The economics of health care is an important concern in countries around the world, and is a particular area of concern in the United States. Hospital care constitutes about one-third of total health care expenditures, and patients who have been hospitalized often have very high costs after discharge, including for rehospitalization, skilled nursing facility, and home health use. Hospitals are increasingly being held responsible for managing these costs. As a result, hospitalists must have a good understanding of the economics of hospital care and the effects that hospitalists can have on health care costs. Many of the most important issues in the economics of hospital care, such as the critical role of health care technology, are relevant to many other aspects of health care economics. However, hospital care has certain fairly unique elements that deserve particular attention.

Health care now consumes about 1 in 6 dollars spent in the United States, up from 1 in 12 dollars in 1960. This increase in spending is not a problem in and of itself; growth in a sector of the economy can be highly desirable if it reflects the development of valuable new technologies (eg, computers). However, in the case of health care there are good reasons to question whether increases in spending have been consistently worthwhile. One reason for concern is that much of health care spending is covered by insurance. Insurance helps ensure that high cost, unpredictable health care is available to people when they need it. However, insurance also causes individuals to consume health care even when it might not be otherwise worthwhile for them. Moreover, because patients may not easily understand many of the complex decisions about their care, often spending may not align well with their underlying preferences. While many efforts are being made to better inform and empower patients to participate in their medical decisions, health care providers, hospitals, insurers, and policy makers must make decisions that patients cannot fully participate in and that influence patient care. Social institutions, such as licensure, accreditation, public reporting of outcomes, and market competition may also help ensure that these parts of the health care system act more effectively as agents of patients.

Indeed, while there is evidence that the value of increased health care spending on average has far exceeded the cost, there is also evidence that a sizable fraction of medical interventions provide little health benefit. The United States spends more per capita on health care than any other country, but many countries achieve comparable or better population health outcomes. These cross-national differences cannot be attributed completely to differences in the health care systems across countries. Nevertheless, the efficiency with which resources are used within these health care systems is a critical concern when seeking to maximize the health outcomes given available resources. Tools such as medical cost-effectiveness analysis are often used to assess how the cost of care compares to the health benefits produced. One metric for assessing cost effectiveness is the incremental cost-effectiveness ratio, which is calculated by dividing the change in costs resulting from an intervention by the change in life years lived, usually adjusted for quality of life. Whereas the decisions that people make about their own health suggest that people may value a one-year increase in life expectancy at about $50,000 to $200,000, some commonly used medical interventions cost more than $1 million per life year saved. Many interventions may not produce any health benefits, regardless of costs. The emerging field of comparative effectiveness research seeks to compare the effectiveness of health care interventions to determine when specific interventions should be utilized. While the appropriate role of costs and cost-effectiveness analysis in comparative effectiveness research is controversial, the concept that both costs and effectiveness of medical interventions are important policy concerns is widely accepted.

A wide range of approaches have been proposed to control health care expenditures. These include market-based approaches such as making patients and providers more sensitive to costs by limiting what services will be covered or how much of their costs will be paid. Consumer-side market incentives at the point of care, such as copayments, have been proven to reduce expenditures in numerous contexts, including the RAND Health Insurance Experiment. However, the ability to control the spending of high-cost consumers through copayments is limited by the high economic burdens these create for these individuals and their families. This limitation is especially important because health care costs are highly concentrated; more than 90% of all health care costs are borne by the top 50% of users. Within Medicare, the top 5% of users constitute 50% of spending. Since hospitalized patients are typically among these high-cost users, consumer-side cost sharing often has little effect on hospital spending because hospitalized patients often will have reached caps on out of cost payments.

Another approach to controlling health care spending is to reduce payments to providers. The extent to which this is possible is limited by the need for providers to maintain their financial solvency, but will generally reduce expenditures in the short run and place downward pressure on long run cost growth if it is maintained. Nevertheless, in a fee-for-service environment, reducing payments to providers may cause providers to engage in “demand inducement” in which they increase the quantity of services provided in order to make up for lost revenue. Indeed, this is one reason that many health economists believe that controlling health care costs will require paying for all of health care with fixed payments to cover all of a person’s care over a defined period of time (capitation). Indeed, the single most important cost containment approach for hospitals has been the use of prospective payment for hospital care, in which hospitals are paid a fixed amount of money for a hospitalization for a given condition. We return to these ideas in the following section. Market-based approaches remain important under capitation because competition among providers may encourage providers to be more efficient in order to offer greater value to patients. Even in more regulated systems such as single-payer national health insurance systems, such competition between providers may increase quality and allow reductions in costs over time.

Most hospitals in the United States are not-for-profit institutions operated by staff employed by the hospital and acting under the supervision of a board that typically includes community leaders, physicians, patients, and others representing the diverse stakeholders that have interests in the operation of the hospital. To maintain their not-for-profit status and associated tax advantages, not-for-profit hospitals cannot make profits and must demonstrate evidence of the benefits they create for their community. Such community benefits can be hard to define, and even not-for-profit hospitals may be heavily influenced to make decisions that benefit hospital managers and staff more than patients. For-profit hospitals do not have the same community benefit obligations as not-for-profit hospitals and are less likely to provide types of care that are not profitable. However, the differences in services between for-profit and not-for-profit hospitals are often less than one might expect. Even government safety net hospitals, such as county hospitals, may face economic incentives to provide care for which insurance coverage is better. In general, payment rates in the United States are highest for private insurance, followed by Medicare, then Medicaid. Under the Emergency Medical Treatment and Active Labor Act (EMTALA), hospitals must ensure the provision of care for persons without insurance who face immediate life-threatening conditions. As an unfunded mandate, EMTALA has adverse effects on the financial well being of some hospitals that serve low income communities and the availability of emergency and hospital services in those communities.

The compensation of physicians varies across hospitals, with physicians in many for-profit and not-for-profit hospitals being paid through the professional fees that they bill, while physicians in government hospitals, academic medical centers, and hospitals owned by staff-model HMOs are more often paid a salary. Often, physicians working fee-for-service have unpaid institutional obligations, such as caring for uninsured patients or serving on committees, while physicians paid by salary will also have incentives for productivity. Thus, the differences in these means of paying physicians may not always be as large as they would seem.

Nevertheless, understanding the organizational structure of a hospital is essential to understanding how various policy changes may affect hospital care. For example, hospital managers will tend to want hospital resources to be very heavily used, while physicians may prefer that the hospital has excess capacity so that they and their patients can more easily access care. Decisions regarding the adoption of costly new technologies may have similar dynamics among physicians and hospitals. One exception is when hospitals can be paid more for care that is provided using an expensive new technology. In these cases, in areas with many hospitals, hospitals may compete with each other to attract doctors by buying costly new technologies in what has been termed a “medical arms race” (Zwanziger and Melnick 1988). This contrasts with the typical expectation that competition will drive down costs as more efficient organizations drive less efficient ones out of business. In recent years, as payment policies have been less generous, hospital competition has been associated with lower costs.

Before the 1980s, almost all hospitals were retrospectively paid fee for service for the care that they provided. This meant that when the patient received more care, for example by staying an extra day in the hospital, the hospital would receive more payment. Since rates typically covered the cost of hospital care plus some profit, hospitals had incentives to provide more care in order to increase profits or produce surplus revenue in excess of costs to help them achieve other parts of their mission. Not surprisingly, hospital costs grew rapidly.