Elsevier

Health Policy

Volume 70, Issue 2, November 2004, Pages 175-184
Health Policy

Pricing health services for purchasers—a review of methods and experiences

https://doi.org/10.1016/j.healthpol.2004.04.012Get rights and content

Abstract

This article reviews methodologies and international experience related to costing and pricing health services for health care purchasers. The main factors affecting price-setting methods are: (1) provider payment systems; (2) information available on actual costs, service volumes and outcomes; and (3) characteristics of providers and purchasers.

These factors are strongly interrelated. Provider payment systems determine the unit of services to be priced. In order to minimize incentives for under- or over-utilization, the prices that purchasers pay for health care services should be related to the actual unit costs of services, but accurately calculating real unit costs is intensive in terms of resources and information. Pertinent provider characteristics influencing price-setting include provider autonomy, provider negotiating power, and the degree of competition.

The article presents a series of examples that run through each of these three sets of factors. The examples are from Denmark, the UK, and Thailand (for capitation); Australia, Hungary, and the United States (for case-based payment); and Germany, Korea, and Taiwan (for fee-for-service payment mechanisms). From these experiences, the article concludes with appropriate lessons for low- and middle-income countries, where the principal constraint on the development of provider payments systems is the limited availability of information on costs, volumes, and patient characteristics.

Introduction

This article reviews methodologies and international experience related to establishing levels of payment for health services from the perspective of purchasers. Health care purchasers are considered to be organizations, public or private that procure health services on behalf of a defined population. Purchasers are often health insurance organizations, but they can also be employers, cooperatives, and other institutions that pool funds and purchase health care on behalf of their beneficiaries.

There are three key sets of factors that affect the determination of the prices purchasers pay for health services. These include:

  • (1)

    The method of provider payment.

  • (2)

    The availability of information, including providers’ costs, volumes, outcomes, and methods used to calculate costs.

  • (3)

    Characteristics of purchasers and providers, including the regulatory environment, provider autonomy, negotiating power, and the degree of competition.

The article presents a series of examples that run through each of these three sets of factors. The examples are drawn from high and middle-income countries. The specific examples employed are from Denmark, the UK, and Thailand (for capitation); Australia, Hungary, and the United States (for case-based payment); and Germany, Korea, and Taiwan (for fee-for-service payment mechanisms). Each of these examples is first described in Section 1.1, and is then discussed in terms of the availability and use of information to calculate costs (Section 1.2), and the characteristics of purchasers and providers that further influence pricing (Section 1.3). From these experiences, the article concludes with appropriate lessons for low and middle-income countries.

One of the first questions to be answered in setting prices for health services is: what unit of payment is being priced? The answer is generally set in the context of the applicable provider payment system, including whether payments are made retrospectively or prospectively, and whether payments are variable or fixed. Table 1 summarizes provider payment methods and their incentives for provider behavior. As shown, provider payment methods can be classified according to the units of the services purchased. The unit of service can be each health service provided (fee-for-service), all services related to a diagnosis (per-case), all services for a patient over a period of time (capitation), or all services over a period of time (global or line item budgets). The features of these basic payment systems are often combined, mixing incentives for both providers and patients.1

Another characteristic of payment systems influencing how price levels are set is whether the payment is retrospective or prospective. Retrospective payments are calculated and paid after the service is delivered, while prospective payments are made before delivery of the service. The key distinction is that the price paid in a prospective payment should be an accurate prediction of future costs, while the price paid in a retrospective system should be aligned with the actual costs incurred. An additional important dimension is whether the payment system is variable or fixed. In variable payment systems, the aggregate amount of payment services is proportional to the volume of activity; in fixed systems, there is a limit on total payments [1].

Line item and global budgets are prospective, fixed aggregate payments for a stipulated period [2]. The payment size is generally based on previous payments, which may be adjusted by an inflation factor [3]. Line item budgets do not allow for reallocation of resources across service categories; global budgets do. By themselves, these budgets can encourage the under-provision of important health care services, and they tend to lock in historical levels of resource use [2], [4]. Line item and global budgets are the most common reimbursement methods for hospitals in low and middle-income countries, generally, because a lack of information systems prevents more sophisticated reimbursement arrangements [5], [6], [7]. Because line item and global budgets do not involve setting levels of reimbursement for specific services, we do not consider them further in this review, except when they are used in combination with other reimbursement methods.

Fee-for-service payments are retrospective, variable payments made for each service provided. The price paid for each service, the “fee schedule,” is determined by setting the relative value of each service vis-à-vis other services, then determining the amount paid per relative value unit (the “conversion factor”). The fee schedule can be set in a range of ways, ranging from heavy reliance on information from costing studies to exclusive reliance on negotiations. Fee-for-service payments are administratively straightforward but can encourage overproduction of services [4]. Many countries with fee-for-service payments systems mix these systems with other types of payment to counteract the inflationary tendencies of fee-for-service.

The German health care system combines elements of fee-for-service reimbursement with an overall limited global budget. Ambulatory care physicians are reimbursed retrospectively per service provided. Two national fee schedules determine the prices paid. The first, for the private sector, is determined annually at the national level and sets the price per service in currency units [8]. The second applies to payments to physicians by sickness funds, the publicly financed insurers that cover the most of the population. In each region of the country, the assigned budget caps are divided by the total number of relative value units for services provided by physicians, if physicians provide a higher volume of services, their remuneration per service is lower [9].

The United States uses a similar fee schedule for physician payment in the federal Medicare program. As in Germany, total expenditure is limited by a global budget; the size of the United States global budget “target” is linked to growth in the national per capita gross domestic product. If spending exceeds the global budget, the remuneration per relative value of service is lower (Medpac, 2002). The mixed payment systems in the United States and Germany are variable at the micro-level, but fixed at the macro-level, providing incentives that differ from a pure variable fee-for-service system [1].

Both Korea and Taiwan have predominantly used fee-for-service purchasing in the context of rapidly expanding public health insurance programs. Both countries have also introduced mixed payment systems to modify the inflationary incentives of fee-for-service reimbursement. Korea lowers reimbursement for physicians providing an exceptionally high volume of services (OECD, 2002).

Capitation payments, simply defined, are prospective, fixed payments to providers to care for a defined population for a defined period of time. The price of services under a capitated payment system is, therefore, the rate paid to the provider per insured person per time period. If prices perfectly equaled expected costs, any surplus or deficit in revenue for the provider would be due to random events and treatment patterns. If prices are below expected costs, providers can be expected to make up for the deficit by lowering expected costs by selecting lower risk patients.

To set prices as close as possible to the expected costs of treatment, payments can be adjusted according to the insured’s cost-associated characteristics through risk adjustment. However, since risk adjustment is only partially successful in predicting the actual treatment costs, incentives for patient selection remain [10]. A mixed payment system, capitation plus other forms of payment, can mitigate providers’ incentive to select healthier patients [11]. Capitation provides for strong controls on the price and volume of services, but may also encourage under-provision or poor-quality care if payments are too low [4].

Denmark uses a mixed capitation payment system for general practitioners. These physicians receive about one-third of their payment as capitation and the remaining two-thirds as fee-for-service [12]. The combination mixes the fee-for-service incentives to provide more services with those of capitation to provide fewer. In the UK, primary care physicians are organized into regional associations called Primary Care Groups or Primary Care Trusts, with the latter having a greater degree of managerial autonomy. These groups are paid via a capitated payment from regional Health Authorities, and can either provide or purchase health services for their enrolled population.

Public health insurance programs in Argentina, Brazil, Nicaragua, and Thailand have also adopted capitation. In Thailand, a middle-income country, the Social Security Administration to pay capitated payments to contracted public and private hospitals on behalf of insured workers. Capitated payments to contracted hospitals cover all inpatient and outpatient services not necessitated by a work-related illness [6], [7].

Payments per-case are either prospective or retrospective variable payments made per hospital discharge, usually weighted by diagnosis [1]. Key steps in setting prices for diagnosis-based payments include: developing a diagnosis classification system; determining the relative weights of each group within the classification; determining the payment per relative weight unit; and establishing adjustments in the payment rate. These payments ensure that costs are limited by type of service but may encourage increased hospital admissions.

In Australia, hospital payments are administered at the state level. All but one state make prospective per-case payments based on an Australian system of classification of diagnoses, the Australian national diagnosis-related groups (AN-DRGs), adapted from the DRG classification used in the United States [13]. Hungary is a transitional middle-income country that has implemented case-based hospital payments. This reform faced the challenge of converting a centrally planned hospital sector, where payments had been made through global budgets based on negotiations and hospital size to a per-case payment system [14]. The classification system used to define cases has been periodically adapted, using United States DRGs as the starting point [14].

The principal reimbursement methods discussed here, fee-for-service, capitation, and case-based payments, have very different requirements in terms of the information needed to determine reimbursement levels. While each method employs different techniques to arrive at appropriate reimbursement levels, they all seek to link the prices paid for services to the actual costs of those services.

If prices do not reflect actual costs and public health objectives are not taken into consideration in pricing health services, a range of undesired consequences may result. Providers may charge informal payments to compensate for inadequate formal payments, or they may avoid treating sicker patients. Services provided may be of suboptimal quality. Inappropriate referral patterns may develop between different levels or sites of service. Services may be either under- or over-utilized, depending on the relationships between the price, the actual cost of services, the value of services to individuals, and the presence of positive externalities for services, such as immunization, that provide health benefits beyond the individual to whom they are directly provided.

Activity-based costing (ABC) is a retrospective approach to allocating costs used to calculate the unit costs of health services in the United States, and has been applied in low and middle-income countries ([15]; Waters, 2001). Traditional costing procedures typically group indirect costs in one pool and allocate these costs to products based on relative production figures. Because of economies of scale in production, this approach attributes too high a cost to high-volume products and too low a cost to low-volume ones. ABC goes further by attributing support costs based on the actual consumption of the goods and services provided, measured by time allocation (Fig. 1). ABC is typically used to calculate costs for specific services, appropriate for fee-for-service reimbursement, but can also be used to calculate the cost of a bundled package of services for the same patient [16], [17].

A related approach used in lower and middle-income countries is to allocate costs derived from line item budgets across inpatient departments, avoiding ABC’s need for data on personnel time distribution. An additional technique to allocate costs, employed in Kyrgystan and Kazakhstan, is to develop a simple case mix with weights for different procedures that can be used as a simple diagnostic-related groups (DRG) system on which purchasers can base reimbursement levels [4].

Some health services have social costs or benefits that are not directly absorbed by either the provider or the patient. These costs and benefits, also called “externalities,” should be included in the price paid in order to encourage the socially optimal volume of these services. For example, an individual’s vaccination will provide a health benefit not only for the individual, but for those around the individual; this benefit is a positive externality. Therefore, a public purchaser in order to provide the maximum health benefit to society would pay a higher price for the vaccination than its cost to the provider, encouraging the provider to perform more vaccinations. Externalized costs and benefits are difficult to measure. However, public purchasers may adjust their prices paid for certain services where it is clear that society will benefit from an increased volume of provision than would be found if the prices only reflected the private costs of the service to its provider.

The Medicare program in the United States uses a fee schedule to directly reimburse physicians for outpatient services. This fee schedule, the resource based relative value scale (RBRVS), was initially informed by an economic study of the resources used to provide each service [18]. Three types of resources are used to set relative values: (1) physician work, including the time, intensity of effort, skill, and risk to the patient associated with each service; (2) practice expenses, including the cost of non-physician staff, office space, equipment, and supplies; and (3) professional liability insurance (Medpac, 1999). Payments are also adjusted for geographic differences in price levels. The amount paid per relative value unit is updated using a formula linking payment growth to that of the national economy (Medpac, 2002).

Other countries have relied more on negotiations and less on data collection than the United States Medicare system. Korea has relied on the empirical work conducted for the establishment of the United States RBRVS scale, adopting the Medicare relative value weights (OECD, 2002). The conversion factor, on the other hand, is determined through annual negotiations between the government and physicians. In Germany, price-setting for each relative value unit of payment is driven mainly by negotiation, with little emphasis on the calculation of actual costs [19]. Each service is given a relative value, determined through a mix of expert judgment by physicians and political negotiations between the various specialty societies [20]. The Taiwan Bureau of National Health Insurance also determines both the relative values of services and the conversion factor through negotiation, similar to the German model (Chiang, 1997).

These approaches to setting prices paid under a fee schedule have very different information needs. The German and Taiwanese approach, relying heavily on negotiations, does not require information beyond expert judgments and historical payments, although other information on costs could be and doubtlessly is used by specialty associations. The United States RBRVS methodology, on the other hand, required a large national study of the costs of physician services. The United States model has moved closer to the German and Taiwanese approach in the updates of its original fee schedule, however. Updates to the relative value scale in the United States are based on expert consultations (Medpac, 2002). All of the countries have used mixed payment systems to counteract the inflationary incentives of fee-for-service payment. Germany and the United States have lightened the importance of the average weighted level of prices through global caps on the amount paid.

Prices paid to Danish physicians are negotiated annually at the national level between the association of county councils (purchasers) and the association of general practitioners. Capitated payments are adjusted by age and sex alone, without other risk adjustment or adjustment of prices. The low level of risk adjustment lightens the administrative burden but increases the likelihood of patient selection. In Denmark, the only information requirement is an accurate roster of enrolled patients with their age and gender at enrollment.

In contrast, the UK uses an information-intensive approach to pay primary care groups via capitation. In the UK, Health Authorities calculate the expected costs of treating the enrolled population using a risk adjustment formula. The current capitation formula is based on the number of enrolled persons, individual-level data on age and sex, and community-wide data on socioeconomic status and chronic illness levels (NHS, 2002a; Majeed et al., 2001). This requires an accurate count of enrolled persons and data on their age, sex, and address.

Primary care groups and trusts also have a high degree of responsibility for measuring their costs in order to allocate the capitated payments effectively. The unified budget must be allocated among hospital care, prescribing, primary care, and other services. National cost data are used to derive a national price schedule for health services, eliminating price competition in the commissioning of health services (NHS, 2002c).

The price paid for Thai Social Security capitation payments has been determined by the government. No risk adjustment by age, sex, or other factors was implemented to align prices more closely with expected costs. This was not considered necessary since the beneficiaries, adult workers, had similar expected health care utilization [21].

Since capitation payments in the Thai insurance system are not set to match individuals’ expected costs, the system would be expected to encourage selection of healthier patients by providers. Under social security, this issue has been attenuated by the fact that the beneficiaries, all adult workers, were generally healthy. Nevertheless some evidence of “dumping” sicker patients has emerged through interviews with leading public hospital clinicians and members of the Complaints Committee for the Social Security System [21]. Recent health reforms extend payments to previously uninsured individuals, making risk adjustment of capitation prices more likely, due to the more uneven risk profile of the beneficiaries. A technical advisory group has tentatively recommended adjustment by age and sex at a minimum, and possibly by diagnosis [22].

In the Australian state of Victoria, relative weights were established by measuring costs and adapting weights from other diagnosis-based payment systems [23]. The costs of each DRG are based on patient-level resource utilization. Annual costing studies collect data from a sample of around 15 hospitals to determine costs per DRG [23]. A substantial investment in measuring costs is necessary to collect patient-level data for costing.

In Hungary, relative weights for each DRG were determined through a series of national studies [4]. However, since Hungary has adapted from a budget-based hospital payment system to a per-case payment system, they have not relied on costing studies to set the prices paid per DRG [24]. Instead, as the per-case payment system was implemented, hospital-specific factors were used to adjust prices paid so that historical remuneration patterns were not interrupted. These hospital-specific factors were eventually eliminated five years after the implementation of per-case payments, in 1998, so that the price paid per DRG was equal across hospitals [25]. However, there is a global budget on hospital services, so that the price per DRG decreases as volume increases, similar to the German fee-for-service payment system.

The experiences of Australia and Hungary illustrate a range of methods for pricing DRG payments. Both countries have made the investment necessary to develop a relative value scale for services delivered in their country, using the existing United States scale as a starting point. However, Victoria has also developed the capability to collect data to determine the cost associated with each value unit, while Hungary has not. Victoria uses patient-level data collection systems to determine the price paid per diagnosis-related group. Hungary has not used such detailed costing information to set the prices paid per DRG. The data necessary for such a costing study would require substantial investment. In the transition from budget-based hospital payments. Hungary has taken a more ad-hoc approach to setting the price paid per DRG. Victoria’s approach is most likely to align prices with true costs but also usually requires the capability to capture patient-level data.

The characteristics of health care providers and their relations with purchasers have a strong influence on the way prices for health services are determined. Among the most pertinent characteristics are provider autonomy, provider negotiating power, and the extent of competition. Provider autonomy can be thought of as a continuum from complete ownership of the provider by the purchaser to private ownership with contractual relationships with purchasers. In the special case, where the functions of purchasing and delivery are combined within the same public sector organization, the differences in the incentives of these two functions are minimized. Moving along a continuum toward greater provider autonomy, the incentives associated with purchasing and delivery increasingly diverge.

Provider negotiating power is important in many systems for setting prices in which the providers are not directly managed by purchasers but also do not tender competitive bids to determine prices. Providers may negotiate with purchasers over service prices, which services are reimbursed, and how they are reimbursed. In Germany, Switzerland, and Canada, for example, payment levels are determined through negotiations between purchasers and provider groups. Prices depend directly on the negotiating effectiveness of the provider associations.

Provider competition affects prices in systems where prices are determined through a process of bidding by autonomous providers. In a perfect market, competitive bidding would be expected to produce socially optimal price levels. However, health care markets include many well-documented market failures, with subsequent justification for government intervention. An example of a competitive bidding process for provision of health services can be found in the United States, where hospitals enter contractual relationships with private health insurers. Regulation by the states affects many aspects of this process. [26] showed that hospital prices were lower in areas on California with relatively low levels of hospital concentration. This illustrates the importance of the number of providers on the price effects of the competitive bidding process. If a hospital is the only provider for a region, for example, it could use its monopoly power to obtain higher prices for its services through a unilateral bid for a contract rather than through a negotiating process with a purchaser.

The prices for ambulatory services in the German system are clearly related to the relative negotiating power of providers compared to purchasers. Furthermore, there are multiple interrelated areas of negotiation that affect prices, including the amount of the regional capitated budgets, the services that are remunerated, and their relative values. Chancellor Gerhard Schroeder commented after his recent re-election that he would like to decrease the negotiating power of the National Association of Statutory Health Insurance Physicians, potentially bypassing the association by contracting directly between sickness funds and individual doctors (Reuters, 2002). Such a change would be a return to the negotiation system used in the early years of the German public insurance system in the late 19th century [19]. Reforms in 1989 sought to increase the negotiating power of the purchasers compared to the providers by centralizing all negotiations [19]. Physicians are not permitted to strike but in previous negotiations they have publicly threatened to ration care by placing patients on waiting lists (Reuters, 2002).

Provider autonomy and negotiating power are important in determining the level of payment per DRG in Australia. Although the price per relative unit of weight can be informed by costing studies, such as in Victoria, it is also determined through political processes. In addition, payment levels can be affected by adjustments for special types of hospitals, for example, a politically powerful teaching hospital association may be able to adjust its payment levels upwards. Competition may affect prices in some systems. For example, providers in the United States may contract for different prices per DRG with private insurance companies than the amounts paid through the Medicare program.

In Hungary, the health system has transformed from a socialized system where hospital budgets were largely dependent on political influence to a system with greater hospital autonomy and more objectively determined payment levels. This transition was accomplished by gradually adjusting historical payment levels to per-case payments based on a national relative value scale. This transition has decreased the importance of provider characteristics in determining prices while increasing the importance of data on costs and utilization of hospital services.

Similar to the German process, prices paid to Danish general practitioners depend to a great extent on their negotiating power. If the physician association and county councils cannot reach agreement, the federal Ministry of Health fixes payment amounts unilaterally until agreement is reached (Rublee, 1995). Since these physicians earn one third of their revenue through capitation, they have some incentive to enroll more healthy patients to increase their revenue, although there is no published evidence of a selection bias towards healthy patients.

In the UK, frequent reforms of the National Health Service (NHS) have drastically changed the roles of providers and purchasers. The most recent incarnation of the NHS, with devolved purchasing and a high degree of provider autonomy in managing the health of an enrolled population, will continue to provide lessons for other countries (Dixon and Preker, 1999). Primary care groups will have to increase their managerial capacity in order to adjust to their new autonomy in order to set prices appropriately for the services provided (Wilkin, 2002). Meanwhile, the method used to set the price of their capitated budget is also evolving. Future capitation rates will depend on negotiating power of the provider groups as well as expert input.

Section snippets

Conclusions

The main factors influencing how prices are set are the unit and method of payment, the measurement of costs, and the characteristics of purchasers and providers. These factors are strongly interrelated. For example, many low- and middle-income countries use global and line item budgets for hospital payments. This payment system is simple to administer since it does not rely heavily on measuring costs; prices paid are determined mainly from historical levels. However, since global and line item

Acknowledgements

This article is based on work funded by the World Bank. The authors are grateful to Alexander Preker and Jack Langenbrunner of the World Bank for important conceptual input and to anonymous reviewers for helpful suggestions.

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