The Effect of Prospective Payment on Medicare Expenditures

Medicare's prospective payment system was introduced in 1983 to slow the growth of expenditures for hospital care, which form the bulk of Medicare costs. Instead of reimbursing hospitals for the actual costs of patient care, the system pays them at fixed rates for each admission. In this study, we estimated the savings to Medicare from the use of prospective payment. We analyzed the expenditure projections published in 10 successive annual reports (1979 to 1988) by the trustees of the federal Hospital Insurance Trust Fund, which pays hospital bills for Medicare beneficiaries. To show the effect of prospective payment, these projections were adjusted to correct for the different assumptions about inflation and admissions made in each report. We also examined trends in expenditures from the Supplementary Medical Insurance Trust Fund, which pays for outpatient services, to see whether the savings in hospital expenses were offset by higher spending for out-of-hospital services. We found that prospective payment has reduced Medicare's hospital costs substantially. Expenditures from the Hospital Insurance Trust Fund for 1990 are expected to be $12 billion less in 1980 dollars, and $18 billion less in 1990 dollars, than was expected shortly before prospective payment went into effect — the equivalent of a savings of approximately 20 percent. By contrast, the effect of prospective payment on the supplementary fund has not been great. We conclude that the prospective payment system is having a major impact on Medicare's hospital expenditures and that the savings is not offset by an increase in outpatient expenditures. (N Engl J Med 1989; 320:439–44.) ON October 1, 1983, Medicare replaced its cost-based system of reimbursement for hospitals with prospective payment. Instead of receiving payment for the costs actually incurred in caring for Medicare patients, hospitals now receive a rate fixed in advance for each admission. The rate depends on the patient's diagnosis-related group (DRG) and on certain characteristics of the hospital. The primary purpose of the new payment system was to slow the rapid growth of Medicare expenditures, the bulk of which are for hospital care. Indeed, when prospective payment was under consideration in 1982 and early 1983, the Hospital Insurance Trust Fund, which . . .