Major Healthcare Payment Systems

Why This Matters

Healthcare payment systems aren't just administrative details—they're the economic engines that drive provider behavior, patient access, and the overall efficiency of healthcare delivery. When you're being tested on healthcare financing, you need to understand that every payment model creates specific incentives that shape how care is delivered. The fundamental tension in healthcare economics is balancing cost control, quality of care, and access—and each payment system prioritizes these differently.

Don't just memorize what each system pays; know why it was designed that way and what behaviors it encourages or discourages. Exam questions will ask you to analyze trade-offs, predict provider responses to incentive structures, and compare systems that seem similar but produce very different outcomes. Master the underlying economic logic, and you'll be able to tackle any scenario they throw at you.

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Volume-Based Payment Models

These traditional models reimburse providers based on the quantity of services delivered. The more you do, the more you get paid—which creates powerful incentives that can work for or against patients.

Fee-for-Service (FFS)

• Providers are paid per service rendered—each office visit, test, and procedure generates separate payment based on a predetermined fee schedule
• Creates volume incentives that can lead to overutilization, as providers benefit financially from ordering more tests and treatments
• Maximizes patient choice since patients can select any provider and service without gatekeeping restrictions

Prospective Payment System (PPS)

• Payment rates are set in advance based on patient classification systems, most commonly used in Medicare inpatient hospital services
• Shifts financial risk to providers—hospitals must manage costs within the predetermined rate regardless of actual expenses incurred
• Encourages operational efficiency by incentivizing hospitals to streamline care delivery and reduce unnecessary resource use

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Episode-Based Payment Models

These systems bundle payments around specific conditions or treatments, encouraging providers to think about the complete care pathway rather than individual services.

Diagnosis-Related Groups (DRGs)

• Hospital cases are classified into groups based on diagnosis, treatment complexity, and expected resource use—each group receives a fixed payment
• Incentivizes shorter lengths of stay and cost control, as hospitals keep any savings but absorb any losses beyond the DRG payment
• Encourages efficiency over volume—unlike FFS, hospitals don't benefit from ordering additional tests or extending hospitalizations

Bundled Payments

• Single payment covers all services related to a specific treatment or condition, spanning multiple providers and care settings
• Promotes care coordination by giving providers financial incentive to work together and eliminate fragmented, duplicative care
• Distributes risk among providers—if total costs exceed the bundle, participating providers share the loss; if costs are lower, they share savings

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Population-Based Payment Models

These models pay providers a fixed amount to care for a defined population, shifting focus from treating illness to maintaining health.

Capitation

• Fixed payment per patient per period—providers receive the same amount whether a patient needs extensive care or none at all
• Transfers financial risk to providers, who must manage all care within the capitated amount or absorb losses
• Incentivizes preventive care since keeping patients healthy is more profitable than treating illness, though underutilization becomes a concern

Global Budgeting

• Fixed budget allocated for a defined period—the healthcare system or provider must deliver all necessary care within that ceiling
• Controls total healthcare spending by setting hard limits, commonly used in single-payer systems and some hospital networks
• Creates resource allocation challenges—providers must prioritize services when demand exceeds budget capacity

Accountable Care Organizations (ACOs)

• Provider networks coordinate care for a specific patient population, sharing financial accountability for outcomes and costs
• Shared savings model rewards providers who deliver quality care below cost benchmarks while meeting performance metrics
• Encourages collaboration across traditionally siloed providers—primary care, specialists, and hospitals align incentives

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Quality-Linked Payment Models

These systems tie reimbursement to measurable performance outcomes, attempting to reward value rather than volume.

Pay-for-Performance (P4P)

• Financial bonuses or penalties based on meeting specific quality metrics—patient satisfaction, clinical guideline adherence, and health outcomes
• Aligns provider incentives with patient goals by making quality financially relevant, not just ethically important
• Requires robust measurement systems to track metrics like readmission rates, preventive screening completion, and patient-reported outcomes

Value-Based Purchasing (VBP)

• Reimbursement directly linked to quality scores—providers meeting benchmarks receive higher payments, underperformers receive less
• Shifts focus from volume to value—the goal is better outcomes at lower cost, not more services at any cost
• Medicare's Hospital VBP Program adjusts payments based on clinical outcomes, patient experience, safety, and efficiency measures

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Government Program Models

These systems reflect how Medicare and Medicaid structure provider reimbursement, often serving as testing grounds for payment innovation.

Medicare and Medicaid Reimbursement Models

• Medicare uses multiple payment systems—FFS for outpatient services, DRGs for inpatient care, and increasingly value-based models like ACOs and bundled payments
• Medicaid varies significantly by state—some use FFS, others mandate managed care with capitation, creating a natural experiment in payment policy
• Both programs are shifting toward value—the trend away from pure volume-based payment reflects federal priorities to control costs while improving outcomes

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Quick Reference Table

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Self-Check Questions

1. Which two payment models both use fixed prospective payments but differ in whether they apply to individual services or entire care episodes? What behavioral incentives does each create?

2. A hospital administrator wants to reduce average length of stay. Which payment system creates the strongest financial incentive for this goal, and why might FFS work against it?

3. Compare capitation and ACOs: What problem with pure capitation do ACOs attempt to solve, and what mechanism do they use to address it?

4. If an FRQ asks you to recommend a payment model that reduces care fragmentation for patients with chronic conditions requiring multiple specialists, which model would you choose and what evidence would you cite?

5. How do value-based purchasing and fee-for-service represent opposite approaches to the volume-versus-value debate in healthcare economics? What trade-offs does each model accept?