Catch Me If You Can: Hospitals, Cost Shifting, and the Game of Medicare Payment Policy

Policy History ConferenceMay 20-23, 2004 (St. Louis, MO)

Rick Mayes, Ph.D.Asst. Professor of Public Policy Faculty Research FellowDepartment of Political Science Petris Center on Healthcare MarketsUniversity of Richmond School of Public HealthRichmond, Virginia University of California, Berkeley

Jason Lee, Ph.D.Principal Senior Advisor

National Organization for Research at Chicago (NORC)1350 Connecticut Ave., Suite 500 NW

Washington, D.C.

OverviewThis presentation examines:

1. the background and economic debate over cost shifting,

2. hospitals’ unique position in our country’s health care system as risk-bearing institutions, and

3. how cost shifting affects and is affected by Medicare.

Definition of Cost Shifting“The phenomenon in which changes in administered

prices of one payer [e.g., Medicare] lead to compensating changes in prices charged to other payers [e.g., private insurers, employers] for care.”- Paul Ginsburg, former Chair of the Physician Payment Review Commission (PPRC)

“The allocation of unpaid costs of care delivered to one patient population through above-cost revenue collected from other patient populations.”

- Allen Dobson, President of The Lewin Group

Source: Allen Dobson & The Lewin Group

Hospital Cost Shifting “Hydraulic"

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

120%

130%

Cost

10 80 907060504030200 100

Below Cost PayersAbove Cost Payers

Pay

men

t to

Cos

t R

atio

Percentage of Market Share

B = C + MarginContribution

Margin

Cost Shift

Shortfall

A

B

C

What is Cost Shifting? (continued)• Cost shifting is an implicit social compact between public

payers and providers.

• Cost shifting supplements public funding of safety net providers.

• Cost shifting varies geographically based on market power of the providers, public payer (Medicaid) payment levels, and the levels of uncompensated care.

• Without cost shifting, providers might not be able to modernize and replenish physical plants and equipment.

What is Cost Shifting? (continued)• Privately insured patients have generally

financed losses from other payers:– below-cost (marginal cost) reimbursement rates– uncompensated care

• The ability to cost shift to compensate for one payer’s reduction in revenue is limited if hospitals have already maximized revenues on remaining payers.

Hospitals as Risk-Bearing Institutions

hospitals’ bottom line: total/overall margin

“This measure compares total revenues from patient care and other sources with the total expenses of the institution, including all of the hospital’s activities.”

- Stuart Guterman, Director of Research (CMS)

Economic Debate Over Cost Shifting• Old joke about economists: “They’re people who don’t believe

something can happen in practice until they can first demonstrate it in theory.”

• In theory, cost shifting can occur only if two conditions are met: (1) the provider must have sufficient market power to raise prices to private payers, and (2) the provider must not have been fully exercising this power.

• Looking back on the late 1980s/early 1990s, “cost shifting appears to have died, killed off by new forms of insurance, price competition among hospitals, and greater cost consciousness in health care.” Michael Morrisey

• “Without exception, for all hospital types during all time periods, lower Medicare prices were associated with statistically significant increases in private pay prices.” Jan Clement; J. Zwanziger, G. Melnick, A. Bamezai; J. Mitchell, J. Hadley, J. Gaskin

Hospitals as Risk-Bearing Institutions

“For hospital administrators, theirs is a balancing act to make sure they keep their institution’s doors open. So they’re thinking about maximization of revenue within the parameters of (1) retail prices, which are paid by few people, (2) wholesale prices, which are paid by many people, and (3) government prices, which are imposed on them.”

- Chip Kahn, President of the Federation of American Hospitals (FAH)

“One of the nice things about being an economist is that one can say that even if people don’t consciously make a decision, they act as though they did. And that certainly sounds to me like hospitals acting as though they are cost shifting, because implicitly that’s what they’re doing.”

- Stuart Guterman, Director of Research (CMS)

Source: Stuart Guterman, CMS

Contribution to Total Hospital Margin, By Revenue Category, Selected Years 1980-2000

4.2

9.1

29.3

20.518.5

-1.2

0.4

-10.9

4.30.3

-3.8

-8.9

-14.6-17.7 -19.2

2.84.9

8.2

15.017.5

-30

-20

-10

0

10

20

30

40

1980 1986 1992 1997 2000

Year

Con

trib

utio

n to

tota

l mar

gin

(in $

bill

ions

)

Private Medicare Other Patients Other Sources

1984-1996: Medicaid vs. Private ratios: r = .02

1984-1996: Medicare vs. Private ratios: r = -.81

Hospital Payment-to-Cost Ratio by Payer, 1980-2000

60

70

80

90

100

110

120

130

140

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Year

Ra

tio

(in

percen

t)

Medicare Medicaid Private

Hospitals as Risk-Bearing InstitutionsOn average:

• Medicare represents 35-45% of most hospitals’ total revenue;

• Private payers represent 40-50%; and • 5-25% comes from a mixture of Medicaid and other

government and private subsidies (philanthropy, revenues from assets, etc .)

All the revenues from these sources have to compensate a hospital for its charity care. So, as Chip Kahn explains, “it doesn’t matter whether it’s a not-for-profit or a for-profit hospital. In either case, you’ve got to make a profit.”

Hospitals as Risk-Bearing InstitutionsSimilar to many service industries (e.g., airlines,

telecommunications, higher education), hospitals routinely charge different prices to different payers.

Hospitals are also similar to many service industries in that they have high fixed costs (e.g., buildings, maintenance, utilities, equipment, capital, some salaried labor costs) and low variable costs (e.g., medication, paper, food, medical tests, disposable supplies).

example: computer tomographic (CT) scan

On average, fixed costs account for 58-75% of hospitals’ costs; variable costs account for 25-42%.

Hospitals as Risk-Bearing InstitutionsThe combination of high fixed costs and low variable costs

produces low marginal costs.

Thus, the overall change in a hospital’s total costs for providing one additional service or procedure is low, often minimal. This reality frequently (if not constantly) encourages hospitals to try to increase their volume.

Marginal cost is a critical concept because a hospital that seeks to reduce its total costs by reducing services will often only save on marginal costs and, in the process, decrease its revenues (a very great sin in any business).

Hospitals as Risk-Bearing InstitutionsWith low marginal costs and public patients as roughly half of their revenue base, hospitals’ expenses have often chased their revenues. In other words, when Medicare payments increase, hospitals frequently increase their purchase of new technologies and other capital investments and, consequently, increase their operating expenses in the long run . . .

• Mayes: Others I’ve interviewed have said that hospitals will cry, cry, cry [about their financial status and Medicare reimbursement], but that you have take it with a grain of salt sometimes.

• Scully: Oh, they’re doing great!  I’ll tell you, go find me a hospital that hasn’t built a giant new bed-tower in the last few years.  They’ve actually slowed down, because the government has phased out Medicare capital (reimbursement)… We used to pay for capital in Medicare; it was a DRG add-on for capital expenditures.  Well, if you’re getting 40% of your revenues from Medicare and you want to build a new building and Medicare will pay for 40% of it, right? Then, why not?  So what you were getting all through the 1980s was a massive building spree up into the early 1990s and even through the ‘90s, because it was a 10-year phase out. 

If you wanted to build a new hospital wing in 1990—even if you didn’t have any patients for it—if you budgeted $100 million, Medicare would write you a check for $40 million!  So what do you get?  You got a hell of a lot of big new hospital wings, need them or not. This is one of the reasons we’ve had such massive over-capacity… You’d have to be an idiot not to put up a new building every couple of years, because Medicare paid for such a big part of it.  That is slowing down now and you’re starting to see the demand catch up on capacity in a lot of markets.[i]

[i] Tom Scully, CMS Administrator, interview with R. Mayes (October 24, 2002).

Hospitals as Risk-Bearing InstitutionsIn their efforts to manage their financial risk, hospital

administrators ultimately face two distinct challenges:

(1) The first is to decrease the cost/per unit of each individual medical service; to improve the management of their (variable) costs -- to increase efficiency/productivity.

(2) The second challenge is to maximize reimbursements relative to expenditures for the services it provides.

Source: Stuart Guterman (CMS)

Hospitals Administrators’ Behavior Over Time: Maximize Reimbursement First, Decrease Costs Later

Change in Costs per Case andHospital Revenue Flows from Private, Medicare, and Other Patients, 1986-2000

8.6

1.6 2.0

10.9

-0.7

0.5

6.3

4.7

0.9

10.2

1.70.5

-5

0

5

10

15

1986-1992 1992-1997 1997-2000

% A

nnua

l Cha

nge

Costs per Case Private Medicare Other Patients

Source: Stuart Guterman (CMS)

Hospitals Administrators’ Behavior Over Time: Maximize Reimbursement First, Decrease Costs Later

Cumulative Change in Hospital Inpatient PPS Payments Per Case and Medicare-Allowed Costs Per Case, 1984-1999

0

20

40

60

80

100

120

140

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Per

cent

Payments per case Costs per case

The Origins of Large-Scale Cost Shifting

• transition in Medicare’s reimbursement model to a prospective payment system, 1983

• 467 Diagnosis-Related Groups (DRGs)

• Congress’ painless budgetary “savings” by simply restraining the annual increases in DRG payments rates below the “market basket” rate of medical inflation

Source: ProPAC, 1996

The Origins of Large-Scale Cost Shifting

Hospitals' Inpatient Medicare (PPS) Margin and Overall Margin,* 1984-92

-5

0

5

10

15

84 85 86 87 88 89 90 91 92

Year

Per

cent PPS Margin

Overall Margin

The Origins of Large-Scale Cost Shifting• “What was going on beginning in the late 1980s and even into the ‘90s was

this enormous drive to balance the federal budget. At that time Medicare was, if it wasn’t the biggest program, and/or the fastest growing program, it was pretty close to it. And Medicare was viewed as a deficit reduction device in a big way. Providers, particularly hospitals, were always viewed as an easier target than doing anything that would have ever affected beneficiaries… It was all, “How much money can we save by making this tweak to Medicare’s payment system or that tweak?” For instance, the annual update factor for DRGs [hospital payments] was supposed to be based on the annual increase in the “market basket” [a measure of the rate of medical inflation]. But instead it has always been “market basket minus” some number.

I don’t know how many people on the Hill would be up front in admitting this, but they would sort of have a hole in the budget target to reconciliation … and they’d save the PPS update factor to be the last thing to be determined. And they would say, “Ok, we gotta’ save a billion bucks over three years, so let’s just make it ‘market-basket minus 0.5 percent.’ Or ‘market basket minus 1.5 percent’.” At the end of the day, it was legislated in the back rooms and it was all a budget number.”

- Rick Pollack, Vice President (AHA) interview with R. Mayes (December 27, 2002)

70%

80%

90%

100%

110%

120%

130%

140%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Pay

men

t-to

-Cos

t R

atio

Medicare Medicaid Private Payer

Cost Shifting as an Evolving Phenomenon in the Hospital Industry

Source: Allen Dobson; MedPAC report to Congress, March 2002, Figure 5-9 as modified by The Lewin Group.

Cost Shifting

Deficit

Less need for cost shiftingas public payment increases relative to costs & managed care

Re-emergenceof cost shifting pressures?

Medicare, Medicaid and Private Payer Payment-to-Cost Ratios

Source: Stuart Guterman (CMS)

Medicare as a “Deficit Reduction” DeviceMedicare Hospital Inpatient PPS Margin, 1984-2003Under Alternative Assumptions About Cost Increase

13.4 13.0

8.7

5.9

2.7

0.3

-1.5-2.4

-0.9

1.3

5.6

11.1

15.916.9

13.9

11.910.8 11.0 11.6 11.6

8.19.0

9.9 9.3

-5

0

5

10

15

20

1984 1986 1988 1990 1992 1994 1996 1998 2000* 2002*

Year

Mar

gin

Margin (MBI) Margin (MBI-1)

Hospitals’ “Perfect Storm” 1997-1999• BBA, 1997:

“We looked at 5 or 6 different factors [in adjusting Medicare’s payment policy]… The first one was not what was happening with health care spending or particularly what was happening with Medicare spending. The thing that drove us to the table to begin talking about the Balanced Budget Act was the overall level of the federal budget deficit. That was the number one thing we thought about in looking at health care policy. I’m not sure I agree that that’s what we should have been thinking about, but that was what precipitated the discussion.” - Nancy-Ann DeParle, former Administrator of HCFA, interview with R. Mayes (November 4, 2002)

• Justice Department’s increased anti-fraud campaign beginning in 1997

• the accumulated growth in managed care’s market share

Hospitals’ Response• successfully lobbied Congress for two “give

back” bills (1999, 2000)

• Increased consolidation, renegotiation of contracts with insurance companies and employers, and utilization of their existing economic/political leverage to negotiate better payment rates

Results• decade-long downward trend in hospital pricing

reversed itself in 1999

• Average annual health insurance premium increases of between 10 and 14% since 2000 have reflected larger hospital payments.

• 2001: hospital spending ($451.2 billion total) increased 8.3%, its fastest growth since 1991

• Increases in hospital spending alone accounted for 30% of the increase in total health spending in 2001, the largest hospital contribution to the annual increase in total spending since 1992.

Implications of Cost Shifting for Medicare Policymaking• Question: Do policymakers knowingly take account and advantage of

cost shifting?• Answer: well, yes and no

Stuart Altman, former Chair of ProPAC: “I don’t want to speak for all states . . . . But I can tell you that in Massachusetts and in several other states that I deal with, policymakers are very conscious of their ability to cost shift. And there is no question that they are much more willing to cut the rates or not pay hospitals anywhere near their costs than they are to do that to nursing homes. Why? Because they know Medicaid is only 10% of hospitals’ revenues on the patient side, but it’s 60 to 80% of nursing homes’ revenues. And this has a big impact on where policymakers put their marginal dollars. So, yes, Medicaid consciously knows that.

Medicare, on the other hand, is a much bigger player on the hospital side. And, therefore, it’s more difficult for Medicare to play the “I’m just the marginal payer” kind of a game… Ultimately, the big cost shifter is Medicaid. And then next to that is Medicare.

For Community Hospitals, as the Cost Shift Burden Increases the Private Payment-to-Cost Ratio Increases

Source: The Lewin Group analysis of data contained in AHA TrendWatch Chartbook: Trends Affecting Hospitals and Health Systems, 2001.Includes data for hospitals that reported data in the AHA Annual Hospital Survey.

The correlation coefficient betweenPrivate Payer Payment-to-Cost Ratio andMedicare, Medicaid & Uncompensated Care cost shift burden is 0.753

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0% 5% 10% 15% 20% 25%

Medicare, Medicaid & Uncompensated Care Cost Shift Burden (in %) by State

Pri

vate

Pay

er P

aym

ent-

to-C

ost

Rat

io

Implications of Cost Shifting for Medicare Policymaking

Policymakers’ challenge in setting fair and appropriate payment rates is made all the more difficult by the fact that it is next to impossible to determine what exactly “Medicare costs” are.

As discussed previously, the majority of any hospital’s costs are fixed regardless of who receives its services. Moreover, hospitals do not have separate wards for Medicare and private patients that could, theoretically, allow an accountant to more clearly distinguish the costs a hospital incurred serving the two different patient populations.

Therefore, as S. Altman explains, “The reality of the situation is that with all the joint costs and interconnectedness, there is no such thing as ‘Medicare costs.’ Nevertheless, we behave like there are Medicare costs; and even under those definitions, Medicare consciously and unconsciously takes account of other implications.”

Implications of Cost Shifting for Medicare Policymaking

Two hospital sectors that policymakers have consciously subsidized for years with comparatively more generous payment rates:

(1.) teaching hospitals (GME, IME = $6 billion in 1999)

(2.) indigent safety-net hospitals (DSH = $5 billion/per year)

Cost Shifting among Academic Health Center Hospitals has Declined

Source: Allen Dobson; The Lewin Group, “Financial Performance of Academic Health Center Hospitals, 1994 – 2000,” prepared for The Commonwealth Fund, September 2002.

As have Academic Health Center Hospital Margins

Source: Allen Dobson; The Lewin Group, “Financial Performance of Academic Health Center Hospitals, 1994 – 2000,” prepared for The Commonwealth Fund, September 2002.

Implications of Cost Shifting for Medicare Policymaking• “We have known almost from day one—and I can say we, ProPAC

and I think Congress—that teaching hospitals, on a purely cost basis, were being paid more than they could really justify on a cost basis for teaching. What held me back, and I think other members of ProPAC back, was that we also looked at teaching hospitals’ total margins.

We then looked at the total margins of other hospitals and said, “My God, if we really forced the teaching adjustment down to what technically the regression equation suggests we should pay them, we could force teaching hospitals into very serious financial shape. And we count on them to provide a disproportionate amount of uncompensated care. We count on them, one way or another, to really be subsidizing teaching and education in different sorts of ways. Quite frankly, we’re a little afraid of finding out how far we can push it.”

- Stuart Altman: Quoted from “The Policymakers’ Perspective: How Has Current Policy Developed and How Can the Past Inform the Future?” When Public Payment Declines Does Cost-Shifting Occur? Hospital and Physician Responses, Symposium Sponsored by Changes in Health Care Financing and Organization (HCFO), Washington, D.C., (November 13, 2002).

Implications of Cost Shifting for Medicare Policymaking• Ultimate Question: So what should Medicare pay providers?• (Stock) Answer: A “fair” amount, which produces “rough justice.”• (Real) Answer:

The issue is just: What can the political market bear … for Medicare payment grossly in any given year? And then how does that play out to all of the individual payments? And with all due respect to the great work that ProPAC, PPRC, and ultimately MedPAC have done over the years, very little analysis actually plays through to that ultimate decision. The ultimate decision on payment policy is a political decision made in the market place. As a public policy decision, public purpose is a piece of it. But special interests get involved and whether it’s the people that are pushing DSH payments or indirect medical education, they sort of push and if they push hard enough and they’re smart enough, they affect the ultimate whole. And I would argue that at the end of the day it has very little to do with the market price. It just has to do with what the government can bear.

At the end of the day for the hospital administrator, they look at that and say, “Gee, how much do I have to make? And what can the market bear in the real marketplace with retail prices and these negotiated payments?” Then they just sort of work it out and pray that it all comes together at the end of the day and that they have enough to meet their operating costs and make some margin for future purposes.

- Chip Kahn, President of the Federation of American Hospitals (FAH)

Conclusion• Perhaps cost shifting is best thought of as a lubricant

within a massive series of financial feedback loops between:

- government (Medicare, Medicaid),

- providers (hospitals, physicians), and

- private payers (insurance companies,

employers, individuals).

Future Concerns I• The ultimate cost shift is both prevalent and

increasing in scope and degree: employers passing on a larger and larger share of their increased health care costs to their employees in the form of higher monthly wage deductions and/or increased co-payments, deductibles, and out-of-pocket costs (especially for employees’ dependents).

• Beyond this strategy, more and more employers have simply stopped offering health insurance (15% of the U.S. population is uninsured; 42.6 million individuals or the aggregate population of 24 states, 2002)

Future Concerns II• Increased segmentation of medical provision:

private, independent physician-owned surgical and delivery centers (e.g., cardiac, orthopedic, radiological services)

• These centers skim off the best paying patients who ordinarily subsidize many hospitals’ loss-making departments; makes cost shifting more difficult because there are fewer patients over whom a hospital can spread its risk and costs.

Exit Question: What do providers do when every payer only wants to pay the marginal cost? How do we finance the entire health care system?