Hospital Global Budgets: A Promising State Tool for Controlling Health Care Spending

Abstract

• Issue: Rising prices for hospital services paid by private insurance plans have led to interest in government-administered and -regulated pricing systems for commercial payers or regulated rate systems that apply to all payers.
• Goal: To provide background on state-level, government-administered regulated pricing systems, focusing on the characteristics and potential benefits of all-payer hospital global budgets.
• Methods: Review of published literature and analysis of past and existing global budget models.
• Findings and Conclusions: A flexible global budget pays hospitals based on their variable costs for incremental increases or decreases in volumes. This approach may help remove fee-for-service incentives that induce hospitals to provide unnecessary and low-value care, while at the same time giving states a tool to effectively constrain hospital expenditure growth for all payers. Such a payment system is also less complex than systems that set explicit prices or price caps for every service.

Introduction

High hospital prices are responsible for most of the difference between health care spending in the United States and other high-income countries.¹ Fueled by increasing levels of hospital consolidation and negotiating leverage, hospital prices paid by commercial health plans in the U.S. have increased rapidly since the early 2000s. In 2018, commercial hospital prices were two-and-a-half times the rates that Medicare pays. There is also strong evidence showing that multiple rounds of hospital consolidation have raised hospital payment levels without improving quality of care or operating efficiency.²

Proposed solutions to the U.S. health care cost problem fall along a continuum from procompetitive initiatives (for example, greater price transparency, tiered- and narrow-provider networks, greater antitrust enforcement) to government regulation of provider prices. While beneficial, strategies to promote competition on their own have not been successful in controlling hospital price and cost growth, because these initiatives do not directly address the market power accumulated by hospitals and other providers.³ Given these circumstances, state and federal policymakers and legislators have voiced renewed interest in the development of government-administered pricing systems.⁴

How Global Budgets Expand Opportunities to Manage Costs

Five categories of administered pricing systems applicable to hospital services have been examined in the research literature in recent years:

• Direct itemized pricing: Explicit prices are set for every service or service bundle. Diagnosis-related group (DRG) payments are one example.
• Rate update limits: Restricting the amount by which rates can be increased during negotiations with commercial insurers.
• Price caps for all hospital services: A regulatory agency sets caps on how much hospitals can be paid for specific services; there is usually a rate update limit as well.
• Price caps for out-of-network services only.
• All-payer hospital global budgets: Total revenues are capped for a specified period (typically one year) for all services provided to a patient population.⁵

While all five of these prospective payment models provide incentives to control costs, the first four pay on a fee-for-service basis (that is, for each test, hospital day, hospital case). This leads to misaligned incentives — providers make more money by providing more services. The more fixed costs a hospital has — for example, building and equipment expenses, administrative overhead, and stand-by staffing costs — the more lucrative it is for the hospital when volumes are increasing. Conversely, hospitals with higher proportions of fixed costs tend to lose money when volumes are contracting (see sidebar) Thus, fee-for-service payment systems tend to induce hospitals to increase the services they provide.⁶

Under hospital all-payer global budgets, however, hospitals are not paid on a fee-for-service basis. Instead, hospitals are paid a prospectively determined amount for all inpatient and outpatient services provided to a patient population in a given year. Global budgets counteract the volume-inducing characteristics of itemized payment systems by expanding the bundle of services. Other payment approaches bundle together services. For example, episode of care payments might cover all hospital care for joint replacement patients, for 30 days pre- and posthospitalization. However, as shown in Exhibit 1, hospital global budgets provide additional incentives and opportunities to manage volumes and costs. In this way, global budgets are meant to give hospitals clear incentives to manage their provision of care within a budget constraint, emphasizing the policy objective of cost containment.

In addition to cost containment, global budgets seek to encourage hospital investments in population health initiatives. Although evidence is limited, global budgets contain incentives to encourage hospitals to implement strategies for managing and coordinating care as well as improving patients’ overall health. These activities in turn can help keep people from needing hospital care. A global budget hospital that invests in community-based initiatives that emphasize care coordination, expanded access to and follow-up by primary care providers, and early intervention for chronically ill patients will tend to realize reduced costs and savings for the hospital under its global budget.⁷

Hospital global budgets also can encourage investments in resources that address social determinants of health and social supports, such as improved access to housing and food, if the hospital believes such investments will serve both its social mission and financial interests.⁸ Any resulting global budget surpluses can be reinvested in further efforts to improve population health. To ensure hospitals are using these savings, or other funding they receive, in effective ways, a state may wish to require hospitals to submit care transformation plans detailing how the funds will be spent to bolster primary and preventive care and improve population health.⁹ These strategies are consistent with Medicare’s accountable care organization (ACO) program goals: to improve the effectiveness of care management and care coordination in order to reduce unnecessary health care services and improve population health.¹⁰

Shortcomings of the Fixed Budget and Benefits of the Variable Budget

Generally, hospital global budget payment models such as those in Europe and Canada have been administered by a government entity and structured to provide a fixed amount of funding for a set period, usually one year. A shortcoming of this fixed budget approach is that it is not responsive to shifts in patient volume — initiated by a managed care company or an ACO, for example — from one hospital to another. These shifts are often an attempt to move care to lower-cost and higher-quality facilities. Under a fixed budget, the hospital receiving these new volumes does not receive any additional revenue to treat these new patients. Fixed hospital budgets also provide disproportionately strong incentives for hospitals to reduce, or in some cases restrict, the care they deliver, leading to long wait times for elective and emergency room services.¹²

For this reason, global budget frameworks need to be designed to ensure that hospitals are maintaining appropriate volumes and meeting quality standards. Without such mechanisms, a global budget can become, in effect, a block grant to be spent at the hospital’s discretion, with no guarantee that patients will receive needed services.¹³

An alternative to a fixed budget is a variable budget, such as the volume adjustment system used in an early version of the Maryland hospital rate-setting system from 1976 to 1990.¹⁴ The volume adjustment system was a budget that flexed up or down on the basis of a hospital’s variable costs. This approach had the advantage of creating appropriate hospital incentives with regard to the provision of services, while being flexible enough to adjust for changes in patient volume based on changing disease incidence or consumer and payer preferences.

A similar system used in the public utility sector, marginal cost pricing, is a well-accepted payment methodology to discourage excess power production by eliminating variable revenue earned in excess of variable costs required to produce an incremental service.¹⁵ Likewise, the volume adjustment system for hospitals helps neutralize incentives to provide excess or unneeded services. In addition, these more flexible budget models accommodate patient flow from hospital to hospital, with revenue following the patients, consistent with market competition principles. The methodology also can allow hospitals to maintain their revenues at levels sufficient to cover fixed costs should volumes decline.

The flexibility of the variable global budget also allows it to be applied to hospitals of any size in any geographic region. That is because the variable cost factor used as the basis for payment can change depending on a hospital’s proportion of variable costs. For example, larger hospitals might have a 50 percent variable cost factor while for smaller ones it might be 20 percent to 30 percent. The more flexible approach to budget setting also potentially supports market competition, since, at least in theory, patients remain free to choose their hospital rather than be assigned to a particular one.

In addition to variable adjustments, other design elements can further strengthen the goals of cost savings and improved population health goals. These elements include:

• Use of supplemental pay-for-performance incentive programs, such as Medicare’s hospital readmission and hospital-acquired condition incentive payment approaches, complemented by expanded reporting on hospital quality performance metrics like patient satisfaction, rates of hospital-acquired conditions, hospital-acquired infections, and emergency department wait times.
• Inclusion of certain nonhospital services, such as hospital-employed physicians, home health, and postacute care, to align the incentives of nonhospital providers with the incentives of the global budget.
• Use of an aggregate stop-loss provision to limit the hospital’s financial risks and losses (for example, holding profit margin losses to 2 percent in a given year).

Conclusion

Rapidly rising hospital prices continue to undermine the affordability of hospital care for both state governments and commercially insured patients. A hospital all-payer global budget model is one potential solution for states to consider. Relative to other hospital health care payment structures, hospital global budget arrangements have great potential for controlling overall costs, including by containing or reducing unnecessary hospital services. At the same time, adjustments such as use of a volume-adjustment system allow for adequate incentives to manage overall costs and service use while expanding the global budget’s flexibility to account for patient shifts from hospital to hospital.

Overall, global budgets can create the conditions necessary to hold hospitals accountable for the cost of services they provide while requiring a minimum of regulatory complexity to implement and enforce. In addition, this payment approach can provide hospitals with a stable and predictable amount of annual revenue, facilitate more rational allocation of hospital resources, and provide hospitals with the financial flexibility necessary to meet the diverse and unique health needs of the communities they serve.