Why Medicare’s Hospital Wage Index Exceptions Jumped 60%

Medicare is a national program, of course, and it covers a national population that is therefore broad and diverse. There are beneficiaries who live in big cities and small towns. It pays providers delivering care everywhere from the redwood forests to the Gulf Stream waters. Now the cost of doing business in one region can differ quite a bit from one part of the country to the next.

And so when the inpatient perspective payment system was created in 1983, it made sense to implement a hospital wage index that standardizes Medicare hospital payments for labor cost differences. So, otherwise, equivalent hospitals might be paid more when they operate in areas with higher labor costs than in areas with lower labor costs. It's a relatively straightforward adjustment, but what happens when we create a series of exceptions to that system? Do they achieve their policy goals, or do they undermine the broader program?

And just how broadly might those exceptions be applied over time? That's our question on the podcast today. I'm here with Doctor. Geoffrey Jay Hoffman, an associate professor at the University of Michigan School of Nursing, Together with his coauthor Syracuse University's June Lee, they have a new paper in the June issue of Health Affairs.

Its title is also one of its main findings. Quote, Medicare's Hospital Wage Index exceptions grew by nearly 60% from 2016 to 2024. It's a really fascinating study on a topic that's not well understood and definitely not well covered, and we're so pleased to be publishing it. I'm looking forward to learning more about it here today.

Doctor. Geoffrey Jay Hoffman, welcome to A Health Podyssey. Thank you so much for having me. It's a pleasure and a privilege to be here.

All right, well, let's dive right in. In my introduction, I gave a sort of very brief description of the hospital wage index and how it works. Can you say a little more about sort of the mechanics and, generally what it does? It's fairly complex, although the premise is pretty straightforward.

The premise is you wanna make sure you're adequately reimbursing hospitals for their labor costs. And, to wit, you wanna standardize by sort of area labor prices to make sure that if you're in the Bay Area with really expensive labor prices, you're able to hire the right skill mix and, offer, you know, postings with the right salaries so you get the high quality care to deliver to patients, in the Medicare population. Similarly, if you're in a lower cost area, you would standardize, to to appropriately reimburse in those areas.

So so far so good. Obviously, the the the devil's in the details. And so over time, this program, which started out, sort of with a a pretty straightforward chassis, if you will, sort of you you identify the average hourly wages in various labor markets across the country, and you standardize to a wage index of one, which would be your right on the nose of the national average hourly wage, you get a wage index higher than that if you have a higher average hourly wage in your labor market and so on and so forth.

But over time, it's become, frankly, increasingly complicated with more, parts and whistles, and and elements built on top of the initial chassis. So so the the the good part of that is that, I think the the ensuing developments as the Wagenyx has grown in complexity have been well intended. The point purpose was really to address some of the inherent shortcomings, which are sort of mechanical. You can't perfectly identify what is the labor market, how exactly the commuting patterns work, and what is the price of labor versus sort of hospital decisions about the types of wages they want to offer for reputational or other reasons.

Policymakers have thought about the types of data that have gone into the wage index. But over time, there have been a number of exceptions that have evolved. But but the basic premise is pretty straightforward. As I say, hospitals supply their their wages.

CMS uses that to compute these wage indices, and then they're applied to, each hospital's base operating payment, if you will. Great. Well, you said the devil's in the details. Let's, let's face this devil, straight on.

You alluded to these exceptions, and I'm wondering if you can say a little more about how the exceptions to the index are established, and maybe you can give us an example of how it might affect a hospital's reimbursement. So, I mean, there are several types of exceptions, and some of them involve this idea of reclassification. Others involve something called the rural floor and the low wage adjustment. There's a frontier adjustment.

There's a there's a a handful of them. Reclassification is maybe the easiest place to start. The Wage Index basically uses CMS's definition of a rural or urban hospital to start, which are based on statistical area criteria. So are you in a metropolitan area or not?

All hospitals that are in an MSA or metropolitan area each have their own wage index that's assigned to them that's empirically computed. For all the other hospitals that are not in metropolitan areas, those are considered rural hospitals under the wage index criteria set forth by CMS. And they whether they're all contiguous or not, any hospital in a rural area is assigned the same wage wage index. So what ends up happening is you you have these neighboring labor market issues where hospitals will assert that, yes, I'm on this side of the of the labor market, you know, divide, but we pull from the same labor market as this other hospital.

We're actually facing higher prices. The ones that are assigned to us empirically are not appropriate. So there is a mechanism for hospitals to apply to reclassify so they can do one of three things. They can, within MSAs, move to, for the purposes of the wage index, a separate MSA.

Presumably one with higher a higher reimbursement. With a higher reimbursement. So it's based on geographical proximity and then relative wages. So there are certain criteria you have to meet.

But, essentially, if you're in Riverside County and you're adjacent to Los Angeles County and you qualify under these criteria, you can apply to the reclassification board, and they will grant you this exception or reclassification for a three year period. Other types of reclassification can be actually from an urban to the statewide rural area or vice versa. And there are technicalities and benefits to each of these for hospitals and why they do them and why some are growing in prevalence over time that are kind of interesting.

So, essentially, if you just think of, the San Jose or not San Jose, but the, Riverside County to Los Angeles MSA, reclassification, what could end up happening is you reclassify, and then your wage index increases. Let's say it increases by about, 10%. The pass through from the wage index to the actual payment that comes from CMS is about 60 to 70%. So, essentially, the way that works mechanically is that the the wage index is multiplied by the labor related portion of the base operating payment.

So depending on whether the wage index is above or below the national average, that can range from a 62%, the labor portion of the base payment, or up to 69%, but those vary by year. So, basically, if you get a 10% increase through this reclassification, every single payment you get from Medicare, you get a 6% to 7% increase in your reimbursement. Okay. Well, let's dive right into your paper then sort of with that background.

You conducted a descriptive trend analysis of those exceptions from fiscal year twenty sixteen through fiscal year twenty twenty four. Give us some of your top line findings. What we found looking over this nine year period is essentially boils down to pretty large growth in the use of exceptions over time in this hospital wage index policy. The growth was primarily driven by several of these various exceptions that I, referenced a few minutes ago.

The main one is, what's called the low wage adjustment, which was introduced in fiscal year twenty twenty and then actually expired in fiscal year twenty twenty four due to some court cases. And that, by definition applied to 25%, the lowest, quartile of hospitals in terms of their annual wage index. So that applied to if there's some 6,500 IPPS hospitals that are subject to the wagener next, it's a quarter of those. And then you add really large growth in what's called the rural floor policy as well.

And the rural floor is a separate exception where if you are in an urban area for the purposes of the wage index, you, by definition, need to have a wage index value that's higher than the statewide rural wage index. And so there was really large growth in that exception as well. So, basically, we went from less than half of hospitals getting an exception to this policy back when our study period started up to seven in 10 hospitals getting a wage and exception now. So, basically, like, if you think that you've developed a really good program for standardizing payments, but seven out of 10 of, the hospitals this policy applies to are getting exception, maybe, yeah, something's not working.

You initially thought. Yeah. Yeah. Well, I wanna ask you a little more about, those details.

But first, let's take a quick break. And we're back. I'm here with doctor Jeffrey Jay Hoffman from the University of Michigan talking about, his new paper in the June issue of Health Affairs about Medicare's hospital wage index exceptions. You started looking at these exceptions.

Fewer than half of hospitals were taking them when you started your study period, and now it's about seven and ten. I'm curious if you have a sense of what's behind that growth. Is it that there are more exceptions, or is it that more hospitals are seeing these exceptions as a avenue to increasing their revenue? Yeah.

It's a great question. And, you know, I'm not sure with this study we can provide any definitive answers. I think based on sort of intuition from studying this program, it's probably a combination of the two. I think one part of the growth is just purely mechanical, the introduction of this low wage this was a policy that was designed with the intent of helping the hospitals that tend to have low wage indices over time get out of what is in the policy vernacular called the circularity trap.

Essentially, like, once you're down at the bottom, you're really gonna have a hard time digging out. And there's several reasons for that. One is as you continue to get lower payments, you can't then hire more costly labor to sort of get out of that trap. And secondly, there's a huge lag between the actual wages paid and when those data are incorporated into the wage index calculation, so four year lag.

So even if you somehow manage to start increasing wages, you're still gonna be stuck with the low wage index values over time for a while. So the low wage, adjustment was sort of intended to address this phenomenon, you know, just sort of by by fiat, you know, if you're in that low wage group, after all the other exceptions are applied, like, you're sort of straggling, hey. We're gonna we're gonna, basically give you an adjustment relative to that twenty fifth percentile value.

We're gonna if you're, like, down at the tenth percentile, we're gonna give you half the difference essentially. So a lot of hospitals benefited from that. And so as that disappeared at the end of our study period, you will see a decrease, in wage and next exceptions. That said, there's still growth in other areas that's noteworthy and we think is worth some policy attention.

The rural floor in particular grew a lot. And, again, to sort of re restate the the the issue here. So rural floor is all urban hospitals in a given state are mandated by statute to have a wage index that's at least as high or higher than all the hospitals in the statewide rural areas. So as an example of this historically that policymakers have pointed out, as problematic, in Massachusetts, a critical access hospital back in, I believe, 2008 converted to rural hospital status.

And because it was on Nantucket Island where it had high wages, And because of that, all the urban hospitals in the state at that time were subject to the rural floor, meaning their wage indices increased, not through any sort of labor market phenomenon that was materially affecting the prices they faced, but simply due to this sort of, you know, reclassification phenomenon, of a smaller hospital. And so the rural floor, because of that, was recognized as being gameable. So, basically, you could be an urban hospital reclass and higher wage and reclassify as rural, particularly if you're a chain hospital, then the other hospitals in the chain and other hospitals can get this bump.

So over time, you've had more and more hospitals, obtaining the roll floor adjustment, which has been really good for them. And but the rural floor is being set by fewer and fewer hospitals, so you're sort of getting this weird asymmetry. So what CMS did back in 2020 was they basically said, we're gonna try to get ahead of this gaming. If you're an urban hospital and reclassify as rural, We're not gonna include your reclassified hospital's wages into the rural floor calculation to sort of subvert this opportunity of gameability, if you will.

But that too, like the low wage adjustment, was struck down by courts. And so CMS flipped the script in 2024 and sort of reopened what has been characterized as that loophole by MedPack. And so I think we're seeing growth, again in the exceptions due to that phenomenon. But this study didn't particularly study that using sort of the econometric methods, so this is more conjecture based on the descriptive findings.

Well, so as these exceptions grow, I presume it sort of makes the problem harder and harder to fix. This is sort of like the struggle of putting the toothpaste back in the tube that sort of people kind of start to build their business models around these exceptions and then it makes it a lot harder to undo them. Are there steps that policymakers can take in this space to ensure that the exceptions are actually achieving a worthwhile policy goal? Yeah, I think so.

And just briefly before I jump into that, I wanna just state sort of the scope of this. So we've been talking about the hospital wage index, which obviously applies to hospitals, but the hospital wage index is also applied to outpatient, the outpatient payment system, the SNF, skilled nursing facility payment system, hospice, and home health. So it's a really sort of broader phenomenon. Now the exceptions component is not included in the skilled nursing facility wage index, but this sort of issue carries through, into a lot of other sectors.

In terms of potential fixes, people have been studying this going way back to, early two thousands. CMS contractors have written reports on it. MEDDPAC has periodically written reports. There are a lot of proposals out there.

I think MEDDPAC and, the National Academies of Science and Medicine have proposed as going as far as just eliminating the all exceptions to the wage index and sort of starting from scratch, if you will. But there are other, potential fixes that I think there's some consensus on across, across policymakers. So, one big fix is getting rid of hospitals reporting their own wage data. So there's sort of this endogeneity problem there.

Endogeneity just meaning, like, you're reporting your own wages. There's opportunities for obviously, if you report higher wages, you get more. So how specific hospitals sort of classify contract and other types of labor and figuring that out, you could sort of address that issue through using a separate wage data source. The other problem with the data is that we use hospital specific data where the prices you face in the labor market may be broader than just hospitals.

You're competing with skilled nursing facilities, home health agencies for nursing labor. So, there's been many proposals to use the Bureau of Labor Statistics data, which have occupation industry wide data and sort of weight weight those wage data by occupation. MedPAC also has, discussed, trying to address the phenomenon of where you, like, have statewide rural areas that encompass hospitals in rural areas that, like, in Alaska might be thousands of miles apart, but also within MSAs, which can be very large, like the Los Angeles one, and looking at variation within them, gets at, sort of the potentially the desire of hospitals to reclassify if there's already recognition that, you know, in Ronald Reagan Hospital in Westwood is gonna have a different labor price than something abutting Riverside County over there.

I'm going to LA County because I used to live there. Anyway, and then finally, there's the sort of cliff issue, which is, like, if you're just on one side of the market versus another, trying to smooth those borders so it's not such a cliff, which could also mute the desire incentives of hospital to try to game or in or reclassify. Others have contended that once you go down that route, you're blending and blending and blending. And then those that don't blend, then you're still getting distortions in the sort of true, prices of hospitals.

But there are certainly ways to get away from the distortions in the current setup. So before we wrap up, a few thoughts from you perhaps on other opportunities for research in this area. As you said, you sort of made some conjectures about what was driving some of these, some of this growth. Where would you like to turn next as a researcher in this space?

Yeah. There's a lot of opportunities for growth in this space. As you know, there have not been a lot of sort of peer reviewed studies in this area, which I think is, you know, unfortunate given the sort of payment implications. There's a couple of avenues.

One sort of easy place to start are just the various exceptions and just sort of seeing a what are the effects of obtaining or losing some of these exceptions just in terms of financial implications? The second is, does the Wage Index actually sort of obtain its policy goal of helping hospitals hire higher wage and higher skill mix labor. So that's an outstanding question. Do they just use additional dollars for sort of administrative costs or other things?

I don't think we know much about that. A sort of broader, more extensive look could look at does this over time if these are really big financial, payments. Does it particularly if they're empirically un unmerited, do these lead to improvements or harms in patient health, things of that nature? And I think just going further than that, you could think about, you know, the wage index also affects sort of, Medicare Advantage.

There's a small component of Medicare Advantage payments, sort of what happened during COVID and other phenomenon that that affected the labor market, and wages. So lots to look at that, is an exciting area of research. Indeed. Well, lots to look at and lots to, investigate down the road.

Doctor Jeffrey Jay Hoffman, thank you so much for taking the time to join us here on A Health Podyssey. Thank you so much, Rob. It was a pleasure. To our listeners, thanks for tuning in.

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