American Journal of Law & Medicine

Provider sponsored organizations and provider service networks - rationale and regulation.(Health Care Capitated Payment Systems)


When a provider accepts capitation from a health plan(1) for a pool of patients, it assumes risk from the plan. The risk is that the cost of furnishing health care needed by the patients may exceed the funds paid to the provider by the health plan. There are several levels of risk. The first level is capitation arrangements for services rendered by the provider. The next level is capitation arrangements where the provider assumes risk not only for its own services, but also the services of other providers. As the number of services of other providers for which risk is assumed increases, the risk-taking provider comes closer and closer to assuming risk for the entire benefits package. At some point, it makes sense for the risk-taking provider to become a licensed health plan. As providers become more capable in managing large amounts of risk, they become more interested in organizing health plans.

As provider interest in developing health plans grows, an important public policy question arises: whether legislation should build on that interest by facilitating the development of health plans owned and operated by providers. As of the date of this writing, the federal government is considering exactly that kind of legislation. Proposed budget reconciliation bills in Congress(2) would facilitate the formation of provider sponsored organizations (PSOs)(3) and provider service networks (PSNs).(4)

As this Article is written, these budget reconciliation bills are the subject of negotiations between President Clinton and the Republican leadership of Congress. When the Article is published, the negotiations may still be continuing, the legislation may have been passed, or the legislation may have been rejected. If passed, then a rulemaking process to develop standards for PSOs and PSNs has begun. If negotiations are continuing, the issue of whether federal legislation should facilitate the formation of PSOs will still be a topic in the dialogue. If rejected, whether there should be such legislation will continue to be debated and will probably be the subject of future proposals at the federal and state level.

This Article discusses current legislative proposals, the rationale for legislation that would facilitate the formation of PSOs and PSNs, and issues that are likely to be addressed in any legislation and supporting regulations meant to facilitate their formation. The Article argues in favor of the legislation, and makes recommendations about how these legislative and regulatory issues should be handled.(5)


The proposed legislation consists of three budget reconciliation bills. One of these bills, House Bill 2491, was passed by Congress but vetoed by President Clinton on December 7, 1995. This bill was initiated by the Republican leadership in the House of Representatives (Republican bill). Another bill, House Bill 2530, submitted to the House of Representatives by a coalition of conservative Democrats and informally known as the "Blue Dog" bill. A third bill proposed by President Clinton, has not been formally submitted to Congress (Clinton's bill).(6)

All three bills would create a new Part C option(7) for Medicare patients as an alternative to Parts A and B of the Medicare program and the existing Part C. Currently, Parts A and B are fee-for-service (FFS) systems, with Part A covering hospital services(8) and Part B covering physician services,(9) which allow patients an unlimited choice of providers. Patients must pay a premium to the government to receive services under Part B, and they are subject to the copayments, deductibles, and limits on coverage of both Parts A and B.

As an alternative, under the existing Part C portion of the Medicare statute, a patient may choose to be covered by a qualified health maintenance organization (HMO) or competitive medical plan (CMP) that operates where the patient resides.(10) These HMOs and CMPs underwrite the entire Medicare benefits package, but they may restrict the choice of providers available to Medicare patients. This alternative is informally known as the Medicare risk contract program, because the HMOs and CMPs assume the risk that Medicare patients will need medical services. The Medicare risk program pays a fixed premium to HMOs and CMPs selected by patients. In return, the HMOs and CMPs must provide the patients with the full Medicare benefits package. However, to the extent that HMOs can provide the package (including a reasonable profit) for less than the premium, they must provide additional benefits to the patients.(11) Thus, an HMO or a CMP may provide more benefits to Medicare patients than they would receive under the FFS program of Parts A and B.

The new Part C option is similar in concept to the existing Part C Medicare risk program. Medicare would allow patients to select a health plan and would pay the health plan a fixed premium. However, the Republican bill and the Blue Dog bill would replace the existing Medicare risk contract program and would expand the types of health plans available to Medicare patients (Part C health plans). Among the types of health plans that Medicare patients could select would be PSOs, preferred provider organizations (PPOs), traditional indemnity plans, and others.(12) In addition, health plans could offer more benefits than the Medicare benefits package and could charge an additional premium for them.(13) Some of these plans may allow patients freedom of choice of providers.

By allowing such wide choice, Part C in the Republican bill and in the Blue Dog bill are similar to the Federal Employees Health Benefits Program (FEHBP).(14) That program allows federal employees to select from a wide variety of health plans for their coverage. The federal government makes a fixed contribution toward the premium. The object is to stimulate competition over price and quality among health plans by giving the employees a wide choice of plans from which to select.

In contrast, Clinton's bill modifies the Medicare risk contract program in the existing Part C by adding a limited number of new choices for Medicare patients. The new choices include PSOs, PPOs, other managed care plans that are similar to CMPs and meet requirements to be developed by the Secretary of the Department of Health and Human Services (HHS),(15) and partial risk contracts.(16) These adjustments are much less far reaching than the program that would be introduced by the other two bills.

All three bills require Part C health plans to be licensed under state law.(17) However, under the Republican and Blue Dog bills, the states would have to apply standards developed for Part C health plans by the federal government, otherwise the state licensing requirements would be preempted.(18) Clinton's bill would preempt state solvency requirements for PSOs that did not conform to federal standards.(19) The bills set forth standards for how Part C health plans must be operated. These standards are primarily for the protection of Medicare patients, and include requirements for coverage of services, quality assurance, credentialing and retention of providers, fairness in marketing, nondiscrimination among applicants for coverage, utilization review procedures, grievance procedures, health plan solvency, and others.(20) The bills also have standards and procedures for how health plans would be paid.

While the bills set forth broad standards, more detailed standards would be developed by regulations. HHS would have responsibility for drafting interim regulations that would be used until final regulations could be established.(21) The bills require HHS to consult with one or more outside parties in developing the regulations.(22) All of the bills require consultation with the National Association of Insurance Commissioners (NAIC).(23) HHS would then accept or modify these standards as it saw fit, and presumably would then finalize them using the public notice and comment procedures of the Federal Administrative Procedures Act.(24)

The scope of the regulations that would be developed under the Republican bill and the Blue Dog bill is very broad. They would substantially replace the regulatory structure for the existing Medicare risk contract program. Under Clinton's bill, much of the existing regulatory base for the Medicare risk contract program is retained, and would be modified as needed to accommodate the new choices for Medicare patients.(25)


A PSO is one kind of health plan that could be selected by Medicare beneficiaries.(26) PSOs would be owned and operated by providers, including physicians, hospitals, and others.(27) A single provider could own and operate a PSO, or groups of affiliated providers could do so.(28) The provider or affiliated providers would be required to provide a substantial part of the Medicare benefits package through the PSO.(29) In other words, the providers who own and operate the PSOs would be required to have the capacity to deliver a substantial part of the Medicare benefits package without contracting with other providers for services to the PSO.

That PSOs would be owned and operated by providers with the capacity to deliver health care without purchasing services from other providers distinguishes a PSO from other kinds of health plans. Most health plans are financial intermediaries as opposed to health care providers. That is, the health plan receives premiums and then buys services needed by plan members from health care providers. Most of the operating assets of the health plan are concentrated in administrative capacity, and other assets are generally invested in financial instruments of various kinds. In contrast, providers who own and operate a PSO have their investments concentrated in health care delivery.(30)

The capacity of the owners of a PSO to deliver care is the basis for differences in the way PSOs, as distinct from other Part C health plans, would be regulated. The major differences would be in solvency standards, tests for assuring that Medicare patients would receive the same quality of care as other patients, tests to assure that the health plan has adequate operating experience, rate calculation, and the treatment of tax exempt hospitals.


All three bills would require that separate solvency standards be developed for PSOs.(31) Solvency standards are designed to assure that health plans remain financially sound and capable of meeting their obligations to pay for or provide the health care services needed by their members. They typically require health plans to maintain a minimum net worth or capitalization. They may also require health plans to maintain a restricted reserve fund that is available to pay for unanticipated claims, to contribute to a state guaranty fund maintained to fulfill the obligations of insolvent HMOs, or to meet other requirements. The factors that would be considered in developing the PSO solvency standards differ from bill to bill. However, they are generally directed at recognizing factors that would enable PSOs to meet solvency requirements with a smaller amount of liquid financial resources(32) than other kinds of health plans.(33)

The rationale for different solvency standards for PSOs is that they have the capacity to deliver care, and therefore are able to weather unexpected patient needs. In contrast, most health insurers are financial intermediaries that must purchase any unexpected amounts of health care services needed by their beneficiaries. Therefore, PSOs would need fewer liquid assets to pay for unexpected amounts of health care than would other kinds of insurers. In addition, the assets of provider-owners of PSOs would be concentrated in health care delivery, such as land, buildings, equipment, and personnel. Although these assets would enable PSOs to respond to unexpected demand for services, they are often not recognized as assets in conventional solvency standards for insurers because they tend to be illiquid.


The delivery of care by PSO owners is also the basis for a different test to assure that Medicare patients receive the same level of quality as patients covered under other types of health plans. The Medicare statute currently requires that Medicare and Medicaid patients constitute no more than fifty percent of the enrollment of HMOs and CMPs qualified to enroll them.(34) The purpose is to assure that the quality of the HMOs and CMPs is competitive with private sector health plans; this is achieved by requiring HMOs and CMPs to compete successfully for private sector patients.

The rationale for eliminating the requirement is that the primary business of PSO owners is delivering health care, and they generally compete for and provide care to private sector patients, not just Medicare patients. The provision of care to PSO patients would be one dimension of services rendered by these providers. Therefore, the rationale for the fifty percent enrollment rule ceases to apply.

The Republican bill does not include the requirement for any Part C health plan. The other two bills retain the requirement for Part C health plans including PSOs,(35) but modify it. The Blue Dog bill exempts PSOs whose commercial payments to participating providers exceed Medicare payments.(36) Clinton's bill retains the rule at least until HHS finalized quality assurance regulations, and perhaps beyond that time, depending on the approach taken in those regulations.(37) It also allows waivers for Part C health plans that operate in areas where more than fifty percent of the population is Medicare eligible, the first three years of operation of Part C plans owned by government entities that are making a good faith effort to enroll non-Medicare patients, Part C health plans operating in rural areas, contractors with good past records, and situations where HHS would determine that it was in the best interests of beneficiaries to waive the requirement.(38)


The current Medicare risk program also requires that a qualifying HMO or CMP have at least 5000 members if urban, but may have less than 5000 if rural (these can be private sector patients).(39) The purpose of this requirement is to assure that the HMO or CMP has sufficient operating experience and will be able to handle Medicare patients. The owners of PSOs are providers that have experience in managing a broad spectrum of patients, therefore the premise of this standard does not apply.

The Republican bill and the Blue Dog bill would reduce the minimum enrollment for PSOs to 1500, and 500 if primarily rural.(40) In addition, the minimum enrollment requirement could be waived for any Part C plan for a three-year period.(41) The Blue Dog bill also allows a waiver beyond three years in areas where a low percentage of Medicare patients selected a Part C health plan.(42) Clinton's bill does not eliminate this requirement for PSOs, but allows waivers for Part C plans in rural areas or in such situations as HHS may determine is in the best interests of the beneficiaries.(43) The minimum enrollment would be reduced to 1500 for plans with partial risk contracts.(44)


The Republican bill and the Blue Dog bill would allow a difference in the way that PSOs calculate rates in comparison to other Part C health plans. Clinton's bill does not have any provisions for PSOs in the rate calculation area.

Under the Republican bill and the Blue Dog bill, premiums charged by Part C health plans may include coverage for the services required under the Medicare benefits package and nonrequired supplemental services offered by the plan.(45)

Under the Republican bill, the portion of the premium attributable to the required services can not exceed an adjusted community rate calculated for the plan by HHS.(46) The adjusted community rate is calculated pursuant to the method in [sections] 1302(8) of the Public Health Service Act, with the exception of paragraph C of that section, or as estimated by HHS.(47) The community rate calculated is then adjusted to reflect differences in the utilization characteristics of the individuals in the Part C plan and commercial enrollees in the same plan.(48) If data were not available to make those adjustments, then HHS could use data about the differences between the utilization characteristics of Medicare patients in other Part C plans or other Medicare patients and the utilization characteristics of the rest of the population.(49) However, HHS could base the adjusted community rate for PSOs on data from the general commercial marketplace or, during a transition period, on costs incurred by the PSO in providing its health plan.(50) This provision allows PSOs more flexibility in rate calculation, and that flexibility could help new PSOs become established more easily.

Under the Blue Dog bill, the portion of the premium attributable to the required benefits package can not exceed the Medicare Choice capitation rate.(51) The Medicare Choice capitation rate is calculated by taking the annual per capita rate of payment described in [sections] 1876(a)(1)(C) of the Social Security Act(52) for the year 1995, and then increasing it pursuant to a formula.(53) There is no differences between PSOs and other Part C health plans in this process. However, there is a difference in calculations for whether the Part C health plan is able to provide the required benefits below the Medicare premium. For Part C health plans generally, the actuarial value of the minimum benefits package, which is subtracted from the Medicare premium to determine any excess amount that must be used to provide additional benefits or for another purpose, is calculated based on the adjusted community rate described in [sections] 1302(8) of the Public Health Service Act.(54) However, for PSOs, the adjusted community rate may be calculated using data in the general commercial marketplace or, during a transition period, based on the costs incurred by the PSO in providing the product.(55)


Many hospitals are exempt from federal taxation under [sections] 501(c)(3) of the Internal Revenue Code (I.R.C.) of 1986. However, tax regulations bar many kinds of financial arrangements between tax-exempt hospitals and physicians or for-profit entities where the earnings or assets of the hospital accrue to the benefit of the physicians or for-profit entities. Accrual of such benefits is called private inurement or an impermissible private benefit. When such benefits accrue, the Internal Revenue Service may terminate the hospital's tax exemption. Because physicians are expected to participate as owners in PSOs, and because PSOs may have to be for-profit entities in order to accommodate physician ownership, the bar against private inurement and the conferral of impermissible private benefits is of concern to not-for-profit hospitals that also want to participate in such PSOs.

The Republican bill has a provision which provides that a tax-exempt hospital would not lose its tax-exempt status simply because it participates in a PSO.(56) This provision provides assurance to not-for-profit hospitals that they can participate in PSOs where physicians or other for-profit entities are among the owners and not lose their exemption. However, the provision also clarifies that financial arrangements between the hospital and the physicians in the PSO could not result in any hospital earnings being channeled to the physicians--that would still be considered private inurement, and probably the conferral of an impermissible private benefit as well. Therefore, hospitals would not be allowed to contribute equity out of proportion to their voting rights in the management of the PSO, physicians could not gain returns on their investment in amounts which are disproportionately large given the hospital investment, and physicians could not be compensated for work done for the PSO, either as administrators or as health care-givers, in amounts that cannot be justified in terms of the value provided.


The Medicare/Medicaid antifraud and abuse laws bar any provider from offering remuneration to gain the patronage of Medicare patients.(57) In its most obvious form, the laws prohibit a hospital from offering money to a physician to admit Medicare patients in the hospital, or a specialist physician from offering money to primary care physicians in return for the referral of Medicare patients. The scope of these laws is extraordinarily broad, and questions have been raised about how they affect financial arrangements between managed care health plans and providers, and between health care delivery networks and providers where the providers are sharing substantial financial risk.

The Republican bill would help resolve these questions by creating an exception for any remuneration between a Part C health plan organization and an individual or entity providing items or services or any combination thereof pursuant to a written agreement.(58) As used in this part of the bill, the term organization appears to mean a federally qualified HMO. It is not clear whether the Part C health plan would have to be a federally qualified HMO, or whether it could be a FFS plan, such as a PPO. The exemption may be limited to organizations in order to restrict it to capitation arrangements, and to prevent the exemption from being applied to FFS arrangements such as those used in PPOs.

The Republican bill would also create an exception for written agreements between an organization and any individual or entity where the agreement places the individual or entity at substantial financial risk for the cost or utilization of items or services, or a combination thereof, which the individual or entity is obligated to provide.(59) Agreements involving substantial financial risk include fee withhold arrangements, capitation, incentive pool arrangements, per diem payments, or any other similar risk arrangement. Again, in this context, organization appears to mean a federally qualified HMO.

The rationale for these provisions is that the types of arrangements permitted are designed to reduce costs, not to facilitate overutilization or allow substandard providers to gain entry to a market. …

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