IMPROVING ECONOMIC INCENTIVES IN-HOSPITAL PROSPECTIVE PAYMENT SYSTEMSTHROUGH 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 don e previously. An increasing number of other insurers have adopted a si milar method of hospital payment. In these systems, the price, which d epends on the patient's Diagnosis Related Group (DRG), is derived from the average cost over all hospitals of all patients in that DRG. We p ropose an alternative method for setting prices in hospital prospectiv e payment systems, called equilibrium pricing, in which prices are der ived from a linear programming model of competitive equilibrium. To ev aluate the improvement in incentives associated with equilibrium prici ng, we define a measure, called the disincentive index, of the extent to which a set of prices creates economic disincentives to efficient b ehavior. In the situation in which all hospitals compete in a single m arket 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 tha t, with an appropriate generalization of the disincentive index, equil ibrium prices for a single market area are also optimal for multiple m arket 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 prospec tive payment system. This empirical study shows a dramatic improvement in the incentives created by equilibrium pricing compared to average- cost pricing.