What’s the issue?
Medicare pays for inpatient services and outpatient services under separate and very different payment systems, which can produce substantially different payment amounts for similar patients receiving similar services. The cost-sharing implications for beneficiaries under the two systems can also vary significantly.
Until recently, the Centers for Medicare and Medicaid Services (CMS) had provided little guidance to hospitals on how to determine whether a particular patient should be treated on an inpatient or outpatient basis. In the absence of guidance–and in response to other CMS efforts to ensure proper payments, including creation of the Recovery Audit Program–hospitals’ shifting of services between inpatient and outpatient settings has had significant implications for the beneficiaries receiving such services and for the Medicare program as a whole.
In 2013 CMS announced the so-called two-midnight rule to clarify 
when it expected a patient to be designated to inpatient status. Under this rule, only patients that the doctor expects will need to spend two nights in the hospital would be considered as hospital inpatients.
This brief describes the perceived need by CMS for the two-midnight rule, how it would work, and the implications for Medicare payment. It also reviews the heated response to the rule and its current status.
What’s the background?
Hospital inpatients are patients who are admitted to the hospital to receive services and are expected to occupy a hospital bed. Outpatients are people who are not admitted to the hospital but are registered as outpatients and receive services. Outpatient services can include planned procedures or care provided in the emergency department. In many cases, the same service could be provided on an inpatient or an outpatient basis, but Medicare pays hospitals very differently for inpatient versus outpatient care.
Payment for inpatient services. For a beneficiary admitted to the hospital as an inpatient, Medicare pays for the care under the inpatient prospective payment system (IPPS). The IPPS provides a single payment for all of the services provided to the beneficiary by the hospital during the inpatient stay, including nursing staff, room and board, use of operating or diagnostic facilities, and drugs. CMS assigns each inpatient admission (or case) to a Medicare severity diagnosis-related group (MS-DRG) based on the diagnosis codes reported by the hospital. The MS-DRG assignment determines how much the hospital will be paid for caring for that patient.
The MS-DRG payment is based on the average cost of caring for Medicare patients with similar diagnoses and takes into consideration complicating conditions that might make it more difficult and expensive to treat a particular patient. Hospitals have discretion about what specific care is provided to each patient, and they generally do not receive additional payment for providing more services or for patients who stay in the hospital longer than usual, although hospitals can receive additional outlier payments to help pay for extremely costly cases. The MS-DRG payment includes all care provided by the hospital during the stay, regardless of the length-of-stay, and any services related to the hospital stay provided by the hospital during the seventy-two hours preceding admission, which can include items such as preoperative testing.
The MS-DRG payment reflects the average length of time that Medicare beneficiaries with similar diagnoses and severity of condition are in the hospital to receive care. An individual patient may end up staying in the hospital for a longer or shorter period than the national average depending on the clinical needs of that particular patient. If the patient has a shorter length-of-stay than the national average, then the MS-DRG payment the hospital receives is more likely to exceed the actual cost of caring for that particular patient than for patients whose hospital stay is closer to the average.