Section 1861(v)(1) of the Social Security Act, as amended in 1972 by section 223 of
P.L. 92-603, gives the Secretary the authority to set limits on reimbursable costs
of providers for services furnished to Medicare beneficiaries. These limits may be
based on estimates of costs necessary in the efficient delivery of needed health services.
The limits shift the burden of justifying high cost to the provider which must request
an exception to the limits based on certain criteria specified in regulations. Limits
on home health agency and skilled nursing facility costs were first established in
Regulations implementing section 223 of P.L. 92-603 were published in the Federal
Register on June 6, 1974. The regulations provided that prospective limits on Medicare
reimbursable costs would be determined for various classes of providers depending
on characteristics such as the type of services rendered, geographic, economic and
demographic factors, size, mix of services, and type and mix of patients. The limits
had to be based on cost report data or other indicators of current costs adjusted
to reflect prospective periods to which the limits would apply. The regulations provided
for the cost limits to be published as a Notice in the Federal Register. In addition,
the regulations established the right of a provider to obtain reclassification, exemption
from, or exception to the cost limits where justified by evidence presented. New providers
were allowed a 5-year period to recover unreimbursed costs so that “start-up” conditions would not be a disadvantage. Companion regulations specified the conditions
under which Medicare beneficiaries could be charged for amounts in excess of the cost
limits. (See 11197. Provider Charges to Beneficiaries for Excess Costs).
The regulations were revised effective July 1, 1979. The new regulations established
several new exceptions and specified a time limit for the filing and processing of
requests for exceptions. An exemption for new providers of inpatient services was
established to replace the administratively cumbersome process for recovery of unreimbursed
costs. An exception was created covering newly established home health agencies. Also,
the new regulations provided that CMS could, at its discretion, conduct an operational
review of a provider and make future exception determinations contingent on the results
of the review.
Although the methods for establishing the 223 limits vary by provider type, they all
have several features in common. The limits are derived from reported costs of comparable
facilities. Comparability is achieved by classifying providers according to predetermined
criteria. The criteria are uniformly applied so that the basis for classification
is identical for each facility. The result is a classification system that produces
reasonably homogeneous groups so that costs from similar providers are compared. For
each group costs beyond a certain statistical threshold are presumed, in the absence
of evidence to the contrary, to be greater than the costs necessary to deliver health
services efficiently. The cost limits, therefore, restrict the recognition of “reasonable cost” to a standard cost representative of that experienced by similar providers.
The initial system of hospital cost limits established in 1974, was rudimentary. Hospitals
were classified using only two variables—bed size and economic environment. The latter
variable was defined according to geographic location (urban vs. rural) and area per
capita income levels. At that time, per capita income statistics were the best means
available for distinguishing between high cost and low cost markets. Since no methods
existed for measuring the effects of factors such as case mix and scope of service,
limits were applied only to inpatient general routine costs which are less sensitive
to differences in the types of cases treated. Routine costs are basically the costs
of room, board, and general nursing services and exclude any costs associated with
ancillary services and special care units, such as intensive or coronary care. Limits
were set at the 90th percentile plus 10 percent of the median cost in each group.
This permitted a wide margin for the effects of variables not recognized in the system.
The basic method for defining routine cost limits remained essentially unchanged until
it was substantially revised for the hospital limits effective July 1, 1979. All urban
hospitals were classified into four bed size groups without any distinction for economic
environment. Rural hospitals were categorized into three bed size groups in the same
way. The revisions were based on a number of suggestions from the hospital industry
as well as CMS"s experience in administering the cost limits. In particular, a days
of care adjustment was included to assure that the limits would not unfairly penalize
hospitals where more intensive services may result in a shorter length of stay. At
the same time, costs not reflective of relative efficiency of operation such as capital,
malpractice insurance, and medical education expenses were excluded in deriving and
applying the limits. The portion of cost attributable to wages was adjusted for differences
in area wage levels by an index developed from hospital wages paid in each the locale.
Hospital costs were adjusted for inflation using a “market basket” of goods and services hospitals typically purchased in furnishing routine care. An
adjustment was provided to increase the limits for hospitals located in States furnishing
fewer days of care per 1,000 Medicare beneficiaries than the national average. Limits
were set at the 80th percentile of group cost. A further adjustment was provided effective
July 1, 1980 to account for additional costs which result from teaching programs but
which are not specifically identified as teaching costs. Also, the proportion of costs
subject to adjustment by the wage index was increased to more closely approximate
the actual economic environment. Because these improvements resulted in more homogeneous
groupings, the level of the limits was set at 112 percent of the mean cost in each
group effective July 1, 1980. (See Note below.)
The evolution of hospital cost limits provided the foundation for limits on inpatient
routine costs of skilled nursing facilities (SNFs). The system, which took effect
October 1, 1979, is similar in design to the system used for hospital cost limits.
Comparability is achieved by classifying SNFs according to location (urban or rural)
and status as either a freestanding or hospital-based facility. SNFs are classified
in this manner because hospital-based SNFs as a class, incur higher costs as a result
of the Medicare cost allocation requirements for distributing hospital overhead costs
to the SNF departments. The initial limits were set at 115 percent of mean cost in
each group. A revised set of limits incorporating several refinements and reducing
the limits to 112 percent of mean cost in each group became effective October 1, 1980.
Section 223 limits on home health costs were first established July 1, 1979. The initial
limits were based on a classification system which distinguished only between urban
and rural providers. Limits were set at a fairly high level, the 80th percentile of
per visit costs in each group.
Although CMS calculated limits for each type of home health service (skilled nursing,
physical therapy, occupational therapy, speech therapy, medical social service, and
home health aide service), the various cost finding methods used by providers made
it impractical to apply the limits directly to the per visit costs of individual services.
Therefore, HHA cost limits were applied on an aggregate basis. That is, the limits
for each type of service were multiplied by the number of visits for that service.
The sum of the resulting amounts was then compared to the agency"s aggregate allowable
Effective July 1, 1980, HHA cost limits adopted several features common to the hospital
and skilled nursing facility methodologies. The revised system was based on an urban/rural
classification system with separate categories for hospital-based and freestanding
agencies. The latter distinction recognized the different cost allocation Medicare
requires of hospital-based facilities. The new methodology also incorporated the hospital
wage index to recognize differences in area wage levels (an HHA specific index is
presently not available) and relied on an HHA market basket for inflation adjustments.
(See Note below.)
Cost limit systems for hospitals, SNFs and HHAs have continued to evolve into more
sophisticated systems as experience has been gained. The effective dates of all three
sets of limits are as follows:
NOTE: P.L. 97-35, the Omnibus Reconciliation Act of 1981, directed the Secretary to establish
hospital cost limits at 108 percent of the group mean and HHA cost limits at the 75th
percentile of costs. These changes become effective October 1, 1981.