CMS Pub. 100-04, ch. 3, § 20.1

Section 1886(d) of the Social Security Act (the Act) sets forth a system of payment for the

operating costs of acute care hospital inpatient stays under Medicare Part A (Hospital

Insurance) based on prospectively set rates. Under the PPS, Medicare payment for hospital

inpatient operating costs is made at predetermined, specific rates for each hospital discharge.

Discharges are classified according to a list of diagnosis-related groups (DRGs).

The base payment rate is comprised of a standardized amount that is divided into a labor-related share and a nonlabor-related share. The labor-related share is adjusted by the wage

index applicable to the area where the hospital is located; and if the hospital is located in

Alaska or Hawaii, the nonlabor-related share is adjusted by a cost-of-living adjustment

factor. This base payment rate is multiplied by the DRG relative weight.

If the hospital treats a high percentage of low-income patients, it receives a percentage add-on payment applied to the DRG-adjusted base payment rate. This add-on payment, known as

the disproportionate share hospital (DSH) adjustment, provides for a percentage increase in

Medicare payments to hospitals that qualify under statutory formulas designed to identify

hospitals that serve a disproportionate share of low-income patients. For qualifying hospitals,

the amount of this adjustment may vary based on the outcome of the statutory calculations.

If the hospital is an approved teaching hospital, it receives a percentage add-on payment for

each case paid under the PPS (known as the indirect medical education (IME) adjustment).

This percentage varies, depending on the ratio of residents to beds.

Additional payments may be made for cases that involve new technologies that have been

approved for special add-on payments. To qualify, a new technology must demonstrate that it

is a substantial clinical improvement over technologies otherwise available, and that, absent

an add-on payment, it would be inadequately paid under the regular DRG payment.

The costs incurred by the hospital for a case are evaluated to determine whether the hospital

is eligible for an additional payment as an outlier case. This additional payment is designed

to protect the hospital from large financial losses due to unusually expensive cases. Any

outlier payment due is added to the DRG-adjusted base payment rate, plus any DSH, IME,

and new technology add-on adjustments.

Although payments to most hospitals under the PPS are made on the basis of the

standardized amounts, some categories of hospitals are paid based on the higher of a

hospital-specific rate determined from their costs in a base year as specified in the statute, or

the PPS rate based on the standardized amount. For example, sole community hospitals

(SCHs) are the sole source of care in their areas, and small rural Medicare-dependent

hospitals (MDHs) are a major source of care for Medicare beneficiaries in their areas. Both

of these categories of hospitals are afforded this special payment protection in order to

maintain access to services for beneficiaries (although the statutory payment formulas for

SCHs and MDHs differ as described below in section 20.6).

The existing regulations governing payments to hospitals under the PPS are located in

42 CFR Part 412, Subparts A through M.