Medicare is a federally funded social health insurance program that consists of four “parts” or types of benefits—A, B, C, and D—each covering different items, services, or types of care, and paid for pursuant to specific payment methodologies. The following is a brief overview of what services and items Medicare generally covers under the various benefits, and a summary of Medicare’s primary payment systems for Parts A and B.

What Health Care Items and Services Are Covered by Medicare?

Part A – Hospital Insurance

Medicare Part A covers hospital inpatient services, post-hospital skilled nursing facility (“SNF”) care, certain home-health services, and hospice care.

With respect to hospital inpatient services, Part A generally covers the costs associated with a hospital stay, whether it be in a general acute care hospital or a specialty hospital (such as a long-term acute care hospital, psychiatric hospital, or rehabilitation hospital), up to 90 days per “spell of illness.”

After 90 days, if the beneficiary is not well enough to return to his or her normal routine, Part A covers other types of care. If the beneficiary is still extremely ill, Part A covers the cost of staying in a skilled nursing facility or SNF for up to 100 days per spell of illness. However, the SNF benefit is only available where the beneficiary is admitted to the SNF within 30 days of being discharged from the hospital. If the beneficiary is well enough to return home but ill enough that he or she will be confined to the home, Part A covers up to 100 home health visits. The home health benefit is only available where the beneficiary required a hospital or SNF stay of three days or longer, and was discharged from that stay within 14 days of the first home health visit. If the beneficiary is terminally ill and elects hospice coverage, Part A covers pain management, palliative care, and other associated services and supplies, including drugs, provided in a variety of settings (for example home, hospital, or SNF) for 90-day or 60-day benefit periods.

Part B – Supplementary Insurance

Part B is a supplementary insurance benefit that is generally similar to private health insurance in that it requires beneficiaries to pay a monthly premium, satisfy a deductible, and pay co-insurance. If beneficiaries elect Part B coverage, it covers a variety of health care services and items, subject to certain exclusions and limitations. Examples include office visits (such as a physician’s professional services plus those services performed in the physician’s office that are “incident to” the physician’s services), outpatient hospital department care, diagnostic laboratory services, physical/occupational therapy, and some home health care. It also covers items to be used in the home that meet the Medicare definition of durable medical equipment (“DME”) (for example, wheelchairs, walkers, and inhalers), prosthetic devices (such as artificial limbs, pacemakers, etc.), items furnished to beneficiaries “incident to” the physician’s services (such as splints, casts, etc.), and certain drugs that either meet specific criteria with respect to how they are administered or are expressly authorized by the Social Security Act.

Part C – Medicare Advantage

Part C is otherwise known as the Medicare Advantage (“MA”) program (formerly, Medicare + Choice). Through Part C, Medicare beneficiaries who are entitled to Part A benefits and are enrolled in Part B can choose to receive health benefits from private health plans offered by MA organizations. Three different types of plans are available under Part C: coordinated care plans (for example, health maintenance organizations—“HMOs”; provider-sponsored organizations— “PSOs”; special needs plans—“SNPs”; and preferred provider organizations— “PPOs”), private fee-for-service plans, or combination plans (which include both a basic health plan and a medical savings account into which CMS will make deposits).

At a minimum, MA plans must cover “basic benefits”—i.e., those services that are otherwise covered under Medicare Parts A and B (discussed above), except for Part A hospice services. MA plans also may offer optional supplemental benefits at an additional cost to beneficiaries, as long as the option is available to all beneficiaries in the plan, or requires beneficiaries to purchase supplemental benefits, subject to CMS approval.

Part D – Prescription Drug Benefit

Medicare Part D is the Medicare prescription drug benefit that became effective  Jan. 1, 2006 and covers outpatient prescription drugs. Through contracts with CMS, plan sponsors offer coverage through various types of plans (for example, stand-alone prescription drug plans—“PDPs,” or Medicare Advantage prescription drug plans—“MA-PDs”). Whether specific types of drugs are covered depends on the individual plan’s formulary and, in some cases, the setting where the drug is being administered. CMS requires each plan’s formulary to include at least two drugs from each therapeutic category. If specific drugs are not on a plan’s formulary, they are generally not covered unless the drug is medically necessary, in which case the beneficiary may be entitled to an exception. Further, if drugs are covered under Parts A or B, Part D coverage is not available.

In addition, coverage is only available up to a certain threshold, above which there is a coverage gap (known as the “donut hole”) until a beneficiary’s drug expenditures reach the “catastrophic” threshold when coverage is once again available. The beneficiary is responsible for the cost of all outpatient prescription drugs unless/until out-of-pocket expenditures exceed the coverage-gap limit.

What Are the Payment Systems for Medicare Parts A and B?

Complex payment systems reimburse providers and suppliers under Parts A and B. The most prevalent systems are Prospective Payment Systems (“PPS”) and fee schedules. The following is a brief overview of these payment systems.

Prospective Payment System

Established to create an incentive for health care entities to operate more efficiently and more profitably, the Medicare PPS identifies pre-determined prices that Medicare uses to reimburse many health care providers and suppliers for services provided to beneficiaries. Theoretically, beneficiaries receive better, more focused treatment under a PPS methodology than a traditional fee-forservice reimbursement system.

A traditional fee-for-service system ties a health care provider’s revenue stream directly to the number of procedures performed for a beneficiary (e.g., each exam, each test, and each procedure). Under the Medicare PPS, health care entities are paid one predetermined flat rate for care that is based on the beneficiary’s diagnosis and condition. Because a health care entity receives only a preset PPS amount—regardless of actual costs incurred—a PPS payment may exceed a provider’s full costs for treating the beneficiary, thereby forcing the facility to absorb the excess cost. By changing the revenue stream, the PPS system’s reimbursement methodology places inherent pressure on providers and suppliers to streamline their operational costs and treatment—such as eliminating redundant or unnecessary tests on patients whose medical problems are straightforward.

Largely following the hospital PPS model, PPS methodologies have since been developed for each of the other major parts of Part A coverage—inpatient rehabilitation, long-term care hospitals, skilled nursing facilities, home health agencies, and inpatient psychiatric facilities.

Prospective Payment System Methodology – In general, a PPS rate represents the average cost, nationwide, of treating a Medicare beneficiary according to his or her medical condition, or the average cost of providing certain outpatient services. Medicare employs two complex classification systems to identify these average costs—diagnostic related groups (“DRG”) for inpatient services, and ambulatory payment classification (“APC”) groups for outpatient services.

Diagnostic Related Groups – DRG classifications are used in the inpatient prospective payment system (“IPPS”) for inpatient hospital stays. Medicare sets prices for more than 550 DRGs that are organized into 25 major categories. Only one DRG is assigned to a patient for a particular hospital admission. The scope of each DRG encompasses a principal diagnosis and procedure, which has a payment weight assigned to it, based on the average resources used to treat a Medicare beneficiary in that DRG. Secondary diagnosis, beneficiary age, sex, discharge status, and the presence or absence of complications and comorbidities also factor into DRG payment weights and assignments. The location and type of hospital may impact DRG payments as well. For example, a hospital-wide percentage add-on payment is applied to the IPPS payment rate for teaching hospitals and hospitals that treat a high percentage of low-income patients.

While only one DRG payment covers all hospital costs for treating a beneficiary during a specific inpatient stay, a Medicare safety net applies to unusually costly inpatient hospital cases. These Medicare “outlier” payments are additional payments designed to protect a hospital from large financial losses as a result of unusually expensive cases.

Ambulatory Payment Classification Groups – Serving in the same capacity as DRGs in the inpatient payment system, APC groups are predetermined payment rates employed by the outpatient prospective payment system (“OPPS”) for designated services furnished by hospitals and other facilities providing outpatient services. Each APC group contains services and procedures that are clinically comparable and use roughly the same amount of resources. Currently, more than 450 APC groups cover services such as surgical procedures, radiology and other diagnostic procedures, clinic visits, emergency department visits, medical supplies and surgical dressings, and various preventive services.

However, unlike DRGs under the inpatient payment system, depending on the number and type of outpatient services provided to a beneficiary, single or multiple APC groups, each with separate associated reimbursement payments, may apply.

Fee Schedules

Medicare Part B currently employs complex fee schedules to reimburse physicians and other health care suppliers of services and equipment.

Part B services provided by physicians and other health care suppliers are reimbursed through the “physicians’ fee schedule.” This fee schedule is an elaborate price list that Medicare uses to reimburse physicians for the services they, and other health care suppliers, furnish for items and services that are not “bundled” into PPS methodologies—things like clinical laboratory tests, durable medical equipment, and some prosthetic devices. For each service provided, there is an associated reimbursement rate that Medicare recalculates annually.

Other suppliers of services and equipment (e.g., durable medical equipment, prosthetic devices, and orthotics) are reimbursed under Part B through either regional fee schedules or on a “reasonable charge” basis. However, as a result of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“MMA”), Medicare will shift from a fee schedule to a competitive bidding system. Payments will soon be based on competitive bids in which CMS will determine a single payment amount for each item or service in separate competitive acquisition areas. By 2009, competitive bidding will occur in 80 of the nation’s largest metropolitan statistical areas. The remaining areas will have competitive bidding phased in after 2009.