Over the next several weeks, we’re going to walk through the payment models that drive American healthcare: fee for service, prospective payment, capitated payment, value-based care, bundled payments, and global budgeting. Each one shapes a different piece of the system you live inside every day. Understanding them is understanding why your hospital makes the decisions it makes, why your doctor seems rushed, and why your bill might not make sense. We start today with the model that built American healthcare as we know it.
Fee for Service
The concept is as simple as it sounds. A doctor or hospital does something — sees you, runs a test, performs a procedure, delivers a baby — and then sends a bill for that specific thing. You get paid for what you do. Do more, get paid more.
That’s fee for service. And for most of American healthcare history, it has been the dominant way money changes hands.
It makes intuitive sense. You go to a restaurant, you order food, you pay for what you ordered.
How it works with private insurance
When you have private insurance through your employer, through the ACA marketplace, or through a plan you bought yourself, your insurer has negotiated a contract with your doctor or hospital. That contract sets specific rates for specific services. A routine office visit might be billed at $250, but the insurer’s contracted rate is $140, so that’s what actually gets paid. Your cost-sharing with your copay, deductible or coinsurance is calculated on top of that contracted rate.
The doctor submits a claim. The insurer processes it. Payment follows. For every individual service, every single time.
Private insurers negotiate these rates differently depending on their market power. A large insurer covering millions of people in a region can negotiate rates down significantly. A smaller insurer, or a patient paying out of pocket, pays more. The same appendectomy at the same hospital can generate wildly different payments depending on who’s paying.
This is not a glitch. It is a feature of the fee for service system with private insurance. The price is not the price. The price is whatever was negotiated, and those negotiations happen behind closed doors.
How it works with government payment
Medicare and Medicaid also pay fee for service, but they do it differently, and the rates are set by the government, not negotiated.
For Medicare, the federal government publishes a fee schedule which is a list of every medical service with a corresponding payment amount. Those amounts are calculated using a formula based on the relative work involved, the practice expenses, and a geographic adjustment. A knee replacement in Manhattan pays differently than one in rural Mississippi. But the formula is the same, and it is public.
Medicaid rates are set by each state and are generally lower than Medicare, sometimes dramatically so. A physician seeing a Medicaid patient may be reimbursed at 60, 70, or 80 cents for every dollar Medicare would pay for the same service. This is one reason why many private practices limit how many Medicaid patients they accept. It is not cruelty. It is math.
The gap between what Medicare and Medicaid pay and what private insurance pays is called the payment shortfall. Hospitals and health systems make up that shortfall through higher rates charged to private insurers. This cross-subsidy is one of the most important and least understood dynamics in American healthcare finance.
What fee for service does well
It rewards volume. If you are a patient who needs a lot of care, fee for service means your doctor gets paid every time they see you, every test they order, every procedure they perform. There is no financial incentive for your provider to see you less.
It is also transparent in structure, if not in price. Every service has a code. Every code has a rate. The system is documented, auditable; and, at least for Medicare, publicly available.
What fee for service gets wrong
Here is the problem. When you pay for volume, you get volume. Not necessarily the right volume. Not necessarily the most effective volume. Just more.
Fee for service creates no financial reward for keeping you healthy, for coordinating your care across multiple providers, for calling you after a procedure to make sure you’re recovering well, for preventing the hospitalization that could have been avoided with better follow-up. None of that generates a billable code.
It also creates pressure to do more. Order another test. Schedule a follow-up. Perform a procedure rather than watchful waiting. Most physicians resist this pressure and practice with integrity. But the incentive is there, baked into the structure of how they get paid.
And it has made American healthcare extraordinarily expensive. We spend more per person than any other country in the world. We do not have better outcomes to show for it. Fee for service is not the only reason. But it is a significant one.
Fee for service is not going away. It is still the backbone of how most care in this country gets paid for. But it is under pressure from every direction: from the government trying to spend less, from insurers trying to pay less, and from a growing movement toward payment models that try to reward outcomes instead of activity.
Next Friday we’ll talk about prospective payment. This is a model in which the payer decides in advance what they’ll pay for an entire episode of care. It changed hospital finance overnight when Medicare introduced it in 1983. See you next Friday!