Medicare Prospective Payment System


The essay is a critical analysis of Medicare prospective payment system and how the Medicare payments to hospitals and physicians for services they render to patients are calculated. Additionally, this paper looks at ratio analysis and its applicability in assessing financial health of an organization.

Medicare prospective payment system

According to Marcinko, 2009 Medicare Prospective Payment System abbreviated PPS saw the light in 1st October 1983. This was after the federal government deemed it fit to have the system in place so that hospitals are offered with financial incentive so as to change their behavior. This was to be achieved through effectively managing the costs of providing medical services to customers.

For this system, hospitals are given money that is already determined for admitting a patient. It is required that the patient be categorized in a Diagnosis-Related Group, this is to be in line with the clinical data. It is worth mentioning that there are cases where especially patients with very high medical cost makes it then a different case as the payment will not be a flat rate.

The information required in the bill includes the age, sex of the patient, the discharge disposition, surgical procedure and complications and comorbidites. It is worth noting that this system replaced the one adopted (Retrospective Cost-Based Reimbursement) immediately the country established Medicare back in 1965 which paid hospital actual costs incurred while providing medical services to patients (Marcinko, 2009).

According to Brady & Barbie, 2002, from 1965 the population and expenditure in Medicare tremendously increased by 16.9% in 1985 from 9.2% in 1967. Increased cost of expenditure raised an alarm and the costs were attributed to the methods used to make payment and ever increasing cost of innovation in Medicare. As mentioned previously, PPS was meant to change the way healthcare facilities delivered their services.

Calculation of Medicare payment

The calculation of Medicare payment fundamentally rests on the weigh associated with Diagnosis-Related groups. The weights are meant to factor in discrepancies that arise due to varied kind of treatments. The first thing is to calculate the DRG weights, it is important to note that charges by the incurred by the patient are standardized. This is done to do away with wage difference effects, indirect costs in medical education as well as the additional payments that are meant to treat patients that earn very low wages (Brady & Barbie, 2002).

The standardized sum is arrived at by adding charges for all the reported cases in the various DRG and then divided by the sum of the number of cases categorized in the diagnosis-related group (Miller & Ryan, 1995). Outliers, those cases that statistically deviate from the value are eliminated. Then what is found to be the average for every diagnosis related group is again calculated then divided by the charge the nation set as the standard one, this is done for every case so that we establish the weight of the DRG.

Additionally, there are four factors that are usually considered in making adjustments to DRGS. These include application of wage index, costs of outliers, disproportionate share payments and indirect medical education costs. Others include consideration of hospital as either a sole community, a Medicare that is rural dependant or it being referral are factored in the calculation (Cleverly, 1995).

Ratio analysis and assessment financial health of an organization

It has been noted that each and every organization more often than not need to measure how it performs as well as establish it own stability or health. There are various methods of doing this but the most prominent is the use of financial information especially ratio analysis (Melissa, 2007). Financial ratio analysis comprises of five major groups; these ratios include debt, assets activity, profitability as well as liquidity.

Profitability ratio includes gross profit margin, net profit margin, ratio on return of assets operating profit margin and ratio of return on equity. When all this factors are considered, the ratio measures how profitable a healthcare facility is. Liquidity ratio includes both quick current ratio; the obtained results shows how able is hospitals can meet their short-term requirements (Weygandt, 1996).

According to Melissa, 2007 debt ratio usually measures the debt being used by an organization as well as its capabilities to pay such debts. It is arrived after including debts to the total assets ratio as well as earnings from the interest rates. Finally, the assets activity ratio which encompasses collection period ratio, the inventory turnover as well as total asset turnover ratio shows the organization how effective it is in utilizing assets at its disposal. For instance when comparing the total number of beds and those occupied, a hospital can use such data to establish the direction it is taking and of course make necessary steps to correct when things seem going in an undesired direction (Brady & Barbie, 2002).


From the review, PPS was introduced by the federal government in 1983 to help hospital change the way they delivered healthcare services to patients. The manner with which the payment is arrived at is a bit complex but it has been made manageable and realistic. It is with noting that there are a number of factors that are put into consideration before arriving at the actual amount. Major steps in calculating PPS include calculating the standard rate, adjusting for wage index factor, DRG weights, disproportionate share payment, and indirect medical education payment and finally out-liar payment.

Additionally, financial ratios are among the various tools that can be used by any organization to establish how stable and healthy it is. Ratios such as debt, liquidity, asset activity among others are indicators of the state of any organization including hospital.


Brady, T & Barbie R. (2002). Medicare Hospital Prospective Payment System: How DRG Rates Are Calculated and Updated. Web.

Cleverly, W. (1995). “Understanding your hospital’s true financial position and changing it”. Health Care Management Review, 20 (2):62-73.

Kramer, A. K. & Ellertsen, R. J. (2002). “Using PCs for effective case-mix based budgeting”. Healthcare Financial Management, 47 (6), 52-55.

Marcinko, E.D, (2009). Understanding the Medicare Prospective Payment System. Web.

Melissa, B. (2007). Using Ratio Analysis to Assess Financial Stability. Web.

Miller, T. R. & Ryan, J. B. (1995). “Analyzing cost variance in capitated contracts”. Healthcare Financial Management, 49 (2), 22-23.

Weygandt, J. et al., (1996). Accounting Principles (4th ed.). New York: Chichester.