Health care payment reform efforts focus on substituting cost-effective value for volume and ultimately aligning the financial incentives of provider reimbursement with expectations for patient outcomes, care management, and efficiency.  The complex dynamics and trade-offs of different payment reform models are discussed in a helpful new report from the Urban Institute and Catalyst for Payment Reform – Payment Methods and Benefit Designs: How They Work and How They Work Together to Improve Health Care.  Aimed at diverse stakeholders, this research report presents nine payment methods in terms of their strengths and weaknesses—as well as key objectives, compatibility with other payment methods, and potential impact on provider prices and behavior.

Introduction and Background of Payment Reform Methods

The authors specify in the report’s introduction that, “…most of what are considered value-based payment reform models are being implemented on top of current, volume-based payment approaches.” Additionally, they point out that, “Too often, analyses of payment methods are based on idealized versions and focus on the incentives the payment method embodies while ignoring practical issues.”  Explored in this large-scale report are a range of attributes embodied in the various reform approaches, along with the payment methods that constitute their underlying architecture.

Context, Design, and Operational Issues in Payment Methods

The context, design, and operational issues involved in the described payment methods are crucial in terms of their achieving value in terms of health economics outcomes. As the report presents, “Pricing power resulting from some form of consolidation may therefore have differential impacts on the success of payment methods, such as population-based payments, designed for large provider organizations.” Furthermore, the report’s authors suggest, “…private payers have more flexibility than traditional Medicare to design benefits that complement particular payment approaches.”

Overall Perspectives on Health Insurer Payment Methods

The authors’ overall perspective is illustrated in the introductory statement, “A fee schedule inherently contains incentives to provide more services, often more than needed or appropriate.” Moreover, the report’s underlying viewpoint is that “…too much of the discussion of payment reform has focused on payment models’ theoretical effects rather than on their interactions with other payment methods.”

Consequently, this report focuses on the nine provider payment methods used by third-party payers or insurers—public and private—to pay physicians and hospitals, in order to determine complementary payment and benefit design approaches that are the most likely to achieve the goal of value-based, cost-effective medical care.

While different naming labels may be applied to payment models, the models described in this report are based on those included in Berenson et al’s A Typology of Payment Methods. The nine specific payment methods described in this report are:

  • Base Payments: 1) fee schedules for physicians and other health professionals; 2) primary care capitation; 3) per diem payment to hospitals for inpatient stays; 4) diagnosis related group-based payment to hospitals for impatient stays; 5) global budgets for hospitals; 6) bundled episode-based payments; 7) population-based payments, including capitation.
  • Incremental Payments: 8) shared savings; 9) pay-for-performance.

Fee Schedules for Physicians and Other Health Professionals

In many health systems of other nations as well as the U.S., fee schedules are the foundational approach on which other payment methods are based. Public payers historically have viewed predetermined payment maximums as a preferred approach. Medicare’s physician fee schedule as of 1992 has been based on estimates of covered services’ relative resource costs; the value of a physician’s work as measured by (a) time, and (b) service intensity, and professional liability costs. As the report points out, “Most U.S. payers base their own fee schedules on Medicare’s, although they generally use different conversion factors.”

The following are some of described strengths of this approach:

  • In contrast to payments based on provider charges, a fee schedule gives payers more control over payment, offers predictable payments, and counters the inevitable inflationary effect of UCR-based payment methods.
  • A fee schedule implicitly adjusts for the different case mixes different physicians and group practices experience, thereby paying comparatively more for sicker patients that require more services.
  • The approach provides payers and healthcare researchers with data about patient care, which can then be analyzed to establish performance measures.

Its major weaknesses include:

  • Fee schedules encourage over-provision of services.
  • This method ignores whether the service was appropriate or performed well.
  • Fee schedules can contribute to care fragmentation.
  • Activities not coded and covered for payment may be marginalized.

In regard to the fee schedule based payment model, “Payers, including Medicare, have recently recognized they can create new fee schedule codes to reward evaluation and management activities that had never been specifically paid, including complex chronic care management.” They also perceive, “Some elements of value-based payment can actually be included on a fee schedule.” Lastly, “For physician payment, only capitation approaches represent a rejection of fee schedules as the base payment.”

Primary Care Capitation

Capitation is described in this report as a prospective unit of payment in which a payer (insurer) makes a fixed payment to a provider for a defined set of services, regardless of the quantity of services actually provided to the patient.  Typically, the provider organization assumes financial risk for most health services under their direct delivery.  (The context here is capitation at the provider level, sometimes referred to as sub-capitation, rather than how capitation is used by purchasers to pay a health plan.)

This payment model typically entails patient selection of a primary care physician (PCP) who acts as a gatekeeper. A major point presented in reference to primary care capitation is that it “establishes spending limits for the patients a physician is responsible for, thereby creating financial incentives in favor of activities that reduce spending.”

Strengths of this method are the following:

  1. Primary care capitation places “performance risk” on clinicians, providing them financial incentives to limit provision of unnecessary services.
  2. Approach internalizes to the PCP decisions over the allocation of activity and costs, permitting more flexibility in individualizing medical care to meet patients’ needs.
  3. Gives payers predictable and capped costs, while providing the recipient clinician a predictable cash flow.

One major weakness of this method is that it can lead to short-changing on patient care (e.g., prevention services) that does not compromise clinician care to a given patient in the short-term, but may foster future chronic disorders. Another is that per capita payment provides physician practices a financial incentive to accept more patients than is optimal in comparison to their total capacity to effectively care for them.

How Capitation Can Lead to Carve Outs

The report’s authors observe that, “Primary care capitation gives physicians strong incentives to refer patients to providers outside the purview of their capitation payments”. They also describe how a shared savings approach is now being employed by Accountable Care Organizations (ACOs) to manage risk-pool health spending. The opinion expressed in the report is that “Payers can encourage performance of particular services by making them targets of a complementary P4P [pay-for-performance] program or ‘carving out’ services from the capitation package.” Their conclusion is that a hybrid approach of capitation, fee schedule payments, and P4P programs are compatible.

For example, Medicare’s Merit-Based Incentive Payment Program (MIPS), mandated by Congress in 2015 and being phased-in starting in 2017, links Medicare Part B physician fee-for-service payments to performance. This program factors in four performance categories to determine the provider’s composite performance score: 1) quality, 2) resource use, 3) clinical practice improvement activities, and 4) meaningful use of electronic health record (EHR) technology.

Per Diem Payment to Hospitals for Impatient Stays

The per diem payment method still predominates in payer-hospital contracting for inpatient services. According to this report, large medical centers and ACOs are advantaged in per diem payments. The researchers believe that—if the payer and inpatient facility can accurately predict the number and mix of cases—a more accurate calculation of per diem rate can be determined. In other words, the larger the volume of cases corresponding to a payer, the more predictable they believe will be the average daily cost and concomitant per diem rate. Meanwhile, “carve-outs” allowing separate payment of high-cost items are often incorporated into per diem contractual arrangements.

Per Diems versus DRGs

Historically, most U.S. health insurers preferred per diem rates because it helped the insurer control volume-based utilization by denying additional inpatient days not supported by medical necessity.  It is also simpler to administer. However, private payers are now finding DRG-based payment methods more attractive because of the stronger financial incentive for shorter inpatient stays.

Two suggested strengths of the DRG payment method are:

  1. Per diem payments have led for over 30 years to straightforward administration and contracting, which has facilitated administrative standardization and supporting software development to facilitate coding and billing.
  2. Per diems provide some constraints on cost-generating “revenue management” behavior of hospitals.

Per diem payment method weaknesses described in this report are:

  1. Hospitals have no incentive to avoid unnecessary inpatient days for a given patient;
  2. The per diem payment model does not engender much transparency in contrast to DRGs about hospitals’ clinical activities or outcomes.
  3. Efforts to control costs may require monitoring through third-party length-of-stay (LOS) medical reviews, thereby introducing administrative complexity and even inappropriate intrusion into the medical care provided.

Diagnosis Related Group Based Payment to Hospitals for Inpatient Stays

While private health plans and state Medicaid agencies often use different methodologies than Medicare, the basic set-up for diagnosis-related group (DRG) based payments reflect these core elements:

  • A patient classification system to group patients with similar clinical characteristics and relatively homogeneous resource consumption (into hundreds of DRGs).
  • Hospital cost information used to determine DRG weights.
  • A standard monetary conversion factor, used to convert DRG weights into base payment rates for each DRG.
  • Actual payment rates, obtained by adjusting the DRG base rates for structural differences across hospitals.

Three key strengths of DRG payment systems are:

  1. Because the payment amount per principal diagnosis is fixed, hospitals have strong incentives to reduce costs per inpatient stay.
  2. DRGs may be more market-oriented than other hospital payment systems because hospitals may improve quality and efficiency by especially treating patients for which the hospital has a competitive advantage.
  3. Having a uniform, standard classification system facilitates transparency and permits inter-hospital comparisons by hospitals and consumers.

However, three weaknesses are:

  1. With a fixed payment per case, hospitals retain an incentive to increase the number of patients hospitalized despite feasibility of ambulatory care for these patients.
  2. DRGs entail more complexity as a payment system, requiring coding expertise, data systems, and coding oversight by payers.
  3. Hospitals may transfer patients to other hospitals or post-acute facilities, generating insurer over-payments from the artificially-low LOS.

The DRG payment approach assumes that hospitals treat a random variation of patients, per the report’s authors. They also mention that most DRG payment systems include outlier payments as insurance against incentives to avoid or prematurely discharge potentially costly patients. In assessing the compatibility with other payment methods, this report concludes that “DRGs can readily be used in the calculation of bundled episode payments.”

Global Budgets for Hospitals

The main objective of global budgeting is to constrain the amount a hospital can spend in order to limit the total dollars spent on health care within the system. As the authors explain, “A global hospital budget implies that all payers participate and thus is simpler to operationalize in a single-payer or all-payer environment.”  These hospital global budgets are generally established through one of three approaches:

  • Historical
  • Capitated
  • Normative

Global budgets may be less compatible with tired-network payer benefit designs per this report.

Bundled Episode Payments

A prospective payment is made in this payment method for all medical care a patient receives over the course of a defined clinical episode or period of management. Additionally, the episode of care has the following two dimensions: 1) a clinical dimension, and 2) a time dimension. This approach is designed to transfer financial responsibility for the technical risk that is under the included provider’s control, but not the probability/insurance risk that relates to the burden of illness in any large patient population. Therefore, the bundled providers—both the clinicians and medical facilities—have common financial incentives to control the cost of the bundle.

Global Capitation to an Organization

Capitation payment in this model for services delivered by different physicians—or at different levels of care—is combined into a single prospective payment to an integrated care organization or a large physician group practice. For health plan enrollees, capitated payments are expressed as per member per month (PMPM) payments, and usually adjusted for at least age and sex and ideally by other factors, including health status.

As the report’s authors state, “By accepting a defined fixed payment to provide contracted services, providers assume the financial risk for their patients.” Because of insurance risk, organizations working under this payment system typically purchase reinsurance.

Similarities of Investors and the Healthcare Marketplace?

Akin to savvy financial investors’ asset diversification preference, the inclusion across a sufficient number of members to spread insurance risk—and reduce potential volatility—is considered the most desirable approach within this global capitation framework. While HMOs have been mostly associated with this payment model, the report’s authors mention that self-funded employers are generally precluded from shifting risk to provider organizations.

Global capitation works best with implementation of sophisticated risk adjustment for patients’ health status.

While these authors reported global capitation as the most robust method for medical care services across the spectrum to internalize incentives for improving efficiency, they also note that the model places insurance and technical risk on providers, which can potentially result in financial losses outside of providers’ control. Subsequently, this can lead to indiscriminate service reduction.

Healthcare Administration Options

This report emphasizes that—for the most part—health care payment methods should be “viewed as falling on a continuum rather than with a clean line separating them.” The authors also believe that that health policymakers should thoroughly consider payment methods’ attributes to decide how or even whether to proceed with a given payment reform.

The report was funded by The Robert Wood Johnson Foundation written by Robert A. Berenson, MD and Divvy K. Upadhyay, MPH of the Urban Institute and Suzanne F. Delbanco, PhD, and Roslyn Murray of the Catalyst for Payment Reform (CPR).

The full report is available here (PDF).


  1. Berenson RA, Upadhyay DK, Delbanco SF, and Murray R. [Urban Institute and Catalyst for Payment Reform] (Updated June 2016). Research Report. Payment Methods and Benefit Designs: How They Work and How They Work Together to Improve Health Care; Payment Methods: How They Work.
  2. Berenson Upadhyay DK, Delbanco SF, and Murray R. [Urban Institute] (April 2016). Research Report. Payment Methods and Benefit Designs: How They Work and How They Work Together to Improve Health Care; A Typology of Payment Methods.
  3. Centers for Medicare and Medicaid Services (CMS). The Medicare Access and CHIP Reauthorization Act of 2015 Path to Value. [PowerPoint presentation]