How US Healthcare Works, Part 16: How Providers Get Paid

The pricing step in part 13 looked up "the allowed amount from the contract". This part opens up that contract. Every payment method answers one question differently: who carries the risk if care costs more than expected? The answer shapes what providers do, which is why changing how providers are paid has been the main tool of US health policy for forty years.

1. The spectrum of payment methods

Moving down the table moves risk from payer to provider, and changes the incentive: from doing more, toward doing what keeps total cost down. The risk at the bottom is the opposite of the risk at the top. Under capitation, the danger is doing too little.

2. Medicare's physician fee schedule

Medicare pays physicians and other professionals from the Medicare Physician Fee Schedule, which sets a price for each of thousands of CPT and HCPCS codes. Each code has three relative value units (RVUs):

• Work: the physician's time, skill and effort,
• Practice expense: staff, equipment, rent and supplies, which is higher when the service is done in an office than in a hospital, and
• Malpractice: the cost of insurance.

Each RVU is adjusted for local costs by a geographic practice cost index, the three are added, and the total is multiplied by a conversion factor in dollars:

Payment = (Work RVU x Work GPCI + PE RVU x PE GPCI + MP RVU x MP GPCI) x Conversion factor

For 2026, Medicare has two conversion factors: $33.4009 for most clinicians and $33.5675 for those who qualify through participation in advanced alternative payment models. Both include a one-year 2.5% increase set by Congress in 2025.

The relative values are revised regularly, with recommendations from an American Medical Association committee of specialty societies. Because the system is budget neutral, raising the value of one service lowers the conversion factor for all of them, so specialties argue hard over each change. As part 7 described, many commercial fee schedules are written as a percentage of these Medicare rates, so changes here move much of the market.

3. Hospitals: DRGs and APCs

Inpatient stays in traditional Medicare are paid under the Inpatient Prospective Payment System (IPPS): the stay's MS-DRG weight (part 4) times a base rate adjusted for local wages, plus add-ons for teaching hospitals and hospitals serving many low-income patients, plus an outlier payment for exceptionally expensive cases. The hospital keeps the difference if the stay cost less, and absorbs it if it cost more, which is the incentive to discharge efficiently.

Medicare also adjusts hospital payments for quality, for example through the readmission penalties mentioned in part 11.

Outpatient services are paid under the Outpatient Prospective Payment System (OPPS), which groups services into Ambulatory Payment Classifications (APCs), each with a set rate, and packages minor supplies and services into the main one.

The same service can be paid differently depending on where it's done: a clinic visit in a hospital-owned outpatient department often costs Medicare more than the same visit in an independent office. Moving toward site-neutral payment, paying the same for the same service wherever it's done, is a long-running policy debate.

4. Commercial rates

Commercial plans negotiate each contract privately (part 7), and the results are much higher than Medicare's, especially for hospitals. RAND's study of claims from employers and state databases found that in 2022 private plans paid hospitals 254% of what Medicare would have paid for the same services at the same hospitals, with state averages ranging from under 170% to over 300%.

That gap is a big part of why employer premiums are high (part 2), and why hospitals depend on commercial patients to make up for lower Medicare and Medicaid rates.

5. Capitation

Under capitation, the payer pays a provider group a fixed amount per member per month (PMPM) for each member assigned to it, whether or not the member uses care. The group pays for the care its members need, from its own doctors or by buying it from others.

• Professional capitation covers physician services only.
• Global capitation covers nearly everything, including hospital care.

Capitation is common in Medicaid managed care and Medicare Advantage, and in parts of California, where large physician groups take capitation from health plans and manage care themselves. The provider group now does part of the payer's job: it needs its own utilization management, claims processing for referred care, and care management.

6. Value-based contracts

Between pure fee-for-service and full capitation sits a family of arrangements usually called value-based care:

• Accountable care organizations (ACOs): groups of providers that take responsibility for the total cost and quality of care for a population. Medicare's Shared Savings Program lets ACOs keep a share of the savings if spending comes in below a benchmark and quality targets are met, and in some tracks share losses if it comes in above.
• Bundled payments: one budget for an episode of care. From January 2026, Medicare's mandatory TEAM model holds more than 700 hospitals in selected areas accountable for the total cost of five surgical episodes, through 30 days after discharge: hip and knee replacement, hip fracture surgery, spinal fusion, coronary bypass and major bowel procedures. Hospitals that come in under a target price are paid the difference; those over it repay some of it.
• Pay for performance: bonuses or penalties tied to quality measures such as HEDIS (part 11).

Most of these still pay claims fee-for-service through the year and settle up afterwards, in a reconciliation. So the claim systems from parts 12 and 13 still run as before; value-based contracts add a layer of calculation on top.

7. How CMS pays Medicare Advantage plans

Payers are paid too. For Medicare Advantage, CMS pays each plan a monthly amount per member, set in steps:

1. Benchmark. For each county, CMS sets a benchmark from average traditional Medicare spending there, ranging from about 95% to 115% of it, higher in counties with lower spending. The quality bonus from part 11 raises the benchmark for plans with 4 or more stars.
2. Bid. Each plan submits a bid: what it says it needs to cover Medicare's benefits for an average member.
3. Rebate. If the bid is below the benchmark, the plan gets part of the difference as a rebate, which it must spend on extra benefits or lower premiums. Higher-rated plans keep a larger share.
4. Risk adjustment. The payment for each member is multiplied by their risk score, from the CMS-HCC model, which maps the member's documented diagnoses to condition categories. A member with diabetes and heart failure brings a higher payment than a healthy one. CMS finished moving to an updated version of the model, V28, in 2026.

Risk adjustment is why diagnoses matter to Medicare Advantage plans (part 11) and why CMS audits them (part 15). Medicaid managed care plans are paid in a similar way, with capitation rates that each state sets and an actuary certifies.

8. One appendectomy, three ways

The husband's appendectomy from part 3 shows how the method changes the money:

Same patient, same operation, three different amounts, and three different incentives about what happens before and after it.

9. Limits

• Every method has a way to game it. Fee-for-service rewards volume, DRGs reward coding complexity, capitation rewards withholding care, and risk adjustment rewards documenting diagnoses. Each needs its own oversight.
• Prices aren't costs. Fee schedules and DRG weights are set by formulas and negotiation, not measured costs, so some services are very profitable and others lose money.
• Value-based care is still mostly fee-for-service underneath. Most "value-based" contracts add bonuses or shared savings on top of service payments, rather than replacing them.

Remember

Next, in part 17: pharmacy and PBMs, how the drug benefit runs on its own rails, from formularies and rebates to the pharmacy counter.

Sources

• CMS, Physician Fee Schedule
• CMS, Acute Inpatient PPS
• RAND, Hospital Price Transparency Study, Round 5
• CMS, Transforming Episode Accountability Model (TEAM)
• CMS, Medicare Shared Savings Program
• MedPAC, Medicare Advantage program payment system