In PYA’s ongoing Medicare Payment Primer Series, we will next broach the topic of cost-based reimbursement, which we will break down into four parts. The first part (#3a in our series) defines the term “cost” as used in the Medicare reimbursement context. The term has many definitions and applications depending on the purpose for determining cost. For example, when any physical item is purchased, the established purchase price is the cost to the purchaser; however, the seller’s cost is likely different. There are many types of costs including economic, opportunity, and sunk.
Defining cost under Medicare reimbursement principles can be challenging. To understand cost, and therefore cost reimbursement, it is better to begin with what is not cost as Medicare defines it.
Here are some examples. Medicare cost is NOT:
Charges
In the ordinary course of business, a charge refers to the listed price of an item or service. This is often described as the sticker price, manufacturer’s suggested retail price, or rack rate. The reality is that in almost every situation, the ultimate consumer of the good or service does not pay the sticker price. In healthcare, and particularly within the Medicare context, there are few, limited exceptions where charges form the basis of payment.
Under the principles of reimbursement, “charges” are specifically defined as: The regular rates established by the provider for services rendered to beneficiaries and to other paying patients. Charges should be related consistently to the cost of the services and uniformly applied to all patients whether inpatient or outpatient. [PRM-I, Section 2302.6]
Expenses
Expenses represent the money or outlay businesses incur to generate revenue. Under traditional cost and financial accounting, expenses can be either fixed, variable, or periodic. Expenses are often categorized within natural expense classifications such as salaries, benefits, supplies, administrative, depreciation, amortization, and interest. Any of these items individually do not constitute cost; rather, elements of all expenses define the cost of a good or service. Just because one or several elements can be identified does not establish that cost has been defined. Cost can only be defined or established when all of the elements required to produce a good or service are known and can be systematically and rationally allocated to a particular unit of service. In the context of Medicare reimbursement cost-finding principles, the unit of service is a patient day or a ratio of total cost to total charges applied to the individual charges for a particular item or service.
Reimbursement
The reimbursement a provider or supplier of services receives may be the cost the payer incurs; however, that is not the payer’s full cost because the payer also has administrative costs not reflected in the payments to the providers/suppliers. Similarly, even when reimbursement is based on cost, the providers/suppliers are incurring costs beyond the payment due to regulatory and payment formulas.
For example, critical access hospitals are reimbursed by Medicare based on reasonable cost, with Medicare’s share of allowable costs assigned under the cost allocation and apportionment process. Even this reimbursement may be adjusted by patient deductibles, coinsurance, and in some instances, sequestration. Sequestration is a statutory reduction in payments, currently between 1% and 2% of the net reimbursement, depending on the applicable time frame.
Discussion
Medicare defines cost in a specific manner, and Medicare cost includes the following characteristics:
All-Inclusive (Sum of All Expenses)
In the context of Medicare cost finding and principles of cost reimbursement, allowable costs include all types of expenses a provider may incur in the ordinary course of business. These may include salaries, benefits, supplies, depreciation, interest, and other reasonable patient care costs. They are Medicare-specific terms of art. “Reasonable” and “related to patient care” are outlined in the Provider Reimbursement Manual [CMS Pub 15-1] and the regulations governing Medicare reasonable cost reimbursement [42 CFR 413.5]. These provisions and regulations create guardrails to define allowable costs, which are the real foundation of cost-based reimbursement.
The methodology by which Medicare shares in a provider’s cost is described below:
- Usually Expressed as a Unit Cost Measure: Once cost is determined, it’s often expressed on a per-unit basis. This provides for comparability between fiscal periods and across organizations.
- Per Diem: Cost per day is often captured at the facility level (total costs divided by total patient days) or applied to specific payers such as Medicare (Medicare cost divided by Medicare days). Even facilities not reimbursed based on cost will track per-diem costs to determine if a particular patient encounter has a positive contribution. When such per diems are calculated, close attention should be given to accounting for overhead costs (generally fully fixed costs) and the impact of outpatient services on overall cost per diems. Organizations can adjust the per-diem calculations by dividing the calculated per diem by the ratio of inpatient revenue to total revenue. “Adjusted cost per day” is commonly used within the healthcare industry. In the Medicare context, interim payment rates for certain types of facilities and other types of reimbursable costs are expressed as a per diem and are either paid as an adjustment to the per diem or handled via a biweekly payment mechanism.
- Per Case: While certain private payers may pay a flat rate per case, the more typical scenario, including payments made by Medicare under various inpatient prospective payment systems, is that there are several facility-specific and case-specific adjustments necessary to arrive at the final payment amount. The per-case costs will not correlate to case-based reimbursement. Like per-diem costs, per-case calculations can also be adjusted to account for the impact of outpatient services.
- Per Visit: Per-visit cost calculations are primarily used for outpatient services, including physician visits, outpatient encounters, and home health visits. Since all of these are subject to unique episodic payment mechanisms for the type of services rendered by the provider and delivered to the patient, it is likely that the reimbursement for the encounter will not directly correlate to the per-visit cost incurred by the renderer of the service.
Different Than Management Cost Accounting Methods
Management cost accounting may view fixed and variable costs differently than the way allowable cost is determined under Medicare reimbursement principles. Management cost accounting methods may use different approaches for determining the cost of a particular item or service. Medicare relies on uniformly applying a cost-finding formula to all services provided within a hospital. This methodology is defined through the cost reporting instructions for each type of reporting entity [CMS Publication 15-2]. Management cost accounting methods may rely on expenses reported on either a cash or accrual basis and may or may not follow generally accepted accounting principles (GAAP). The determination of costs under Medicare involves the application of program regulations and manual instructions that may also be different than GAAP methods.
- Medicare “Reasonable Cost”: Reasonable cost includes all necessary and proper costs incurred in rendering the services, subject to principles relating to specific items of revenue and cost [PRM-I, Chapter 21, Section 2100]. The reasonable costs of any services are determined in accordance with regulations establishing the method or methods to be used, and the items to be included. Reasonable cost considers both direct and indirect costs of providers of services, including normal standby costs. The objective is that under the methods of determining costs, the costs for individuals covered by the program are not borne by others not so covered, and the costs for individuals not so covered are not borne by the program [PRM-I, Chapter 21, Section 2102.1]. Embedded in the concept of reasonable cost is that the costs are related to patient care. These include all necessary and proper costs that are appropriate and helpful in developing and maintaining the operation of patient care facilities and activities. Necessary and proper costs related to patient care are usually costs that are common and accepted occurrences in the field of the provider’s activity. They include personnel costs, administrative costs, costs of employee pension plans, normal standby costs, and others. Allowability of costs is subject to the regulations prescribing the treatment of specific items under the Medicare program [PRM-I, Chapter 21, Section 2102.2].
Established by Medicare Law, Regulations, and Cost Report Instructions
The Medicare Act defines “reasonable cost” in Section 1861(v). The Provider Reimbursement Manual [CMS Pub 15-1] provides guidance related to the determination of a variety of allowable costs. The Provider Reimbursement Manual [CMS Pub 15-2] provides instructions for completing cost reports in accordance with the other levels of guidance.
In Place and Evolving Over the Life of Medicare Program
When Medicare began, most guidance followed the then-current accounting standards and practices adopted from the insurance industry. As the program matured, it became clear that additional guidance would be required to ensure the protection of Medicare program assets and achieve consistent reporting across all providers.
For example, as providers began using more complex financing arrangements, instructions were added to the manual to offer guidance on the proper Medicare accounting treatment. Similarly, as the payment methodology moved from full-cost reimbursement to various prospective payment systems, additional guidance was required to address how certain types of costs should be handled for cost-reporting purposes.
Does Not Always Follow Financial Accounting Guidelines
Accounting standards provide a basis for fairly reporting the financial position of an organization as of a point in time and are designed so that financial information for various types of organizations and industries is reported as comparably as possible.
Reporting financial information is not the same purpose as using financial information to determine allowable and reimbursable costs as a basis for retroactive and prospective reimbursement. This significant difference requires the Medicare program to implement manual guidance and regulations reflective of the way providers operate, and can generally apply to most providers.
Resources
Related Insights in our Medicare Payment Primer Series cover:
- The mechanics of cost reimbursement (Part 3b)
- Provider types and components (Part 3c)
- Other areas dependent on cost report ratios and processes (Part 3d)
If you have questions about any matter related to reimbursement, strategy and transactions, compliance, or valuation, one of our executive contacts would be happy to assist. You may email them below, or call (800) 270-9629.
