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Provider Compensation

4 Provider Compensation


After completing this module, you will be able to:

discuss the problems presented by fee-for-service (FFS) compensation of healthcare providers and how capitation addresses those problems;After completing this module, you will be able to: explain how capitation works; describe other provider

explain how capitation works;providers and how capitation addresses those problems; describe other provider compensation arrangements used by

describe other provider compensation arrangements used by health plans;addresses those problems; explain how capitation works; describe withholds, risk pools, and pay for performance

describe withholds, risk pools, and pay for performance (P4P) programs; andprovider compensation arrangements used by health plans; compare compensation arrangements in terms of the risk

compare compensation arrangements in terms of the risk assumed by providers.risk pools, and pay for performance (P4P) programs; and As we learned in earlier modules, in

As we learned in earlier modules, in traditional indemnity health insurance healthcare providers are generally compensated by fee-for-service (FFS). That is, when a provider performs a service for an insured, the provider bills the insurer her normal fee for that service, and the insurer pays. Health plans continue to use the fee-for-service approach in some cases, but they have also developed a number of other compensation methods, which we will discuss in this module.

Incentives and Risk

As we have mentioned briefly before, the fee-for-service approach creates a problem. The more healthcare services a provider delivers, and the more expensive the services, the more the provider is paid. Consequently, providers have a strong financial incentive to deliver more care, and they have few incentives to avoid unnecessary services. Combined with the need many physicians feel to perform unnecessary tests and treatments to make sure they cannot be accused of not doing everything conceivably possible (defensive medicine), this creates strong pressure for the overutilization of healthcare and drives up costs. Also, FFS gives physicians no financial incentives to focus on preventive care or promote wellness, since it is only when people get sick that they are paid.

In response to this problem, other provider compensation methods have been developed and are used by health plans. These methods give providers incentives to deliver care in a cost-effective way, avoid unnecessary services, and promote prevention and wellness. One of the main ways they do this is risk-sharing. In the context of health plans, financial risk is the possibility that plan members will need more healthcare than projected, resulting in a financial loss. A health plan collects premiums from members and purchasers such as employers. Premium amounts are set to cover the level of healthcare services that the plan’s members are expected to need. If members need more services than projected, the premiums collected may not be sufficient to cover costs, and the plan suffers a financial loss. Under fee-for-service compensation, healthcare providers do not share this riskif insureds need more services, the providers deliver them and bill the insurer for them, and the insurer pays the additional

Provider Compensation

cost. But under other forms of compensation, providers do share risk, and this gives them an incentive to hold down costs, as we will see in this module.

Why do providers accept these other forms of compensation and the risk they entail? Because of the volume of patients health plans can offer. To become a participating provider with a health plan, a provider may have to accept a compensation arrangement that pays somewhat less for services that she normally charges and that requires her to assume a certain amount of risk. But doing so gives her access a large population of patients, so that participation is financially advantageous for her.


How Capitation Works

Capitation is a provider compensation method that is very different from fee-for-service. Under FFS a provider is paid based on the number of services she provides and the cost of those services. Under capitation the provider is paid based on the number of people she cares for (she is paid per capita,meaning per person), regardless of how many services she provides to them or what those services cost. More specifically, a health plan pays a provider a set amount (a capitation rate) for each plan member under her care for each time period. In exchange, the provider must deliver whatever healthcare services are needed by those members during that period. Whether the provider delivers many services or few or none, she receives the same amount.

Most commonly, a capitated provider is paid on a per member per month (PMPM) basis. For example, a plan may pay a primary care provider a certain dollar amount per month for each plan member assigned to her. In return for that PMPM payment, the PCP must provide whatever primary care those members need.

Risk and Incentives

Under FFS, as we have seen, a provider assumes no risk. If insureds need more services that expected, she delivers them and is paid for them. Under capitation, on the other hand, providers do bear risk. If members need few or no services, a provider will have to do little for her capitation payment, but if they need a lot of care, she will have to deliver many services and will not be paid any more.

This risk-sharing gives capitated providers a strong incentive to avoid unnecessary services and control costs. And it promotes healthcare quality as well, because physicians also have a strong incentive to promote prevention and wellnessit is in the doctors’ interest for the members assigned to them to stay healthy so that they do not need services and for sick patients to get well soon and avoid complications and more expensive treatments.

Capitation Considerations

In addition to PCPs, other physicians including specialists may be compensated by capitation. So may groups of physicians (including multi-specialty groups) as well as hospitals. When an organization such as a group practice is paid by capitation to provide care for a plan’s members, capitation may cover primary care only, or primary and specialty care but not ancillary services, or all services.

Provider Compensation

In designing capitation arrangements for PCPs, a plan must decide what services will be

considered primary care and therefore covered by the capitation payment and stipulate these services in the provider contract. Likewise, if a hospital is paid by capitation, the contract must clearly set forth what services are included.

A hospital that accepts capitation for providing the care needed by a health plan’s members assumes a considerable amount of riskif members need more hospital care than expected, the hospital will be responsible for providing it without additional

compensation from the plan. Consequently, such a hospital must have a strong program

to manage utilization, and it may purchase stop-loss insurance, which covers costs if

expenditures go above a certain level.

As we have seen, some health plans (such as PPOs and POS plans) allow members to receive care from non-network providers. This can create a situation in which a plan is paying a provider a capitation payment to provide the care needed by a member, but in fact the member is receiving services from a non-network provider instead. Various adjustments may be made to account for out-of-network care.

Trends in Capitation

In the early decades of managed care, when most health plans were HMOs, capitation

was a very common form of compensation. But as we saw in Module 1, in the 1990s PPOs and other plan types became more popular, and they tend not to use capitation. As a result, currently only a small minority of physician compensation is capitated. However, as healthcare costs continue to rise and policymakers and health plans seek

ways to control them, capitation is getting another look, and many proposals for reform

of provider compensation include elements of capitation, often blended with other

approaches. So capitation may play a greater role in the future. 1

Other Compensation Arrangements

In addition to traditional fee-for-service and capitation, there are a number of other

compensation arrangements between health plans and providers.

Fee Schedule

A health plan may pay providers on a fee-for-service basis but limit the amounts paid by

means of a fee schedule. This is a list of healthcare services and procedures with the

maximum amount that the plan will pay for each service. This approach is also referred

to as fee maximums, capped fees, or fee allowances.

Providers serving a plan’s members agree to charge the plan no more than the maximum listed in the fee schedule and to accept that amount as payment in full. This means that providers may not engage in balance billing of members. For instance, if a doctor normally charges $100 for a service, but a plan’s fee schedule allows only $85, the doctor must accept the $85 as payment in full and may not charge the member the remaining $15. Thus, although this is a form or fee-for-service, the provider accepts some degree of riskwhile the allowable fee will normally cover the cost of providing a service, if it does not, the provider must bear the cost.

Provider Compensation

A fee schedule is typically based on usual, customary, and reasonable (UCR) fees. A UCR fee for a service is the amount commonly charged for the service by physicians in the region, and health plans may determine UCR fees by collecting data on physician charges.

Discounted Fee-for-Service

Another common compensation arrangement is discounted fee-for-service. The plan pays the provider the UCR fee for a service minus a negotiated percentage discount. As with a fee schedule, the provider agrees to accept this amount as payment in full and so accept as certain degree of risk.

Relative Value Scale

Some plans use a relative value scale (RVS). The plan gives a numerical value to each medical procedure or service. This value is multiplied by a dollar amount negotiated by the plan and providers, yielding a payment amount. For example, a plan rates the value of a particular service as 5 and another service as 7. It multiplies these values by $11 dollars (the dollar multiplier agreed to by the plan and providers) and pays $55 for the first service and $77 for the second.

Simple RVS systems tend to give a high value to medical procedures (such as surgery) and a relatively low value to other activities such as seeing patients in office visits or researching patients’ condition. To address this problem, the Resource-Based Relative Value Scale (RBRVS) was developed. RBRVS seeks to take into account all the resources that physicians use in providing care to patients, including not only physical and procedural resources, but educational, mental, and financial resources as well.


In some HMOs some physicians are employees and are paid a salary. A salaried doctor generally assumes no riskshe is paid the same whether members need more or less care. However, some HMOs use withholds or other arrangements (see below) to share risk with employee-physicians, and many offer incentive payments to doctors who meet cost-effectiveness or quality goals.

Diagnosis-Related Groups (DRGs)

The federal Medicare program developed the Diagnosis-Related Group (DRG) system for compensating hospitals, and some health plans use it as well. When a member is hospitalized, her case is classified as one of about 500 DRGs based on her diagnosis, her age and gender, the procedures to be performed, and any complications or other medical conditions. Cases in the same DRG generally require about the same amount of hospital resources, and a fixed payment amount is set for each DRG based on average costs. The hospital is paid the DRG rate for the hospitalization, regardless of how long the stay actually lasts or how much it costs the hospital. This means that the hospital assumes riskit must bear the cost if expenditures exceed the DRG rate.

Per Diems

Provider Compensation


health plan may pay a hospital a fixed per diem amount for each day a plan member


in the hospital, regardless of the services used. The amount may be higher for some

types of care (such as intensive care or cardiac care), and sometimes a higher amount

is paid for the first day, as this is often the most costly for the hospital.

The per diem amount is negotiated by the plan and the hospital. The more patients a plan provides to a hospital, the lower the per diem rate the hospital is likely to agree to. As with a DRG rate, the hospital assumes risk and bears the cost if expenses are greater than the per diem amount.

Episode-Based Payments

A compensation method that is being developed and drawing increased interest is

episode-based payments. The health plan pays a single amount for all the services associated with a single episode of care, such as a hospitalization. For example, one payment might cover a surgical procedure, the associated hospital stay, and all related care for 90 days after discharge from the hospital. This payment would be shared by the hospital, the surgeon, and other providers involved in the case.

Episode-based payments encourage doctors, hospitals, and others to work together to coordinate their services and avoid overlap and waste. They also promote longer-term accountabilityif providers must pay for any care needed for 90 days after the patient leaves the hospital, there will be strong incentives to avoid complications that might require additional care or even readmission. The main challenges to this approach are getting hospital, physicians, and other providers to work together and to equitably distribute the payment among them. 2

Multiple Compensation Methods

Note that health plans typically use different compensation arrangements for different types of providers. For example, a plan might use capitation for PCPs, discounted fee- for-service for specialty physicians, and per diem payments for hospitals.

Other Compensation Provisions

Some other provisions can be used in conjunction with the compensation arrangements described above, to further share risk and give providers incentives to provide cost- effective, high-quality care.


A withhold may be used with some compensation arrangements. For example, a health

plan pays PCPs by capitation, but each month it does not pay a certain percentage of the capitation payment. At the end of the year, if the number of referrals by PCPs to specialists has been as projected, the withheld money is paid to the PCPs. But if there have been many referrals, the plan uses all or part of the withheld funds to cover the cost, and the PCPs do not receive it. A withhold may also be used for salaried physicians.

What is the purpose of such a withhold? Since capitated providers receive the same payment regardless of the amount of services they deliver, some may be tempted to

Provider Compensation

reduce their workload by referring patients they could treat themselves to a specialist. A withhold gives them an incentive to avoid this. It also gives them an incentive to focus on preventive care and wellness so that their patients do not develop the need for specialty care.

Risk Pools

Risk pools are another way of giving providers an incentive to deliver care themselves and to promote prevention and wellness so that the need for non-primary care does not develop. For example, a plan pays monthly capitation payments to PCPs, and it also pays monthly capitation payments into three pools, one for specialty care, one for hospital care, and one for ancillary services. The money in the pools is used to cover the costs of these services, but if members do not use many services and there is money left over, some of it is distributed to the PCPs. On the other hand, if members need many services and the money in the pools is insufficient, physicians may have to make up part of the shortfall.

Pay for Performance (P4P) Programs

Many health plans have pay for performance (P4P) programs. Targets are set for measures of physician performance, which may be in the areas of quality of care, patient satisfaction, utilization, or cost-effectiveness. If a doctor meets these targets, he is rewarded, typically by means of a percentage increase in compensation or a bonus. Some plans share with physicians meeting the targets the savings realized through cost- effectiveness efforts. Most P4P programs give physicians report cards showing how they are doing in relation to the targets and what they can do to meet them. Targets may be based on nationally developed and recognized measurements or may be developed by the plan itself.

P4P has been widely adopted in the healthcare industry and is being touted as an important way of promoting high-quality and cost-effective care. So far these programs have had some positive impact but have not resulted in major improvements. P4P programs are evolving, and many details are still being worked out, such as identifying and obtaining the most relevant data and setting incentives payments at the right level to influence physician behavior. 3

The Risk-Sharing Continuum

The provider compensation arrangements discussed in this module can be seen as falling on a continuum based on the degree of financial risk borne by providersthat is, the extent to which, if the care needs of plan members are greater than expected providers must bear the cost.

At one end of the spectrum is traditional fee-for-service, under which providers bear no risk. If plan members need more services, providers deliver them and charge the plan for them. The plan must cover all costs with the premiums it receives, and if costs exceed premiums, the plan suffers a loss.

At the other end of the spectrum is capitation, under which providers bear most of the risk. They receive the same payment whether the members they are responsible for require no care, a few services, or many services. If members need much more care

Provider Compensation

than expected, providers must deliver it without any extra compensation. Meanwhile, the plan bears relatively little risk, as its costs are fixedthe set PMPM fees it pays providers.

Between these two extremes are the other arrangements we have looked at. Under fee schedules, discounted fee-for-service, and RBRVS, a physician receives a set amount for a service; this amount is calculated to cover his costs, but if it does not, he must cover any extra himselfhe may not bill the plan or the member for any more. Thus he incurs a certain amount of risk. Per diems and DRG rates for hospitals are similarthey are flat rates intended to cover costs, but if they do not, the hospital must bear any additional cost and so assumes some risk.

Salary compensation is near the no-risk end of the continuum. Employee-physicians receive the same salary whether members need few or many services, and they do not bear any losses if costs are high. But as noted, withholds and other arrangements may be used to share some risk with salaried doctors.


1 Samuel H. Zuvekas and Joel W. Cohen. “Paying Physicians by Capitation: Is the Past Now Prologue?Health Affairs 29, no. 9 (2010), 1661-1666. Available at

2 Robert E. Mechanic and Stuart H. Altman. “Payment Reform Options: Episode Payment Is a Good Place to Start.” Health Affairs 28, no. 2 (2009), w262-w271. Available at

3 Cheryl L. Damberg, Kristiana Raube, Stephanie S. Teleki, and Erin de la Cruz. “Taking Stock of Pay for Performance: A Candid Assessment from the Front Lines.” Health Affairs 28, no. 2, (2009), 517-525. Available at