Inpatient Practice Medical Economics

The High Cost Of Observation Status

Medicare and commercial insurance companies love observation status. When a patient has to be hospitalized but only for “less than 2 midnights hospital stay”, then that patient is classified as being in observation status rather than admitted to the hospital. This classification means that the patient is technically an outpatient and not an inpatient and therefore the cost to Medicare is considerably less. Medicare uses this as a way to control the high cost of health care. But is it really less expensive when you look at the big picture?

To understand observation status, you have to understand the difference between Medicare Part A and Part B:

  1. Part A – covers inpatient care, skilled nursing care, home health care, and hospice care. Part A has no co-pay.
  2. Part B – covers outpatient medical and surgical care, emergency department care, durable medical equipment, and physician charges. Part B has a 20% co-pay.

So, if a person is in observation status, then Medicare Part A does not cover the bills, instead, Part B does. From the patient’s standpoint, this is a critical distinction because if that patient is considered an inpatient, then Part A covers the inpatient charges, including medication costs, with no co-pay. On the other hand, if that patient is considered to be in observation status (i.e., an outpatient), then Part B covers it but the patient is billed a co-pay and importantly, the patient is also billed the medication costs.

If you read the Medicare website, it sounds like the decision about whether a patient is considered as observation or inpatient is the hospital’s decision but this really could not be farther from the truth. The Medicare website states: Your hospital status (whether the hospital considers you an “inpatient” or “outpatient”) affects how much you pay for hospital services. But the hospital is not really the one making the decision about inpatient or outpatient. Medicare has very strict rules about what they consider to be criteria for inpatient status versus observation status. If the hospital believes that the patient should be inpatient status, and bills Medicare Part A, then Medicare can audit that patient’s chart and if they determine that the patient should have really been in observation status by their definition, then Medicare will ask for the Part A money back and in some cases can even fine the hospital for “fraudulent” billing. Moreover, if the patient has already been discharged then the hospital cannot bill the patient for their Part B co-pay or for the cost of the medications that the patient received due to the “MOON” regulations. In other words, if the hospital bills the patient as an inpatient but Medicare does not agree, then the hospital loses a boatload of money on that patient. Therefore, the hospital really, really wants that patient to be in inpatient status and not in observation status but risks not getting paid at all if Medicare disagrees with the inpatient status decision.

Another key difference between observation status and inpatient status is that there is a weird rule in Medicare that a patient has to be an inpatient for 3 days before being discharged to a skilled nursing facility for Medicare to pay for that nursing home charge. If the patient is in observation status, then the hospital cannot discharge the patient to a nursing home and instead has to discharge the patient to their regular home.

The reason Medicare and commercial insurance companies like observation status so much is because they don’t have to pay the hospital as much. But the costs do not go away, they are just transferred to the patient, instead. Many patients are shocked when they were sick enough that they needed to be hospitalized but then get an enormous bill for a 20% co-pay for all of their costs plus a bill for all of the medications that they received when they were in the hospital. These additional co-pays and medication bills require additional layers of administrative costs on the part of the hospital in order to bill and collect and can also be both costly and confusing to the patient.

So, from the patient’s perspective and from the hospital’s perspective. it is better to be an inpatient than to be in observation status. But from Medicare and insurance companies’ perspective, it is better to be in observation status than inpatient status. This has resulted in the hospitals becoming a battle ground for deciding who is an inpatient and who is in observation status.

The most recent victim of this battle is the knee replacement. in the past, knee replacement surgery was considered an inpatient procedure but recently, Medicare has classified knee replacement as an outpatient surgery. But almost no one goes home the same day that they have a knee replacement – those patients need physical therapy, need to recover from general anesthesia, and need to have their pain managed. The result is that almost all patients spend at least one night in the hospital after a knee replacement.

But Medicare will allow for a knee replacement surgery to be billed as an inpatient if the physicians and the hospital can document extenuating circumstances why that particular patient needs to be an inpatient (in other words, why that patient is expected to spend more than 2 midnights in the hospital). These extenuating circumstances are usually co-morbid medical diseases, like sleep apnea, heart failure, insulin-dependent diabetes, etc. But the catch is that these conditions need to be documented in the patient’s chart before surgery because Medicare rules require the decision about whether an order for inpatient admission to be made before or at the time of surgery. This generally means that the patient has to go to a “pre-admission testing evaluation” by a physician, nurse practitioner, or physician assistant where these medical illnesses can be laid out in a way that justifies the surgery taking place as an inpatient procedure.

Furthermore, the hospital has to employ a “physician advisor” who can then review the chart and confirm that the patient actually meets the requirements for inpatient status. The physician advisor must then document his/her opinion about whether the patient really needed to be an inpatient or not and also document their reasoning why so that the hospital has documentation to submit to Medicare auditors in the event that the patient’s admission is denied by Medicare. Many smaller hospitals cannot afford to have a group of their own physicians who are trained in the nuances of inpatient versus observation status and be on-hand for 24 hour decision-making so they will contract with an external physician advisor company such as EHR (Executive Health Resources) who they will pay to have physicians who can review the patient’s chart and offer a determination about whether or not the patient should be inpatient or observation status.

In the final analysis, Medicare and insurance companies pay less for observation status, the hospital has to add an expensive layer of administrative costs, and the patient is personally responsible for more of the costs. The net effect is more total societal costs to deliver health care but lower costs directly paid by Medicare.

So, does observation status reduce healthcare costs? The sad answer is no. It actually adds administrative costs and transfers those costs back to the patient or to the hospital.

June 3, 2018

By James Allen, MD

I am a Professor Emeritus of Internal Medicine at the Ohio State University and former Medical Director of Ohio State University East Hospital