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Institute of Medicine (US) Committee on Quality of Health Care in America. Crossing the Quality Chasm: A New Health System for the 21st Century. Washington (DC): National Academies Press (US); 2001.

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Crossing the Quality Chasm: A New Health System for the 21st Century.

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8Aligning Payment Policies with Quality Improvement

Many factors influence how health care organizations and professionals deliver care to patients. For example, information can be used to compare performance with that of peers and motivate improvement. Similarly, tools such as practice guidelines, clinical pathways, or protocols aim to change clinical practice to make it more consistent around a definition of best practice. Health care professionals and organizations are also motivated by public acknowledgment and honorary recognition. Recognition of professional accomplishment and innovation is a strong motivator of improvement.

Payment policies are another strong influence on how health care organizations and professionals deliver care and how patients select and use that care (Hillman, 1991). Thus, to achieve the aims of the 21st-century health care system set forth in Chapter 2, it is critical that payment policies be aligned to encourage and support quality improvement. Yet financial barriers embodied in current payment methods can create significant obstacles to higher-quality health care. Even among health professionals motivated to provide the best care possible, the structure of payment incentives may not facilitate the actions needed to systematically improve the quality of care, and may even prevent such actions. For example, redesigning care processes to improve follow-up for chronically ill patients through electronic communication may reduce office visits and decrease revenues for a medical group under some payment methods. Current payment policies are complex and contradictory, and although incremental improvements are possible, more fundamental reform will be needed over the long run.

The goals of any payment method should be to reward high-quality care and to permit the development of more effective ways of delivering care to improve the value obtained for the resources expended. These goals are relevant regardless of whether care is delivered in a predominantly competitive or regulated environment, and whether the ultimate purchaser is an employer or the patient/ consumer. Payment policies should not create barriers to improving the quality of care.

Recommendation 10: Private and public purchasers should examine their current payment methods to remove barriers that currently impede quality improvement, and to build in stronger incentives for quality enhancement.

Although some purchasers are pursuing payment approaches that include rewards for quality, all existing payment methods could be modified to create stronger incentives for quality improvement. Purchasers should identify ways to (1) recognize quality, (2) reward quality, and (3) support quality improvement. For example, quality could be recognized by developing better quality measures and making their results more broadly available to covered populations, whether through new forms of information or improvements in the ways existing information is shared. Quality could be rewarded by using direct payment mechanisms or by redirecting volume to health plans and providers recognized for providing high-quality care by offering stronger incentives for people to seek out better quality care (e.g., adjustments to out-of-pocket costs). Quality improvement could be supported by exploring the potential for shared-risk arrangements that could encourage making significant changes in care processes to improve quality. Although more fundamental change may be required in the long run, immediate improvements can and should be pursued.

Recommendation 11: The Health Care Financing Administration and the Agency for Healthcare Research and Quality, with input from private payers, health care organizations, and clinicians, should develop a research agenda to identify, pilot test, and evaluate various options for better aligning current payment methods with quality improvement goals.

Although most payment methods have an objective of cost containment or reflect consideration of issues of access (e.g., in determining levels of copayments), they do not have the explicit goal of ensuring quality care or facilitating quality improvement. Approaches to incorporating such an explicit goal into payment policy should be explored. This research agenda should include work in the following areas: blended or bundled methods of payment for providers, multiyear contracts, payment modifications to encourage use of electronic interactions between providers and patients, risk adjustment, and alternative approaches for addressing the capital requirements necessary to improve quality. Blended or bundled payments may offer providers greater flexibility in incorporating quality. Multiyear contracts can encourage longer-term relationships among providers, purchasers, and payers to permit investment in improved quality of care. Payment methods that support electronic or other forms of communication between providers and patients can improve contacts with the health system. Payment methods that are appropriately adjusted for the risk of the patients served can support the provision of needed care and improved sources. Capital will be needed for the redesigning and reengineering of health care that will be required to improve quality. A better understanding is needed of how these, as well as other mechanisms, can enhance the effects of payment policy on the provision of high-quality health care.

The potential to link payment methods to priority conditions should also be explored. As noted in Chapter 4, priority conditions can provide a framework for aligning payment methods with patient needs and the ways care is organized and measured. If payment methods were designed to encompass the scope of services received by patients, providers could allocate resources according to patient needs, across provider types and settings of care. Pilot testing should include an evaluation of the use of bundled payments for priority conditions to provide incentives for redesigning care processes and to permit resources to be allocated according to the scope and types of services needed by patients.

The committee believes certain principles should guide the development of payment policies to reward quality, regardless of the specific payment method used for any given transaction. The aim of these principles is to guide payment policy reforms that can support care that is more patient-centered, evidence-based, and systems-based. Payment arrangements should facilitate alignment of the units of patient care delivered (including consistency with best practice) with the needs of consumers and patients, the unit of payment, and the level at which information is collected and shared. To achieve alignment that can reward quality care, payment methods should:

  • Provide fair payment for good clinical management of the types of patients seen. Clinicians should be adequately compensated for taking good care of all types of patients, neither gaining nor losing financially for caring for sicker patients or those with more complicated conditions. The risk of random incidence of disease in the population should reside with a larger risk pool, whether that be large groups of providers, health plans, or insurance companies.
  • Provide an opportunity for providers to share in the benefits of quality improvement. Rewards should be located close to the level at which the reengineering and process redesign needed to improve quality are likely to take place.
  • Provide the opportunity for consumers and purchasers to recognize quality differences in health care and direct their decisions accordingly. In particular, consumers need to have good information on quality and the ability to use that information as they see fit to meet their needs.
  • Align financial incentives with the implementation of care processes based on best practices and the achievement of better patient outcomes. Substantial improvements in quality are most likely to be obtained when providers are highly motivated and rewarded for carefully designing and fine-tuning care processes to achieve increasingly higher levels of safety, effectiveness, patient-centeredness, timeliness, efficiency, and equity.
  • Reduce fragmentation of care. Payment methods should not pose a barrier to providers' ability to coordinate care for patients across settings and over time.

The remainder of this chapter examines in greater detail the relationship between payment methods and the ability of health care organizations and professionals to undertake quality improvement activities. In the first section, the theoretical incentives of current payment methods are briefly reviewed. The second section focuses on barriers in the payment system that inhibit the achievement of significant improvements in quality. The third section describes how existing payment methods could be adapted to support quality improvement. Although difficult to accomplish in today's environment, examples are provided to illustrate how some health care organizations are attempting to incorporate greater attention to quality in their payment arrangements. Any payment method can be improved to support quality. However, fundamental misalignments will remain; thus fixing current payment methods may be important, but not sufficient. The final section therefore explores the need for a new approach to payment policy that can better align the needs of patients with the unit and type of payment method.


Payment processes link together many different actors in health care. Purchasers, consumers and patients, health plans and insurers, and health care providers are all connected through various financial transactions (see Figure 8–1). Purchasers or funders of health care include public and private purchasers, such as employers and the Health Care Financing Administration; individual consumers and families; and federal, state, and local governments that may offer direct subsidies to certain providers (e.g., public hospitals) or for certain services (e.g., immunizations). Many purchasers buy coverage for their employees or covered populations through contractual arrangements with health plans or insurers. These health plans and insurers, in turn, contract with individual providers and/or provider groups to deliver health care services. In some cases, purchasers and providers may also be directly linked through contracting approaches under which employers contract directly with a provider group to deliver care.

FIGURE 8–1. Linkages through payment arrangements.


Linkages through payment arrangements.

Payment linkages also exist within the boxes shown in Figure 8–1. Purchasers and individuals are linked when purchasers provide a choice of coverage to their workers or covered populations and when individuals contribute to the cost of that coverage. Similarly, different types of providers can be linked through payment, such as when individual physicians receive payment through a larger medical group or when hospitals and physicians are linked financially in shared-risk arrangements. Because of these complex and diverse linkages, any given approach to payment policy can exert a powerful influence on the way services are provided to consumers and patients, and can produce unintended consequences.

Although this chapter focuses primarily on payments involving a payer and a provider, the committee recognizes the need to have a better understanding of how consumer decision making influences payment relationships. Consumers pay for health coverage both when they contribute to the cost of premiums and when they pay directly for health services through copayments, deductibles and payment for noncovered services. Although a great deal of research has been done recently on how consumers use information in selecting a health plan, less attention has been focused on how their decision making affects the payment relationship.

The committee believes consumers and patients should have a direct role in rewarding quality care. To have this role, consumers should have choices, receive information about their choices, and have the power to act on those choices. Not all consumers have a choice of health plans (Trude, 2000), but all have a choice of providers (and some services) within even a single health plan.1 Yet little information is made available to consumers at the level of providers or specific services, particularly relative to quality differences. As a consequence, consumers rarely switch health plans or providers for quality reasons (Cunningham and Kohn, 2000). Additional research is needed to understand how consumer decision making might affect the way payment flows may be altered in the future. A better understanding is also needed of how to communicate effectively with patients about best practices and evidence-based practice so that quantity is not automatically equated with quality.

The remainder of this section focuses on the right side of Figure 8–1— payment to providers for the direct delivery of services, especially the relationship between a health plan or insurer and providers. Other issues of financing health care, such as the source of funds or insurance coverage, are beyond the scope of this report, although the committee believes they are important issues and merit analysis. The following subsections provide a brief overview of common payment methods and the theoretical incentives offered by each. Four types of payment methods are reviewed: methods that pay by prospectively determined budgets regardless of whether services are used, per case payment methods that pay for a bundle of services used in a case, methods that pay by a unit of care as the units are used, and blended methods that combine approaches (Aas, 1995).

Budget Approaches

Under budgeted payment approaches, a budget is set for some defined set of services over a specified period of time and becomes a spending ceiling. A total budget can be set on a per capita basis or be based on historical costs (Aas, 1995). Capitation is a form of budgeting in which the budget is based on a fixed fee for each enrolled person to cover a specified level of health care, regardless of the amount of service actually provided (Aas, 1995; Anderson and Weller, 1999).

The advantages of a budgetary approach are that it provides an incentive to control costs and produce care efficiently, and can encourage innovation in cost-reducing technologies, use of lower-cost settings of care, and investment in health promotion and disease prevention. The approach also can make costs more predictable for the funder. Additionally, it can provide flexibility to providers in deciding how to spend the budgeted amount and coordinate care with other providers encompassed by the budget. Disadvantages include the potential for risk selection to avoid patients who might be high-cost users of care, and the potential to provide insufficient or reduced quality of services to minimize costs and stay within budget (Aas, 1995; Barnum et al., 1995; Lee, 1997). There is also the potential for conflicting incentives if physicians and hospitals are paid under separate risk pools, which could encourage a physician to admit a patient to the hospital (or refer the patient to a specialist) to reduce his or her own costs (Aas, 1995; Barnum et al., 1995).

A variant of the budget approach applied specifically to physician payment is salary. The advantage of the salary approach is good control over total costs and the dissociation of treatment decisions from a physician's financial gain or loss. The main disadvantage is the potential for reduced productivity if sufficient rewards are not built in (Aas, 1995).

Per Case Payment

Per case payment methods were introduced in 1983 by Medicare for short-term hospitals providing acute care services to Medicare beneficiaries (Cleverley, 1992). A prospectively set payment amount is determined on the basis of the diagnosis that resulted in the patient's hospital admission. From the hospital's perspective, the incentive is to reduce the costs of caring for patients within each diagnosis related group (DRG) in order to benefit from the savings achieved. From the purchaser's perspective, spending can be controlled directly through payment rates and updates (Medicare Payment Advisory Commission, 2000a). Medicare prospective payment for hospitals is generally believed to have reduced spending growth and increased efforts by hospitals to control costs, as evidenced by shorter lengths of stay and increased margins (Medicare Payment Advisory Commission, 2000a). On August 1, 2000, Medicare instituted a per case payment method for hospital outpatient care using ambulatory payment classification (APC) groups (Hallam, 2000; Medicare Payment Advisory Commission, 2000b).

Per case payment methods could be applied to the concept of priority conditions. For example, the mix of services covered under a payment method could be extended to include a comprehensive bundle of services that could be provided across different settings of care and over a defined period of time, similar to an episode of care. The advantage of this approach is that it would permit providers to design care and allocate resources for a population of patients (e.g., diabetics). Such an approach could also support the formation of multidisciplinary teams that would span settings of care to improve coordination among providers and foster the use of alternative modalities for treatment, such as e-mail for monitoring patients over time. Additional research would be needed to determine how to define an episode of care, particularly as applied to a chronic condition (Aas, 1995).

Payment by Unit of Care

Payment methods may be based on some unit of care. For example, under fee-for-service payment for physicians, the unit of payment is a visit or procedure. For hospitals, the unit of payment might be a patient day (per diem payment). These are retrospective payment methods in that care is paid for after it is used, although the rate to be paid may be set in advance.

In general, payment by unit of care offers little incentive to contain total costs since the incentive is to produce more of the unit of care that is being reimbursed. Under fee-for-service specifically, there is a potential for overuse of services by increasing the intensity of care and treating more patients. Also, since the method is based on individual units of care or service, it can be difficult to coordinate payment across the many members of a care team. The main advantages of payment by some unit of care are that it reduces the incentive for risk selection (i.e., avoiding people who are likely to be high users of care), and that physicians may specialize in difficult-to-treat medical problems. For per diem payment methods, there can also be an incentive to produce care efficiently to maximize profits per day (Aas, 1995; Barnum et al., 1995; Dudley et al., 1998).

Blended Methods

Approaches for bundling payments to providers have received increasing attention in recent years as a mechanism to align more closely the incentives faced by different providers involved in the care of a single patient. The central characteristic of bundled payment is that it covers multiple providers. The advantage of bundled payment methods is the opportunity to use resources more efficiently if some services across the continuum of care are substitutes for each other. For example, monitored home care could substitute for some office visits. Even if there is no substitution, a payer can make one entity responsible for a bundle of services and provide that entity with an incentive to deliver an efficient combination of services (Welch, 1998). Any possible gains associated with shifting patients among services is diminished.

Concerns with bundled payment approaches include questions about which entity should receive the payment and be held responsible for care (Welch, 1998). Possible responsible entities include health plans, hospitals, and physician groups. Another concern is feasibility in rural areas, where providers may face special difficulties in managing a continuum of services. Concerns have also been raised regarding the technical issues involved in building billing systems that can combine services offered by multiple providers (Schmitz, 1999). Additionally, legislative changes may be required to bundle payments for some combination of services, such as acute and postacute care (Welch, 1998).

One evaluated program that illustrates the potential of bundled payment is found in the Medicare Participating Heart Bypass Center demonstration, begun in 1991 by the Health Care Financing Administration (Cromwell et al., 1997). Four hospitals were paid a single fee for all inpatient institutional and physician care for heart bypass patients. Hospitals and physicians could split the fee in whatever manner they chose; however, no additional inpatient billing was permitted. The average total costs fell in three of four hospitals, and length of stay for patients in the program declined in all four hospitals. The savings were achieved because of changes in physician practice patterns that occurred when hospital and physician incentives were aligned. Surgeons took a more active role in discharge planning, review of drug protocols, and elimination of unnecessary standard orders for routine testing.

Payment methods could be combined along several dimensions (Aas, 1995; Barnum et al., 1995). First, a payment approach could blend methods for a specific type of provider. For example, physicians could be paid using a combination of fee for service and a target rate of growth in overall spending for physician services. Medicare applied this approach when it combined a fee schedule with a sustainable growth rate system for updating physician payment rates (Medicare Payment Advisory Commission, 2000c). Second, methods could be blended by the type of service provided. For example, a provider could be paid under capitation, with certain services designated for separate payment (Maguire et al., 1998). Third, methods could be blended by category of provider. For example, in an integrated delivery system, physicians could be paid under capitation and hospitals paid on a per diem basis. Finally, methods could be blended by time horizon. For example, providers could be paid under a prospectively determined budget, with a retrospective adjustment for the mix of patients actually seen.


In general, payment methods based on budget for a range of care are better at controlling the total costs of that care, but can create concerns regarding underuse. They may also require greater institutional investment in information and management systems so the provider organization can monitor care and costs. Payment on a per unit basis has the opposite effect: it is often easier for providers to manage, but is usually less amenable to controlling total costs.

The payment methods used most commonly today are based on payment for some unit of care as it is used (see Table 8–1). Physicians are typically paid through fee-for-service methods and hospitals through billed (discounted) charges, per diem or per case. Some surveys suggest that capitation may be increasing for physicians (Kane et al., 1998; Simon and Emmons, 1997); however, other sources suggest its use may be flat or declining (Lesser and Ginsburg, 2000). The use of capitation for hospitals may also be declining in favor of per diem, perhaps influenced by reductions in length of stay so that health plans prefer to “rent beds” on as as-needed basis (Rauber, 1999). Information is not available on the frequency of use of budget approaches. It is important to note, however, that most providers receive payment from a variety of payers that may rely on different methods. Therefore, any given provider faces a mix of incentives and rewards, rather than a consistent set of expectations. This mix has a significant influence on how payment methods can inhibit quality improvement, as discussed in the following section.

TABLE 8–1. Current Payment Methods for Physicians and Hospitals Based on Privately Insured Patients.


Current Payment Methods for Physicians and Hospitals Based on Privately Insured Patients.

Finally, as was noted at the beginning of the chapter, different payment methods are designed to meet different objectives, but none automatically has quality improvement as an objective. Such an objective must therefore be explicitly designed into any payment method.


There is a growing body of evidence that quality improvement can translate into dollar savings (Classen et al., 1997; Clemmer et al., 1999; Conrad et al., 1996; Jarlier and Charvet-Protat, 2000). Poor quality is costly in several ways. First, quality-related problems can result in waste, such as when a step in the care process fails so that treatment must be repeated (e.g., the CT scan has to be redone), or extra resources are required to fix the failed process (e.g., treat an avoidable complication). Second, quality-related problems can lead to inefficiencies, as when two processes can produce the same outcome, but the more costly alternative is selected. An additional issue is that some processes may produce superior outcomes but utilize more resources, therefore resulting in cost increases. There is no advantage to this kind of quality improvement. In an environment that evaluates costs but not results, Anderson and Daigh (1991) suggest that quality waste accounts for 25–40 percent of all hospital costs.

Despite the evidence that poor quality costs money, however, health care organizations and professionals have not adopted quality-based process management to compete in today's marketplace. In fact, there are cases in which significant financial losses have resulted in the elimination of quality projects rather than the intensification of such efforts (Shulkin, 2000). Indeed, a variety of barriers embodied in current payment methods prevent health care organizations from pursuing quality improvement. The following subsections describe examples of four such payment barriers: perverse payment methods, adverse risk selection, annual contracting arrangements, and up-front investments required by provider groups.

Perverse Payment Mechanisms

Two examples of how payment mechanisms can inhibit quality improvement were provided at the IOM workshop held on April 24, 2000, by Dr. Brent James of the Intermountain Health System, Salt Lake City, Utah:

Example 1

A physician group paid primarily on a fee-for-service basis instituted a new program to improve blood sugar control for diabetic patients. Specifically, pilot studies suggested that tighter diabetic management could decrease hemoglobin A1c levels by 2 percentage points for about 40 percent of all diabetic patients managed by the physician group. Data from two randomized controlled trials demonstrated that better sugar controls should translate into lower rates of retinopathy, nephropathy, peripheral neurological damage, and heart disease (The Diabetes Control and Complications Trial Research Group, 1993). The savings in direct health care costs (i.e., reduced visits and hospital episodes) from avoided complications have been estimated to generate a net savings of about $2,000 per patient per year, on average, over 15 years (Demers et al., 1997). Across the more than 13,000 diabetic patients managed by the physician group, the project had the potential to generate over $10 million in net savings each year. The project was costly to the medical group in two ways. First, expenses to conduct the project, including extra clinical time for tighter management, fell to the physician group. Second, over time, as diabetic complication rates fell, the project would reduce patient visits and, thus revenues as well. The savings from avoided complications would fall to the insurer or a self-funded purchaser.

Example 2

A delivery system refined and implemented the American Thoracic Society's practice guideline on community-acquired pneumonia in ten rural Utah hospitals, focusing on indications for hospitalization and choice of initial antibiotics. In a prospective nonrandomized controlled trial using other Utah hospitals as controls, compliance with the guideline in the intervention hospitals increased from 22 to 40 percent (p<0.001); the proportion of patients suffering significant complications fell from 15.3 to 11.6 percent (p<0.001); inpatient mortality rates fell from 7.2 to 5.3 percent (p=0.015); and costs fell by 12.3 percent (p<0.001), primarily as a result of expenses avoided through the lower complication rate. The cost savings in those ten small rural hospitals totaled more than $500,000 per year, but an analysis of net operating income showed a loss to the facilities of over $200,000 per year. The reason was that as the complication rate fell, patients shifted from diagnosis related groups (DRGs) associated with complications (such as DRG 475, respiratory system diagnosis with ventilator support, carrying a per case payment of about $16,500 and providing a small excess of payment beyond treatment costs) to classifications such as DRG 89 (simple pneumonia and pleurisy, age>17, with complications or comorbidities, carrying a per case payment of about $4,730, which failed to cover the full costs of care).

Quality problems can be grouped in three categories (Chassin et al., 1998). Overuse is the provision of a health care service under circumstances in which its potential for harm exceeds the possible benefit. Underuse is the failure to provide a health care service when it would have produced a favorable outcome for a patient. With misuse an appropriate service is provided, but a preventable complication occurs, and the patient does not receive the full potential benefit of the service. Efforts to correct each of these kinds of problems are affected differently by alternative payment methods, given the theoretical incentives described in the previous section. An example is provided below of what happens at the delivery level in trying to correct each type of quality problem, along with the effects of different payment methods.

Correcting Problems of Overuse. An example of correcting problems of overuse is a reduction in unnecessary surgical procedures. If a physician (or medical group) were paid under fee-for-service methods, the physician would lose revenues because fewer procedures would be performed. However, physicians paid under a budgeted approach (such as capitation or a shared risk arrangement) could benefit financially because fewer resources would be used in caring for affected patients. Hospitals would lose revenues under most payment methods (billed charges, per case, or per diem) because of the reduced volume of care, but, like physicians, would potentially gain financially under a capitation or shared-risk arrangement.

Correcting Problems of Underuse. An example of correcting problems of underuse is the provision of needed services to those who were previously untreated. Physicians paid under fee-for-service methods would potentially gain financially by seeing more patients who need care, but could lose under capitation or risk-sharing arrangements if patients in their current panel received more services. Similarly, hospitals would gain under most payment methods (billed charges, per diem, per case) because they would be serving more patients, but could suffer financial losses under capitation or shared-risk methods for the same reasons as physicians.

Correcting Problems of Misuse. An example of correcting problems of misuse is a reduction in infections acquired by patients while receiving needed health care services. Under fee-for-service payment, physicians would potentially lose revenues if fewer services were needed by patients because there were fewer infections. Under capitation or risk-sharing arrangements, physicians could benefit by expending fewer resources to manage the avoided infections. Hospitals would face a potentially mixed set of effects. Under billed charges, the hospital could lose revenues if reduced infections meant fewer services provided. Hospitals could gain under per diem methods if the length of stay remained the same for patients, but they used fewer resources each day because of the avoided infections. However, hospitals could also potentially lose under per diem payment if the avoided infections reduced patients' length of stay. A mixed effect is possible as well under per case payment. A hospital could gain financially if fewer resources were required per case, but could potentially lose financially if patients fell into a lower-paying DRG because of avoided infections (as in example 2). Generally, hospitals would gain financially under capitation or risk-sharing arrangements because patients would require fewer resources.

In sum, efforts to improve quality by correcting overuse, underuse, or misuse all have an impact on provider revenues; no payment method is neutral. Under the most common payment methods, correcting problems of underuse and those of overuse would have opposite effects: providers would gain financially by correcting the former problems, but they would lose by correcting the latter. Correcting problems of misuse would produce mixed effects for both physicians and hospitals, especially since physicians get most of their revenues from fee-for-service payment, and hospitals get a substantial portion of their revenues from per case payment. Thus the most common payment methods have insufficient incentives to fix problems of overuse and present great difficulties in fixing problems of misuse (because of the mixed effects, which can also make it difficult for hospitals and physicians to work together). There is a greater likelihood of financial gain from fixing problems of underuse. This reinforces the perception that improving quality costs money.

Even when care delivery groups want to improve the quality of the clinical processes and outcomes they routinely deliver to their patients, they can be severely limited in their ability to pursue such strategies if providers lose revenues from many quality improvement activities because of the expenses of implementing the improvements and the revenues lost as a result of reduced care delivery. Many health care professionals and organizations conduct activities that are harmful to their bottom line (e.g., provision of uncompensated care). However, it is not possible to sustain broad-based efforts to achieve a substantial improvement in quality if such efforts are financially harmful to those undertaking them. Furthermore, as earlier improvement efforts worsen their financial position, provider groups will not have the resources necessary to pursue additional clinical improvement projects. Therefore, although a payer may reap the initial benefits from quality improvement through reduced intensity or volume of care, the inability of providers to sustain such strategies on a long-term basis will hinder the ability to achieve continuous and lasting improvement.

Two broad options are possible to address problems associated with perverse payment mechanisms. One possible approach is to provide mechanisms to facilitate more shared-risk arrangements that include not only hospitals and physicians aligning purpose, but also payer involvement. Shared-risk arrangements could include capitation, but could also include negotiated arrangements around an agreed-upon budget amount, which might or might not result in per capita payment. Payers gain from reduced care delivery, but hospitals and physicians are responsible for changing the way care is delivered. Shared-risk arrangements could provide mechanisms for all parties involved to gain from changes in care. Alternatively, since fee-for-service payments (or billed charges for hospitals) remain in common use, mechanisms could be developed to compensate providers for the expenses associated with developing and implementing quality improvement programs. This compensation could take the form of making a direct payment or directing increased volume to those providers with recognized and measurable quality improvement initiatives. Both of those options reflect the need for resources to shift if broad-based and lasting quality improvement is to be achieved.

Adverse Risk Selection

Adverse risk selection occurs when an organization that bears financial risk (whether a health plan or provider group) attempts to avoid enrolling or caring for sick patients who have conditions that result in high and/or continuing costs. Both insurers and providers are concerned that undertaking quality improvement and publicizing quality outcomes will attract patients more likely to have conditions that make them high users of care and high-cost (Dudley et al., 1998). For example, if a health plan has a good program for identifying and managing those with diabetes, it is likely to enroll more diabetic patients. Since few purchasers adjust payment for this type of risk, the health plan bears the burden. Such health plans in turn, are unlikely to give their providers incentives to design programs that will attract a disproportionate share of people with diabetes. If financial risk is delegated to the provider group, the providers bear the financial burden of care for this population. The concern is related mainly to chronic conditions rather than acute care needs since the former represent ongoing expenses.

Risk-adjustment methods are an attempt to provide payment to health plans and providers that is commensurate with the health risks of the population served so that the organizations compete on efficiency, service, and quality instead of risk selection (Bowen, 1995). In the context of payment policy, risk is defined as how precisely future medical costs of an enrollee or group can be predicted (Gauthier et al., 1995). Risk adjustment is important because the distribution of medical expenditures is highly skewed, with a small fraction of individuals accounting for a substantial proportion of expenditures in any given year (Luft, 1995; Maguire et al., 1998). It has been estimated that the top 1 percent of spenders account for 30 percent of health care expenditures, whereas the bottom 50 percent account for only 3 percent (Berk and Monheit, 1992). Although some expenditures are unpredictable (such as trauma related to an auto accident), some are predictable (such as people with a chronic illness who are recognized as incurring continuing costs). Since some expenditures are predictable, organizations that assume financial risk for the care of a group can potentially avoid recognized high users of care and their costs.

There are a number of different approaches to adjust for risk, such as use of specific adjustment methods, withholds and risk pools, carve-outs, and reinsurance (Newhouse et al., 1997). Prospective risk-adjustment methods, several of which have been developed in recent years, have gained attention (particularly by the Health Care Financing Administration). Two leading models are adjusted clinical groups (ACGs, formerly referred to as ambulatory care groups) and diagnostic cost groups (DCGs) (Newhouse et al., 1997). Both methods use diagnostic information to improve predictability as compared with the demographic adjustments used by Medicare to pay health plans.

ACGs were developed at The Johns Hopkins University to classify risks by using diagnoses reported in ambulatory visits (Starfield et al., 1991). The system assigns diagnoses to a risk group based on five clinical dimensions, such as a condition's duration, severity, and diagnostic certainty. Both inpatient and ambulatory versions are available.

Initial development on DCGs was conducted through a consortium of researchers at Boston University, Health Economics Research, and the Harvard University School of Medicine, and is based on inpatient diagnoses for prior hospitalizations. The DCG model has been expanded to include both inpatient and ambulatory information and to account for multiple medical conditions patients may experience (Ellis et al., 1996).

Another method is clinical risk groups (CRGs), developed by 3M Health Information Systems (Averill et al., 1999). This clinical classification system assigns each patient to a risk group that relates past clinical information to the amount and type of health services the individual will consume in the future. Additionally, a survey-based approach has been developed at Kaiser-Permanente Health Plan for the working-age population. This method uses a chronic disease checklist and self-reported health status and functional status (using the RAND SF-36) to assess health risk (Hornbrook and Goodman, 1996).

The challenges involved in developing a fair and adequate risk-adjustment system cannot be underestimated. All current methods are limited in their ability to predict variation in expenditures. The Health Care Financing Administration implemented a transitional risk-adjustment system in January 2000 using a form of the DCG model, and is moving forward with an expanded model that will include inpatient, hospital outpatient, and physician encounter data. A number of models for this more comprehensive approach are being considered. It should be noted that improving risk-adjustment methods will likely necessitate more clinical information (rather than just claims information), which in turn will require significantly improved information systems (Dudley et al., 2000).

The goals for risk adjustment need to be balanced with the goals of quality improvement. In risk adjustment, the objective is to identify the subpopulation at risk of high utilization and high cost, whereas in quality improvement, the objective is to identify all patients with a particular condition who could benefit from treatment (Dudley et al., 2000). On the one hand, if there is a potential for higher payment, health care organizations are likely to identify as many at-risk patients as possible and collect whatever information is necessary. On the other hand, doing so could bias quality measures through possible upcoding and might not provide incentives to design efficient and effective systems of care. The potential for payment methods to be based on similar patients with common conditions, including definitions of best practice, may help mediate some of the possible adverse effects.

Annual Contracting Arrangements

In theory, capitation and shared-risk arrangements provide incentives to pursue quality improvement strategies that minimize costs over the long term by keeping people healthy. To the extent that turnover in health plan membership and contracting arrangements occurs, however, suboptimization may result if the organization that undertakes the quality improvement does not see the benefits from those efforts.

Annual contracting arrangements can produce turnover in three ways. First, health plans and purchasers can alter annually the plans offered to consumers and force a change in health plan enrollment. Second, health plans and providers can alter annually the composition of provider networks, forcing patients to switch providers. Third, annual enrollment by individuals in health plans can produce turnover for the plans even if there is no change in the two former arrangements.

Annual contracting cycles may hinder a health care organization's ability to pursue quality improvement initiatives if the organization believes the benefits will accrue to a competitor. If a health plan has even modest enrollee turnover, and a quality improvement project requires an up-front investment while the financial savings span years, patients may very well have shifted to another plan by the time the health benefits and related savings accrue. The same is true for a provider group that may develop a good program for difficult-to-manage diabetics and is able to improve compliance with treatment, but is dropped from the health plan's provider panel, so that those now well-controlled patients go to a competitor's diabetic program. Such turnover can eliminate the benefit for many proposed clinical improvement projects.

Longer-term arrangements among provider groups, health plans, and purchasers may be advisable to facilitate the investments needed to achieve quality improvement and ensure gains to the partners from the benefits that are generated over time (whether in the form of savings or improved outcomes). However, patients and consumers should be able to shift coverage or source of care for quality-related reasons. The ability of consumers and patients to do so can be a strong motivator for clinicians and health plans to offer such good care that people will not want to leave.

Up-Front Investments Required by Provider Groups

Provider groups face two specific managerial issues that are affected by payment arrangements and can hamper efforts by health care organizations to pursue quality improvement: (1) the difficulty of measuring the impact of quality improvement on the organization's bottom line and (2) infrastructure challenges encountered by those organizations seeking to implement broad-based quality improvement programs. Up-front investments are likely to be required to address both of these issues.

Difficulty of Measuring the Impact of Quality Improvement on the Bottom Line

When evaluating the potential for a quality improvement project to improve a health care organization's bottom line, the expense of the proposed improvement is compared with the potential savings in variable costs. Variable costs are expenses that fluctuate directly with patient volumes, such as medications, disposable equipment, other supplies, and staffing levels, and are achieved relatively quickly. The impact of the proposed clinical quality improvement initiative is rarely evaluated in terms of savings in fixed costs, since those costs accrue over a longer time period. Fixed costs are expenses that a physician, clinic, hospital, or delivery system must pay regardless of patient volumes, such as payments for buildings, diagnostic and other equipment, licensing and regulatory fees, malpractice insurance, and minimum required staffing.

Most health care costs are considered fixed, although there is likely variation in how individual health care organizations define their fixed or variable costs. For example, many consider labor costs to be fixed in the short term, but variable over the long term. However, it has been estimated that 60 to 75 percent of all expenses fall into the fixed cost category (Lave and Lave, 1984; Williams, 1996), leaving only about 25 to 40 percent of the savings generated by quality-based elimination of clinical waste (the proportion accounted as variable expenses) to appear quickly on an organization's balance sheet. The remaining 60 to 75 percent of the potential savings, representing the fixed cost portion, appears as unused capacity within the organization. If a care delivery group can recruit additional patients to reduce excess capacity, an immediate benefit will be realized. The organization's fixed costs will be spread across a larger patient population (all of the old patients, plus a number of new ones) so that the effective fixed cost per patient will fall, creating a larger financial margin for each patient treated. However, if the organization cannot increase patient volume, several years can be required to affect the fixed costs. Thus, the proportion of fixed costs in health care affects the ability to measure the impact of quality improvement efforts on an organization's bottom line.

Infrastructure Investments

An organization that wants to use clinical quality as a business strategy must make a substantial investment in skill building and culture change. Clinical process management, a health care delivery organization's core business function, has traditionally been seen as a secondary responsibility of the voluntary medical staff. Practicing physicians are asked to contribute time without compensation and to serve on clinical oversight committees, taking time away from their primary patient care role. An organization must make a substantial investment in medical and other clinical leadership, as well as build an effective management and information infrastructure to use for tracking outcomes, assessing performance, and setting clinical improvement goals. This investment should include tools and training in quality methods, but also adequate information systems that can be applied to clinical quality improvement (see Chapter 7).


As noted earlier, the IOM held a workshop on April 24, 2000, to discuss the relationship between payment and quality improvement. At the workshop, several examples were provided to illustrate how various existing payment methods—including fee for service, capitation, a blended method, and a shared-risk (budget) method—could be adapted to support quality improvement. This section describes the examples presented at the workshop.

Adapting Fee-for-Service Payment

Dr. Glenn Littenberg described how fee-for-service payment could be adapted to provide incentives for quality improvement by encouraging cooperation and providing reimbursement for care outside of the traditional office visit, which is not always optimal for meeting patients' needs. The approach involves developing relative values for the elements of work performed over time by physicians and other health professionals. For example, physicians provide care between visits, including coordination of complex cases, phone consults with patients and other professionals, and follow-up on tests performed. These activities do not require face-to-face contact, but can occupy a significant amount of professional time. A Current Procedural Technology (CPT) code could be developed for use of electronic media with the patient not present for specific communications, for research, for clinical updates, and for coordination of care with other health professionals within a 30-day period. Codes could also be developed and relative values assigned for other organizational innovations designed to improve quality (e.g., anticoagulation clinics, which would include the clinical groups that have key roles, such as physicians, pharmacists, nurses, and dietary staff).

Despite the growth of alternative payment methods, fee-for-service payment remains important. Even in capitated systems, many individual physicians are paid using a fee-for-service method. Additionally, fee-for-service payment levels often serve as the benchmark for other payment methods. As a result, financial support for activities that would improve quality care and rely on fee-for-service payment remains one avenue for building in rewards for quality care.

Adapting Capitation Payment

Dr. Sam Ho described how PacifiCare Health System has developed a payment structure that rewards quality care provided by the 700 medical groups with which the plan contracts. PacifiCare pays the majority of medical groups by capitation for all professional services. Hospitals are also paid predominantly through capitation. The health plan retains risk for certain hospital, pharmacy, and ancillary services (e.g., durable medical equipment). The core of the system is a report card program that provides quality performance information to both physicians and consumers. The provider profile contains about 80 measures enabling medical groups to compare their own performance over time, as well as with regional and national benchmarks. The consumer-focused performance report currently contains 32 indicators, with more being added each year. Preliminary analysis conducted by PacifiCare indicates that the medical groups with higher scores on “best practice” are seeing statistically significant increases in membership and high member retention rates.

Two specific elements of the PacifiCare approach are worth noting. First, the approach focuses on the availability of data, relying on depth and breadth of data. Second, much of the information is directed toward consumers as decision makers. Rather than being directed at selection of a health plan, the information is at the medical group level, where consumers can evaluate their own trade-offs among cost, quality, access, and any other dimensions of importance to them.

Adapting Blended Payment Methods

Ann Robinow of the Buyers Health Care Action Group, Minneapolis, Minnesota, described what some have termed a direct contracting approach. The group contracts with “care systems,” defined as groups of primary care physicians and affiliated specialists and facilities that could assume responsibility for the provision of a full continuum of care (Christianson et al., 1999). Payment is blended in that a budget target is set prospectively and adjusted retrospectively. Each year, care systems set a financial target for all care to enrollees (including pharmacy) that becomes the price to consumers and the benchmark for financial performance. The prices are risk adjusted every quarter using ACGs by comparing the care system's performance for the most recent 12-month period with the target (Christianson et al., 1999), which is adjusted each quarter to reflect the relative illness burden of patients during the same time period for which financial information is being collected. Because it is a claims-based system in which each employer pays its own fees, fee levels are increased or decreased over time so that the fees approximate the target submitted (fees increase if the organization is below target and decrease if the target is exceeded). Consumers receive comparative information at the care system level. Ms. Robinow indicated that the group's own analysis indicates people are moving from the higher-cost to the lower-cost systems and that systems with higher satisfaction scores have also had higher enrollment gains.

Two notable elements of this approach are its focus on the care system and consumer involvement. The focus on the care system places responsibility at the level at which processes of care can be modified to improve quality. Providing comparative information to consumers at this level of the care system gives them information about care delivery and not just health coverage. This information is perceived as being more valuable for patients.

Adapting Shared-Risk (Budget) Arrangements

Dr. Brent James of Intermountain Health Care described the organization's recent experience in moving toward shared-risk arrangements in which partnerships are established with purchasers, and risk is shared around a budget based on the expectations of caring for a population. Costs are typically projected on the basis of a particular set of disease entities in clinical programs that represent the work of smaller groups. These are referred to as care processes. These groups do not manage just one activity (e.g., mammography), but rather a number of processes for a single condition (e.g., breast cancer). The price is negotiated among the partners. If Intermountain is able to produce care for the population below budget, all the partners share in the savings.

Intermountain perceives several advantages to this approach. First, it permits the organization to share in the benefits of quality improvement. Second, care can be organized around processes that are meaningful to health professionals, patients, and purchasers, which helps align incentives and work priorities. Third, the approach uses a budgeted target to impose financial discipline, but does not rely on capitation, which means it can be applied to smaller groups of practitioners and patients that would not assume actuarial risk. The challenge is the need for good data to set budgets fairly and monitor clinical processes of care.


Although incentives to improve quality could be strengthened through incremental improvements in existing payment methods, more significant reform of the payment system will be needed over the long term. All health care organizations face serious barriers in pursuing broad-based efforts at quality improvement, and providers face a mix of incentives from different payment methods. Conceptually, a provider group could manage effectively in an environment that was entirely fee for service or entirely capitation, but the present environment is a mix of both. An organization that manages to succeed predominantly under fee-for-service payment will fail under the incentives of capitation. On the other hand, an organization that manages to succeed under capitation will fail on the portion of care that is paid through fee for service. Thus, health care organizations are faced with a financial situation in which it is almost impossible to manage for quality.

There are several ways to improve the way payment methods reward quality care. One option is to refine existing payment methods to provide greater rewards for quality. As noted in the preceding discussion, all existing payment methods can be improved to reward quality better. However, although these incremental improvements are important to pursue, a more fundamental restructuring of the payment system is needed. One of the common threads that runs through most of the recent innovations in payment is greater attention to subpopulations with common clinical needs.

Chapter 4 describes the need for a classification system around priority conditions to facilitate the provision of care based on the common reasons for which people seek care. Although it would be premature to recommend payment based on priority conditions, it is appropriate to study their feasibility as a tool for aligning the scope of services provided with the scope of payment. For example, a patient with a chronic condition may be seeking the acute care services traditionally covered under insurance, but may also need, for example, services related to counseling and behavior change, support groups, e-mail access for communication between visits, strongly managed and continuous coordination with other health professionals, and medical supplies. However, today's payment approaches offer a chronically ill patient face-to-face office visits as the primary mechanism for receiving care and rarely encompass the range of services needed across the continuum of care. Furthermore, the fragmentation of payment by service can make it difficult for care to be coordinated efficiently across multiple settings. There is a misalignment among what the patient needs, the services provided, and how needed services are paid for. Organizing care and payment around priority conditions could offer a framework for aligning payment incentives around a common clinical purpose that is consistent with meeting patient needs as completely and efficiently as possible.

The committee recognizes that such redesign could require significant changes in the purpose and structure of the insurance function. The role of health plans could shift toward a heavy emphasis on obtaining information from various configurations of providers and, in turn, releasing information to the public. Consumers' responsibilities could also shift if they are to become more directly involved in comparing options for care and the arrangements through which they wish to receive care. Despite the challenges, however, the committee believes good-quality care can be recognized and rewarded through payment policies.

Although this chapter focuses on current payment policy and its shortcomings, the committee also discussed a set of larger economic issues. The committee recognizes that the recommendations in this report will reduce costs in some areas and increase costs in others. In general, correcting problems of overuse and misuse is likely to result in cost reductions, whereas correcting problems of underuse is likely to increase costs (Chassin et al., 1998). Quality problems related to overuse increase costs through the provision of services from which patients do not benefit. Patients may also be exposed to unnecessary risks associated with treatment (Fisher and Welch, 1999). Quality problems related to misuse increase costs when tests and procedures have to repeated or when avoidable complications increase treatment needs. On the other hand, quality problems related to underuse represent artificial “savings,” as patients do not receive beneficial services, such as immunizations.

In terms of the specific recommendations in this report, there are several potential areas in which cost savings may be produced. Greater use of information technology (see Chapter 7) should result in costs savings in several ways. First, automation of certain functions may reduce some labor costs. This has happened in other industries, such as manufacturing. Second, information technology may permit substitution of less costly alternatives of care. For example, to the extent that monitoring of patients can occur partly through e-mail, some office visits may be eliminated, as in the case of patients with controlled chronic conditions who may be able to visit their physician's office twice a year instead of quarterly, relying on electronic communication between visits. Third, use of computerized drug prescribing has been shown to reduce medication errors, which are known to increase costs (Bates et al., 1997, 1998, 1999).

Cost reductions may also be possible with better application of the evidence base (see Chapter 6). Standardizing care around best practices and reducing variation in treatment patterns should result in reduced and/or more predictable costs of care. The use of effective decision support systems can reduce variation in practice through improved compliance with practice guidelines (Balas et al., 2000; Shea et al., 1996).

Finally, cost savings may be achieved through greater use of multidisciplinary teams (see Chapter 5). When teams are well coordinated and are able to sufficiently plan care and share information, it may become possible to substitute less-costly personnel for higher-cost personnel. Developing and using care teams properly can improve coordination across settings and over time to reduce inefficiencies associated with handoffs among members of the care team.

The committee recognizes, however, that not all activities to improve quality will be cost-reducing. In addition to cost increases associated with correcting problems of underuse, as noted above, there will also be costs associated with implementing changes in the organization and delivery of care. Even if a change ultimately reduces cost, the process of evolving from the current system to the system of the 21st century may incur significant costs. Although some public support can help move such a process forward, health care organizations themselves will need to invest in change, just as other industries (e.g., banking) have invested in transforming their business procedures. Key transitional areas that are likely to increase costs in the short- to mid-term time frame include (1) the need to train people for new jobs in health care (or in other fields) as some workers are displaced by new approaches to organizing and delivering care, (2) investment in information technology and associated training costs, (3) the need to maintain duplicative systems temporarily while redesigning care processes (i.e., retaining the old process while the new process is being implemented and refined), and (4) capital investment to support redesign and reengineering of the current system.

It is not known how cost increases and decreases will ultimately balance over time. Regardless of the final calculus, however, what can be obtained is better value for the resources expended. Good value does not lie in spending over $1 trillion on health care that leaves some people receiving care they do not need and others not receiving the care they need. There should be a strong commitment to evaluating the economic and other impacts associated with improving the quality of care. However, such evaluations may not be amenable to existing measurement approaches. For example, benefits from information technology have included easier access to medical histories, improved access to summary patient details, support for protocols or guidelines, and quicker reporting of results of treatment (Lock, 1996). These benefits are difficult to quantify and to incorporate into a traditional return-on-investment analysis. Therefore, assessing the impact of new approaches and innovative programs designed to improve quality may require new measurement approaches.


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Increasing interest in defined contribution plans suggests the potential for consumers to entertain more choices.


Much of the discussion in this section draws on a paper prepared by Brent James, M.D. presented at an IOM-sponsored workshop on the relationship between payment and quality improvement held on April 24, 2000.

Copyright 2001 by the National Academy of Sciences. All rights reserved.
Bookshelf ID: NBK222279


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