Code Red: Two Economists Examine the U.S. Healthcare System

September 30, 2011

Do Hospitals Cost-Shift?

Filed under: mysteries of health economics — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 11:32 am

This blog continues my exploration of the great mysteries of health economics.

Northwestern University is one of Blue Cross of Illinois’ largest customers. Suppose that premiums for all BC plans are expected to increase by 10 percent, but NU is able to force Blue Cross to accept a 5 percent increase. Would you expect Blue Cross stick McDonalds with a 15 percent increase in order to cover the shortfall from NU? I wouldn’t, for two reasons. First, McDonalds would probably threaten to take its insurance business elsewhere. Second, the scenario I have described is inconsistent with profit maximization by Blue Cross. After all, BC’s ability to stick McDonalds with a 15 percent increase surely does not depend on the price paid by NU. Any negotiator whose willingness to stick it to McDonalds is conditional on the price charged to NU is leaving money on the table and probably would have been fired a long time ago.

We might never expect BC to raise prices to some customers to make up for shortfalls from others, so why do we believe that hospitals do this all the time? It is impossible to discuss Medicare and Medicaid payments without someone invoking the mantra of cost-shifting. The theory of cost-shifting is deeply ingrained in the minds of healthcare decision makers and the policy implications of the theory are profound. Consider that if hospitals cost shift, then the burden of Medicaid cutbacks falls on privately insured patients, not on Medicaid patients and the hospitals that serve them. This calls into question whether the cutbacks will result in any savings for taxpayers and cause any harm to Medicaid beneficiaries. It also makes you wonder why hospitals that serve low income communities struggle to survive. Couldn’t they just cost-shift their way out of financial difficulty? A cost-shifting zealot would conclude that the managers of these hospitals are incompetent.

I must confess that I perpetrated one of the best cited papers providing evidence of cost-shifting. I studied what happened at hospitals in Illinois in the early 1980s after a substantial cut in Medicaid fees, finding that hospitals did raise prices to privately insured patients by enough to make up about half the Medicaid shortfall. But things were different back then, and I don’t believe that evidence can be used to describe what happens today. For one thing, there was essentially no managed care in Illinois, so insurers had to accept the prices set by hospitals. Insurers are far more powerful today than they were back then. Second, all of the hospitals in Illinois were nonprofits and, as far as I could tell, most placed mission above profits. So it is possible to believe that prior to the Medicaid cutbacks, hospitals really were leaving private sector money on the table. With all the empire building that hospitals are engaged in today, it is hard to believe they would ever leave insurer money on the table. This makes it equally hard to believe that they would need the excuse of government cutbacks before sticking it to insurers.

Cost-shifting may be a flawed theory, but there may still be a disconnect between theory and practice. Hospitals might cost shift because, well, that is what they think they are supposed to do. So what does the modern evidence show? Will White and I published another paper about a decade ago that tracked what happened at hospitals in California after large Medicaid cutbacks. We found that hospitals that experienced large Medicaid cuts also experienced relatively slower increases in private sector payments, the opposite of what would have occurred under cost shifting. There are quite a few other studies showing that the quality of care delivered to Medicaid and Medicare patients suffers when government payments fall. This would not occur if hospitals could cost-shift.

Unfortunately, there are a lot of more stylized analyses that seem to show that cost shifting is alive and well. The typical analysis finds that profits from privately insured patients are negatively correlated with profits from government-insured patients both in the cross-section and over time. This is cited as conclusive evidence of cost-shifting.

There is alternative explanation that, unfortunately for the cost-shifting zealots, is quite consistent with the institutional facts. To motivate the explanation, consider an industry in which all firms earn zero profits, but the firms’ accounting systems are somewhat arbitrary and assign costs to different customer groups in a somewhat haphazard fashion. If a firm in this industry has two groups of customers, it may appear to be profiting from one group due to the way it allocates costs. Because the firm earns zero profits overall, it must appear to lose money from the other group. Thus, reported profits will be negatively correlated between customer groups.

Now suppose that one group of customers got its act together and demands lower prices. This would have no impact on the price paid by the other group in the short run. In the long run there would be exit, because some firms were losing money. This would drive up prices and again create a negative correlation in pricing both in the cross-section and over time. But this would not be cost-shifting as it is commonly discussed. (Nor would it require arbitrary cost-accounting.)

If we relax the assumption of zero profits but instead suppose that profits are constrained to a fairly narrow band, then we would still get the same negative correlation in both the cross-section and over time, provided there is a fair degree of arbitrariness to cost allocation. And this, I believe, pretty well describes the hospital sector, where most hospitals have profits in a range of plus or minus 5 percent, and cost allocation is speculative even in the best institutions.

So I can explain away the stylized evidence without invoking the mantra of cost-shifting. But that does not make my explanation correct. Cost-shifting is so deeply engrained that CFOs might do it even though it is not profit maximizing. I think I could even construct a game theoretic model in which hospital CFOs use government cutbacks as a kind of focal point for passing along tacitly collusive price increases, so that cost-shifting is profit-maximizing in a strategic sense. My point is not to deny cost-shifting so much as to point out that there are good reasons to question both the theory and evidence. Whether or not hospitals cost-shift remains one of the great mysteries of health economics.

Blog at

%d bloggers like this: