Costs and revenues

Formica raises a really interesting point in comments yesterday:

My further understanding is that the large pool of lives insured by Medicaid creates another “block buy” phenomenon where hospitals and other providers are incentivized to accept Medicaid reimbursement rates, which vary but are often lower than Medicare rates by percentage.

The result, as I understand it, is that hospitals and providers are forced to recover costs incurred accepting Medicaid and, to a lesser extent, Medicare patients by increasing rates or more aggressively billing private insurance, making the much higher prices that privately insured Americans pay being a de facto subsidy of the the two largest public systems. Is this an accurate description, or an oversimplification?

The concept that Formica is reaching for is the idea of cost-shifting. It is a facially intuitive process: a hospital needs/wants to make $X in revenue or profit and if a major payment stream shrinks, it will raise prices for the other payment streams in order to reach $X revenue or profit.

Let us think of a two-payer world, Public and Private to a single sector of M. In our initial state, our revenue looks like the following.

M(1) = (Q(pu) *Public Price) + (Q(pr) * Private Price)

And now we have a change in Public Price down and a change in private price up. X is the drop in public prices and Y is the increase in private prices to balance everything.

M(2) = (Q(pu) * (1-x)*Public Price) + (Q(pr) * (1+y)Private Price

Which leads to M1= M2.

That is the effective model that Formica implicitly proposes.

There are three problems with this idea.

First, it does not think about quantity. Unless we are at COVID demand surge levels, there is flexibility in a system. A doctor has the option to schedule another appointment or to work on their golf game at 4:30 on Friday afternoon. Higher price levels will likely lead to worse golf scores and more appointments. Lower price levels will likely lead to improved handicaps and fewer appointments available. We have really good evidence that Medicaid patients have a harder time getting doctor appointments than privately insured individuals because Medicaid almost always pays individual doctors less. The Medicaid patient is less likely to get a marginal appointment.

Secondly, this is an assumption that costs are independent of revenue. Costs are heavily dependent on revenue. A medical provider that has a fat payment stream will find ways to distribute that payment stream to stakeholders; the group owner gets large profits, the clinicians get big bonuses, all the staff is flown to Puerto Rico for a week long educational trip every spring, the waiting room is wicked nice — hookers and blow for everyone as the revenue gets eaten up by costs. Conversely an operation that is on a thin revenue stream might hire more certified nurse practitioners instead of MD/DO primary care providers, have an old waiting room that is clean and tidy but worn out, and offer only quarter decent coffee as a staff perk.

Finally, and most importantly, it assumes profit level targeting behavior from private firms, including many owned by Wall Street private equity firms. By that I mean, the C-level is aiming for a given level of profitability, no more and no less. If they score above the profit target, If we assume a hedge fund will stab their grandmother with a rusty butter knife to get an extra half a percent return on investment, should we expect the same in the medical sector?

I think that we should assume that a significant chunk of the medical sector is acting as if they are trying to profit maximize at all times in the United States. The deal that a hospital that is trying to profit maximize takes with one payer is not directly linked to the deal it takes with another payer. The hospital is always trying to get the best deal possible from each contract. The scope of the deal will be a function of how many lives and how many procedures will likely be performed at a given price. Some prices make sense for the hospital to agree to. Some prices are too low and the hospital can walk away if that price level is the final and best offer. Very few hospitals walk away from Medicare although they can; some walk away from Medicaid and many don’t contract with particular insurers. The price of any deal is a function of leverage and need. The side with better leverage and less need will likely get a deal closer to their ideal point than the other contracting party.

Under a theory that price shifting happens a lot, we would expect that if public rates go down due to a significant policy change like sequester or the BBA of the late 90s, than private rates would increase faster than they otherwise would.

Under a theory of profit maximization, we would expect private rates to shrink slightly compared to the no policy change counter-factual and a reduction in total units of medical services supplied.

We see the latter. We see a quantity and lower private price response.

Cost-shifting is a seemingly intuitive explanation that gets trotted out by a hospital PR firm every time there is discussion about not increasing public payment rates at a previously projected pathway but to actually see it in action requires assumptions about behavior that we don’t see in the wild.