A Prospective Payment System (PPS) is a fixed method of reimbursement in healthcare where the payment amount is set in advance of a patient receiving care. This predetermined rate is paid to a provider for a specific episode of care, procedure, or defined period of service, regardless of the actual costs incurred. Medicare introduced PPS in the 1980s primarily to manage and contain the rapid growth of healthcare expenditures. By establishing a predictable payment, the system shifted financial risk and incentivized providers to manage resources efficiently.
Prospective vs. Retrospective Payment
The PPS model represents a fundamental shift away from the traditional retrospective payment system, which was dominant before its adoption. Retrospective payment, often called fee-for-service, determined reimbursement after services were rendered by calculating the total actual costs or charges submitted by the provider. This system incentivized providers to increase the volume and intensity of services, as greater utilization led directly to higher revenue. The financial risk of high costs was largely borne by the payer, such as the government or an insurance company.
The prospective model sets a fixed price before the patient is treated, fundamentally altering financial incentives and risk allocation. Providers know the exact payment they will receive for a defined patient case or service bundle. This structure encourages efficiency and cost control, motivating hospitals and practitioners to reduce unnecessary testing, shorten lengths of stay, and streamline care delivery. If a provider’s cost is less than the fixed prospective rate, they keep the difference; if the cost exceeds the rate, they absorb the loss.
This difference in timing changes the focus from volume to efficiency. While the retrospective system rewarded the quantity of services provided, the prospective system rewards the efficient management of resources within a fixed budget. Moving the financial risk onto the provider, PPS aims to slow the overall rate of increase in healthcare spending. The predetermined payment also allows both payers and providers to forecast budgets with greater certainty.
The Methodology of Rate Determination
Determining the fixed prospective payment rate relies on a formula combining national data and local adjustments. The calculation begins by establishing a base payment amount, derived from historical cost data and updated annually using a “market basket index” to account for inflation. This base rate represents the national average cost of providing care for a standardized patient encounter.
The base payment is then adjusted to reflect patient-specific and facility-specific variables to ensure fairness. A significant patient-specific adjustment is the Case Mix Index (CMI), which measures the relative complexity and resource intensity of a provider’s patient population compared to the national average. A hospital treating sicker patients with multiple conditions will have a higher CMI and receive a corresponding upward adjustment to the base rate.
Facility-specific factors also influence the final payment, particularly geographic variation in labor costs. A “wage index” is applied to the labor portion of the base rate to adjust for higher wages and salaries in a specific labor market area. Specialized hospitals, such as those with significant teaching programs or those serving a disproportionate share of low-income patients, may receive additional adjustments to cover unique operational costs. This methodology aims to standardize payment for similar episodes of care while acknowledging differences in patient severity and local economics.
Major Prospective Payment Models
The principles of PPS are implemented across the healthcare system through various classification models tailored to different settings of care. The most recognized application is the Inpatient Prospective Payment System (IPPS), which utilizes Diagnosis-Related Groups (DRGs) or Medicare Severity Diagnosis-Related Groups (MS-DRGs) to classify inpatient hospital stays. Under this model, a patient is assigned to an MS-DRG based on their primary diagnosis, surgical procedures, and complications, and the hospital receives a single, fixed payment corresponding to that group.
For physician services, the Resource-Based Relative Value Scale (RBRVS) is the primary PPS model used by Medicare and many commercial payers. RBRVS assigns a relative value unit (RVU) to each service based on estimated resource costs, including the physician’s work, practice expenses, and professional liability insurance costs. The RVU is then multiplied by a monetary conversion factor and adjusted for geographic cost differences to determine the final payment.
PPS models are applied to numerous other healthcare settings beyond hospitals and physician offices. This includes the Outpatient Prospective Payment System (OPPS), which uses Ambulatory Payment Classifications (APCs) to bundle hospital outpatient services. Specific PPS frameworks also exist, demonstrating the widespread adoption of predetermined payment methodologies:
- Skilled Nursing Facilities (SNF PPS)
- Home Health Agencies (HH PPS)
- Long-Term Care Hospitals (LTCH PPS)