Myth Busters #5: Hospital Rate Setting

With the repeal of the Health Planning Act in 1982, a lot of health policy wonks found themselves out of work. They had to come up with something new to earn a living and justify their PhDs.

They had learned a very expensive lesson — that reducing supply at a time of growing demand is a bad idea because it results in rising prices. This is something most people less expensively in Econ101, but it seems to have escaped the health policy community, which often reflects Ivy Baker Priest’s famous quote, “I am often wrong, but never in doubt.”

So, they decided that this time they would control prices. I was still In Maine, when we adopted a hospital rate setting system in 1983. This initiative was based largely on a study published in the New England Journal of Medicine in 1980, “Hospital Cost Inflation under State Rate Setting Programs,” by Brian Biles, Carl Schramm, and Graham Atkinson.  The article concluded, “

the average annual rate of increase in hospital costs in (the six) rate-setting states has been 11.2 per cent, as compared with an average annual rate of increase of 14.3 per cent in states without such programs.

In 1986 the authors updated that information through 1984 in an article in Health Affairs, “Controlling Hospital Cost Inflation: New Perspectives on State Rate Setting.”

It is interesting that these were state-based systems. With Ronald Reagan as president it was unlikely that private sector price controls could have become federal law. But the health policy community is nothing if not inventive. Like a broken sewer pipe, it will follow the path of least resistance

Of course, the six rate-setting states (Connecticut, Maryland, Massachusetts, New Jersey, New York, and Washington) started out as probably the most expensive and wasteful states in the nation. That is why they were prompted to adopt these systems in the first place. There was already plenty of fat to be trimmed, which would not be true for other states.

Indeed, the Health Affairs article reported that the non-regulated states had a per capita hospital cost of $107.02 in 1972, while the states that adopted the price controls were spending $135.08 per person. Further, these costs were spread over a much larger hospitalized population in the non-regulated states, which had an admissions rate of 152.8 per thousand in 1972, compared to 131.1 per thousand in the states that adopted regulations.

Usually in research if there is a self-selected sample being studied, the researchers look to see what might distinguish the sample from the rest of the population and adjust their findings accordingly. Not so for health policy advocates who are so eager to push their preferred remedies that they ignore what should be standard techniques of research.

The study mentioned above completely overlooked many pertinent differences between the six regulated states and the forty-five (including DC) non-regulated areas. Obvious differences include that the six states tended to be no-growth or low-growth states, so they had little need for new hospital construction. They also tend to be high Medicaid enrollment states, but also with higher average incomes than the non-regulated states. Other possible differences that would have been worth exploring include the relative percentage of uninsured, the ratio of teaching hospitals, the availability of non-hospital alternatives such as home health services or free standing surgical services, and the presence of for-profit hospitals. All of these differences could have had a profound effect on the viability of hospital rate setting in the various states but none were even considered.

As it was, what the research discovered was that after 13 years of experience:

  • The high-cost states remained high cost.
  • These states began with lower rates of admissions, and ended with lower rates of admissions.
  • They began with lower operating margins and ended with lower operating margins.

Yet somehow the researchers concluded that hospitals in the regulated states were “more efficient” than those in the non-regulated states, though it would seem that having fewer admissions at higher costs while maintaining low profit margins would be a slam dunk argument that these regulated hospitals were anything but more efficient.

Such one-sided research was persuasive enough to the “health policy community” that 30 states ended up adopting similar rate setting programs during the 1980s. Here is yet another example of an unscrutinized idea that led to yet another failure — but only after more wasted money and time.

In 1997 Health Affairs published another article with a somewhat different tone. This was “Tracking the Demise of State Hospital Rate Setting,” by John McDonough. The article said, “Now, in the mid-1990s, state rate setting is nearly gone; most major systems have been deregulated during the last ten years.” (Ultimately these systems were repealed by every state but Maryland.) The article explained that the growing managed care companies thought they could negotiate lower hospital rates than were available through price-controls, and that the regulators themselves agreed their rules were “incomprehensible.”

Not mentioned by the author, but fairly obvious, was the reality that once state government becomes responsible for setting prices, it also becomes responsible for assuring the solvency of the facilities. Inefficient facilities are protected from failure, and any decision to close a hospital becomes a political, not an economic, one. A threatened facility can generate enough political support to keep its doors open, even when it makes no economic sense to do so.

In any case, once again an idea was tried and failed miserably at the cost of many billions of dollars and who knows how many lives lost or destroyed. All on an idea that was poorly thought through in the first place.

Comments (16)

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  1. Michelle says:

    Spot on, as per usual. Thanks for sharing.

  2. Buster says:

    It is definitely true that any attempt to close an unprofitable hospital generates cries about how the community will suffer.

  3. Tom H. says:

    Good post, Greg. I enjoy your Myth Busters.

  4. Neil H. says:

    You have to wonder what kind of thinking leads to the desire to do the impossible: set prices in a highly complex system.

  5. Virginia says:

    Has anyone ever done a study of the number of failed versus successful public policy initiatives? It seems like we would have established that central planning, especially for something as complicated as the health care system, is fundamentally flawed.

  6. Richard Amerling, MD; New York, NY says:

    Another in the very long list of failed price control schemes. What was that definition of insanity again?

  7. Bob Lucisano says:

    I would like to see opinions on doing away with networks and assigment of benefits. I always thought he who has the money controls the price they pay for services, and let the bidding begin. A little competition is always good.

  8. Frank Timmins says:

    Thanks for the analysis of this mess Greg. While on the subject, it seems clear that hospital costs are the 800 lb. primate in the health reform room. I am curious as to the approach you favor in the inclusion of hospital costs in the free market solutions for reform.

    With all the purposeful lack of transparency (clearly it is best to keep the public ignorant of prices), and the price fixing of government programs along with the secretive contracting with BUCA, how can this mess be unraveled and rebuilt?

  9. Greg Scandlen says:


    I would like to see a program like the late Jim Pendleton proposed — a quasi-indemnity payment system. If you recall, Jim suggested fixing the reimbursement at the average per procedure in the region and then adjusting it up or down on a sliding scale. If the patient goes to a lower-cost facility a portion of the saving is put into her HSA. If at a higher-cost facility, the patient makes up some of the difference.

    No networks, no “negotiated” fees, and complete freedom of choice for the patient with incentives to use lower cost facilities.

    Top that off with no restrictions on competition and you would get a dynamic, innovative market for hospital services — including off-shoe providers.

  10. Greg Scandlen says:

    Ooops. That should be “off-shore providers.”

  11. Frank Timmins says:

    Thanks for the clarification Greg. I was bemoaning one more bit of terminology that I knew nothing of – thinking maybe “off shoe” means “in patient” or sumsuch.

    Anyway, yes I remember Jim Pendleton’s ideas. although I never completely understood how it could be done. Is it a kind of sophisticated DRG approach? Are you talking about only Medicare/Medicaid, or is this feasible for the private market? If so, wouldn’t it take legislation to compel the hospitals to participate?

  12. Greg Scandlen says:

    Jim was from Pennsylvania where they have a requirement that all hospitals reveal their average charge per service. So he could collect and publish the charges and find a median point. He found a VERY wide range of prices. Other states would need to do something similar. Not a DRG because each facility can charge anything it wants, but obviously people will shun the high cost ones — if they have to pay part of the excess fee.

    Jim wasn’t thinking about Medicare and Medicaid, just private carriers. There would be no need for the carrier to have a contract with the facility so there wouldn’t be any “participation” other than publishing the charges, which would be done by a state agency.

    I’ll see if I still have Jim’s paper around, but I have had a number of computer crashes since that time.

  13. Frank Timmins says:

    It sounds like a plan. There certainly hasn’t been any other suggestions that make sense. I wish this idea could find its way into the staffs of congress for development. Is NCPA aware if this approach?

  14. Steve Bassett says:

    Greg, Jim’s idea is on it’s way ( a table of allowances with cash incentives for members who achieve the best price). Some folks are calling it reference based pricing. As you and I have discussed the key will be adequate incentives to the member. If this happens price signals to the individual (not third party) will lead to a competitive market, and send cost and quality in the right direction.

  15. Greg Scandlen says:


    I would not want Congress to touch this idea with a ten foot pole. And I sure wouldn’t trust staff to “develop” it. What could they possibly bring to it? Other than getting rid of obstacles like any relevant anti-kickback regulations. All I want Congress to do is — UNDO.

  16. Frank Timmins says:

    “I would not want Congress to touch this idea with a ten foot pole. And I sure wouldn’t trust staff to “develop” it.”

    No argument from me on that. Are you saying that this should be pursued on a state by state basis? In other words, is some authority is going to have to require the posting and standardize the procedure?