Posted: 10/13/2017

It all started with emergency department (ED) patients who couldn’t be fully evaluated within the usually brief ED time frame. With full waiting rooms and open front doors, hospitals had to make room for new emergency patients, often by moving those still being evaluated to another location. Before the days of observation units these patients were typically placed in “holding areas” or med/surg beds as outpatients mingled with inpatients, where their “ED evaluation” continued, but now at the pace of an inpatient rather than the frenetic pace of the ED. The Centers for Medicare and Medicaid Services (CMS) defined this as “observation care” but initially did not reimburse for it. Lacking the ability to be paid for room and board for outpatients in beds, hospitals could bill Medicare Part B for diagnostics and other Part B services but had to swallow the cost of providing outpatient bedded hospital care outside the ED.

When the Inpatient Prospective Payment System (IPPS) with its Diagnosis Related Groups (DRGs) was implemented in 1983 hospitals faced reductions in payment for inpatients. Some found that by keeping patients in observation they could generate more revenue billing Part B than by admitting them. Long observation stays – up to a week or more – became common. In 1996, in the Medicare Hospital Manual, Publication 10, CMS responded to this practice by stating that: “The purpose of observation is to determine the need for further treatment or for inpatient admission. Thus, a patient in observation may improve and be released, or be admitted as an inpatient…Due to evidence of abuse, such as beneficiaries being held in observation for days or weeks, observation services will be limited to a maximum of forty-eight (48) hours…Observing a patient for up to 24 hours should be adequate in most cases.” First Coast Service Options, Inc. (Florida Medicare Administrative Contractor) stated it explicitly in its LCD for Outpatient Observation Services (L13798): “Outpatient observation services are not to be used as a substitute for medically necessary inpatient admissions.” Nonetheless, unsure when it was OK to admit from observation, many patients remained in observation beyond 24 or even 48 hours.

In 1998, the Work Plan of the Office of Inspector General (OIG) of the Healthcare Finance Administration (HCFA, the precursor of the Department of Health and Human Services, HHS) addressed observation abuse by including an effort to: “determine the financial impact on the Medicare program and its beneficiaries of miscoded outpatient observation stays…The Prospective Payment Assessment Commission identified this as a problem area in 1994, because many of the observational stays should have been coded as inpatient admissions to the hospital. HCFA has subsequently changed its policy to deny coverage for observation stays longer than 2 days.”
On August 1, 2000, the Outpatient Prospective Payment System (OPPS) was rolled out. Payment for outpatient services was based on an APC (Ambulatory Payment Classification), a bundled payment similar to an inpatient DRG, except that while the DRG was all-inclusive, hospitals could bill for Part B services not included in the APC. Payment for observation services, however, was always “packaged” with the associated services (generally the ED visit or outpatient surgery). The result: No payment for observation until 2002 when CMS began to allow payment for observation by bundling observation with the facility fee for the ED visit. But payment was available for only 3 diagnoses: chest pain, asthma, and heart failure. (It never made sense to me at the time that hospitals were paid for just 3 diagnoses when the services provided to all observation patients were comparable.)

It wasn’t until 2007 that CMS allowed payment for observation for all diagnoses, but the purpose of observation didn’t change: It was clearly intended to be a brief period to complete an ER evaluation or short term treatment (such as intravenous fluids) that would enable the physician to determine whether the patient could be safely released or required admission. For surgical patients, observation served the same purpose but could be used only for acute clinical problems that complicated standard recovery from outpatient surgery. Here, too, payment was packaged – this time into the APC for the surgical procedure.

Then along came the RACs (Revenue Audit Contractors – a demonstration project in 2005-2008 and a national program beginning in 2010) that found fertile ground in recouping Part A payments from hospitals for short inpatient admissions that the auditor felt should have been classified as outpatients based on an ambiguous definition of inpatient care that relied heavily on the physician’s assessment of the severity of illness and risk of an adverse outcome. The aggressiveness with which the RACs recouped money and the subjectivity of the standard lead to a massive number of appeals, a majority of which were successful at the Administrative Law Judge level, and the freezing up of the appeal system under the weight of millions of appeals on the dockets of 65 judges. The OIG got on the bandwagon in 2012 when its Work Plan included, “Observation Services During Outpatient Visits”. It stated, “We will review Medicare payments for observation services provided by hospital outpatient departments to assess the appropriateness of the services and their effect on Medicare beneficiaries’ out-of-pocket expenses for health care services...”

But wait a minute…in 2006 the OIG was investigating hospitals for underuse of observation but in 2012 it was just the opposite. So hospitals that had followed the guidance to reduce the use of observation were now, without any warning, being penalized for doing so based on a standard that, as subjective as it was, was also all too often incorrectly applied by the auditors.
The important concept is that prior to the two-midnight rule observation was basically an extension of the ED visit. The facility fee for the ED evaluation was packaged with payment for observation and although they were still able to bill for other Part B services (i.e., diagnostics and outpatient treatments) that were provided, hospital revenue for observation was the same regardless of the length of the stay. This put pressure on hospitals to make observation care more efficient and observation or clinical decision units (CDUs) sprung up like daisies.

In 2013 the two-midnight rule changed all this. Now observation care was no longer an extension of the ED visit. It was no longer oriented toward the rapid decision to admit or release. The rule based the admission decision on the expectation (or actuality) of a two-midnight stay, and observation was expected to end with admission or release prior to the second midnight of medically necessary hospital care. Outpatient observation had indeed become a substitute for what had previously been most short inpatient stays.

Yes, a patient can still be admitted based on the physician’s well-documented “expectation” of care surpassing two midnights. When evaluating patients, physicians of course considered the acuity of their patient’s illness and the potential for a dire outcome but they have found it difficult to understand and master the documentation required for the two-midnight length of stay expectation. This is just not how physicians are trained to think, nor are they particularly comfortable in this role. And although we teach physicians to “Think In Ink”, at the time of admission most physicians are thinking about the patient’s clinical needs and not what an auditor may want to see months or years later. This is not meant to defend weak documentation; it is just to understand it.

Hospitals have expended massive resources to educate physicians (and non-physician providers) on the critical need to document the clinical condition and thought process responsible for the length of stay expectation that drives their decision to admit. But lacking compelling documentation, the clock and the calendar have ruled.

In 2016, when CMS designated observation as a comprehensive APC (C-APC), it began to bundle all Part B services - the bed charge, all diagnostics, and all therapeutics with the exception of inpatient only procedures - into a single payment, making hospital reimbursement for observation indistinguishable from inpatient DRG payment except that the C-APC often paid the hospital half to two-thirds less than the respective DRG.

Observation had in most cases has become the new de facto one-day stay.

Thanks to Stefani Daniels and Marianne Raimey for “A Brief History of Observation” in The Leaders Guide to Hospital Case Management, 2004.