Elements of Utilization Management

While price management is the first step in managing the health care cost equation, some regard it as a "one-time" savings once the plan sponsor gains discounts. This is not entirely correct since continuing price management is crucial to controlling ongoing costs. However, the long-term cost advantage of managed care rests in its ability to reduce the rate of increase of utilization. The rate declines, with stronger and stronger forms of managed care thereby, ideally, reducing the number of units of unnecessary health care services delivered. Reducing that number is the principal function of medical utilization management (UM).

Primary Utilization Management

Primary utilization management programs can be found in all forms of managed care and they are often the principal controls in managed indemnity and PPO plans. These programs have generally focused on controlling hospital confinements, either through reducing the number of admissions and/or reducing the average length of stay. The following programs are typically included:

1. Precertification reviews the medical necessity of inpatient care and identifies potential case management opportunities prior to admission.
2. Concurrent review monitors patient care during hospital confinements with the intent of managing the length of stay by identifying alternate settings that can provide less costly care.
3. Discharge planning assesses whether additional services are needed following discharge and prepares the patient's transfer to less costly alternate settings for treatment (e.g., a skilled nursing facility or home health care).
4. Large case management provides a continuous process of identifying members with high risk for problems associated with complex, high-cost health care needs and of assessing opportunities to improve the coordination of care.

Primary UM programs are typically handled by telephone (e.g., a toll-free help line) to the managed care company's central member services offices, although selected cases may be supplemented with local on-site review, either through clinical representatives of the managed care company or through contracted medical professionals.

Expanded Utilization Management

Expanded utilization management programs are more commonly included with stronger forms of managed care, such as POS and HMO plans, although they are increasingly available with PPO plans on a stand-alone basis. Some programs are fairly sophisticated, combining protocol-based telephonic intervention services with more intensive clinical analysis of specific treatments of care. Because of the nature of HMO and POS plans, many of these advanced UM programs are initiated by the primary care physician and are ideally transparent to the member. Provider compliance with the requirements of these programs is essential to managing care. Elements of these programs often include the following:

1. Referral management is the primary UM technique differentiating HMO and POS plans from PPO plans. It requires members to access care through their PCPs, who then manage referrals to specialists within the provider network. Properly handled, referral management, also known as the "gatekeeper" approach, ensures that high quality care is delivered in the most cost-effective setting possible by coordinating care through one source (the PCP) and eliminating unnecessary or inappropriate care.
2. Outpatient precertification requires prior authorization from the managed care company for certain outpatient surgical and medical procedures, with the intent being to reduce unnecessary, inappropriate, and potentially harmful procedures.
3. Managed second surgical opinion replaced voluntary second surgical opinion programs which had been widely used in the 1980s and requires the member to contact the managed care company, which evaluates the necessity of surgery and recommends less invasive medical treatment if appropriate.
4. On-site concurrent review complements telephone-based concurrent review in basic UM services by placing clinically trained nurses at hospitals and other inpatient facilities to review the necessity of continued confinements, proposed tests, and procedures.
5. Centers of excellence include a network of designated, nationally recognized medical facilities that perform selected, highly sophisticated, and high-cost procedures (e.g., organ transplants, open-heart surgery, and advanced forms of cancer treatment). The managed care organization typically negotiates preferred rates with the centers.
6. Prenatal advisory services (also called prenatal planning and maternity management services) help identify women who may be at risk for delivering low-birth-weight, preterm, or unhealthy babies and provides education and counseling on proper prenatal care.

Most managed care companies use sophisticated protocols and medical guidelines to develop and administer their UM programs. Whether their operations are centrally based or located in local member service centers, today's UM programs are highly automated and integrated with the claims payment systems, so that there are minimal delays in the handling of member claims after UM procedures are approved. Similarly, the managed care company will usually provide toll-free numbers for both members and providers and extended customer service hours to decrease the "hassle factor" often associated with having to preauthorize confinements, referrals, or outpatient procedures.

Risk-Sharing Arrangements | Costs and Evaluating Plans

Risk sharing is best suited for stronger-form managed care plans, such as HMO and POS plans, since these models rely on the primary care physician (PCP) as the central control point for member health care delivery. The PCP is best positioned to monitor a member's care and to control benefit utilization. Furthermore, integrated delivery systems (e.g., group practices, IPAs, physicians hospital organizations [PHOs]) have shown interest in risk-sharing models because they have the administrative systems to monitor broad levels of member care and can better assume the risks associated with such financial incentives.

The risk-sharing model has to be flexible enough to adapt to local market conditions and to grow and change over time. An effective risk-sharing model should generally include the following conditions:

1. A PCP in place for each member to serve as the entry point for referral and hospital care.
2. Risk pools that include about 10 to 12 PCPs per pool, in order to aggregate claims experience.
3. A given PCP that has a minimum concentration of membership (e.g., 150 to 200 members) in order to make the revenue flow significant enough to be "at risk."
4. Risk sharing within group and IPA HMO models that takes a variety of forms depending on the following conditions:
   1. Receptivity of the provider community.
   2. Membership leverage by the managed care company among its participating providers.
   3. Sophistication of the provider group and the managed care company.

Types of risk-sharing models include:

1. Case management fee where the managed care company pays the PCP a set fee per member for overall case management services. This fee is paid in addition to charges for medical services rendered. It is intended to compensate physicians for the added work of acting as case manager for their membership, but this approach is typically not favored by managed care companies. Many companies feel PCPs should already serve as overall case managers for their membership and should not receive additional compensation. Furthermore, case management fees alone do not provide an effective vehicle to influence specific physician behavior.
2. Physician incentive/bonus rewards positive performance in specific measurable categories, such as financial results (e.g., average monthly costs per member), quality assurance compliance, and member satisfaction survey results. Results are shared with providers on a regular basis to improve effectiveness of performance-based incentives. Some advantages of using bonus plans are that they are relatively easy to develop and establish, and can be administered in conjunction with other risk arrangements. Concerns include whether bonus payments are large enough to outweigh gains from potential plan over utilization and whether comparative systems need to be developed to measure performance among PCPs.
3. Fee-for-service with a "withhold" reduces provider reimbursement by a withheld amount (e.g., 15 percent) at the time the claim is adjudicated, and this withhold is placed in specially assigned risk pools. Cumulative withholds are either returned or retained each year based on the results of the risk pool compared to expected results. Typically, catastrophic claim costs are not charged against the selected risk pool so that they do not unfairly influence the results of the risk pool. Some advantages of the withhold arrangement are that it is relatively easy to develop and administer, and it encourages PCPs to deliver services within its practices rather than refer to other specialists, which helps control utilization. Concerns include the following: There is the possibility of overutilization of physician services to increase revenue in order to offset the withhold; the plan can be "nickeled and dimed" on PCP services; and providers often perceive withholds as part of their discounts and do not put serious effort into adjusting performance to regain the withholds. Effective use of withhold arrangements requires critical information system tools, physician profiling data systems to monitor performance criteria, a limit on the number of specific fees for office visits, and regular communication with PCPs, so they can properly manage their practices.
4. Capitation for defined services provides a fixed monthly payment for each member selecting a PCP, as compared to payment for each service delivered by that physician. It is critical to define exactly what services are to be covered in that capitation payment so that a physician knows what level of care is being covered through the reimbursement. PCP services typically include the following:
   • Office visits, including routine exams and well-baby care;
   • Immunizations and therapeutic injections;
   • Inpatient visits while member is confined in a hospital or other facility;
   • Specific list of routine lab and diagnostic services (e.g., EKGs);
   • Specific list of routine office procedures (e.g., minor surgical procedures);
   To supplement the capitation for defined services, the managed care company also may pay the PCP additional fee-for-service reimbursement for after-hour and emergency treatment to avoid the higher cost of sending the member to the emergency room.
   Capitation rates are usually age/sex specific (e.g., different rates for adult versus child, male versus female) to recognize differences in the member population. It is possible to capitate most types of providers or groupings of providers (e.g., hospitals, IPAs, PHOs, labs, drug vendors), provided there are clear definitions as to the services to be provided and the expectations of the provider. Advantages of capitation for defined services are that it rewards prudent utilization of services (PCPs "keep" excess capitation payments above their actual costs of delivering care), and it eliminates claims processing for low-cost, routine, high-volume services.
   Concerns about capitation models include the following: it can be more difficult to recruit physicians if they are not willing to accept capitated services; and it can be difficult to collect accurate and relevant encounter (claims) data because physicians have no incentive to complete paperwork. Effective audit systems must be established to ensure that services contracted under the capitation agreement are not also submitted and reimbursed as under fee-for-service; physicians must have sufficient financial strength to assume the risk inherent in capitation; and the managed care organization (MCO) must closely monitor the practice to make sure PCPs are delivering appropriate care, rather than simply referring care to other providers (for which the MCO pays additional fees). Thus, critical tools for implementing capitation for defined services include a clear and workable definition of capitated services, monitoring reports to identify inappropriate referrals, systems support to give PCPs information necessary to manage their budgets, and quality screens to protect against underutilization.
5. Capitation with a withhold is the same as capitation for defined services, except that a portion of the capitation payment is withheld as a tool to reduce PCP "triaging" (i.e., making too many referrals) to other providers. The withhold is returned at the end of the fiscal year, depending on PCP performance. The key advantage is that the PCP has a financial stake in properly managing referral care. The same concerns about capitation exist, and recruiting primary care physicians who will accept this model is tricky.
6. Capitation for complete services capitates the PCP for all services rendered to a member, including referrals to specialists and hospital services. The capitation payments are used to establish a PCP budget, against which the costs for all services are charged. The PCP has a stake in managing the total care for assigned members. However, unless PCPs are careful, a string of catastrophic cases can be financially devastating (usually protected against by some type of stop-loss coverage).
7. Budgeted capitation sets up a pool, which is funded directly from premiums, for a group of PCPs. Claims are charged directly against the budgeted pool during the fiscal year; if the pool runs dry, no further monies are paid out for services, but excess monies in the pool at the end of the fiscal period can be available as surplus and shared with providers. Advantages of budgeted capitation include those noted above for other methods of capitation, plus the added feature that medical expenses cannot exceed premiums collected. However, an added concern is that the PCP's average member costs vary by plan group and the PCP has no control over them.
8. Salaried physicians are employed by staff model HMOs. Like capitation models, a key advantage is that the supposed financial incentives for overutilization are removed, and more importantly this "vertically integrated" approach to health care delivery allows for efficiencies not possible in other types of arrangements. However, it is crucial that the appropriate "corporate" goals/policies are developed and broadly communicated to give staff providers direction on utilization and quality.

Non-Risk-Sharing Arrangements

In traditional plans, and even in managed indemnity and many PPO plans, fee-for-service is the standard reimbursement method for non-facility health care providers, such as physicians. While discounts are sometimes applied to fees, fee-for-service does not directly control utilization.

1. Fee-for-service—Reasonable and Customary (R&C) or Usual, Customary and Reasonable (UCR) utilizes a schedule of maximum allowable (or "prevailing") fees for covered services within a particular geographic area. The prevailing R&C fee is typically set at the most frequently occurring charge within a particular range. Physicians are paid the lesser of billed charges or the prevailing R&C fee. This is the way traditional plans have operated for years, and most patients do not even realize a prevailing fee schedule is being used unless the provider "balance-bills" the patient for any excess over the prevailing fee. Since this arrangement reimburses the provider for each service, there is no specific incentive for providers to effectively manage utilization. R&C reimbursement is common with indemnity and managed indemnity plans since it requires no established contract with providers.
2. Fee-for-service—Fee Schedule reimburses physicians based on negotiated rates (e.g., using a relative value scale). The physician is reimbursed the lesser of billed charges or the negotiated maximum, which is usually based on the current procedural terminology (CPT) code. The entire fee schedule is subject to a relative value scale (RVS) which takes into account the physician's type of specialty and location. Like the R&C method, this arrangement reimburses the physician for each service, resulting in little incentive to manage utilization. These fee schedules are common in PPOs, in which a negotiated contract sets the fee schedule in advance with contracted physicians. Participating physicians agree to accept the scheduled fee as payment in full and they agree not to balance bill for any additional charges above the scheduled fee, although they are allowed to bill for allowed copays, deductibles and coinsurance portions which the plan requires of the member. It is crucial that the managed care company provide monitoring and review of physician utilization patterns in order to avoid unnecessary expenses.
3. Resource-based relative value scale (RBRVS) is a variation of RVS under which the relative value assigned to a procedural code is derived from the components of physician work units (including time and skill), practice expense units, and malpractice expense units with the intent of reimbursing according to comparable costs of doing business, not according to specialty. Medicare adopted this approach in 1992.

Health Care Cost Equation

In the 1980s and 1990s, most plan sponsors were asking: "Should we move our plan into managed care?" and "Does managed care save money?" Today, with about 95 percent private industry health plan membership in some type of managed care plan, the questions more likley are: "What type of managed care is best for our health care benefit plan?", and "How does managed care save us money?" Few questions in the vast industry of employee benefits are getting more attention today, and this text would not be complete without trying to answer them. However, it is important to note that these two latter questions are distinctly different questions.

The question, "What type of managed care is best for our health benefit plan?" requires a response more complex than just how much savings are produced by the various forms of managed care. While cost control has been the primary driver behind the establishment of managed care products, there are many other fundamental considerations for the plan sponsor, such as the impact on employee satisfaction, the degree of plan design flexibility, and whether managed care networks are available to plan participants.

The plan sponsor must also consider the types of managed care in the broader context of its employee benefit philosophy. If senior management does not understand, nor fully support, the offering of managed care, the plan sponsor may not devote adequate internal resources to ensure proper employee education and acceptance of the plan. Managed care plans rely heavily on proper understanding of, and acceptance by, the member population, for the plan sponsor to fully realize expected savings. So, the first step to achieving expected savings from any managed care plan requires the plan sponsor to establish clear expectations and to make the necessary commitment to its success.

The second question is the primary subject "How does managed care save money?" To answer that question, it is first important to understand the elements that drive health care costs. Savings will reflect the initial cost reductions from transitioning membership from a traditional indemnity plan to some form of managed care, as well as the level of provider discounts, the change in benefits, and the degree of utilization control included in the new managed care plan.

To understand the potential impact of managed care alternatives on the costs of medical care, it is important to understand the basic health care cost equation: Cost = Price × Use, where Price is the average cost per unit of health services delivered, and Use (or utilization) represents the average number of units of health services.

Effective managed care strategies must address both portions of the cost equation: price management, which is a function of network development and provider reimbursement strategy; and utilization management, which is a function of medical management capabilities and quality controls employed by the managed care company.

Elements of Price Management

Provider reimbursement methodology is the cornerstone of price management. It must cover broad provider service categories, and it must be actively managed, with regular review and renegotiation. Those health plans that fail to take advantage of negotiated pricing will bear greater and greater cost shifting from governmental and other managed care plans.

Hospital reimbursement strategies are most important, since facility expenses account for, on average, more than a third of total health care expenditures. Common strategies include the following:

1. Straight discount (percentage off) is simply a negotiated percentage (e.g., 15 percent) off billed charges with no risk sharing by the provider. Managed care companies disfavor straight discounts because they do not protect expenses against general medical inflation; hospitals can still increase their prices, while the managed care company can only take the same discount off higher and higher costs. Furthermore, this method does little to control increased utilization of hospital services.
2. Diagnostic (diagnosis) related group (DRG) pays a prenegotiated amount to the hospital for the total cost of treatment, for each of about 520 specific "diagnoses." DRGs became increasingly common after they were universally adopted for Medicare reimbursements in 1984. With DRGs, the hospital has an incentive to manage utilization of services, by being put at some financial risk to effectively manage length of stay and intensity of services per admission. However, since the number of admissions is not limited, hospitals could discharge patients early and readmit them. Stop-loss arrangements are often set up to protect the hospital from catastrophic cases. Additional problems with DRGs include negotiating an appropriate pricing level for the various DRG categories, which requires significant claims data; artificially high charges can occur if the base is determined before utilization has been aggressively managed. The additional administrative burden of assigning a DRG number requires advanced billing and claims adjudication software to avoid "DRG creep" whereby a hospital raises the classification of an illness in order to receive a higher amount. Periodic claim audits are critical to assure actual treatment matches the assigned DRG for the hospital confinement.
3. Case rates are flat negotiated reimbursements for a specific type of service (e.g., outpatient surgery rates or obstetrical (OB) case rates), rather than for all services related to a specific diagnosis. With this arrangement, the hospital is at risk for managing cost as well as increases in cost for services but not for managing the actual number of services provided.
4. Per diem entails a prenegotiated fixed daily rate, usually set up in broad categories, such as medical/surgical, delivery, intensive care, and so on. Per diem allows the managed care company to share some risk with the hospitals and gives the hospital an incentive to effectively manage cost per day. However, in contrast to DRG reimbursement, the hospital is paid for each day of care and thus has no incentive to control admission rates or the average length of stay (ALOS) per admission.
5. Global rates pay a specific fee for a major episode of care. They are broader than DRG reimbursement because the negotiated fee includes all professional, ancillary, anesthesia, and facility fees associated with the episode of care, so one payment is made for all services rendered (usually to the facility). Under global rates, the hospital is at risk for effectively managing all health costs related to the negotiated episodes as well as increases in the cost of these services. These arrangements are typically restricted to high cost, catastrophic types of care, such as organ transplants, or where larger integrated health systems already have wholly owned facility and professional services.

It is not uncommon for HMOs to engage in multiple reimbursement arrangements with various hospitals and other inpatient facilities. Based upon the HMO Industry Report 9.1, in July 1998, 72 percent of hospital contracts used discounted charges, 86 percent used per diems, 50 percent used DRGs, and 33 percent used a combination of case or global rates.

Physician reimbursement strategies depend largely on the type of managed care plan, discussed in detail below. Physicians costs are influenced two ways in a managed care environment:

1. Non-risk-sharing arrangements, which focus only on negotiating unit prices and then employ specific utilization management procedures, such as detailed medical treatment protocols coupled with advanced information measurement systems, which intend to intervene, monitor, and influence physician practice.
2. Risk-sharing arrangements that give providers financial incentives to control patient utilization.

Most managed care programs rely on both of these strategies, depending on the readiness and sophistication of the local provider community. But it is the physician reimbursement strategy that provides the basic structure in controlling costs.

Hearing Care | Managed Care Health Plans

A majority of benefit packages do not contain this coverage. The aging population, coupled with a noisy contemporary society, contribute to hearing loss/impairment, and it is estimated that more than 10 percent of the population is affected. Despite the generally acknowledged increase in the number of hearing-impaired persons and the substantially improved technology of hearing-aid instruments available, many would rather continue with this impairment than bear the stigma of wearing a hearing aid in public.

Coverage

Surgical procedures affecting the ear are normally covered in standard medical policies. Beyond this, some HMOs, major medical, and comprehensive policies include hearing aids. However, more complete coverage is afforded by plans designed specifically to cover hearing care.

Hearing Care Benefits

A common benefit package includes an 80 percent reimbursement of services and materials up to a ceiling of $300 to $600. The frequency of benefit availability is usually every 36 months. The following items are often covered:

• Otologic examination (by a physician or surgeon).
• Audiometric examination (by an audiologist).
• Hearing instrument (including evaluation, ear mold fitting, and follow-up visits).

Preferred provider plans in which access to a panel would result in discounts for audiologist fees as well as hearing-aid instruments are also available. Several administrators have developed service plans in which copayments apply when participating providers are utilized. Material costs can be reimbursed on a cost-plus dispensing-fee basis. However, identical procedures vary in different geographic areas and even within specific metropolitan areas.

As with vision care expenses, an FSA is a convenient vehicle through which to budget for hearing care expenses in the absence of employee benefit coverage.

Vision Care

Most of us would rank vision as a very important, if not the most important, of our senses. Yet vision care is often neglected. Eye disease, treatment, and surgery traditionally are covered under hospital, surgical, major medical, and comprehensive medical policies. However, most of these plans exclude routine vision examination and eyewear from coverage. Separate (freestanding) vision plans cover services such as routine examinations and materials (products) such as lenses, frames, and contact lenses. In a purist sense, some do not consider this coverage insurance because of the absence of illness or disease. Nevertheless, the need for appropriate vision care is real, as about 60 percent of the adult population in North America wears corrective eyewear. A routine vision exam not only confirms whether prescription eyewear is necessary but may detect unrelated problems such as diabetes and high blood pressure. Aside from the obvious medical benefits to employees, vision care plans have the potential of reducing accidents and increasing production, factors that are of major importance to the employer. Vision care often is compared to dental care because of its frequently elective and predictable nature. However, despite general reductions in employee benefit programs, some—not many—employers are adding or continuing to provide vision care benefits.

Providers

There are three types of vision care professionals.

Ophthalmologists are medical doctors (MDs) specializing in the total care of the eye, including diagnosis, treatment of eye diseases, and surgery. Many perform eye examinations and prescribe corrective lenses.

Some also dispense corrective eyewear. An ophthalmologist typically completes four years of premedical training, another four years of medical school, and subsequent internship/residency.

Optometrists are doctors of optometry (ODs) who are licensed to examine, diagnose, treat, and manage diseases and disorders of the visual system, the eye, and associated structures as well as diagnose related systemic conditions. They are trained to detect eye disease and/or symptoms requiring the attention of ophthalmologists. In addition to performing vision examinations and prescribing lenses, most optometrists dispense glasses and contact lenses. An optometrist typically completes undergraduate work and is graduated from a college of optometry.

Opticians fit, adjust, and dispense eyewear (lenses, frames, and contact lenses) prescribed by ophthalmologists and optometrists. They are eyewear retailers and provide advice on which lenses and frames are most appropriate. Many grind and fabricate eyewear, verify the finished products, and repair and replace various ophthalmic devices. Optician certification, licensure, and registration vary by state, as do training and apprenticeship.

Covered Benefits

Vision Examination

A thorough examination includes a history of general health, vision complaints, and an external and internal eye exam. Other services may include various ocular tests, usually including but not limited to coordination of eye movements, tonometry, depth perception (for children), and refraction testing for distance and near vision. In addition to the possible need for corrective eyewear, the exam could detect cataracts, glaucoma, diabetes, and brain tumors. Some plans allow an examination at 12- or 24-month intervals, and it is up to the employee to arrange for eyewear if needed. HMOs often feature "exam-only" plans.

Lenses

The lens is the heart of sight-corrective material. Single-vision lenses are the most widely used, with multivision lenses (bifocal, trifocal) also being dispensed in large quantities. Plastic has replaced glass as the predominant lens material, and a wide array of lenses, such as oversized, photochrometric, and tinted, are available. Most plans consider these "cosmetic extras" and outside normal plan limits. Many plans do provide benefits for contact lenses even though they are likely to be worn for cosmetic rather than for medical reasons.

Many dispensers have an in-house laboratory for grinding and fabrication of the more routinely prescribed eyewear, while others use full service labs.

Frames

The cosmetic element is much more obvious in the area of frames than in lenses. Frames are increasingly being selected for cosmetic purposes and at times are part of a fashion wardrobe. The cost can run into hundreds of dollars for plastic or metal frames of almost limitless sizes, shapes, and colors. Herein lies a dilemma for the payor. The frame is a must, but how does one avoid paying for fashion while giving a fair reimbursement for utility? Certain plans make allowances up to a specified dollar figure, while others approve a limited selection; for example, $100 frames each for men, women, and children.

Vision Benefits in Flexible Benefit Plans

Flex plans increasingly include ancillary benefits, including vision care. They enable an employee to choose among various coverages, taking into account factors such as overall health, spouse coverage, and specific family needs. Although the design of these plans varies, employers sometimes allocate a certain number of "flex credits" to each employee, who then uses these to "purchase" benefits. Each employee chooses the benefits that best fit his or her needs. Once the employer allocation has been used, the employee may purchase additional benefits at his or her own cost. They place vision care in competition with other coverages.

Flexible Spending Accounts (FSAs)

If not covered under a medical plan or a freestanding plan, eligible vision care expenses are covered by a flexible spending account if the employer maintains one. Under an FSA arrangement, the employee may reduce income and Social Security taxes by funding benefits such as vision care with pretax dollars.

At the beginning of the plan year, employees can designate a certain amount of money (up to a maximum) to be deducted from salary, thereby reducing the base upon which taxes are paid. The employer holds the money and "reimburses" the employee upon verification of covered expenses. 

Occupational Safety and Health Administration (OSHA)

OSHA requires employers to provide protective eyewear to employees in positions exposing them to the danger of eye injury. These "safety glass" programs are usually outside the normal health benefit package.

Effective Reward Management

The criteria for judging the effectiveness of a reward management system is the extent to which it:

• is fit for purpose — the contribution it makes to achieving organizational objectives and recognizing the needs and wants of stakeholders;
• is appropriate — fits the culture and context of the organization;
• is designed in accord with what is generally regarded as good practice in the particular context of the organization, subject to the requirement that it must be appropriate;
• functions in line with well-defined guiding principles, which include the need to achieve fairness, equity, consistency and transparency in operating the reward system;
• includes processes for valuing and grading jobs and rewarding people according to their performance or contribution that are properly conceived and function well;
• makes a significant impact on performance through performance management or contributions to high-performance working;
• has produced an attractive employee-value proposition;
• provides rewards that attract and retain people and enlist their engagement;
• maintains competitive and equitable rates of pay;
• incorporates successfully a total rewards approach;
• manages reward processes carefully and obtains value for money;
• provides for the evaluation of reward processes and taking corrective action as necessary;
• communicates to all concerned how the reward system operates and how it affects them;
• provides for the devolution of a reasonable degree of authority to line managers to make reward decisions, taking steps to ensure that they have the skills and support required and that their decisions are in line with reward policy guidelines.

Effective Reward in the Best Performing Firms

The best-performing firms view their reward programmes differently from the lower-performing organizations:

• Top firms are more likely to use rewards as tools to engage people in improving business performance.
• These firms make greater efforts than others to communicate their plans and to measure reward plan effectiveness.
• They are more likely than the rest to link rewards to their organization's business strategies.

Reward management: six tips

• Reward people according to the value they create.
• Reward people according to what the organization values and wants to pay for.
• Take account of employee as well as business needs.
• Best fit is preferable to best practice.
• Strive to be different, even unique, when developing reward policy and practice.
• Adopt an evidence-based management approach that involves managing reward systems on the basis of fact rather than opinion, on understanding rather than assumptions, on grounded theory rather than dogma.

Fundamental Concepts | Reward Management

Fundamental Concepts

The following fundamental concepts influence the aims of reward management, reward strategy and how people are valued.

The Resource-Based View

This is the view that it is the range of resources in an organization, including its human resources, that produces its unique character and creates competitive advantage. HRM delivers added value and helps to achieve sustainable competitive advantage through the strategic development of the organization's rare, hard to imitate and hard to substitute human resources. The situation in which people are employed with competitively valuable knowledge and skills, as one that confers ‘human capital advantage’.

The role of reward management is to contribute to the acquisition and retention of such people.

Human Capital Management

The concept of human capital is often associated with the resource-based view. ‘it is human capital that is the differentiator for organizations and the actual basis for competitive advantage’. Human capital management (HCM) is often described as being about measurement in the sense of obtaining, analysing and reporting on data relating to employees that inform HRM decisions. But it is sometimes defined more broadly without the emphasis on measurement. Chatzkel states that ‘Human capital management is an integrated effort to manage and develop human capabilities to achieve significantly higher levels of performance.’ HCM as ‘The total development of human potential expressed as organizational value’. He believes that ‘HCM is about creating value through people’ and this is a prime purpose of reward management.

Human Process Advantage

A distinction should be made between ‘human process advantage’ and ‘human capital advantage’. The former results from the establishment of ‘difficult to imitate, highly evolved processes within the firm’, while the latter follows from employing people with competitively valuable knowledge and skills. This suggests that one of the roles of reward management is to differentiate from rather than imitate the ‘best practices’ of other firms.

Motivation Theory

Motivation is the force that energizes, directs and sustains behaviour. Motivation theory explains how motivation works and the factors that determine its strength. It deals with how money and other types of rewards affect the motivation to work and levels of performance, what creates job satisfaction, and the link between job satisfaction and performance. It therefore influences decisions on how people should be valued, the choice and design of financial rewards and the use of non-financial rewards.

A distinction is made between extrinsic and intrinsic motivation. Extrinsic motivation occurs when things are done to or for people to motivate them. These include rewards, such as incentives, increased pay, praise, or promotion, and punishments, such as disciplinary action, withholding pay, or criticism. Intrinsic motivation is provided by the work itself.

There are four main categories of motivation theories as described below.

Instrumentality Theory

‘Instrumentality’ is the belief that if we do one thing it will lead to another. In its crudest form, instrumentality theory states that people only work for money. It assumes that people will be motivated to work if rewards and penalties are tied directly to their performance; thus the awards are contingent upon effective performance. Instrumentality theory has its roots in the scientific management methods ‘It is impossible, through any long period of time, to get workmen to work much harder than the average men around them unless they are assured a large and permanent increase in their pay.’

Content (Needs) Theory

This theory focuses on the content of motivation in the shape of needs. It provides guidance on what needs should be satisfied by the reward system if motivation is to occur. The basis of content theory is the belief that an unsatisfied need creates tension and a state of disequilibrium. To restore the balance a goal is identified that will satisfy the need, and a behaviour pathway is selected that will lead to the achievement of the goal and the satisfaction of the need. All behaviour is therefore motivated by unsatisfied needs. 

The main needs identified by these and other writers are those for achievement, recognition, responsibility, autonomy and the opportunity to develop and use skills. These have to be taken into account in deciding how people should be rewarded and also in achieving motivation through job design. But a note of caution is necessary. Content theories propose that to a large extent all people strive for the same fundamental goals. In fact, people are more varied and complex than this. Theories stating that there are strong similarities between people lead to the conclusion that there is ‘one best way’ to motivate and reward them, which is simply not true. Process theory as described below is based on more realistic, albeit more complex ideas.

Process Theory

In process theory, the focus is on the psychological processes or forces that affect motivation, as well as on basic needs. The three main theories are:

• Expectancy theory which states that motivation will be high when people know what they have to do to get a reward, expect that they will be able to get the reward and expect that the reward will be worthwhile.
• Goal theory which states that motivation and performance are higher when individuals are set specific goals, when goals are difficult but accepted, and when there is feedback on performance.
• Equity theory which states that people will be better motivated if they are treated equitably, and demotivated if they are treated inequitably. There are two forms of equity: distributive equity or distributive justice, which is concerned with the fairness with which people feel they are rewarded in accordance with their contribution and in comparison with others; and procedural equity or procedural justice, which is concerned with the perceptions employees have about the fairness with which company procedures in such areas as performance management, promotion and discipline are being operated.

The main distinction between content and process theory is that the former provides guidance on what needs should be satisfied by a reward system while the latter indicates how they should be satisfied, especially in pay schemes that are contingent on performance, contribution or skill. In their case, process theory is the most important.

Cognitive Evaluation Theory

Cognitive evaluation theory (CET) argues that placing strong emphasis on monetary rewards decreases people's interest in the work itself, thus dampening a powerful alternative source of motivation. In other words, extrinsic rewards erode intrinsic interest.

Principal Agent Theory

Principal agent theory, sometimes known as agency theory, is based on the supposition that the separation between the owners (the principals) and the agents (the managers) means that the principals may not have complete control over their agents. The latter may therefore act in ways which conflict with what the principals want. So it is desirable to provide for ‘incentive alignment’, which means paying for measurable results deemed to be in the best interests of the owners.

The Psychological Contract

A psychological contract is a set of unwritten expectations that exist between individual employees and their employers. It is concerned with: ‘The perceptions of both parties to the employment relationship of the reciprocal promises and obligations implied in that relationship’. A psychological contract is a system of beliefs that encompasses the actions employees think are expected of them and what response they expect in return from their employer, and, reciprocally, the actions employers believe are expected of them and what response they expect in return from their employees.

The concept of the psychological contract highlights the fact that employee/employer expectations take the form of unarticulated assumptions. Disappointments on the part of management as well as employees may therefore be inevitable. These disappointments can, however, be alleviated if managements appreciate that one of their key roles is to manage expectations, which means clarifying what they believe employees should achieve, the competencies they should possess and the values they should uphold. All this can be done through reward and performance management.

Contextual Factors | Reward Strategies

Reward strategies and practices must take account of the internal and external context — the concept of ‘best fit’.

Internal Context

The characteristic features of the internal context are as follows.

The Organization's Culture

Organizational culture consists of shared values, norms and assumptions that influence the way people act and the way things get done. In reward management, the most important aspects of culture that need to be taken into account are the core values of the organization, which express beliefs on what sort of behaviour is desirable. Reward practices should fit in with and support the culture and they can help to reshape it.

The Organization's Business or Sector

The business or sector of the organization, for example manufacturing, financial services, retail services, transport, media, public sector services, not-for-profit services or education — will govern its ethos and therefore its core values. It will influence the type of people it employs and the degree to which it is subject to turbulence and change. All these factors will contribute to the reward strategy.

Work Environment

The ways in which work is organized, managed and carried out will influence pay structure and the use of contingent pay. The introduction of new technology may result in considerable changes to systems and processes. Different skills are required, new methods of working and therefore reward are developed. The result may be an extension of the skills base of the organization and its employees, including multiskilling (ensuring that people have a range of skills that enable them to work flexibly on a variety of tasks, often within a teamworking environment). Traditional piecework pay systems in manufacturing industry have been replaced by higher fixed pay and rewards focused on quality and employee teamwork.

People

People's occupations may affect their wants and needs. Entrepreneurial directors or sales representatives may be more interested in financial incentives than, say, people engaged in charitable work. Reward strategies and policies should take account of the different needs of people and this may mean segmenting rewards to meet those individual needs.

Business Strategy

Where the business is going — the business strategy — determines where reward should go — the reward strategy. Integrating reward and business strategies means combining them as a whole so they contribute effectively to achieving the mission or purpose of the organization.

Political and Social Climate

Organizational politics and social factors such as the way people interact will affect how the organization functions and therefore what approach to reward management it adopts.

External Context

The following aspects of the external context may affect reward management policies.

Globalization

Globalization requires organizations to move people, ideas, products and information around the world to meet local needs. Traditionally, discussions of international reward strategies and practices have tended to focus on an elite of expatriate workers, sourced from headquarter locations and rewarded in isolation from local country staff. We are now seeing a more diverse and complex pattern emerging, requiring a much more strategic approach.

Rates of Pay in the Market Place

The external environment exerts a major influence on rates of pay and pay reviews within organizations. Market or going-rate levels and movements have to be taken into account by organizations if they want their pay to be competitive. Some organizations are affected by national agreements with trade unions.

The Economy

The economy, whether it is in a boom or bust mode, will inevitably affect reward policy and practice. A recession such as the one that began in 2008 increases the attention organizations pay to getting value for money and reduces the amounts that can be distributed in the form of base and contingent pay and the scale of benefits provision.

Societal Factors

Views about reward held in society at large may affect internal reward policies. For example, the opprobrium levelled in 2009 at ‘fat cats’ in boardrooms and the bonus culture in the City may possibly have some influence on members of remuneration committees. Again, it may not.

UK Employment Legislation

The following pieces of UK legislation directly or indirectly affect pay policies and practices:

• The Equal Pay Act 1970 and the Equal Pay (Amendment) Regulations 1983 provide that pay differences are allowable only if the reason for them is not related to the sex of the job holder. The Employment Act 2002 provides for the use of equal pay questionnaires. Equal pay legislation is described in Chapter 17.
• The National Minimum Wage Act 1998 provides workers in the UK with a level of pay below which their wages must not fall — regardless of where they live or work or the sector or size of company in which they work. It is not a going rate. The government prescribes by regulation the minimum wage.
• The Working Time Regulations 1998 provide, inter alia, for a limit of 48 hours on average weekly working time, which an individual worker may voluntarily agree to exceed, and a minimum of four week's paid annual leave subject to a 13-week qualifying period.
• The Data Protection Act 1998 provides among other things that employees are entitled to make a formal request to access information on the personal data held on them and the uses to which this will be put.
• The Transfer of Undertakings (Protection of Employment) Regulations 1981 (TUPE) provide that when a business or part of a business is transferred, the workers in that business automatically transfer into the employment of the transferee together with their existing terms and conditions of employment (except for pensions) intact and with their accrued periods of continuous service.
• The Financial Services Act 1986 places restrictions on the provision of financial advice to employees. Only those who are directly authorized by one of the regulatoryorganizations or professional bodies are permitted to give detailed financial advice on investments.

The Trade Unions

Trade unions influence reward practices at national level through national pay negotiations, pronouncements on such issues as the pay of top executives, and exerting pressure to achieve equal pay. They produce policies and advice for their members on job evaluation (they are in favour of analytical schemes while emphasizing the need for involvement in their design), pay structures (they tend to be against broad-banded structures) and performance-related pay (they are generally hostile to it, preferring the traditional service-related incremental scales).