The following originally appeared on The Upshot (copyright 2015, The New York Times Company).
To hear some hospital executives tell it, they have to make up payment shortfalls from Medicaid and Medicare by charging higher prices to privately insured patients. How else could a hospital stay afloat if it didn’t?
But this logic is flawed.
Study after study in recent years has cast doubt on the idea that hospitals increase prices to privately insured patients because the government lowers reimbursements from Medicare and Medicaid.
Indeed, one recent study found that from 1995 to 2009, a 10 percent reduction in Medicare payments was associated with a nearly 8 percentreduction in private prices. Another study found that a $1 reduction in Medicare inpatient revenue was associated with an even larger reduction — $1.55 — in total revenue.
This would be impossible if hospitals were compensating for lower Medicare revenue by charging private insurers more. (Under different market conditions in prior eras, but not today, a few studies found some evidence that hospitals made up shortfalls from one payer with higher prices charged to another. Some are reviewed in a paper by me in Milbank Quarterly, and older ones are summarized in work by Michael Morrisey.)
The theory that hospitals charge private insurers more because public programs pay less is known as cost shifting. What underlies this theory is that a hospital’s costs — those for staff, equipment, supplies, space and the like — are fixed. A procedure or visit simply takes a certain amount of time and requires a specific set of resources. Therefore, if Medicare, say, does not pay its full share of those costs, a hospital is forced to offset the loss with higher prices demanded of private insurers.
The cost shifting theory goes back decades. But economists have long been skeptical of it, pointing to two key weaknesses. One is that it assumes hospital costs are immutable. We should be just as suspicious of such claims in health care as we would be for any other industry.
Jeffrey Stensland, Zachary Gaumer and Mark Miller — who serve on the commission that advises Congress on Medicare payment policy — offered a different view in a 2010 article in Health Affairs. Hospital costs, they said, can change and do so in response to market forces. They found that hospitals that face little competition are less efficient and have higher costs. With few competing hospitals to turn to, private insurers have little choice but to cover those high costs. But Medicare’s prices are fixed and are therefore low relative to the high costs of these inefficient hospitals.
Conversely, hospitals in more competitive regions are more efficient and can earn a profit on Medicare prices. But, because of competition, they must charge lower prices to private insurers. Put it together and it is hospitals’ underlying costs, driven by competition — not cost shifting — that lead to differences in prices charged to insurers and Medicare shortfalls or profits. This theory was conveyed in a report to Congress in 2011.
Another weakness of the cost shifting theory is that it runs counter to basic economics. Hospitals that maximize profits, or even maximize revenue to fund charity care, would not raise private prices in response to lower public ones. In fact, such a hospital would already be charging the highest possible prices to all payers. And, instead of raising them to one insurer if another paid less, they’d do exactly the opposite. Prices charged to two types of customers would move together, not in opposition, for the same reason it does so in other industries.
If a theater finds that bulk ticket purchasers are unwilling to pay as high a price as expected — perhaps because demand by tourist groups and corporations is down — it wouldn’t raise ticket prices for individual purchasers. Because it had filled fewer seats than anticipated from bulk sales, it would reduce prices to others in order to increase sales volume. With seats to fill, when bulk purchasers pay less, so do individual ones. Likewise, retailers charge lower prices to clear inventory, not higher ones to make up for less revenue from early purchasers. Economists have shown that the same logic applies to hospitals: They shift volume from Medicare and Medicaid to privately insured patients by lowering private prices in response to lower public ones — a spillover effect.
Though hospitals don’t seem to cost shift, it remains true that they do cross subsidize. That is, more profitable customers and services enable the provision of less profitable ones. That’s often confused as cost shifting, but there’s a key difference. Cross subsidization isn’t a dynamic process. If one customer becomes less profitable, that doesn’t automatically cause the hospital to charge another more, as the cost shifting theory demands.
The evidence is clear: Today, hospital cost shifting is dead, and the spillover effect reigns. A consequence is that public policy that holds or pushes down Medicare and Medicaid prices (or their growth) could put downward pressure on the prices hospitals can charge to all its customers and, in turn, on the premiums we pay to insurers.
It’s natural, then, that hospital executives continue to promote the idea of cost shifting. The widespread belief they encourage — that it promotes higher premiums — could foster support for larger public payments. It may be a politically useful argument, but it is an economically flawed one.