Medicaid/Medicare Supply of Medical Services

PPS and Competition

Prospective Payment Systems (PPS) and competition go hand in hand.  Without competition, a PPS gives hospitals and physicians the incentive to minimize health care outlays.  A competitive fee-for-service (FFS) system-to which most Americans were accustomed to in the 1980s-can lead to severe cost increases due to the problem of moral hazard.  Combining PPS and competition will lead to efficient provision of health care services; at least this is the thesis of a 2002 paper written by Meltzer and Chung (“Effects of Competition under prospective payment on hospital costs among high-and low-cost admissions“). 

Meltzer and Chung look at hospital financial data from the California Office of Statewide Health Promotion and Development before (1983) and after (1993) the Medicare and Medi-Cal PPS was implemented.  In 1983, the authors find that under the FFS regime the higher competition level in an MSA, the higher the price increases.  After the PPS , the authors found that increased competition levels lead to significant decreases in cost.

Meltzer and Chung also hypothesize that these effects would be exacerbated in ‘high cost’ patients.  The authors claim that “declines in hospital cost growth will be concentrated at the top of the spending distribution.”  To motivate this claim, the authors construct the following hospital profit maximization model:

  • max D(q)[P-c(s)-c(q)]

Here ‘q‘ is the quality of care which is implicitly a function of the patient’s sickness level ‘s‘.  Since we are dealing with a PPS, the price ‘P‘ is not dependent on quality.  The first order condition (after dividing both sides by c(s) is:

  • [P-c(s)-c(q)]=[c'(q)*D(q)]/D'(q)

or rearranging

  • [P-c(s)-c(q)]/c(q)=[e_{c,q}]/[e_{D,q}]

where [e_{a,b}] is the elasticity of a with respect to b.  This equation says that the ratio of profit to cost should equal the ratio of the cost and demand elasticities.  Totally differentiating this first order condition shows that dq/ds<0.  This means that quality will decline in a PPS system as the severity of the illness decreases.  The data support this as we see that the cost reductions under PPS are greatest for the groups in the sickest quantiles.  This paper provides strong suggestive evidence but is not overwhelmingly convincing.  The largest decreases in cost most likely occur in the most expensive patients since they make up the largest portion of hospital expenses.  One would expect any secular trend to show up most in these 'expensive patients.'  Further, hospitals may have reduced inpatient costs for these very sick patients, but may have made up the difference with higher outpatient costs as treatment methods became more flexible in the 1990s.  Further, the hypothesis that more competition leads to faster cost reduction under FFS, may not be robust if there are omitted variables which are not taken into account.  The authors do control for population size and average income in the MSA, but the regression may be improved by using regional or state dummies, as well as a measure of migration to the MSA.

David Meltzer and Jeanette Chung (2002) “Effects of Competition Under Prospective Payment on Hospital Costs Among High- and Low-Cost Admissions: Evidence from California, 1983 and 1993”, Forum for Health Economics & Policy, Forum: Frontiers in Health Policy Research, Volume 5: Article 4.