PYA Covid-19 Information Hub
Medicare Payment Primers: The Fundamentals of Prospective Payment Systems
Published October 13, 2022

Medicare Payment Primers: The Fundamentals of Prospective Payment Systems

Under a prospective payment system, payments are made based on a predetermined, fixed rate. Medicare pays for covered facility services under several unique prospective payment systems.

Different payment systems exist for:

  • Inpatient acute hospitals.
  • Outpatient hospital services.
  • Inpatient rehabilitation sub-provider units and free-standing rehabilitation hospitals.
  • Inpatient behavioral medicine sub-provider units and free-standing behavioral medicine hospitals.
  • Long-term acute care hospitals.
  • Skilled nursing facilities or distinct part units.
  • Home health agencies.
  • Hospice

Each of these prospective payment systems is:

  • Established by Medicare over the last 40+ years to standardize payment amounts and processes.
  • Designed to reduce costs, or at least minimally reduce the rate of growth in program expenditures.
  • Composed of unique payment characteristics and base payment unit.
  • Widely adopted by Medicaid and commercial payers and managed care organizations.

As many facility-based services are paid through a prospective payment system under the Medicare program, it is important to first understand the purpose and fundamentals of the payment methodology before looking at payments for individual types of providers.

The goal of a prospective payment system is to incentivize facilities to:

  • Improve productivity.
  • Use less expensive inputs where possible, while maintaining patient safety and quality.
  • Influence physicians to reduce the length of stay, limit the volume of services provided, and use a less expensive mix of services to treat patients.
  • Adopt cost-reducing technologies, while avoiding those that increase costs.

The common components of a prospective payment system are:

  • Base payment rate per defined patient encounter.
  • Facility-specific adjustments:
    • Differences in area wages.
    • Urban vs. rural setting.
    • Teaching status.
    • Volume of low-income patients.
  • Patient/case-specific adjustments:
    • Intensity of services (case-mix index).
    • Excessive case costs (outliers).
    • Partial treatment (transfers and “short-stays”).


Base Rate

All prospective payment system methodologies start with a base payment amount. Although called different things for different facility programs, the base rate is the monetary starting point for all providers.

The base rate is applied to all facility services included in the patient encounter. Examples of encounter types include patient days, discharges, episodes of care, and various bundled services. This amount is adjusted annually (either calendar or federal fiscal year) based on the change in costs from year-to-year (called the “market basket update”), and further adjusted for changes in productivity and behavioral adjustments. The payment amount also includes facility- and patient/case-specific adjustments, not all of which are applicable to each of the payment systems.

Future articles in this series will explore the various prospective payment systems by facility type.

Facility-Specific Adjustments

Differences in Area Wages: All Medicare facilities are classified into geographic areas based on their physical location. The area wage index measures the relative level of hourly wages in a labor market to the national average hourly wage. Wage index data includes salaries, benefits, and contract labor reported in annual Medicare cost reports submitted by hospitals and other provider types. For wage index purposes, wages include salaries, contract labor, and employee benefits. The portion of the total base rate adjusted by the area wage index depends on a hospital’s location and other classifications.

The wage index is based on historical data, which leads to its “circularity.” Low-wage providers have a lower payment rate (labor share of the base rate times a low-wage index); therefore, wages tend to stay below the national average. Different types of facilities located within the same geographic area may be subject to different wage indices because each of the prospective payment systems uses different wage index calculations.

Urban vs Rural Setting: Certain prospective payment systems include increased or add-on payments for services provided in a rural setting. Hospitals located in rural areas may also be eligible for payment adjustments due to specific classifications established by Medicare. Examples include rural referral centers, sole community hospitals, and Medicare-dependent hospitals.

Teaching Status: Some payment systems include payment adjustments to those facilities that operate approved graduate medical education residency training programs. These added payments are intended to reflect the additional indirect costs for patient care associated with the training of residents and are commonly known as the “indirect medical education (IME)” adjustment. These payments are separate from reimbursement received for the actual costs of operating an approved residency program. These IME costs are treated as an add-on to the acute inpatient hospital, psychiatric facility, and rehabilitation facility for qualifying facilities.

Volume of Low-Income Patients: Certain prospective payment systems are adjusted for those providers with high volumes (disproportionate share) of low-income patients. These additional payments are intended to partially offset lost revenues and incremental costs associated with furnishing uncompensated care and treating patients who may present at the hospital with limited “pre-hospital” care.

Paying for Value: Certain prospective payment systems adjust provider-specific payments based on quality of care—paying for value. Measures across the various programs include readmissions, hospital-acquired conditions, patient satisfaction, and spending per Medicare beneficiary.

Patient/Case-Specific Adjustments

Intensity of Services: Each prospective payment system involves a methodology for categorizing patients into similar groups. Patient classification provides categorization of patients who are similar clinically and in terms of resource use. This grouping is often based on diagnosis but can also be accomplished through the time spent with patients or other measures of intensity.

Excessive Case Cost: Many prospective payment systems include an add-on payment for extremely costly cases—costs exceeding a threshold above typical case costs. These are commonly referred to as “outliers.”

Partial Treatment: In instances where the full duration of care is not provided at the initiating facility, the provider could see an adjustment in payment to account for the reduction in expected services calculated in the determination of the base rate. Under the inpatient prospective payment system, these situations result in “transfer payment adjustments.”

This Insight is part of our Medicare Payment Primers Series. If you would like additional information about prospective payment systems and reimbursement, or have questions about any matter related to 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.

Executive Contacts

Interested in Learning More?

Sign Up for Our Insights, Including COVID-19 Bulletins!

    Select Your Subscriptions