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Methods of Reducing the Financial Risk of Physicians Under Capitation
Gerard F. Anderson, PhD;
Wendy E. Weller, MHS
Arch Fam Med. 1999;8:149-155.
ABSTRACT
In today's rapidly changing medical marketplace, managed care plans are not the only entities assuming risk for the care of enrollees through capitation. Increasingly, managed care plans are transferring this risk to their primary care and specialty physicians by paying them on a fully or partially capitated basis. Although capitation provides a strong incentive for physicians to provide cost-effective care, there are concerns that capitation may place some physicians at considerable financial risk. Our purpose is to familiarize physicians with issues they will want to consider when they evaluate capitation options and methods that are available to reduce their financial risk. Specifically, we analyze 3 issues: the range of services that are capitated, who accepts the risk, and size of patient panel. We conclude with a discussion of 3 methods for reducing or limiting risk—reinsurance, "carve outs," and risk adjustment.
INTRODUCTION
In today's rapidly changing medical marketplace, managed care plans are not the only entities assuming risk for the care of enrollees through capitation. Increasingly, managed care plans are transferring this risk to their physicians by paying them on a fully or partially capitated basis. A recent survey conducted by the American Medical Association showed that the percentage of physicians with at least 1 capitated contract increased from 26% in 1994 to 33% in 1995.1 Another study of managed care plans showed that more than half of network or independent practice association model health maintenance organizations surveyed capitated their primary care physicians and certain specialists, such as cardiologists, mental health specialists, and radiologists.2
In theory, capitation at the provider level can lower health care costs by creating financial incentives for physicians to reduce the volume of services by more effective management of health care utilization. Under capitated arrangements, physicians receive a fixed payment for each enrollee under their care, regardless of the amount of services actually provided. Capitation rates are usually based on the average projected cost of the enrolled group, perhaps with adjustments for demographic characteristics (eg, age and sex). Typically, capitation rates are not adjusted for the health status of the specific individuals under the physician's care.
Although capitation provides a strong financial incentive for physicians to provide cost-effective care and may allow physicians greater flexibility in providing or arranging for services not normally covered under fee-for-service plans, there are concerns that capitation may place some physicians at considerable financial risk and that this may affect the quality of care provided.3-6 For example, payments to physicians whose panel of patients is consistently sicker than average may be insufficient if capitation rates are not adjusted to reflect the higher-than-average costs of this population. In addition, a few individuals who happen to incur very high costs in a single year may also pose a financial risk to individual physicians and small groups of physicians who are capitated.
As a larger percentage of physicians' income is generated from capitation, it is critical for them to understand the risk they are accepting under capitation at the plan and provider levels. A recent survey, however, found that most physicians are unaware of these risks when they accept capitation in a managed care contract.1 Our purpose is to familiarize physicians with 3 issues that can have an impact on the amount of risk they assume under capitation and to discuss methods to reduce their financial risk in an increasingly capitated environment. Our article is directed to primary care physicians in solo or group practice who are considering accepting capitation for their services. However, we will briefly discuss capitation of specialty physicians.
SCOPE OF SERVICES
The first issue relevant to physicians who are considering accepting capitation is the scope of the services that are included in the capitation payment. In practice, the scope of physician capitation ranges from full capitation to partial capitation to capitation only for the services provided directly by the individual physician or physician group. In general, the financial risk and responsibility for managing risk increases as the scope of services covered by capitation increases.
Full Capitation
Under full capitation, almost all risk, including hospitalization, is transferred from the managed care plan to physicians, along with about 80% to 90% of the premium dollar. Physicians who are fully capitated assume risk for the full range of services covered by the managed care plan, such as hospital, physician, home health care, durable medical equipment, and other services. In most cases, administrative functions (eg, authorizing or denying referrals, monitoring use of services) are also assumed by the physician(s) under full-risk arrangements.7 Full capitation usually has been reserved for large groups of physicians (ie, independent practice associations or, more recently, medical groups) rather than individual physicians, because of the substantial financial risk that is involved.7
Full capitation arrangements may be mutually beneficial to physicians and patients as fully capitated physicians assume more responsibility for medical decision making. However, fully capitated physicians must face decisions similar to those of health plans, in terms of deciding appropriate use of health care services and payment rates for a wide range of services. Concerns have been raised that fully capitated physicians may be at substantial risk for services over which they have no direct control and, when faced with a deficit, may consciously or subconsciously withhold services.5, 8 Physicians who are fully capitated also need information systems that allow them to monitor use of health care services and health status. Developing such information capabilities can be costly and time-consuming. Individual physicians or small groups of physicians may not have the capital required to invest in these data management systems.9
Table 1 presents the distribution of spending, by service category, for all children aged 0 to 18 years enrolled in the Washington State Medicaid program in 1992-1993 and for children with selected chronic conditions. The expenditures are actual payments made by the Medicaid program during this period. It shows what services a fully capitated physician would be responsible for providing and the magnitude of spending for each covered service. Table 1 suggests that nonphysician services can account for a substantial portion of total per capita expenditures. A comparison with overall health care spending in the United States suggests that this distribution is similar to that of spending in other populations.10
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Table 1. Distribution of Spending for Children Aged 0-18 Years in the Washington State Medicaid Program, 1992-1993*
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Partial Capitation
Physicians who are partially capitated are responsible for a narrower range of services, such as all physician services, rather than the full range of services (eg, inpatient hospital, ancillary services) covered by the health plan. Although partially capitated physicians may be only at risk for a limited range of services, they generally assume risk for all services whether or not they (or their group) directly provide the services. For example, a primary care physician who is partially capitated for all physician services receives a set amount of money each month to cover primary care services provided by the physician and any services provided by specialist physicians. Although the primary care physician who receives the capitation payment may not directly provide specialty services, that physician is responsible for paying the specialist from that capitation payment.
Although partially capitated physicians receive a smaller portion of the premium dollar, physicians are at financial risk for a smaller scope of services. This may be more manageable and less risky for physicians, at least in the short run, compared with full capitation. However, physicians must still be aware of the specific services included under partial capitation.
Finally, plans may choose to capitate physicians for the services they actually are responsible for providing directly. For example, primary care physicians would be responsible only for the primary care services that they provide directly. The obvious advantage of this approach is that the physicians accept risk for the services they can control directly. The major disadvantage is that primary care physicians do not have a financial incentive to manage referrals to specialists and will not be rewarded financially if they provide high-quality, cost-effective primary care.
WHO ACCEPTS THE RISK?
A second issue to consider is what type of physician is capitated. Historically, most plans have chosen to capitate primary care physicians. Plans are now starting to capitate entire specialties, such as cardiology, mental health, and radiology.2 Such arrangements have been described previously as specialty "carve outs" because money to pay certain specialty services is carved out of the pool of money to compensate physicians.3 In a study of physician involvement with capitated contracts, 50% of general practitioners and family physicians, 48% of general internists, and more than 60% of pediatricians had 1 or more capitated contracts in 1995.1 The same study showed that a smaller portion of specialists had 1 or more capitated contracts, ranging from a low of 16% for anesthesiologists to a high of 33% for subspecialists in internal medicine. The percentage of practice revenues that were capitated averaged 19% across primary care physicians and specialists.1
There are advantages and disadvantages for accepting risk, depending on whether one is a primary care physician or a specialist. From the point of view of the primary care physician, capitation may allow more flexibility over management of patient care. For example, capitation may provide an opportunity to focus on counseling patients against high-risk behaviors, such as smoking, something that is not necessarily rewarded in a fee-for-service system. However, primary care physicians may find capitation disadvantageous if they have 1 or 2 patients who happen to require intensive medical care during a given year or consistently have a sicker panel of patients relative to other primary care physicians.
SIZE OF PATIENT PANEL
A third issue relevant to capitated physicians is the size of their patient panel. For some physicians, a large panel of patients may help reduce the effect of random variation in health care expenditures. A large panel of patients will make it easier to absorb the high costs associated with 1 or 2 catastrophic cases. Family physicians, general internists, and pediatricians who are able to maintain a large panel of patients with a mix of healthy and sick individuals may be better positioned to spread the higher costs of a few patients over the entire panel. Also, groups of physicians are better able to accept risk than individual physicians.
A large number of individuals in the panel, however, will not be sufficient to protect physicians if the panel does not have an average mix of healthy and sick individuals. This may be a particular concern for physicians who are known for their expertise in treating certain conditions. For example, physicians whose panels include a large proportion of persons with chronic illnesses will need to receive higher payments per capita to be able to provide appropriate medical care. According to Hoffman et al,11 the annual per capita medical care costs in 1987 for individuals with more than 1 chronic illness was $4672 compared with $1829 for individuals with only 1 chronic illness and $817 for individuals with acute conditions only. Even if physicians are able to provide effective care for chronically ill patients, each patient may still require more time for appropriate assessment, treatment, and management than a panel of patients who are relatively healthy or have less complicated conditions.
METHODS OF REDUCING FINANCIAL RISK TO PHYSICIANS UNDER CAPITATION
There are 3 major methods for limiting financial risks to capitated physicians: reinsurance, carve outs, and risk adjustment. These methods are applicable to individual as well as groups of physicians. Each method presented, however, is designed to address different issues related to risk, and each has its own strengths and limitations. The most appropriate method or combination of methods may depend on the type of physician who is capitated and that physician's panel of patients.
Reinsurance
Many studies have shown that in any given year, a small portion of the population accounts for a large portion of health care expenditures. This pattern also holds within specific populations, eg, Medicare enrollees,12-13 Medicaid enrollees,14 the employed population,15 and other groups of individuals. Figure 1 shows the distribution of expenditures for all children younger than 18 years enrolled in the Washington State Medicaid Program during fiscal year 1993 and for children with selected chronic conditions. A relatively small proportion of the Medicaid enrollees are responsible for a large proportion of the spending. The most expensive 10% of all children in the Washington State Medicaid program, for example, were responsible for approximately 70% of spending in 1992-1993. This means that 90% of children in the Washington State Medicaid program accounted for only 30% of all expenditures in the same period. Somewhat more surprising, however, is that the spending distribution is similar for selected chronic illness. The most expensive 10% of children with diabetes or with asthma, for example, accounted for approximately 67% of all spending for children with either of these conditions.
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Percentage of the population vs percentage of payments for selected chronic conditions, for fiscal year 1993 Medicaid payments in Washington State.
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One mechanism that capitated physicians can use to protect themselves against large losses, particularly losses over which they have limited or no control, is through the purchase of reinsurance or the inclusion of stop-loss provisions in their contracts.1, 3 As shown in Figure 1, there is considerable variation in the distribution of health care expenditures. Reinsurance is primarily designed to protect individual physicians or groups of physicians from unpredictable or random variations in health care expenses. According to the literature, an estimated 20% to 25% of the total variation in health care expenditures on an individual basis is predictable, and the remainder is random.16
The most common form of reinsurance is individual reinsurance, or individual stop-loss coverage, where the physician is responsible for the health care costs of an individual up to a certain dollar threshold for a given time. The reinsurer is partially or entirely responsible for costs incurred beyond this amount. Specific dollar thresholds often depend on the size of the group. Smaller groups can spread risk across fewer people and therefore are at greater financial risk from even 1 catastrophic illness. Individual physicians or small groups of physicians who are fully or partially capitated are frequently covered by individual stop-loss reinsurance with an annual threshold of $5000 or less. Large health plans and large physician groups have higher thresholds, ie, $100,000 per year or higher.17
As the dollar threshold is lowered, the costs of reinsurance increase dramatically. Higher premiums reflect the larger portion of risk that is transferred to the reinsurer at low thresholds. In practice, most managed care plans withhold a portion of a physician's base capitation to fund the reinsurance premium, or the physician group purchases reinsurance from a commercial reinsurer. Therefore, lower reinsurance thresholds can translate into lower base capitation payments.
The major strength of reinsurance is its potential to protect capitated providers, especially small groups, from losses due to catastrophic illnesses or events. This is particularly a concern for fully or partially capitated providers who accept responsibility for a broad scope of services. Concerns that the scope of some physician capitation arrangements may be too broad have prompted some states and the federal government to require health plans to purchase reinsurance for physicians deemed to be at substantial financial risk, particularly for services they do not provide directly. The Health Care Financing Administration, for example, requires managed care organizations with Medicare risk contracts to provide physicians or physician groups with reinsurance and to monitor enrollees' access to and satisfaction with care if the plan places a physician or physician group at substantial financial risk for services they do not provide directly. The Health Care Financing Administration considers capitated physicians or physician groups to be at substantial financial risk if they have fewer than 25,000 patients and if more than 25% of the group's income comes from withholding or bonuses.18
Despite the potential importance of reinsurance as a method for limiting risk to capitated physicians, there is evidence that many physicians with capitated contracts do not understand the principles of reinsurance or even whether they are covered by reinsurance. Based on responses from the 1995 American Medical Association's physician survey, Simon and Emmons1 determined that 56% of primary care physicians with at least 1 capitated contract did not know if they had reinsurance. Perhaps even more interesting is the finding that physicians with a larger share of revenues from capitation were not more likely to report having reinsurance provisions.1
Carve Outs
Carve outs are another method for reducing risk to capitated physicians. Certain services, conditions, or populations can be "carved out" of the capitation payment and paid for separately. Recently, for example, there has been a trend toward carving out some preventive health care services, such as immunizations, from primary care physicians' capitation payment and reimbursing these services on a fee-for-service basis.3
Certain consistently high-cost conditions can also be removed from the capitation payment and be reimbursed separately by establishing a separate capitation amount or a modified fee-for-service arrangement.19 Examples of conditions that have been carved out by states or other organizations include certain types of organ transplantations, very low birth weights in infants, advanced human immunodeficiency virus disease, and muscular dystrophy.20-21 Physicians who have patients with a carve-out condition usually receive a fixed, lump sum or a capitated monthly payment based on the expected cost of treating someone with that specific condition. Carve-out conditions may not only protect capitated physicians from the high cost of certain conditions, but may also increase access to care for individuals with these conditions. For example, physicians may be more inclined to accept a patient with acquired immunodeficiency syndrome in their panel if they know they will receive the average cost of treating such a patient rather than the average cost of treating all of the enrollees.
Carve outs may work well for physician groups who accept capitation and may have a higher proportion of patients with certain conditions or who specialize in 1 type of illness, assuming that capitation rates are adequate. Carve outs alone, however, may not be feasible to protect physicians who care for individuals with a broad range of illnesses. First, they have been applied to a narrow range of medical conditions.20-21 Second, they may be cumbersome to implement and to maintain. They require some entity to determine which conditions are appropriate to carve out and to establish adequate payment amounts for each. Third, physicians may have an incentive to identify patients with carve-out conditions, if they have the discretion to do so. To prevent this "gaming" of the system, individual-level data could be collected to verify that individuals do in fact have a carve-out condition. However, these are often sensitive data and raise concerns about protection of patient confidentiality. Because there is likely to be wide variation in the costs of treating individuals with the carve-out conditions (Figure 1), there may be a financial incentive to identify and to attract the least severe (expensive) individuals with that condition. To eliminate this problem, it may be possible to identify complications and/or comorbidities associated with some chronic conditions that can be used to identify the most expensive individuals with that condition. This would further refine the carve-out condition to achieve more homogeneous groups.19
Risk Adjustment
The third method that can be used to reduce financial risk to capitated physicians is to adjust the capitated payment based on the expected costs of the physician's panel of patients. Capitation rates that are not adjusted to reflect the differences in health status of panels of patients would, in effect, penalize such a physician for attracting a mix of patients who are sicker than average.22-23
A variety of approaches have been suggested to adjust for risk associated with an entire population of enrolled individuals. Demographic factors, functional health status, self-reported health status, previous use of health care services, and clinical indicators have all been proposed to adjust capitated payment rates.14, 24 The proposed methods have been evaluated according to numerous criteria, including predictive accuracy, susceptibility to manipulation, patient confidentiality, incentives for appropriate care, and administrative feasibility.14
Demographic adjusters consider characteristics such as age and sex to predict future health care expenditures. Researchers repeatedly have criticized the ability of demographic factors to predict future use of health care services at the individual level.25-26 It is anticipated, for example, that a 20-year-old man with acquired immunodeficiency syndrome will have higher costs than a healthy 20-year-old man. Despite their inability to adjust for this type of difference in expected health care costs, demographic risk adjusters are the most common prospective risk adjuster used today.
Functional health status models use measures of an individual's ability to perform activities of daily living, such as bathing and dressing, to set payment rates.27 This information is usually collected through questionnaires administered by a clinician or self-administered by the patient. Self-reported health status models use measures of perceived health status, such as the 36-Item Short-Form Health Survey, to predict future health care expenditures.22, 28-29 Functional and self-reported health status models have been used primarily for demonstration purposes and have not been adopted widely to pay health plans or physicians.
Information on an individual's previous health care spending and use of health care services in a previous year can be used to measure health status indirectly and to predict future expenditures. Knowing an individual's present utilization is a good predictor of future utilization, and therefore models of previous utilization tend to score relatively well in predictive accuracy.24 However, they score poorly on susceptibility to manipulation and incentives for appropriate care criteria, since payment in future years is based on expenditures in present and past years.24
Researchers have focused most of their efforts on developing risk-adjusted capitation models that use clinical indicators to set rates. Clinical indicator models use diagnostic information on the individual to establish capitation rates. Several clinical indicator risk-adjustment models have been developed, including the ambulatory care groups, the hierarchical coexisting conditions, and the disability payment system.27, 30-31 The major difference across the 3 models is how they organize clinical information on the individual to establish a payment rate. Although many of the existing clinical indicator models were developed using Medicare data, they have been applied to non–Medicare enrollees.22 Clinical indicator models typically use information obtained from the claims or encounter data to predict use of health care services and cost in the subsequent year. This information is routinely maintained by health plans and is therefore less administratively burdensome than other prospective rate-setting options that rely on the collection of primary data. The predictive accuracy of models based on clinical indicators are equal to or better than the other prospective models.22-23,32
An example of how 1 clinical indicator model would be used in practice is shown in Table 2. It uses a new version of the ambulatory care groups, the ambulatory diagnosis group–major diagnostic cost group model (ADG-MDC), to set capitation rates for 3 different individuals.33 In this example, the model is calibrated on aged Medicare beneficiaries and uses data from 1991 to establish 1992 payments. The payments that would be paid under the ADG-MDC model are compared with the present Medicare system, which uses demographic characteristics, welfare status, and institutional status to adjust payment rates. To keep the example simple, a 65-year-old man who does not receive welfare and who is not institutionalized is used in each example, and the payment rates are not adjusted for geographic location. Table 2 shows that the present Medicare formula would pay the same amount regardless of the health status of the individual. The ADG-MDC model, however, would adjust the payment based on the individual's health status. An individual with no apparent health problems (individual 1) would be associated with a much lower payment than an individual with multiple health problems (individual 3). In this way, the physician who cares for a high proportion of enrollees with chronic illness would receive considerably more per enrollee. The physician who provides care to predominantly healthy individuals would receive less per enrollee under a system that adjusts for the enrollee's health status.
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Table 2. Determining Capitation Rates for 3 Individuals Using 2 Different Risk Adjustment Measures*
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The major strength of all types of risk adjusters is that they use information about individuals to measure predictable risk and prospectively set payments at the beginning of the year.20 This can limit physician losses due to sicker than average populations and reduce incentives for physicians to avoid these populations while maintaining incentives for efficiency.
Like all methods for limiting risk, risk adjusters have their limitations. First, using these adjusters alone may leave physicians vulnerable to losses from unpredictable risk. Second, compared with reinsurance and carve outs, these risk adjusters may require a greater effort to implement and maintain. The amount of effort will vary according to the type of risk adjuster used. Third, risk adjustment methods may be more susceptible to manipulation than reinsurance and carve outs.
CONCLUSIONS
Physicians accepting full or partial capitation need to be aware of the financial risk they are accepting and approaches that are available to reduce it. No single approach will protect all physicians against predictable and unpredictable risk. The major strengths and limitations of the 3 major methods of limiting or adjusting risk to capitated physicians discussed herein are summarized in Table 3. The type of risk that a capitated physician may encounter and the methods used to reduce that risk will largely depend on the physician's panel of patients. Reinsurance alone may be sufficient to protect capitated primary care physicians with a large, broad patient base. These physicians will be most susceptible to large losses from a few patients with high, unpredictable costs. Condition-specific carve outs, alone or in combination with reinsurance, may be a more appropriate method to limit the risk of capitated physicians who focus mostly on the care of individuals with 1 particular type of illness or care for a higher proportion of patients with certain conditions. Finally, risk adjustment may be most useful for primary care and specialty physicians with a panel of patients who are sicker than average and therefore are likely to incur overall health care costs. Some physicians may require a combination of reinsurance, carve outs, and risk adjusters to protect themselves against financial risk.
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Table 3. Strengths and Limitations of Reinsurance, "Carve Outs," and Risk Adjusters*
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AUTHOR INFORMATION
Accepted for publication April 7, 1998.
This work was supported by grant 95-2016 from the David and Lucille Packard Foundation, Los Altos, Calif, and grant 96169 from the Commonwealth Fund, New York, NY.
Corresponding author: Gerard F. Anderson, PhD, Center for Hospital Finance and Management, The Johns Hopkins University, 624 N Broadway, Baltimore, MD 21205 (e-mail: ganderso{at}jhsph.edu).
From The Johns Hopkins Center for Hospital Finance and Management, Baltimore, Md.
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