Cover: Government Policy and the Cost and Quality of Nursing Homes

Government Policy and the Cost and Quality of Nursing Homes

Published 1996

by Paul Gertler, Donald Waldman

Research Brief

The long-term convalescent health-care industry in the United States faces three well-documented problems: (1) many indigent patients cannot gain access to nursing homes; (2) the quality of nursing home care is often suspect; and (3) the cost of this care is considerable and continues to increase at a worrisome pace.

The Medicaid program, which helps indigent patients gain access to nursing home care by directly reimbursing the homes, is the dominant purchaser of nursing home services in the United States.[1] Nursing home administrators argue that the Medicaid program can induce them to admit more Medicaid patients and provide higher quality if the program pays a higher rate of return on Medicaid patient care. RAND investigated this issue and found that increasing the rate of return on Medicaid patients would induce nursing homes to admit more Medicaid patients, but it would not induce them to increase quality.

Regulation and Nursing Home Behavior

The business of nursing homes is to provide patients with a package of commodities such as medical care, room and board, and social activities. Some of these services are devoted to rehabilitation and others toward lifestyle maintenance. Together these components constitute the quality of care provided to patients.

Nursing homes care for two types of patients: those who finance their care privately and those whose care is paid for through the Medicaid program. However, the sum of private-pay and Medicaid patients cannot exceed a level determined by regulation. A nursing home's capacity is regulated by the Certificate of Need (CON) cost-containment program. The program attempts to control total industry expenditures by limiting the supply of nursing home beds. CON requires that before an existing home can be expanded or a new one built, the government must certify that the proposed facility is indeed "needed." Thus the program effectively limits the capacity of existing nursing homes and new entries into the market.

It can be assumed that nursing homes provide private-pay and Medicaid patients with the same level of quality. This assumption follows from the legal restrictions that homes cannot discriminate in the provision of service based on source of payment, and that most nursing home services, such as nursing care, social services, and dietary services are jointly produced for both types of patients and exhibit economies of joint production. Thus, it is both legally and technically difficult to improve the level of services provided to private-pay patients without also improving them for Medicaid patients.

Homes charge private-pay patients what the market will bear; thus, private-pay demand is a function of price and quality. In contrast, homes receive a set Medicaid reimbursement rate for the care of Medicaid patients, and thus Medicaid demand depends only on quality, since Medicaid patients pay zero out-of-pocket expenses.

Because private-pay patients pay a positive price and nursing homes must supply the same level of quality to both types of patients, it can be assumed that quality must be above the minimum level at which Medicaid patients (who pay zero) prefer nursing home care to independent living. It follows, then, that there is considerable demand among Medicaid patients for nursing home care; and the study found that there are indeed long lists of Medicaid patients in hospitals waiting for nursing home openings. Most nursing homes operate well above 90 percent capacity; and in the New York State sample examined in this study, most homes had well over 95 percent capacity.[2]

In sum, the Medicaid program has created a "secondary market" for nursing home care, and CON restricts supply so that there is excess Medicaid demand. Homes charge private-pay patients what the market will bear and receive the Medicaid reimbursement rate for the care of Medicaid patients. The homes use price and quality to maximize profits as they compete for private-pay patients, knowing that they can always fill excess capacity with Medicaid patients at the Medicaid reimbursement rate.

Effects of Policy Actions on Nursing Home Costs and Quality

The study team used econometric modeling to examine a sample of 455 nursing homes in New York State. Since higher quality is produced primarily through labor-intensive activities such as personal contact with patients by employees and highly personalized physical and psychological therapy, policies designed to improve quality are relatively expensive. The modeling showed, for example, that a policy that increases quality 1.3 percent will increase cost by 10 percent. In contrast, cost-containment policies can achieve large savings without producing a large deterioration in quality.

The researchers examined the effects of two critical policies in the nursing home industry: competition and the return allowed on Medicaid patients. With respect to competition, the appropriate market to analyze is the private-pay market, since homes do not compete for Medicaid patients. The analysis showed that increases in competition are associated with higher levels of quality, since this is the way that nursing homes seek to attract more private-pay patients. However, restricting competition would have the effect of reducing costs, because the homes would not have to provide expensive quality improvements to attract patients away from competitors. In sum, increasing competition to promote quality would lead to more costly care, while restricting competition achieves considerable savings without a large sacrifice in quality.

In examining the second policy question, whether the government could purchase increased access to nursing homes for the poor and higher quality as well, the researchers found that there is a quality-access trade-off. Increasing the rate of reimbursement for Medicaid patients would induce nursing homes to admit more Medicaid patients, but it would not lead to higher quality of care, because improving quality is very expensive and is targeted toward the private-pay market.


  • [1] Of the $75 billion spent on nursing home care in 1994, approximately 65 percent was in the form of government expenditures (federal, state, and local), with Medicaid accounting for over 80 percent of the government's share.
  • [2] Homes cannot operate at 100 percent capacity for several reasons: (1) they must hold beds open a certain number of days for patients who have temporarily entered hospitals for treatment of acute illnesses; (2) there are always a few days between the discharge of a patient and the admission of a new patient; and (3) homes may hold beds open longer for preferred patients (e.g., a Jewish home may wait longer for a Jewish patient who must remain hospitalized a few days longer than a non-Jewish patient).

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