Last Friday we talked about fee for service, the model where every needle, every test, every fifteen minute visit gets billed and paid for separately. It is the oldest payment model in American medicine, and for most of the twentieth century it was the only one that mattered.
By the late 1970s, it was breaking the country.
Hospital costs were rising faster than inflation, faster than wages, faster than the rest of the economy. Medicare, only a teenager at that point, having been signed into law in 1965, was hemorrhaging money. The hospital trust fund was projected to go insolvent. Congress had a problem, and the problem was the math.
The math was this: under fee for service, every additional service a hospital provides generates additional revenue. There is no incentive to be efficient. There is every incentive to do more.
So in 1983, the federal government did something that, in retrospect, was revolutionary. It changed the rules.
Under fee for service, the hospital treats the patient, then sends a bill for everything it did. The payer pays after the fact, line by line. This is called retrospective payment. You find out what it cost after it happened.
Prospective payment flips the equation. The payer decides, in advance, what an entire episode of care is worth. The hospital gets that amount. Period. If they spend less, they keep the difference. If they spend more, they eat the loss.
This is also commonly called bundled payment, because instead of unbundling every service into its own line item, the payer bundles all the services for a given episode into a single price. Same concept, different name. You will hear both terms used interchangeably, especially in policy conversations.
The mechanism Medicare adopted in 1983 was called the Inpatient Prospective Payment System, or IPPS, built around something called Diagnosis Related Groups, or DRGs. The idea was deceptively simple: take every possible reason a person might be admitted to a hospital, sort those reasons into clinically similar groups, and assign a payment amount to each group. A heart attack pays X. A hip replacement pays Y. A pneumonia admission pays Z. The hospital knows the price before the patient walks in the door.
It was the largest change to Medicare since the program was created. And it went almost entirely unnoticed by the general public.
The motivation was cost containment. Full stop.
By the early 1980s, Medicare hospital spending was growing at roughly three times the rate of general inflation. The Medicare Part A trust fund was projected to run out of money. Congress had two choices: raise taxes to keep up, or change the way hospitals got paid.
They chose to change the payment model.
The intellectual groundwork had already been laid. Researchers at Yale, Robert Fetter and John Thompson, had spent the 1970s developing the DRG framework as a way to classify hospital cases by clinical similarity and resource use. New Jersey had piloted DRG based payment beginning in 1980. By the time Congress was ready to act, there was a workable system on the shelf.
The shift was philosophical as much as financial. For the first time, the federal government set the price. Hospitals no longer told Medicare what something cost. Medicare told hospitals what it would pay. The balance of power between hospitals and the program that paid them changed overnight.
The early results were dramatic. Hospitals that had once kept patients longer because longer stays meant more billing started discharging them faster. Length of stay dropped. Admissions per capita dropped. Hospital management got serious about efficiency in a way it had never had to before.
It also created problems we are still living with. Pressure to discharge patients before they were truly ready. Hospitals gaming the coding system to land patients in higher paying DRGs. Rural hospitals struggling to survive under fixed payments. Every payment model creates its own set of incentives, and prospective payment is no exception. But on the central question of whether it slowed Medicare hospital spending growth, the answer was clearly yes.
It didn’t stay limited to inpatient care
For its first seventeen years, prospective payment applied only to inpatient hospital admissions. Outpatient services, like same day surgeries, emergency room visits, imaging, and infusions, were still being paid on the old retrospective basis.
In August 2000, Medicare extended the model to outpatient care through the Outpatient Prospective Payment System, or OPPS. The grouping mechanism is different. Outpatient services are sorted into Ambulatory Payment Classifications, or APCs, instead of DRGs. But the principle is identical. A predetermined payment for a predetermined service.
Today OPPS sets the rates for hospital outpatient departments and ambulatory surgical centers across the country. The 2026 OPPS rule alone affects approximately 4,000 hospitals and 6,000 ambulatory surgical centers. If you have ever had a same day surgery, an emergency room visit you didn’t get admitted from, or an outpatient infusion under Medicare, prospective payment is what determined what your hospital was paid.
Private insurers caught on
Once Medicare proved the model could control costs without, based on the available evidence, devastating quality, commercial insurers started building their own versions.
Horizon Blue Cross Blue Shield of New Jersey began rolling out condition specific bundled payments in 2011, and over the following years expanded them to cover joint replacement, cardiac bypass surgery, hysterectomy, bariatric surgery, colonoscopy, pregnancy and newborn care, and several cancers. They built care pathways with the participating physicians and tied payment to adherence to those pathways.
Other commercial insurers followed. Some states pushed the model into Medicaid and the commercial market simultaneously. Arkansas built a multi payer initiative covering perinatal care, joint replacement, and several other episodes that included both Medicaid and commercial payers paying providers under the same bundled framework.
Medicare also kept evolving the model. The Bundled Payments for Care Improvement initiative, launched in 2013, expanded prospective payment from individual hospital stays to entire episodes of care, meaning the bundle includes the surgery, the hospital stay, and the post acute care that follows, sometimes for 30, 60, or 90 days. The Comprehensive Care for Joint Replacement model went further still, mandating bundled payment for hip and knee replacements in selected geographic regions.
Joint replacement has been the clearest success story. Studies have shown that hospitals participating in Medicare’s bundled payment programs for joint replacement reduced episode spending by roughly 2 to 4 percent without measurable harm to quality. And those efficiencies spilled over into commercially insured and Medicare Advantage patients treated at the same hospitals. When a hospital reorganizes itself to do joint replacements more efficiently for Medicare, it does them more efficiently for everyone.
The picture for other procedures has been more mixed. Bundled payment seems to work best when the episode of care is well defined, predictable, and elective. It works less well when the patient population is heterogeneous and the course of treatment is harder to anticipate.
Why this matters
Prospective payment was the first serious attempt by an American payer to say: we are not going to keep paying you more just because you did more. We are going to decide what this is worth, and that is what we will pay.
It is the philosophical opposite of fee for service. Where fee for service rewards volume, prospective payment rewards efficiency. Where fee for service is open ended, prospective payment is fixed. Where fee for service is invisible to the patient, prospective payment shapes, quietly, behind the scenes, when you get admitted, how long you stay, what happens after you go home.
It is also the bridge to everything that came after it. The bundled payment models of the 2010s, the accountable care organizations, the value based contracts that now dominate policy conversations all trace back to the moment in 1983 when Medicare decided it would set the price.
Next Friday we’ll talk about capitated payment. What happens when the payer hands the provider a fixed amount per patient per month and says, here, this is your budget. Keep them healthy.