Inefficient pricing can kill: the case of dialysis industry regulation.

• Author: Barnett, Andy H.

1. Introduction

   Regulation of the health care sector of the U.S. economy is pervasive. Virtually all industries contained in this sector are subjected to myriad government controls over one or more dimensions of performance--price, output, investment, entry, and quality |7; 8~. It is our general thesis that, to varying degrees, the chronic problems exhibited by many individual health care industries can often be traced to ill-conceived, anticompetitive, and conflicting regulatory policies that seriously distort market incentives for firms to operate efficiently. To support this general thesis, we focus here on one particular industry that has recently been shown to perform poorly--the dialysis industry.

   Recent empirical evidence strongly suggests that rising mortality rates observed among the population of dialysis patients is at least partially attributable to a pronounced trend of dialysis clinics shortening patients' prescribed treatment duration below medically optimal levels.(1) Here, we show how the current pricing structure imposed on these clinics by the Health Care Financing Administration (HCFA, a part of Medicare) encourages (or, perhaps, even requires) clinics to set running times for dialysis patients at levels below those obtainable with a more efficient pricing structure for the same HCFA expenditure. In addition, we also show how regulatory adjustments to reimbursement rates over time tend to exacerbate this problem. Thus, both static and dynamic aspects of the existing regulatory policy are shown to contribute to this increasingly severe problem. As a result, rising patient mortality appears attributable to an inefficient regulatory pricing policy.

2. Some Facts about the Dialysis Industry

   Dialysis clinics earn profits by providing dialysis and related services to persons suffering from renal failure. Eighty-three percent of the independent (i.e., non-hospital based) clinics are operated on a for-profit basis |9~. Their revenues come primarily from HCFA under the End Stage Renal Disease (ESRD) Program, a part of Medicare. This program was initiated in 1972 to relieve kidney patients of the catastrophic costs of dialysis by covering 80 percent of the costs of the service. Expenditures under the ESRD Program have grown phenomenally over time. Its budget has increased from $229 million in its initial year of operation to $3.7 billion in 1988 as the number of patients undergoing dialysis has grown from approximately 11,000 to 110,000 over this period |1; 11~.

   The dialysis industry is highly labor intensive. Labor costs, which consist largely of nurses' and technicians' wages, account for some 70-75 percent of total costs. Moreover, this cost structure is dictated by the existing technology for providing dialysis service. Specifically, patients must remain connected to a dialysis machine for approximately two to five hours generally three times per week. This machine performs two essential functions normally provided by the kidneys--it filters impurities from the blood and removes excess fluid.

   During treatment, patients must be monitored at regular intervals so that various symptoms that typically arise (e.g., cramps, nausea, and hypotension) can be treated. In addition, all patients must be evaluated (weighed, blood pressure, temperature, and pulse taken, etc.) both prior to and following treatment, and they must be connected to the machine by inserting two large (15 to 17) gauge needles into a vascular access that is usually located in the patient's arm. As a consequence of these care requirements, clinics must employ approximately three to four nurses (RNs and LPNs) or technicians for every ten patients undergoing dialysis treatment at a given time. As a result, the costs associated with these employees per patient dialyzed increase with the duration of the treatment provided.(2)

3. Static Equilibrium under the Current Pricing Structure

   HCFA's current regulatory pricing structure for dialysis services consists of a single fixed payment per patient per treatment. At the present time, this payment is approximately $128 on average |4~. It varies slightly from one region of the country to another to reflect cross-sectional differences in nurses' wages, but in all regions it remains a fixed fee per treatment delivered. Because revenues per treatment delivered are unaffected by the length of time the patient is dialyzed under this pricing structure while costs per treatment increase monotonically with the length of run, there is a functional relationship created between profits earned per treatment and the duration of the treatment prescribed. Moreover, as noted above, treatment duration has been shown to be a significant determinant of the efficacy of the dialysis service; i.e., reduced running times cause an increased rate of mortality among dialysis patients, ceteris paribus |3~.

   Given this pricing structure, we want to model the dialysis physician's (or clinic operator's) choice of treatment duration. To do so, it is convenient to adopt the following notation and assumptions:

   z = patient treatment duration (an indicator of treatment quality);(3)

   N(z) = number of patients demanding and receiving dialysis treatment given quality z. We assume N(z) is twice differentiable with N|prime~(z) |is greater than~ 0, N|double prime~(z) |is less than~ 0 for all z;

   |C.sub.1~ = fixed costs of dialyzing each patient (i.e., costs that do not vary with the treatment duration);

   |C.sub.2~ = constant variable costs per unit of time that the patient undergoes treatment;

   p = HCFA's fixed reimbursement rate per dialysis treatment delivered;

   |Pi~ = dialysis clinic's profits; and

   U(|Pi~, z) = clinic operator's utility as a function of profits and treatment quality (duration). We assume |U.sub.|Pi~~ |is greater than~ 0, |U.sub.|Pi~|Pi~~ |is less than~ 0, |U.sub.z~ |is greater than~ 0, |U.sub.zz~ |is less than~ 0, and |U.sub.|Pi~|Pi~~|U.sub.zz~ - |(|U.sub.|Pi~z~).sup.2~ |is greater than~ 0 (i.e., U(|Pi~, z) is strictly concave).

   We assume that the clinic operator selects a level of quality z |is greater than or equal to~ 0 to maximize utility U(|Pi~, z):

   |Mathematical Expression Omitted~,

   where clinic profit |Pi~ is given by

   |Pi~ = p |center dot~ N(z) - |C.sub.1~ |center dot~ N(z) - |C.sub.2~ |center dot~ N(z) |center dot~ z

   = N(z)|p - |C.sub.1~ - |C.sub.2~ |center dot~ z~. (2)

   The first-order condition for an interior solution, z*, to (1) is given by

   |U.sub.|Pi~~ |center dot~ (|Delta~|Pi~/|Delta~z) + |U.sub.z~ = 0, (3)

   where subscripts denote differentiation.

   We note immediately that (3) requires |Delta~|Pi~/|Delta~z |is less than~ 0 at z*. That is, the clinic operator who cares about quality (i.e., an operator for whom |U.sub.z~ |is greater than~ 0) offers a level of quality beyond that which maximizes profits. The interpretation of condition (3) is straightforward: quality is increased until the utility of the additional profits foregone from further quality improvement (|U.sub.|Pi~~ (|Delta~|Pi~/|Delta~z)) equals the direct effect that quality improvement has on the clinic operator's utility (|U.sub.z~). Because this direct effect is positive (|U.sub.z~ |is greater than~ 0), the quality chosen exceeds that which would result from pure profit maximization.

   The...