The MedPAC Blog

Hospital Costs: What to Make of Them

by MedPAC Staff | Dec 11, 2014


Each year during its update process (read this post for more on that), the Commission examines Medicare’s payments to hospitals for inpatient and outpatient care. As part of this analysis, MedPAC compares Medicare’s payments to hospitals’ costs to determine a Medicare “margin.”  For several years, these margins have been negative, indicating that on average, Medicare’s payments are less than hospitals’ costs.  

Some would argue that negative margins are an indication that Medicare needs to increase its payments to cover hospital costs. A different way to think about the issue is to ask whether hospitals’ costs have to be as high as they are and whether hospitals have the ability to control costs. Said differently, we wondered, “Are hospital costs immutable?”

For the last several years, the Commission has published analyses (here, here, and here) establishing that when hospitals are reimbursed higher commercial rates, they have higher costs per patient. Commercial rates are linked to a hospital’s market power. When a hospital or hospital system has significant market power, it can demand higher payment rates from commercial insurers. In addition to the Commission’s work, this finding has been shown here and here. In recent years, many hospitals have increased their market power through consolidation (acquiring or merging with other hospitals in their market and acquiring other providers, such as physician practices).

What explains the link between high commercial rates and high costs? When a hospital receives higher payments from commercial payers, the financial pressure on the hospital is lower. It therefore has less incentive to keep its costs low. As the hospital’s costs rise along with its commercial payments, Medicare’s payments look worse by comparison. On the flip side, MedPAC has also shown that providers under financial pressure, who receive lower commercial reimbursements, are able to restrain their costs.

A new analysis presented at our November meeting takes a different look at hospital costs. Instead of looking at the relationship between hospital costs and payment rates, we look at the relationship between hospital costs and occupancy rates.  The prevailing view is that the majority of hospital costs are fixed in the short run. Following from this, if hospitals engage in efforts to control utilization – like in the context of an Accountable Care Organization looking to reduce unnecessary hospital admissions – they will have fewer patients to help cover their fixed costs, and costs per patient will rise as a result. 

If the majority of costs were fixed, we would expect to find that hospitals with low occupancy rates and declines in admissions have relatively higher costs per patient. We do find that when admissions fall and occupancy rates decline, hospital costs per patient are higher, but the effect is relatively small, suggesting that the majority of costs are not fixed in the short run. In fact, we estimate that only between 10 and 30 percent of hospital costs are fixed in the short run.  More detail on our analysis is here.

MedPAC will consider these findings and others as it makes recommendations around hospital payments for the March report, and going forward in other Reports to Congress. 

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