We Need a New Way to Finance Hospital Externalities

Paying hospitals for beneficial mission-related costs has been a hit and miss affair. These costs fall under the general headings of providing indirect medical education, ensuring standby capacity for trauma services, piloting new technologies, supporting medical research and treating those unable to pay for care. Providing funding for each of these categories is not without controversy – principally over how much support is warranted and how much contributes to wasteful inefficiency or just plain inequitable hospital funding. Whether we believe too much or too little is being given to support these community benefits, the existing structural problems for financing these mission-related costs are being exacerbated by changes in the insurance market.

Payment for inpatient admissions varies by facility even when payments are established by a regulatory system that aligns payment to efficient cost. Some differences, like labor and capital costs or the patient’s clinical condition, are related to a hospital’s cost of production. Others, such as add-on payments for indirect medical education (IME), are related to and are intended to benefit the community as a whole. Because hospitals act as training grounds for the doctors of tomorrow, they have elevated costs per case. These higher costs, which could be interpreted as inefficiencies, are in fact investments we make in the human capital of physicians. When an efficient level for per-case payment to the hospital is constructed, allowances are made in the form of “add-ons” for these additional costs because they yield external benefits to the broader community. However, payments for these externalities are directly linked to hospital volume—and this causes two problems.

First, hospital volumes are needlessly tied to externalities rather than efficient quality based service delivery. Under the existing payment system the level of funding for external benefits is proportional to the volume of cases. Remember, add-on payments are for community benefits that are not directly linked to use of services by an individual; however, many of these externalities positively impact individuals as well as the broader community. Individuals within a region want trauma services to be available but hope not to use them and they (or their family) will need doctors in the future even if they do not visit the hospital in which they train. This results in higher costs for hospitals that have trauma services or train physicians. Add to this that elected officials pass laws, such as EMTALA to provide a minimum level of coverage in the ER, which also need to be funded and which have a cost impact on all hospitals. You get the point!

Payers have strong incentives to avoid high cost hospitals—both those that are inefficient and those that have high costs due to the external benefits they generate. By avoiding hospitals with high costs associated with externalities, payers can deliver lower premiums. This leaves hospitals to shift externality costs onto the remaining patient volume. While payers are looking to shrink volume to avoid community costs, hospitals need to maintain patient volume over which to spread the additional overhead. This flies in the face of numerous policies incentivizing hospitals to reduce admissions (or penalizing them if they do not).

Second, what often gets forgotten in the interaction between insurer and hospital is the effect upon individual patients. For many years insurers and government payers built networks that contained those high-cost hospitals that deliver added benefits, recognizing that they were an essential resource. Rates paid to the hospitals were high, but coinsurance and deductibles were modest so the variation in out-of-pocket expenses (money tagged on to premiums) was minimal for an individual. Higher rates paid to high-cost hospitals were spread across all of the plan’s members through premiums. This is now changing as more people are moved into high deductible plans. As individual out-of-pocket expenses grow as a share of financing, so does the share of funding for hospital externalities paid for by the patients who are using the hospital. This is an inherently unfair situation—both for those that are living in close proximity to these facilities and for the facilities themselves that need to maintain volumes (and deal with disgruntled, soon-to-be impoverished patients).

An obvious solution is for costs associated with externalities to be clearly defined and paid to hospitals in the form of a block transfer of money based upon a formula that is not linked to volume. Such a solution would promote transparency, tie funding for externalities to presumed benefit rather than hospital volume, and limit the ability for insurers and the community at large to act as “free riders” on the system. There are numerous, well-respected groups such as the Council on Graduate Medical Education, the Institute of Medicine and MedPAC, which are focusing on the big picture reforms for funding medical education. But, first, let’s start by moving away from volume-based financing so we can both better compare hospitals and more fairly allocate financing of their missions.

Richard Fuller, MS, is an economist with 3M Clinical and Economic Research.

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