Risk adjustment in healthcare is a regulatory tool used to balance payments to health plans based on the expected healthcare needs of the populations they cover. This system ensures that health insurance plans receive appropriate funding to cover patient care costs, accounting for underlying health conditions and demographic factors like age and gender. Its primary goal is to promote fairness within the competitive insurance market by mitigating the financial incentive for insurers to enroll only the healthiest members.
Why Health Plans Require Risk Adjustment
The structure of risk adjustment is designed to solve a fundamental economic problem in health insurance markets known as adverse selection. Adverse selection occurs when individuals know more about their health status than the insurance company does, leading those who expect high healthcare costs to be the most motivated to purchase generous insurance plans. This imbalance can cause market instability, as the pool of insured people becomes disproportionately sicker and more expensive to cover.
Without risk adjustment, insurance companies would be incentivized to engage in “cream skimming” or “cherry-picking,” actively trying to enroll only healthy, low-cost individuals while avoiding those with chronic or complex conditions. Insurers could achieve this by designing plans or marketing strategies that subtly deter sicker members. This undermines the goal of widespread access to care.
Risk adjustment mitigates this incentive by transferring funds between plans based on the actual health risk of their enrolled population. Plans covering a population with higher expected costs receive payments from a pool funded by plans covering a healthier population. This transfer neutralizes the financial advantage of having a healthier-than-average membership. It rewards plans for efficiency and quality of care, regardless of the health status of their enrollees. By making all enrollees equally profitable, risk adjustment helps ensure that plans are willing to cover all applicants, including those with pre-existing conditions.
The Mechanism: Translating Diagnoses into Risk Scores
The core function of risk adjustment is to convert a patient’s medical history and demographic profile into a single numerical value called a risk score. This score is a prediction of the expected healthcare costs for that individual over the next year. The calculation begins with the diagnoses submitted by health plans and providers, which must be accurately documented during patient encounters.
These recorded diagnoses, typically using the International Classification of Diseases (ICD) codes, are mapped to a structured framework called Hierarchical Condition Categories (HCCs). HCCs group together related medical conditions that require similar healthcare resources, such as diabetes with complications or chronic heart failure. Each HCC is assigned a specific weight, reflecting the relative severity and anticipated cost of treating that condition.
The process incorporates more than just disease status, including demographic factors like age, gender, and in some models, institutional status or eligibility for other government programs. The weights from all applicable HCCs and demographic factors are summed together to produce the patient’s final risk score. This numerical score is standardized, or “normalized,” around a value of 1.0, which represents the average expected cost of a member within that specific insurance program.
A patient with a risk score above 1.0 is anticipated to incur higher-than-average healthcare costs, resulting in a higher payment to their health plan. Conversely, a score below 1.0 signifies a healthier member with expected costs below the average, leading to a lower adjusted payment. This adjustment ensures that plans are financially compensated for the complexity of the patients they serve, particularly those with multiple chronic conditions.
Key Programs Utilizing Risk Adjustment
Risk adjustment is foundational to stabilizing major segments of the U.S. health insurance market, most notably within Medicare Advantage and the Affordable Care Act (ACA) Marketplaces. These programs rely on the system to ensure fair competition and adequate funding for the populations they serve.
In Medicare Advantage (MA), which is the private-plan alternative to traditional Medicare, risk adjustment directly determines the capitated payments made by the government to the MA plans. The Centers for Medicare & Medicaid Services (CMS) uses the risk scores to adjust the base payment for each enrollee, ensuring plans receive more money for sicker beneficiaries. This application is not budget-neutral, meaning the government’s total outlay is adjusted based on the overall health of the MA population compared to traditional Medicare.
The ACA Marketplaces, established by the Affordable Care Act, also mandate a risk adjustment program for all non-grandfathered plans in the individual and small group markets. The goal here is to stabilize the market by transferring funds among carriers with different risk profiles. Unlike the MA model, the ACA risk adjustment program is designed to be budget-neutral within each state’s market, meaning the total charges collected from plans with healthier populations equal the total payments made to plans with sicker populations.
The methodologies used in these two programs, the CMS-HCC model for Medicare Advantage and the HHS-HCC model for the ACA Marketplace, reflect the specific characteristics of their respective populations. Both applications provide the necessary financial predictability for private insurers to operate successfully in regulated, competitive environments.