Uwe E. Reinhardt is an economics professor at Princeton. For previous posts in his series on why the United States spends so much on health care, click here.

Few Americans probably have any inkling of how their neighborhood hospital prices the myriad of distinct services rendered patients. I doubt many patients can understand the long hospital bills that feature exotic items such as “cath porta cath perit” or “OP6-central line reposit,” and so on. Even fewer still likely understand why a Tylenol pill or a rubber glove can carry the humongous price tags hospitals put on them.

Americans can be forgiven their ignorance on this issue because, as I put it in a recent paper on the subject, the pricing of hospital services is best described as “Chaos Behind a Veil of Secrecy.”

For starters, a hospital is paid by several quite distinct methods, depending on who is paying.

The federal Medicare program for the elderly typically pays hospitals a flat fee per hospital case, with a different per-case price for each of around 750 distinct diagnostically related cases (D.R.G.’s) — such as a hip replacement without complications or one with complications, and so on.

These payments originally were set by Medicare in 1983 to reflect the cost then of producing each D.R.G. case. They have been updated annually and periodically recalibrated by the federal government, with the advice of Congress’s Medicare Payment Advisory Commission, a permanent body of private stakeholders with its own research staff. Through lobbying and other informal political channels the hospital industry can, of course, influence these administered prices as well. Over time, the attempt has been to keep these rates close to the average cost of providing the services per case, although many hospitals claim that often the case payments they receive are below their own full costs.

From the federal-state Medicaid program for the poor, blind and disabled, hospitals receive either (1) case-based payments (D.R.G.’s) or (2) a set amount of dollars per day of inpatient stay (per-diem payments) or (3) fees for individual services and supplies (fee-for-service or F.F.S. payments). The levels of these payments are set unilaterally by the state governments. In many states these payments are much lower than the full cost of providing the services.

Private insurers pay hospitals predominantly on the basis of per-diems or fee-for-service schedules. On average these payments exceed the hospital’s cost of providing the underlying services. The profits built into these payments cover the losses hospitals book on serving Medicare and Medicaid patients, who are billed high prices but often do not pay their bills in full. Private insurers also feed the net profits that most for-profit and not-for-profit hospitals book.

The per-diems or myriad fees that private insurers pay hospitals are negotiated annually between each hospital and each insurance carrier. A given hospital may thus negotiate one by one with several dozen or even several hundred insurers.

Readers may wonder how the many fees that hospitals receive under the fee-for-service method are negotiated separately with each hospital. Generally, the fees are not negotiated individually, but as across-the-board discounts off a giant schedule of list prices that each hospital maintains — like list prices at car dealers that no one actually pays. These schedules of list prices are known as the hospital’s “charge master.” (For an illustration, see this list of prices for some 7,500 items charged by Dameron Hospital in California.) For uninsured patients the discount is negotiated by the hospital on a patient-by-patient basis, with appeal to the patient’s ability to pay.

Each hospital has its own charge master and updates it periodically by its own unique process. Consequently, across hospitals in a given state, the list price for a particular item – e.g., a normal chest X-ray — can vary tenfold or more. In most states — California being one exception — hospitals are not required to make these charge masters public.

Over all, then, annually establishing the prices that a given insurer will pay a particular hospital and the prices charged the uninsured is an enormously cumbersome and highly labor-intensive process not used by any other health system in the industrialized world. It adds a significant component to the high administrative cost that is unique to the American health system.

One interesting aspect of this process is the wide variation in how much a basic medical service costs at different hospitals — a variation that does not appear to be tied to quality.

Tables 6.3 to 6.5 below exhibit ranges or averages of the total payments that two private health insurers make to hospitals in their state for standard medical cases. The data in the table should be understood as the total payments — per diems or fee-for-service — per standard case. I had asked for these data in my role as the chairman of the New Jersey Commission for Rationalizing Health Care Resources in 2007. The tables below are taken directly from the commission’s final report.

No one really understands the determinants of the wide variations in prices paid hospitals by a given insurer for basically the same medical episode. Presumably these variances reflect the relative bargaining strength of the two parties in each instance. Large insurance companies with relatively more market power vis-a-vis doctors and hospitals usually pay lower prices for given services than do smaller insurers with less market power. And traditionally, the uninsured, lacking any market power, have been charged the highest prices (i.e., granted the lowest discounts off the charge master), although in recent years more and more hospitals have switched over to a means-tested schedule of discounts off the charge master.

Critics of the federal Medicare program routinely call Medicare a “dumb” price setter. Perhaps it is. But it stretches one’s cerebral processes to conclude that the varied prices emerging from the cumbersome private market process described above are any smarter or more conducive to a rational, efficient health system. This does not mean, of course, that some economists and other defenders of the system would not try.