Cost Shifting

Cost shifting exists when a hospital, physician group, or other provider raises prices to one set of buyers because it has lowered prices to some other group. The term has also been applied to managed care firms that are similarly said to have raised premiums to one set of purchasers because it had to lower premiums to some other set.

The term has been commonly used in debates over health care reform. Some have argued, for example, that efforts to reduce Medicare expenditures by lowering payments to hospitals under the Medicare prospective payment system, or through the encouragement of Medicare managed care plans, may save money for Medicare but will increase costs to younger folks. This is said to occur because to make up the difference, hospitals will simply raise their prices to private insurers. Insurers, facing higher hospital prices, will then tell employers they have to raise health insurance premiums because they are “being cost-shifted against” by hospitals.

Simply charging one group a higher price than another group does not constitute cost shifting. Firms in many industries do this: Airlines routinely charge different prices to people on the same plane. Movie theaters routinely charge different prices to adults and children. Restaurants and banks give senior citizen discounts. Hotels offer convention rates.

Cost shifting is different. Not only must the provider charge different prices to different payers, but also it must raise prices to one payer in response to lower prices from another. To be able to do this, two things are necessary. First, the provider must have market power, that is, it must have the ability to set prices above costs. Second, and critically important, the provider must not have already fully exercised its market power.

The first condition is straightforward. Suppose a hospital had no market power. When it attempted to raise its prices to, say, private insurers, the insurers would drop them from their network of participating hospitals and the insurers' subscribers would get their care from other hospitals in town. If there is substantial competition in the relevant provider market, cost shifting cannot occur.

The second condition is more subtle. A profit-maximizing firm with market power takes advantage of its power. Suppose it has two groups of buyers: Medicare and private insurers. It charges Medicare the most the government will allow. It sets the private price based on the marginal revenue and marginal cost of privately insured patients. (Note that the relevant cost of a private patient may be the Medicare revenue given up.)

If Medicare decided to lower its payment rate, a profit-maximizing hospital can't make it up by charging private insurers more. It is already charging the profit-maximizing price. The economics imply that the hospital will reduce the number of beds it is willing to fill with Medicare patients and shift that capacity to privately insured patients, who are now relatively more profitable. However, to get more privately insured patients it must lower (not raise) its price to private insurers. Thus, a profit-maximizing provider that has market power still will not shift costs. Instead, it will lower its prices. Similarly, if Medicare raises its payment rates, providers will raise their private prices.

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