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An Arm and a Leg

by Avik Roy

Hospitals are to blame for obscene health-care costs

In 1994, two eminent Boston hospitals, Massachusetts General Hospital and Brigham and Women’s Hospital, merged. Officials hailed it as a new era for integrated, high-quality care. The state’s secretary of health and human services signed off on the merger without a public hearing, with the blessing of Republican governor William Weld.

The merged hospital entity, called Partners HealthCare, immediately went about raising rates for insurers. Blue Cross Blue Shield of Massachusetts, the state’s largest private insurer, wanted to fight — in 2000, at a gathering of the company’s executives, some suggested refusing to pay the higher fees. But executive Peter Meade delivered a cold slap of reality: “Excuse me, did anyone here save anyone’s life today? We are a successful business up against people that save people’s lives. It’s not a fair fight.”

For 50 years it hasn’t been a fair fight. And understanding that is the key to solving a mystery that has puzzled conservatives for decades: Why is it that no matter what, the largest component of government spending — health care — keeps rising?

In debates about health care, we spend a lot of time arguing over how we buy it: whether through government payers, private insurers, or health savings accounts. But there’s an equally important story, one that nearly everyone in the political class has neglected: how we sell health care. Hospitals are at the center of this story. And they are using their economic and political power to drive up the price of their product.

If the Congressional Budget Office’s projections are right, health care will account for almost all increases in government spending for the foreseeable future, excluding interest on the debt. And increasing spending on hospital care is the biggest driver of rising health-insurance premiums, which are in turn the main cause of wage stagnation for middle-income Americans. Put simply, we cannot confront the growth of government, nor of middle-class economic insecurity, without first confronting the central role that hospitals play in causing both.

Hospitals have quite cleverly avoided blame for these problems. In 2009 and 2010, Democrats attacked private insurance companies for rising premiums. “There have been reports just over the last couple of days of insurance companies’ making record profits, right now,” said President Obama during a 2009 news conference. “At a time when everybody’s getting hammered, they’re making record profits, and premiums are going up. What’s the constraint on that?”

The president’s comments were disingenuous. As a proportion of revenues, profits for health-insurance companies have stayed relatively constant for decades at about 5 percent. What has happened is that hospitals have charged more and more for the same services and treatments, and insurers have passed these costs on to consumers in the form of higher premiums. Insurers are a convenient scapegoat, both for the real culprits — hospitals — and for a political movement that is hostile to the concept of private health insurance. But blaming insurers is like shooting the messenger.

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.

These higher prices are responsible for the growth in the cost of health insurance. And as insurance becomes less affordable, hospitals don’t try to make their services cheaper, as a normal business would. Instead, they lobby the government for more subsidies, often pointing to the fact that they are required by law to provide free emergency-room care to the uninsured. In 2009, President Obama was happy to adopt this as a talking point for his health-care law: “Those of us with health insurance are also paying a hidden and growing tax for those without it — about $1,000 per year that pays for somebody else’s emergency-room and charitable care.”

It will not surprise you that the American Hospital Association eagerly supported Obamacare; hospitals will be the single biggest beneficiary of the trillions in new spending that the law will authorize. Currently approximately one-third of government health spending ends up in the pockets of hospitals. This year, before the implementation of Obamacare, U.S.-government entities will send $500 billion to American hospitals, a figure that the Centers for Medicare and Medicaid Services expects to grow to $800 billion a year by 2021. And the more money hospitals get, the more powerful they become, giving politicians even greater incentive to cater to their interests.

It was Lyndon Johnson’s Great Society that turned American hospitals into a political and economic juggernaut. Before the establishment of Medicare and Medicaid in 1965, progressive efforts to pass single-payer health care had been stymied by two powerful forces: conservative southern Democrats (who resisted centralization in general and feared integration mandates) and the American Medical Association.

However, the 1964 elections resulted not only in Johnson’s reelection, but also in large Democratic congressional majorities. The Democrats gained 37 seats in the House, giving them a 295–140 majority, and two seats in the Senate, for a total of 68. (By comparison, after the 2008 elections, Democrats enjoyed a 257–178 House majority and controlled 59 seats in the Senate.) Since Johnson’s agenda was likely to pass with or without southern support, a number of congressional conservatives switched sides and, as had happened with the New Deal, decided to ride the Big Government gravy train for all it was worth, sponsoring an even more expansive version of Medicare than Johnson had originally intended.

The only opposition left was the AMA, which had, up to that point, been a resolute opponent of socialized medicine. In 1961, during a previous battle over nationalized health care, the AMA had organized a successful cross-country campaign in which women organized coffee klatches and played a record, narrated by Ronald Reagan, inveighing against the proposed single-payer plan.

Johnson, recognizing the AMA’s pull, softened doctors’ resistance by assuring them that Medicare would contain no cost controls. The Medicare bill promised to pay doctors and hospitals according to “usual, customary, and reasonable” rates. The result was that doctors and hospitals could charge whatever they wanted to.

And they did. In the first year of Medicare’s existence, hospital spending increased by 22 percent. For the next five years, hospital spending grew by an average of 14 percent a year. In the decades since, growth in hospital spending has continued to exceed that of the rest of the economy. In 1965 Congress projected that by 1990, accounting for inflation, the government would spend $12 billion on Medicare. In actuality, the government spent $110 billion on Medicare that year, and another $74 billion on Medicaid. Eight years from now, the Centers for Medicare and Medicaid Services projects, U.S. public spending on health care will approach $2.4 trillion. One-third of that, as noted above, will flow to hospitals.

Every president since Nixon has made a half-hearted attempt to rein in government health spending. It was the Reagan administration, in 1983, that introduced price controls into Medicare. But price controls only incentivized doctors to provide more kinds of services at a higher volume, to make up for lower prices. And hospitals have responded to Medicare’s price controls by “cost-shifting” — i.e., charging higher prices to people with private insurance, and astronomical prices to the uninsured.

Private insurers don’t have the same leverage as the government. If a private insurer refuses to play ball with the major hospital in town, the insurer will lose customers to a competitor who is willing to pay the hospital more. And, as the Blue Cross executives in Massachusetts understood, politicians demonize insurers and lionize hospitals, so insurers look like the bad guys if they deny their customers access to famous but costly local hospitals.

This problem, in turn, is caused by the fact that most consumers of private insurance don’t buy it directly, but instead receive it through their employers, making them less sensitive to its price. Workers want access to the top hospitals and get upset when their plan denies that access, because they don’t directly see how much they would save by choosing a cheaper hospital.

The Partners case is just one example of a tactic that hospitals all over the country have used to gain leverage over private insurers: consolidation. In most sectors of the economy, the government uses antitrust laws to prevent the formation of monopolies. But federal agencies and courts have been uniquely passive in the face of hospital monopolies.

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.

In 1992, hospital markets in the U.S. had an average HHI of 2,440. Nearly half of all localities in America already had a highly concentrated hospital market. Based on antitrust guidelines for the rest of the economy, the U.S. government ought to have blocked the vast majority of hospital mergers that took place thereafter.

Instead, however, the DOJ and the FTC challenged only a handful of deals. The agencies determined that they would bother to address hospital mergers only if those mergers drove the HHI to near 5,000. Hospitals, defending their mergers against the government’s opposition, played up their traditional image to sympathetic judges: as instruments of charity, as nonprofit pillars of their communities.

The tactic worked. From 1993 to 2008, the DOJ and the FTC failed to block a single hospital merger in the United States. By 2006, the average hospital-market HHI had increased from 2,440 to 3,261.

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.

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.

Yale–New Haven Hospital (YNHH), as the name implies, is the academic hospital associated with the Yale School of Medicine, in New Haven, Conn. In 2011 New Haven had a population of 129,585, making it America’s 192nd-largest city. But Yale–New Haven is the fourth-largest hospital in the country. The Yale–New Haven Health System, of which YNHH is the flagship, has gradually acquired many of the major hospitals in Connecticut — most recently its major crosstown competitor, St. Raphael’s, for $160 million. Rest assured that hospital prices in New Haven will not be going down.

And hospitals aren’t just buying up rival hospitals. They’re also acquiring physicians in private practice. According to an analysis by Aetna, in 2002, two-thirds of medical practices were owned by physicians, compared with one-quarter by hospitals. By 2011, these numbers had reversed.

Hospitals acquire private practices because it lets them control the patients whom private physicians see. Independent physicians can refer their patients to any hospital that accepts their insurance; hospital-affiliated doctors are required to refer patients to the hospitals they work for.

Hospital-affiliated physicians, in turn, can take advantage of hospitals’ market leverage to charge higher prices to patients with private insurance, an important counterbalance (for them) to the increasing number of people on government-sponsored health insurance, which pays much less.

Rather than address this problem, Obamacare, at the hospital lobby’s behest, actively suppresses the ability of physicians to compete with hospitals. Section 6001 of the Affordable Care Act bars the construction of new physician-owned hospitals if those hospitals will accept Medicare patients. While a few such hospitals have dropped plans to accept Medicare patients in order to evade the law’s restrictions, in other cases investors have lost fortunes shuttering halfway-completed projects.

Physicians are trying to persuade Congress to reverse the ban. But that effort “faces an uphill battle with Democrats,” reports Alicia Mundy of the Wall Street Journal, because the ban was a crucial tool they used to gain the hospital industry’s support to begin with.

Democrats learned an important lesson from the failure of national health-care reform in the Clinton years: Don’t anger powerful special interests. So Obama’s team took great care to buy off the pharmaceutical industry and the AARP, to cow the insurers into silence, and to cater to the interests of hospitals.

In most congressional districts, a hospital is the largest or second-largest employer. Combine this fact with hospitals’ prestige as “nonprofit” pillars of their communities, and they receive enormous deference from members of Congress. Put simply, Obamacare would not have passed if it harmed hospitals.

This is why Democrats adopted an explicit strategy of “coverage first, cost later”: They knew their primary goal of achieving near-universal coverage would go nowhere if they tried to crack down on hospitals’ high prices. Even raising taxes was politically easier than taking on the American Hospital Association.

Indeed, as noted above, President Obama explicitly framed his health-care law as a way to send more money to the hospital industry. But his reason for increasing these subsidies — that charity emergency-room care by hospitals is a “hidden tax” on the insured — was a mere pretext. Hospitals claim that they spend $50 billion a year on uncompensated care, but Obamacare will replace this “hidden tax” with more than $200 billion a year in spending on the uninsured — spending that is funded mostly by explicit taxes.

And $50 billion is an entirely fictitious number. In March, for Time, Steven Brill documented the degree to which hospitals massively overcharge the uninsured. Hospitals do not expect to collect payment on these huge bills, but they can claim any unpaid balance as uncompensated care for public-relations and tax purposes.

For example, Sean Recchi, an uninsured lymphoma patient, went to MD Anderson Cancer Center, a world-renowned facility in Houston. The hospital charged him $283 for a chest X-ray for which it would have charged Medicare $20. It charged him more than $15,000 for blood tests that normally cost a few hundred dollars. It charged him $13,702 for a dose of Rituxan, a lymphoma drug for which the average U.S. hospital price is around $4,000. All told, Recchi’s course of treatment cost $83,900. Whatever he couldn’t pay was called “uncompensated care.” (MD Anderson is not struggling under the weight of bills unpaid by the uninsured. In 2010, it recorded revenue of $2.05 billion and operating profits of $531 million.)

In May, for the first time, the Centers for Medicare and Medicaid Services released data on the prices that hospitals charge for common medical procedures. They found wide discrepancies. Jackson Memorial Hospital in Miami, for example, listed an average price of $66,030 for implanting a pacemaker. The University of Miami Hospital, across the street, listed an average price of $127,038. In some cases, the costliest hospital charged five or six times what the cheapest hospital did. Hospital prices are usually set almost arbitrarily. They have no relationship to what the services cost to provide, or to what insurance companies and the uninsured actually pay, let alone to any sort of classical notion of supply and demand.

The biggest domestic-policy problem facing America today is our fiscal crisis. The biggest driver of our fiscal crisis is the growth and scale of our health-care entitlements: Medicare, Medicaid, Obamacare, and related programs. And the growth and scale of our health-care entitlements is, in turn, driven by the enormous political and economic power wielded by hospitals.

Furthermore, as hospitals charge ever-higher prices to a shrinking cohort of privately insured and uninsured individuals, more and more Americans will demand that the government further subsidize the cost of health insurance, a measure that would only make the problem worse.

So what can be done? Simply put, we must reduce the economic — and thereby the political — power of hospitals by countering the effects of hospital consolidation.

There are two ways to do so: one, increasing the market power of the people who pay for health care: consumers, private insurers, and/or the government; and two, decreasing the market power of hospitals by loosening the restrictions on hospital competition.

The progressive approach is to impose price controls on hospitals. Price controls, as a rule, make a market less efficient, not more. However, in extreme cases, they might serve as an effective regulatory threat, given the difficulties of antitrust litigation. For example, the federal government could require that all hospitals accept Medicare prices from private payers, including the uninsured, if the market concentration in a given area exceeded a specified HHI threshold, say 4,000. This might, in the future, deter hospitals from merging for the sole purpose of gaining a pricing advantage.

It’s an unattractive solution — but the status quo is worse. If we do nothing, hospital monopolies and duopolies will become increasingly difficult to dislodge. Building new hospitals is a costly and capital-intensive business. It’s a bit like the airline and automobile industries: Hospital entrepreneurs do come along from time to time, but only rarely, and they frequently fail.

Fortunately, there are other solutions more friendly to the free market. Federal and state agencies can more aggressively pursue antitrust action against hospital mergers. Congress can repeal Obamacare’s restrictions on new hospital construction. States can harmonize their medical-licensing regulations so that doctors can send patients to health-care providers in other states. And states can loosen their “certificate of need” laws, which allow bureaucrats friendly with incumbent hospitals to prevent entrepreneurs from building new facilities.

In addition, we can do more to place Americans in charge of their own health dollars. Today, the vast majority of Americans don’t pay for care directly; instead, it is paid for on their behalf by their public or private insurer. Most economists agree that third-party payment for any service will tend to drive up its cost; just ask anyone who’s paid for an open bar at a wedding.

But on top of that, the vast majority of Americans don’t pay for their own insurance directly either. We have a third-party system for purchasing third-party health insurance: in effect, a ninth-party health-care system. Is it any wonder that the prices hospitals charge bear no relationship to the value of their services to consumers?

Ultimately, we have to realize that hospitals — and the government policies that empower them — are the principal driver of rising health-care spending. America’s hospitals form a trillion-dollar, taxpayer-subsidized behemoth that will do everything it can to grow larger and larger at the expense of the remainder of the economy.

If Republicans are serious about returning their focus to the economic problems of the middle class, they must make the affordability of health care a central plank of their agenda. To do that, certainly, we must reform the way we pay for health care. But we must never lose sight of the corrupt and inefficient ways that hospitals sell it.

Mr. Roy is a columnist for National Review Online and a senior fellow at the Manhattan Institute.

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