This article investigates the influence of governmental payment mechan
isms under the Medicare program on contractual relationships and verti
cal integration between hospitals and nursing homes. The ''prospective
payment system,'' implemented in 1983, created strong incentives for
hospitals to reduce costs per admission by shortening the average leng
th of patient stays, which in turn created a new dependency of hospita
ls on nursing homes. In contrast to the bilateral contract negotiation
s which resolve analogous problems in other industries, the price paid
to the nursing home to accept a hospital patient cannot be negotiated
between the hospital and the nursing home but is established unilater
ally by Medicare. However, Medicare does not determine the implicit tr
ansfer price governing patient flows between the hospital and nursing
home divisions of vertically integrated health care organizations. The
impact of administered pricing on vertical integration is confirmed e
mpirically using 1982-90 data on acute care hospitals and skilled nurs
ing facilities.