How Medical Costs Are Calculated
A comprehensive explanation of the payment systems, data sources, and formulas behind every cost estimate on MedicalCosts.info.
Table of Contents
- Medicare Physician Payment (RVU Methodology)
- The Conversion Factor
- Geographic Practice Cost Indices (GPCIs)
- Commercial Insurance Rate Estimation
- Hospital Outpatient (OPPS) Rates
- Ambulatory Surgery Center (ASC) Rates
- Drug Pricing (NADAC, AWP, WAC)
- DRG-Based Hospital Stay Costing
- Geographic Cost Variation
- Limitations & Caveats
1. Medicare Physician Payment (RVU Methodology)
The Medicare Physician Fee Schedule (PFS) is the foundation of physician payment in the United States. Established by the Omnibus Budget Reconciliation Act of 1989 (OBRA '89) and implemented in 1992, the Resource-Based Relative Value Scale (RBRVS) assigns a numeric value to every medical service based on the resources required to provide it.
Every CPT (Current Procedural Terminology) and HCPCS (Healthcare Common Procedure Coding System) code in the fee schedule has three components of Relative Value Units (RVUs):
The Three RVU Components
Work RVU (wRVU)
Accounts for the physician's time, technical skill, physical effort, mental effort, and judgment required. Determined by surveys of physician practice time and intensity, reviewed by the AMA's Relative Value Scale Update Committee (RUC).
Practice Expense RVU (PE RVU)
Covers clinical staff wages, medical equipment, supplies, and office overhead. Calculated separately for facility settings (hospital, ASC) and non-facility settings (office/clinic), because the provider's practice expense is lower when a facility bears the overhead costs.
Malpractice RVU (MP RVU)
Reflects the cost of professional liability insurance, which varies by specialty and procedure risk. A neurosurgeon's malpractice RVU is higher than a dermatologist's for comparable work.
The total RVU is the sum of all three components. For example, CPT 99213 (established patient office visit, low-moderate complexity) has approximately:
2. The Conversion Factor
The Conversion Factor (CF) translates RVUs into dollar amounts. It is set annually by CMS through the Federal Register rulemaking process.
The Medicare Payment Formula
For CY 2026, the national conversion factor is $33.40.
The conversion factor has changed over time. Congress has repeatedly intervened to prevent scheduled cuts under the sustainable growth rate (SGR) formula (repealed in 2015 by MACRA) and its successor update mechanisms. The CY 2026 CF of $33.40 reflects the latest Congressional action.
For a simple national rate (without geographic adjustment), the formula simplifies to:
3. Geographic Practice Cost Indices (GPCIs)
Healthcare costs vary dramatically by location due to differences in wages, rent, and malpractice premiums. CMS accounts for this through Geographic Practice Cost Indices (GPCIs), which adjust each RVU component separately for 109 Medicare payment localities.
Each locality has three GPCI values:
- Work GPCI: Reflects local physician compensation (range: ~0.98 to 1.10). A floor of 1.0 applies in many localities, meaning CMS pays at least the national rate for work.
- Practice Expense GPCI: Reflects local office rent, staff wages, equipment costs (range: ~0.80 to 1.60). This has the widest variation -- Manhattan's PE GPCI can be 50%+ above rural areas.
- Malpractice GPCI: Reflects local malpractice insurance premiums (range: ~0.40 to 1.90). States with tort reform tend to have lower MP GPCIs.
Example: CPT 99213 in Manhattan vs. Rural Mississippi
Manhattan (Locality 01)
Rural Mississippi (Locality 99)
Same procedure, 49% cost difference due to geography alone.
4. Commercial Insurance Rate Estimation
Medicare rates serve as a benchmark, but most patients under 65 have commercial insurance, which pays providers at significantly higher rates. Estimating commercial rates from Medicare rates requires understanding the typical multiplier.
Key research on the Medicare-to-commercial ratio:
- RAND Hospital Price Transparency Study (2024): Found that commercial hospital prices average 254% of Medicare nationally, with wide variation (from ~150% at competitive hospitals to 400%+ at monopoly hospitals). [Source]
- KFF Employer Health Benefits Survey (2024): Documents that employer-sponsored plans face steadily increasing costs, with hospital services being the primary cost driver. [Source]
- MedPAC Reports to Congress: The Medicare Payment Advisory Commission regularly publishes analyses showing private payer rates averaging 150-200% of Medicare for physician services and higher for hospital services. [Source]
- Health Affairs (Lopez et al., 2020): Analysis of commercial claims data showing physician commercial rates averaging 143% of Medicare, while hospital outpatient commercial rates averaged 264% of Medicare.
Our Commercial Rate Estimation
On MedicalCosts.info, we estimate commercial insurance rates as a range:
- Low estimate: 150% of Medicare rate (competitive markets, primary care)
- High estimate: 250% of Medicare rate (concentrated markets, hospital-based)
These are rough estimates. Actual commercial rates depend on the specific insurer-provider contract and are not publicly available in most states.
5. Hospital Outpatient (OPPS) Rates
When a procedure is performed in a hospital outpatient department (rather than a physician's office), two separate payments are generated:
- The physician/professional fee (paid under the PFS using facility PE RVUs)
- The facility fee (paid to the hospital under OPPS)
The Outpatient Prospective Payment System (OPPS) groups procedures into Ambulatory Payment Classifications (APCs). Each APC has a relative weight, and the payment is calculated as:
For patients, this means hospital outpatient procedures typically cost more than the same procedure in a physician's office, because the hospital charges a facility fee on top of the professional fee. This "site-of-service differential" is a major driver of healthcare cost growth as hospitals acquire physician practices.
On MedicalCosts.info, we display the OPPS facility fee (labeled "Hospital Outpatient" cost) separately from the physician fee. The total patient cost for a hospital-based procedure is the sum of both.
6. Ambulatory Surgery Center (ASC) Rates
Ambulatory Surgery Centers (ASCs) are freestanding facilities that provide same-day surgical care. CMS pays ASCs under a separate payment system that uses a modified version of the OPPS APC groupings but with lower payment rates.
Key differences from hospital outpatient rates:
- ASC rates are typically 30-50% lower than OPPS rates for the same procedure
- ASCs cannot perform procedures requiring overnight stays
- ASCs have lower overhead costs and more focused surgical capabilities
- Patient copays under Medicare are generally lower at ASCs
We display ASC rates alongside hospital outpatient rates so patients and referring physicians can compare costs between settings. Many procedures -- cataract surgery, colonoscopy, joint arthroscopy, hernia repair -- can be safely performed in either setting.
7. Drug Pricing (NADAC, AWP, WAC)
Drug pricing in the US involves multiple reference prices, each measuring something different:
NADAC (National Average Drug Acquisition Cost)
What we use. NADAC reflects the actual price pharmacies pay to acquire drugs, determined through a weekly survey of retail pharmacies conducted by Myers & Stauffer for CMS. NADAC is considered the most accurate publicly available measure of actual drug costs. Published by Medicaid.gov and updated regularly.
AWP (Average Wholesale Price)
Often called "Ain't What's Paid" in the industry. AWP is a list price set by manufacturers that bears little relationship to actual transaction prices. Historically used as a benchmark for PBM reimbursement (e.g., "AWP minus 15%"), but increasingly replaced by NADAC-based pricing. AWP is typically 20-25% higher than actual acquisition cost.
WAC (Wholesale Acquisition Cost)
The manufacturer's list price to wholesalers, before any rebates, discounts, or chargebacks. WAC is roughly equivalent to the drug's "sticker price." Actual net prices (after rebates) can be 30-50% lower for brand-name drugs, but rebate amounts are confidential.
ASP (Average Sales Price)
Used by Medicare Part B for physician-administered drugs (infusions, injections). ASP is the weighted average of all sales to all purchasers, net of rebates and discounts. Medicare pays ASP + 6% for Part B drugs. ASP is closer to actual transaction prices than AWP or WAC.
On MedicalCosts.info, drug prices reflect NADAC per-unit costs. Retail pharmacy prices include a dispensing fee above NADAC. Patients' out-of-pocket costs depend on their insurance formulary tier, deductible status, and whether they use a coupon or patient assistance program.
8. DRG-Based Hospital Stay Costing
Inpatient hospital stays are paid under the Inpatient Prospective Payment System (IPPS) using Medicare Severity Diagnosis Related Groups (MS-DRGs). Each admission is classified into one of approximately 770 MS-DRGs based on diagnoses, procedures, complications, and comorbidities.
IPPS Payment Formula
The hospital base rate (also called the standardized amount) for FY 2026 is approximately $6,500-$7,000 for operating costs, with a separate capital payment. Each DRG's relative weight reflects the expected resource intensity relative to the average case.
DRGs with higher weights indicate more resource-intensive stays. For example:
- DRG 470 (Major Hip/Knee Replacement, no MCC): Weight ~1.8
- DRG 871 (Sepsis, no MV, 96+ hrs, with MCC): Weight ~2.2
- DRG 207 (Respiratory System with Ventilator 96+ hrs): Weight ~5.9
- DRG 001 (Heart Transplant or Implant of Heart Assist, with MCC): Weight ~27.0
On MedicalCosts.info, we supplement CMS DRG weights with actual discharge data from:
- CMS Medicare Inpatient Provider & Service Data: Average charges, payments, and costs by DRG across 3,000+ hospitals
- NY SPARCS Hospital Discharge Data: 400,000+ discharge records with both total charges and total costs, broken out by severity (Minor, Moderate, Major, Extreme)
9. Geographic Cost Variation
Geographic cost variation in healthcare is driven by multiple factors:
Input Costs
Labor (nurses, techs), real estate, malpractice insurance, and supplies all vary by region. CMS GPCIs capture these differences for Medicare payment.
Market Concentration
Areas with fewer hospitals or physician groups tend to have higher commercial prices due to weaker competition. Hospital mergers have reduced competition in many markets.
Practice Patterns
Some regions have higher utilization rates (more tests, procedures, imaging) independent of patient health status. The Dartmouth Atlas Project has documented these variations extensively.
Regulatory Environment
State laws on certificate of need, scope of practice, tort reform, and insurance regulation all affect costs. States with strong tort reform tend to have lower malpractice costs.
On MedicalCosts.info, our state pages show GPCI-adjusted rates for each Medicare locality within the state. The comparison tool lets you see side-by-side costs for any procedure across multiple states.
10. Limitations & Caveats
- 1. Medicare rates are not what most patients pay. Medicare rates are a floor, not a ceiling. Commercial insurance rates, uninsured/cash prices, and out-of-pocket costs can differ substantially.
- 2. Single-code pricing does not capture episode costs. A knee replacement involves surgeon fees, anesthesia, implant costs, facility fees, physical therapy, imaging, and follow-up visits. Individual CPT codes capture only one component.
- 3. Commercial rate estimates are approximations. The 150-250% multiplier is based on published research but actual negotiated rates vary by insurer, provider, and market.
- 4. Drug prices change frequently. NADAC is updated weekly. The prices shown may not reflect the most current acquisition costs, particularly for drugs with volatile pricing.
- 5. DRG costs are averages. Individual hospital stays vary based on complications, length of stay, and patient characteristics. The average cost for a DRG is not a prediction for any individual case.
- 6. Geographic data has resolution limits. GPCIs are at the Medicare locality level (109 areas), not county or ZIP code level. Costs within a locality can still vary by provider.
- 7. This is not medical advice. Cost information should inform, not replace, conversations with your healthcare provider and insurance company about your specific situation.
References & Further Reading
- CMS. Medicare Physician Fee Schedule. CY 2026 Final Rule.
- CMS. Hospital Outpatient PPS. CY 2026 Final Rule.
- RAND Corporation. Hospital Price Transparency Study. 2024.
- MedPAC. Report to the Congress: Medicare Payment Policy. March 2024.
- KFF. Employer Health Benefits Survey. 2024.
- Medicaid.gov. NADAC (National Average Drug Acquisition Cost).
- Dartmouth Atlas Project. Geographic Variation in Healthcare.
- Lopez, E. et al. "How Much More Than Medicare Do Private Insurers Pay?" Health Affairs, 2020.