Pricing Rules for Hospitals

The widespread cross subsidization observed in hospital rate structures has become the focus of increasing controversy. This paper shows how this pricing practice can play a critical role in compensating for distortions and inequalities in existing health insurance coverage. The hospital pricing decision is modeled as a problem in public enterprise pricing. Theoretically derived prices are then compared with those charges actually observed in a representative hospital. Cross subsidization among ancillary services, special procedures, and daily accommodations is found to have potentially significant welfare gains. These results suggest that the frequently cited norm of average cost pricing in hospitals may have serious drawbacks.