A Proposal for Incentive Reimbursement for Hospitals

In the early 1960's, a number of observers argued that the current method of reimbursing hospitals by third parties would be a factor contributing to increasing hospital costs. In this report, we analyze one method of reimbursing hospitals—we postulate and test a number of hypotheses about the nature of the incentives that are built into the program, and then propose an alternative way of reimbursing hospitals. It is argued that a prospective reimbursement formula be negotiated and developed that depends on two factors: 1. an agreed upon rate of general inflation, and 2. an estimated cost function which captures important aspects of the case-mix which accounts for differential costs across hospitals. The cost function is presented, and various aspects of the proposed formula are discussed.