This week’s contributor is Benedic Ippolito, an economist at the American Enterprise Institute. His research focuses on health care costs and the pharmaceutical market.

Private insurers pay high and rising prices to hospitals. But whether this is “good” or “bad” depends on what’s behind this phenomenon. Do high prices reflect investments in quality? Or do they instead reflect issues like lack of competition due to hospital consolidation? The answer matters for efforts to reduce health care spending.

In a new paper in the Journal of Health Economics, Craig Garthwaite, Christopher Ody and Amanda Starc investigated whether the prospect of financial rewards drove differences in hospital quality measures — including things like mortality rates, patient experience, technology adoption and emergency department wait times. Specifically, the authors’ examined whether hospitals are more likely to invest in quality if they will be rewarded through higher prices. This is more feasible if they’re serving lots of commercially insured patients, since private insurers may pay higher rates if patients value those hospitals. But that strategy may not be successful in areas with large shares of the population on Medicare and Medicaid, which do not negotiate prices. 

The researchers found that:

• Hospitals in areas with more privately insured patients had higher quality scores compared to hospitals with more publicly insured patients.
• Hospitals targeting more privately insured patients also had higher costs than those relying more on payers like Medicare and Medicaid.

These results suggest hospitals make strategic investments in quality to attract privately insured patients. This is consistent with what one might expect from market competition and the results of other recent research. These findings do not, however, imply that prices are “optimal.” Prices also reflect factors like provider consolidation that have little observable effects on quality. Indeed, hospital prices likely reflect a mix of valuable and wasteful spending.

The analysis does have limitations. The authors used the demographics of the areas around the hospital instead of each hospital’s actual potential mix of patients. In addition, it is possible that some quality differences across hospitals actually reflect differences between patients with private and public insurance which aren’t easy to capture in data. However, the authors’ results were similar across several quality measures, including those where this is less of a concern.

These results can help better inform efforts to reduce health care costs. Policymakers interested in reducing hospital prices should be aware that doing so might reduce investments in quality. This suggests placing a greater emphasis on policies that target prices stemming from clear sources of inefficiencies, like consolidation, since such tradeoffs are likely smaller.