The Public Pays the Bill

Too many of the incentives written into medical legislation and hospital-care plans tend to increase costs, waste, and duplication, says Assistant Professor Rosenthal of Harvard’s department of economics. The upward spiral will continue, he believes, until the public finds ways to force hospital administrators and doctors to more efficient planning and procedures. The author is a consultant to the U.S. Bureau of the Budget and the Department of Health, Education, and Weltfare, and a member of Harvard’s Inter-Faculty Program in Health and Medical Care.

by Gerald Rosenthal

THE American hospital is predominately a local institution serving a particular area. But the decisions made by individual hospitals regarding the services they provide, the size of hospital, the quality of care, and even staff privileges have significance beyond the concerns of a single institution.

Every taxpayer in the United States pays part of the cost of construction of each hospital supported under the federal program of grants-in-aid for building new hospital facilities. In the enabling legislation, Congress attempted to ensure that the taxpayers’ interests would be protected. First, matching fund provisions were set up to allow poorer states to receive a larger share of the total cost. Second, numerical standards for facilities per 1000 population were established beyond which federal funds would not be spent. And most significant, a requirement was added that no funds could be spent in a particular area until it could be demonstrated that the proposed projects were consistent with an overall plan for the entire area. Funds for this planning activity were made available, and concentrated efforts have been made to develop area-wide planning agencies to evaluate all requests for capital construction within broad geographic areas, regardless of the sources of funds involved. The planning requirement in the federal program — indeed, all planning beyond a single institution — encourages individual hospitals and communities to coordinate their desires with the broader public interest. The use of public taxes makes protection of the public interest imperative.

Just as the sources of capital available to the individual hospital for construction of facilities have expanded beyond the actual and potential users, similar changes have occurred with respect to the sources of payment for the services provided by these facilities. Less and less of the payment for the use of the hospital is received from the patient. A large proportion of patients in the hospital pay the hospital nothing out-of-pocket, and few pay the entire bill. While the institutions which have developed to take the place of the individual as a payer for services are varied, in every case the result is to involve a broader segment of society in paying for than in using the hospital’s facilities.

To what extent have the institutions been adapted to these changes? Do expenditure decisions for the use of hospital services reflect the preferences of the payer and the public as well as those of the patient? Granted that individual hospitals are run efficiently and economically, have we allowed a pattern of expenditures for hospital services to develop which yields considerably less benefit to society than might other feasible expenditure patterns? Is the hospital system, as a whole, inefficient in the economic sense? That is, could greater benefits to society be provided for the same cost, or could the same benefits be achieved with less duplication of resources?

While the actual distribution of payments to the hospital varies considerably depending on the institution, hospitals ordinarily receive most of their revenue from Blue Cross, insurance companies, and patients’ cash. The proportions vary widely. In one county served by three hospitals, of an average daily bill of $36.54, only $7.85 (21.5 percent) was paid by the patient, while Blue Cross, other insurance, and welfare paid $11.11 (30.4 percent),

$9.48 (25.9 percent), and $3.23 (8.8 percent), respectively. In addition, $4.87 (13.3 percent) of the average bill was written off or charged to the hospitals’ own accounts. For one of the hospitals in the community, patients’ cash was only 10.6 percent of receipts, while the welfare share was 28.4 percent. In the other hospitals, patients’ cash covered more than 30 percent of billings.

The proportion of bills which are paid entirely by the patient is smaller still. In one hospital, approximately 10 percent of the bills were paid wholly by the patient, and this included some insurance payments direct to the patient. However, this 10 percent represented less than 7 percent of the total billing, since the higher the bill, the less likely it is that the patient pays it all.

Usually each hospital deals with many separate insurance companies, but primarily with a single Blue Cross plan. This means that even if a hospital receives most of its payments from insurance companies, it is still likely that the largest single payer for services is Blue Cross. The other significant source of payment is welfare. Although the importance of this source varies widely among institutions and areas, nevertheless for the hospital system as a whole, welfare represents a large payer.

While there are other sources of revenue, such as research grants and some small separate charity funds, the only other major category against which billings are charged is allowances. This category is significant in that it measures the difference between the prices which the institution sets for services and the actual cash receipts. These allowances are of two general types. In some cases they represent “discount by agreement” for purchasers who have special pricing arrangements, such as Blue Cross and welfare. In other cases they represent uncollectible debts from patients.

Also there is a considerable difference between the prices which the hospital prints on the bill (and the public discusses) and the actual prices paid for services. Very few people pay the “list price.”When the insurance is of the indemnity type, the patient is liable for the whole bill at “list price,” but his out-of-pocket payment is less. For the other major payers — Blue Cross, welfare, and the new Medicare program — a different pricing arrangement is made. The implications of these pricing policies and their role in relation to the public interest are key elements in a discussion about the efficiency of the American hospital.


Under the free enterprise system, price is one of the elements necessary to ensure an economically efficient allocation of resources. From the individual’s point of view, prices provide a guide for decisions. His resources are not infinite, and he alone can know his own preferences. The prices of alternative uses of his limited resources enable him to compare and select. Even if everyone values hospital services highly, there is a wide range of possible expenditures, each of which yields a somewhat different amount and kind of satisfaction to the individual. If the only relevant criterion for the patient’s decision were its impact on the medical outcome, the lowest priced medically acceptable service would be as satisfying as the most expensive, and he would probably settle for the cheaper.

More elaborate hospital care requires more resources to produce, and the hospital has to charge a higher price to cover the higher cost. If no patients felt that the additional services were worth the increased price, hospitals would divert their resources to other uses which would increase the return to society. This would result in an economically more efficient use of resources.

For certain services, the waste involved and the adverse impact on medical quality are obvious. According to the President’s Commission on Heart Disease, Cancer, and Stroke, 30 percent of the 777 hospitals equipped to do closed-heart surgery had no such cases in the year under study. Of the 548 hospitals that did have cases, 87 percent did fewer than one operation per week. Of all hospitals equipped to do open-heart surgery, 77 percent did not average even one operation per week, and 41 percent averaged under one per month. Little of this work was of an emergency nature, and the mortality rate of both procedures, the Commission reported, is “a far higher rate than in institutions with a full work load.” There are sound reasons for discouraging this kind of duplication, but our reimbursement structure is such that the public accepts without protest the higher costs involved. Indeed, ten hospitals on the same block would be reimbursed for the higher average costs involved in maintaining the facilities for open-heart surgery even if no operations were performed.

According to one highly competent radiologist, “every fully equipped radiology department should have a deep therapy unit.” There is no question about that. The question which must be answered is, How many fully equipped radiology departments do we need to provide quality medical care for the American public?


This is a drastic simplification of the whole economic argument, but it provides the basis for a look at the impact of hospital pricing policies on efficiency. It has been argued that the only relevant decision-maker in determining the use of hospital services is the physician, and that the basis for the decision is medical and not affected by prices. There is, however, considerable evidence that increased hospital insurance and other forms of price reduction which spread the cost result in an increased use of the hospital. Patients go to the hospital because their insurance pays the bill for services which it does not cover at home, if, indeed, physicians did make the decision without considering the patients’ preferences, the impact of price would be much less significant, since the physician need not even know what the price is.

This reduction of the influence of the price level on the patient’s decisions has produced pressure on all hospitals to expand both the breadth and variety of medical services offered and the luxury of the surroundings. Some of this improvement in hospital services is related to medical quality in that the medical outcome of a hospital experience is improved. Much of this improvement, however, is related to the patient’s convenience and preference. Since the patient does not pay the full cost of these improvements, he is more likely to demand them than if he were faced with a direct choice between plain or fancy care and plain or fancy costs.

These pressures have tended to create a situation in which all hospitals want to produce only fancy care. The potential for “Cadillac only” medicine is nowhere more real than in the American hospital. Nevertheless, the mere existence of pressures from patients and physicians for expansion of services in quantity and quality would not be sufficient to elicit the expansion if the payers, who might have other preferences, were in a position to refuse to pay for the higher priced services.

The current reimbursement structure does not encourage this kind of buyer control. The insurance companies are unaffected by higher prices since, for the most part, their fiscal obligation is limited to a fixed dollar indemnity, regardless of the total bill. Both Blue Cross and welfare operate under special pricing arrangements. In most cases, individuals covered under the programs are entitled to given amounts of services rather than a fixed dollar value of service. This means that these payers are strongly affected by changes in prices.

While there are specific differences among plans, in general Blue Cross contracts with the hospitals to pay “the lower of costs or charges.” This usually results in a reimbursement structure in which the price to Blue Cross directly reflects the actual cost of the service. Welfare also typically reimburses the hospital for some of the costs incurred. Although there are differences in regard to what costs are reimbursable, particularly with regard to teaching and research activities in the hospital, the payers actually exercise little control over prices and offer little or no resistance to increases. In the case of welfare, the public automatically picks up the bill by paying higher taxes. For Blue Cross, it may be necessary to seek a rate increase, which must be authorized by some public authority. In actual fact, such authorization cannot be denied. Here, too, the public pays, through Blue Cross taxexempt status and the widespread community base of its support.

This automatic “cost pass-through” from hospital to payer, together with the decreased relevance of the price to the patient, provides a basis for the considerable inefficiency of the hospital system as a whole. If a fancier radiology department (conceivably with absolutely unchanged quality) would cost twice as much annually to operate, the “price” charged to Blue Cross would rise proportionately without affecting demand from patients. The impact would be most felt in the ultimate increase in Blue Cross premiums, proportionately much less than the cost rise because of the broad base of subscribers. For uninsured patients or welfare patients, the impact will be greater but not offsetting. In such a circumstance, there is little reason to expect the hospital to resist running a fancier radiology department. From the hospital’s point of view, improving services helps it to compete with other hospitals and laboratories serving the same area. But it is hardly consistent with the public interest.

Such behavior is inevitable, however, since no controls have been instituted which can protect the public interest. No requirement, similar to planning for construction, is attached to the payment to the hospital for services received. It is interesting to note that Blue Cross has denied payments to a hospital constructed without permission to build from the area-wide planning council. The argument made by Blue Cross was that excessive facilities lowered occupancy and thereby raised average costs and the cost per unit of service to Blue Cross.

This same argument could apply to services within the hospital. However, few Blue Cross plans, created by the hospitals whose representatives make up a good proportion of their boards, are likely to pursue this course, and welfare does not account for enough revenue to exert effective control.


There is now a new payer on the scene, Medicare, which will also reimburse hospital costs, thereby increasing the pressures for higher prices. In this program, as in the other major cost reimbursement programs, each hospital is treated in isolation from other hospitals, or the “system” as a whole. According to the guidelines issued by the government:

The provision in the law for payment of reasonable cost of services is intended to meet the actual costs, however widely they may vary from one institution to another. This is subject to a limitation where a particular institution’s costs are found to be substantially out of line with other institutions in the same area which are similar in size, scope of services, utilization, and other relevant factors.

Although there is no indication of how the limitation will be implemented, this proviso suggests that those who drew up the guidelines are aware of the danger in simply removing the lid on costs.

Effective hospital planning requires that each hospital should be related in a meaningful way to other hospitals serving the same region. For certain services, such as open-heart surgery, the area served by a single institution should be quite large; for other services, such as obstetrics and emergency services, the area may be considerably smaller. It is impossible to provide a complete range of services in all institutions without excessive duplication, economic waste, and a reduction in quality.

Much of the growing proportion of personal income devoted to health expenditures — over 6 percent in 1964 — is spent by people who do not go to the hospital; indeed, some may not need any health services at all in a given year, although they continue to pay their taxes and insurance premiums. As costs increase, this silent public is becoming more aware of the inconsistency between what they get and what they pay for. The response to these pressures has been shown in the increasing interest in hospital planning. If the planning is to be successful, the payment mechanisms which we develop must operate as incentives, not hindrances, to efficiency. The deficiencies in our current system of payments are clear. It remains to be seen whether the new government-sponsored plans aimed at making high-quality medical care available to all Americans will bring about the necessary controls. If they do not, the public will have to find ways to force the issue.