Hospital Cost Containment and Length of Stay: An Econometric Analysis.

• Author: Carey, Kathleen

Kathleen Carey [*]

In recent years, concern in the United States over rising health care costs has led to precipitous reductions in the lengths of hospitalizations. While perceptions of compromised medical care quality following this practice and others have prompted policy makers to consider stricter regulation of health insurance organizations, little attention has been given to the extent to which length of stay reductions are responsible for decreasing hospital costs. This paper provides empirical evidence on that point. The method utilizes a hospital total operating cost function estimated on 2792 U.S. hospitals for the period 1987-1992. Three different panel data estimating techniques are applied, including a random effects model that is distinctive in allowing for correlation between hospital effects and observable regressors, circumventing inconsistency problems following from standard generalized least-squares estimations. The cost elasticity of length of stay is calculated from the regression results. This measure is low, falling in the range 0.09-0.12. It suggests that common perceptions regarding the extent of cost savings resulting from length of stay reductions have been overestimated.

1. Introduction

   Concern in the United States over the rising share of national resources consumed by health care costs has become widespread in recent years. Hospitals, accounting for approximately 40% of this expense, have been a primary focus of cost control strategy, as both government and private insurers have pressured them to absorb an increasing portion of the financial risks associated with their treatment decisions. A predominant response to these pressures has been reduction in the number of days that patients remain hospitalized. Perceptions of compromised medical care quality following this practice and others have prompted policy makers to consider stricter regulation of the conduct of health care providers and insurance organizations.

   The length of hospitalization issue has become prominent with the general public and for some procedures has been widely criticized for being extreme. Maternity and newborn care, for example, became a heavy target for insurers who in many cases were limiting reimbursement for stays to only 24 hours. This case became very controversial, eventually rising to high political ground and resulting in recent Congressional action requiring insurers to cover 48 hours of hospitalization for these patients. The U.S. Congress as well as numerous state legislatures currently face a number of articles of proposed legislation that directly or indirectly regulate the length of hospitalizations. These include measures that give physicians more authority over treatment decisions, that make health plans legally liable for their actions, and that establish appeals procedures for treatment not deemed medically necessary or appropriate by health plans.

   While controversy surrounding length of stay reductions have focused on the quality of service being delivered by the health care system, attention given to the economics of this strategy is limited. It is unclear to what extent length of stay reductions are responsible for decreasing hospital costs. Presumably, the inpatient days that are now being eliminated are the least costly ones. A provocative stance has been taken by Reinhardt (1996) who argues that the strategy of length of stay reduction in the United States is single minded and unproductive. He hypothesizes that the hospital is not the expensive setting that is commonly perceived.

   Researchers have tracked carefully the trends in hospital lengths of stay and have explored the effects of various reimbursement strategies on hospital utilization. Previous studies have also addressed the potential tradeoff between length of stay and quality of care. If quality has not diminished, then longer hospitalizations may have been largely superfluous. This is a clinical issue. Little empirical effort, however, has been aimed at determining what costs are actually saved by these measures. This paper aims to provide evidence on this point. Rather than asking what health interests might be foregone as a result of shorter hospitalizations, the inquiry here is what economic benefits are being gained. This research takes a hospital cost function approach to measuring the cost savings achieved by U.S. hospitals through reduction in length of hospital stays. The remainder is organized as follows. Section 2 provides background to the problem and the next section describes an econometric model for addressing it. Section 4 presents the data and describes the functional form. Section 5 discusses empirical results and section 6 provides discussion. The final section concludes.

2. Background and Institutional Framework

   Broad attempts at controlling hospital expenditures began in the 1980s. The most notable single event was the step taken in 1983 by Medicare, the government program of health care funding for the elderly, and hospitals' largest third-party payer. Medicare adopted the Prospective Payment System (PPS) that altered the basis of reimbursement from reasonable cost to prices based on historical costs for specific diagnoses across hospitals. This initiative by the Federal Government was followed by more gradual changes in the forms of private insurance payment. Over time, the nonfederal sector has become increasingly dominated by managed care organizations. These insurers attempt to control expenditure growth through negotiating discounted prices and establishing utilization management protocols with hospitals and by performing reviews of the appropriateness and necessity of hospital care.

   Changing reimbursement systems have altered the financial incentives facing hospitals. Historically, on the private payer side, hospitals were reimbursed for reasonable cost on a per diem basis, receiving a flat payment for each hospital day provided. Under current managed care plans, negotiated prices largely retain this linear structure, thereby failing to account for falling daily treatment costs as stay lengthens. While this system of payment allows hospitals to recover greater fixed cost as marginal cost declines, payers are eager to obtain contractual arrangements that reduce the lengths of hospitalizations.

   Under Medicare's PPS policy, hospitals are reimbursed for well-defined hospital cases based on diagnosis-related groups (DRGs). While not an unprecedented arrangement, PPS transformed hospital incentives on a wide scale, because at the time of its implementation in 1983, Medicare produced approximately 40% of hospital revenues. Some private insurers followed the government initiative and adopted similar payment systems. Case-based reimbursement mechanisms create strong incentives within hospitals to shorten lengths of stay and increase admissions.

   Much research effort has gone into documenting the effects of PPS on hospital performance. This literature is well reviewed by Coulam and Gaumer (1991). In sum, the average length of stay initially declined relative to historic norms. Concern over increased admissions was mitigated; admission rates actually declined during the early PPS period for reasons that are not well understood. In general, research shows slower rates of growth in hospital expenditures under PPS (Guterman et al. 1988; Hadley, Zuckerman, and Feder 1989; Hadley and Swartz 1989; Russell and Manning 1989).

   Studies of managed care effects attribute cost containment progress to a range of factors. Miller and Luft (1993) found fewer resources consumed by health maintenance organization (HMO) patients because of lower use of ancillary services during hospitalization as well as shorter lengths of stay. In a study that more broadly models hospital strategy for managing care, Conrad et al. (1996) find payment incentives, use of systematic clinical strategies, and sharing of resource use information with clinicians to be the prime movers in improving hospital efficiency. Stem et al. (1989) report lower lengths of stay but comparable costs for HMO versus fee-for-service patients at one major teaching hospital between 1983 and 1985.

   While the reviews of PPS and of managed care effects were appearing and being interpreted, the shape of the U.S. hospital itself as an institution began changing. The first stage of managed care replaced the traditional fee-for-service system with new forms of insurance plans that attempted to reduce costs by restrictions on provider options, negotiation of lower prices with providers in return for volume of patients, and emphasis on preventive care. The second wave of managed care is now underway. This is characterized by large-scale rearrangement of formerly separate entities in the provision of health care. Distinctions between hospitals, physicians, and insurers are fading, and new models of health care delivery marked by vertical or horizontal integration are emerging. Hospitals occupy a centrality within these organizational hybrids or organized delivery systems that offer a continuum of care that may also include prevention and ambulatory services, home health, long-term care, and hospice care, among other features (Robinson 1994; Shortell, Gillies, and Devers 1995; Morrisey et al. 1996). Hospital economic incentives are changing yet again under this second generation of managed care. Patients increasingly are insured according to capitation contracts under which revenue is provided for each enrollee at a fixed rate per member per month. Under...