By Christine H. Monahan, Kennah Watts, and Ariel Winter
Like Baskin-Robbins ice cream, hospitals come in a wide variety of flavors. Each of these flavors has unique legal requirements and funding streams that affect a hospital’s overall financial status and operations. Such factors are also likely to shape the development of any reforms aimed at reducing health care spending growth while ensuring that patients can access care. So, it is critical that policy makers, researchers, advocates, and journalists understand these variations.
With this article, we describe how Medicare reimburses different types of hospitals and the implications these distinctions have for ongoing policy debates and future research. Our analysis is distilled from a recent guide we helped develop with colleagues at Georgetown University McCourt School of Public Policy’s Center on Health Insurance Reforms and Blood Cancer United.
Breaking Apart The “Medicare Rate”
Medicare rates are often used as a benchmark to which commercial rates are compared. This comparison can inadvertently give the impression that Medicare pays a single, uniform amount to all hospitals for the same service or inpatient stay. In reality, a hospital’s payments are far more individualized. For example, as we explain below, targeted supplemental payments represent a large share of Medicare payments for many hospitals.
The general intent of Medicare’s complex payment rules is to accommodate the range of costs and circumstances different hospitals can face. In many ways, these rules are significantly more rational and transparent than payment variations in the commercial market, where hospital and health system negotiating power and, to a lesser extent, the negotiating power of private payers, largely dictate prices.
However, Medicare’s current rules and funding levels are not necessarily all well-targeted. Some may be contributing to the growing divide between “have” and “have not” hospitals. Particularly as more policy makers contemplate commercial-market reforms that reference Medicare payment rates, such as hospital price caps, or rely on Medicare classifications to distinguish which hospitals a policy reaches, it is important to understand how Medicare’s system operates.
How Medicare Hospital Payments Can Vary Across Hospitals
Traditional (fee-for-service) Medicare pays most hospitals under the inpatient prospective payment system (IPPS). This system makes a fixed payment for each inpatient discharge based on the patient’s diagnosis-related group (DRG), reflecting their illness severity, complexity of service, and resource use. Hospitals receive a different base payment for each DRG, adjusted for the typical wages of hospital employees in each geographic region based on the area wage index.
On top of a base payment, IPPS hospitals may receive supplemental payments. For example, teaching hospitals can receive direct and indirect graduate medical education (GME) funds to cover the cost of training medical residents. Hospitals that serve a higher share of low-income Medicare and Medicaid patients may receive disproportionate share hospital (DSH) payments. According to the Medicare Payment Advisory Commission (MedPAC), GME, DSH, and other supplemental payments comprised nearly 17 percent of total IPPS payments in fiscal year (FY) 2023. The relative importance of supplemental IPPS payments varied widely by type of hospital. For example, supplemental payments accounted for almost 22 percent of total IPPS payments for sole community hospitals, a designation that offers significant payment enhancements to geographically isolated hospitals. By contrast, supplemental payments comprised less than 6 percent of total payments for hospitals that were neither DSH hospitals nor teaching hospitals.
Non-IPPS hospitals have their own special Medicare payment rules. For example, critical access hospitals, freestanding children’s hospitals, and 11 statutorily identified PPS (prospective payment system)-exempt cancer hospitals are paid at or slightly above their actual costs. Cost-based reimbursement generally results in higher payments than these hospitals would receive under the IPPS, which was designed to limit hospital cost growth. Other specialty hospitals—including rehabilitation, long-term acute care, and psychiatric hospitals—have their own unique prospective payment systems tailored to the care they provide.
For outpatient care, traditional Medicare pays most hospitals, including many not subject to the IPPS, under the outpatient prospective payment system (OPPS). Some hospitals, such as PPS-exempt cancer hospitals, benefit from special rules that can result in higher OPPS payments. Critical access hospitals receive cost-based reimbursement for outpatient services.
Medicare Hospital Classifications At The Heart Of Current Policy Debates
How Medicare classifies and pays hospitals has ramifications far beyond the Medicare program. Below are three examples highlighting the relevance of these distinctions in current policy debates at the state and federal level.
Rural Hospitals
Medicare provides special treatment to rural or geographically isolated hospitals to counteract the financial and operational challenges they face. Nonetheless, the financial circumstances of rural hospitals can vary significantly, both across and within different types of rural hospitals. For example, our analysis of data from 2023 Medicare cost reports revealed that the aggregate operating margin of rural referral centers is five time greater than that of low-volume hospitals (5 percent versus 1 percent). A recent analysis by Brown University’s Center for Advancing Health Policy Through Research found substantial variation in overall operating margins between independent and system-affiliated critical access hospitals (0.4 percent versus 7.2 percent).
Evaluating a hospital’s financial health requires more than just one metric, but these distinctions indicate that rural hospitals are far from monolithic. Our guide helps reveal many other ways they can vary. Compare, for example, the aforementioned low-volume hospitals and rural referral centers. To qualify as a low-volume hospital, a hospital must be located a minimum distance from another hospital and have relatively few discharges. Qualifying hospitals receive an upward adjustment on their IPPS rates, but no other special treatment under Medicare. As of 2023, approximately three-quarters of low-volume hospitals were located in rural areas (that is, outside of a metropolitan county) and nearly 30 percent were government-owned. Both percentages substantially exceed national averages, with approximately one-third of US hospitals located in rural areas and just one-fifth government-owned.
Rural referral centers, in contrast, are high-volume hospitals that either are in rural areas or have a large share of Medicare patients traveling long distances. They do not receive supplemental IPPS payments but access many other benefits, including uncapped Medicare DSH payments and special rules to facilitate participation in the 340B program. Participating in 340B allows them to acquire outpatient drugs at steep discounts to improve access for uninsured patients while also generating additional revenue when they provide 340B drugs to insured patients.
Additionally, rural referral centers can be treated as rural for one purpose while also being treated as urban for a different purpose. If they are located in an urban area (that is, within a metropolitan county), they can apply to be treated by Medicare as if they were in a rural area, which opens the door to additional funding. At the same time, they can receive an urban wage index, which results in higher IPPS payments. In short, they can leverage Medicare’s payment system to maximize their revenue. Our analysis found that only one-quarter of rural referral centers were geographically rural and only 13 percent were government-owned—lower percentages than national rates. Other research has found that a majority of urban hospitals that have reclassified as rural for some benefits were simultaneously paid using the urban wage index.
These distinctions suggest that state policy makers may want to be mindful in how they identify rural hospitals for new supplemental payments, such as Rural Health Transformation Program funding, or when crafting other reforms. Rather than using existing hospital designations, policy makers may want to explore strategies that look directly at hospital financial performance or measures of financial distress.
Federal policy makers also may want to revisit existing rural hospital designations and payment rules to reduce opportunities for a hospital to be dually classified as both rural and urban, and ensure that funds are well-targeted to current needs. At both the state and federal level, policy makers may find that they must grapple with whether they have a responsibility to ensure that all hospitals in an area remain open or to ensure that a sufficient number of hospitals remain financially viable so that patients have access to care.
Medicare DSH
Medicare provides additional payments to IPPS hospitals that serve a high share of low-income Medicare and Medicaid patients. These payments include DSH operating and capital payments, as well as a separate uncompensated care payment for DSHs.
Before FY 2014, most DSH payments were DSH operating payments—upward adjustments to a hospital’s IPPS operating payments, which generally cover labor and supplies—while a small proportion helped cover capital costs for large, urban hospitals. As of FY 2014, to account for the Affordable Care Act’s (ACA’s) coverage expansion, Congress substantially reduced DSH operating payments to 25 percent of the total under the pre-FY 2014 formula and added a separate uncompensated care payment.
For the uncompensated care payments, the Centers for Medicare and Medicaid Services estimates what Medicare would have paid in total under the original DSH formula, excluding 25 percent, and reduces this amount by the percentage change in the national uninsurance rate since 2013. Medicare then distributes the resulting amount across DSHs based on the share of uncompensated care they provide. Collectively, these payments totaled approximately $12.2 billion and reached 45 percent of US hospitals in FY 2023.
However, Medicare DSH participation is likely to decline in the coming years. As millions of Americans lose Medicaid coverage, fewer hospitals are likely to meet the “DSH patient percentage” threshold to qualify for DSH and uncompensated care payments, even though they may serve a growing number of uninsured patients.
A hospital’s DSH patient percentage is the sum of the share of its Medicare inpatient days provided to patients eligible for Supplemental Security Income benefits and the share of its total inpatient days provided to non-dually eligible Medicaid patients. Hospitals with a DSH patient percentage exceeding 15 percent are eligible to receive DSH operating and uncompensated care payments. Because the number of people with Medicaid will probably decline in the future, the proportion of hospital inpatient days provided to Medicaid patients will also likely fall, which will make it harder for hospitals to meet the threshold to receive DSH and uncompensated care payments.
Reductions in Medicaid coverage will also affect the level of DSH payments that the remaining DSH-eligible hospitals receive. DSH operating payments could go down for hospitals that treat fewer Medicaid patients, since the payment formula incorporates a hospital’s DSH patient percentage. In addition, hospitals that lose their eligibility for DSH payments will no longer be able to receive uncompensated care payments, even if their uncompensated care costs increase, because only DSH hospitals may receive uncompensated care payments. However, remaining DSHs may benefit from higher uncompensated care payments if the uninsured rate increases.
For most types of hospitals, eligibility for the 340B program is also contingent on receiving specified levels of Medicare DSH payment adjustments. This means fewer hospitals are likely to qualify for 340B as Medicaid enrollment declines in the coming years. If this happens, the hospitals will lose another meaningful (but actively debated) revenue source, while current and newly uninsured patients could see diminished access to discounted drugs.
These potential changes underscore that current eligibility rules for the Medicare DSH were designed during passage of the ACA, with national uninsured rates expected to decline and remain relatively low and Medicaid coverage expected to increase. If policy makers aim to maintain safety-net services for low-income patients––whether uninsured or covered by public insurance––they must recognize the likely impacts of recent policies on Medicare DSH and 340B hospitals.
Site-Neutral Payment Exemptions
Both Medicare and commercial plans typically pay more for the same service when it is provided in a hospital outpatient department than a freestanding physician’s office. To promote greater efficiency and reduce the incentive for hospitals to acquire physician practices, Medicare has begun to lower hospital payment rates for certain settings and services so that the total amount paid is the same regardless of the site of care. MedPAC has recommended expanding “site-neutral” payments to all outpatient services that can be safely and effectively provided outside of a hospital.
There is significant interest among state-level policy makers in adopting reforms that complement or build on Medicare’s site-neutral policies. These range from laws that prohibit hospitals from billing certain outpatient facility fees to commercial site-neutral payment reforms, such as the Fair Pricing Act in New York, under which total payment levels would be set so that hospitals would no longer be paid more than freestanding offices for specified services.
In addition to identifying the scope of services and settings to address, policy makers must determine whether to extend their policies to all hospitals or provide for some exceptions. Several categories of hospitals are unaffected by Medicare’s site-neutral payment reforms. Those include hospitals not paid under the OPPS (for example, critical access hospitals), those explicitly exempt from site-neutral payment policies (for example, rural sole community hospitals and rural emergency hospitals), and those held harmless from policies that would reduce their payments for outpatient care (for example, freestanding children’s hospitals and PPS-exempt cancer hospitals). Whether these exceptions make sense for the commercial market warrants further research.
Conclusion
Effective, targeted policy reform will require thoughtful consideration of hospital classifications and financial operations. Medicare’s payment structures play a critical role both in the revenue they provide hospitals and as the foundation for other policies at both the federal and state level. Policy makers can use our guide to better understand these payment structures, as well as other federal requirements and classifications that apply to hospitals. This knowledge should guide their proposals for reform.
Authors’ Note
The Center on Health Insurance Reforms (CHIR) published What to Ask (About) a Hospital in partnership with Blood Cancer United, with funding from Arnold Ventures. Ariel Winter provided consulting services to CHIR for this project.
Christine H. Monahan, Kennah Watts, and Ariel Winter “What Medicare Hospital Payment Classifications Mean For Policy Making” January 5, 2026, https://www-healthaffairs-org.proxy.library.georgetown.edu/content/forefront/medicare-hospital-payment-classifications-mean-policy-making. Copyright © 2026 Health Affairs by Project HOPE – The People-to-People Health Foundation, Inc.
