by Tom Robertson
Executive Director, Vizient Research Institute

In 1964, an eclectic group of seven strangers set out on what was to be a three-hour sightseeing excursion, only to become shipwrecked on a seemingly deserted island.  Through syndication and reruns, the seven hapless castaways of Gilligan’s Island appear in our living rooms over 50 years later, still stranded but apparently none the worse for wear. At first glance, the passengers and crew of the SS Minnow would not appear to offer lessons related to health care pricing, but a closer look suggests that they just might.

Interestingly, the shipwreck on Gilligan’s Island virtually coincided with the introduction of Medicare in 1965. Initially, Medicare based its payments to hospitals on their reported costs. Intuitively appealing as a concept, cost reimbursement had unintended consequences, one of which was the fact that hospitals were paid more if their costs increased. In particular, if “non-cash” costs such as depreciation increased, Medicare reimbursement rates increased, resulting in positive cash flows for the hospitals. Between 1967 and 1983, Medicare costs rose ten-fold, from $3 billion to $37 billion per year. In 1982, in an effort to control costs, Medicare shifted to a prospective payment system based on diagnosis-related groups (DRGs), and since that time the federal government has unilaterally set hospital prices for inpatient services.

For many hospitals, the DRG-based Medicare payment rates have fallen short of covering costs and as annual adjustments to these payment rates often lag the medical component of the consumer price index (medical CPI), the gap between hospital costs and Medicare revenue has widened over time. Exacerbating the Medicare payment shortfall, Medicaid payment rates in many states are even lower, adding to the problem of unreimbursed hospital costs. With no opportunity to negotiate payment rates in the public sector, hospitals have by necessity turned to the private sector to close the gap. 

Contract negotiations have long been contentious between hospitals and commercial insurers, with each party attempting to minimize or maximize the payment rates, depending upon which side of the table they sit. Since the introduction of prospective payments, hospitals have closed the gap between their costs and government payment rates with revenue accruing from their contracts with commercial insurers. Hospitals with significant bargaining clout (those without which commercial insurers would find it difficult to enroll beneficiaries) have negotiated higher payment rates than hospitals with low bargaining clout, but most hospitals have subsidized government payments with revenue from commercial insurance contracts. And that practice, often referred to as “cost shifting,” brings us back to our island castaways.

Imagine being marooned on an island with no short-term prospects for rescue. It rains intermittently, creating opportunities to collect fresh water, but far less than the group needs to survive. The less-than-sustaining rainfall is analogous to government payment rates for hospitals. On the island there is a single deep well, with a reservoir of fresh water. The reservoir has a fixed capacity; when the water is gone, it’s gone. The well is analogous to the private sector contracts – we supplement the insufficient rainfall with water drawn from the well.

If we did not know how long we’d be stranded, we would ration the water in the well, to guard against consuming it too quickly. On our island, however, we post no guards at the well – in fact, there is a common misconception among our stranded cohabitants that the well is spring-fed and that it could last forever. There is no expectation that we will only draw from the well what we absolutely need to supplement the rain – everyone takes from the well what they can carry. Now imagine that some of us have large buckets and others have smaller pails. Hospitals with more bargaining clout lower large buckets into the well, while hospitals with little bargaining clout dip small pails into the water.

In a recent Vizient Research Institute Touch Point, we explored the impact of cost shifting on working families covered by commercial insurance policies. In 2001, cost shifting added approximately $104 to the typical working household’s annual health insurance premium. By 2016, cost shifting amounted to roughly $115 per month for the typical working household. It’s not clear how much longer we can go to the cost shifting well for more water, but when the impact on working households starts to look like a car payment, we may see the well go dry.

It’s interesting to note that the Medicare Payment Advisory Commission found that hospitals experiencing more pressure from commercial insurers (those with less bargaining clout) had costs 8 percent below the national median after controlling for case mix, wage index, outliers, transfer cases, interest expense, teaching, and low-income Medicare patients. On the other hand, hospitals experiencing lower pressure from insurers (those with more bargaining clout) had adjusted costs 2 percent above the median and 10 percent higher than the low bargaining clout hospitals.

The hospitals with lower bargaining clout in the private sector were marginally profitable at prevailing Medicare payment rates while hospitals with more private sector bargaining clout were significantly unprofitable under Medicare payment rates. Those of us with larger buckets appear to be subsidizing government payment rates with higher commercial revenue while those with small pails have learned to live with less water.

As the baby boomers age into Medicare and both federal and state governments struggle to afford unchecked health care spending, nothing portends higher government payment rates. There are no rescue boats on the horizon, and no expectation that rainfall will increase sufficiently to meet our current consumption. As the burden of cost shifting threatens to crowd out other essential spending for the typical working household, the well from which we have traditionally drawn subsidies may run dry. Those of us with the biggest buckets should take a lesson from those with smaller pails, and learn to get by with less water.

About the author and the Vizient Research Institute™. As executive director of the Vizient Research Institute, Tom Robertson and his team have conducted strategic research on clinical enterprise challenges for 20 years. The groundbreaking work at the Vizient Research Institute drives exceptional member value using a systematic, integrated approach. The investigations quickly uncover practical, tested results that lead to measurable improvement in clinical and economic performance.

Published: May 23, 2017