A Cost Shift Study Done Right

Good, policy relevant, health economics studies are hard to do. They have to satisfy many criteria in multiple dimensions, being fundable, tractable, publishable, timely, relevant, built on accepted methods appropriate for the application, and for which data are available. Moreover, given the delays in funding, the time it takes to do the work, and the slow journal review process one must anticipate by years what is likely to be important. So, it is hard. But when it is done well it is a thing of (wonky) beauty.

Lately there have been quite a few health care cost shifting studies that fail to be beautiful, even in the eye of a wonk. In health care “cost shifting” is the idea that lower public payments to providers lead (causally) to higher private payments and health insurance premiums. Not too long ago I described a recent cost shift study and traced its assumptions back to their source. I found that it was built on a weak foundation and therefore didn’t advance our understanding of cost shifting. From poor assumptions and inappropriate methods incorrect results follow, leading to the wrong policy recommendations.

This is, of course, relevant. The notion that most or all of public payment reductions are or will be shifted to private payers is pervasive. With Medicare expansion part of the Senate public option compromise there are renewed claims from hospital and physician groups that low payment from Medicare leads to higher private payments and insurance rates.

Fortunately, a sound cost shifting study by Vivian Wu has recently been published (Hospital Cost Shifting Revisited: New Evidence from the Balanced Budget Act of 1997, International Journal of Health Care Finance and Economics, 12 August 2009). It satisfies the criteria of a good study and leads to sensible policy recommendations consistent with those implied by other studies. Wu’s is just the latest in a growing body of work suggesting that increasing competition among hospitals should be part of an overall strategy to control health care costs.

Wu’s main result is that on average prices paid to hospitals by private payers increases by 21 cents in response to each dollar reduction in public revenue. By way of comparison, this 21% rate of cost shift is about half of the lowest estimates produced by industry studies and is far below their common assumptions of 50% to 100%.

If you can stand a bit of economic, econometric, and public policy wonkery read on. The details reveal just how good a job Wu did in her study and why others are not up to the highest standards of good technique and scholarship. First, Wu describes the two schools of thought on cost shifting. One espouses the “market power” hypothesis which is that hospitals with large shares of private patients are able to cost shift more due to their greater bargaining power. The other abides by the “strategy” hypothesis leading to the notion that hospitals with a greater share of private payers cost shift less because they are relatively more immune to changes in public payments. (Here “strategy” refers to that of the public programs, which includes free riding on high private payments.)

Next Wu thoroughly reviews the academic cost shifting literature, some of which I’ve covered in prior posts (under the cost shift tag). In doing so she makes the crucial point that changes in private and public revenues are endogenous, as is revealed directly by the “strategy” school argument, though there are other reasons. Quoting Wu’s paper,

On the one hand, Medicare prices can affect private prices because the latter are negotiated after observing Medicare prices. On the other hand, Medicare revenues can be affected by private prices as well. Medicare, knowing private payers’ generosity, can strategically set prices too low to free ride.

Hence, one cannot conclude anything about cost shifting by direct examination of private and Medicare revenues, a mistake made in many studies. One must use more sophisticated techniques (instrumental variables to use precise jargon) to relate changes in private revenues to the exogenous component of public revenue changes.

Of course, having made this point Wu applies appropriate methodology to estimate a (plausibly) causal relationship between private price changes and changes in hospital Medicare revenue due to the 1997 Balanced Budget Act (over the period 1996-2000). In addition to finding a 21% cost shift she also finds evidence that the “market power” hypothesis dominates. That is, if the “strategy” hypothesis holds it is weaker and therefore overwhelmed by market power forces. To put this more simply, in a more competitive hospital market one should expect less cost shifting.

The policy implications are clear. Wu doesn’t state them, but I will. Within the range of variation studied by Wu, with respect to hospital payments, overall health costs can be reduced by 79 cents per dollar of Medicare payment reduction, the other 21 cents being shifted to the private sector. However, the more competitive the hospital market the less the cost shift. For some hospitals in some markets Wu found cost shifting rates as low as 5%. Therefore, sound public policy would encourage greater competition among providers (wherever possible) in tandem with reductions in public payments. Doing both concurrently would reduce public health expenditures with minimal impact on private payments.

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