Medicare doesn’t pay providers a single flat rate for everything. Instead, it uses several different payment systems depending on the type of care, where it’s delivered, and whether the provider is a doctor, hospital, or private insurance plan. The core idea is the same across all of them: Medicare sets a price for each service or condition in advance, and providers are paid based on that predetermined amount rather than whatever they choose to charge.
How Doctors Get Paid: The Physician Fee Schedule
When you see a doctor, Medicare pays them through the Physician Fee Schedule. Every medical service, from a routine office visit to a complex surgery, is assigned a code. Each code carries a point value called a Relative Value Unit (RVU), which reflects how much time, skill, and resources that service requires. The RVU has three components: the physician’s work (their time and expertise), practice expenses (rent, staff, equipment), and malpractice insurance costs.
Those three components are each adjusted by a Geographic Practice Cost Index, which accounts for the fact that running a medical practice in Manhattan costs more than running one in rural Kansas. A doctor in a high-cost area gets a higher adjustment on each component. Once adjusted, the three values are added together and multiplied by a single dollar figure called the conversion factor. For 2025, that conversion factor is $32.35, down about 3% from $33.29 in 2024. This final number is the Medicare-approved amount for that service in that location.
The conversion factor changes every year, and in recent years it has trended downward, which is a source of ongoing frustration for physicians. Congress sometimes intervenes with temporary fixes, but the base formula remains the same.
How Hospitals Get Paid: Diagnosis-Related Groups
Hospital inpatient stays under Medicare Part A work differently. Instead of paying for each individual test, procedure, and day in the hospital, Medicare pays a flat rate per admission based on what’s wrong with you. Each hospital stay is categorized into a Diagnosis-Related Group (DRG), and each DRG has a payment weight that reflects the average resources needed to treat patients with that condition.
The hospital’s base payment rate is split into a labor portion and a non-labor portion. The labor share is adjusted by a local wage index so hospitals in expensive labor markets receive more. That adjusted base rate is then multiplied by the DRG weight to produce the payment for that admission. A straightforward pneumonia case gets a lower weight than open-heart surgery.
Several add-on payments can increase the amount. Hospitals that serve a high percentage of low-income patients receive a disproportionate share adjustment. Teaching hospitals with medical residents get an additional payment that scales with their resident-to-bed ratio. And for cases that turn out to be unusually expensive, Medicare makes an outlier payment to protect the hospital from absorbing massive losses on a single patient. All of these adjustments stack on top of the base DRG payment.
This system is called the Inpatient Prospective Payment System, and its design is intentional: by paying a fixed amount per diagnosis rather than per service, it gives hospitals a financial incentive to treat patients efficiently. If the hospital spends less than the DRG payment, it keeps the difference. If it spends more, it absorbs the loss.
How Medicare Advantage Plans Get Paid
If you’re enrolled in a Medicare Advantage plan (Part C), your care is delivered through a private insurer rather than traditional Medicare. But CMS still funds it. Each month, CMS pays your plan a per-person amount that’s adjusted based on how sick you are, using a system called the Hierarchical Condition Categories (HCC) model.
Every enrollee is assigned a risk score based on their diagnoses, age, sex, disability status, and whether they also qualify for Medicaid. Each condition and demographic factor adds a coefficient to the score. Someone with diabetes, heart failure, and chronic kidney disease will have a much higher risk score than a healthy 65-year-old. A higher risk score means CMS pays the plan more, on the theory that sicker patients cost more to treat. The model is calibrated using spending data from traditional fee-for-service Medicare, so traditional Medicare essentially sets the benchmark.
Once the plan receives that monthly payment, it decides how to pay its own network of doctors and hospitals. Some plans use fee-for-service internally, others use capitation (a flat monthly payment per patient), and many use a hybrid. This is why your experience with billing and copays can vary significantly between different Medicare Advantage plans.
Quality Performance Adjustments
Medicare doesn’t just pay based on volume anymore. Under a law called MACRA, most physicians in traditional Medicare are subject to the Merit-based Incentive Payment System (MIPS), which adjusts their payments up or down based on performance in four areas: quality of care, how efficiently they use resources, how well they use electronic health records, and clinical practice improvement activities.
High performers earn a bonus on top of their standard fee schedule payments. Low performers face a penalty. The maximum reduction for clinicians in the bottom tier is 9% per year. These adjustments apply to payments two years after the performance period, so your doctor’s 2023 performance scores affect their 2025 reimbursement rates.
Participating vs. Non-Participating Providers
How much you personally owe depends partly on whether your provider “accepts assignment,” meaning they accept the Medicare-approved amount as full payment. Participating providers agree to this for all services. They bill Medicare directly, collect the approved amount (minus your coinsurance and deductible), and can’t charge you anything beyond that.
Non-participating providers haven’t signed that agreement. They can charge up to 15% above the Medicare-approved amount, a cap known as the limiting charge. You may need to pay the full bill upfront and submit a claim to Medicare yourself for reimbursement. Some providers have opted out of Medicare entirely, which means Medicare won’t pay any portion of their charges. Before scheduling an appointment, it’s worth confirming where your provider falls.
How Claims Actually Get Processed
Medicare doesn’t process its own claims. Instead, CMS contracts with private insurance companies called Medicare Administrative Contractors (MACs), each assigned to a geographic region. When your doctor or hospital submits a claim, it goes to the MAC for your area. The MAC reviews the claim, checks that the service is covered and coded correctly, calculates the payment based on the applicable fee schedule, and sends payment to the provider.
MACs also handle first-stage appeals if a claim is denied, answer provider questions about billing rules, audit hospital cost reports, and establish local coverage decisions for services that don’t have a national coverage policy. There are separate MACs for standard Part A and Part B claims and for durable medical equipment claims. For beneficiaries, this process is mostly invisible. You’ll see the results on your Medicare Summary Notice, which shows what was billed, what Medicare approved, what Medicare paid, and what you owe.
Why Reimbursement Rates Vary So Much
Two providers performing the exact same procedure can receive different Medicare payments depending on several factors. Geography is the biggest one: the cost-of-living adjustments built into both the physician fee schedule and the hospital payment system mean providers in expensive metro areas receive more. Whether the service happens in a doctor’s office or a hospital outpatient facility also matters. Hospital-based settings typically have higher reimbursement rates because of facility fees that get added to the professional fee.
The physician fee schedule even uses two separate formulas depending on location: a “facility” price for services performed in hospitals or ambulatory surgery centers, and a “non-facility” price for office-based care. Both use the same RVU and GPCI structure, but the practice expense component differs because the overhead costs differ. This is why the same blood draw or imaging study can cost Medicare significantly more when performed in a hospital outpatient department than in an independent physician’s office.