Cost Shifting

Overview

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

Two policy prescriptions emerge from this argument. First, private insurers should support coverage for the uninsured; the costs of the subsidy will be less than they appear because the hidden cost shift will be eliminated. Second, it is sometimes argued that cost shifting requires the systemic reform of healthcare. Any piecemeal effort to control costs will ultimately be eroded by increases in costs to some other payer, with the result that costs are not controlled. While subsidizing care for the uninsured and reforming the healthcare system are important goals, however, cost shifting is unlikely to be a serious component of the rationale.

Simply charging one group a higher price than another does not constitute cost shifting. Firms in many industries routinely do this. For example, airlines routinely charge different prices to people on the same airplane. Movie theaters routinely charge different prices to adults and children. Restaurants and banks give senior citizen discounts. Hotels offer convention rates. This is known as price discrimination.

Cost shifting is different. Not only must the provider charge different prices to different payers, it must also raise prices to one group in response to lower prices from another group. To be able to do this, two things are critical. First, the provider must have market power (i.e., it must have the ability to set prices above costs). Second, and most importantly, 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 a local preferred provider organization (PPO), the PPO would simply drop the hospital from its network and channel its subscribers to other nearby hospitals. Thus, if there is substantial hospital competition in the local market, a hospital is unable to shift its costs.

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