Causes and Effects of Expensive Hospitalizations

by Emmett B. Keeler

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Medicare's prospective payment system (PPS) pays hospitals a fixed amount per case to give them incentives to economize. Differences between average hospital payments and costs remain, however, and the distribution and causes of these differences (inefficiency, higher quality and intensity of services, or sicker patients) are of great interest. This Note analyzes previously collected data on costs, sickness, process, and outcomes from a large, nationally representative sample of hospitalized Medicare patients. The author transformed charges to costs and defined standardized (for payment factors) costs as costs standardized by dividing the payment adjustments for diagnosis-related group weights, a wage index, disproportionate share, and teaching status. Scales to predict costs based on patient sickness were derived. Improved process of care was associated with higher standardized costs, showing that the costs of providing higher quality were not recaptured by the cost savings of fewer complications of bad care. Average sickness and process were important determinants of average hospital costs/payments, as was an indicator for urban government hospitals. Under certain assumptions, the optimal payment formula uses a weighted average of national average costs and hospital-specific costs.

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