Introduction
Healthcare reimbursement is not one system but several parallel payment models, each designed for different types of services and each creating distinct financial incentives. A hospital is paid differently than a physician, who is paid differently than a drug manufacturer. Understanding these payment models is essential for healthcare bankers because the reimbursement model determines how revenue is generated, what drives margins, and where the financial risks lie.
This article covers the five major payment models that healthcare bankers encounter most frequently.
Fee-for-Service: The Foundation
Fee-for-service (FFS) is the traditional payment model in which providers are paid for each service rendered. More services equal more revenue. While healthcare is shifting toward value-based models, FFS still accounts for the majority of healthcare payments and underpins the physician fee schedule, hospital outpatient payments, and many commercial contracts.
- Fee-for-Service (FFS)
A payment model where providers receive a separate payment for each service, procedure, or visit. Revenue is driven by volume (number of services) and price (reimbursement rate per service). FFS creates an inherent incentive to increase service volume, which has been criticized for driving unnecessary utilization. Despite decades of reform efforts, FFS remains the dominant payment model in US healthcare, particularly for physician services and outpatient care.
The two most important FFS payment systems are the DRG system (for hospitals) and the physician fee schedule (for physician services).
DRG-Based Payment: How Hospitals Get Paid
The Medicare DRG system is a prospective payment model that pays hospitals a predetermined amount per inpatient admission based on the patient's diagnosis and procedures performed. The payment is fixed regardless of the actual resources consumed.
The DRG payment formula:
Where the base rate is set nationally by CMS and updated annually, the DRG weight reflects the relative resource intensity of the diagnosis (higher for complex surgeries, lower for routine admissions), and the wage index adjusts for geographic labor cost variation.
Commercial insurers also use DRG-based payment for inpatient admissions, but at negotiated rates that are typically 150-250% of Medicare DRG rates. The commercial DRG payment uses the same classification system but with higher base rates, which is why commercial payer mix is so important for hospital profitability.
Physician Fee Schedule: RVU-Based Payment
Physician services under Medicare Part B are paid based on the Resource-Based Relative Value Scale (RBRVS), which assigns Relative Value Units (RVUs) to each procedure code.
- Relative Value Unit (RVU)
A standardized measure of the value of a physician service, consisting of three components: physician work (52% of total, reflecting time, skill, and intensity), practice expense (44%, covering overhead like rent, staff, and equipment), and malpractice expense (4%). Each CPT code has an assigned RVU value. The RVU is multiplied by a national conversion factor (currently approximately $33 per RVU) and adjusted geographically to determine the Medicare payment amount.
The RVU system matters for healthcare services valuation because it directly links physician productivity to revenue. The key metrics:
- RVUs per provider per day: Measures physician productivity and utilization. Higher RVUs per provider indicate more procedures or higher-complexity work
- Collections per RVU: Measures the blended reimbursement rate across all payers. A practice with high commercial payer mix collects more per RVU than one with high government mix
- Provider capacity utilization: The percentage of available clinical hours that generate billable RVUs
| Specialty | Typical RVUs/Year | Medicare Revenue/Provider | Key Revenue Driver |
|---|---|---|---|
| Primary Care | 4,000-5,500 | $150-200K | Visit volume, panel size |
| Orthopedics | 7,000-10,000 | $300-500K | Surgical case volume |
| Dermatology | 5,000-8,000 | $200-350K | Procedure mix (Mohs, biopsies) |
| Cardiology | 6,000-9,000 | $250-400K | Imaging, catheterization volume |
| Gastroenterology | 6,000-9,000 | $250-400K | Colonoscopy volume |
ASP+%: Drug Reimbursement
Physician-administered drugs (primarily oncology infusion therapies, ophthalmology injections, and specialty biologics) are reimbursed under Medicare Part B at Average Sales Price plus 6% (ASP+6%).
The ASP is calculated quarterly based on manufacturer-reported sales data, and the 6% add-on compensates the physician or facility for acquiring, storing, and administering the drug. This payment model has significant implications:
- Manufacturer pricing power. Because reimbursement is tied to ASP, manufacturers can increase reimbursement by raising the drug's price. This creates a different dynamic than the DRG or RVU systems, where rates are set by CMS
- Physician economics. The 6% markup means physicians earn more from administering higher-priced drugs. This has raised concerns about incentives to prescribe more expensive therapies, and has been the subject of ongoing policy debate
- IRA impact. Medicare drug price negotiation under the IRA will directly reduce ASP for negotiated drugs, which reduces both the base reimbursement and the 6% markup
Capitation and Value-Based Payment
Capitation represents a fundamentally different approach: instead of paying per service, the payer pays a fixed monthly amount per patient (per-member-per-month, or PMPM) regardless of what services the patient uses.
Medicare Advantage plans are the largest capitated payer, but commercial insurers also use capitation for primary care and some specialty services. Bundled payments (a fixed amount for an entire episode of care, such as a joint replacement from pre-surgical evaluation through post-operative rehabilitation) represent a hybrid between FFS and capitation.
The shift from fee-for-service to value-based payment has created new types of healthcare companies (value-based primary care platforms, risk-bearing provider organizations) and new M&A activity as health systems and insurers acquire capabilities to manage capitated populations.
The final article in this section covers the drug pricing and gross-to-net dynamics that determine how much pharmaceutical companies actually collect from their products.
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