Hospital Competition and Reimbursement

1. Hospital Competition and Reimbursement Econ 737.01 10/14/10

2. Outline • I. Competition under a cost-based reimbursement system • II. Competition under a prospective payment system • III. Competition under managed care

3. I. Competition under a cost-based reimbursement system • Hospital reimbursement was cost-based through the early 1980s => little incentive to keep costs down • Physicians and patients made the decisions about which hospital to choose, yet insurance paid most of the bill => price competition ineffective • How would you therefore expect hospitals to compete with each other?

4. I. Competition under a cost-based reimbursement system • During this period, hospitals tended to compete by continually trying to “one-up” each other in terms of quality • Ways to do this included investing in the latest technology (regardless of its cost-effectiveness), hiring more staff, and improving amenities • This phenomenon is known as the “medical arms race” (MAR)

5. I. Competition under a cost-based reimbursement system • Example: Two hospitals are deciding whether to purchase the latest MRI machine, which costs $2.5 M. If neither or both purchase it, they keep their existing market shares. If only one purchases it, it will steal $5 M of business from the one that does not.

6. I. Competition under a cost-based reimbursement system • Nash equilibrium: both hospitals will purchase the machine and each lose $2.5 M • Cooperative outcome: neither purchase it • The hospitals are therefore trapped in a prisoner’s dilemma that will lead to excessive investment. • This simple example ignores other factors such as patient utility and potentially higher reimbursement rates. • However, it is sufficient to illustrate the idea that competition could actually increase hospital costs

7. I. Competition under a cost-based reimbursement system • Empirical evidence on the MAR • Robinson and Luft (1985): More competing hospitals within 15 miles => higher costs per admission • Robinson et al. (1988, 1987, and 1986): More competing hospitals => higher employee/patient ratio and more of a variety of specialty services • Zwanziger and Melnick (1988): Competition increased hospital costs in CA in 1983 but not 1985; they attributed this to increased managed care • Conner et al. (1997): Found evidence of non-price competition in 1986 that shifted to price competition by 1994 • Dranove et al. (1992): More thorough set of control variables; competition only increased supply of 2 of 13 specialty services in CA in 1983

8. II. Competition under a prospective payment system • Medicare Prospective Payment System (PPS) (1983) • Switched from cost-based to diagnostic related group-based reimbursement. • Theoretical effect on incentives • Shleifer (1985): incentive to select most efficient production tecnhology • Dranove (1987): incentive to dump sickest patients within a DRG onto local public hospital • Allen and Gertler (1991): model showing that hospitals would undertreat relatively ill patients and overtreat relatively healthy patients within a DRG; mixed reimbursement scheme based partially on DRG and partially on cost is needed • Other papers support finding that mixed scheme needed to optimally balance cost and quality

9. II. Competition under a prospective payment system • Empirical evidence • Ellis and McGuire (1996): New Hampshire Medicaid switching from cost-based reimbursement to PPS in 1989 reduced length of inpatient stays for psychiatric patients • Newhouse (1989): hospitals more likely to admit patients in profitable Medicare DRGs, but do not transfer unprofitable patients to other hospitals after admission • Cutler (1995): Changes in reimbursement levels after implementation of Medicare DRG system negatively correlated with inpatient mortality

10. II. Competition under a prospective payment system • Utilization review (UR) • When a health insurance company reviews a request for treatment (either proactively or retroactively) to determine if it is appropriate • Along with the PPS, Medicare implemented UR through Peer Review Organizations (PROs). • Many private insurers also began implementing UR in the 1980s, almost all did by late 1990s.

11. II. Competition under a prospective payment system • UR • Positives • Addresses moral hazard problem created by third party payers (like a supervisor) • Addresses asymmetric information issue between doctors and patients • Helps spread information from medical outcomes research to physicians • Empirical evidence suggests it does reduce inpatient utilization • Negatives • Extra layer of bureaucracy • Are the services being eliminated actually the wasteful ones?

12. II. Competition under a prospective payment system • Cost-shifting • When hospitals respond to reduction in prices from one payer (i.e. Medicare or Medicaid) by raising prices for another payer (i.e. private insurance) • Would not make sense for a for-profit hospital but might in a non-profit (Dranove, 1988) • In order to cost-shift, hospitals would need to have the power to change prices for privately-insured patients (which is hard with managed care) • The most credible empirical evidence suggests that hospitals used to cost-shift but don’t anymore, probably because of the rise of managed care

13. III. Competition under managed care • Managed care is essentially the result of private insurers trying to exercise control over prices and utilization the same way public insurers did • Payers created organizations that contracted with providers to obtain discounted prices • Patients given strong financial incentives to use these “in-network” providers • Payer essentially acts as the “shopper” on behalf of the patient • Providers are willing to offer these discounted prices because of the large volume of patients the managed care organization brings

14. III. Competition under managed care • Theoretically, we would expect managed care to increase the price elasticity of demand and therefore bring competition back to the price dimension instead of just the quality dimension • Empirical test: what is the effect of market concentration on price? • Lower concentration (more competition) increasing price: consistent with quality competition (MAR) • Lower concentration (more competition) decreasing price: consistent with price competition • The most credible empirical evidence (Dranove et al., 1993) suggests that lower concentration switched from increasing price in the early 1980s to decreasing price in the late 1980s, consistent with a switch from quality to price competition caused by the penetration of managed care • This has obvious antitrust implications.