Renee Leary, MPH
Dean Farley, PhD

The private sector drags its feet over Ambulatory Payment Classifications. Here are some suggestions to move acceptance along.

Renee Leary, MPH

Dean Farley, PhD

When Medicare implemented its APC-based (Ambulatory Payment Classifications) hospital outpatient prospective payment system (OPPS) four years ago, a rapid diffusion of this or similar payment systems into the commercial sector was expected.

Many state Medicaid programs, Blue Cross plans, and commercial insurers had piggy-backed on Medicare's success with inpatient DRGs (diagnosis-related groups)and had achieved cost savings on inpatient services by implementing some variation of DRG-based reimbursement.

Faced with rapid increases in outpatient spending, commercial payers were expected to view the Medicare OPPS as an attractive option for controlling costs. In reality, APC expansion beyond Medicare has been limited.

A key obstacle for commercial payers has been the number of Medicare-specific coding/billing requirements incorporated into this outpatient payment system. In addition, the APC-based OPPS, as implemented by Medicare, is a complicated and dynamic system that changes quarterly.

With Medicare constantly striving to improve the system, no one has had the time or resources to become an expert in its workings. This article will help payers recognize the benefits — and challenges — of adopting OPPS or some variation of APC-based reimbursement.

APCs and the Medicare OPPS

Most outpatient services furnished by hospitals participating in the Medicare program are covered by the Medicare OPPS, which has at its foundation a case mix classification system called the Ambulatory Payment Classifications or APCs. Generally, APC assignment is based on HCPCS (Healthcare Common Procedural Coding System) procedure codes (either HCPCS Level I/CPT or HCPCS Level II), with two types of APCs being assigned — clinically-based APCs and payment policy APCs. The clinically-based APCs generally represent groups of outpatient services that are clinically similar and have comparable patterns of resource use. There are clinical APCs for ambulatory surgeries, other significant procedures, medical visits, and ancillary services. The nonclinical APCs implement Medicare payment and policy decisions for high cost drugs and devices, new technologies, observation, and partial hospitalization (psychiatric) services.

While APC assignment is based on HCPCS procedure codes, not all procedure codes are assigned to APCs or are eligible for payment under the OPPS. Each procedure code is assigned a "payment status indicator" that tells how Medicare will pay for that service (or HCPCS procedure code) when it is billed. Medicare does not assign APCs to services that it believes should be treated in an inpatient setting; to noncovered services; to services paid under a fee schedule or other prospectively determined rate (e.g., ambulance services, physical and occupational therapy, and clinical diagnostic laboratory services); or to services paid for reasonable costs (e.g. vaccines and corneal tissue acquisition). Medicare has also identified a number of services that are considered integral to the delivery of some other primary procedure and for which payment is included or packaged with the payment for the primary procedure. There is no separate APC assignment or payment for these packaged services. Payment status indicators and APC eligibility are noted in "Hospital Outpatient PPS Payment Status Indicators and APC Eligibility" below.

Hospital outpatient PPS payment status indicators and APC eligibility
Status Indicator Type of service Eligible for APC
A Services paid under fee schedule or prospectively determined rate No
B Not payable on hospital outpatient bill type; may be payable to other payers No
C Inpatient services or procedures — not paid under outpatient PPS No
E Noncovered items or services or Medicare does not use code in question — not paid No
F Paid reasonable costs, coinsurance or copayments apply (e.g., corneal tissue acquisition and certain CRNA services) No
G Drug/biological transitional pass-throughs Yes
H Device category transitional pass-throughs and brachytherapy; sources paid on a cost basis Yes
K Non pass-through drug/biological, radiopharmaceutical agent, certain brachytherapy seeds, paid APC rate Yes
L Paid reasonable costs, no coinsurance or copayments apply (influenza and certain pneumococcal pneumonia vaccines) No
N Incidental services or procedures — packaged into APC rate No
P Partial hospitalization services, paid per diem rate Yes
S Significant procedures not subject to multiple procedure discounting Yes
T Significant procedures eligible for multiple procedure discounting Yes
V Visit to clinic or emergency department Yes
X Ancillary service Yes
Y Nonimplantable DME; services must be billed directly to DMERC No

For the most part, only a limited number of hospitals are exempt from the Medicare OPPS. These include Maryland hospitals (paid under a prospective payment system waiver), hospitals of the Indian Health Service, and critical-access hospitals. Cancer hospitals, children's hospitals, and some rural hospitals, however, are "held harmless" or guaranteed not to receive reduced payments under the OPPS.

Medicare has implemented a number of different pricing strategies under the OPPS. Payment for most clinically-based APCs is based on a rate that is weighted for the acuity level of the services in that APC. Payment for many nonclinically based APCs, such as new technologies and devices, is based on cost. In addition, Medicare has implemented an outlier policy for sharing the risk of high-cost cases. This policy is service-specific, with both Medicare and the provider assuming responsibility for 50 percent of the costs above an APC-specific threshold.

Outpatient code editor

A fundamental component of the Medicare OPPS is the Outpatient Code Editor (OCE), which is more than just a data-quality editor, as its name implies. Rather, the OCE performs all functions within the OPPS that require specific reference to an HCPCS procedure code. In addition to basic data-quality editing, the OCE assigns APCs and preprocesses data for pricing. It also implements payment policy decisions that are based on codes, such as eligibility for partial hospitalization and observation payment.

In designing, implementing, and maintaining its OPPS, Medicare has intermingled policy and payment decisions with the basic rules for classifying and categorizing services for payment. Implementing APCs and OPPS means accepting some of Medicare's policy decisions, which may not be appropriate for other payers. Before implementing Medicare's OPPS and APCs, commercial payers should weigh the benefits and drawbacks of such an implementation.

Potential benefits

The implementation of inpatient prospective payment systems, supported by the development of new procedures and technologies, has created a financial incentive for providers to shift services from the inpatient to the outpatient setting. Increased outpatient service volumes, coupled with rapidly rising outpatient charges, have resulted in an average annual increase per capita of 10 percent for hospital outpatient services, as compared to 5 percent for inpatient services. In addition, as shown below in "Growth in Hospital Charges in Selected States," charges for hospital services as compared to costs have risen over 200 percent in many areas of the country.

Growth in hospital charges in selected states
  Charges as percent of costs
State 2000 2005 Difference
California 150 247 97
Florida 139 238 99
Illinois 107 163 56
Nevada 215 257 42
New Jersey 123 324 201
New York 68 129 61
Texas 114 184 70
Vermont 44 66 22

Increased outpatient volumes and rapidly rising outpatient costs have affected commercial payers most dramatically because most continue to contract for outpatient services on a percent-of-charge basis. With this in mind, the single most significant benefit of implementing an OPPS is to institute a mechanism for reducing medical expenses and constraining the growth of these services.

Under an OPPS, prices are fixed in advance and payment is tied to the actual services delivered, instead of billed charges. Financial incentives that currently favor the delivery of hospital outpatient services are eliminated, and providers are put at risk for inefficient practice patterns.

While reduced outpatient spending is the most obvious benefit of implementing an OPPS, there are many secondary benefits including: aligning provider and payer incentives; creating incentives for more accurate coding and billing; improving information for network development, medical management, and contracting; and simplifying operations.

Because prospective payment systems set prices for services in advance, they align provider and payer incentives. From a payer's perspective, decisions relative to site of care are now based on medical appropriateness and are not financially driven. From a provider's perspective, appropriate decisions should now be possible without intrusive medical management.

Because OPPS is service-driven, it creates incentives for more accurate coding and billing, giving payers a clearer measurement of what services have been provided and how health care dollars are actually being spent. Beyond this, improved coding on incoming claims will lead to the development of a much better historical database to support network development, medical management, and future contracting.

Current hospital outpatient contracts are complicated and often require charge increase reporting and charge description master (CDM) submissions. OPPS replaces this with a single integrated structure, without the need for charge-based reporting requirements.

Challenges for commercial payers

Commercial payers will find that implementing an outpatient PPS based on Medicare's APCs and payment rules is more difficult than implementing an inpatient PPS based on DRGs. On the inpatient side, a single DRG is assigned to each patient discharge (as compared to outpatient visits, where none, one, or many APCs may be assigned); DRG payment rules are relatively straightforward; Medicare updates the system annually and updates are well-documented; and the system is based on standard coding and billing requirements. It is generally possible for commercial payers to implement a DRG-based inpatient PPS using Medicare rules. Variations from Medicare rules are generally operational and affect choices such as which set of DRG rules to implement, effective date of changes, differences in outlier policy and payer-specific weights, and conversion factors.

On the outpatient side, it is not practical to simply adopt Medicare's OPPS and payment rules. There are a number of issues in the Medicare system design that must be addressed, as summarized in "Issues to Address Adapting the Medicare OPPS to a Non-Medicare Population".

Issues to address in adapting the Medicare OPPS to a non-Medicare population

Issue & Description

  • Scope of the OPPS — how to deal with facilities not included in the Medicare OPPS or treated specially
  • APCs are not all inclusive — how to pay for outpatient hospital services not assigned to APCs
  • CPT coding issues — how to deal with Medicare's requirement to bill for some services using HCPCS Level II codes, rather than CPT-4
  • Inpatient only procedures — whether and how to pay for procedures that Medicare feels should only be paid in the inpatient setting
  • Payment policy APCs — how to deal with those Medicare APCs that are not clinically based, but implement Medicare payment policies
  • OPPS operational and billing issues — Medicare software incorporates policy decisions
  • OPPS implementation may bring financial risk

The first issue that must be dealt with is the scope of Medicare's OPPS. Commercial payers need to decide if they want to follow Medicare policy by excluding or financially protecting certain classes of hospitals in the non-Medicare setting. If so, they need to determine which facilities should be excluded or held harmless and how they should be paid.

A second issue is that Medicare does not pay for all hospital outpatient services using the APCs. Many services are paid under a fee schedule, and are not assigned to APCs, including clinical laboratory services and therapies (payment status A). Services not covered by Medicare (payment status B or E), packaged services (payment status N) and "inpatient only" procedures (payment status C) are also not assigned to APCs.

Commercial payers must identify all services not assigned to APCs, determine the volume of these services, and construct rules for grouping and paying for these services.

A third issue is that Medicare does not recognize many valid CPT-4 codes. These codes have been assigned a payment status indicator of E, indicating that Medicare expects the service to be billed using an HCPCS Level II code, which generally reflects a greater level of specificity. For example, Medicare requires billing of HCPCS code G0001 (routine venipuncture for collection of specimens), rather than CPT-4 code 36415 (collection of venous blood by venipuncture). Commercial payers must decide whether or not to implement the same coding expectations as Medicare.

In a similar fashion, Medicare has identified a number of procedures that are only paid in the inpatient setting. Commercial payers will want to examine Medicare's complete list of inpatient-only procedures, using some predetermined set of criteria to remove procedures from this list. Strategies for grouping and paying for these procedures would then be required.

As mentioned above, not all APCs are clinically based. Some APCs were created to implement Medicare payment policies on observation services, partial hospitalization services, new technologies, and high cost drugs and devices. Commercial payers will need to decide whether the payment policies embedded within these APCs fit their contract obligations. If not, alternative strategies for paying for these items will be necessary. Partial hospitalization, for which there are extensive Medicare billing requirements that involve diagnoses, procedures, and condition codes, is especially problematic because so many private payers subcontract for behavioral health services from specialized management companies.

Out of sync

Another significant issue is how implementation of an OPPS-like system will affect the payer's claim- processing system. Medicare's OCE, for example, cannot be implemented without modification since this software includes many Medicare-specific policy decisions. Payers will need to determine if they have the resources to modify this software to accommodate deviations from Medicare APC assignment, editing and pricing rules. The Medicare system changes quarterly and updates are not well defined or publicly documented. How will this be dealt with? If a non-Medicare system is frozen at a particular time, holding changes constant, then payment rules will be out of sync with Medicare and may cause operational burdens on facilities. Additional billing issues are:

Provider identification number. Medicare processes claims using a Medicare Provider Number (MPN) but commercial claims are generally billed with a Federal Tax Identification Number (TINs). A mechanism for linking these different provider identification numbers will be necessary.

Physician charges. Commercial claims for hospital outpatient services often include physician charges. Payers will need to develop procedures to remove physician services from claims, at least temporarily, to ensure proper editing, grouping, and pricing.

Medicare billing requirements. To support OPPS implementation, Medicare has mandated a number of billing procedures including a requirement to submit only one bill for all services delivered in a hospital outpatient department on a single date. To implement an OPPS-like system, commercial payers need to impose similar requirements or to develop special rules for handling multiple claims with the same dates of service.

Implementation of an OPPS is not without risks. Experience has shown that when payers implement prospective payment systems and payment becomes based on codes, the coding and billing that drive payment become more complete and accurate. Medicare uses the Discounted Service Mix Index (DSMI) to measure the intensity of services that are reported on hospital outpatient bills and paid under its APC system. For hospitals reporting data from 2000 to 2004, the average increased during the first two years of APCs . The increase from 2.16 to 2.42 represents about a 12 percent increase in the DSMI that translates directly into greater hospital payment (see table, below). Commercial payers need to recognize that contracting under the APCs may result in more complete coding and to anticipate this effect in negotiating initial payment rates.

Discounted service mix indexes reported by CMS
  Fiscal Year
  2000 2002 2004
Median 2.14 2.37 2.33
Mean 2.16 2.42 2.37

Protocol for success

A successful OPPS implementation begins with a strong preparatory effort. Begin by using historical data to understand and document the current outpatient environment. Identify how and where outpatient dollars are spent and establish a baseline against which OPPS implementation can be later monitored and evaluated.

Also analyze historical data to identify coding and billing issues, identify potential operational difficulties, and simulate payments under the OPPS. To do this, edit, group, and price historical claims using Medicare rules and software.

Apply the Medicare OCE to historical claims and examine the frequency and reasons for edit failures. Use these findings to determine which OCEs are appropriate for a non-Medicare population, and which implement Medicare policy and should be either modified or bypassed. Also use edit results to identify common causes of edit failures (e.g., use of discontinued HCPCS codes or invalid modifiers).

Share this information with providers and work with providers to implement strategies to prevent such failures. Estimate the volume of claims that must be corrected and resubmitted by providers before payment would be possible.

From an operational perspective, use historical data to measure the percentage of hospitals that have special OPPS payment status, as well as the volume of claim dollars they represent. Use this information to decide whether to extend "special" status to these hospitals or to fold these hospitals into the OPPS. Also look at those services not assigned to APCs, including inpatient-only procedures, noncovered services and valid CPT-4 codes not recognized by Medicare.

Look at the volumes and dollars they represent and simulate alternative payment strategies, including assigning an APC, custom fee schedules, or payment as a percentage of charges. Look at criteria for observation reimbursement as well as for partial hospitalization (mental health) payment.

Establish an interdepartmental task force to review claims analysis, and to create and maintain an implementation plan. At a minimum, membership in this task force should include representation from the following departments: information systems, actuarial services, claims processing, provider relations, and network management.

This group must ensure that appropriate personnel are fully trained in OPPS requirements. It must also determine what contract or regulatory requirements are needed to support system implementation.

Access and document the ability of your claims processing system to handle OPPS implementation. Determine exactly what software is required and how it will be acquired, integrated, and tested. Determine just how much custom programming will be necessary to implement required changes. Determine what, if any, changes are needed to warehouse OPPS data.

Communicate with providers and involve them early in system analysis, design, and implementation. Providers have operational experience with OPPS as well as expertise in coding and billing. Look for a provider to serve as a beta site. Ensure providers have adequate notification regarding system design and requirements.

Prepare for and institute a process for ongoing evaluation. Since payment is driven by codes, be sure to monitor and analyze changes in coding and billing practices. Compare actual experience to the baseline established before program implementation. Identify emerging issues and problems and monitor financial success.


Health plans need to be realistic in their expectations and recognize that it will take time to work through the issues listed above, as well as to alter their claims processing systems. Financial benefits may be limited in the short run.

One option might be to consider a partial implementation strategy involving prototype agreements with willing providers or APC-based payment for selected product lines or services, such as ambulatory surgery, emergency rooms, clinics, or specific ancillary services. Implementation of APCs or an APC-like system is inevitable as commercial payers are pressured to find strategies for managing and controlling outpatient costs.

While APCs can be used for non-Medicare populations, Medicare OPPS is not completely transportable. Key issues involve changes in coding and billing requirements, system scope, and the fact that Medicare policy is embedded in the APC system.

We can expect to see a number of different models and a fair amount of experimentation as private health plans discover how best to adapt APCs to their own business requirements.

Renee Leary is president and chief operating officer of HSS Inc., which streamlines the coding, regulatory, and reimbursement processes at provider and payer organizations. She is a member of Managed Care's Editorial Advisory Board. Dean Farley, PhD, is HSS's vice president for health care policy and analysis.

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