The MedPAC Blog

Meeting highlight: hospital consolidation and its implications for Medicare

by MedPAC Staff | Nov 15, 2016


At its November public meeting, the Commission held a session to discuss hospital consolidation and its implications for the Medicare program. The Commission has been tracking trends in provider consolidation, Medicare and private insurer payment rates, and provider costs for many years. In this post, we pull together a variety of analyses from MedPAC and others for a comprehensive backgrounder on hospital consolidation and Medicare.    

The difference in Medicare and commercial rates paid to hospitals

There has been a growing divergence between the rates that Medicare and commercial insurers pay hospitals. While commercial rates vary widely from hospital to hospital and insurer to insurer, on average, commercial rates are about 50 percent higher than hospital costs and often far more than 50 percent above Medicare rates (Cooper et. al. 2015, Health Care Cost Institute 2014, Medicare Payment Advisory Commission 2016b, Selden et al. 2015). For example, Selden and colleagues found that average private rates were 75 percent higher than Medicare rates in 2012; Aetna and Blue Cross of California paid hospitals rates that were often 200 percent of Medicare’s rate for inpatient care and 300 percent of Medicare’s rate for outpatient services in California in 2014 (California Department of Insurance 2014a, California Department of Insurance 2014b). This trend is driven by two factors: Medicare has restrained rates in recent years, while commercial payers increased their rates faster than economy-wide inflation (HCCI 2015).  Even in recent years when hospital employees’ wage growth has slowed and uncompensated care costs have declined, hospitals have generally continued to obtain material rate increases (i.e., 4-6 percent) from commercial insurers (HCCI 2014, HCCI 2015).  The result is that hospital all-payer profit margins reached a 30-year high in 2014, averaging 7.3 percent nationwide (MedPAC 2016a).

A key question is whether Medicare should increase its rates to keep pace with private sector prices.  To help answer this policy question we investigate five questions:

  • Why are commercial rates high?
  • Are healthcare rates equally high in other OECD countries?
  • What drives the higher costs of hospital care in the US?
  • What policies have others proposed to improve the market for hospital services?
  • If Medicare resists price increases, will beneficiaries’ access be at risk?

Why are commercial rates high?

Commercial rates are linked to a hospital’s market power, and this market power undercuts insurers’ ability to negotiate prices. Therefore, hospital systems with significant market power obtain higher payment rates from commercial insurers (Cooper et al. 2015, Gaynor et al. 2014, Melnick et al. 2011, White et al. 2013). 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). 

Hospitals’ negotiating leverage may also be enhanced by their ability to balance bill out-of-network patients for emergency care (Kaiser Foundation Hospitals and Permanente Medical Group 2008). Insurers may be reluctant to leave hospitals out of networks if those hospitals will be receiving emergency patients and can balance bill them for the difference between charges and what is covered by their insurer. The inability of patients to avoid out-of-network hospitals in emergency situations can pressure insurers to have wide networks even if it means paying high prices. This can lead to high and widely varying prices even for in-network services (Ginsburg 2010, MedPAC 2016a, Reinhardt 2012).

When examining Truven-Marketscan data from commercial insurers, we have seen that rates received by hospitals vary widely for identical services (MedPAC 2011b).  We recently looked at the variation for two common emergency room services.  Rates for a typical ED visit (CPT 99284) varied by a factor of over four, with 10 percent of hospitals receiving an average of less than $275 and 10 percent receiving an average of over $1,311 for an in-network visit in 2013. Head CT scans (CPT 70450) varied by a factor of six, with 10 percent of hospitals receiving less than $236 for per in-network CT and 10 percent receiving more than $1,472 for an in-network CT (MedPAC 2016a).  The wide variation in rates that we and others have found suggest the market is simply not working to bring rates down to a competitive level (Cooper et al. 2015, Reinhardt 2012).

Are healthcare rates equally high in other OECD countries?

The literature and our analysis suggests that Medicare’s hospital payment rates are roughly 50 percent higher than hospital rates in other OECD countries (MedPAC 2014). Commercial insurers’ hospital rates in the United States are often over 100 percent above OECD rates.

Just as Medicare rates are about 50 percent above OECD, U.S. hospitals’ input costs are also about 50 percent higher than input costs in other OECD countries after adjusting for the cost of living (International Federation of Health Plans 2013, Koechlin et al. 2010, Organisation for Economic Co-operation and Development 2012). One way to compare the relationship between payment rates and costs in different countries is to look at ratios of payment rates for specific services to specific input costs (e.g., nurse wages, physician wages, and drugs). If the ratios are similar, that suggests that the comparison countries have similar price-to-cost relationships.

We compared payment rates for a set of common procedures (hip replacement, bypass surgeries, MRI scans, and cataract surgeries) to the cost of a common input (nurses’ wages). We found that in OECD countries, the rate paid to hospitals for a hip replacement is 20 to 26 percent of a nurse’s annual wage; the Medicare rate for a hip replacement is 24 percent of a nurse’s annual wage (MedPAC 2014). We see a similar story when looking at the other procedures. Given the similarity between these ratios, the relationship between payments and costs in Medicare appears similar to those in other OECD countries. In other words, Medicare rates and rates in OECD countries both reflect the relative input costs in those countries.

What drives the higher costs of hospital care in the U.S.?

One implication of these OECD comparisons is that Medicare rates are higher than OECD rates because U.S. hospitals have higher input costs. However, another way to look at this issue is to ask what causes U.S. hospitals’ input costs to be higher than input costs in other countries. In other words, are hospitals’ costs immutable?  We find that costs are highly dependent on the financial pressure that a hospital experiences. For the last several years, the Commission has published analyses establishing that when hospitals are reimbursed higher commercial rates, they have higher costs per patient and can cut costs when they are under competitive and fiscal pressures (MedPAC 2009, MedPAC 2016a, Stensland et al. 2010).

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. For example, we found that hospitals with low private payer profits from 2009 to 2013 had a median standardized Medicare cost per case in 2014 that was about 9 percent less than the national median, and generated a median overall Medicare profit margin of 6 percent. In contrast, hospitals with high private payer profits over the same period had higher costs per case (2 percent above the national median) and lower Medicare margins (–8 percent) (MedPAC 2016a). Other analyses have also found that costs are not immutable (Robinson 2011, White and Wu 2014).

For-profit hospitals also have a stronger incentive to control their costs than not-for-profit hospitals. For-profit hospitals are expected to maximize profit for their investors, whereas not-for-profit hospitals typically incorporate any excess profits into their cost structure, thereby raising their costs and reducing their Medicare margins. In 2014 for-profit hospitals had positive overall Medicare margins (1 percent).

The key insight of these analyses is that hospitals can control their costs if they have a financial incentive to do so.  Over the years, the market power of hospitals has resulted in limited pressure to constrain costs, resulting in an average cost structure across the United States that is higher than in similar countries (even after accounting for the general cost of living), and in commercial payer rates that exceed even this high cost structure by 50 percent. In addition to the impact that this lack of cost constraint imposes on payers, patients also bear the burden of rapid cost growth. Over the 2004-2014 period, per capita hospital out-of-pocket spending grew 58 percent, compared to only a 21 percent increase in median household income (Census Bureau 2015, Centers for Medicare & Medicaid Services 2015).

What policies have others proposed to improve the market for hospital services?

Many observers agree that there is a need for greater antitrust vigilance to prevent further deterioration of competition, but many “markets are already highly concentrated, so there does have to be some concern about exactly how effective antitrust enforcement can be…” (Gaynor 2011). Rolling back the existing level of concentration in the hospital market may not be a practical policy solution. Therefore, some states and Congress have looked to other measures to improve performance of the market for health care services.

Four options that have been proposed or implemented are:

  • Reference pricing, where the insurer sets a price limit for planned procedures and the consumer must pay the cost above that level. CalPERS, a state agency that administers health benefits for California public employees and retirees, has shown some success with this strategy (Robinson 2013, Robinson et al. 2015)
  • High deductible plans, which can create incentives for patients to seek lower cost care—while price shopping is still not the norm, cost sharing can have some effect on overall costs of care (Newhouse 2004)
  • Limiting out-of-network prices charged in emergency situations, which can reduce the need for insurers to have large hospital networks. California, Florida, and Texas have all recently moved in this direction (Hoadley et al. 2015), and a similar strategy has long been employed in Medicare Advantage, where out-of-network hospitals are only paid the Medicare FFS rate. This has helped Medicare Advantage plans negotiate hospital rates for their patients that are almost exactly equal to FFS rates (Berenson et al. 2015, MedPAC 2013b)

The four strategies above all attempt to make the private insurance market more price competitive. A simpler strategy to put pressure on providers to constrain costs is to directly restrain increases in Medicare prices. In recent years, Congress has chosen not to increase Medicare rates to keep pace with private insurer rates. This may have helped reduce the growth in hospital costs, but some have raised concerns about the gap between Medicare rates and commercial rates paid to hospitals with market power.  A key question is whether this gap will cause access problems for Medicare beneficiaries.

If Medicare resists price increases, will beneficiaries’ access be at risk?

Despite this growing gap between commercial rates and Medicare rates as well as the fact that Medicare rates are now below the average cost of care, we do not expect to see any near-term material reductions in Medicare beneficiaries’ access to care for several reasons:

  • Most hospitals have excess inpatient capacity: in 2014, the average hospital occupancy rate was 61 percent. Occupancy rates averaged only 41 percent at rural hospitals (MedPAC 2016a).
  • Medicare payment rates, while less than the total cost of care, are still sufficient to generate a marginal profit of approximately 10 percent on each additional Medicare patient (MedPAC 2016a). Therefore, it is still profitable for the average hospital to fill its empty beds with Medicare patients.

Because hospitals have a financial incentive and the capacity to serve Medicare patients, we do not expect beneficiary access issues for the foreseeable future. However, in the long run, the growing disparity between Medicare rates and commercial rates (which continue to grow at roughly 4 percent to 5 percent per year) will have to be addressed. The gap cannot be closed by increasing Medicare rates by 4 percent to 5 percent or more per year; the Medicare trust fund would not be able to absorb those price increases, and past evidence suggests this will fuel growth in hospitals’ costs.


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