Implications of Severity-Graded DRGs for Service Line Structure, Part I

Mark T. Morgan, Rita E. Numerof, and Stephen Rothenberg, for HealthLeaders Media , July 21, 2008

Editor's note: This is the first in a two-part series that examines the service line structure and implications associated with severity-graded DRGs. Part II details how to improve quality of service and patient care by restructuring service lines in response to the new cost-based DRG system.

The use of service line management as an organizing concept has been growing in healthcare delivery for nearly 20 years. Originally borrowed from the for-profit world, service line management has been effective in concentrating resources and management focus, particularly on disease states that offered the most significant reimbursement margins. So it's not surprising that the introduction of changes to the reimbursement schemes designed to eliminate systemic biases presents important implications for an organizing principle adopted to capitalize on those same biases.

CMS initially proposed DRGs as a way to relate payments made for the treatment of patients covered by Medicare and Medicaid to the resources consumed in their treatment. Initially this worked reasonably well, but as time went on a number of cracks began to appear in the system. Two external trends drove these problems: the aging of the population, and the rapid advance of technology and capital-intensive treatment.

The aging of the treated population increased the proportion of cases treated that had serious complications, which made one of the flaws in the current system salient—very complicated cases were not sufficiently reimbursed. The capital intensive nature of treatment for specific diagnoses created problems in accounting for various support services such as nursing and overhead—which in turn caused some DRGs to become highly profitable and others to become money losers. Not surprisingly, investments flowed to those service lines that were more profitable (e.g. cardiology and orthopedics) and away from general medicine.

The gulf grows

These trends have caused widening inequities within the healthcare system. Hospitals dealing with a relatively high percentage of CMS patients (primarily in economically depressed areas) have been inadequately reimbursed, putting them under increasing pressure to control costs and find alternative sources of funding to keep their doors open. At the same time, standalone clinics specializing in high-margin diagnoses (like those treated with minimally invasive surgery) have proliferated, grabbing a sizable share of these markets and creating systematic shortfalls in full service hospitals' revenue streams.

In response to these recognized weaknesses, CMS tightened things up. First, CMS introduced some preparatory modifications to DRG classifications in the 2007 fiscal year intended to increase the ability to recognize severity of illness for select diagnoses. For the 2008 fiscal year, CMS made wholesale changes to the DRG classification system and the Inpatient Prospective Payment System, overhauling its ability to account for severity of cases across the entire spectrum of diagnoses. These changes created the so-called cost-based DRG system, which went into effect Oct. 1, 2007, and have significant implications for treatment on a continuum of care perspective.

Eliminating the "sweet spot"

Under the previous charge-based system, which effectively recognized only two levels of severity (or degrees of complication), there was a sweet spot along the "complication continuum." In other words, cases with minor complications were often reimbursed far above treatment costs. That created undue pressure to strictly control costs of treatment for the most complicated cases, which presumably reduced the quality of care these patients received. It also meant that if a hospital employed systems that (inadvertently, of course) caused patients to be treated only after developing minor complications, that hospital would have higher margins. Meanwhile, some patients (e.g. severely ill spine- and back-surgery patients) were huge money losers. The new payment system recognizes three gradations of severity, greatly alleviating this problem.

In addition, the charge-based system favored surgical care over medical care, largely as a result of the more rapid increase in capital intensity within the surgical realm. This outcome is also at odds with optimal treatment. There will always be cases at the margins-the "should we take this person to surgery or continue to observe?" cases-and the decisions made with respect to these cases will be influenced by the incentives that are in place. That leads directly to the conclusion that the ideal system from the perspective of quality of care is neutral with regard to when and how a patient is treated. Finer gradations of severity, and the removal of differential incentives for medical versus surgical care, create a more neutral system.

Finally, the new rules will address inequalities in the payment structure that favor treatment of one diagnosis over another and make it highly profitable to operate within certain service lines. The revisions to IPPS largely eliminated these windfalls. Some will be hurt by this, especially those who are set up under the charge-based system specifically to treat "overcompensated" cases, while many others (including full-service hospitals) will see their situation improve.

Implications for service line structure

There is general agreement that the ideal service line provides the right care at the right time with the right resources available. Defining each of those has proven complicated. As idealistic humanitarians, we'd like the criterion against which outcomes are measured to be the health of our prospective patient pool (that is, all patients we might treat)—a broad measure that encompasses the general health of the community in which we operate. Education, prevention, and early treatment are the hallmarks of that mission, and the extent to which hospitals engage in them—despite generally not being compensated financially, and despite the fact that education and prevention can be expected to subtract from the top line—shows the seriousness with which this mission is treated. Hospitals (even for-profit hospitals) are semi-capitalist structures, not completely devoted to maximizing the bottom line.

But "semi-capitalist" does not mean that they are free of the need to actually turn a profit on their operations. The phrase "no margin, no mission" still applies. So will severity-grading bring margin-producing activities more closely in line with the mission of hospitals, and if so, how can we take maximal advantage of it?

The answer to the first of those questions is clearly "yes." Severity grading, by creating more neutral financial incentives with respect to the extent of complications, gives service models that encourage the identification and treatment of uncomplicated cases equal footing with those that treat later. That removes any perverse incentives encouraging the proliferation of "treat late" models, which is an outcome everyone can agree is beneficial.

Changes in the respective compensation of various DRGs relative to the true cost to treat have a similar impact—but on diagnoses rather than complications. For the past decade, the literature has been full of advice on how to maximize the inflow of profitable patients in light of "skimming" by standalone clinics and other challenges. We've written some of it ourselves, but with these changes to IPPS, the differences in profitability between diagnoses will largely disappear. That's great news, because it means that the focus can be placed on delivering quality care with maximal efficiency without regard to diagnosis or extent of complications.

The major implication for service line structure is that most service lines can be made profitable (because payments are more likely to cover costs of treatment, regardless of the service line under consideration), but very few service lines will produce outsized profits. This implies that the penalty to full-service hospitals with a broad array of currently unprofitable service lines will decrease, while the array of high-quality services available to all patients will increase, because the disincentives to offering these services will disappear. This applies in every region, whether there is competition or not. It applies to every hospital—nonprofit or for-profit, with or without a medical education mission, rural or urban. Service lines will become more aligned with the needs of patients, because those needs are no longer in conflict with the financial incentives provided by CMS.

Mark Morgan is a senior business analyst, Rita E. Numerof is president, and Stephen Rothenberg is a business analyst for Numerof & Associates Inc., a strategic management consulting firm in St. Louis. They may be reached at

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