PROVIDER RATE REGULATION

Governmental regulatory pricing systems can control health care costs because the regulating agency has the legal authority to both set the initial (or base) price levels for each health care services delivered by a provider and to determine the rate at which these prices increased year over year (i.e., regulate annual “updates” to the base regulated prices). In the past, such annual regulated price updates were traditionally set to be lower than historical growth rates in prices thus creating savings relative to past experience. The legal ability to first set base price levels and then control the growth in these prices over time allowed these governmental systems to be more effective at controlling health care cost growth than unregulated or “market-based” systems, which relied on multi-lateral negotiations between many different insurers and providers to determine both the level of prices and the rate of growth of prices. Beginning in the early 1990s, the rapid consolidation of provider groups (through two rounds of hospital mergers and acquisitions) into large multi-hospital health systems gradually tipped the balance of the negotiating power over prices in favor of hospitals. Since that time, hospitals have continued to merge (“horizontal” mergers) and engage in so-called “vertical” mergers with area physicians, adding to the negotiating power of these providers. This circumstance is a primarily reason why commercial health care prices have grown so rapidly since the mid- to late-1990s.

The cost control capabilities of regulated pricing systems were also enhanced by modifications in the “structure” of regulated payments (also referred to as the “bases of payment”). Early price regulatory systems, at both the state and federal levels, set regulated prices on the basis of reported provider costs in a previous year (referred to as “cost-based” or “retrospective” payment systems).  These early payment systems led to rapid and unsustainable increases in governmental spending on health care, because knowing that any retrospective increase in operating costs would be reflected in higher governmental prices in a future year, providers had little incentive to control their operating costs.

To correct this weakness, government regulators developed what is referred to as a “prospective” payment system. Under prospective payment, the government established a rate for each service in advance of a particular year and kept that rate in effect for the entire year. Providers were paid these prospectively established rates regardless of the operating costs they incurred during a year. Prospective payment systems represented a substantial departure from previous retrospective cost-based payment systems of the past because prospective payment gave providers strong incentives to improve their operating efficiency. This was because under prospectively established prices, increases in provider operating costs during a year would result in operating losses, while decreases in operating costs (i.e., improved provider operating efficiency) would result in higher profits. Prospectively established prices were then updated annually by regulatory agencies at rates that were lower than the historical growth in provider prices and consistent with prevailing governmental budgetary constraints. Regulated prospective pricing and price update systems were first developed on an experimental basis in four of the five all payer state-based hospital rate setting systems and have since been commonly used by governmental payers around the world in and in the U.S. by the Medicare and Medicaid programs.

Although these governmental payment systems were more effective at controlling provider spending than the unregulated and multilateral negotiated commercial payment systems, providers realized they could generate increased payments and higher profit margins by increasing the number of services they provided per patient. In response, both the state-based all payer hospital rate regulatory systems and Medicare and Medicaid developed what were referred to as “bundled payment structures,” payment for bundles of services provided to the patient when admitted or when treated on an outpatient basis. Bundled payment structures offset the tendency of providers to increase the volume of services per patient episode they delivered because providers were paid a fixed amount per type of case (based on a patient’s clinical diagnosis) for inpatient care and a fixed amount per outpatient visit for outpatient care, regardless of the services provided during the patient care episode.

In what is continuously a game of “cat and mouse” between regulators and regulated providers, price regulated hospitals responded to the government’s innovative bundled payment approach and restrictions on annual price updates by increasing the number of admissions, visits, and procedures they performed during a year. To counter this behavioral response of providers several state-based all-payer regulatory systems developed rate mechanisms (“volume adjustment systems”) within their payment approach that adjusted provider price updates based on providers’ annual volume changes (lowering rate updates when volumes grew and increasing price updates when volumes declined). This volume adjustment system was highly effective at reducing provider incentives to unnecessarily increase the provision of health care services.