The Origins, Development, and Passage of Medicare's Revolutionary Prospective Payment System

This article explains the origins, development, and passage of the single most influential postwar innovation in medical financing: Medicare's prospective payment system (PPS). Inexorably rising medical inflation and deep economic deterioration forced policymakers in the late 1970s to pursue radical reform of Medicare to keep the program from insolvency. Congress and the Reagan administration eventually turned to the one alternative reimbursement system that analysts and academics had studied more than any other and had even tested with apparent success in New Jersey: prospective payment with diagnosis-related groups (DRGs). Rather than simply reimbursing hospitals whatever costs they charged to treat Medicare patients, the new model paid hospitals a predetermined, set rate based on the patient's diagnosis. The most significant change in health policy since Medicare and Medicaid's passage in 1965 went virtually unnoticed by the general public. Nevertheless, the change was nothing short of revolutionary. For the first time, the federal government gained the upper hand in its financial relationship with the hospital industry. Medicare's new prospective payment system with DRGs triggered a shift in the balance of political and economic power between the providers of medical care (hospitals and physicians) and those who paid for it--power that providers had successfully accumulated for more than half a century.