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Health Affairs Study On Hospital Profitability Gives Us Some Important Factors To Watch Going Forward

Editor’s Note: This blog post first appeared on the Health Affairs Blog.

In a recent article published in Health Affairs, Ge Bai and Gerard Anderson used Medicare cost report data to measure the profitability of U.S. hospitals and to identify factors associated with higher and lower hospital profitability. The study’s findings point to a small number of factors that we should pay attention to as we think about how to restructure our health care system to improve its economic performance.

Factors Associated With Higher Profits

It is important to keep in mind that profits can be high, either because prices are high or underlying production costs are low (relative to each other). The Bai and Anderson study does not decompose profits but rather measures overall accounting profits as reported to Medicare. So, higher profits do not always indicate excess prices. Higher profits could be the result of lower costs resulting from greater efficiency.

Most hospitals that make positive profits do so from their services to commercially insured patients in health plans such as Blue Cross, CIGNA, and others. Medicare and Medicaid, the largest payors, generally have regulated prices that are independent of local market competition and any other characteristic that hospitals can control.

In contrast, hospitals and health plans negotiate prices for commercially insured patients, usually for one- to three-year periods. The outcome of these negotiations is highly dependent on competitive conditions for both parties. More hospital competition generally results in lower prices paid to hospitals, as does less health plan competition. Both sides understand these dynamics and their importance in determining prices and profitability.

Acceleration Of Ongoing Trends

Several ongoing and accelerating trends in both hospital and health plan markets are linked to factors identified by Bai and Anderson as being associated with hospital profitability.

Hospital Consolidation And Multi-Hospital Systems

In the early days of managed care contracting, most hospitals were independently run and faced a lot of competitors in their markets. This resulted in slower hospital price growth than we typically see today (and even declining prices in some cases). As time went on, more and more hospitals realized that having so many nearby competitors hurt their prices, and a consolidation trend (mergers and acquisitions) among local competitors began.

The trend began first with local market mergers but then evolved to include the formation of large multi-hospital systems that cover different, non-overlapping geographic markets. For example, California has two large systems, Dignity Health with 31 hospitals and Sutter Health with 25 hospitals, covering many different local hospital markets. The net effects of hospital consolidation are twofold. First, it reduces the number of competitors in the local market and, second, it allows some multi-hospital systems to negotiate as a single large entity with health plans, often demanding higher prices for all system members if the plan wants to include any of its members as in-network hospitals in their insurance products.

Bai and Anderson report two profitability-related factors that reflect the effect of hospital consolidation trends: regional power and system affiliation. Regional power refers to hospitals that face less competition in their local markets, while system affiliation indicates hospitals that are part of multi-hospital systems. Both are associated with higher profitability in their study.

More and more hospitals across the country are joining systems that operate outside their local markets. This is due, in part, to the fact that antitrust regulators have limited local market mergers but have not, in general, adapted their models of hospital market competition and antitrust to address non-local mergers. As a result, hospitals in some instances are able to join systems, gain market power, and raise their prices without necessarily improving quality or service. My own research in this area (forthcoming in INQUIRY) shows that hospitals that are part of the largest multi-hospital systems in California were able to negotiate price increases that are consistently well above all other hospitals in that state.

Health Plan Consolidation And HMO Penetration

Sitting on the other side of the table from an increasingly consolidated hospital industry are commercial health plans. There has also been a long-term trend of consolidation in this sector. However, until recently, health plan consolidation has lagged hospital consolidation.

My prior research with colleagues shows that in 2004, most local hospital markets were much more consolidated than health plan markets. This study, along with others, shows that as the number of competing health plans declines, average market share of remaining health plans increases, and this is associated with lower prices paid to hospitals, especially in markets where there are one or two dominant health plans.

This is important because we are in the midst of a significant wave of consolidation of commercial health plans in the U.S., which is likely due, in part, to recognition by health plans that hospitals had the upper hand in many markets. The presence of health maintenance organizations (HMOs) in a market can also affect hospital prices. For example, HMOs may contract with fewer hospitals in local markets to attempt to create greater price competition and then try to leverage this dynamic to negotiate lower price increases.

Market Share Of State’s Largest Insurer And HMO Penetration In The Market

The Bai and Anderson study reports a negative association between hospital profitability and two factors: market share of state’s largest insurer; and, HMO penetration in the market. The first reflects health plan consolidation, while the second reflects how important HMO enrollment is in local markets.

Many U.S. hospitals are likely to face increasingly consolidated local health plan markets in the future, as the big (already announced) health plan mergers are finalized and implemented. At some point, some markets will become highly concentrated on both sides of the bargaining table. It is difficult to predict the pricing outcomes in these cases, however there are some aspects of these markets to keep in mind.

The Affordable Care Act has stimulated entry into insurance markets by newly formed insurance companies, many of which are owned or sponsored by providers. If this trend continues, it could reduce market shares of the largest insurers and weaken the price reducing effects of health plan consolidation. Dominant hospitals and large hospital systems could launch competing health plans and threaten to drop out of other plans’ networks. The providers may have the upper hand in this showdown since health plans need (but don’t own) hospitals to sell their products, while hospitals can quickly build health plans (and potentially offer lower prices to their own plans) as market alternatives.

In a related trend, we see the emergence of Accountable Care Organizations (ACOs). These are new payment models that mimic HMOs in many ways but are for the most part invisible to consumers (at least for now). Health plans contract with providers on more or less a fixed budget basis, and providers are at risk for some or all medical care, which could include hospital services. In theory, this could stimulate competition among providers, resulting in lower prices and lower profitability. Alternatively, ACOs could represent a new round of cost-increasing provider consolidation that combines local hospitals with local doctor groups into even more dominant regional power providers.

Looking Forward

Bai and Anderson highlight a number of potentially important factors to monitor over time. It will also be important to decompose profits into prices and costs and to increase transparency and reporting so that we can do a better job measuring key factors. With the advent of larger, more complicated health care enterprise organizations with inter-related entities, such as multi-hospital systems and ACOs, hospital-level data alone will likely give us a less complete picture of costs, payments, and other factors going forward.

We must also monitor the effects of consolidation of health plan markets. Our research database for these markets is not as well developed as that for hospital markets, and we are entering a new phase of increased consolidation. While it is possible that health plan consolidation can help keep provider price increases down, that may not automatically show up in reduced insurance premium rates. We will need to monitor these markets to ensure that there is sufficient competition within health plan markets to ensure that any price savings resulting from consolidation are passed on to consumers.

Recent entry of new competitors in insurance markets in many states as a result of the ACA and health insurance exchanges shows that entry is feasible and can be fairly quick. This should provide some assurance that health plan markets can remain competitive, but better data and research are needed. Ultimately we will need to expand the list of factors that we examine for impacts of hospital and health plan consolidation, including quality, service, consumer satisfaction, as well as health insurance premiums and out-of-pocket costs and overall population health.

Copyright ©2015 Health Affairs by Project HOPE – The People-to-People Health Foundation, Inc.