Improving Economic Incentives in Hospital Prospective Payment Systems Through Equilibrium Pricing

Under the Prospective Payment System (PPS) implemented by Medicare in 1983, hospitals are paid a set price for each Medicare patient treated, rather than being reimbursed for the patient's costs as had been done previously. An increasing number of other insurers have adopted a similar method of hospital payment. In these systems, the price, which depends on the patient's Diagnosis Related Group (DRG), is derived from the average cost over all hospitals of all patients in that DRG. We propose an alternative method for setting prices in hospital prospective payment systems, called equilibrium pricing, in which prices are derived from a linear programming model of competitive equilibrium. To evaluate the improvement in incentives associated with equilibrium pricing, we define a measure, called the disincentive index, of the extent to which a set of prices creates economic disincentives to efficient behavior. In the situation in which all hospitals compete in a single market area, we show that equilibrium pricing creates the best possible economic incentives, i.e., by reducing the disincentive index to zero. The analysis is then extended to the more realistic situation where hospitals compete in limited geographical market areas, whereas prices must be uniformly set for a number of such market areas. We prove that, with an appropriate generalization of the disincentive index, equilibrium prices for a single market area are also optimal for multiple market areas. Finally, actual cost and utilization data from hospitals that compete in eastern Massachusetts are used to determine prices and to evaluate the associated disincentive index for a simulated prospective payment system. This empirical study shows a dramatic improvement in the incentives created by equilibrium pricing compared to average-cost pricing.