism remains a long-range possibility.” 1982 HHS Report to Congress

Under the current Medicare IPPS, a hospital is not permitted to discount the DRG payment amount to attract patients. Thus, price is not a consideration in a Medicare beneficiary’s selection of a hospital. The practical effect of this policy is to eliminate opportunities for price competition among hospitals for Medicare beneficiaries.

DRGs provide a clearly described product and price for hospital services and can be a natural basis for introducing competition into IPPS (Kalison, Averill, 1986). IPPS could be modified to allow hospitals to provide a discount to the DRG rates in order to attract additional Medicare patient volume, thereby creating a competitive IPPS. With over capacity in many hospital markets and an increasing focus on filling available beds, the opportunity to compete for additional Medicare patient volume could be an attractive option for hospitals.

How would it work? Hospitals that want to provide a discount would submit a discount schedule to Medicare at the beginning of each fiscal year. The discount schedule would be expressed as a percent discount from the hospital’s actual DRG payment rate. A hospital’s DRG payment amount includes adjustments for factors such as teaching status and disproportionate share. These adjustment factors represent legitimate costs of doing business and result in higher DRG payments to some hospitals. By expressing the discounts as a percent discount of the applicable DRG payment amount, teaching hospitals and disproportionate share hospitals are not put at an inherent competitive disadvantage. (Goldfield, Fuller, 2014) Since relative pricing information would be expressed in terms of an easy to understand discount level, there would be clear and unbiased price transparency across hospitals. In addition, the DRG inherently adjusts for the patient’s clinical condition, so this impact on service cost is automatically taken into consideration.

The discounts would remain in effect for the entire fiscal year. In subsequent years, a hospital would be able to increase, decrease, or entirely eliminate its Medicare discounts. Whether to offer discounts and the level of the discount would be at the discretion of the hospital. Discounts could apply only to specific types of patients (DRGs), such as those needing cardiac surgery, or they could be applied across the board.

For discounts to be effective, Medicare beneficiaries must be informed of the availability of the discounts and must share in the financial benefits. Savings generated from the selection of a discounted hospital could be shared between Medicare and the beneficiary, for example, on a 50-50 basis. For a beneficiary, the savings would be put into a health saving account (HSA) that the beneficiary could use to pay deductibles, coinsurance, Part B premium or D premium. Unless the financial benefit is shared, there would be no incentive for the beneficiary to select hospitals with discounts.

To ensure that beneficiaries are aware of the availability of price discounts, physicians would be required to inform patients being admitted for non-emergency services that hospital discounts exist in the patient’s general geographic area using an information sheet provided by CMS, in a manner similar to patients being informed of their confidentiality rights under HIPAA. The obligation to help patients seek price information has already been initiated in some states (Massachusetts General Laws Chapter 111 Section 228). The CMS information sheet would list hospitals with a discount by clinical area, expressed as a dollar range payable to the beneficiary’s HSA (the exact dollar amount would not be known until the final DRG assignment at the time of discharge).

The discount could be made more attractive to the beneficiary by using the savings to automatically pay the beneficiary’s deductible with any remaining amount going into the beneficiary’s HSA, thereby avoiding any short-term out of pocket beneficiary payments. Assuming there are no Stark issues, physicians could also be given a small payment if the beneficiary selects a discounted hospital as compensation for their time encouraging the beneficiary to go to a discounted hospital. In addition, practical information on the quality performance of individual hospitals needs to be available to beneficiaries so they can be informed consumers, balancing quality and price in the selection of a hospital.

Assuming that some consumers will select hospitals based in part on price, the benefits of price discounting would be significant:

  • Efficient hospitals attract additional Medicare patient volume
  • Out-of-pocket costs to beneficiaries are reduced
  • Beneficiaries retain freedom of provider choice
  • Medicare expenditures are lowered
  • Teaching hospitals and disproportionate share hospitals are not put at an inherent competitive disadvantage; and
  • The impact of the patient’s clinical condition on service cost is automatically taken into consideration by the DRG assignment

Price discounting permits Medicare to incentivize beneficiaries to be active participants in the cost-containment process rather than passive parties to administrative cost control efforts. Because the DRG infrastructure is in place and the discount amounts for hospital care can be significant, a Medicare hospital discounting program can provide a real test of whether consumers (patients) will select hospitals based on price. If price discounting proves effective in only selective markets, it will be important to understand the competitive conditions in those markets. Given the extensive provider consolidation that has been occurring, there may no longer be any opportunity for price competition in certain areas which should be of concern to policy makers. Price discounting in the context of the Medicare DRG IPPS provides an ideal and straightforward means of testing whether price transparency can be an effective cost control strategy. If DRG price discounting does not prove to be effective, it is doubtful whether other efforts aimed at creating transparent prices will be successful.

Richard Averill is a principal at The Hesperium Group. He was formerly the senior vice president for Clinical and Economic Research at 3M Health Information Systems and continues to serve as senior healthcare policy advisor to the company.

Richard Fuller is an economist with 3M Clinical and Economic Research at 3M Health Information Systems


Schweiker, R. S. (1982, December). Hospital prospective payment for Medicare [Report to Congress]. Washington, DC: US Department of Health & Human Services.

Kalison, M., Averill, R. (1986). The challenge of “real” competition in Medicare. Health Affairs, 5(3), 47–57.

Goldfield, N., Fuller, R. (2014) We Need New Ways to Finance Hospital Externalities.

Massachusetts General Laws Chapter 111 Section 228