The Headache of Hospital Pricing – Jared Rhoads

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Some of the most persistent problems in American healthcare can be traced to structural features that conceal economic realities from patients, providers, and policymakers. The tax preference for employer-sponsored insurance is one. Over-reliance on third-party payment is another. These features have dulled price sensitivity, inflated spending, and caused patients to disengage from the economic realities of the care they consume. Another such defect that deserves more attention is the extent to which we have normalized internal cross-subsidization across different services, particularly within the hospital context.

It sounds technical, but put simply, hospitals have come to depend on an internal financial arrangement in which some lines of business are reliably profitable while others are chronic money losers. For example, elective, specialized, and outpatient-oriented services such as orthopedics, cardiology, and imaging often generate substantial margins. By contrast, emergency care, psychiatric services, obstetrics, and pediatrics are often financially weak or negative. This arrangement is causing problems, especially for anyone trying to introduce competition, transparency, or lower prices into healthcare.

This is not the same type of cross-subsidization that you might have heard about in which private payers are said to subsidize public programs by paying more for the same healthcare services than payers such as Medicare and Medicaid. That issue is important, too, but somewhat murky. In that debate, the facts are hard to pin down, and nobody has access to all the data. Talk to a C-suite hospital person, and they will assure you that cross-subsidization between private and public payers is real. Check the literature from the academic health economists, and some of them will claim that it’s not.

The issue of internal cross-subsidies is different: it is about some hospital departments being used to prop up others. This situation holds back progress because once one part of the system starts to depend on hidden internal subsidies, every effort to introduce change through competition or lower prices in another high-profit area is met with outsized resistance. One service can be shown to be wildly overpriced, but the response is, “Yes, but that’s what keeps the emergency department open.”

How This Plays Out

Consider imaging, which is a service category that tends to be highly profitable, in part because Certificate-of-Need (CON) laws keep new competitors from moving in and bringing prices down. Free-market health policy advocates can push for repeal of CON laws, but part of what makes it possible for incumbents to push back is the argument that over at the big hospital in town, those big margins are often needed to support some other service, perhaps labor and delivery. Or take another profitable service: orthopedic surgery. Some of those expensive surgeries could be provided at lower prices in new direct-pay (i.e., cash-only) ambulatory centers, but legislative efforts that would allow the licensing of direct-pay facilities attract pushback from incumbent hospitals that, once again, need those profits to sustain other unprofitable parts of their mission.

In American twentieth-century history, airlines and railroads both went through phases of cross-subsidization. As Dwayne Banks et al. note, “First, airlines cross-subsidized shorter-haul and lower-density traffic with profits from longer-haul, higher-density traffic. Second, railroads (at least until the creation of Amtrak in 1971) cross-subsidized money-losing passenger service with profits from freight.” But these arrangements tend to be unstable over time. Once competition emerges, the cross-subsidy gets exposed and becomes harder to maintain. Incumbents need to become increasingly political in order to fend off competitors who want to break into certain market segments. This is how we get incumbents making allegations of “cream skimming.”

Cross-subsidization across hospital services is not what one would normally expect to see in a free and properly functioning market. In most industries, each product or service is expected to stand largely on its own. Usually when a business continually loses money on one service or product line, it responds by raising prices, cutting costs, finding a more efficient delivery model, or shutting down that product or service altogether.

Hospitals operate differently because our public policy choices have made them operate differently. The clearest example is emergency care. Under the Emergency Medical Treatment and Active Labor Act (EMTALA), hospitals must provide emergency care and stabilizing treatment regardless of a patient’s ability to pay. Whatever one thinks of that obligation, we have never paired it with a transparent financing mechanism. Instead, it basically functions as an unfunded mandate, which forces hospitals to...