Getting Incentives Right in Payment Reform: Thinking Beyond Financial Risk

Successful payment reform requires strong incentives for provider organizations to limit health care spending. Global budget payment models, the most prominent of which is the accountable care organization (ACO) model, seek to limit spending through risk contracts in which provider organizations share savings or losses when spending is below or above a budget or “benchmark.” Much of the debate over how to strengthen these models has focused on specific terms of the payment contract. For example, under recent rule changes announced by the Centers for Medicare & Medicaid Services, ACOs in the Medicare Shared Savings Program (MSSP)—the largest federal ACO initiative—face increasing exposure to “downside risk,” which requires an organization to pay a penalty if spending exceeds its benchmark (1).

Often overlooked in the debate over how to strengthen global budget models is that incentives to lower spending may differ markedly by organization type, even if the terms of a payment contract are the same. For example, physician group ACOs in the MSSP have stronger incentives than hospital-based health system ACOs to reduce potentially wasteful hospital care and, accordingly, have generated greater savings to date (2). Understanding why incentives vary across provider organizations is critical for moving payment reform forward.

Why Incentives Differ for Health System Versus Physician Group ACOs

Fee-for-Service Incentives

Most ACO contracts lie between traditional fee-for-service reimbursement and a capitation model. In a capitation model, a provider organization receives a prospective payment for a patient population and keeps the full difference between this payment and the cost of care for that population. However, providers in the MSSP are paid on a fee-for-service basis and receive bonuses (or penalties) proportionate to the difference between their fee-for-service spending and their benchmark for spending.

This persistence of fee-for-service payments weakens incentives for hospital system ACOs to reduce unnecessary admissions for 2 reasons. First, a system that hospitalizes fewer patients may receive a bonus equal to a portion (such as 50%) of the reduction in Medicare spending, but it forgoes fee-for-service profits from those hospitalizations. Second, admitting patients is generally profitable for hospitals, because fee-for-service payments in Medicare reflect average rather than marginal costs of care. Average costs comprise variable costs (costs that vary with the level of service volume, such as those for medications, disposable supplies, and fee-for-service payments to clinicians) and a portion of fixed costs (costs that do not vary with service volume in the short run, such as those for buildings, equipment, and contracted salaries). Therefore, Medicare’s payment for an admission usually exceeds the marginal cost (that is, the incremental variable cost) of the hospitalization. For example, if a hospital system ACO is paid $10 000 for an admission with a marginal cost of $4000, the ACO’s profit from allowing the hospitalization ($6000, assuming no downside risk) would exceed the potential bonus from preventing it ($5000, assuming a 50% shared savings rate); thus, the hospital system derives a greater profit ($1000 more) from allowing the admission. Conversely, a physician group in the same ACO contract would earn a $5000 bonus by preventing the hospitalization without forgoing any fee-for-service profits.

High Fixed Costs

The cost structure of hospital systems amplifies these disincentives to reduce unnecessary hospital care. Fixed costs account for a large portion of hospital operating expenses—more than 80% according to one estimate (3). Therefore, reducing hospitalizations might cause a system’s revenues to fall faster than its costs over the short run. In the long run, a hospital system that reduces its admissions can realize greater savings if it lowers its fixed costs (for example, by repurposing or divesting capacity). However, systems may be reluctant to undertake these changes if payers, such as Medicare, continue to “rebase” or recalculate future benchmarks to reflect the new, lower level of spending, rendering any financial gains from reducing fixed costs short-lived.

Negative Spillovers

A hospital-based health system also may be reluctant to implement widespread changes to reduce wasteful care if these changes erode fee-for-service revenue among patients for whom the system does not bear risk as an ACO. These negative spillovers might occur if a system maintains fee-for-service contracts with some payers or if a system is not financially accountable for some patients in a global budget payment model. In the MSSP, for example, ACOs bear risk only for Medicare patients who receive the plurality of their primary care from the ACO’s providers. As a consequence, ACO contracts may cover relatively little of a health system’s revenue from specialty and inpatient care.

Positioning health systems to minimize these negative spillovers might have unintended consequences. For example, allowing a health system to become regionally dominant could minimize spillovers by increasing the proportion of the system’s revenue that is covered by ACO contracts. However, dominant systems face little competition to provide efficient care and can negotiate higher global budgets from commercial payers, thereby increasing spending.

Thinking Beyond Financial Risk

Successful payment reform may depend as much (or more) on the types of provider organizations participating in new payment models as on the risk-bearing requirements of payment contracts. Policies that encourage participation in global budget payment models among organizations with strong incentives to lower wasteful spending will be critical to success. These policies may include refinements to the rules governing new payment models and reforms to support competitive provider markets.

First, global budget payment contracts should give sufficient participation incentives to organizations with the greatest potential to save. In the MSSP, however, recent changes to how ACO benchmarks are set have been followed by the disproportionate exit of physician group ACOs and provider organizations with high baseline spending and thus greater capacity to save (4, 5).

Second, policymakers might focus on supporting the ability of physician group ACOs to promote competition by referring their patients to the most efficient hospital or specialist providers. However, exemptions to antitrust rules granted to ACOs risk entrenching hospital-based health systems’ market power by favoring organizations that can refer patients internally for specialty or hospital care, even though these may not be the lowest-cost providers (6). The Centers for Medicare & Medicaid Services has proposed broadening these exemptions despite concerns that they might elicit anticompetitive behavior (7).

Third, policies supporting competitive markets also might expand the pool of potential independent physician group ACOs (8). For example, Medicare pays more for most outpatient services in hospital-owned clinics, including professional and facility fees, than it does for the same services in independent physician practices. Eliminating this payment differential could remove one important driver of hospital–physician consolidation.

In summary, incentives in new payment models are closely connected to the structure of the health care delivery system. Policies that ignore this relationship and focus only on the risk terms of payment contracts may miss opportunities for progress.