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JOURNAL OF THE HISTORY OF MEDICINE AND ALLIED SCIENCES, Volume 62, Number 1
© The Author 2006. Published by Oxford University Press. All rights reserved.
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Advance Access publication on February 8, 2006 doi:10.1093/jhmas/jrj038
The Origins, Development, and Passage
of Medicare’s Revolutionary Prospective
Payment System
RICK MAYES*
A
BSTRACT. This article explains the origins, development, and passage of
the single most influential postwar innovation in medical financing: Medicare’s
prospective payment system (PPS). Inexorably rising medical inflation and
deep economic deterioration forced policymakers in the late 1970s to pur-
sue radical reform of Medicare to keep the program from insolvency.
Congress and the Reagan administration eventually turned to the one
alternative reimbursement system that analysts and academics had studied
more than any other and had even tested with apparent success in
New Jersey: prospective payment with diagnosis-related groups (DRGs).
Rather than simply reimbursing hospitals whatever costs they charged to treat
Medicare patients, the new model paid hospitals a predetermined, set rate
based on the patient’s diagnosis. The most significant change in health policy
since Medicare and Medicaid’s passage in 1965 went virtually unnoticed by the
general public. Nevertheless, the change was nothing short of revolutionary.
For the first time, the federal government gained the upper hand in its financial
relationship with the hospital industry. Medicare’s new prospective payment
system with DRGs triggered a shift in the balance of political and economic
power between the providers of medical care (hospitals and physicians) and
those who paid for it—power that providers had successfully accumulated
for more than half a century. K
EYWORDS: Medicare, prospective payment,
hospitals, diagnosis-related groups (DRGs), Social Security, Nixon, Carter,
Reagan.
* University of Richmond Department of Political Science, 28 Westhampton Way,
Richmond, VA 23173. Email: bmayes@richmond.edu.
JRL62(1).book Page 21 Thursday, November 16, 2006 12:26 PM
22 Journal of the History of Medicine : Vol. 62, January 2007
Medicare’s traditional model of cost reimbursement was insanity. On the face of
it, it encouraged people to do more; it paid them to do more and not in any par-
ticularly rational way. Going to prospective payment with DRGs, therefore, had
all the right things going for it politically and conceptually. . . .
—Sheila Burke, Chief of Staff
Former Senator Bob Dole (R-KS)
The CEO of one of the companies in my Federation, who shall remain nameless,
said to me, “The day this becomes law,” he told me this as the Medicare legislation
was going through in ’83, he said, “I’m selling the company the day this [prospective
payment] law passes.” I said, “Why?” He said, “Because you could be an idiot and
make a fortune on Medicare reimbursement. Any mistake you made you got
reimbursed.” I suppose that was true, but on the other hand if you want to do the
right thing and reward efficiency, then the law was good.
—Michael Bromberg, Former Executive Director
Federation of American Hospitals
HE 1970s marked a period of enormous change within the
American health care system. Rapidly increasing medical
inflation forced those who paid for patients’ care—employers
and the government—to begin pursuing limits on medical providers’
professional autonomy. They felt that they had no choice. Medicare’s
expenditures, in particular, were doubling at what was perceived as
an unsustainable rate of every five years, and employers’ health
insurance premiums were increasing by upwards of 15–20% a year.
1
“In a short time, American medicine seemed to pass from stubborn
shortages to irresponsible excess,” Paul Starr has noted. “Rising costs
brought medical care under more critical scrutiny, and the federal
government, as a major buyer of health services, intervened in
unprecedented ways.”
2
The assault by policymakers on the medical profession’s authority
took different forms and involved shifting tactics over the course of
the decade. It began with crude wage and price controls imposed by
President Richard Nixon in 1972 and included major changes
enacted by Congress to Social Security and Medicare, which placed
the first-ever limits on what hospitals could charge for Medicare
1. See Theodore Marmor, Political Analysis and American Medical Care (Cambridge:
Cambridge University Press, 1983), 61–75.
2. Paul Starr, The Social Transformation of American Medicine: The Rise of a Sovereign Profes-
sion and the Making of a Vast Industry (New York: Basic Books, 1982), 379.
T
JRL62(1).book Page 22 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 23
patients’ routine or “hotel” costs (room and board). Meanwhile,
innovative researchers at Yale and the University of Michigan pio-
neered new systems for measuring and categorizing what hospitals
actually did to patients and how much it cost them. For the first
time, policymakers could compare prices across different hospitals
for the same services. And when they did, they found significant and
inexplicable variation, which contributed to a stunning loss of confi-
dence in the ability of doctors and hospitals to regulate their own
affairs.
By the end of the decade, unrelenting medical inflation forced
President Jimmy Carter to subordinate his national health insurance
proposal to an ambitious plan for containing hospital costs. The goal
that had guided policymakers for years—to expand medical care and
insurance coverage—became eclipsed by (and then contingent on)
the urgent need to control health care costs.
THE PINNACLE OF MEDICAL PROVIDERS’ POWER
When the decade began, doctors and hospitals ruled American med-
icine. Their efforts at accumulating economic, professional, and
political power, dating back to at least the 1920s, had met with
extraordinary success. Even the first political “defeat” that the
American Medical Association (AMA) suffered—the passage of
Medicare and Medicaid in 1965—turned out to be to physicians’
and hospitals’ enormous financial benefit. With hospitals and physi-
cians in control of American medicine, those who paid the bills they
charged had little to no means of questioning either the legitimacy
or the necessity of the care that patients received. The not-for-profit
Blue Cross (hospital) and Blue Shield (physician) systems, along with
commercial insurers, essentially served as efficient payment opera-
tions. As such, they made the practice of medicine very lucrative.
The federal government had become deeply involved in expand-
ing the country’s health care system.
3
It built up the supply of
hospitals and doctors through increased funding of medical research
and federal subsidies for hospital construction. It also greatly
expanded the demand for, and access to, medical providers’ services
through Medicare and Medicaid. Medicare, in particular, strengthened
3. Lawrence Brown, Politics & Health Care Organization: HMOs as Federal Policy
(Washington, D.C.: The Brookings Institution, 1983), 12–13.
JRL62(1).book Page 23 Thursday, November 16, 2006 12:26 PM
24 Journal of the History of Medicine : Vol. 62, January 2007
doctors’ and hospitals’ power by paying them on a “customary, pre-
vailing, and reasonable” basis,
4
which was preceded by Blue Cross/
Blue Shield’s “usual, customary, and reasonable” system of reim-
bursement.
5
Medicare essentially adopted the same third-party, fee-for-
service reimbursement model developed by Blue Cross/Blue Shield,
and then incorporated them as “primary intermediaries” to perform
the bulk of Medicare’s day-to-day work of receiving bills from doctors
and hospitals and making payments to them.
6
Consequently, profes-
sional power was cemented through a reimbursement system that
neither imposed limits nor required outside approval. Instead, the
system “insulated the doctor-patient relationship from lay interfer-
ence, and preserved the physician’s right to untrammeled use of his
own and the hospital’s resources to resolve the patient’s medical
problem,” explains Jeff Goldsmith.
7
With medical providers in control of the health care system,
unrestricted cost reimbursement became the modus operandi for
financing American medical care. Moreover, demand on the
nation’s medical system increased, which resulted in skyrocketing
health care spending. When hospitals increased their costs, they
received more revenue and could expand their operations. If they
lowered their costs, they received less revenue and ran the risk of
falling behind their competitors. Thus there was no incentive what-
soever to lower costs.
8
William Hsiao, who later spearheaded the
development of Medicare’s fee schedule for physicians in the 1980s,
began his career in 1969 by examining hospitals for the Social Security
Administration (SSA). He remembers the hospital industry’s opposi-
tion to even adopting standard accounting procedures:
The first question I asked was: “Why do we pay hospitals 2 percent extra
on top of their costs?” The answer was that they had bad debts, that hospi-
tals had to grow, and so on and so forth. So I then asked: “Alright, how do
the hospitals calculate their costs?” And we discovered that there was no
uniform accounting system or anything close to it. . . . So I was deputized
4. Starr, The Social Transformation of American Medicine, 385.
5. Ibid.
6. See Herman Somers and Anne Somers, Medicare and the Hospitals: Issues and Prospects
(Washington, D.C.: The Brookings Institution, 1967), 32–34.
7. See Jeff Goldsmith, “Death of a Paradigm: The Challenge of Competition,” Health
Aff., 1984, 3, 5–19.
8. See George Whetsell, “The History and Evolution of Hospital Payment Systems:
How Did We Get Here?,” Nurs. Adm. Q., 1999, 23, 1–4.
JRL62(1).book Page 24 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 25
by the SSA to meet with the AHA’s leaders in Chicago and raise these issues
with them. . . . This eventually led me to Blue Cross, because the govern-
ment paid the hospitals based on what Blue Cross was paying on a cost-basis
to the hospitals. I came to realize that the AHA really did not know that
much and that the rules were set by Blue Cross. Although I and others
pushed, we could not make the hospitals adopt uniform accounting systems.
9
With little to no constraints, hospital costs soared. In retrospect,
“cost reimbursement was just stupid,” admits Michael Bromberg,
former Executive Director of the Federation of American Hospitals
(FAH), which represents the nation’s for-profit, investor-owned
hospitals. “I mean, it was just stupid. The Pentagon learned this les-
son; you don’t give people their costs, because you just give them an
incentive to spend more,”
10
which is what hospitals did. One result
was that Medicare’s financial health became a subject of intense
debate among leading policymakers.
MEDICARE’S COST PROBLEMS
Medicare spending increased dramatically following the program’s
implementation. Policymakers knew that Medicare lacked adequate
cost controls. Wilbur Cohen admitted as much when the program
passed: “The sponsors of Medicare, including myself, had to con-
cede in 1965 that there would be no real controls over hospitals and
physicians. I was required to promise before the final vote in the
Executive Session of the House Ways and Means Committee that
the Federal agency would exercise no control.”
11
The manner in which Congress inaugurated the program partly
explains why Medicare’s expenditures exploded so quickly.
12
Basi-
cally, it immediately “blanketed in” nineteen million beneficiaries on
1 July 1966, without any of them ever having paid into the program.
Medicare’s structure precluded it from experiencing a “grace” period
in which its trust funds could build up some measure of reserves from
annual surpluses.
13
Instead, Medicare began operation as a genuine
9. William Hsiao, oral history interview with the author, 22 October 2002.
10. Michael Bromberg, oral history interview with the author, 23 July 2002.
11. As quoted in Linda Demkovich, “Devising New Medicare Payment Plan May Prove
Easier than Selling It,” Natl. J., 1982, 14, 1981–85, 1981.
12. Rosemary Stevens, In Sickness and in Wealth: American Hospitals in the Twentieth
Century (Baltimore, Md.: Johns Hopkins University Press, 1998), 284–93.
13. Marian Gornick, Joan Warren, Paul Eggerset, et al., “Thirty Years of Medicare:
Impact on the Covered Population,” Health Care Financ. Rev., 1996, 18, 179–237, 184.
JRL62(1).book Page 25 Thursday, November 16, 2006 12:26 PM
26 Journal of the History of Medicine : Vol. 62, January 2007
“pay as you go” system, in which payroll tax revenues from workers
went (and continue to go) directly to providing Part A hospital bene-
fits for retirees.
14
Retirees’ monthly contributions helped finance Part B,
but over time they covered less and less of the program’s costs.
15
Medicare’s cost control problems were also the result of what
Theodore Marmor and Starr have both referred to as the program’s
“politics of accommodation.”
16
In attempting to gain the cooperation of
doctors and hospitals, the Social Security Administration’s approach to
running Medicare demonstrated three accommodating characteristics:
(1) a commitment to remaining primarily a distributor of popular entitle-
ment benefits; (2) a desire to avoid controversy and have operations run
smoothly; and (3) an effort to secure exclusive administration of Medi-
care.
17
The SSA’s strategy was eminently successful in getting Medicare
up and running, notes Judith Feder. “But in the process, maintaining the
compromises through which the goal was achieved became an end in
itself.”
18
One result of the SSA’s desire to have the medical community
embrace Medicare was that doctors’ “customary, prevailing and rea-
sonable” fees—the criteria on which the program based its reim-
bursement—rose precipitously. Young doctors began billing at
unprecedented levels, and the SSA paid them. When older doctors saw
the behavior of their younger associates, they too raised their fees.
19
While doctors’ demands became a major cause of Medicare’s prof-
ligacy, increased physician costs paled in comparison to those of hos-
pitals. “Medicare gave hospitals a license to spend,” according to
Rosemary Stevens. “The more expenditures they incurred, the more
income they received. Medicare tax funds flowed into hospitals in a
golden stream, more than doubling between 1970 and 1975, and
14. See Jonathan Oberlander, The Political Life of Medicare (Chicago: University of
Chicago Press, 2003), 74–106.
15. The monthly premiums of participating senior citizens contributed only 50% of Part
B’s total costs. Moreover, the elderly’s share of Part B’s costs had dropped to 25% by 1983,
because the increase in their premium rate was limited to the percent increase in OASI
benefits, which rose much more slowly than increases in medical costs.
16. Theodore Marmor, The Politics of Medicare, 2nd ed. (New York: Aldine de Gruyter,
2000), 96–99; Starr, The Social Transformation of American Medicine, 374–76.
17. Marmor, The Politics of Medicare, 374–77.
18. Judith Feder, “The Social Security Administration and Medicare: A Strategy of
Implementation,” in Toward a National Health Policy: Public Policy and the Control of Health-
Care Costs, ed. Kenneth Friedman and Stuart Rakoff (Lexington, Mass.: Lexington Books,
1977), 19. See also Judith Feder, Medicare: The Politics of Federal Hospital Insurance (Lexington,
Mass.: Lexington Books, 1977), 149.
19. Starr, The Social Transformation of American Medicine, 385.
JRL62(1).book Page 26 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 27
doubling again by 1980.”
20
Medicare’s formula for hospital reim-
bursement invited abuse because it operated on a “cost + 2% basis”
for all services. Since the 2% was a percentage of costs (and added by
Congress to reflect, among other things, the added nursing costs for
Medicare patients),
21
it amounted to an open-ended proposition by
offering hospitals a small bonus for each and every cost increase. So
while the Consumer Price Index increased 89% between 1966 and
1976, hospital costs grew a staggering 345%.
22
In effect, medical providers took advantage of the unique eco-
nomic dynamics surrounding medical care: although the occur-
rence of illness usually exists beyond one’s control, the demand for
care constitutes essentially a discretionary decision. Insurance against
the financial costs of health services, such as Medicare, allows the
consumption of those services to vastly increase.
23
Moreover, as
economist Kenneth Arrow famously demonstrated, patients are
uniquely and utterly dependent on physicians to make informed
decisions on their behalf due to the patients’ lack of medical knowl-
edge.
24
Therefore, if physicians decided that some form of medical
care was needed, it was promptly provided and paid for without
question by third-party insurers.
25
Because Medicare lacked sufficient financial restraint, cost esti-
mates soon fell glaringly short of initial predictions.
26
When Congress
20. Stevens, In Sickness and in Wealth, 284.
21. Email exchange with Clif Gaus, former Associate Administrator of Policy, Planning
& Research, HCFA, 11 February 2003.
22. Executive Office of the President’s Council on Wage and Price Stability Staff
Report, “The Rapid Rise of Hospital Costs” (Washington, D.C.: Government Printing
Office, 1977), 9–11.
23. For more information on these dynamics, see Martin Feldstein, Hospital Costs and
Health Insurance (Cambridge, Mass.: Harvard University Press, 1981), 176, 306. See also
Congressional Budget Office, “Expenditures for Health Care: Federal Programs and Their
Effects” (Washington, D.C.: Government Printing Office, 1977), 5; and Feder, Medicare:
The Politics of Federal Hospital Insurance, 143: “The Medicare law promised to pay for medi-
cal care for the elderly without interfering in its delivery. But this promise ignored a basic
economic fact: How care is paid for significantly influences the quantity and quality of care
delivered. Thus a payment program necessarily interferes in the practice of medicine. If an
agreement to pay for care has no strings attached, it removes any fiscal constraints on physi-
cians’ and hospitals’ development and delivery of medical services.”
24. See Peter Hammer, Deborah Haas-Wilson, Mark Peterson, William Sage, eds.,
Uncertain Times: Kenneth Arrow and the Changing Economics of Health Care (Durham, N.C.:
Duke University Press, 2003).
25. Ibid.
26. See Staff Report, “Medicare and Medicaid: Problems, Issues, and Alternatives,”
Senate Committee on Finance, 91st Congress, 1st Session (Feb. 1970), 4.
JRL62(1).book Page 27 Thursday, November 16, 2006 12:26 PM
28 Journal of the History of Medicine : Vol. 62, January 2007
passed Medicare in 1965, the House Ways and Means Committee
projected annual expenditures of $238 million. Assuming that 95% of
the elderly might enroll in Part B (this prediction proved accurate),
the committee estimated that, at most, total Medicare expenditures
would be $1.3 billion in 1967, the first full year of operation.
27
The
figure instead came in at $4.6 billion. The committee also predicted
hospital spending to be $3.1 billion for 1970 and $4.2 billion for
1975, with money left over in the hospital trust fund. Actual expen-
ditures were $7.1 billion and $15.6 billion, respectively.
28
Medicare
27. “Summary of Major Provisions of P.L. 89–97, the Social Security Amendments of
1965,” House Committee on Ways and Means, House of Representatives, 89th Congress, 1st
Session (Sept. 1965), part F, “Statistical Data,” 20–21. See also “Administration of Medicare
Cost-Saving Experiments,” Hearings before the Subcommittee on Oversight, Committee on Ways
and Means, House of Representatives, 94th Congress, 2nd Session (14–17 May 1976);
“History of the Rising Costs of the Medicare and Medicaid Programs and Attempts to
Control These Costs, 1966–1975,” Department of Health, Education, and Welfare
(Washington, D.C.: Government Printing Office, 1976).
28. Ibid.
Fig. 1. Medicare Enrollees and Expenditures, 1972–1982.
Source: Data from Centers for Medicare & Medicaid Services, Tables 3.5 and 3.6;
also found in Rick Mayes, Universal Coverage (Ann Arbor, Mich.: University o
f
Michigan Press, 2005), 113.
0
5
10
15
20
25
30
35
40
45
50
55
72 73 74 75 76 77 78 79 80 81 82
Year
enrollees (millions) $ expenditures (billions)
JRL62(1).book Page 28 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 29
spending was doubling every five years. Consequently, as Jonathan
Oberlander explains, Medicare “quickly acquired a reputation, as
chairman of the Senate Finance Committee Russell Long put it, as a
‘runaway program.’”
29
THE 1972 SOCIAL SECURITY AMENDMENTS
As more and more policymakers became concerned about Medi-
care’s finances, they began looking for ways to control the program’s
costs. The process began with an admission by some leading govern-
ment officials, who had championed the program and pushed for its
passage, that Medicare’s design was inherently inflationary. Toward
the end of his service as Social Security Administrator in 1972,
Robert Ball stated that Medicare had “simply accepted the going
system of the delivery of care” by modeling its reimbursement pat-
terns on Blue Cross plans for hospitals and private insurance policies
for doctors. Seven years after Medicare’s passage, he argued, atti-
tudes had significantly changed. The public was beginning to favor
reforms in the basic system of health care financing and looked to
Medicare “to help provide the leverage to bring about change.”
According to Ball, “the program no longer received criticism for
interfering too much in the health care system but rather for inter-
fering too little.”
30
Policymakers’ initial efforts to control Medicare’s cost growth
culminated in Section 223 of the 1972 Social Security Amendments.
Stuart Altman, President Nixon’s key health care policy advisor,
explains the legislation’s background and intent:
Now that’s a fascinating piece of legislation, because it’s a combination of
half cost controls and half expanded spending. It included new Medicare
coverage for “end stage renal” patients, the disabled, nursing homes, and
so on. But it also included Section 223, which said that even though
Medicare is obligated to pay for whatever a hospital’s costs are in treating
Medicare beneficiaries, there are certain costs that can be deemed “unrea-
sonable.” There was a lot of controversy over what was “unreasonable.”
But ultimately what they implemented were limits that differentiated two
29. Jonathan Oberlander, “Medicare: The End of Consensus,” paper presented at the
Annual Meeting of the American Political Science Association, Boston, Mass. (3–6 Sept.
1998), 4.
30. Edward Berkowitz, Robert Ball (Madison, Wisc.: University of Wisconsin Press,
2004), 205.
JRL62(1).book Page 29 Thursday, November 16, 2006 12:26 PM
30 Journal of the History of Medicine : Vol. 62, January 2007
kinds of hospital costs: (a) routine and (b) ancillary. The argument was that
if a cost was ancillary and if it was related to how sick the patient was or if
it was new technology, then Medicare should and would pay for it. But if
the cost was routine, then there should be limits to it.
31
In short, Section 223 attempted to define what allowable costs were
and then constrain the variability in these costs across hospitals.
32
Or,
as James Mongan, a senior health policy advisor to President Carter,
put it: “We understood that people might be sicker and have different
ancillary costs, but by God the routine or ‘hotel’ costs ought to bear
some similarity to all other hospitals.”
33
The limits began operation
in 1975, soon after Nixon’s Economist Stabilization Program ended
(under which hospitals’ annual wage and price increases had been
limited to 5.5%).
34
Over time, the new restrictions on allowable hos-
pital costs had a modest effect in limiting hospital cost inflation.
As with virtually all regulatory efforts, though, hospital adminis-
trators quickly learned how to maximize reimbursement. “Now if
you look over the course of the 1970s, the hospitals kept modifying
the definitions and extending the line beyond which costs were
considered ‘unreasonable.’ Essentially, the hospitals kept redefining
what was ‘routine’ and what was ‘ancillary,’” explains Altman. “For
example, they would take nurses and change them into ‘respiratory
nurses,’ which made them a fully reimbursed ancillary cost. In other
words, what were previously considered routine costs became ancil-
lary by category and fully reimbursed.”
35
In addition to setting the first limits on what Medicare would pay
hospitals, the 1972 Social Security Amendments also authorized the
government to begin experiments with alternative forms of hospital
reimbursement (Section 222). Fortunately for the SSA, it did not
have to construct its own experiments in new forms of hospital pay-
ment from scratch. After the 1972 Social Security Amendments
passed with Section 222 included, several states approached the SSA
with requests to conduct payment experiments. Maryland was the
31. Stuart Altman, oral history interview with the author, 22 July 2002.
32. Margaret Sulvetta, “Achieving Cost Control in the Hospital Outpatient Depart-
ment,” Health Care Financ. Rev. Annu. Suppl., 1991, 13, 95–106, 95.
33. James Mongan, oral history interview with the author, 4 October 2002.
34. See Marsha Gold, Karyen Chu, Suzanne Felt, Mary Harrington, and Timothy Lake,
“Effects of Selected Cost-Containment Efforts: 1971–1983,” Health Care Financ. Rev., 1993,
14, 183–89.
35. Altman, oral history interview with the author.
JRL62(1).book Page 30 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 31
first state to seek a waiver from the SSA in order to set its own
Medicare payment rates. As part of an “all-payer” system, Medicare,
Medicaid, and private insurers would all pay the same rates for the
same hospital services. One purpose of the “all-payer” model was to
make sure no patients became viewed as “second class” due to their
status as lower payers.
In the long run, Robert Hackey has observed, Section 222 had a
tremendous impact on health care regulation and reimbursement
politics. It encouraged the proliferation of state rate-setting experi-
ments that redefined the relationship between payers, providers, and
government regulatory agencies. In addition to strengthening the
power of state health care bureaucracies, the “Section 222” demon-
stration projects provided federal officials with unique opportunities
for extensive policy learning at the state level that would otherwise
have been impossible.
36
CONCEPTUAL INNOVATION AT THE UNIVERSITY OF MICHIGAN
AND YALE UNIVERSITY
The same year that the SSA gave the approval for state Medicare
waivers saw the first scholarly article on the topic of what became
known as “prospective payment.” In September 1974, Inquiry
published University of Michigan Professor William Dowling’s
article “Prospective Payment of Hospitals.”
37
It was the first con-
ceptual description of the significant transformation and shifting
of financial risk that Medicare would initiate a decade later.
38
The
concept of prospective payment was predicated on the controver-
sial and untested theory that the cost of medical care was rela-
tively predictable and responsive to changing economic
incentives. Yet how would the prospective rates be determined,
especially if each patient’s medical cost varied significantly across
and even within hospitals, due to factors such as a patient’s age,
gender, or the severity of his or her condition? In other words,
how predictable could the costs of medical care truly be? Nobody
knew for sure.
36. See Robert Hackey, “Groping for Autonomy: The Federal Government and American
Hospitals: 1950–1990,” J. Econ. Issues, 1999, 33, 625–46.
37. See William Dowling, “Prospective Reimbursement of Hospitals,” Inquiry, 1974, 11,
163–80.
38. Ibid.
JRL62(1).book Page 31 Thursday, November 16, 2006 12:26 PM
32 Journal of the History of Medicine : Vol. 62, January 2007
In order to establish a system for paying hospitals’ predetermined
rates, patients would first have to be separated into unique “prod-
uct” categories based on different diagnoses or procedures (e.g.,
pneumonia, hip replacement, congestive heart failure, etc.).
Performing the necessary research for establishing product categories
and payment rates would require the cooperation of hospitals,
which was hard to come by. Moreover, hospital record-keeping in
the 1970s was generally sloppy at best and occasionally nonexistent
at worst. Even if researchers had readily available and comparable
hospital data, how would they run their analyses? At the time there
were no statistical software systems for analyzing complex medical
records. Personal computers did not yet exist. And performing mas-
sive statistical analyses was a labor-intensive, arduous activity involv-
ing enormous and enormously expensive mainframe computers that
only a select number of major institutions could afford.
Serendipitously, the solutions to these formidable obstacles came
by way of researchers trying to solve other problems and answer dif-
ferent questions. In the early 1970s, a research team at Yale University
headed by John Thompson—a former nurse who once worked the
night shift on Bellevue Hospital’s prison ward and a professor of
public health and hospital administration—was trying to find out
why the cost of maternity, newborn, and non-maternity medical
care among Connecticut’s thirty-five hospitals varied by as much as
100% (double).
39
This striking variation in costs had no obvious
explanations because “Connecticut is not like other states,” Thompson
observed. “There is essentially one labor market [with] people going
from town to town. Moreover, all hospitals in Connecticut were
accredited, and there were no for-profit hospitals.”
40
In short, all
hospitals in Connecticut were not-for-profit and had roughly the
same labor costs. So, as Thompson asked, “What was going on in
the most expensive hospitals and in the cheapest hospitals?”
41
At the time, Yale was uniquely positioned to generate the kind of
conceptual innovation necessary for developing prospective pay-
ment. It had some of the brightest researchers within small depart-
ments, which provided for far more interdisciplinary collaboration
39. John Thompson, oral history interview with Lewis E. Weeks, Jr. (July 1989, Ann
Arbor, Mich.), 46, manuscript in possession of author.
40. Ibid., 46–47.
41. Ibid., 47.
JRL62(1).book Page 32 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 33
than is usually the case at most major research universities. Accord-
ing to Richard Averill, who became the lead project manager for
Thompson’s research team:
It all began when Thompson said that studying the significant variation in
hospital costs “sounds like an industrial control problem. But I don’t nec-
essarily know all that much about industrial control, so I’ll find out who-
ever the guru is at the School of Administrative Sciences in this area.” So
he went over and spoke with Bob Fetter—a Professor at the School of
Organization and Management—and he said, “Well, tell me what your
products are.” And John said something like, “We treat patients.” And
Bob would say something like, “and Ford makes cars, but there’s a big dif-
ference between,” in those days, “a Pinto and a Lincoln.”
And so this started the genesis of essentially saying, “In order to do any
analysis of real statistical quality with controls, you need a product definition
in a hospital.” But then you kind of start working backwards and say, “Okay,
in order to come up with a product definition, we first need some data.”
42
In order to categorize all the different products that hospitals pro-
duced and how much it cost them for each one, Thompson and
Fetter needed a significant amount of hospital data. Fortunately, by
law, the thirty-five hospitals in Connecticut had been reporting
audited costs to the state legislature since 1948 according to a uniform
chart of accounts. From 1960 on, the Connecticut Hospital Associa-
tion (CHA) had collected the standardized financial information from
all thirty-five hospitals, broken down among maternity, newborn,
and non-maternity patients.
43
In addition, recalls Thompson, “We
had the Connecticut Hospital Association and Connecticut Blue
Cross who were very close to our program and who gave us a lot of
data.”
44
Given the unprecedented amount of claims data from multi-
ple Connecticut hospitals, Thompson and Fetter could perform the
first major analysis of substantial variation in costs between hospitals.
With the assistance of their colleagues, Fetter and Averill created
an interactive computer program designed to facilitate the rapid
analysis of complex medical information.
45
“You could sit doctors
42. Richard Averill, oral history interview with the author, 19 March 2003.
43. William White, ed., Compelled by Data: John D. Thompson (New Haven, Conn.: Yale
University Press, 2003), 72, 85.
44. Thompson, oral history interview with Weeks, 45.
45. Ronald Mills, Robert Fetter, Donald Riedel, and Richard Averill, “AUTOGRP:
An Interactive Computer System for the Analysis of Health Care Data,” Med. Care, 1976,
14, 603–15.
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34 Journal of the History of Medicine : Vol. 62, January 2007
down and say, ‘Now here’s a diagnosis. What factors do you think
are going to affect the use of resources treating this diagnosis? Is it
age? Is it certain complications? Is it the patient’s sex? What is it?’”
explains Thompson. “We could sit there and test it on this interac-
tive program, which was called AUTOGRP.”
46
Thompson and Fetter’s goal was to group all patients into a limited
number of distinct and medically meaningful diagnostic categories
(Diagnosis Related Groups, or DRGs), and then measure each individ-
ual patient’s consumption of hospital resources. Ironically, the primary
purpose of prospective payment with DRGs was not cost control,
which is what it became later at the state (New Jersey) and federal level.
Rather, they envisioned their work serving as a basis for quality assess-
ment to improve care for patients and for the better use of limited and
expensive medical resources. Thompson and Fetter were surprised at the
total lack of interest within the hospital community over their findings:
There we were with what we thought was a major management break-
through. In other words, hospital administrators could now begin to see
how much it was costing them to produce these “products” [Diagnosis
Related Groups, DRGs] and whether the medical staff was treating these
patients differently, keeping some patients in too long, ordering too many
X-rays or too much lab work. . . . This was the first time anybody in
hospital management could do this. . . . We went all over the United
States to preach the gospel of hospital product lines, and it was absolutely
amazing how little attention anybody paid to this idea.
47
Thompson and Fetter had demonstrated for the first time that
hospitals could separate their patients into distinct categories based
on the diagnosis and then measure how much each category cost the
hospital financially. Hospital administrators were slow to realize the
extent to which Thompson and Fetter’s innovation could transform
American medicine, but a handful of progressive health officials
were ready for a revolution.
NEW JERSEY AS A “POLICY LABORATORY” FOR
EXPERIMENTATION
Following their “discovery” of prospective payment, as Thompson
later described it, he and Fetter grew increasingly eager to test their
46. Thompson, oral history interview with Weeks, 48.
47. Ibid., 49.
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Mayes : Medicare’s Revolutionary Prospective Payment System 35
new system of hospital reimbursement somewhere. “Then one of
those serendipitous things happened,” according to Thompson.
“The health officer of New Haven was a young physician by the
name of Joanne Finley, and she was called down to New Jersey by a
candidate for governor by the name of Brendan Byrne who said that
hospitals had become a big issue in his campaign. . . . She knew all
about DRGs, because, as health officer in New Haven, she was on
the Yale faculty and had come to the various research symposiums
on the new system. She said yes and Byrne was elected.”
48
Joanne Finley and her department set about transforming the tradi-
tional relationships between hospitals and payers. They moved to a
new rate review system known as the Standard Hospital Accounting
& Rate Evaluation (SHARE) system.
49
SHARE was designed to
have all hospitals report their expenditures in a standardized way to
allow for meaningful comparisons between hospitals. The essential
feature of the SHARE system was “peer grouping” hospitals within
different categories (for example, small, large, urban, suburban). The
unit of payment to hospitals under the new system was a “per diem”
(or a “per day” rate), and the basis of payment was the hospital’s
costs.
50
If any hospital’s proposed budget for the following year
exceeded by 10% the median increase of its peers, it had to negotiate
with New Jersey’s Department of Health for an exception in order to
receive per diem rate increases from both Blue Cross and Medicaid.
51
In other words, it had to persuade the state’s Department of Health
that, because of its “uniqueness,” it deserved to receive higher pay-
ments than its peer institutions for the same hospital procedures and
services. Only 12.3% of all hospital requests for such an exception
were successful.
52
Moreover, the state established a target percentage
increase in per diem payment rates for each year. In the system’s first
year, 1975, the target rate was 2%, which was laughable on its face
given the overall rate of economic inflation at that time. The state
quickly had to compromise upward to a 9% annual increase.
53
48. Ibid.
49. See Robert Fetter, Youngsoo Shin, Jean Freeman, Richard Averill, and John Thompson,
“Case Mix Definition by Diagnosis-Related Groups,” Med. Care, 1980, 18, vii–53.
50. Ibid., 33.
51. Office of Technology Assessment, Diagnosis Related Groups and the Medicare Program:
Working Paper (Washington, D.C.: Government Printing Office, 1983), 6–7.
52. Ibid., 7.
53. Ibid., 6–7.
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36 Journal of the History of Medicine : Vol. 62, January 2007
SHARE was an initial but modest attempt to both rationalize
hospital payments and challenge the hospital industry’s power in
New Jersey.
54
The program only regulated Blue Cross and Medicaid
payment rates (roughly 40% of total hospital payments), which led
hospitals to shift more of their costs to their unregulated payers,
mostly commercial insurers. Within five years, payments from com-
mercial insurers were 30% higher than payments from Blue Cross
for the same services.
55
Many urban hospitals, which served a dispro-
portionate share of Medicaid and uninsured patients, were experi-
encing serious budget deficits under the new SHARE system. Due
to their location, they did not have enough commercially insured
patients to whom they could shift their costs. Eighteen of the state’s
hospitals were pushed to the verge of financial collapse.
56
Dissatisfied with a system that regulated hospitals on a per diem
rate and only for Medicaid and Blue Cross payers, Finley and her
colleagues in the Department of Health entered into negotiations
with the New Jersey Hospital Association and Blue Cross for the
purposes of moving to a new system.
57
They wanted a statewide
prospective payment system. In order to regulate prices for all payers
in the state—which constituted far more governmental control over
the hospital industry than had ever existed—Finley and her col-
leagues found an ingenious way to neutralize the hospital industry’s
otherwise unified and formidable political opposition.
58
They pro-
posed that the state’s new regulatory system for all payers should set
hospital payment rates in such a way as to cover hospitals’ uncom-
pensated charity care (or bad debt). Because both would benefit
financially, the state’s inner-city hospitals—often headed by charis-
matic and articulate nuns—became aligned with the state’s commercial
insurers in favor of the state’s new proposal.
59
Finley was reported to
54. Fetter, Shin, Freeman, Averill, and Thompson, “Case Mix Definition by Diagnosis-
Related Groups,” 33–34: “The SHARE methodology was not equipped to address the
problems of 1) defining and measuring hospital case mix, productivity and effectiveness; 2)
providing incentives for better management; 3) avoiding business gamesmanship; 4) foster-
ing communications between the hospital financial systems and physicians.”
55. James Morone and Andrew Dunham, “The Waning of Professional Dominance:
DRGs and the Hospitals,” Health Aff., 1984, 3, 73–87, 77.
56. Ibid.
57. Office of Technology Assessment, Diagnosis Related Groups and the Medicare Program:
Working Paper, 34.
58. Morone and Dunham, “The Waning of Professional Dominance,” 80.
59. Ibid.
JRL62(1).book Page 36 Thursday, November 16, 2006 12:26 PM
Mayes : Medicare’s Revolutionary Prospective Payment System 37
have told Jack Owen, president of the New Jersey Hospital Associa-
tion, “If you don’t come along on this plan, I’ll split your damned
association.”
60
This clever mixture of cross-cutting politics enabled Finley and
her allies to push their reform legislation (S.446) into an advanta-
geous political position. Urban hospitals desired financial assistance
for providing care to their disproportionately poor patients; com-
mercial insurers wanted relief from increased cost shifting imposed
on them by all hospitals; state legislators desired an increased mea-
sure of cost control to address Medicaid’s cost escalation; and the
federal government wanted states to experiment with different forms
of hospital reimbursement in order to develop a national model of
reform for Medicare. As a result, S.446 passed easily in 1978.
61
The
legislation outlined a timetable for a new, prospective system of
reimbursement to begin in early 1980.
PRESIDENT CARTER AND HOSPITAL COST-CONTAINMENT
BATTLES
The late 1970s were marked by a growing national preoccupation
with inflation, particularly in the area of health care. In 1977, Medi-
care and Medicaid expenditures were double what they had been
only three years earlier.
62
From 1974 to 1977, hospital costs increased
at an annual rate of approximately 15%, more than double the econ-
omy’s overall rate of inflation.
63
Public opinion polls showed that
health care costs were among Americans’ top three domestic policy
concerns.
64
Consequently, hospital cost containment emerged as the
leading health policy initiative by President Carter and his adminis-
tration, particularly Joseph Califano (Secretary of Health, Education
& Welfare). With medical inflation growing at unsustainable rates,
Carter’s campaign pledge of achieving national health insurance
became linked to the goal of first trying to control hospital costs.
Carter’s initial proposal in April 1977 marked the first major
attempt by the federal government to aggressively regulate the
60. Thompson, oral history interview with Weeks, 51.
61. Office of Technology Assessment, Diagnosis Related Groups and the Medicare Program:
Working Paper, 34–35.
62. Starr, The Social Transformation of American Medicine, 406.
63. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 189.
64. Ibid.
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38 Journal of the History of Medicine : Vol. 62, January 2007
hospital industry. The president actively campaigned for his pro-
posal, arguing that its passage would “slow a devastating inflation
trend, which doubles health costs every five years.”
65
Carter’s plan
entailed setting a 9% cap on the annual growth in hospital prices; it
also imposed strict limits on the construction of new health care
facilities.
66
The plan would have placed limits on all hospital pay-
ment rates, public and private. An extreme step, and perhaps outside
the government’s regulatory power, Carter’s proposal was justified
on the basis that “rapid increases in hospital spending” threatened
“presidential objectives to balance the federal budget.”
67
Califano
claimed that hospitals had abused the cost reimbursement model for
too long. Rather than being “institutions of last resort,” he argued,
hospitals had become “settings of first choice for treating too many
minor ailments, especially when the insurance coverage was
good.”
68
President Carter’s proposal galvanized the hospital industry.
“Califano helped us achieve the unanimity when he talked about
hospitals making obscene profits,” according to Alex McMahon,
president of the American Hospital Association (AHA) at the time.
“Nothing drives you together better than a very visible enemy, and
Califano became one by his own choice.”
69
The industry responded
by vigorously opposing Carter’s proposal and offering a Voluntary
Effort (VE) in its place.
70
Carter’s 1977 proposal failed in large part because congressional
Democrats, notably Representatives Dan Rostenkowski (Chair of
the House Ways & Means Health Subcommittee) and Richard
Gephardt, favored going with the hospitals’ voluntary approach first.
“I’ve got commitments from the hospital Associations that if I let
them come up with a voluntary program, they will embrace cost
containment,” Rostenkowski recalls telling President Carter in one
65. Congressional Quarterly, CQ Almanac, 1977 (Washington, D.C.: Congressional
Quarterly, 1977), 499–500.
66. Hackey, “Groping for Autonomy,” 640–41.
67. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 189.
68. Quoted in Stevens, In Sickness and in Wealth, 309.
69. John Iglehart, “Hospitals, Public Policy, and the Future: An Interview with John
Alexander McMahon,” Health Aff., 1984, 3, 20–34, 25.
70. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 190.
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Mayes : Medicare’s Revolutionary Prospective Payment System 39
highly charged conversation. “And I told the hospital representa-
tives, as I stuck my index finger in their nose, Mr. President, ‘You
screw me and I’ll be around for a long time and you better watch
out.’”
71
As it turns out, the hospitals’ VE did have a salutary effect in
1978, bringing the rate of hospital cost inflation down to 12.8%, but
it proved to be short-lived.
72
In an effort to improve Medicare’s operation, President Carter
removed the program from the Social Security Administration’s
control in March 1977. As Feder explains, the “purpose was to
unify administration of the federal government’s two major health
financing programs, Medicare and Medicaid, which had been run
independently, and often without coordination, since their incep-
tion. Congress created a new agency, the Health Care Financing
Administration (HCFA), to administer the programs.”
73
The idea
to remove Medicare from the SSA came from those who were
deeply committed to social insurance. Yet many within the SSA
were devastated: “The saddest day for Medicare is the day that
Califano took the program away from Social Security and gave it
to the Health Care Financing Administration. . . . Medicare was
never the same after that.”
74
In 1979, hospital spending increased 14.5% as Carter reintroduced
a modified version of his original cost containment plan.
75
The only
significant difference between the president’s first and second pro-
posal is that the latter bill had a “sunset clause” of five years.
76
This
time Carter’s proposal advanced further than his 1977 proposal had.
It was voted out of committee and onto the House floor. Carter’s
new plan would impose controls on hospitals only if their cost
increases exceeded a limit of approximately 13%.
77
Again, though,
the hospital associations—together with the help of the American
71. Dan Rostenkowski, oral history interview with the author, 25 June 2002.
72. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 191.
73. Feder, Medicare: The Politics of Federal Hospital Insurance, vii.
74. “Recollections (Discussions) by Social Security Administration Officials’ Knowledge
and/or Involvement in Certain Stages of Early Implementation of the Medicare Program”
(Calendar Year 1966), SSA Regional Office, Atlanta, Georgia, 25 September 1992, 20,
provided to the author by Arthur Hess.
75. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 192.
76. Ibid., 190.
77. Ibid., 191.
JRL62(1).book Page 39 Thursday, November 16, 2006 12:26 PM
40 Journal of the History of Medicine : Vol. 62, January 2007
Medical Association—were able to defeat Carter’s plan.
78
Virtually
all Republicans opposed Carter’s plan as excessively complex and
an overly intrusive violation of the private sector by the govern-
ment at a time when deregulation was rapidly gaining popularity.
Democrats were split. Urban Democrats generally favored the
president’s plan, but Sun Belt and southern Democrats from areas
with growing populations were less enthusiastic. Many of them
thought that Carter’s plan would restrain the growth of hospital
revenues in an inequitable manner that would lock southern hos-
pitals into an inferior quality level relative to their northern coun-
terparts (the “fat will get fatter,” critics charged).
79
On 15
November 1979, the president’s proposal went down in defeat in
the House by a vote of 234 to 166.
80
The onus now was squarely on the hospital industry to deliver
results. Caps and price controls were rejected in favor of renewed
pledges from hospital representatives that they would “clean up their
act.” Their voluntary effort failed. Hospital cost inflation jumped
13% in 1980 and 18% in 1981.
81
The hospital industry’s political
credibility plummeted as the failure of its second Voluntary Effort
embarrassed even its closest political allies.
82
The voluntary effort
“was tremendously successful in its first year,” argues the AHA’s
McMahon, “partially successful the second year, and then really fell
apart in about its third year when nobody paid attention” any-
more.
83
Looking back on this period as one of “treading water,”
McMahon noted that the hospital industry “began to hear a message
from the federal and state governments and, increasingly, from busi-
ness, a thoroughly powerful message that said, ‘Okay, if you don’t
like government price controls, figure out something to do.’ The
pressures were there, and so ‘treading water’ pretty soon turned into
a movement toward finding a new system of incentives.”
84
The
78. Paul Feldstein, The Politics of Health Legislation: An Economic Perspective (Chicago:
Health Administration Press, 2001), 153.
79. Iglehart, “Hospitals, Public Policy, and the Future: An Interview with John Alexander
McMahon,” 26; Don Moran, oral history interview with the author, 28 October 2002.
80. Starr, The Social Transformation of American Medicine, 414.
81. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 192.
82. See Linda Demkovich, “Who Can Do a Better Job of Controlling Hospital Costs?,”
Natl. J., 1979, 11, 219–23.
83. Iglehart, “Hospitals, Public Policy, and the Future,” 25.
84. Ibid., 26.
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Mayes : Medicare’s Revolutionary Prospective Payment System 41
stage was now set for a radical transition in hospital reimbursement.
Yet it did not come from the private sector. Ironically, it came from
a Republican president who professed a love for the free market and
inveighed against government intrusions in the private sector.
NEW POLITICAL LANDSCAPE AMID MOUNTING FISCAL PRESSURES
The 1980s began with a continuation and worsening of medical
inflation from the previous decade. Hospital spending grew more
than 10% per year, as the nation’s total health care expenditures
reached $230 billion in 1980, a threefold increase from $69 billion in
1970.
85
Ronald Reagan, the Republican Party’s presidential nomi-
nee, won a landslide victory over the Democrat incumbent, Jimmy
Carter, by, among other things, arguing for the expansion of the free
market and reduced government regulation. Yet the free market was
not solving the problem of medical inflation. In Reagan’s first full
year in office, hospital spending increased 17.3%.
86
The following
year the country slipped into the worst recession in half a century,
with the unemployment rate reaching almost 11%.
The Republicans’ takeover of the White House and Senate coin-
cided with a deep recession, as well as a growing conviction among
policymakers of both political parties that Medicare’s rate of expen-
diture growth was unsustainable. The hospital industry had been
given two opportunities to voluntarily contain its cost growth and
had markedly failed at both. It appeared that the forces that drove
hospital inflation were beyond hospital administrators’ control.
Thus, by 1981, even leading representatives of the hospital industry
were convinced of the political inevitability of major reform to
Medicare’s payment system.
87
Paradoxically, the Republican takeover actually created a more
favorable political environment for a Medicare reform plan—one
involving increased government regulation—than had previously
existed. With Republicans in control, the onus fell squarely on them
to find a way to avoid Medicare’s approaching insolvency. Given the
administration’s short-term goals for reducing domestic spending,
85. Starr, The Social Transformation of American Medicine 380
86. See Congressional Budget Office, Hospital Cost Containment Model: A Technical Anal-
ysis (Washington, D.C.: Government Printing Office, 1981).
87. Iglehart, “Hospitals, Public Policy, and the Future: An Interview with John
Alexander McMahon,” 25–26.
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42 Journal of the History of Medicine : Vol. 62, January 2007
however, a free market approach to reforming Medicare was not
possible.
88
As a result, fiscal necessity overwhelmed political ideol-
ogy.
89
Republicans would have to increase the government’s
authority over medical providers, because the federal government
needed budgetary savings immediately and the hospital industry
had shown it was unable to reform itself. “We basically concluded
that we had to fix the hospitals because there are fewer of them,
they’re less political, there’s a lot of money there, and we thought
we could beat them up a lot easier than three to four hundred
thousand doctors,” recalls Allen Dobson, head of HCFA’s Office
of Research.
90
Reagan’s choice for Secretary of Health & Human Services,
former Republican Senator from Pennsylvania Richard Schweiker,
proved particularly auspicious for Medicare reform. In contrast to
Carter’s HHS Secretary, Joseph Califano, Schweiker was a more
conciliatory policymaker. He also had years of experience handling
health care policy in Congress as a senior member of the Senate
Finance Committee. The failure of the hospital industry’s two
voluntary efforts had persuaded him that the government would
have to initiate payment reform.
91
In fact, restraining the escalation
in health care costs became his highest legislative priority as Secre-
tary of HHS.
92
As a regular summer visitor to the New Jersey
shore, Schweiker formed close personal relationships with health
care representatives and policymakers who were initiating the
state’s experiment using prospective payment for hospitals.
93
He
had read the two existing books on DRGs and, over time, grew
convinced that prospective payment was the way to go.
94
Transi-
tioning Medicare to a prospective payment system emerged as his
primary goal, “sort of his crowning achievement as secretary of
HHS,” according to Julian Pettengill, a leading HCFA analyst at
the time.
95
88. Oberlander, The Political Life of Medicare, 123.
89. Ibid.
90. Allen Dobson, oral history interview with the author, 11 October 2002.
91. Oberlander, The Political Life of Medicare, 123.
92. Linda Demkovich, “Relying on the Market—the Reagan Approach to Containing
Medical Costs,” Natl. J., 1982, 14, 194–97, 194.
93. Robert Rubin, oral history interview with Edward Berkowitz, 16 August 1995.
94. Ibid.
95. Julian Pettengill, oral history interview with the author, 29 October 2002.
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Mayes : Medicare’s Revolutionary Prospective Payment System 43
Political and economic events in the early 1980s were making
Medicare reform seem increasingly necessary. The Republicans’
takeover of the Senate in 1981 coincided with the highest recorded
rates of hospital cost inflation. Bob Dole became chair of the power-
ful Senate Finance Committee, which, along with the House Ways
& Means Committee, controlled Medicare policy. Recognized at
the time as the most important figure on Capitol Hill for health
financing legislation, Dole saw the failure of the hospital industry’s
voluntary efforts as evidence of the need for radical reform to safe-
guard Medicare’s financial solvency.
96
Dole’s chief of staff, Sheila Burke, became the key staff member
on the Senate side in leading the effort for Medicare payment
reform. A former nurse, she viewed the traditional model of cost
reimbursement as “. . . insanity. On the face of it, it encouraged
people to do more; it paid them to do more and not in any particu-
larly rational way,” she explains. “Going to DRGs, therefore, had all
the right things going for it politically and conceptually. . . . In
effect, you could say to the average member of Congress—who
tended to not want to get into the minutiae of Medicare policy
because it was one of the more boring aspects of their lives—‘Why
should it [a specific hospital service or procedure] cost anything
different between L.A. and San Francisco or San Francisco and
Chicago, or Chicago and Detroit?’”
97
Dan Rostenkowski, who became chair of the powerful House
Ways & Means Committee in 1981, similarly concluded that the
private sector was incapable of reforming itself. Paul Rettig, who
worked for Rostenkowski, observed that most members of the
Ways & Means Committee shared Rostenkowski’s opinion that cost
reimbursement was something they had to get rid of as soon as pos-
sible.
98
The key to a prospective payment model, Rettig added, was
that select members of Congress thought it could fundamentally
96. John Iglehart, “Health Policy Report: Medicare’s Uncertain Future,” N. Engl. J.
Med., 1982, 306, 1308–12, 1308. “Our current fiscal crisis, which is, I assure you, a real, not
a fictitious crisis, is forcing us to examine very carefully what health services we pay for, and
how we pay for them. The problem becomes even more evident when we look down the
road to a nation with a growing population of elderly citizens and a Medicare trust fund
which is sure to go broke within a short period of time if we don’t take appropriate action.
In fact, the entirety of the Social Security system is in real trouble.”
97. Sheila Burke, oral history interview with the author, 2 October 2002.
98. Paul Rettig, oral history interview with Edward Berkowitz, 14 August 1995.
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44 Journal of the History of Medicine : Vol. 62, January 2007
change the decision-making habits of doctors and hospitals.
99
Previous
efforts had failed to do this, but it was necessary if Medicare’s rate of
expenditure growth was ever to be brought under control. Conve-
niently, federal policymakers could turn to some of their colleagues
at the state level, especially in New Jersey, to learn from their exper-
iments with different forms of prospective payment.
NEW JERSEY’S EXPERIMENT WITH DRGS
New Jersey’s experimental hospital reimbursement plan, which had
passed legislatively in 1978 and began operation in 1980, seemed partic-
ularly promising.
100
The state’s new prospective payment system sought
to significantly transform the financial incentives for hospital administra-
tors. With traditional cost reimbursement, the more a hospital did for a
patient, the more money it received in payments. Under New Jersey’s
DRGs, however, policymakers established a standard price in advance
for each and every case that a patient could present. If a hospital could
treat the patient for less than the standard DRG payment, it could keep
the difference as profit. If the hospital spent more than the standard
DRG payment, it had to absorb the difference as a loss.
A major problem with evaluating the new program’s performance,
however, was the considerable lag in hospital data that researchers
could analyze. Bruce Vladeck, who later became Administrator of
HCFA (1993–1997), was Assistant Commissioner for Health Planning
& Resources Development under Joanne Finley from 1979 to 1982.
As the Principal Investigator of New Jersey’s DRG experiment,
Vladeck had the responsibility to assess the DRGs’ performance. He
explains how technology limitations hindered the process of evalu-
ating the state’s experiments:
Vladeck: The most amazing thing about this experience was that all of the
time we were doing this until when I left the Department in early 1982
and even after we had set the 1982 [hospital payment] rates, the New
Jersey Department of Health did not own a computer!
Mayes: You did it by calculators?
Vladeck: No, it was done on computers. The Yale people did some of the
work on their computers and then we had to time-share with 1 of the 3 or
99. Ibid.
100. Morone and Dunham, “The Waning of Professional Dominance,” 80.
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Mayes : Medicare’s Revolutionary Prospective Payment System 45
4 state mainframe computers in those days, which was controlled by New
Jersey’s Department of Transportation. But it was always very frustrating.
We also bought time through the time-sharing system at Rutgers Univer-
sity. But we could only afford, given our budget constraints, to run our
stuff at night. It was all mainframe stuff and all the data entry was still
pretty much done manually, so it took us quite a while. And the data sub-
missions from the hospitals themselves were manual, so we had to get
them all keypunched in before we could do anything with them.
101
Ultimately, the New Jersey experiment, as much as anything,
provided a feasible alternative to traditional cost reimbursement.
“Over time we clearly demonstrated that at the barest minimum,
you could get such a system off the ground and the hospitals kept
functioning and, lo and behold, they seemed to be responding to the
incentives in the system,” recalls Averill. “Hospitals got paid,
grandma was not thrown out onto the street prematurely by hospi-
tals, and so it was generally viewed as a positive change despite all
the predictions to the contrary.”
102
Federal policymakers were espe-
cially encouraged that an alternative reimbursement system existed,
because Medicare’s financial health was deteriorating rapidly.
SOCIAL SECURITY & MEDICARE’S TRUST FUND CRISES
By 1982, federal policymakers’ concerns about the financial stability
of Medicare were escalating and becoming part of even larger wor-
ries about growing federal budget imbalances. Mushrooming budget
deficits (stemming from Reagan’s major tax cuts passed the previous
year), together with the highest unemployment rate and the worst
recession since the Great Depression, created a sense of fiscal and
economic crisis. The immediate concern of leading members of
Congress was the fact that declining payroll taxes threatened to
exhaust Social Security and Medicare’s trust funds. When the Social
Security Boards of Trustees released their annual reports on 1 April
1982, they noted “that unless action was taken soon, the Social
Security system would be unable to pay cash benefits on time to
retirees and survivors, beginning in July 1983.”
103
Medicare’s trust
101. Bruce Vladeck, oral history interview with the author, 14 August 2002.
102. Richard Averill, oral history interview with the author, 19 March 2003.
103. See Social Security Board of Trustees, Summary of the 1982 Annual Reports of the
Social Security Board of Trustees: Old-Age, Survivors, and Disability Program (Washington,
D.C.: Office of the Actuary Social Security Administration, 1 April 1982).
JRL62(1).book Page 45 Thursday, November 16, 2006 12:26 PM
46 Journal of the History of Medicine : Vol. 62, January 2007
funds were in better shape, they reported, but the program still
“faces very serious financial problems—indeed, bankruptcy—in the
late 1980s or early 1990s unless taxes are increased considerably or
expenditures are greatly reduced.”
104
The short-term solution to Social Security’s crisis that policymakers
adopted only exacerbated Medicare’s financial problems. They bor-
rowed from Medicare’s Hospital Insurance (HI) trust fund to shore
up Social Security’s Old Age and Survivors Insurance (OASI) trust
fund.
105
Carolyne Davis, HCFA’s Administrator, recalls that inter-
fund borrowing became a leading catalyst for forcing a major reform
of Medicare:
I remember when Secretary Schweiker called and he said, “I really need to
borrow $14 billion.” That sounded very odd, and I remember saying to
him, “Mr. Secretary, I would really like to not give it to you, because our
[Medicare] trust fund is going to be bankrupt in 1995.” And he said, “I can
appreciate that, but you don’t understand that I have to send Treasury
checks out next month to Social Security beneficiaries and we don’t have
the money. So I have to borrow it from you even though I am sympa-
thetic to the fact that you’ve got a problem with that. But we’ll fix
it.” That was my first acknowledgement that they were going to fix
Medicare. . .
106
Inter-fund borrowing and the recession’s effect on payroll tax reve-
nue combined to move up the projected insolvency date of Medi-
care’s HI trust fund to 1988.
107
It also did not help that hospital costs
in 1982 increased at three times the general rate of inflation.
108
Congress responded to the mounting fiscal crises by passing the
Tax Equity and Fiscal Responsibility Act (TEFRA) in August
1982.
109
Signed into law on 3 September 1982 by President Reagan,
TEFRA predominantly dealt with closing tax loopholes and other
revenue provisions entirely unrelated to Medicare.
110
But it also
104. Iglehart, “Health Policy Report,” 1309.
105. Summary of the 1982 Annual Reports of the Social Security Boards of Trustees.
106. Carolyne Davis, oral history interview with Edward Berkowitz, 8 November 1995.
107. Medicare Board of Trustees, Federal Hospital Insurance Trust Fund, 1983 Annual
Report, Federal Hospital Insurance Trust Fund, House of Representatives, 98th Cong., 1st
Sess., Doc. No. 98–75 (Washington, D.C.: Government Printing Office, 1983), 19–20.
108. John Iglehart, “Medicare Begins New Prospective Payment of Hospitals,” N. Engl. J.
Med., 1983, 308, 1428–32.
109. Tax Equity and Fiscal Responsibility Act, 1982, P.L. 97–248.
110. Daniel Palazzolo, Done Deal? The Politics of the 1997 Budget Agreement (New York:
Chatham House Publishers, 1999), 27.
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Mayes : Medicare’s Revolutionary Prospective Payment System 47
included various measures aimed at curtailing Medicare’s cost
growth, particularly stringent cutbacks on Medicare payments and a
strict limit on how much the program’s total hospital expenditures
would be allowed to grow in future years.
111
Growth in Medicare
reimbursements per patient discharge was limited for a three-year
period.
112
These measures effectively sounded the official death knell
for retrospective reimbursement, the system that the hospital indus-
try had painstakingly fought for and solidified over decades.
113
As a
result, TEFRA became a key stepping-stone to passing prospective
payment legislation the following year.
TEFRA represented a major political and strategic shift in policy-
makers’ focus on containing hospital costs. Whereas the Carter
administration’s proposals had sought to cap hospital prices for all
payers, public and private, the Reagan administration narrowed its
attention to just the “problems” of government programs. “The
focus turned very much to, ‘We’re running these public programs.
We have to run them better, more efficiently. We have to econo-
mize our expenses,’” according to Paul Ginsburg, Deputy Assistant
Director of the Congressional Budget Office (CBO) at the time.
114
In contrast to Carter’s efforts, which were derailed by intense parti-
sanship, Congress approved the new Medicare constraints with little
disagreement between politicians of widely divergent political
views. Regulating prices for just Medicare was far less threatening to
the hospital industry than Carter’s “all-payer” proposal. Republicans
in general and Senator Dole, chairman of the Senate Finance Commit-
tee, in particular, led the attack on behalf of tough new constraints
on hospital spending. Representatives of the hospital industry were
reduced to a strategy of damage control.
115
TEFRA was a preliminary but strategically effective measure.
The fact that it set per diem limits on Medicare reimbursement,
111. David Abernethy, oral history interview with the author, 19 June 2002; Lawrence
Brown, “Technocratic Corporatism and Administrative Reform in Medicare,” J. Health
Polit. Policy Law, 1985, 10, 579–99, 593.
112. See Congressional Budget Office, Analysis of Medicare Hospital Reimbursement
Changes in the Tax Equity and Fiscal Responsibility Act of 1982 (Washington, D.C.: Govern-
ment Printing Office, 1983), 3.
113. Office of Technology Assessment, Diagnosis Related Groups (DRGs) and the Medicare
Program: Working Paper, 23.
114. Paul Ginsburg, oral history interview with Edward Berkowitz, 22 August 1995.
115. John Iglehart, “The New Era of Prospective Payment for Hospitals,” N. Engl. J.
Med., 1983, 308, 1288–92, 1288.
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48 Journal of the History of Medicine : Vol. 62, January 2007
which hospitals loathed, “was not coincidental,” according to sev-
eral observers.
116
Moving to a payment system that hospitals hated
and feared provided Congress with political leverage and a supe-
rior bargaining position when DRGs were introduced for consid-
eration the following year.
117
As something of a “doomsday
device,” TEFRA signaled to the hospital industry that systemic
change was inevitable and imminent.
118
The not-so-subtle implica-
tion was that the hospital industry should “come to the bargaining
table” to support the transition to a prospective payment system.
119
It worked.
120
To show that the AHA was willing to cooperate in a transition
to prospective payment, McMahon and a number of state
hospital association executives asked Jack Owen, President of the
New Jersey Hospital Association, to become their Washington
representative in the spring of 1982.
121
His experience of having
worked successfully with policymakers in New Jersey gave him a
unique credibility in representing the nation’s largest hospital orga-
nization. The AHA was especially eager to cooperate with policy-
makers to change Medicare if it meant getting rid of TEFRA’s
new payment policies. “People really wanted to create a better set
of incentives,” according to Rick Pollack, current Executive Vice
President of the AHA, who joined the organization in 1982.
“TEFRA was kind of a stopgap to put the tourniquet on Medicare
spending, but it wasn’t anything that people wanted to see go
beyond a stopgap kind of approach. So, yes, we were very much
‘on board.’”
122
116. Robert Rubin, oral history interview with the author, 23 August 2002.
117. Bruce Vladeck, oral history interview with the author, 14 August 2002.
118. Charles “Chip” Kahn, oral history interview with Edward Berkowitz, 22 August
2002: “In TEFRA you had the per diem limits. And in a sense, they were so horrendous in
terms of how they were going to affect hospitals that they drove the hospitals into being
willing to accept DRGs. But from the standpoint of [Senator] David Durenberger and a
cadre of members of Congress—and Sheila Burke I think was a part of this, too, although I
don’t know how well she conceptualized it—Dave [Durenberger] and these others had a
notion that they wanted to use Medicare as a change agent. And rather than the cost con-
tainment approach where you have broad-based government intervention, they wanted to
use Medicare as the big purchaser to have a payment scheme or schemes that were designed
to align the incentives for providers appropriately.”
119. Oberlander, The Political Life of Medicare, 124.
120. Iglehart, “The New Era of Prospective Payment for Hospitals,” 1292.
121. Jack Owen, oral history interview with the author, 1 October 2002.
122. Rick Pollack, oral history interview with the author, 27 December 2002.
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Mayes : Medicare’s Revolutionary Prospective Payment System 49
DEVELOPING A PROSPECTIVE PAYMENT PROPOSAL WITH OR
WITHOUT DRGS
TEFRA called for the Secretary of HHS to develop, in consultation
with the Senate Finance and House Ways & Means Committees, a
proposal for prospective reimbursement by 31 December 1982.
123
Had there not been almost a decade of research and demonstrations
by HCFA, it literally would have been impossible to meet the four-
month deadline.
124
But policymakers were able to draw upon years
of research by HCFA’s Office of Research and Development and, to
a lesser extent, New Jersey’s experience with DRGs. “The DRG
prospective payment system moved forward as rapidly as it did,
because it basically was a wrinkle on all the work that had been done
for the implementation of the Section 223 cost limits,” argues Judith
Lave, Director of HCFA’s Office of Research and Development
from 1977 to 1982. “Basically, how you do DRGs, how you weight
them, what you should take into consideration, how you should
analyze them, so many of the technical issues—not all of them of
course—but much of the analytical groundwork had already been
laid.”
125
The two models that the task force ultimately proposed to
Schweiker both included DRGs but in different ways. The model
that the task force preferred entailed a flat-rate payment per hospital
discharge that only used DRGs to establish total cost limits for indi-
vidual hospitals. The second model used DRGs as the central price-
setting device. It bore a greater resemblance to New Jersey’s system
that, at the time, appeared to be working better than any of the other
state experiments (see Table 1).
126
According to David Smith,
Schweiker was “flabbergasted at their final recommendation.”
127
The
flat rate approach was “clearly unacceptable” to him, because it
encouraged hospitals to “skim off” the healthier patients while offering
them minimal incentives to improve their technology and become
more efficient. In the end, he overruled the preferences of his task
123. Section 101(c) of the Tax Equity and Fiscal Responsibility Act, 1982, P.L. 97–248.
124. U.S. Department of Health and Human Services, Report to Congress: Hospital Pro-
spective Payment for Medicare (Washington, D.C.: Government Printing Office, 1982), 1.
125. Judith Lave, oral history interview with the author, 30 July 2002.
126. David Smith, Paying for Medicare: The Politics of Reform (New York: Aldine de
Gruyter, 1992), 33.
127. Ibid., 44.
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50 Journal of the History of Medicine : Vol. 62, January 2007
force and instructed its members to design his department’s prospec-
tive payment proposal with DRGs as the key price-setting device.
128
The Reagan administration came to view prospective payment with
DRGs as “the response of a prudent purchaser concerned with creat-
ing incentives for efficiency and reducing the federal budget deficit.”
129
In short, DRGs would reduce costs by putting the hospitals at financial
risk. With the threat of operating losses for those hospitals unable to
deliver care at or below DRG payment rates, prospective payment
would virtually force hospitals to increase efficiency and productivity
and, in the process, lower their costs.
130
And lower hospitals costs, pro-
ponents argued, would translate into lower Medicare expenditures.
131
128. Ibid., 44–45.
129. Gold, Chu, Felt, Harrington, and Lake, “Effects of Selected Cost-Containment
Efforts: 1971–1993,” 193–94.
130. Robert Rubin oral history interview with Edward Berkowitz, 16 August 1995:
“DRGs were an example of [using] financial or economic incentives for getting people to
do the correct thing versus coercing them, the difference between the carrot and the stick.”
131. Ibid. See also Richard Averill and Michael Kalison, “Prospective Payment by
DRG,” Healthc. Financ. Manage., 1983, 13, 12–16; Richard Averill and David Sparrow,
“TEFRA’s Two-Part Strategy Will Reduce Medicare’s Financial Liability to Hospitals,”
Healthc. Financ. Manage., 1983, 13, 72–77.
table 1
Annual Percent Increase in Inpatient Hospital Costs: Demonstration
States vs. U.S.
Source: Adapted and modified from U.S. Department of Health and Human Services,
Report to Congress: Hospital Prospective Payment for Medicare (Washington, D.C.: Decembe
r
1982), Tables 3, 21.
1979 1980 1981
Connecticut 8.1% 11.4% 15.9%
Maryland 12.19.815.6
Massachusetts 7.614.114.1
New Jersey 11.210.711.4
New York 8.510.814.1
Rhode Island 10.912.416.3
Washington 11.210.918.9
Wisconsin 10.712.617.6
United States 11.312.717.3
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Mayes : Medicare’s Revolutionary Prospective Payment System 51
PIGGY-BACKING ON SOCIAL SECURITY’S BAILOUT AND BUYING
OFF THE OPPOSITION
Financial necessity, particularly the specter of imminent bankruptcy,
is often the mother of all kinds of major programmatic invention.
Policymakers’ seminal reform of both Social Security and Medicare
in 1983 is a classic example. According to Don Moran, Reagan’s
Associate Director for Budget and Legislation, Social Security’s
approaching insolvency provided the perfect vehicle for changing
Medicare’s Part A hospital program to a prospective payment system
with DRGs:
Ideas like DRGs have an intellectual life of their own . . . but at some point
these ideas hit their nexus to the real world, tactical political situation and
they either do or do not adhere. So, yes, DRGs had an independent life of
their own quite without regard to what anybody in the Reagan administra-
tion thought about them per se. But we just pulled them off the shelf as a
“plug” to solve the short-term solvency problem with Social Security. Inter-
fund borrowing had sprung a temporary leak in Medicare’s HI [Hospital
Insurance] Trust Fund, so we needed some kind of magic asterisk to stick in
the Social Security deal to say, “Notwithstanding the fact that we are cur-
rently bankrupting the HI Trust Fund, we have a fig leaf [prospective pay-
ment] to stick in as a plug when inter-fund borrowing expires on June 30th,
so that we can lower the five-year forecast outlays in the HI Trust Fund and,
in so doing, prevent its bankruptcy over the next five years.”
132
Obviously there was more momentum and technical development
behind prospective payment’s ascendancy than Moran’s statement
suggests. But his argument that extraordinary political and fiscal cir-
cumstances opened a rare window of opportunity for a major policy
change is undeniable.
Ironically, the first person to suggest the possibility of strategically
attaching Medicare’s prospective payment proposal to Social Security’s
bailout bill was Dan Rostenkowski, chair of Ways & Means, who
had played the leading role in defending the hospital industry from
Carter’s hospital cost containment plans.
133
Rostenkowski contacted
Secretary Schweiker about the idea. He was initially surprised but
quickly supported it.
134
Shortly thereafter, as John Iglehart has
132. Don Moran, oral history interview with the author, 28 October 2002.
133. John Salmon, oral history interview with the author, 28 June 2002.
134. Smith, Paying for Medicare, 50.
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52 Journal of the History of Medicine : Vol. 62, January 2007
chronicled, Rostenkowski’s Chief Counsel, John Salmon, asked
Schweiker’s Assistant Secretary for Policy & Planning, Robert Rubin,
“How fast can you do prospective payment?”
135
Rubin responded,
“In six weeks.” Salmon said, “How about 11 days?” and then
explained to him the merits of “one of the greatest legislative engines
we’ll ever see—the Social Security bill.”
136
Bob Dole, Rostenkowski’s
counterpart as chair of the Senate Finance Committee, objected to
the idea at first but eventually agreed after receiving a personal guar-
antee from the AHA’s Jack Owen that “we will get the hospitals to
go for it.”
137
According to Owen, “My job was not to stop it, but
just to help it and go along with it.”
138
Once senior congressional leaders and the administration were in
agreement, attention turned to buying off any opposition from the
hospital industry. It helped that TEFRA’s stringent cost controls
were set to begin later that same year. Hospitals were looking for
anything to avoid TEFRA.
139
Besides the prevailing sense that
reform was unavoidable, a major factor that contributed to the hos-
pital industry’s relatively receptive attitude about reform was the
unprecedented potential for significant profits. “That was one of the
things you could sell, because there was a lot of financial slack in the
hospital business,” acknowledges Owen. “Once they started pulling
back on their slack, the hospitals could really start making some
money.”
140
Hospital representatives, however, were still divided in their
opinion of prospective payment. The Federation of American Hos-
pitals, which represented for-profit hospitals, was enormously
enthusiastic.
141
The AHA was comparatively less so but was still
eager to avoid the effects of TEFRA.
142
Representatives of the
nation’s teaching hospitals, however, were strongly opposed to the
plan.
143
Due to the fact that they train residents, employ academic
physicians, and conduct medical research, academic medical centers
135. Paul Rettig, oral history interview with Edward Berkowitz, 14 August 1995.
136. Iglehart, “Medicare Begins New Prospective Payment of Hospitals,” 1430.
137. Owen, oral history interview with the author.
138. Ibid.
139. Rubin, oral history interview with the author; Pollack, oral history interview with
the author; Owen, oral history interview with the author.
140. Owen, oral history interview with the author.
141. Demkovich, “Who Says Congress Can’t Move Fast?,” 705.
142. Ibid.
143. Iglehart, “Medicare Begins New Prospective Payment of Hospitals,” 1429.
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Mayes : Medicare’s Revolutionary Prospective Payment System 53
are less efficient than community hospitals. At the same time, they
serve a unique and essential need: advancing medical progress. Mov-
ing to a national prospective rate system, therefore, would have put
them in the impossible situation of competing financially with hos-
pitals that could and would consistently beat them on price.
Consequently, staff members in HCFA and on the Ways &
Means Committee recommended increasing DRG payment rates to
teaching hospitals as a “cushion.”
144
Different economic simulations
of this increase, though, produced different results. The issue was
critical, because adjusting the payment rates involved massive swings
in the total amount of money that teaching hospitals would receive.
Too low of an adjustment and teaching hospitals would be severely
harmed financially; too high of an adjustment and the hospitals
would receive absurd financial windfalls at Medicare’s actuarial
expense. Robert Rubin ultimately pushed for a generous doubling
of the “resident-to-bed” adjustment in DRG rates to teaching
hospitals.
145
“It was a bribe, pure and simple,” says Allen Dobson. “It
was a bribe and it worked.”
146
Teaching hospitals relented and
became supportive of prospective payment with DRGs. As Rubin
explains,
Were we overly generous on the teaching adjustment? Sure. I’ve said
publicly innumerable times that the real number was not 2 [a doubling].
I mean, any fool would know that 2 is a totally made-up number, but it
was close to 2. . . . That made the teaching hospitals reasonably happy and
it gave us a very important part of New York’s political delegation, includ-
ing [Pat] Moynihan and Charlie Rangel. That was not a trivial issue. We
also got the Mayo Clinic exemption, which made Senator [David] Duren-
berger [R-MN] happy. And we had exemptions for the cancer hospitals,
which made the folks in Texas happy.
147
The Ways and Means and Senate Finance Committees made a few
other important adjustments to account for “outlier” cases and to
exclude various items from being factored into the DRGs, namely
hospital capital and direct medical education. The latter two items
would continue to be reimbursed on a traditional cost basis.
148
144. Smith, Paying for Medicare, 52.
145. Rubin, oral history interview with the author.
146. Dobson, oral history interview with the author.
147. Rubin, oral history interview with the author.
148. Smith, Paying for Medicare, 55.
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54 Journal of the History of Medicine : Vol. 62, January 2007
Having bought off the hospital industry’s opposition, members of
both committees were able to pass the legislation quickly and easily.
Attaching Medicare reform to critical Social Security reform was a
purely opportunistic, but effective, decision. It produced a veto-
proof bill that was immune to any single or collective interest-group
veto due to its sheer urgency.
149
Most members of Congress did not
even understand how prospective payment worked.
150
They voted for
it, however, because Medicare was approaching insolvency and even
more so because the Social Security legislation had to pass for the pro-
gram’s millions of monthly checks to continue uninterrupted.
151
“There was no serious debate [about prospective payment] of any
consequence,” notes Paul Rettig. “It was so overwhelmed by the
Social Security rescue that it received very little political attention.”
152
After roughly two months of legislative consideration, most of it
focused on adjustments to the OASI program, Congress passed the
Social Security bill on 24 March 1983. President Reagan signed it
into law one month later, on 20 April.
153
The single biggest change
to the American health care system since Medicare and Medicaid’s
passage in 1965 went largely unnoticed outside a small group of hos-
pital representatives and health policy leaders.
CONCLUSION
Following a decade of development, experimentation, and analysis, the
passage of Medicare’s new prospective payment system with
DRGs represented nothing short of an administrative revolution. It
149. See Timothy Clark, “Congress Avoiding Political Abyss By Approving Social Secu-
rity Changes,” Natl. J., 1983, 15, 611–15. See also Paul Light, Still Artful Work: The Con-
tinuing Politics of Social Security Reform (New York: McGraw-Hill, 1995), 1: “This is a story
about a legislative miracle. Under extreme time pressure in 1983 (and largely because of it),
Congress and the President finally passed a Social Security rescue bill. Two years in the
making, the legislation arrived just moments before the Social Security trust fund was to
run dry. Without the $170-billion package of tax increases and benefit cuts, millions of
checks would have been delayed.”
150. Iglehart, “Medicare Begins New Prospective Payment of Hospitals,” 1429: “A
remarkable reality of the process in both chambers was how few legislators were actually
involved in designing the legislation. For the most part, professional staff members made
the key decisions.”
151. For more on the Social Security crisis, see Joseph White and Aaron Wildavsky, The
Deficit and the Public Interest (Berkeley, Calif.: University of California Press, 1989), ch. 14,
“A Triumph of Governance: Social Security”; Paul Light, Artful Work: The Politics of Social
Security Reform (New York: Random House, 1985).
152. Rettig, oral history interview with Edward Berkowitz.
153. Iglehart, “Medicare Begins New Prospective Payment of Hospitals,” 1430.
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Mayes : Medicare’s Revolutionary Prospective Payment System 55
altered the power relationship between Medicare and health care pro-
viders. Key to policymakers’ success was the strange political attraction
of prospective payment. Hospital industry representatives were already
desperate for any alternative to TEFRA, but they quickly became keen
on the opportunity to make significant profits under the new reim-
bursement system. Congressional leaders of both parties and Reagan
administration officials wanted more control of Medicare to restrain
the program’s rate of growth, despite the fact that prospective payment
required significantly increased government regulation and control of
health care. And with Social Security literally on the verge of bank-
ruptcy in 1983, policymakers finally had a legislative vehicle for com-
prehensive Medicare reform that was unstoppable.
Following the rapid passage of Medicare’s new reimbursement
system, a new set of concerns arose: Would the system actually
work? Would Medicare’s rate of expenditure growth subside? How
would hospitals respond to the new incentives? Would any particu-
lar set of hospitals be wiped out financially by the new system? How
would patients be affected, if at all? “There was great sensitivity that
we were going down a path none of us had gone down before,”
notes Sheila Burke:
There had been some rough sort of testing on the state-level, but nothing
on the scale of Medicare. We all knew only too well the impact of any
change in Medicare could lead to seismic changes in the industry, because
Medicare was such a big purchaser. So we were all enormously sensitive to
that, and also enormously sensitive to not really knowing how to defend
or describe what appeared to be real differences between hospitals, their
costs and their mix of cases. We knew far less than one would have hoped
about what would occur after making these changes.
154
The only thing policymakers did know for sure was that, with a pro-
gram as immense as Medicare, it was impossible to change just one
thing.
155
The ripple effects of moving to a prospective payment system
were bound to be extensive and, as history reveals, they were.
156
ACKNOWLEDGMENTS. The author wishes to thank Robert Berenson, David Colby, Tim
Jost, David Smith, Tom Weil, Joseph White, and several anonymous reviewers for their
helpful comments and constructive criticism.
154. Burke, oral history interview with the author.
155. Morone and Dunham, “The Waning of Professional Dominance,” 74.
156. Rick Mayes, “Causal Chains and Cost Shifting: How Medicare’s Rescue Inadvert-
ently Triggered the Managed Care Revolution,” J. Policy Hist., 2004, 16, 144–74.
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