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The Hospital
Eric Jacobson
Health Economics
First Hospitals
• The word hospital was first used in 12th
century to refer to a facility run by the church
that housed and cared for the sick, the disabled
and the insane, as well as providing lodging for
pilgrims and other travelers, orphans, and the
poor.
• Only those with no homes stayed in the
hospital.
• Turn of century brought scientific advance in
antiseptics, anesthesia, anatomy, physiology
and invention of X-ray
First U.S. Hospital…which state?
• Pennsylvania hospital - 1751
• Created by a bill passed by the Assembly with
the support of Benjamin Franklin
• Obligated governor to provide 2,000 to match
2,000 in public donations for construction.
• Six outstanding physicians worked twice a
week without pay.
• Major expenditure category of 18th and 19th
century hospital?
. . . FOOD
Community Hospital Revenues
Avg Total Rev (1995) $60m
Other
Self-pay 8%
4%
Insurance
33%
Medicare
43%
Medicaid
12%
Three very different categories of
financial success 
• Basket-case institutions held together by bailing
wire and disproportionate share funding (“Dish
payments” from CMS). Often in the inner city,
often in deep financial trouble from their heavy
loads of uncompensated care.
– Disproportionate share hospital payments: additional
reimbursement payments received by states from the federal
government to defer the high cost of providing medical care to a
large number of low-income individuals.
Three very different categories of
financial success 
• Teetering on the edge. Mostly nonprofits
but including almost all for-profits.
Damaged but not destroyed by managed
care. Downsized in mid-1990s fearing
capitation. Today, this group is surviving
but not thriving. Vulnerable to the
reduction in funding of the Balanced
Budget Act of 1997, which eroded Medicare
margins.
Three very different categories of
financial success 
• Monopolists. Organizations tend to be
found in affluent suburban, low
unemployment areas. During the late
1990s, operating margins in these top-tier
financial performers often exceeded 10% more than twice the national average.
Hospitals obtain revenues in a
variety of ways
• Charges - “list prices” vs. “discounted charges”
• PPS/DRGs - Medicare’s DRG system has been
adopted by many other payers.
• Per Diem - per day payment of services, favored
in managed care contracts.
• Capitation – still relatively rare in hospitals.
Stalling rather than proliferating.
• Global budgets - getting a fixed grant for all of its
costs (VA hospitals, Canada, England)
• Philanthropy and Grants (2%)
Hospitals differ from the standard
firm in 3 significant ways:
• Medical care largely controlled by docs who
neither pay nor receive any money from the
hospital. Since doctors are the dominant voice
in hospital operations, they often take on the
role of “employees” and “owners.”
• Patients do not pay, due to insurance or
charity.
• Ownership is usually unclear due to nonprofit
structure of the organization.
Who gets the “profits” from a
nonprofit hospital (NFP)?
•
•
•
•
Medical staff?
Administrative staff?
Patients?
Community?
NFPs & Quality of Care
• Why would we expect more quality from
NFPs?
• Evidence from medical records for Medicare
beneficiaries--no difference
• Other evidence mixed--psychiatric hospitals
complaints favor NFP; others show no
difference; LTC complaints favor NFP
• Adoption of new technology: no difference
Cost Shifting
• This is the process of charging one group (e.g.,
commercially insured patients) more to cover
the loss due to undercharging another group
(indigent patients or Medicaid).
• The pervasiveness of cost shifting and
insurance coverage gives managers far more
room to raise revenues and little incentives to
find efficiencies that would reduce costs.
Dr. Solomon’s Dilemma – After
Reading Dranove
1. Many hospital networks, such as the Beth
Israel Deaconess Medical Center, are created
from the merger of previously independent
hospitals. List several reasons why you think
so many hospitals have merged.
2. Beth Israel Deaconess has been a big money
loser. What factors might account for this?
What recommendations would you suggest to
turn the bottom line around? Explain.
New Developments
• Systems/ Networks – Dranove?
• PHOs
• Joint Ventures / IDS
From Dranove, Ch 5:
“The emergence of managed care changed
everything. Now hospitals and other providers must
successfully compete within their local markets,
which is why the merger wave of the 1990s is local.
Whether to cut costs, boost prices, or both, providers
are partnering.”
“A wealth of economic research from many
industries generates two basic facts about mergers:
the risks are great, and the savings are usually
smaller than anticipated.”
“Perhaps the 1990s mergers were less about saving
money and more about creating market power.”
What economic principle suggests
provider networks will create
efficiencies?
• Economies of scale?
• Economies of scope? What?
• E of Scale – situations in which the LRAC of a
provider decline as output increases. Some
studies suggest E-of-S and D-of-S, with efficient
scale ~250 beds).
• E of Scope – situations in which an
organization can jointly produce two or more
goods (or services) more cheaply than under
separate production of the goods.
Physician Hospital Organization
(PHO)
Joint ventures between physicians,
hospitals, and other providers. At a
minimum negotiate with third party
payers.
Physicians originate 70 -80% of
hospital’s financial decisions.
PSOs: New health care plans run
by doctors & hospitals
• By the mid-1990s when the PSO trend reached
its zenith, nearly 40 percent of all new HMOs,
were being started by doctors and hospitals.
• Becoming underwriters, providers thought,
would put decisions about how to treat patients
back in their own hands.
New health care plans run by doctors
& hospitals are a sickly bunch
 Most plans that have run into trouble seem
to have a hard time cracking down on the
overutilization of medical services.
 Why?
New health care plans run by doctors
& hospitals are a sickly bunch. Why?
1. More difficult to cut hospital utilization.
 Hospitals with their own health plans often
wound up using them to funnel patients to their
beds.
 But a managed-care plan makes money by
keeping people out of the hospital.
New health care plans run by doctors
& hospitals are a sickly bunch
2. More difficult to demand lower physician
fees or impose capitation payments.

Squeezing physician pay doesn't come naturally to plans
owned by doctors and hospitals. Hospitals rely on the
goodwill of doctors to bring patients to the hospital, so
their health plans don't have a lot of leverage.
New health care plans run by doctors
& hospitals are a sickly bunch
3. More difficult to limit enrollment of bad risks.
 Hospitals and doctors also have tended to enroll
patients they see often as the core membership of their
health plans, forgetting that the profits in health
insurance come from healthy people who pay their
premiums but don't utilize services.
4. Short actuarial experience, scale, and capital
(for marketing and $$$$ computer systems).
5. Plus bad market timing. (1995-99: years of falling
profits due largely to more competition and the federal
government's tightening grip on Medicare
reimbursements.)
Definition of an Integrated System
A single economic entity offering the
entire continuum of care, from
outpatient to inpatient to home care,
in a single contract. Involves both
horizontal and vertical integration.
What economic principle suggests
IDS will create efficiencies?
• Economies of scale?
• Economies of scope? What?
• E of Scale – situations in which the LRAC of a
provider decline as output increases. Some
studies suggest E-of-S and D-of-S, with efficient
scale ~250 beds).
• E of Scope – situations in which an
organization can jointly produce two or more
goods (or services) more cheaply than under
separate production of the goods.
Field of Dreams
“…when values, theory, incentives and strategies were
aligned. Hospitals were going to vertically integrate
to keep utilization and costs down and also be
accountable for health, not just health care; and
finally, once under the integrated umbrella, we could
shift resources to their highest and best use across
the continuum of care: from inpatient to outpatient,
from step-down to home care, from inpatient
surgery to the outpatient surgery center. It was a
beautiful moment…we rejoice and moved on.” (Health
Care in the New Millennium, p. 185)