The frightening future that’s haunting hospitals

On this Halloween, hospitals around Indiana are spooked. The state’s three largest hospital systems have all announced plans to cut about 900 positions from their work forces. Most smaller hospital systems have also had cuts—just not large enough to make the news.

So what’s haunting these hospitals’ C suites?

The simple answer is, cuts in payments to hospitals by Medicare, the federal insurance program for seniors.

Here’s a rundown of Medicare cuts of the recent past and present:

Since about 2008, Medicare has been reducing payments for some specialist physicians—many of which are now employed by hospitals. The fiscal-cliff deal on Jan. 1 this year chopped out $15 billion in payments to hospitals. And the budget sequester, which hit March 1, sapped another $10 billion.

But the scariest picture comes from future cuts—and the very real possibility that hospitals will not be able to make up for Medicare’s reductions by hiking prices on private insurers. If anything, it looks like private insurers will mimic Medicare’s by whittling down their own payments to hospitals.

For the most sobering picture of the Medicare cuts that could come, check out the graph on page 7 of this May report by the Office of the Actuary at the Centers for Medicare and Medicaid Services.

It shows that Medicare paid 67 percent as much as private health insurers for the same inpatient services. And more importantly, it shows that percentage will decline steadily for the next 75 years, until Medicare payments equal just 40 percent of private insurers’ payments. The report warns that such cuts are not realistic if allowed to go on indefinitely, because they will put hopsitals out of business. But for now, they are the law.

Why will Medicare payments decline? Because a provision of the Affordable Care Act, aka Obamacare, calls for a new way to calculate the annual increases in Medicare’s payments to hospitals that assumes hospitals are going to get better at being cost efficient.

Before, Medicare essentially compared hospitals’ cost of operations against their peers, but now the Medicare program will assume that hospitals can generate the same level of productivity gains as the rest of the economy.

Judging by hospitals’ track record, they have no hope of keeping up with the rest of the productivity gains of the rest of the economy.

One reason for this is that labor-intensive businesses, like health care, have a much harder time reducing costs than, say, manufacturers, who can more readily replace people with robots.

But another key reason is that hospitals, especially those that are not-for-profit organizations, are inherently revenue maximizers, not cost minimizers. (I borrow these notions from this article by economist Joe Newhouse, now at Harvard Medical School.)

That is to say, whatever money the hospitals bring in they seek to spend—on new services, new facilities, new people. They do not try to keep costs low in order to maximize profits or to entice more consumers with lower prices. That's a good situation for holding up quality standards, but it also generates higher and higher levels of spending that must be maintained.

Hospital spending appears to go up so long as Medicare allows it, and it only goes down when Medicare forces it to go down.

That’s what Chapin White, a senior research fellow at the D.C.-based Center for Studying Health System Change, found when he studied hospitals’ behavior after the sudden Medicare cuts that were passed as part of the Balanced Budget Act of 1997.

Those cuts didn’t affect all hospitals equally: some saw cuts, and some kept seeing increases in Medicare payments. The hospitals that saw cuts, reduced their expenses—mainly through staff and fewer staffed beds—to exactly match the new revenue level, maintaining profit margins at roughly the same size as before.

Hospitals, like those in the Indianapolis market, that enjoyed continued increases, also kept their margins about the same—which means they raised their spending to match the extra revenue.

This time, the Medicare cuts are hitting the Indianapolis hospitals—and they are cutting staff and expenses right in line with White’s latest research findings.

White’s research has been groundbreaking because he was able to analyze data from private insurers, in addition to more widely available Medicare data. What he found was that insurers generally followed Medicare payments—whether they were going up or down. So if hospitals now hope to make up falling Medicare payments by “cost shifting” to private insurers, White thinks that’s a pipe dream.

Instead, as I have written before, hospitals are in the frighteningly unfamiliar position of being forced to do more with less.