Medicare's prospective payment system: a critical appraisal - Cost-Containment Issues, Methods, and Experiences

Health Care Financing Review, Annual, 1991 by Robert F. Coulam, Gary L. Gaumer

Margins

Profit margins are important measures of hospital financial condition. The combined effects of very modest annual update factors and the complete phase-in to national rates by PPS 5 have led to a situation in which a majority (57 percent) of hospitals earned negative margins on Medicare inpatients by PPS 6. During this period, total hospital margins have fallen and stabilized at levels that are similar to those in 1980, which were higher than margins during the 1970s. (For a discussion of this trend, see Russell, 1989.)

Although many analysis look to variously defined profit trends as "gold standard" evidence of the sufficiency of payment rates, there are many reasons to doubt the importance of such measures. First, research certainly does not directly support a view about levels of margins (PPS or facility as being too high or too low, because it is not possible to say whether hospitals are operating at maximum efficiency, or if PPS payment levels reflect the "most efficient" level (Russell, 1989). Second, unlike margins in profit-oriented industries, margins for hospitals are largely means, not ends. Their level may not reflect anything about an institution's welfare in a given period, its success in operations, its ability to attract funds from external sources, or the security of top managers in their positions. Finally, the massive reorganizations and product-mix changes occurring in the industry in recent years likely after the necessary rate of return for these organizations, in comparison to the hospital industry of the 1970s or early 1980s. Among other things, we would expect overall margins to settle t a somewhat higher level in the industry under PPS than under cost reimbursement, because hospitals are assuming more business and financial risk.

There is interesting and important new evidence that the distributions of margins are diverging across the industry, stemming from different PPS payments and a failure of expenditures to realign across hospitals so that margins are the same. Recent work by both ProPAC (1991a) and Cromwell and Burge (1991) demonstrate a lack of year-to-year profit convergence. Suggestive data are shown in Table 3. Essentially, the winners (hospitals with consistent high margins) did not experience the declines in margins of the typical hospital, and the losers experienced continued declines.

                           Table 3
     Margins in chronically high- and low-margin hospitals
                                  Average PPS margin, by year
Characteristic of hospital       PPS 3       PPS 4       PPS 5
Urban Hospitals                             Percent
Chronically low margin(*)        -9.4        -15.9       -24.1
Middle margin                     8.6          5.2         0.3
Chronically high margin(**)      22.0         20.9        19.2
Rural hospitals
Chronically low margin(*)       -23.4        -28.6       -33.4
Middle margin                     0.8         -1.1        -2.6
Chronically high margin(**)      18.1         17.9        17.6
(*) Lowest quartile of margins in each PPS 3, 4, and 5.
(**) Highest quartile of margins in each of PPS 3, 4, and 5.
NOTES: PPS is prospective payment system. The abbreviation
PPS followed by a number indicates a particular year under the
system., e.g., PPS 1 is the first year of PPS.
SOURCE: (Prospective Payment Assessment Commission, 1991a).