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Generally, are Healthcare providers price setters or price takers? Explain

Answer the following questions in a 3-page paper.

Page 1

Generally, are Healthcare providers price setters or price takers? Explain.

Which should be used by hospitals to care for non-insured poor?

Page 2

Besides using RVUs for pricing, it is becoming increasingly common to use RVUs to determine physician compensation. How do you think the use of RVUs for physician compensation will affect quality of care?

Read the article Hospital Pricing. The author does not take a very favorable viewpoint on hospital pricing. Do you think the ACA will improve the situation, or make it worse?

Page 3

Describe the following methods used to estimate the cost of individual services:

a. Cost-to-charge ratio (CCR) method

b. Relative value unit (RVU) method

c. Activity-based costing (ABC) method

Explain the essential differences between full cost pricing and marginal cost pricing strategies.

What would happen financially to a health services organization over time if its prices were set at a. Full costs?

b. Marginal costs

The Pricing Of U.S. Hospital
Services: Chaos Behind A Veil
Of Secrecy
An economist’s insights into what causes the variation in pricing, and
what to do about it.

by Uwe E. Reinhardt

ABSTRACT: Although Americans and foreigners alike tend to think of the U.S. health care
system as being a “market-driven” system, the prices actually paid for health care goods
and services in that system have remained remarkably opaque. This paper describes how
U.S. hospitals now price their services to the various third-party payers and self-paying pa-
tients, and how that system would have to be changed to accommodate the increasingly
popular concept of “consumer-directed health care.” [Health Affairs 25, no. 1 (2006): 57–
69]

A
s k e d b y a wa l l s t r e e t j o u r n a l r e p o r t e r to explain how U.S. hos-
pitals price their services, William McGowan, chief financial officer of the
University of California, Davis, Health System and thirty-year veteran of

hospital financing, responded: “There is no method to this madness. As we went
through the years, we had these cockamamie formulas. We multiplied our costs to
set our charges.”1

Exhibit 1 illustrates his point. Although the list prices reflected in Exhibit 1
vary by only a factor of slightly more than 4, they reportedly vary by as much as
seventeenfold across all hospitals in California. However, these “charges” are
much higher than the prices U.S. hospitals are actually paid. In 2004, for example,
U.S. hospitals were actually paid only about 38 percent of their “charges” by pa-
tients or their insurers.2 The actual prices they were paid appear to vary much less
than “charges” do, although even that variation is remarkable large. For example,
in 2001 the prices hospitals were actually paid by private health insurers serving
the Federal Employees Health Benefits Program (FEHBP) varied by “only” 259
percent across the United States.3

Only a handful of Americans truly comprehend the complex payment system
for U.S. hospitals—mostly those whose job it is to set, negotiate, and study hospi-

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Uwe Reinhardt (reinhard@princeton.edu) is the James Madison Professor of Political Economy, Center for Health
and Well Being, Woodrow Wilson School of Public and International Affairs, Princeton University, in Princeton,
New Jersey.

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tal prices. Self-paying, uninsured patients certainly do not understand these prac-
tices. Quite aside from the incomprehensible variation of list prices across hospi-
tals within a state, these patients might wonder why their neighborhood hospitals
billed them more than twice the amount for a given procedure than what that
same hospital billed their neighbor’s insurance carrier for the same procedure.4

This paper has several purposes. First, I attempt to describe more fully the man-
ner in which hospitals now price their services to the fiscal intermediaries who
provide the bulk of the hospital’s revenue, and also to self-paying individual pa-
tients. I should note at the outset, however, that any such description overlooks lo-
cal variations to more general patterns. Next, I offer an economist’s perspective on
the widespread practice of “price discrimination” in the hospital industry—that
is, the practice of charging different payers different prices for identical health
care goods or services. I conclude by giving some thought to the problem of how
prospective patients could be apprised of a hospital’s prices under what has come
to be known as “consumer-directed health care.” Although the cost of a single in-
patient episode typically will exceed the deductibles of consumer-directed plans
and revert the matter to third-party payment, many consumer-directed policies
require sizable coinsurance in addition to the deductible, which gives prospective
patients a financial stake even in the prices charged for inpatient care.5 Further-
more, a growing fraction of total hospital revenue now comes from outpatient ser-
vices—36 percent of hospitals’ total gross patient revenues in 2004.6

How Hospitals Set Their Prices, And How They Are Paid
� The hospital’s chargemaster. Overarching the U.S. hospital payment system

is each individual hospital’s “chargemaster.” The data shown in Exhibit 1, for exam-
ple, were taken from the chargemasters of the hospitals featured in the exhibit. A
hospital’s chargemaster is a lengthy list of the hospital’s prices for every single proce-
dure performed in the hospital and for every supply item used during those proce-
dures. A sample chargemaster posted on the Web site of California’s state govern-

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EXHIBIT 1
Charges For A Chest X-Ray (Two Views, Basic) At Selected California Hospitals, 2004

SOURCE: L. Lagnado, “California Hospitals Open Books, Showing Huge Price Differences,” 27 DecemberWall Street Journal,
2004.

Doctors Medical Center (Modesto)

Sutter General (Sacramento)

UC Davis (Sacramento)

Cedars Sinai (Los Angeles)

West Hills Hospital (West Hills)

Scripps Memorial (San Diego)

San Francisco General

0 500 1,000 1,500
Dollars

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ment, for example, contains close to 20,000 items.7

Traditionally, each U.S. hospital has had its own chargemaster, but through the
Health Insurance Portability and Accountability Act (HIPAA) of 1996, Congress
has sought to impose a standard national format on that nomenclature, a process
that is yet to be completed.8 Hospitals update their chargemasters at least annu-
ally but often more frequently. Typically, a hospital will submit, for all of its pa-
tients, detailed bills based on its chargemaster, even to patients covered by Medi-
care. An advantage of these bills is that at least in principle, patients can check
whether all of the supplies and services listed on the bill were actually delivered.
A disadvantage, for hospitals, is that these bills are very lengthy and add up to
large totals that do not bear any systematic relationship to the amounts third-
party payers actually pay them for the listed services. As noted earlier, these actual
payments tend to be less than half of the amounts that originally were billed.

Hospitals do not follow a common practice in updating their chargemasters.
Some hospitals might simply raise every price in the list by the same percentage
once a year. Others might update prices for particular items or procedures sepa-
rately, by different percentages, which makes it difficult to know by what overall
percentage a hospital has increased its prices. These updates sometimes occur
more than once a year. In general, the process appears to be ad hoc, without any
external constraints—the “ madness” alluded to by McGowan.9

With the exception of California, which now requires hospitals to make their
chargemasters public, hospitals are not required to post their chargemasters for
public view. It may be just as well. If the sample chargemaster posted by Califor-
nia’s state government is any guide, prospective patients would be hard put to
make sense of these price lists.

An individual hospital might be paid by a dozen or more distinct third-party
payers, each with its own distinct set of rules for and levels of payment, which are
negotiated separately with each private insurer once a year. Medicare and Medic-
aid have their own extensive rules for paying hospitals. Relative to hospitals paid
under the much simpler national health insurance schemes in other countries, the
contracting and billing departments of U.S. hospitals therefore are huge enter-
prises, often requiring large cadres of highly skilled workers backed up by sophis-
ticated computer systems that can simulate the revenue implications of the indi-
vidual contract negotiations. Furthermore, because violations of contracts with
the government programs can trigger severe civil or criminal penalties, hospital
billing departments are strictly monitored and supervised by sizable internal con-
trol operations.

� Medicare hospital payments. U.S. hospitals now receive abut 31 percent of
their net revenues from Medicare. About 88 percent of Medicare’s total payments to
hospitals directly for patient care is for inpatient services; the remainder goes for
outpatient services.10

For inpatient services, Medicare pays hospitals flat fees per hospital case, ac-

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cording to a schedule of close to 600 distinct diagnosis-related groups (DRGs).
The system assigns relative payment weights to each DRG. To arrive at the actual
payment for a particular DRG in a given year, that DRG’s relative payment weight
is multiplied by that year’s monetary conversion factor (the “base payment
amount,” in dollars). That payment is then further adjusted for regional variations
in the cost of labor and of other hospital inputs, and for other local factors that
might affect a hospital’s cost of producing care.11 To accommodate complex cases
whose resource use greatly exceeds that foreseen in the closest DRG, the system
provides for “outlier” payments that, in principle, are set to reflect the hospital’s
estimated cost of providing the additional supplies and services used.

The DRG weights used in this system were originally based on the relative aver-
age costliness of cases in DRGs in the early 1980s. They have been recalibrated reg-
ularly on the basis of average standardized, billed charges for all cases falling into
each DRG in the most recent Medicare file.12 Congress updates the monetary con-
version factor annually, to reflect changes in technology, practice patterns, and
economywide market conditions—for example, in the so-called market-basket
price index of hospital inputs (such as energy) affecting hospitals in all regions.

The DRG system, which is, in essence, a system of centrally administered prices,
has had its critics in the United States over the years. None other than Tom Scully,
the Medicare administrator during President George W. Bush’s first term, has dis-
paraged Medicare as a “dumb price fixer.”13 Ironically, that very system was origi-
nally put into place by none other than the staunchly market-oriented Ronald
Reagan. In any event, since it was first introduced in 1983, the DRG system has had
a number of imitators abroad, notably in Australia and Germany.

For outpatient services, Medicare originally reimbursed hospitals retrospec-
tively for allowable, incurred costs, for which beneficiaries were required to make
copayments. By 1997 these copayments had come to equal about 50 percent of to-
tal Medicare payments to hospitals for outpatient care.14 In the Balanced Budget
Act (BBA) of 1997, Congress mandated Medicare to replace that inherently infla-
tionary, retrospective, full-cost reimbursement system with a prospective fee
schedule, whose basic payment unit is either a service or a particular procedure.
This schedule went into effect in 2000.

In developing the new fee schedule, Medicare bundled—as much as is sensi-
ble—entire sets of supplies and services associated with each major procedure
into one lump-sum fee for that procedure. These procedure categories are classi-
fied into some 600 distinct groups, each of which contains major procedures that
“are clinically similar and use comparable amounts of resources.”15 The grouping
was made according to an ambulatory payment classification (APC) scheme de-
veloped through health services research. These APCs are still evolving, as Medi-
care gains experience with them and as new technology emerges.

As in the DRG system, the dollar amount paid hospitals for a particular APC is
determined by multiplying the relative cost weight of that APC (based on median

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costs for that APC) by a monetary conversion factor. Further adjustments are
made for regional variations in input costs, especially wages, and other factors
thought to affect hospital outpatient costs. Once again, there is a provision for
outlier payments. There is also provision for pass-through payments covering
costly new technology (such as drugs) going into particular treatments.

The Medicare payment system is highly complex, in part because government
payment systems must observe rules of fairness, strict accountability to taxpay-
ers, and other social goals not imposed on private payers. Critics of the system
sometimes overlook the fact that these requirements pose administrative chal-
lenges not shared by private enterprise. However, the myriad of distinct payment
systems for U.S. private insurers are very complex as well, by international stan-
dards, and often still based on paper claims.

� Medicaid hospital payments. Medicaid now accounts for about 17 percent of
total national spending on hospital care.16 Payment methods vary from state to state,
but two methods dominate for inpatient payments: flat fees per DRG or flat per
diem payments.17 The DRG payments are unilaterally set by the state governments,
usually as a percentage of Medicare DRGs. For outpatient services, the most com-
mon approach traditionally has been what is called “cost reimbursement,” or fee
schedules set by the state governments. Many states, however, are considering
switching to the APC system pioneered by Medicare.18

As Allen Dobson and his colleagues show elsewhere in this volume, on average,
for the nation as a whole, Medicaid’s payments to hospitals fall well short of fully
allocated costs, even after the separate disproportionate-share hospital (DSH)
subsidies paid by the federal government and the states to hospitals with dispro-
portionately large loads of uninsured or Medicaid patients are accounted for.19

That shortfall must be covered by other payers—mainly private insurers.
� Private insurance. Hospitals receive roughly one-third of their net revenues

from private health insurers, which pay hospitals on the basis either of steeply dis-
counted charges (with discounts in excess of 50 percent), negotiated per diems, or
flat charges per entire episode (DRGs). Usually an insurer pays most claims on one
base (for example, per diems), although an insurer may pay some hospitals on other
bases as well.

Discounted charges tend to be used by smaller insurance companies for inpa-
tient services. They are used by all insurers for outpatient services, although in-
surers often bundle all of the services going into a major procedure (such as a lap-
aroscopic cholecystectomy) into one code, just as Medicare and Medicaid do with
the APC system. Case-based payments are each insurer’s own adaptation of the
Medicare DRGs. Usually the insurers will use the Medicare DRG groupings, but
each will assign its own relative weights to the individual DRGs.

Whatever an insurer’s base for paying hospitals might be, the dollar level of pay-
ments is negotiated annually between each insurer and each hospital. Under a
DRG system, for example, the item to be negotiated is the monetary conversion

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factor for the year and, possibly, some of the DRG weights. These actual dollar
payments have traditionally been kept as strict, proprietary trade secrets by both
the hospitals and the insurers. Recently Aetna announced that it will make public
the actual payment rates it has negotiated with physicians in the Cincinnati area.20

That this small, tentative step toward transparency made national news speaks
volumes about the state of price-transparency in U.S. health care. It remains to be
seen whether that first step will trigger a larger industrywide move toward re-
moving, at long last, the veil that has been draped for so long over the actual prices
paid in the U.S. health system.

� Uninsured patients. Until recently, only uninsured, self-paying U.S. patients
have been billed the full charges listed in hospitals’ inflated chargemasters, usually
on the argument that the Medicare rules required it.21 This is how even uninsured
middle-class U.S. patients could find themselves paying off over many years a hospi-
tal bill of, say, $30,000 for a procedure that Medicaid would have reimbursed at only
$6,000 and commercial insurers somewhere in between.22

Because uninsured patients often are members of low-income families, many of
them ultimately paid only a fraction of the vastly inflated charges they were origi-
nally billed by the hospital, but only after intensive and morally troubling collec-
tion efforts by the hospital.23 After a series of searing exposes of these collection ef-
forts in the press—notably by staff reporter Lucette Lagnado of the Wall Street
Journal—Congress held hearings on these practices.24 Partly under pressure from
consumers and lawmakers and partly on their own volition, many hospitals now
have means-tested discounts off their chargemasters for uninsured patients,
which bring the prices charged the uninsured closer to those paid by commercial
insurers or even below.25 Some very poor patients, of course, have received hospital
care free of charge all along, on a purely charitable basis.

� Payment clearinghouses. Traditionally, both the structure of hospitals’
chargemasters and the prices they contained varied from hospital to hospital, and
they did not match the diverse nomenclatures used by insurance carriers to describe
hospital services. The resulting chaos brought forth new business ventures, such as
WebMD, as clearinghouses.26 Their proprietary software was designed to translate
invoices expressed in a hospital’s nomenclature into the different nomenclature
used by the relevant insurer.

To eliminate this chaos, and the persistence of paper claims it begot, in 1996
Congress passed HIPAA, whose “administrative simplification” provisions sought
to impose a uniform format and data content on all U.S. health care transactions,
to ease electronic transactions among all payers and providers. In the meantime,
the health industry has made strides toward that goal. As of this writing, however,

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“The failure to attain uniform coding standards provides a continued
reason for the clearinghouse industry to stay in business.”

full “HIPAA compliance” with complete, direct, two-way information exchanges
between providers and payers has not yet been attained in the United States; in-
surers are the main laggards.27 This failure to attain uniform coding standards
throughout the industry provides a continued reason for the clearinghouse indus-
try to stay in business.28 It also adds to the health system’s administrative over-
head.

Price Discrimination By Hospitals
It might be argued that because hospitals initially bill all of their patients at

their chargemaster prices, they do not engage in “price discrimination”—the prac-
tice of charging different customers different prices for identical goods or services.
Invoices at chargemaster prices, however, are insincere, in the sense that they
would yield truly enormous profits if those prices were actually paid. The reality
is that hospitals accept different payments from different payers for identical ser-
vices, and that can properly be called price discrimination.

Price discrimination is sometimes decried as unfair, and it may be so. It is, how-
ever, commonly practiced by the hotel, airline, pharmaceutical, and telecommuni-
cations industries; by public utilities; and by universities, where different classes
of students are granted widely varying discounts off full tuition, partly as a reward
for intellectual acumen, or on the basis of the family’s ability to pay. Price discrimi-
nation also is a perfectly natural phenomenon in any health system not subject to
price regulation.

All of these industries have several things in common: They have high annual
fixed costs relative to the incremental cost of producing additional services; they
can segment their markets into distinct classes of customers, each with different
degrees of price-sensitivity; and customers cannot resell their products among
themselves, because it is either technically impossible (such as for physician or
hospital treatments) or illegal (such as for pharmaceutical products).

� The objective of price discrimination. The sellers of a good or service might
practice price discrimination in the pursuit of two quite distinct objectives. First,
sellers might simply seek to maximize the total amount of revenue that can be ex-
tracted from society for a given volume of output and, thus, their profits. By charging
some groups more than others, profit-seeking sellers can extract from the buy side
more revenue and profits for a given sales volume than they could with a single price.
The distinguishing characteristic of such sellers is that they would never sell any
output to any market segment at prices below incremental production costs, unless
that had profitable public relations value or they were mandated to do so by law—
such as under the Emergency Medical Treatment and Active Labor Act (EMTALA)
of 1986.29

Alternatively, sellers—especially not-for-profit sellers—might price-discrimi-
nate merely to cover their fully allocated total costs (plus, perhaps, a modest profit
margin) in a way that conforms to prevailing distributive, social ethics. Physicians

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have always defended their erstwhile sliding fee scales on those ethical grounds,
although not all economists have been persuaded by that rationale.30

Richard Steinberg and Burton Weisbrod recently presented a model in which
nonprofit institutions price-discriminate to achieve ethically desirable distribu-
tional goals.31 An important, relevant insight from their model is that competition
from either for-profit or nonprofit organizations in a market area severely limits
the nonprofit’s ability to pursue that policy. Under truly severe competition, the
authors show, even nonprofit organizations will behave more and more like profit-
maximizing enterprises, to survive in the long run. That is, of course, precisely the
situation in which many nonprofit U.S. hospitals now find themselves. In that
market context, price discrimination probably is profit-maximizing more often
than practiced to pursue ethical goals.

What prevailing distributive ethic in U.S. society, for example, would dictate
that uninsured patients be billed the highest prices for hospital care and then be
hounded, often mercilessly, by bill collectors? What prevailing distributive ethic
dictates that large insurance carriers with market muscle be granted steeper dis-
counts off charges by hospitals than smaller insurance carriers with less bargain-
ing power?

Probably the best defense hospitals can make for their current patterns of price
discrimination is that both the federal and state governments can use their mo-
nopsony power to impose unfunded mandates in the form of shortfalls of pay-
ments from fully allocated costs. That practice, along with lingering excess capac-
ity in most hospital market areas, can explain why for-profit and nonprofit
hospitals alike now have little choice but to price their services to private payers
essentially as profit-maximizing enterprises.

Hospital Pricing And Consumer-Directed Health Care
Until now, the U.S. health care “ market” has been analogous to an imaginary

world in which, say, employers offered to reimburse their employees 80 percent of
the “reasonable cost” of all attire deemed “necessary” and “appropriate” on the job
but, under the contracts negotiated with department stores by the fiscal interme-
diaries administering this “Clothes Benefit Program,” employees had to enter de-
partment stores blindfolded. Only months after a shopping trip would the em-
ployee receive from the fiscal intermediary a so-called Explanation of Benefits
(EOB) statement, explaining how much the employee had to pay for whatever he
or she had stuffed, blindfolded, into the shopping cart on that shopping trip.
Framed in bright red on that EOB would be the statement: “Pay X amount.” X
would represent 20 percent of what the intermediary would have judged, ex post,
to be “reasonable prices” for those garments in the shopping cart deemed by that
intermediary, ex post, to have been “appropriate” attire for the particular em-
ployee’s circumstances. It also would include 100 percent of the prices charged by
the stores for items in the cart that were deemed by the intermediary, ex post, as

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“not necessary” or “inappropriate” and that were therefore not covered by the
Clothes Benefit Program.

Ridiculous though it sounds, such an arrangement closely resembles the cur-
rent payment system for U.S. health care. It is difficult to reconcile this picture
with increasing demands by employers, insurers, and policymakers that patients
be forced to act as more responsible “consumers” of health care, a movement now
gathering force under the banner of consumer-directed health care.

� Consumer-directed health care. This term has come to describe health in-
surance policies with annual deductibles ranging anywhere from $2,000 to more
than $10,000 per family and, often, coinsurance in addition. The costs borne by the
insured can be defrayed out of health savings accounts (HSAs) into which both em-
ployers and families can make annual deposits that are not taxable income to the
employee. Amounts in the HSA not spent in a given year can be rolled over to the fol-
lowing year, which means that for chronically healthy families, the HSA can become
a major, tax-preferred savings account earmarked for future out-of-pocket pay-
ments on health care.

This construct can be offered by employers, in lieu of the traditional, more com-
prehensive employer-sponsored insurance. It also can be procured by households
in the market for individual insurance.32 A major advantage to both is that the pre-
miums for the construct are lower than those for more generous insurance coverage.

The central idea of consumer-directed care is that the high degree of cost shar-
ing will force patients to take a more active interest than they hitherto have had in
the cost-effectiveness of their care. This “consumer empowerment,” as it is some-
times called, can only occur, however, if prospective patients actually have easy
access to user-friendly, reliable information on at least three dimensions of their
care: the prices charged by competing providers of health care; the costliness of
practice styles adopted by these various providers—that is, the prices times the
quantities of services and supplies they package into the treatments they render;
and the quality of these providers’ services. If such a transparent information infra-
structure now exists anywhere in the United States, it would be the rare exception.

In connection with hospital care, of course, it could be argued that prospective
patients (“consumers”) require only better information on “quality,” because the
cost of even moderately expensive hospital stays typically will exceed the pa-
tient’s annual deductible, so that “price” and “costliness” are no longer important
to the patient. That argument overlooks the fact that a growing fraction (now
more than a third) of all hospital revenue comes from outpatient services, whose
individual costs might be below the deductible. Furthermore, patients increas-
ingly face coinsurance payments for inpatient care, too, which gives them an inter-

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“ ‘Consumer empowerment’ can only occur if prospective patients
actually have easy access to user-friendly, reliable information.”

est in the actual prices of those services. Thus, the question remains how the
prices charged by hospitals could be revealed to prospective patients in ways they
could digest and act upon as “consumers.”

� The Porter-Teisberg proposal. In June 2004, Michael Porter and Elizabeth
Teisberg published a paper titled “Redefining Competition in Health Care.”33 Much
of that paper repackages familiar ideas that have long been espoused by policy ana-
lysts such as Ellwood, Enthoven, and Etheredge; Pauly, Danzon, Feldstein, and Hoff;
Herzlinger; and numerous other authors who have wrestled with the idea of forcing
genuine price and quality competition onto the U.S. health system.34 But Porter and
Teisberg do offer some radical ideas on the pricing of health care services, which
makes them relevant to the present inquiry.

In a nutshell, they would replace the current payment system with an all-payer
system, albeit one centered on individual providers. Thus, a hospital could set its
own prices, but it would have to post them for public view and apply them to all
patients, without price discrimination. Where possible, prices for individual ser-
vices and supply items would be bundled into lump-sum prices for major proce-
dure categories, akin to Medicare’s DRG and APC systems.

� National DRG and APC weights. In 1993 I proposed a somewhat similar
idea.35 I proposed that the government should expand the DRG system to all hospi-
tal patients (which would now include the recently established APC for outpatient
services). There would be only one national set of weights for the various DRGs and
APCs, which every hospital would have to adopt. These weights would be devel-
oped and continuously kept up to date by an authoritative national body of ex-
perts—perhaps the current Medicare Payment Advisory Commission (MedPAC).

To avoid the potential pitfalls of centrally administered, uniform prices for the
entire hospital system of as far-flung a nation as the United States, each hospital
would be free to set its own monetary conversion factor for DRGs and APCs. That
hospital-based conversion factor would then translate the national relative value
scales into hospital-specific, case-based fee schedules. Each hospital, of course,
would be required to make its monetary conversion factor publicly known. It
would be a one-dimensional index of the hospital’s absolute level of case-based
prices and could be easily understood and used by patients.

Even streamlined systems such as these would still confront prospective pa-
tients with lists containing more than 1,000 prices for the various hospitals’ DRGs
and APCs. But these price lists could be supplemented by smaller lists, showing
the total cost billed by a hospital for the far fewer cases that constitute, say, half of
its total revenues. Furthermore, software could be written that would enable pro-
spective patients to obtain, from a dedicated Web site, comparative averages or
medians of the total prices actually billed by a hospital in the past year for a spe-
cific case not on the smaller list. Although never perfect and easy, any such system
would be a step far ahead of the chaos that now reigns behind the opaque curtain
of proprietary prices in the U.S. hospital system.

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Such proposals are, of course, are more easily stated than implemented. To tran-
sit from the current payment system to the proposed system in a way that would
not unfairly create winners and losers raises a host of conceptual and practical
questions, even leaving aside for the moment the nettlesome problem of the unin-
sured and underinsured.

� The potential of reference pricing. There is, for example, Porter and
Teisberg’s recommendation that hospitals must accept third-party payments as pay-
ment in full, without balance billing of patients (aside from regular coinsurance or
deductibles that may be extracted from patients by the third-party payer). Is that
imperative? An alternative approach might be reference pricing, which might also be
called “defined-contribution pricing.” Here third-party payers (perhaps even Medi-
care) would pay hospitals no more than a stipulated conversion factor, benchmarked
perhaps on lower-cost hospitals in a market area, which would leave patients to
pick up the entire difference between the conversion factor covered by the third-
party payer and the conversion factor the hospital has announced publicly and actu-
ally charges. It would be a version of the tiered pricing now being contemplated by
some private insurers.

� Price discrimination. There is the other open question of whether a system of
common relative value scales for inpatient and outpatient care would continue to al-
low individual hospitals to charge different payers different, negotiated monetary
conversion factors. A case can be made for permitting it, as long as patients with
high-deductible policies would be charged by a hospital only the conversion factor
that was negotiated with that hospital by their catastrophic insurer. To shop around
for cost-effective care among hospitals in a market area, patients then would have to
know all of the conversion factors that their own insurer had negotiated with all of
the competing hospitals in the relevant market area. That information, in turn,
would reveal to all the world all of the negotiated conversion factors. In the end, the
system would most likely lead to something approximating an all-payer system in a
market area, without the need for added regulation.

� The uninsured. Under any such novel payment system, separate provisions
would have to be made for low-income households and self-paying patients,
whether or not price discrimination among third-party payers were to be allowed.
One approach would be to have hospitals post their means-tested conversion fac-
tors, which presumably would be income related and might be zero for genuine
charity cases. As Porter and Teisberg also observe on this point, however, in the long
run any U.S. hospital payment system will be seriously impaired by the presence of
large numbers of uninsured Americans.

Concluding Observations
The bewildering and sometimes troublesome picture of contemporary U.S. hos-

pital pricing is not entirely of hospitals’ own making. They are part of a wider sys-
tem of health care financing whose administrative expense now ranks as a major

H o s p i t a l P r i c i n g

H E A L T H A F F A I R S ~ V o l u m e 2 5 , N u m b e r 1 6 7

cost component of U.S. health care (as much as 25 percent).36

An old adage has it that “the only good tax is an old tax.” The idea is that all eco-
nomic agents in society have fully adjusted to an old tax, however inefficient, and
that changing it may unfairly create winners and losers. It is surely so also with a
hospital payment system. To move from the present, chaotic pricing system to-
ward a more streamlined system that could support genuinely consumer-directed
health care will be an awesome challenge. Yet without major changes in the pres-
ent chaos, forcing sick and anxious people to shop around blindfolded for cost-
effective care mocks the very idea of consumer-directed care.

The author gratefully acknowledges the constructive criticism of an earlier draft by three anonymous peer
reviewers. Thanks are due also for valuable insights provided by Al Dobson of the Lewin Group; Stuart Guterman
of the Commonwealth Fund; Chip Kahn, president of the Federation of American Hospitals; Caroline Steinberg of
the American Hospital Association; Mike Parsons, chief operating officer of Triad Hospitals Inc.; Karen Flinn, who
negotiates contracts with private insurers on behalf of Triad Hospitals Inc.; and Becky Yang, who negotiates
contracts with hospitals on behalf of WellPoint-Anthem. None of these contributors is responsible for any errors or
shortcomings in this paper.

NOTES
1. L. Lagnado, “California Hospitals Open Books, Showing Huge Price Differences,” Wall Street Journal, 27 De-

cember 2004.

2. American Hospital Association, Hospital Statistics 2005 (Chicago: AHA, October 2005), Table 3.

3. U.S. Government Accountability Office, Federal Employees Health Benefits Program: Competition and Other Factors
Linked to Wide Variation in Health Care Prices, Pub. no. GASO-05-856, August 2005, http://www.gao.gov/new
.items/d05856 (accessed 10 September 2005).

4. See, for example, L. Lagnado, “Anatomy of a Hospital Bill,” Wall Street Journal. 21 September 2004.

5. As exemplified by plans listed at http://eHealthInsurance.com.

6. AHA, Hospital Statistics 2005, Table 3.

7. See California Office of Statewide Health Planning and Development, “Sample Chargemaster,” 16 June
2005, http://www.oshpd.cahwnet.gov/HQAD/Hospital/SampleChrgmstr (accessed 10 September
2005).

8. See, for example, WebMD, “HIPAA Implementation: The Case for a Rational Roll-Out Plan,” 19 July 2004,
http://www.aao.org/aaoesite/compliance/upload/Practice-Management-HIPAA-Implementation (ac-
cessed 10 September 2005).

9. Lagnado, “California Hospitals.”

10. Medicare Payment Advisory Commission, A Data Book: Healthcare Spending and the Medicare Program, June
2004, http://www.medpac.gov/publications/congressional_reports/Jun04DataBook_Entire_report_links
(accessed 10 September 2005), Charts 5-9 and 6-7.

11. MedPac, Report to the Congress: Medicare Payment Policy (Washington: MedPAC, March 2003), Appendix A.

12. Ibid., 227.

13. U.E. Reinhardt, “The Medicare World from Both Sides: A Conversation with Tom Scully,” Health Affairs 22,
no. 6 (2003): 167–174.

14. MedPac, Report to the Congress, Appendix A, 231.

15. Ibid.

16. See Centers for Medicare and Medicaid Services, “National Health Expenditure (NHE) Amounts by Type
of Expenditure and Source of Funds: Calendar Years 1965–2014 in PROJECTIONS Format,” http://www
.cms.hhs.gov/statistics/nhe/default.asp (Click “Data files for downloading” and select “NHE65-14.zip”)
(accessed 10 September 2005).

17. See, for example, S.G. Lane, E. Longstreth, and V. Nixon, A Community Leader’s Guide to Hospital Finance, 2001,

6 8 J a n u a r y / F e b r u a r y 2 0 0 6

http://www.accessproject.org/downloads/Hospital_Finance (accessed 10 September 2005).

18. ACS State Health Care, “Paying Hospitals for Outpatient Services: A Guide to Medicaid Programs,”
http://208.63.63.72/dloads/Paying%20for%20Hospital%20Outpatient%20Services%202004 (ac-
cessed 10 September 2005).

19. A. Dobson, J. DaVanzo, and N. Sen, “The Cost-Shift Payment ‘Hydraulic’: Foundation, History, and Impli-
cations,” Health Affairs 25, no. 1 (2006): 22–33.

20. Henry J. Kaiser Family Foundation, “Aetna Posts Physician Fees Online for Health Plan Members,” Daily
Health Policy Report, 18 August 2005, http://www.kaisernetwork.org/daily_reports/rep_index.cfm?DR_ID=
32095 (accessed 10 September 2005).

21. SEIU District 1199 Care for Ohio, “Twice the Price: What Uninsured and Underinsured Patients Pay for
Hospital Care,” March 2005, http://s57.advocateoffice.com/vertical/Sites/{56490583-267C-4278-BC56-A7
128CE248A8}/uploads/{374CBAD9-740D-48BC-8536-92ECD76D1444}.PDF (accessed 1 July 2005).

22. Lagnado, “Anatomy of a Hospital Bill.”

23. The reported payment-to-cost ratio is about 0.14. See Dobson et al., “The Cost-Shift Payment ‘Hydraulic’.”
Regarding hospital collection efforts, see L. Lagnado, “Hospitals Try Extreme Measures to Collect Their
Overdue Debts,” Wall Street Journal, 30 October 2003.

24. L. Lagnado, “Jeanette White Is Long Dead but Her Hospital Bill Lives On,” Wall Street Journal, 13 March
2003; and L. Lagnado, “House Panel Begins Inquiry into Hospital Billing Practices,” Wall Street Journal, 17 July
2003.

25. L. Lagnado, “Hospitals Will Give Price Breaks to Uninsured, If Medicare Agrees,” Wall Street Journal, 17 De-
cember 2003.

26. See U.S. Securities and Exchange Commission, “Form 10-K, WebMD Corporation,” http://www.webmd
.com/corporate/content/investor/WebMD_2002_Form_10-K (accessed 10 September 2005).

27. See, for example, WebMD, “HIPAA Implementation.”

28. Ibid.

29. In principle, EMTALA applies only to hospitals that participate in Medicare. In practice, this means that
all hospitals are bound by the statute.

30. See, for example, R.A. Kessel, “Price Discrimination in Medicine,” Journal of Law and Economics 1 (1958): 20–
53.

31. R. Steinberg and B. A. Weisbrod, “Give It Away or Make Them Pay? Price Discrimination and Rationing
by Nonprofit Organizations with Distributional Objectives,” 28 June 2002, http://www.nationalcne.org/
papers/rationnew (accessed 20 June 2005).

32. Examples of individually purchased consumer-directed health plans can be found at eHealthInsurance
.com, a user-friendly, electronic farmers market, so to speak, for a great variety of health insurance prod-
ucts offered by various U.S. health insurers.

33. M.E. Porter and E.O. Teisberg, “Redefining Competition in Health Care,” Harvard Business Review ( June
2004): 1–14.

34. P.M. Ellwood, A.C. Enthoven, and L. Etheredge, “The Jackson Hole Initiatives for a Twenty-First-Century
Health Care System,” Health Economics 1, no. 3 (1992): 149–168; M.V. Pauly et al., “A Plan for ‘Responsible Na-
tional Health Insurance’,” Health Affairs 10, no. 1 (1991): 5–25; and R.E. Herzlinger, Market-Driven Health Care:
Who Wins, Who Loses in the Transformation of America’s Largest Service Industry (Reading, Mass.: Addison-Wesley,
1997).

35. U.E. Reinhardt, “An ‘All-American’ Health Reform Proposal,” American Health Policy 3, no. 3 (1993): 11–17.

36. S. Woolhandler, T. Campbell, and D.U. Himmelstein, “Costs of Health Care Administration in the United
States and Canada,” New England Journal of Medicine 349, no. 8 (2003): 768–775.

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H E A L T H A F F A I R S ~ V o l u m e 2 5 , N u m b e r 1 6 9

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