Professor of Strategy; Herman Smith Research Professor in Hospital and Health Services Management; Director of Healthcare at Kellogg
Member of the Strategy Department from 2013 to 2021
Associate Professor of Strategy
Healthcare in the U.S. is expensive and growing ever more so. By one measure, healthcare spending had climbed to $3.8 trillion in 2019, or $11,582 per person—more than doubling since 2000.
American policymakers and patients across the political spectrum generally agree that rising healthcare prices are a concern, but the question of how to slash them has spurred contentious, headline-dominating debates. Some argue for the expansion of the government’s public healthcare option—often invoking the shorthand “Medicare for all”—which would pay hospitals and other providers substantially less for most services than private insurers currently do. Others have called on the government to regulate healthcare prices directly.
While lower prices sound appealing for consumers, Kellogg professors Amanda Starc and Craig Garthwaite wondered what the domino effects could be of legislating major changes to healthcare markets. In a new paper, coauthored with Christopher Ody, formerly a research assistant professor of strategy at Kellogg, they focus on one question in particular: Would regulating hospital prices in an effort to lower them impact the quality of the services these crucial organizations provide?
“Rising healthcare costs are certainly something we want to think about,” says Starc, an associate professor of strategy. “But from the consumer’s perspective, quality is obviously very important as well. If we change hospitals’ financial incentives, we want to think about how they’ll respond along quality dimensions.”
The researchers theorized that hospitals with a greater ability to draw high-paying, privately insured patients would offer demonstrably higher-quality services than those whose patient bases were largely publicly insured and thus paid less for those services. The reason for this, they believed: hospitals with higher-paying patients made more investments in quality as a way to differentiate themselves—and to ensure their indispensability in private insurance networks.
“From the consumer’s perspective, quality is obviously very important as well. If we change hospitals’ financial incentives, we want to think about how they’ll respond along quality dimensions.”
— Amanda Starc
The researchers’ findings suggest that their theories were right on the money. The team examined the demographics of zip codes near hospitals, which allowed them to estimate the share of privately and publicly insured patients the hospital could potentially attract. This helped them estimate the potential prices a given hospital could command for its services. The team then looked for a relationship between those potential prices and various measures of hospital quality. Importantly, while investments in quality would improve care for all patients, it would only lead to higher prices for the privately insured.
The result was a consistent pattern: across all quality measures, higher scores were associated with a higher share of potential private patients. What’s more, the researchers found evidence that hospitals that expect to court more private patients make costly investments in quality.
“This becomes an important input into the conversation that I think we’re going to have after the pandemic ends about healthcare reform,” says Garthwaite, a strategy professor and the director of Healthcare at Kellogg. “We don’t want to keep having this facile argument that high prices are high just because hospitals are getting extra profits they shouldn’t get—as opposed to recognizing that hospitals are making investments to attract patients. Those two interpretations have very different implications for what might happen in response to widespread use of price regulation.”
To begin, the researchers had to find a way to capture the relative price-setting power of hospitals’ potential client bases. They did this by analyzing zip code–level demographics from the American Community Survey and 2010 Census, and then using a formula based on proximity to predict the share of a hospital’s patients coming from each zip code.
To quantify the actual quality of a given hospital, the researchers built six quality measures:
In using so many different measures, the researchers sought to rule out the possibility that their results were unwittingly capturing a relationship other than the one they sought to explore. In other words, it’s highly unlikely that the hospitals deemed “low quality” across the board in the researchers’ measures are simply those with sicker patients, for example.
“We don’t want to keep having this facile argument that high prices are high just because hospitals are getting extra profits they shouldn’t get—as opposed to recognizing that hospitals are making investments to attract patients.”
— Craig Garthwaite
“We look at a wide range of quality measures, some of which are dependent on outcomes and some of which are not,” Starc explains. “For example, we look at risk-adjusted mortality for heart attack, and we also look at technology adoption. In the latter case, the type of patient doesn’t matter—just, did you invest in this fancy machine or not.”
The researchers’ results confirmed their hypothesis with even greater consistency than they’d expected: Hospitals with higher shares of potential private patients consistently demonstrated higher quality in all measures. And the reverse was also true among hospitals that drew mostly publicly insured patients. The researchers estimate that with every standard-deviation increase in a hospital’s predicted nonprivate patient share, mortality increased by 1.5 percent.
“Consistently what we see is that places that have more opportunity to earn money from quality make costly investments in quality,” Garthwaite says.
To help verify that this increased quality was due to investments, the team next dug into hospital accounting margins, as documented in Medicare Hospital Cost Reports. They pulled two measures from the reports: a Medicare accounting margin, which captured a hospital’s fee-for-service Medicare business, and a non-Medicare accounting margin, which captured all other business.
They hypothesized that hospitals whose expected patients were largely privately insured would have both narrower Medicare accounting margins—since the cost of providing care would be higher for hospitals that had made large investments in quality—and higher prices paid by private payers—which helped offset the cost of the hospitals’ investments. While the prices might be different depending on a patient’s insurance type, hospitals were required to deliver the same quality of care, regardless.This is exactly what they found, suggesting that hospitals expecting to serve more privately insured patients were more likely to make big investments toward the quality of their offerings.
Garthwaite says he and his coauthors chose to tackle this particular project because they believe it’s important to be clear-eyed about the potential impacts of legislation that would transform healthcare markets.
“I don’t think that our paper says that we shouldn’t have ‘Medicare for all,’” he says. “But it does suggest that as part of the conversation about regulated prices, we should be talking about this quality trade-off more than I think is currently happening in the policy debate.”
A natural question follows: How would hospitals change—and what quality trade-offs might they make—if legislation to regulate prices or significantly expand Medicare were enacted?
“It’s very hard to answer questions like, ‘What are they going to cut back on first?’ or, ‘How big is the quality effect?’” Starc says. “I don’t think we know. I do think we have a sense from this paper that, directionally, it’s not zero. If you turn off these incentives to invest in quality, there will be some change.”
Katie Gilbert is a freelance writer in Philadelphia.
Garthwaite, Craig, Christopher Ody, and Amanda Starc. 2021. “Endogenous Quality Investments in the U.S. Hospital Market.” Working paper.