The Cost of Hospital Protectionism

Winter 2019

The political clamor over health-care reform may have calmed, but the rising cost of health insurance remains a top concern of voters, and the share of government spending consumed by health-care entitlements continues to grow. Although both parties have tried to overhaul the insurance market, their reforms have done less to reduce the costs of health-care services than to alter the distribution of who bears them. While advocates of single-payer reforms argue that the government could pay less for hospital care, they have failed to identify any specific hospital expenditures that they believe should be eliminated, instead suggesting only that costs could be cut by emulating the methods of other developed countries.

In fact, our politicians have not only failed to enact meaningful reforms but have generally aimed at the wrong targets altogether. America's health-care system is not distinguished by its level of public spending on care (which is similar as a share of GDP to the OECD average), but by the protectionist nature of government intervention in the marketplace. And this above all means protectionism on behalf of hospitals. Over decades, the structure of state regulations and federal subsidies has encouraged hospitals to inflate their costs by protecting them from competition. This has yielded enormous overcapacity and inefficiency: Whereas the United States has 4,840 community general hospitals, England has only 200 — a quarter as many on a per capita basis.

The various initiatives proposed by left and right will therefore do little to reduce health-care costs so long as they coexist with a protectionist commitment to support the comprehensive delivery of medical services through local community hospitals. Instead, policymakers should seek to consolidate the various forms of assistance to hospitals into a discrete lump-sum subsidy for the provision of uncompensated emergency care at essential facilities, and allow unfettered competition over broader geographic areas to shed unnecessary costs for elective care.

HOSPITAL COSTS

Domestic policymaking has become dominated by health-care reform, and with good reason. The average insurance premium for family coverage has soared from $5,791 in 1999 to $18,764 in 2017. This has created pressure for the government to extend subsidies to those unable to afford their premiums. But health-care entitlements already accounted for 28% of non-interest federal spending in 2017, and CBO expects this to rise to 40% by 2047 even if no additional spending commitments are made. Without action to reduce costs, health insurance is likely to become unaffordable for an increasingly large portion of society.

As hospital and physician services (the most costly of which are delivered through hospitals) together account for around 57% of personal health-care expenditures, any serious attempt to address health-care costs must focus on these facilities. Hospital services are expensive because facilities incur major costs, not because they make huge profits: 92% of outpatient visits and 83% of inpatient admissions are either to government-owned or nonprofit organizations.

Hospital costs are best understood as sticky, rather than entirely fixed. Rebecca Roberts and co-authors calculated in 1999 that 84% of expenses relate to buildings, medical equipment, and (often-unionized) labor — costs which, unlike medications or supplies, cannot easily be expanded or reduced in line with patient volumes. But, to the extent that each of these expenditures can be spread over more patients, prices can be greatly reduced.

For instance, the United States performs only slightly more MRI scans (118 per 1,000 residents) than France (105 per 1,000) but employs three times as many MRI machines (39 versus 13 per million residents). This helps explain the disparity in the average cost of an MRI: $1,121 in the United States but only $363 in France.

America's hospital sector has become plagued with such overcapacity. Whereas the European Union had an average hospital-bed occupancy rate of 77% in 2015, the rate in America's community hospitals was only 63%. Occupancy rates were less than 30% for American hospitals with between six and 24 beds, and 42% for those with 25 to 49 beds.

The United States has 4,840 community general hospitals. The 13 initial Eurozone members, which together have a population slightly greater than the United States, had only 2,901 facilities in 2013. This is not just a matter of population density: To compare states that are similar in both population size and area, Ohio has 179 hospitals, almost twice the Netherlands' 94; Massachusetts's 75 hospitals exceed the 21 in Denmark by more than a factor of three. On average, European hospitals had 235 beds, compared to 150 in the United States.

For procedures with high fixed costs, such as heart surgery, high patient volumes are essential to efficiency, and they reduce the time that expensive equipment and associated skilled personnel at each facility spend idle. Whereas 65% of heart-bypass operations in California were undertaken at facilities performing fewer than 200 procedures per year, only 7% of those in Canada were. Low volumes also inhibit learning (by organizations as well as clinicians) and reduce the quality of care: The 30-day mortality rate following such procedures is 5.2% in low-volume hospitals and 2.1% at high-volume hospitals, with a "safe" threshold achieved by facilities treating at least 415 cases per year.

Operative mortality rates are consistently lower at high-volume hospitals for a wide range of cardiovascular procedures and tumor-resection surgeries. For joint replacements, high surgical volumes are associated with lower risks of complications such as pneumonia, heart attacks, and major infections. Higher clinical volumes also permit sub-specialization, and greatly increase the experience that physicians will have had treating very specific conditions. The median survival time of patients with rare multiple myeloma treated in the highest quartile of hospitals by volume (facilities with more than 10.3 patients in a year) was 83% longer than those treated in the lowest quartile (less than 3.6 per year).

But when it comes to the proliferation of costly, inefficient hospitals, government intervention is not the solution — it is the problem. America's hospital industry is already one of the most politicized sectors of the nation's economy, and its shape and structure are the product of decades of deliberate legislative and regulatory actions.

EXPANDING CAPACITY

Early forms of health insurance were designed and developed by the hospital industry for the purpose of accommodating the growth of hospital expenditures.

To supplement dwindling charitable funds during the Great Depression, the American Hospital Association certified and promoted "Blue Cross" plans to insure hospital bills. They established these early Blue Cross plans as a patchwork of local monopolies, required their boards to include hospital representatives, and reimbursed hospitals according to the costs they incurred. The AHA drafted model legislation that most states used to regulate hospital insurance and secured exemptions from taxes to privilege Blue Cross plans. Subsequent federal tax, labor, and regulatory policies sought to foster their growth, and by the 1950s, the majority of Americans had some form of hospital insurance — most of them through Blue Cross or Blue Shield.

In 1965, Congress established Medicare Part A Hospital Insurance, which copied the structure of Blue Cross plans and employed them to administer reimbursements to providers. Under this arrangement, Medicare paid hospitals for reasonable costs incurred in the delivery of needed health services. By doing so, the introduction of Medicare increased the number of hospital patient days reimbursed according to cost by 75%. As a result, hospitals could rely on the federal government to bankroll major capital investments, expansions of capacity, staffing, or technology.

Amy Finkelstein of the Massachusetts Institute of Technology has calculated that, within the first five years of the introduction of Medicare, the number of patient beds increased by 30% and payroll expenditures by 52% more in the areas where the program did the most to expand insurance coverage. This contributed to a 37% increase in total hospital spending (for all ages), even though only 7.5% of the population gained insurance coverage as a result of the program's creation. Recognizing that many elderly Americans used hospital care prior to insurance coverage, Finkelstein calculated that the creation of Medicare induced an increase of hospital expenditures more than six times greater than one would have expected from the expansion of insurance coverage alone. About half of this increase in hospital costs was due to the establishment of new hospitals; the other half was due to increased spending at existing facilities.

For most of the next two decades, open-ended cost-based reimbursement arrangements dominated, and competition between hospitals was widely characterized as a "medical arms race." The more competitive any local hospital market, the more facilities sought to attract physicians and the patients they referred by investing in expensive facilities for cardiac surgery, radiotherapy, and other costly procedures. Hospitals shifted from being institutions of last resort to all-purpose providers of medical care. While the Consumer Price Index increased by 89% from 1966 to 1976, hospital costs rose by 345%. Of the cost-based reimbursement era, one hospital CEO remarked, "[Y]ou could be an idiot and make a fortune on Medicare reimbursement. Any mistake you made you got reimbursed."

CONSTRAINING COSTS

In 1983, Congress therefore sought to rein in Medicare payments by establishing a set of diagnosis-based rates it would pay for inpatient treatment. There was remarkably little pushback against this reform by the hospital industry, as fees were initially set so that facilities enjoyed a 14.5% profit margin on Medicare inpatient admissions in 1984. Capital expenditures, physician fees, and post-acute-care services were also initially carved out of these payments — and these subsequently began to rise.

Hospital services are disproportionately consumed by those with major illnesses who have already passed deductibles and caps on out-of-pocket costs. As a result, a study by Gautam Gowrisankaran, Aviv Nevo, and Robert Town found that patients pay an average of only 2% to 3% of hospital bills as co-insurance, and are more than 40 times less responsive to prices than those paying out of pocket. From the hospitals' perspective, the most lucrative well-insured patients may be sensitive to travel, quality, and amenities, but are usually insensitive to cost.

Insurers therefore have a much stronger interest in making sure that patients receive cost-effective care than do enrollees who have already paid premiums. As a result, commercial insurers were able to erode the dominance of Blue Cross, despite its tax and regulatory advantages, by cutting costs for employers and individuals purchasing plans.

Indeed, plans may also have more expertise in purchasing quality care, as they have already done so for equivalent procedures many times. These considerations led policymakers to support the rise of managed care — allowing insurers to drive down hospital costs by leaving expensive facilities out of network, by requiring prior authorization before paying for costly procedures, and by giving physicians incentives to reduce the use of unnecessary services. Health Management Organizations, the most restrictive form of managed care, sought the tightest control of costs by delivering care through closed networks of in-house physicians.

As the share of employees receiving coverage through managed-care plans increased from 27% in 1988 to 90% in 1999, the "medical arms race" among hospitals slowed. Areas with a higher prevalence of HMOs saw fewer facilities employing MRI machines, fewer providing mammography, and slower adoption of mid-level NICU units. A study of heart-attack patients by Daniel Kessler and Mark McClellan found that, whereas those treated in competitive hospital markets had previously seen higher costs, from 1991 those treated in competitive markets with relatively high HMO enrollment had lower costs as well as better health outcomes. Mortality rates and costs were highest in the hospital markets where HMOs had done the least to reduce excess capacity.

The growth of managed care and the shift away from open-ended reimbursement by Medicare strengthened incentives for hospitals to cut costs. This was facilitated by the development of minimally invasive surgical methods, which greatly reduced recovery times following surgery. For instance, an appendectomy, which required an average hospital stay of 6.3 days in the 1960s, now needs only a day or two. As a result, the number of inpatient admissions peaked in 1981 at 39.2 million, while volumes of outpatient surgery soared from 3.7 million in 1981 to 32 million in 2005.

With more procedures being done on an outpatient basis with minimal risks of complications, physicians increasingly established their own independent facilities. Ambulatory Surgery Centers (ASCs) gave doctors more incentive and ability to make the most efficient use of time and equipment in performing procedures, and allowed them to benefit from the efficiency of scale in treating specific conditions, without being bound to an oversized and unaccountable institution. The number of ASCs increased from 400 in 1983 to more than 3,300 in 2001. By 2000, 17% of outpatient surgical procedures were performed at such facilities.

Equivalent procedures performed in ASCs take an average of 25% less time than those performed in hospitals, with patients less likely to need subsequent emergency care or admission to the hospital. Although patients treated in ASCs may have less severe medical needs than those who are treated in hospital outpatient departments, money can be saved by separating routine cases from those with complex medical needs, and by treating them more efficiently.

While inpatient specialty hospitals are usually substantially larger institutions than ASCs, the competitive presence of ASCs has also tended to reduce both revenues and costs at nearby general hospitals. Markets where cardiac-specialty hospitals opened saw comparable clinical outcomes but lower overall spending on cardiac procedures as a result of the pressure they put on general hospitals to reduce their costs.

Other factors also squeezed hospital revenues. During the 1980s and '90s, Congress repeatedly cut hospital Medicare payments in order to fund expansions in Medicaid eligibility. Whereas only 17% of hospitals lost money on Medicare patients in 1984, eight years later 60% did. The development of groundbreaking new medications also caused hospital discharges for cardiovascular patients to decline from 5.4 million in 1993 to 4.3 million in 2014 — depriving hospitals of some of their most lucrative customers.

Although the U.S. population rose from 141 million in 1946 to 316 million in 2013, the average daily patient census in hospitals has plummeted from 1.1 million to 0.6 million. As a result of these pressures, the total number of community general hospitals in the U.S. declined from 5,830 in 1980 to 4,915 in 2000. But then politics intervened, and the number has dropped no further.

PROTECTIONIST PUSHBACK

It has become commonplace for economists to bemoan hospital market power and the inflated prices it has engendered. Yet this situation is the product of two decades of deliberate interventions to protect hospitals from falling revenues through a combination of subsidies and restrictions on competition. Hospital protectionism is largely a defensive phenomenon, but this makes it politically potent. The most commanding position in American politics is the status quo.

Whereas hospitals seem strong to economists, they do nothing but plead their weakness to congressional staff: Without assistance, they claim with some plausibility, they will be forced to scale back essential services or close their doors. Members of Congress from both parties, all of whom have hospitals in their districts greatly cherished by their constituents, are highly sensitive to such concerns. In addition to the practical convenience it offers, a well-equipped local hospital gives residents a sense of security and helps anchor a community. Hospitals also bring an enormous number of well-paying jobs (5.7 million in 2015) to places that otherwise may have few. This political power is catalyzed by lobbying spending ($103 million in 2017) that rivals the amount spent by the entire defense industry ($125 million).

Hospitals also serve as insurers of last resort in local communities. Community hospitals are required by federal law to stabilize the condition of patients who need emergency care, and nonprofit facilities must provide "community benefits" as a condition of their tax-exempt status. The American Hospital Association claims that U.S. hospitals delivered $43 billion in uncompensated charity care in 2014 (mostly to the uninsured) for which they were unable to collect payment. The tax exemption of nonprofit hospitals was worth $25 billion in 2011; but their nonprofit status also helps induce charitable donations and gives facilities a competitive advantage over specialty hospitals.

While Medicare's fixed-payment rates were established in 1983 with the intent of forcing different facilities to deliver care at similar levels of cost, add-ons and exemptions have since piled up. In 2013, the GAO estimated that 91% of hospitals were eligible for further upward payment adjustments or exempt from Medicare rates entirely. Through Medicare and Medicaid, the federal government in 2014 provided an additional $50 billion in supplemental payments to help facilities cover the cost of uncompensated care. After 208 rural hospitals closed during the 1990s, Congress gave states the authority to designate facilities as "Critical Access Hospitals" — a status that allowed a quarter of hospitals to return to the old system of claiming open-ended reimbursement from the federal government on the basis of costs they incurred.

The federal government also provides various indirect subsidies to hospitals, which are not specifically enumerated as payments for uncompensated care but are justified as such on Capitol Hill. The government's fee schedules for Medicare services delivered in hospital outpatient departments diverge from those in ASCs or physician offices, so that it sometimes pays more than three times as much for the same procedures when they are delivered by doctors directly employed by hospitals. It requires drug-makers to provide drugs to nonprofit hospitals with discounts worth $6 billion in 2015, but allows hospitals to claim full reimbursements at undiscounted rates from Medicare and other payers. It also provides $16 billion per year to hospitals with medical residency programs — a subsidy that is not needed to get hospitals to employ underpriced skilled labor, but which they nonetheless prize. General hospitals argue they deserve to be paid more than specialty hospitals to account for the higher complexity of medical needs they are required to treat, but they're also paid more to treat routine cases.

Inflated fees for publicly and privately insured patients cannot be used to cross-subsidize uncompensated care if these patients are able to seek treatment from cheaper facilities. Hospital lobbyists therefore argue that their profit centers need to be further shielded from competition. Inpatient specialty hospitals are particular targets of this ire, given their potential to serve as nimble competitors for hospitals' cash cows, such as cardiac surgeries (which can account for 25% to 40% of revenues). Legislation known as the "Stark Law" was enacted in 1992 to ban physicians from referring Medicare or Medicaid patients to specialty hospitals in which they have a financial stake, due to conflict-of-interest concerns — depriving those hospitals of half of their potential customers.

The Federation of American Hospitals justified a 2003 to 2005 moratorium on referral of Medicare patients to physician-owned specialty hospitals on the grounds that they were "lucrative wards that undermine health care by siphoning away vital finances needed to support essential but low-margin services." Section 6001 of the Affordable Care Act sought to effectively prohibit such referrals to newly established entities altogether.

Hospital lobbyists have similarly promoted Certificate of Need (CON) laws as a means of constraining the growth of hospital costs. From 1974 to 1987, the federal government required states to enact CON laws to regulate extensions in hospital capacity and capital investments. Yet such laws have done more to divert spending and restrict competition than to slow the overall growth of hospital costs. Powerful hospital systems, which dominate CON boards, easily get approval for investments they seek to make, while smaller competitors and newcomers can find it hard to establish a foothold or to build the scale needed to challenge incumbents. A 2003 GAO study found that only 4% of specialty hospitals opened since 1990 were located in the 37 states with CON laws. Constrained by regulation, specialty hospitals accounted for less than 1% of Medicare inpatient spending in 2000.

While 21 states with CON restrictions on imaging services saw no fewer MRI, CT, and PET scans delivered through incumbent hospitals, they reduced the number provided by competing providers by 25% to 75%. Unsurprisingly, some of the highest markups charged by hospitals are on imaging services; private insurers are required to pay on average four times more than Medicare for MRI scans.

THE LEGACY OF PROTECTIONISM

In the late 1990s, hospitals charged private insurers an average of 10% more than Medicare fees for equivalent services. By 2012, hospitals' increased market power allowed them to inflate this disparity to 75%. In 2014, privately insured patients accounted for 43% of hospital revenues but only 28% of their inpatient and emergency-department costs. By contrast, prices for physician services do not differ greatly from rates paid by Medicare.

The American Hospital Association claims that Medicare covered only 87% and Medicaid only 88% of their enrollees' hospital costs in 2016 — justifying interventions in the market to allow them to overcharge privately insured patients. But econometric evidence suggests that causality runs in the opposite direction: Inflated private revenues encourage nonprofit hospitals to expand expenditures on facilities, staff, and equipment, causing average costs to exceed revenues from publicly funded patients. Indeed, hospitals in competitive local markets, which must keep their costs below the revenue generated by Medicaid patients, tend to do so.

Hospital employment grew by 28% from 2000 to 2017. Although managed care had been able to constrain the growth of hospital costs during the 1990s, HMOs quickly grew unpopular. As most individuals receive health-insurance coverage through jobs, the savings from managed care went to employers while the reduced choice of providers was borne by employees. This caused a political backlash, fueled by lobbyists for hospitals and physicians, which led most states to restrict the use of these cost-containment practices. One study estimated that such laws, by reducing the ability of plans to control utilization and steer individuals to cheaper providers, inflated health-care spending by $3,000 per household. Another study estimated that, while hospital costs had been 19% to 27% lower in HMO-dominated markets, this advantage was halved in the post-2000 period.

Among the most important ways that hospitals responded to these pressures was through consolidation. From 1998 to 2015, there were 1,410 hospital mergers and acquisitions in the United States — leaving 67% of hospitals as parts of larger systems. These mergers mostly did not serve to reduce excess capacity and tended not to eliminate beds. Rather, hospitals have sought to consolidate into ever-larger systems to strengthen their power in negotiations with insurers — allowing them to increase prices even when facilities served different parts of a state. Indeed, between 1999 and 2003, prices rose twice as fast at hospitals that were members of multi-hospital systems.

Although the Stark Law seeks to prevent physicians from referring Medicare patients to specialty hospitals in which they have an ownership stake, no such regulations prevent general hospitals from purchasing physician practices for the sake of getting more referrals. Indeed, large specialist networks further strengthen the bargaining power of hospitals when negotiating with health plans. From 2004 to 2011, the proportion of physician practices owned by hospitals increased from 24% to 49%.

A recent study by a group at Northwestern University found that prices at physician practices acquired by hospitals increased by an average of 14%, with the increase averaging 34% for cardiologists; those acquired by hospital systems with dominant market positions increased their prices by 35% more than they would have if they had been acquired in a perfectly competitive market. The researchers found that almost half of this increase in prices was due to the exploitation of payment rules.

For instance, Medicare will pay $453 for an echocardiogram performed in a hospital outpatient department, but only $189 if it is performed in a cardiologist's office. From 2007 to 2012, the share of cardiologists in private practice fell from 59% to 36%. As merging with hospitals allows oncology practices to claim federally mandated discounts that increase their margins on drugs from 6% to 49%, the proportion of chemotherapy drugs administered in hospitals to privately insured patients has increased from 6% in 2004 to 46% in 2014 — at an average cost of over $150,000 per patient per year. Therefore, by rewarding consolidation with hospitals, federal payment policy has made it hard for independent providers to compete. Local areas with a higher Medicare patient load saw more instances of hospital consolidation but fewer hospital closures.

Hospital protectionism is starting to work poorly even for its purported intended beneficiaries: the uninsured and those in remote areas. The longer a rural hospital has been able to claim reimbursement on the basis of costs as a Critical Access Hospital (CAH), the more its costs have grown. Fully 81% of CAHs had their own MRI scanners by 2013. Although Medicare rules have limited CAHs to 25 acute-care beds to protect revenues at each facility from competition, the average occupancy rate at small rural hospitals was only 37% in 2014. This makes it hard for insurers to negotiate good rates: Of 650 counties with only one insurer on the exchange, 70% are rural.

Nevertheless, urban hospitals are better equipped and staffed than CAHs, and rural residents are increasingly willing to travel for better-quality treatment: They receive 48% of elective surgical care from non-local providers. This has led to a death cycle of falling volumes and rising costs per case, leaving 283 rural hospitals on the brink of closure in 2015, despite all the interventions to support them.

While the broader array of subsidies, tax preferences, mandated discounts, and protections from competition can in theory be used to cross-subsidize unremunerated services, in practice they merely strengthen incentives to expand already-lucrative ones. Nonprofit hospitals' tax exemption is worth 5.9% of their expenses but induces them to provide only an additional 1.7% of charity care relative to comparable for-profits. As the value of the tax exemption grows in proportion to the demand for expensive hospital services, the facilities receiving the largest such benefits tend to be those located in wealthier communities that have the least indigent-care needs to support.

The value of Medicare and Medicaid add-ons to subsidize uncompensated-care spending grew rapidly in the 1990s, but the provision of such care did not. An additional $1 in such subsidies yielded $0.06 in extra uncompensated care when distributed through Medicaid and $0.17 when spent through Medicare. Reductions in these payments had only slightly more effect: uncompensated care being reduced by $0.47 for every $1 in cuts to subsidies. In fact, a study of California hospitals found that 65% of uncompensated care for the uninsured provided by private hospitals is delivered by those who receive no such subsidies. Nor is there any evidence of association between CON programs and the provision of indigent care.

TOWARD A MORE STREAMLINED SYSTEM

Hospitals are difficult institutions to manage efficiently. They must juggle often-conflicting goals: delivering high volumes of care, providing a diverse range of services, attracting patients from competitors, upgrading equipment, keeping costs under control, avoiding medical errors, and financing uncompensated care. In doing so, they are often constrained by a web of commitments to patients, staff, capital projects, and community partners.

Some scholars have recommended heightened antitrust enforcement to check inflated hospital prices. But the problems of inflated costs and excess capacity in nonprofit organizations are unlikely to be solved simply by preventing mergers. Nor would a single-payer system be likely to shed unnecessary costs through public regulation of prices, since policymakers have deliberately established a complex array of regulations and subsidies to help hospitals inflate their revenues. In fact, most states with all-payer rate-setting systems abandoned them once HMOs began to check hospitals' ability to use inflated private-insurance revenues to finance uncompensated care. CON laws do not function as the health-care industry's version of the Defense Base Realignment and Closure Commission — nor would voters allow them to.

As a political matter, it is easier to shed costs through the gradualism of market competition than by administrative fiat. The hospitals that closed in the 1980s and 1990s were distinguished by their inefficiency (high levels of excess capacity and higher average lengths of stay), rather than by their mix of services and patients. In the absence of bailouts or additional subsidies, loss-making facilities tended to reduce their rate of investment in new technologies. Under the right circumstances, consolidation can even cut costs. Between 1986 and 1994, hospital mergers reduced prices for consumers by an average of 7% — with reductions twice as great in areas with high managed-care penetration but lower in already-consolidated markets.

Where substantial barriers to market entry exist, mergers for the sake of inflating market power will tend to proliferate unchecked. However, when allowed to do so, ASCs tend to enter markets as prices become inflated, so they are more likely to enter and reduce prices in markets that are more consolidated or where there are fewer HMOs. As a result, entry by specialty hospitals will tend to reduce costs where they are most excessive, while posing little threat to the safety-net hospitals that serve unattractive markets.

Nor is market power the whole story. While hospitals without local competitors have prices that are on average 16% higher than those with four or more competitors, most hospital markets in the United States have not become monopolized but still have very high prices for procedures. Within local markets, prices for outpatient care at the highest-priced hospital average nearly double those at the lowest-priced hospital. Hospital prices for lower-limb MRIs vary by a factor of 12 across the United States.

Such monopoly prices are an artifact of localism. If patients are not able to capture the savings associated with travelling to cheaper but more distant facilities, they will not do so. But if they are able to benefit by going to a different town, even consolidated local markets will do little to impede them.

For instance, the California Public Employees' Retirement System, which had been paying $20,000 to $120,000 for knee- and hip-replacement surgery, established a reference price of $30,000 that it would pay for treatment; if employees sought treatment at higher-cost facilities, they would be responsible for all additional costs. In addition to cutting costs for those who switched to cheaper providers, this caused an 18% decline in the cost of surgery at more expensive hospitals — indirectly reducing costs for those not subject to the incentives.

While patients can take time to travel for routine cataract surgery or cancer treatment, there are clearly a set of high-acuity emergency conditions, such as major trauma, cardiac arrest, or sepsis, for which early intervention and proximity are essential. But for some of the most severe cases, treatment at a low-volume local hospital may lead to a higher risk of death than would longer transportation to a cutting-edge regional trauma center.

As only 24% of rural residents can reach a top trauma center within an hour, access to emergency care in rural areas is a major challenge: The mortality rate for car crashes in rural areas is 15 times greater than for otherwise-similar crashes in urban areas. A study of the Chicago area showed that the risk of death was 23% higher among those suffering gunshot wounds more than five miles from trauma centers — and yet, it is clearly impractical to have a specialized surgical team waiting idle in every precinct for occasional incidents.

There is probably some irreducible tradeoff between quality of care and cost, as there is with distance and cost. Expensive academic medical centers, which employ the most cutting-edge technology and the best medical specialists, are able to generate better clinical outcomes. Price controls or single-payer rationing of health-care services would likely truncate the top end of the market — curtailing the process of innovation, which subsequently diffuses benefits more widely.

The objective of public policy should not be to eliminate the costliest cutting-edge institutions, nor to impose their arrangements on all, but to allow competition wherever possible to eliminate inflated costs while establishing a reasonable floor in access to emergency care. Policymakers should seek to establish a ring-fenced subsidy for emergency and safety-net services, along with an expectation of full competition for elective care.

Regulatory constraints on the growth of specialty facilities, such as the Stark Law, Certificate of Need laws, and restrictions on the ability of insurers to steer patients to cheaper hospitals, should therefore be repealed.

Meanwhile, the value of the nonprofit-hospital tax exemption, the value of drug discounts, the cost of Medicare and Medicaid payment add-ons for uncompensated care, the value of other site-of-service payment disparities, and the extra costs of the CAH system should all be consolidated into lump-sum payments for uncompensated emergency care. These funds (worth over $80 billion per year) should be distributed to hospitals or stand-alone emergency departments in return for the provision of specific public goods such as uncompensated emergency care to the uninsured, emergency surge capacity, trauma resources, and access to specialty physicians. Payments should be adjusted to reflect access challenges in rural areas, local practice costs, and the size of the low-income population in each local community.

Hospital fees that cannot be checked by exclusion from insurer networks or the ability of patients to shop around, such as those for emergency procedures, should be regulated by law. Charges for out-of-network emergency-care services delivered at subsidized facilities should be capped at 150% of Medicare rates. Such an arrangement would not only protect patients from exorbitant hospital bills for emergency care, for which they were unable to shop around; it would strengthen the leverage for insurers to negotiate good rates, and also serve to discourage subsidized institutions from expanding at the expense of unsubsidized facilities subject to competition. The combination of regulated out-of-network rates and unregulated in-network payment arrangements, employed by Medicare Advantage, has successfully controlled costs while rewarding innovation, and could be more broadly applied.

By reforming the perverse and counterproductive role that public policy has played in the regulation of American health care, it would be possible to better protect essential services, without neglecting the interests of patients and those responsible for paying for care.