HI 00601.590 Background

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 1979.

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 Medicare cost.

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.