Although U.S. health care spending growth has slowed in recent years, health spending continues to outpace growth of the overall economy and workers’ wages. There are clear signs that rising prices paid to medical providers—especially for hospital care—play a significant role in rising premiums for privately insured people. Over the last decade, some hospitals and systems have gained significant negotiating clout with private insurers. These so-called “must-have” hospitals can and do demand payment rate increases well in excess of growth in their cost of doing business. During the 1970s and ’80s, some states used rate-setting systems to constrain hospital prices. Two states—Maryland and West Virginia—continue to regulate hospital rates. State policy makers considering rate setting as an option to help constrain health care spending growth face a number of design choices, including which payers to include, which services to include, and how to set payment rates or regulate payment methods. To succeed, an authority charged with regulating rates will need a governance structure that helps insulate regulators from inevitable political pressures. Policy makers also will need to consider how a rate-setting system can accommodate broader payment reforms that promote efficiency and improve quality of care, such as episode bundling and rewards for quality.
- Negotiating Power Shifts to Hospitals
- Hospital Price Growth
- History of Rate Setting
- Key Design Questions
- Challenges to Rate Setting
Negotiating Power Shifts to Hospitals
Under pressure from rapidly rising health care costs, employers in the late-1980s and early 1990s began shifting workers into managed care products—primarily health maintenance organizations (HMOs)—with restrictive provider networks and tighter utilization management. Promising increased patient volume, health insurers also pushed hospitals and physicians to accept lower payment rates. At about the same time, hospitals began a wave of mergers and acquisitions to cut costs, eliminate excess capacity and strengthen their negotiating clout with private insurers.
Amid the backlash against tightly managed care in the mid-1990s and the economic boom of the late-1990s, the balance of negotiating power shifted markedly from insurers to providers, especially hospitals. As the economy improved, employers became less concerned with controlling costs and more concerned with attracting and retaining workers. Employers gravitated away from HMOs toward health insurance products with a broad choice of providers—typically preferred provider organizations (PPOs)—to quell worker discontent with restrictions on provider choice. To market attractive PPO and other insurance products, health plans created large, inclusive provider networks. Lacking a credible threat of excluding providers from their networks, health plans lost significant negotiating leverage.
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Provider demands for higher payment rates and other favorable contract terms led to a rash of plan-provider contract showdowns in the early 2000s, when many providers threatened and some actually dropped out of health plan provider networks.1 When the economy slowed again and health care spending growth accelerated rapidly, instead of limiting provider choice, employers began shifting costs to workers through increased patient cost sharing—higher deductibles, coinsurance and copayments.
Hospital Price Growth
In 2000, hospital prices paid by private insurers on average exceeded hospitals’ costs by 16 percent—by 2009, that gap had grown to 34 percent (see Figure 1).2 However, a growing body of research shows hospital prices vary widely both within and across communities.3 Along with market concentration, other factors—for example, hospital reputation, provision of unique specialized services and dominance in geographic submarkets—appear to play a role in the importance that consumers place on hospitals’ inclusion in health plan networks and the prices that hospitals are able to command. Even in markets with dominant insurers, health plans appear unable or unwilling to constrain hospital price increases, because they can pass along higher costs to employers.
Price-variation analyses consistently point to differences in hospital market power as the central explanation rather than differences in hospital quality or patient complexity.4 Elements of health reform that encourage greater integration of hospitals, physicians and other providers—for example, accountable care organizations—likely will encourage more consolidation and potentially increase hospitals’ negotiating leverage.
Two broad options are available to address rapidly rising hospital prices—market forces and regulation. The prevailing market approach involves adopting insurance products that motivate enrollees to consider price. Examples include narrow-network products, which exclude higher-cost providers, and tiered-network products, which place higher-cost providers in tiers requiring higher patient cost sharing at the point of service. The alternative to market forces is hospital rate setting by a public entity. Rate setting could take relatively loose forms, such as a limit based on some multiple of Medicare payment rates, or could be highly structured, such as the system used in Maryland since the 1970s.
This analysis describes key design options that state policy makers would need to consider in developing a rate-setting system, including which payers to include, which services to include, and how to set payment rates or regulate payment methods.
History of Rate Setting
Hospital rate setting, as practiced in the 1970s and 1980s, sought mainly to correct the inherent flaws of the then-dominant hospital payment method—cost reimbursement. Akin to giving providers a blank check, cost reimbursement provided no incentives for hospitals to operate efficiently. Many states considered multi-payer hospital rate setting, and eight eventually enacted laws authorizing public agencies to regulate hospital rates.5 Approaches varied from state to state, but regulators generally focused on constraining inpatient per-diem or per-case payment rates in an attempt to control hospital costs. Responding to regulators’ focus on controlling rates, hospitals in some states provided more units of service, weakening the overall constraints on spending growth.
Studies show strong and consistent evidence that rate setting slowed aggregate total hospital spending in New Jersey, New York, Massachusetts, Maryland, New Jersey and Washington. The exception was Connecticut, where regulators reportedly lacked the authority to enforce payer and hospital compliance with approved rates. Rate-setting studies also found neither adverse nor positive effects on regulated hospitals’ financial status. West Virginia’s regulation of hospital rates did not begin until 1985, and enabling legislation took the form of a rate freeze and initially was limited to mandatory budget reviews. Given its later adoption, West Virginia’s regulatory experiences have not been included in evaluations of rate-setting systems and have received little attention from researchers and policy makers.
Key Design Questions
State policy makers contemplating the design of a new rate-setting system will face key design questions, including:
- Should rate setting be limited to private insurers or also include Medicaid and Medicare?
- Should rate setting apply only to inpatient hospital care or should outpatient and physician services be regulated as well?
- Which entity should assume rate-setting authority, and how should it be funded?
- How should payment rates be set, should a unit of payment be specified, and should constraints be placed on hospital revenue or discharge volume?
- How can rate setting support payment innovations?
Challenges to Rate Setting
To some policy makers, rate setting represents an unacceptable intrusion into the marketplace, but the status quo may be even more unpalatable. If prices paid by private insurers continue to grow at high rates, private health insurance premiums will increase accordingly, making health insurance less affordable for more Americans.
State experiences with hospital rate setting demonstrate that rate regulation can hold down spending on hospital services, but serious challenges would confront any state contemplating adoption of a hospital rate-setting system. The most significant challenges include building a broad reservoir of good faith and insulating regulators from day-to-day political pressures. Hospitals can apply intense pressure on a rate-setting body if its decisions are not perceived as fair and based on evidence. And, given the importance of the health sector as a source of local jobs and economic expansion, resistance to rate regulation should be expected.
Over the long run, decisions about governance and leadership may be more critical to the success of rate setting than the technical details of payment formulas. Enabling legislation that sticks to broad objectives yet allows regulators room to maneuver and respond to changes in market behavior will give a rate-setting system greater resilience over the long run.