Hospitals provide a wide range of services to a diverse group of patients. Both the services and the patients vary extensively in their level of profitability to the hospital. In the next two segments, we will look at two common hospital practices to manage this situation. Cost-shifting and cross subsidization. The two practices are different, yet interrelated. So what makes a service unprofitable? The simple answer is, a service will be unprofitable whenever the cost of providing it exceeds the revenue it generates. In hospital care, there are two key elements that can lead to having insufficient revenue to cover cost. The first element is simply inadequate reimbursement rates. That is, if price lies below cost even if all patients are paying that price the hospital will stand to lose money. The second element is a relatively high proportion of uninsured non-paying patients. Even if reimbursement rates are set above cost, the fact that some patients pay that price and some pay nothing or close to nothing puts the hospital at risk of losing money. One way to address this issue is cost-shifting. Cost-shifting refers to an economic phenomenon, where one group or individuals overpays for services to cover losses generated by a different group or individuals who underpay. For hospitals, it refers to the case where reductions in price paid by public insurers lead to an increase in prices charged to commercial insurers. That is private payers are charged more in response to shortfalls in public payments. Early evidence suggested that cost-shifting is a large and prevalent practice. But recent work argues that while cost-shifting can and has occurred, its prevalence and magnitude has been exaggerated. Cost-shifting by definition results in a case of price discrimination. Price discrimination describe a case where a provider of service charges a different price to different consumers. This is a common pricing strategy designed to maximize profit. For example, offering student discounts is a form of price discrimination. While cost-shifting implies price discrimination, price discrimination does not imply cost-shifting. That is, a movie theater is not charging high prices so they can charge students a lower price, and rest assured. The theater is not losing money on students. The evidence for cost-shifting comes in two flavors. The first is interviews with hospital leaders who argue that this practice is real and pervasive. Their logic was somewhat intuitive. If one insurance pays less someone has to pay more. The second type of evidence provided for cost-shifting are time series, such as those depicted in this figure, the figure shows the aggregate payment to cost ratios for all hospital-based services financed by private payers, Medicare, and Medicaid from 1980 through 2015. At the 100 percent level, we have our benchmark, as this is where the payment equals the cost. Note that private insurance pays rates that are 15 percent to 45 percent above cost, while Medicaid rates are always below cost, Medicare rates are nearly always below cost but consistently above the Medicaid ones. To see the cost-shifting argument, notice that the private payment to cost ratio is negatively correlated with that of public programs. That is, when Medicare's payment to cost ratio is relatively high, private payers payment to cost ratio is relatively low and vice versa. This is indicative of cost-shifting, but it is also consistent with other hypotheses. So if it is not cost-shifting what might be a different interpretation for the trends in payment to cost ratios? One simple explanation suggests that hospitals engage in cost cutting and not cost-shifting behavior. If public payers lower their payments, the hospital may be pressured to cut costs. It is likely that the hospital would not be able to perfectly offset the reduction in reimbursement with a dollar-to-dollar reduction in cost. Which would lead to a reduction in the payment to cost ratios for public payers, but an increase in the payment to cost ratio for private payers. Even if private payers continue to pay the exact same price. Here is a numeric example, assume that the cost per admission is $5,000, and a commercial insurer pays $6,500 per admission, while Medicare pays $4,500, and Medicaid pays $4,000. The payment to cost ratio is 90 percent for Medicare, 80 percent for Medicaid, and 130 percent for the private payer. Now, assume that Medicare and Medicaid reduced their payment by 20 percent, and are now paying the hospital $3,600 and $3,200 respectively. In response, the hospital reduces its costs by 10 percent, from $5,000 to $4,500. Let's evaluate the resulting payment to cost ratios and note that the private payer did not raise payment, that is, there is no cost-shifting. The resulting payment to cost ratio is 80 percent for Medicare, 71 percent for Medicaid, and 144 percent for the private payer. Therefore, cost cutting behavior is consistent with the trends in the payment to cost ratios we saw previously. Cost-shifting behavior is challenging for economic theory as well. To be able to extract higher payments from private payers, the hospital has to possess market power. That is the hospital should have strong bargaining power when negotiating with insurers. But if the hospital has market power and can raise prices why wait for a drop in public payer reimbursement to do so? Many health economists argue that cost-shifting is inconsistent with economic theory, as it requires hospitals to both possess market power and not fully exploited. Therefore, there are only few examples of theories that accommodate profit maximization and cost-shifting. Here is an example of such theory. Imagine a large number of hospitals all negotiating prices with a large insurance company. Hospitals would like to command higher prices and the insurance company would like to pay hospitals low prices. To lower health care spending, insurance companies create hospital tiers. The more hospital competition there is, the more effective the tiering strategy would be. They would offer low levels of cost sharing for top tier hospitals to direct patients to the hospitals. At the top tier, the insurer will feature hospitals willing to accept low payments, in return for high-patient volume. In the second tier, they may feature hospitals that negotiated higher rates and so on. The ability to convince some hospitals to accept lower rates in return for high-patient volume is the result of hospital competition for patients. Now, let's go back to cost-shifting. If public payers lower their payment rates, hospitals that treat a large share of Medicare and Medicaid patients will be hit financially, and may consider exiting the market altogether. But if they exit, members will have less choice of providers and tiering would be less effective. Put differently, if the hospital exit the market, it will raise the bargaining power of all remaining hospitals. Therefore, the insurer may find it advantageous to build this hospital out so to speak by raising payments to this hospital so it can preserve its competitive tier structure. This theory explains why private payers would raise prices when public payers lower prices, and hence it's consistent with both cost-shifting and profit maximization. In the next segment, we will introduce and examine cross subsidization, a different hospital practice to tackle disparities in profitability.
