Of all the many imperfections of U.S. health care markets, the most egregious might be the noncompetitive conditions created when health care providers, particularly hospitals and health systems, began consolidating in earnest in the latter half of the 1990s. The unprecedented levels of market power that provider organizations have amassed since then have led to extremely high and rapidly rising prices — as well as a great deal of pain for employers, federal and state governments, and consumers.
As a result, there’s been renewed interest in government regulation of health care prices. While some attempts by states to establish l rate-setting systems for hospitals have been successful in constraining price growth, many economists are wary of such market intervention. They share concerns that such systems may fall prey to two pitfalls: regulatory failure and regulatory capture. In this post, I explain that while these dangers are real, they are also manageable — and shouldn’t stand in the way of thoughtfully crafted models for reining in health care prices.
It’s pretty simple: regulatory failure is what can result when government regulation makes matters worse rather than better. This can happen when:
- the regulating agency is unresponsive to changing market conditions
- regulations are so complex that they hamper the regulated industry’s ability to respond to the price-lowering incentives on offer
- rules or incentives result in industry performance inconsistent with the public interest
- regulations or policies lead to prices that are too high, too low, or vary widely.
A prime example of regulatory failure in health care was the first comprehensive state-based hospital rate-setting system in the nation: the New York Prospective Hospital Reimbursement Methodology. From 1971 to 1995, the New York State Department of Health was authorized by state law to regulate hospital prices paid by Medicaid, commercial insurers, and Medicare. The system failed for two principal reasons. First, state regulators, motivated primarily by the need to reduce large Medicaid budget shortfalls, set rates and annual rate updates too low, leading some of the state’s most prestigious and critical hospitals to the brink of financial ruin in 1977–78. Second, the system became incomprehensibly complex, undergoing five different legislative overhauls. By the late 1980s, only a small group of New York regulators and hospitals fully understood the rate-setting methodology.
When a regulated price system is both very complex and modified frequently — and particularly when these changes are initiated by powerful members of the regulated industry — the rate-setting agency comes to be viewed as arbitrary and politically driven. This is also an example of how regulatory failure can contribute to regulatory capture.
Although less pervasive than regulatory failure, regulatory capture has received more attention. It happens when regulators end up serving the interests of the regulated industry. This happens when industry representatives perpetually attempt to persuade regulators to adopt or modify existing rate-setting mechanisms in order to promote the industry’s financial interests. Such a strategy is most effective when interactions between the regulatory agency and the regulated industry are frequent, as regulators tend to identify more closely with industry perspectives over time. As a result, there is a blurring of what should be a sharp line between the two parties.
In health care, regulatory capture is perhaps most evident in the influence of the American Medical Association’s Relative Value Scale Update Committee, which has been criticized for enabling specialty medical societies to skew Medicare’s physician payment levels in favor of physician specialists and physicians that perform surgeries and other health care procedures. Another example is the experience of hospital rate regulatory agencies in New York, New Jersey, Massachusetts, and Maryland during the 1980s and ’90s. After achieving some initial success in containing hospital price and expenditure growth, these states relaxed cost constraints after coming under intense political pressure from hospital leaders. Not unexpectedly, hospital rates began to rise rapidly soon after.
Avoiding Regulatory Failure and Capture
Given the potential of regulatory capture and failure, some economists argue that few states can establish and maintain elaborate rate-setting systems that will stand the test of time.
But not all rate-setting systems fall prey to failure or capture. The Rochester Hospital Experimental Payment Program, a 1980s-era Medicare demonstration program in upstate New York, and Maryland’s early rate regulation system (1976–1990), are two examples. The Rochester program avoided the fate partly because it focused on constraining aggregate hospital budgets, as opposed to regulating prices of individual hospital services. As it turns out, hospital global budgets can be relatively easy to develop and administer; the Rochester model was administered by a professional staff of six. A simpler regulatory system is something that hospital and payer personnel, as well as policymakers, will be able to more readily grasp.
Other factors critical to success: taking a long-term perspective and not resorting to drastic and potentially destabilizing short-term regulatory actions; setting attainable, well-understood performance targets; focusing on the costliest hospitals; and avoiding frequent changes in how rates are calculated.
Does Rate-Setting Have a Future?
The demise of state-based rate setting wasn’t because of regulatory failure or capture but the result of loss of interest-group support, the collision of rate-setting with managed care, and rate systems’ inability to meet their primary cost-containment goal. Along with the perception that the rate-setting process had become unintelligible and subject to insider manipulation, these factors led to an erosion in support from politicians, insurers, and the business community.
Fortunately, structural remedies exist to prevent debilitating levels of regulatory capture and failure. One is prohibiting the appointment of regulated industry representatives to a state’s regulatory agency. In addition, less-complex, lower-intensity rate-setting models such as price caps on out-of-network services and flexible hospital global budgets — which allow revenues to flex as patient volumes rise or fall and variable costs change — not only can minimize the danger of failure and capture but also can mitigate the pricing power hospitals now possess.
Regulatory capture and failure have occurred in past pricing systems, and they would likely continue to occur, albeit to a lesser degree, even with these remedies in place. But rate-setting systems still generally provide more benefit to the public than to the regulated industry. Regulation may be imperfect, but highly consolidated, noncompetitive markets may be more so.