Hospital Reimbursement Incentives: An Empirical Analysis

Reimbursement systems for health‐care providers are very complex, like the production systems that they regulate. This complexity has led to some important misperceptions about the incentive consequences of major reimbursement reforms. One example is the prospective payment system (PPS), developed to provide “high‐powered” incentives through fixed prices for hospital admissions for the US elderly. In fact, various features of the DRG system allow reimbursement to vary with actual treatment decisions during an admission, and so are not prospective. This paper develops a general method for measuring actual reimbursement incentives in complex regulated price systems. The method uses regression techniques with variance decompositions to quantify the effects of particular features of the payment system on prospective and retrospective cost sharing, as well as overall generosity of payments. I apply this method to microdata on 20 percent of Medicare hospital admissions in 1987 and 1990 to summarize the incentives created by PPS in practice, and how the incentives are evolving over time. I show that PPS involves limited and decreasing cost sharing with hospitals, most of which is not prospective. The reimbursement incentives vary substantially across diagnoses, demographic groups, and types of intensive treatments, possibly with important implications for hospital behavior and medical expenditure growth. The techniques developed here can be used to analyze a broad range of provider reimbursement mechanisms.