Currently, the predominant method of payment for health care services in the United States has been on a fee-for-service (FFS) basis, meaning that each service is paid for separately and individually. Payment is made for the quantity of procedures performed, without accounting for the quality or efficiency of the care provided. It is important to understand this current iteration of health care delivery before improvements can be made.

The history of physician payment in the United States and FFS¹ is closely tied to the history of Medicare. In 1965, Title XVIII of the Social Security Act, called the Health Insurance for the Aged Act, was signed into law, codifying Medicare. At the time, the program comprised a hospital insurance plan (Part A) and supplementary medical insurance for physicians’ fees and other health services (Part B) for persons age 65 years and older.² Medicare was initially under the control of the Social Security Administration, and the Bureau of Health Insurance was established to administer the program. This bureau was responsible for the development of health insurance policy. In 1977 Medicare was moved from the Social Security Administration to the Health Care Financing Administration, which was established to administer the Medicare and Medicaid programs. In 2001, the Health Care Financing Administration was renamed the Centers for Medicare & Medicaid Services (CMS).² Medicare traditionally was an FFS model and set the payment standard for commercial and private insurance programs.

National health care spending as a percentage of gross domestic product (GDP) was 5.1% in 1960. Over time, this percentage grew steadily, reaching 13.4% in 1992.³ It became apparent early in Medicare implementation that the cost of the program was growing significantly without any clear method to predict or restrain it. Physician services were reimbursed by the “usual, customary, and reasonable” method, which resulted in variations in payment for similar services by various specialties, differences in geographic payments for similar services, and increasing growth in the cost and utilization of physician services.⁴ In an attempt to gain the cooperation of physicians and hospitals, the Social Security Administration’s approach to running Medicare was committed to remaining primarily a distributor of popular entitlement benefits, with little focus on cost containment.⁵ With no legislative restraint, Medicare tax funds flowed into hospitals, more than doubling between 1970 and 1975, and doubling again by 1980.⁶ By 2012, the average annual cost per Medicare beneficiary had risen to $12,210.⁷

At the outset, Medicare reimbursed hospitals and physicians on a cost basis. Because of considerable increases in Medicare spending, the cost basis for reimbursing hospitals was abandoned in 1983, when Congress passed the inpatient prospective payment system (IPPS). The IPPS established diagnosis-related groups (DRGs), which assigned payment amount based on the conditions treated (CMS episode payment models). Other cost-saving programs included the Medicare Economic Index, introduced in 1975, to predict how much the costs of practicing physicians grow annually so that spending increases could be limited (CMS episode payment models). However, the Medicare Economic Index did little to stop the growth in Medicare spending.

Relative value scales were in use for many years before the implementation of the specific Medicare physician payment fee schedule. The California Medical Committee on Fees developed a relative value scale, first published in 1956, called the California Relative Value Studies. The values published were based on existing median charges of California physicians. The California Relative Value Studies were updated periodically from 1957 until 1974, when the Federal Trade Commission decided that the studies might constitute a price-fixing scheme, and updates were no longer provided.

In the late 1970s, a team of researchers headed by William C. Hsiao, PhD, of the Harvard School of Public Health, began to study the relationship of medical services and physician work, with the aim of determining the resources consumed in delivery of those services.⁸ The economic theory behind a resource-based fee scale is that if fees for medical services are based on the cost (resources) of providing those services, then medical decision making will not be influenced by the price of medical services. The Harvard group determined that physician work could be grouped into three components: preservice work, intraservice work, and postservice work. With minor variations over time, these service period definitions have been used as guidelines to describe time elements of physician work that were considered in developing modern physician payment scales such as the
resource-based relative value scale (RBRVS) later introduced by Medicare. The results of the Harvard studies were then published in three separate phases.⁹,¹⁰,¹¹

In 1980, the New Jersey Health Commission, with the support of the Health Care Financing Administration, began a 3-year experiment to introduce the DRG system, to alter the incentives offered to hospitals in order to improve efficiency and, thus reduce growth in health care expenditures.¹² This reimbursement system was designed to constrain hospitals and oblige their administrators to alter the behavior of the physicians and surgeons.¹³ Soon after the DRG system was implemented as part of the Medicare program, Congress responded in 1982 with the Tax Equity and Fiscal Responsibility Act, which led to the development of the office of the Secretary of Health and Human Services, and, with the Senate Finance Committee and the House Ways and Means Committee, a proposal for prospective reimbursement by December 31, 1982.¹⁴ DRGs were assigned to be homogenous units of hospital activity to which binding prices could be attached. DRGs set forth a system of payments for the operating costs of hospital inpatient stays under Medicare Part A based on prospectively set rates. This payment system is known as the inpatient prospective payment system (IPPS).¹⁵ The IPPS reimburses inpatient hospital costs (Medicare Part A services) under a single price. Although hospitals received a single prospective per-discharge payment that included all the facility costs, such as room and board, nursing, and costs associated with specialized care and ancillary services, orthopaedic surgeons and other medical professionals continued to receive separate fees for surgery and other services.

Overall, the initiation of IPPS slowed the rate of increase in Medicare spending and hospital resource utilization, and reduced incentives to keep patients in-house, in turn decreasing lengths of stay.¹⁶,¹⁷,¹⁸ This was one of the first examples of bundling payments for health care services, which was a change from the traditional FFS model. The DRG system was subsequently adopted by many states’ Medicaid programs and private insurance looking for similar cost-saving benefits.¹⁹

In 2009, CMS expanded IPPS by adding physician professional fees through the Acute Care Episode demonstration program, in which physician-hospital organizations negotiated a prospective payment to cover both the inpatient facility (Part A) and inpatient physician (Part B) costs for patients undergoing 9 orthopaedic and 28 cardiovascular services and procedures.²⁰,²¹ This adoption lowered costs of care for CMS.