• Simply put: Price discrimination and cost shifting

    Simply put” is an ongoing series. See the introduction for an explanation of the series and the full list of topics that have been or may be covered. Feel free to suggest other topics in that post.

    It is well-known that hospitals charge different payers (health plans and government programs) different amounts for the same service even at the same point in time, a phenomenon known to economists as “price discrimination” (Reinhardt 2006). Price discrimination is not unusual. Airlines engage in it (charging passengers on the same flight different ticket prices depending on purchase date), as do hotels (different room rates by date of purchase), colleges (via financial aid), movie theaters (senior and child discounts), and many other industries.

    Price discrimination implies cross-subsidization. Those who pay more for a seat at a movie theater are contributing more toward covering the theater’s costs than those who pay less for a seat. However, price discrimination does not mean that someone pays more because someone else paid less. In fact, a business that was trying to earn as much profit as it could should charge each customer as much as it can without driving too many of them to a competitor. In other words, the price you pay at the movies is the profit maximizing price. Even if another class of customer (senior citizens or kids) pays less, the profit maximizing price for you is not higher because they do so. In fact, if the theater lowered its price for senior citizens further and raised those for younger adults, it would drive away the younger ticket purchasers and attract more senior citizens, lowering profit, not raising it.

    However, for some reason when it comes to health care–and in particular, hospital service–it is widely believed that private insurers have to pay more because public programs pay less. This phenomenon is called “cost shifting” (Morrisey 1993, 1994, 1996, Ginsburg 2003).

    In truth, the evidence suggests that there is likely only a small cost shifting effect for hospital services today, though not for physician services or pharmaceuticals. The differing cost shifting behavior of organizations providing these different types of health services is due to the degree to which each tends to maximize profits and the degree of competition each one faces. The greater extent to which an organization maximizes profits or the greater the competition it faces for customers (patients), the less scope there is for cost shifting.

    Many hospitals do not maximize profits and do not face stiff price competition. This allows for the possibility of cost shifting. The best estimates in the literature suggest that today hospitals probably cost shift about 20 cents of each dollar shortfall in Medicare payments. In other words, if Medicare cut its payments to hospitals (for a particular service) by one dollar, private insurers would pay 20 cents more for that service. The remaining 80 cents would be made up by decreases in costs of providing that service (e.g., changes in staffing or reductions in quality). However, during certain periods in the past, the cost shifting rate was higher (perhaps as high as dollar-for-dollar). At other times it was found to be much lower (perhaps as low as zero). The difference, again, depends on how much hospitals had to compete for privately insured patients.

    Thus, though price discrimination is a large, widespread, and pervasive phenomenon in the hospital industry, cost shifting is not. And it is nonexistent for physician services and pharmaceuticals.

    Further Reading

    Frakt A. How Much do Hospitals Cost Shift? A Review of the Evidence. The Milbank Quarterly 89(1), March 2011. All citations above appear in this paper. Also, much of the content of that paper has been conveyed in prior posts.

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