Editor’s note: For more on this topic see Carmela Coyle’s Health Affairs Blog post.

Fee-for-service (FFS) medicine encourages inappropriate volume growth, but a new experiment in Maryland seeks to turn the incentives upside down.  The state, in a Model approved this month by the Centers for Medicare and Medicaid Services (CMS), will transform its hospital rate-setting system from a focus on controlling per-case cost toward population health and the total cost of hospital care per capita.

As the nation’s only all-payer hospital payment system, Maryland affords CMS a unique opportunity to demonstrate that a hospital payment system with properly designed and broadly applicable incentives can generate significant efficiencies.

Since 1977, Maryland’s Health Services Cost Review Commission (HSCRC) has established the rates paid to Maryland acute-care hospitals by both public and private payers. For nearly four decades, Maryland has shown significantly lower per-case cost growth than the rest of the nation, while reimbursing hospitals for uncompensated care and preventing cost-shifting from public to private payers.  The Maryland system has rested on FFS financial incentives, however, and has therefore encouraged hospitals to boost volumes while controlling unit costs.

FFS Payment and the Volume Problem

While recent attention has focused on the increasing negotiating leverage and sometimes predatory pricing practices of highly consolidated hospitals and health systems, the provision of excess and unnecessary hospital services is also a substantial cost driver. For instance, in its 2013 report on Health Care Cost Trends and Drivers, the Massachusetts Health Policy Commission reported that wasteful spending (defined as services that could be eliminated without causing harm to patients or reducing quality) accounted for between 21 and 39 percent of health costs in the state. As the economy recovers, the increased use of health care services may become an even larger cost driver.

The provision of excess services is an understandable response by hospitals to the perverse financial incentives of prevailing FFS arrangements. First, hospitals are paid each time they deliver a service, and they are not paid unless they deliver a service.  Second, the marginal revenue earned for each new case or service (paid at 100 cents on the dollar) greatly exceeds the marginal costs (thought to be 50-60 cents on the dollar). This is based on the author’s experience and discussions with Maryland hospital Chief Financial Officers. The difference provides hospitals with increased cash flow and profitability as volumes increase.

The view of hospitals as “self fueling, ever expanding machines” (as described by Professor James Robinson from the University of California, Berkeley), is consistent with many health economists’ view of the motivations of nonprofit hospital managers. Without the need to distribute profits to owners, managers of nonprofit hospitals and health systems instead have incentives to pursue business augmentation strategies – such as expanded facilities, duplicative technology, or the acquisition of physician practices — “to enhance their self-esteem and status in the community and to justify increased perquisites for themselves.” And many hospitals pay top executives bonuses for volume increases — as shown by Jay Hancock.

FFS payment also discourages hospitals from supporting efforts to reduce unnecessary services.  When hospitals paid under FFS lose volumes, they forfeit 100 percent of the revenue, reducing profitability by limiting their ability to fully fund their fixed costs.

Initially, the Maryland system (as did all state-based all-payer rate systems) included a Volume Adjustment System (VAS) to remove financial rewards associated with volume growth. The HSCRC unwisely scaled back the VAS in the 1990s and eliminated it in 2001. In response, Maryland hospitals greatly expanded their volume (see Chart 1 showing the indexed growth in Equivalent Inpatient Admissions (EIPAs), which is a measure of both inpatient and outpatient volume). Thus, while Maryland controlled the growth in per-case payments, those successes were undermined by increased cost associated with volume increases.

Chart 1
Indexed Rates of Growth in Hospital Volume (As EIPAs)
(Maryland vs. the U.S. 1976 – 2011) 


American Hospital Association Annual Statistical Guide, 1976-2011.

Although Medicare borrowed heavily from the experience of state-based rate systems in designing the IPPS, Medicare failed to incorporate volume adjustments in its hospital payment system.  This policy blunder has likely contributed greatly to excess service growth and to federal budgetary woes over time. It is understandable (yet ironic) that most recent payment reform efforts by CMS and its Center for Medicare and Medicaid Innovation (CMMI) — programs such as bundled payments, readmission reductions, and Accountable Care Organizations (ACOs) — have been focused on curbing the incentives for the delivery of unnecessary or marginal services.

Addressing the Volume Problem in Maryland

Beginning in 2008, the HSCRC started to address its volume problem by reintroducing a version of the VAS; using per-episode payments for most hospitals to remove incentives for readmissions; and negotiating Total Patient Revenue (TPR) arrangements (fixed global budgets that did not vary with volume or cost experience).

Initially, only ten hospitals in more isolated areas were eligible for the TPR. Given the discrete nature of their service areas, their expenditures could be more easily attributed to their community. Thus, TPR arrangements were early examples of population-based payment, providing hospitals with a guaranteed revenue flow to care for a geographically defined population.  The fixed budgets also gave the hospitals very strong incentives to reduce unnecessary or marginal hospital services. Over time, the TPR hospitals have generally produced impressive reductions in admissions, readmissions, and ER visits, along with improved cash flow and profitability, based on data and feedback gained through discussions with the HSCRC staff.

The Maryland Model

After a year of negotiation, CMS approved Maryland’s application for a revised Medicare payment system for a five-year period beginning January 1, 2014. During the third year, the state can submit a plan for continuation, including a proposal for an expansion beyond hospitals to all health services for Maryland residents.

As stated in Maryland’s application, the purpose of the Model is to test the ability of all-payer hospital population-based payment models to reduce hospital expenditures while maintaining or improving the quality of care.  Under the terms negotiated with CMS, Maryland must transition at least 80 percent of hospital revenue to “population-based payment methods” such as the TPR and an extension of the TPR Global Budget structure for suburban and urban hospitals.  The Global Budgets, for other hospitals, are similar to the global models implemented in New York in the 1980s.

During the transition period, all revenues not covered by population-based models must be subject to a more rigorous VAS. The VAS should greatly reduce incentives for volume growth and cushion hospitals in the event of volume declines by allowing them to retain the fixed cost percentage of any lost revenue. The symmetrical nature of the adjustment helps to remove hospitals’ traditional resistance to clinical management efforts to reduce unneeded hospital services.

Most importantly, the growth in total Maryland hospital revenue will now be subject to two specific per capita constraints: 1) a limitation on all-payer per capita hospital charge growth to a fixed 3.58 percent annually, reflecting the ten-year average annual growth in Maryland’s Gross State Product (GSP); and 2) a limitation on the growth in hospital expenditures per Medicare FFS beneficiary to the national rate of growth, less enough to generate cumulative Medicare savings of at least $330 million over the five-year Model. While a number of states have recognized the need to limit health expenditure growth to the growth in GSP annually, only Maryland, with its powerful all-payer rate-setting authority, has a mechanism to achieve this result on a sustained basis.

Finally, the agreement articulates triggering events that could terminate the Model (such as failure to meet the per capita limits or the quality improvement requirements) but allows the state to submit corrective plans approvable at the discretion of CMS.  If terminated or not extended, the agreement allows for a two-year period for Maryland hospitals to transition to standard Medicare payments.

Key Observations and Potential Implications

The Model, if successful, could have significant implications for national payment policy.

First, it represents an important attempt to reintroduce mechanisms to discourage unnecessary volume growth. The Maryland experience may be helpful in getting this important topic back on the national policy agenda.

Second, the Model also will attempt to take these incentives a step further by promoting population-based health. The Maryland agreement could provide CMS with strong evidence that hospital costs can be effectively controlled, while hospitals remain solvent without the need to shift costs to private payers.

Third, linking the growth to GSP could represent another notable policy achievement.  Since 1995, health care expenditures nationally have grown about 1.7 percent faster per year than the growth in domestic product, which has contributed greatly to the growing unaffordability of our health system.

Fourth, the new payment structures can address an inherent contradiction in the design of Medicare’s Shared Savings Program (SSP) ACOs. These programs seek to reduce unnecessary services but largely recruit providers who, under FFS, are still rewarded for every service they provide.  In order to be successful under an SSP, providers paid under FFS must “overcome dominating financial pressure pushing the opposite way.”  By contrast, in Maryland, hospital incentives will be aligned with the incentives of entities operating under SSPs.

Fifth, the incentives of the Model will reduce the demand for excess physician specialty care, much of which is driven by FFS incentives. At the same time, the Model should elevate primary care physicians (PCPs) by emphasizing the need for timely care, appropriate referrals and better care management. Maryland is advantaged by the broad deployment of a sophisticated Patient-Centered Medical Home (PCMH) program by the state’s largest private insurer, CareFirst BlueCross BlueShield. This program provides financial rewards to PCPs to reduce total care costs and improve quality. Medicare now participates in the CareFirst program on a limited basis through a CMMI Innovation Grant. In combination, the Maryland Model and the PCMH have the potential to create an integrated approach capable of achieving the goals of the three-part-aim.

Potential Challenges

Of course, the Model will generate challenges and unintended consequences.

First, Maryland hospitals face significant risk under this arrangement for two reasons: 1) the use of a fixed unwavering number for the all-payer growth cap of 3.58 percent (which equals Maryland’s ten-year GSP trend) could place unacceptable pressure on hospitals if underlying inflation escalates; and 2) an already-tight per-capita test could become even tighter as the federal government seeks entitlement limitations.

Second, while Maryland hospitals now will face strong incentives to control volumes, the dominance of FFS-incentives for physicians, and “productivity-based” contracts between hospitals and doctors will create conflicts that could undermine the success of the Model.

Finally, it will be very difficult to break the revenue-driven hospital culture that has arisen over the last twenty years and which is strongly committed to system expansion, volume growth and market domination. Although the HSCRC possesses powerful rate-setting tools, it has in the past been somewhat reluctant to impose the necessary discipline on a politically powerful hospital industry.


The clear focus of national attempts at payment reform in recent years has been toward the development of more fixed and population-based approaches.  Maryland’s new Model will cover approximately $16 billion in annual hospital payments and will move this agenda forward in an unprecedentedly major way.

The CMS actuaries recently reported that health inflation continued low through 2012, although they are concerned that high expenditure growth could recur as the economy improves. The CMMI appears to be highly receptive to proposals from other states to take more accountability for the total cost and quality of care. The Maryland Model can serve as a template or as a springboard to creative efforts by other states to address an economically dominant provider industry and ever-rising health expenditures.