Introduction: The Medicare Scandal Uncovered
Nearly two decades ago, a major healthcare scandal exposed how hospitals exploited Medicare’s payment system for extraordinary profits. The Centers for Medicare and Medicaid Services (CMS) investigated healthcare companies for charging excessive payments through the “outlier program,” designed to cover extraordinarily costly patient care episodes. While companies settled without admitting wrongdoing, critical questions remained unanswered about how these excess payments were used and what lessons could inform future government contracting.
Atul Gupta, Wharton professor of health care management, alongside colleagues Ambar La Forgia from UC Berkeley and Adam Sacarny from Columbia University, conducted an investigative analysis detailed in their paper “Turbocharging Profits? Contract Gaming and Revenue Allocation in Healthcare.” Their research reveals shocking insights into contract gaming, hospital behavior, and the stark differences between for-profit and nonprofit healthcare organizations.
How the Medicare Loophole Formed
Understanding the Outlier Program Exploitation
The Medicare outlier program’s flawed implementation created a significant loophole that hospitals systematically exploited. Through a practice called “turbocharging,” hospitals rapidly inflated their list prices for treating high-cost patients. This manipulation allowed them to receive dramatically increased Medicare reimbursements far beyond legitimate costs.
Between 1998 and 2003, gaming hospitals conservatively received $3 billion in excess Medicare payments before CMS closed the loophole. The researchers deliberately used the term “gaming” rather than “fraud” because determining intent to defraud Medicare proved impossible. At the scandal’s peak, turbocharging hospitals increased their effective Medicare payment rates by an astonishing 22%.
The Scale of the Problem
The investigation analyzed 120 gaming hospitals between 1994 and 2006, including 42 for-profit and 78 nonprofit institutions. The broader study sample encompassed nearly 1,400 non-gaming hospitals for comparison. Developing an algorithm to identify gaming hospitals proved challenging, with the 120 identified hospitals likely representing an underestimate among the roughly 3,000 hospitals participating in the outlier program.
Identifying Gaming Hospitals
Identifying which hospitals engaged in contract gaming required sophisticated analytical methods. The research team developed specialized algorithms to detect unusual patterns in billing practices and charge inflation. The complexity of Medicare’s payment system meant that gaming behavior could be disguised within legitimate-appearing cost reports and charge structures.
The study’s sample of 120 gaming hospitals emerged after applying multiple filters to ensure accuracy. This conservative approach suggests the actual prevalence of gaming behavior may have been significantly more widespread throughout the healthcare system during this period.
The Money Tracks of Nonprofits and For-profits
Stark Differences in Revenue Allocation
Contract gaming imposes enormous costs on government budgets and taxpayers, yet little was known about which organizations engage in this behavior and how they allocate these engineered windfalls. The research uncovered consistent patterns directly tied to hospital ownership structure.
Nonprofit hospitals deployed most excess revenue toward operating costs that could enhance patient care delivery. Their spending focused on drugs, medical supplies, and operating room and emergency room costs. Significantly, the study detected mortality reductions of 3% only at nonprofit gaming hospitals, following an 8% increase in Medicare spending during the study period.
For-profit hospitals transferred all excess revenue off their balance sheets, distributing large shares to executives and shareholders. Dallas-based Tenet Healthcare led this trend, dramatically increasing executive compensation and stock buybacks during the gaming period by approximately $1 billion.
The Tenet Healthcare Case Study
Tenet Healthcare, the largest for-profit company in the study with 60 gaming hospitals, reached a settlement with the Department of Justice in June 2006. The company agreed to pay more than $900 million to resolve allegations of unlawful billing practices, including $788 million related to excessive outlier payments. Additional allegations involved kickbacks to physicians and irregularities in diagnosis codes to inflate reimbursements.
Spillover Effects on Total Healthcare Costs
Gaming hospitals increased both Medicare and total revenue by approximately 10% between 1998 and 2003, creating massive spillovers affecting other payers. Private insurers typically benchmark their hospital payments on Medicare-approved list prices, called chargemaster rates. Total hospital revenue increased by nearly $80 million at gaming hospitals, translating to approximately $9.6 billion in higher revenues across all 120 gaming institutions.
The Rise and Fall of Outlier Gaming
Origins of the Outlier Program
The turbocharging practice traced back to 1983 when Medicare implemented a prospective payment system for hospital inpatient stays. To incentivize hospitals to admit costly patients, Medicare created the outlier program, paying 80% of costs exceeding deductibles in its standard pricing formula.
However, hospitals discovered they could game this system by inflating treatment costs. If a hospital reported costs of $1,000 instead of $100, CMS would reimburse 80% of the higher amount. Although CMS conducted audits of cost-to-charge ratios, these audits took years to complete. During the delay, CMS continued using outdated ratios based on hospital-reported costs.
Three Catalysts for Increased Gaming
Three developments in the 1990s encouraged hospitals to exploit Medicare’s outlier program more aggressively:
- Increased outlier funding: Medicare lowered the deductible for high-cost outlier payments, expanding the number of patients triggering these payments.
- Bureaucratic delays: Longer lag times to settle cost reports meant CMS deflated hospital charges with increasingly outdated cost-to-charge ratios.
- The Balanced Budget Act of 1997: This legislation reduced Medicare payments for standard procedures while leaving the outlier program largely untouched, creating pressure on hospitals to seek alternative revenue sources.
The Scandal’s Exposure and Response
The gaming scandal first surfaced in October 2002 when a financial analyst revealed Tenet’s heavy reliance on outlier payments. Media reports followed, raising public concerns. A whistleblower lawsuit accused hospitals in New Jersey and Pennsylvania of manipulating the outlier program, prompting Justice Department investigations.
CMS responded swiftly with several policy changes: requiring contractors to use recent cost reports for calculating cost-to-charge ratios, creating frameworks to claw back excess payments, expediting audits, and capping chargemaster rate growth. Outlier payments dropped suddenly in 2004, and federal agencies sued dozens of hospitals for fraudulent billing.
Unfinished Work After Plugging the Loophole
Although CMS effectively closed the loophole, theoretical vulnerabilities remain. CMS doesn’t require hospitals to maintain separate accounts for outlier payment usage, making tracking difficult. The study provided evidence that gaming was far more widespread than the subset of hospitals that faced lawsuits.
Government Oversight Challenges
The $3 billion in excess outlier payments represented a small fraction of CMS’s overall budget ($382 billion in 2002, $1.5 trillion in 2024), explaining why the issue initially escaped regulatory radar. However, contract gaming and fraud contribute to hundreds of billions of dollars in annual federal improper payments. Medicare accounts for 12% of federal expenditures but 34% of improper payments.
Key Takeaways for Healthcare Policy
The research reveals three critical lessons for government agencies and regulators:
First, fraud prevention programs should prioritize for-profit vendors for maximum effectiveness. For-profit hospitals demonstrated stronger incentives to maximize profits for distribution to executives and shareholders, making them more likely to engage in gaming behavior.
Second, CMS and government agencies must account for spillover effects in contract design and pricing. CMS exerts outsized economic influence because private firms follow CMS-established rules. In the outlier scandal, much excess payment came from employer-sponsored insurance, ultimately affecting ordinary taxpayers.
Third, understanding how gaming organizations allocate excess revenues based on ownership structure should inform enforcement priorities. For-profits spent gaming proceeds on executive compensation and stock buybacks, while nonprofits invested in patient care operations. This heterogeneity strengthens the case for focusing fraud prevention resources on for-profit entities.
The study serves as investigative journalism into healthcare system vulnerabilities, offering valuable insights for improving government contract design and protecting taxpayer resources while ensuring quality patient care.
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