The Impact of U.S. Prospective Payment on Hospital Capital Formation : An Initial Analysis of the 1991 Change in Medicare Reimbursement for Capital Costs

In 1991 the Health Care Financing Agency (HCFA) changed the reimbursement system for hospital capital costs from a costs-paid basis to one with a prospective basis, as part of the ongoing battle to control health care costs. This followed the 1984 change for patient costs from a Fee-For-Service basis to one based on DRGs, a prospectively determined amount for specific diagnosis categories. The capital cost reimbursement allowances in 1996, for example, had a $462 base amount, which was pro-rated with an adjustment for patient-specific DRGs. Previous empirical research has shown that hospitals increased net fixed capital when the proportion of Medicare discharges increased, and as the market became less concentrated. In this paper we develop a model of hospital behavior in which non-profit hospitals maximize some combination of quantity, quality and profits; for-profits maximize the more traditional economic concept of profit. Hospitals differ by the number of Medicare and Medicaid patients, concentration of the market in which they are located, and other hospital-specific factors. Using annual Medicare Cost Report data, provided by the Center for Medicare and Medicaid (CMS), we estimate the annual change in real fixed assets, or hospital net investment, in a fixed effects model for Pennsylvania hospitals. These estimates are then used as inputs to measure both the effect of the percentage of Medicare discharges and market concentration on hospital net investment in the 1980s and 1990s. Our results show that hospital capital formation responded in a directly (i.e., positively) to more competitive markets, even after capital reimbursement was restricted/tightened intentionally, via the 1991 payments system change