In the April 2002 budget, the government announced the introduction of patient choice and the abolition of locally negotiated block contracts between primary care trusts and providers. Instead, it set up a system that would see hospitals paid for the activity they undertook under a system called payment by results.

The Department of Health's paper Delivering the NHS Plan, published in 2002, set out that acute trusts could stand to make more money by becoming more efficient. Under the system, hospitals and other health service providers that gain popularity under patient choice or see more patients being referred to them can increase their income and those that lose patients lose money.

However, PbR does not allow healthcare providers to compete on price: a standard national tariff has been introduced for different treatments using a system of healthcare resource groups. Healthcare resource groups, or HRGs, represent groups of clinically similar treatments and diagnoses that consume similar levels of healthcare resource and are priced accordingly. PbR is designed to encourage healthcare providers to lower their costs to the national tariff or below and in doing so retain any surplus to plough back into providing services more efficiently. 'Transitional relief' has been provided over the five-year PbR phase-in period for primary care trusts and acute trusts hit by increased costs in moving towards the national tariff. However, in January 2006 many PCTs said they were shocked to learn that the compensation for those facing rising bills would be halved from April 2006, before being abolished entirely in 2008.

The government has rolled out the PbR system gradually, starting with elective activity and phasing in a national tariff over five years. In 2006-07 more than£22bn worth of services were delivered under PbR. This represents about 35 per cent of PCT revenue allocations, or more than 60 per cent of acute hospital income. 2007-08 is the first year that PbR and the tariff system have been used in all NHS acute organisations.

How payment by results works

Under PbR, healthcare providers are paid only for the treatment they carry out. In theory, when PbR is rolled out fully and is refined to cost complicated procedures and patient pathways, all providers will be paid a fixed price for each treatment they undertake. PbR has replaced the NHS old payments system of locally agreed block contracts, under which providers and PCTs agreed a set payment for a rough volume of activity at the start of the financial year. They were paid this rate regardless of how the amount of activity carried out compared with the amount contracted, with contracts usually based on historical trends. PbR was designed to abolish anomalies in local price setting for the same services across the country.

Under PbR, the government has drawn up a long list of procedures, such as hip replacements or treatment for heart attacks, each with its own healthcare resource group code. There are currently more than 1,000 HRG codes and the government is working to refine these and develop more, to capture as many treatments and procedures a patient might have while in hospital as possible. The Department of Health is also aiming to refine HRG codes so they reflect the treatment a patient receives in hospital and also treatment that is received in different care settings across the patient's care pathway. The price for each HRG procedure is fixed in relation to a national tariff, based on its average costs across the NHS.

This average cost is compiled from 'reference costs', which compare the cost of a procedure at different organisations. The reference costs show how far above or below tariff a trust is for the different procedures it provides

The future

By 2008-09 the DoH hopes the national tariff will cover all acute and specialist hospital services and 'like for like services' provided in the community working to HRG version 3.5. They will also increase the range of indicative tariffs to give commissioners additional flexibility to 'unbundle' payments where particular services, such as diagnostics, are commissioned direct from primary care.

By 2009-10 the DoH will introduce the new version HRG 4 as the currency for the national tariff, a year later than first planned to allow time for analysis of 2006-07 reference costs. These will be the first to be based on HRG 4 and were submitted to the DoH in July and August 2007. HRG 4 will introduce new national currencies for treatments and procedures such as radiotherapy, chemotherapy, renal dialysis, rehabilitation and specialist palliative care. It is hoped that this will help trusts receive fairer pay for the more complex work they carry out. The DoH is also currently considering adjusting the tariff further to allow for more efficiency in high-volume care treatments such as treatment for acute stroke; caesarean section, cholecystectomy, primary hip replacements, primary knee replacements; and treatment for fractured neck of femur. While these cases cover only 19 of the 548 HRGs, they account for almost 10 per cent of hospitals' total costs.