The Medicare prospective payment system (PPS) was designed to create financial incentives for providers to contain costs, but it also places them at financial risk. The system includes provisions to mitigate the risk, but, because they may have limited effectiveness in the case of psychiatric services, specialty psychiatric hospitals and eligible psychiatric units of general hospitals are exempt from the system. A variety of payment options have been proposed to integrate these facilities into the PPS. Empirical studies on the financial risk entailed by these options have focused on their impact on risk in the long run. Our study uses a broader framework to evaluate their impact on short-run as well as long-run risk. We use Medicare discharge data for 1985 to simulate alternative PPS payment options under the assumption that treatment patterns remain fixed. Our results suggest that under current PPS payment rules, risk would be high for psychiatric specialty hospitals. However, alternative options exist, which could substantially reduce their exposure to risk, while maintaining incentives to contain costs.

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