Prospective payment for Medicare hospital capital: implications of the research - Cost-Containment Issues, Methods, and Experiences

Health Care Financing Review, Annual, 1991 by Philip G. Cotterill

Introduction

The 1983 Amendments to the Social Security Act (Public Law 98-21)enacted the Medicare prospective payment system (PPS) for the payment of hospital impatient operating costs, but spending further study, continued cost-based payment of capital costs until October 1, 1986. On June 3, 1986, the U.S. Department of Health and Human Service (DHHS) issued proposed regulations for incorporating capital payments into PPS. In July 1986, legislation (Public Law 99-349) was passed that extended the exclusion of capital from PPS until October 1, 1987. In May and September 1987, DHHS issued proposed and final regulations to fold capital payments into PPS. However, in October 1987, enactment of Public Law 100-119 prevented the final regulation from taking effect. The Omnibus Budget Reconciliation Act of 1987 (Public Lawn 100-203) subsequently required DHHS to implement prospective payment for capital starting October 1, 1992. In February and August 1991, DHHS once again issued proposed and final regulations for a third attempt to incorporate capital payments into PPS. The August 1991 capital regulation took effect October 1,1991, thus initiating a 10-year transition to full prospective payment of Medicare's share of inpatient capital-related costs.

Congressional persistence attests to the widespread belief that change was needed in Medicare capital payment policy. In particular, there was recognition that to encourage efficient resource use, Medicare payment policy should not influence hospitals' choices of how to combine capital and operating inputs. There was also the understanding that with capital paid on a cost basis and operating costs on a prospective basis, Medicare provided hospitals the incentive to substitute capital for operating cost.

Under these circumstances, why did it takes so long to incorporate capital into PPS? Both the special nature of capital and the tradition of cost-based payment inhibited change.

The durability and "lumpiness" of capital distinguishes it from other inputs. Capital tends to be purchased in larger, less divisible quantities at less frequently intervals than operating inputs. The lumpiness of capital creates the need for long-term financing and the contractual commitments that accompany debt financing. Debt obligations make it more difficult to change Medicare capital-payment policy without imposing major adjustments on hospitals with very large debt service costs.

Another consequence of the lumpiness of capital is that, relative to its size, capital cost per discharge varies more among hospitals than does operating cost per discharge. As a result, a prospective payment based on the average capital cost will tend to have a greater relative impact in redistributing payments than was the case for operating cost.

Finally, the tradition of cost-based payment for hospitals has created a tendency to accentuate the uniqueness of capital in people's thinking about Medicare payment policy. Neither the variability nor the lumpiness of capital are unique to hospitals. Only the tradition of cost-based payment is unique to hospitals. Certainly, in the private sector, it is almost impossible to think of a good or service for which the unit of payment separately identifies capital from the other inputs used in producing the good or service. Even in highly capital-intensive publicly regulated industries such as electric power, the return on capital is incorporated into a rate structure based on the unit of service(1) (e.g., dollars per kilowatt hour).

The experience of other industries clearly demonstrates that hospital capital can be paid on a per discharge basis and need not be paid separately from other input costs. However, a shift to prospective payment for hospital capital requires consideration of how to minimize the negative effects of transitional payment redistributions and how to structure the longrun prospective payment for capital.

The next section of this article addresses the issue of payment redistributions by presenting descriptive data on the variation of capital and operating costs. This information quantifies the extent to which capital costs are more variable than operating costs. The effect of capital-cost variability on total-cost variability is also assessed. The specifics of transitional payment mechanisms are beyond the scope of this article, but the details of the policy being implemented are described in the August capital regulations (Federal Register, 1991).

The remainder of this article addresses the issue of the structure of the long-run prospective payment for capital by analyzing and comparing sources of variation in capital cost versus operating and total costs: The empirical models of capital- and total-cost variations that were estimated are described,

and estimation results are presented. The article concludes with a discussion of the policy implications of this analysis.

The regression results reported in this article differ from those found in the August capital regulation in two ways. First, given the focus of this article on comparative analyses, it was necessary to limit the data set to hospitals for which all variables were available. This meant that fewer hospitals were included in the regressions reported here than in the regression actually used to determine the capital payment adjustments in the August capital regulation. Second, because the emphasis here is on understanding sources of cost variation rather than on determining specific payment adjustments, the variables included in the regressions are not identical to those reported in the August capital regression.