Cost pass-through reimbursement to hospitals and their impacts on operating efficiencies

In both the private and public sectors, it is strongly believed that when goods and services are transferred at full cost, efficiency of operation is not encouraged. A cost pass-through payment mechanism, heavily used by the U.S. Federal Government prior to 1983 to reimburse hospitals for in-patient services, has been blamed for part of the annual double digit escalation in health care costs from 1965 to 1983. A cost pass-through formula is still in use for some types of outpatient care reimbursement (especially clinics and ancillary services); additionally retrospective reviews are still used to determine Medicare ‘outlier’ payments under the present prospective system. Finally some private health care plans still utilize a mixed retrospective/prospective payment system. Hence, the issue is still very relevant to health care professionals. Unfortunately it has been difficult to settle this issue empirically since hospitals are characterized by the provision of multiple services, with no clear resource/product allocations; additionally different client mixes and other uncontrollable factors complicate the issue of measurement of efficiency. The authors provide some quantitative insights into this issue, using a new formal hypothesis testing procedure developed by Banker which uses as inputs the technical efficiency ratings from a Data Envelopment Analysis with non-discretionary factors. The data det involved is for 105 North Carolina hospitals, operating in 1978 (before the era of prospective reimbursement); three distinct outputs, three controllable resources and six descriptors of the hospital (bed size, case mix, etc.) are available for each hospital. Additionally the percent of each hospital’s total reimbursement, generated utilizing the cost pass-through formula, was estimated. The hypotheses tested related generally to whether or not an inverse relationship existed between the hospital’s inefficiency rating and the extent of its cost pass-through reimbursement. The data supports the widely held belief that hospitals with higher cost pass-through percent reimbursement indeed tended to be less efficient.