Our Enemy, the Hospitals

by Reihan Salam

I highly recommend Avik Roy’s “An Arm and a Leg,” which focus on the role of large hospitals in driving up the cost of medical care in the United States:

The average hospital stay in the developed world costs $6,222. In the United States, the average hospital stay costs $18,142. That’s true even though the average hospital stay in the U.S. is only five days long, two days shorter than the OECD average. You might guess that the extra $12,000 pays for whiz-bang technology or extra services that Europeans don’t use, but studies have shown that most of the difference cannot be explained by such factors. American hospitals simply charge higher prices.

Part of the story, according to Avik, is consolidation:

Economists and regulators measure market concentration using a tool called the Herfindahl-Hirschman Index, or HHI. The HHI is calculated by taking all the players in a given market, calculating their market shares, squaring each market-share percentage, and adding up the total. For example, a market consisting of four airlines, two with 30 percent each and two with 20 percent each, would yield an HHI of 2,600 (twice 900 plus twice 400); a duopoly that split a market 50–50 would yield an HHI of 5,000; and a perfect monopoly would have an HHI of 10,000. According to guidelines published by the U.S. Department of Justice and the Federal Trade Commission, a market with an HHI between 1,500 and 2,500 is considered “moderately concentrated,” and one with an HHI above 2,500 is considered “highly concentrated” and subject to regulatory scrutiny.

As of 2006, the average hospital-market HHI had reached 3,261. And Avik reports that this concentration has had clear consequences for the prices charged by hospitals:

Hospital monopolies and oligopolies use their market power just as other monopolies do: to raise prices. James Robinson of the University of California looked at six common categories of hospital procedures, such as pacemaker insertions and knee replacements, and compared what hospitals charged for those procedures. He found that hospitals in markets with above-average HHI scores — the highly consolidated ones — charged 44 percent more than their brethren in markets with below-average HHI scores. And nearly all of that extra revenue from higher prices went straight to hospitals’ bottom lines, where it could be used to pay higher salaries, build new wings, and swallow smaller competitors.

One might assume that nonprofit hospitals wouldn’t engage in irresponsible profiteering, so perhaps concentration isn’t a problem in regions with nonprofit hospitals. This assumption is flawed:

Most hospitals are “nonprofit” entities for tax purposes, which gives the public the impression that hospitals focus on healing the sick instead of making money. But that’s not true. “Nonprofit” status simply prevents hospitals from distributing earnings to owners or shareholders; it does not prevent them from paying large salaries to their executives and piling up cash for their proprietors. A McKinsey study found that the nation’s 2,900 nonprofit hospitals have higher profit margins, on average, than our 1,000 for-profit hospitals do; they just retain the profits and use them for expansion, improvements, and so forth.

Avik’s article gets into the guts of the health reform debate. Hospitals are politically influential and deep-pocketed defenders of the Affordable Care Act, and they are deeply invested in a health system built around third-party payment. Those who believe in market-oriented health reform need to recognize that large hospital groups are a key barrier to reform. Perhaps the most pernicious thing hospitals do is block business model innovation by resisting the entry of new firms that aim to “cannibalize” their most profitable business lines. Of course, it’s not clear why new entrants would want to take on businesses that are unprofitable. Recently, Ketaki Gokhale described an Indian firm that has radically reduced the cost of heart surgery:

Devi Shetty keeps photographs of Mother Teresa and Mahatma Gandhi on his desk, and he’s obsessed with making cardiac surgery affordable for millions of Indians. But these two facts are not connected. Shetty’s a heart surgeon-turned-businessman who founded a chain of 21 medical centers around India. Every bit the capitalist, he has trimmed costs by buying cheaper scrubs and spurning air-conditioning and other efficiencies. That’s helped cut the price of artery-clearing coronary bypass surgery to 95,000 rupees ($1,555)—half of what it was 20 years ago. He wants to get it down to $800 within a decade. The same procedure costs $106,385 at Ohio’s Cleveland Clinic, according to data from the Centers for Medicare & Medicaid Services.

“It shows that costs can be substantially contained,” says Srinath Reddy, president of the Geneva-based World Heart Federation. “It’s possible to deliver very high-quality cardiac care at a relatively low cost.”

It is very difficult to imagine a large, politically powerful U.S. hospital allowing an entrepreneur like Shetty to open his doors and drive down the price of various lucrative procedures by building a highly specialized business. The end result is that we are suffering from more medical errors and unnecessary deaths than is strictly necessary, and of course we are paying much more for the privilege.