Geographic adjustments to Medicare payments are intended to accurately and equitably cover regional variations in wages, rents and other costs incurred by hospitals and individual healthcare practitioners. However, a recent report from the Institute of Medicine (IOM) found that 37 percent of hospitals (1,313) have been granted exceptions to how their adjustments are calculated.

The rate of exceptions “strongly suggests” that the mechanisms underlying the adjustments are inadequate, noted the Committee on Geographic Adjustment Factors in Medicare Payment, the IOM committee that authored the study.

The rationale for fine-tuning Medicare payments based on geographic variations in expenses beyond providers' control is sound and should be continued, the committee concluded. “However, several fundamental changes to the data sources and methods the program uses to calculate the adjustments are needed to increase the accuracy of the payments,” the committee wrote.

Medicare payments to hospitals and health professionals working in private practice topped $500 billion in 2010, according to Congressional Budget Office estimates. “Total per capita Medicare spending is not evenly distributed across the country, and the proportion of beneficiaries living in metropolitan and nonmetropolitan areas also varies from state to state,” the authors wrote, noting that federal law requires geographic adjustments to be budget-neutral, meaning any increase in the amount paid to one hospital or practitioner must be offset by a decrease to others.

According to the report, the current system of geographic adjustment for hospital uses 441 labor markets to define payment areas. “Hospitals are classified according to their location in 365 metropolitan statistical areas, with the balance of non-metropolitan counties grouped into rest-of-state areas. The geographic adjustment system for physician payment uses 89 payment areas, some of which comprise large metropolitan areas, whereas 34 are statewide with combinations of metropolitan and nonmetropolitan areas,” committee members wrote.

The group recommended using the same labor market definition for both indexes, to reflect market integration for healthcare employers and workers in local markets.

“The committee acknowledges that moving from 89 to 441 physician payment areas could result in some areas with small sample sizes," they wrote. "To address this potential problem, certain areas could be combined, additional data could be collected or data smoothing techniques using information from adjoining areas could be used.”

Although metropolitan statistical areas (MSAs) reasonably approximate local labor markets, hospitals and clinics on the borders of neighboring MSAs may compete for the same pool of workers yet receive significantly different adjustments based on the average wages in their respective labor markets. Commuting patterns of healthcare workers can capture the economic blurring of labor market boundaries and should be used to smooth out any dramatic differences, the report said.

The authors asserted that commercial rent information would provide a more accurate assessment of variations in the price of office space than information on median subsidized rents for a two-bedroom apartment, which is the Medicare program's current metric. “Because no sources of commercial rent data have the broad geographic coverage necessary, a new source should be developed,” the report stated.

Salaries and benefits make up one of the largest costs of providing care, the report added. The committee recommended that the Medicare program should use health sector data from the Bureau of Labor Statistics (BLS) to develop its indexes for calculating wage adjustments for hospitals and private practice health professionals. BLS data are more accurate, independent and appropriate sources than the hospital cost reports, physician surveys, census data and other information currently used, the committee maintained. However, Congress must revise a section of the Social Security Act to enable this change.

Medicare should also take into account median wage data for all types of workers in private practice settings and hospitals to calculate payments, the report added. Currently, regional wage differences are based on data for registered nurses, licensed practical nurses, health technicians and administrative staff only, which does not reflect the full work force in many practices or hospitals.

“Taken together, these recommendations will mean a significant change in the way that the indexes are calculated and will require a combination of legislative, rule-making and administrative actions as well as a period of public comment,” the report concluded. “If the use of new data sources changes the total payments, the Centers for Medicare & Medicaid Services will need to re-calibrate the payments to maintain budget neutrality.”

The report is the first of three to be issued by the committee. A supplemental report that discusses physician payment issues further will be issued this summer. A final report, to be released in 2012, will present the committee's evaluation of the effects of the adjustment factors on healthcare quality, population health, and the distribution of the healthcare workforce.

Read the 300-page report here.