Medicare: Parts A Through D and How They Pay

Introduction

Medicare is the single largest payer in US healthcare, covering approximately 67 million Americans and spending over $900 billion annually. For healthcare bankers, Medicare is not one program but four distinct payment systems, each creating different revenue dynamics for different types of healthcare companies. Understanding which Medicare Part pays for which service, and how the payment mechanism works, is essential for modeling revenue in healthcare services, pharmaceuticals, medical devices, and managed care.

Medicare Part A covers inpatient hospital stays, skilled nursing facility care, hospice care, and some home health services. It is funded by payroll taxes and has no monthly premium for most beneficiaries.

How Part A Pays: The DRG System

Part A pays hospitals on a prospective payment system based on Diagnosis-Related Groups (DRGs). When a Medicare patient is admitted to the hospital, the hospital receives a fixed payment based on the patient's diagnosis, regardless of how many days the patient stays or how many resources are consumed.

Diagnosis-Related Group (DRG)

A classification system that groups hospital inpatient stays into approximately 750 categories based on diagnosis, procedures performed, patient age, complications, and comorbidities. Each DRG has a relative weight reflecting the average resource intensity of that type of case. The DRG weight is multiplied by the hospital's base rate (adjusted for geographic wage differences) to determine the payment amount. Example: a simple pneumonia admission (DRG weight ~0.7) pays significantly less than a coronary bypass surgery (DRG weight ~6.0+).

The DRG system creates specific financial dynamics for hospitals:

Medicare Part B covers physician services, outpatient hospital services, durable medical equipment, and physician-administered drugs. It is funded by beneficiary premiums (roughly 25%) and general federal revenue (roughly 75%).

How Part B Pays: Fee Schedule and ASP+%

Part B uses two primary payment mechanisms:

Physician services are paid based on the Medicare Physician Fee Schedule, which uses Relative Value Units (RVUs) to set payment rates for each procedure code. The fee schedule is updated annually by CMS, and changes to the conversion factor (the dollar amount per RVU) directly affect revenue for physician practices, ambulatory surgery centers, and outpatient facilities.

Physician-administered drugs (primarily oncology infusion drugs, ophthalmology injections, and specialty biologics) are reimbursed at Average Sales Price (ASP) plus 6%. This formula matters enormously for pharmaceutical companies because it creates a direct link between the drug's market price and Medicare reimbursement.

Medicare Advantage (MA) is the privatized alternative to traditional Medicare. Beneficiaries can choose to receive their Part A and Part B benefits through a private insurance plan (run by UnitedHealthcare, Humana, CVS/Aetna, etc.) instead of directly through the government. Medicare pays the MA plan a per-member-per-month (PMPM) capitation rate, and the plan manages all covered services within that budget.

Medicare Advantage (Part C)

A system where Medicare pays private health plans a fixed monthly amount per enrolled beneficiary, based on a county-level benchmark adjusted for the individual's health status (risk adjustment). The plan must cover all Part A and Part B services and typically offers additional benefits (dental, vision, hearing, fitness) to attract enrollment. Plans profit when they manage total care costs below the capitation payment. Medicare Advantage enrollment has grown from 25% of Medicare beneficiaries in 2010 to over 50% in 2024, making it one of the most important growth trends in healthcare.

Medicare Advantage matters for healthcare bankers across multiple sub-sectors:

Medicare Part D covers outpatient prescription drugs (drugs patients pick up at a pharmacy, as opposed to Part B drugs administered by physicians). Part D is delivered through private Prescription Drug Plans (PDPs) or as part of Medicare Advantage plans.

Part D's payment structure involves a complex interaction among the plan sponsor, CMS subsidies, and patient cost-sharing across four benefit phases (deductible, initial coverage, coverage gap, catastrophic). For healthcare bankers, the key Part D dynamics are:

While Medicare is the largest government payer, Medicaid covers a larger population and creates distinct valuation dynamics through its lower reimbursement rates and significant state-by-state variation.