Government Regulation of Hospital Purchasing -- Michigan Patients Pay a Heavy Price

Regulation-happy government institutions have recently found another way to keep themselves busy. Having succeeded in imposing restrictions on the accounting profession, the U. S. Senate has, seemingly in search of another Enron, recently taken to investigating purchasing structures in hospitals. With a series of articles “uncovering” supposedly unethical operations of voluntary purchasing groups in health care, the New York Times joined in the choir. Though it may seem to be just political grandstanding, the consequences for Michigan health care consumers are severe.

Companies in any sector often join together in Group Purchasing Organizations (GPO). These are voluntary firms, usually of a for-profit nature, that have a single purpose: to benefit their members by reducing the costs of supplies. GPOs use the greater clout vis-à-vis sellers that stems from larger, bundled purchase volumes to negotiate lower prices than their members would obtain individually. Consumers know such organizations under names like Sam’s Club and Costco.

For hospitals, the leading GPOs (among six major competitors) are Premier Inc. and Novation LLC. Novation helps about a third and Premier about a quarter of American hospitals buy medical supplies at lower rates. They serve primarily the smaller hospitals, which are under greatest pressure. GPOs have now raised the suspicion of senators, who blame part of last year’s rise in hospital prices on inefficient and even unethical purchasing practices. At the same time, the Federal Trade Commission (FTC) is investigating whether rising medical costs are due to violations of antitrust law.

What are the charges? The U. S. General Accounting Office claims to have found out that GPOs do not always offer hospitals lower prices. They are accused of having discouraged competition among medical suppliers. Some have developed their own private-label product lines. Now they are charged with pursuing their own commercial interests instead of working on behalf of their members.

The truth of the matter is that health care is one of the industries most plagued by government regulation, and such regulation can work against the interests of patients. Federal actors in the regulation game include institutions such as the Department of Health and Human Services, the Occupational Safety and Health Administration (OSHA), and the Centers for Medicare & Medicaid Services. The State of Michigan regulates health providers through licensing and certification, authorizes certain capital expenditures by health agencies, and licenses persons who practice medicine and provide other health services.

This socialist system, which involves not only providers of services under Medicare and Medicaid but also private hospitals, drives up the cost for consumers. Government mandates on product standards and medical procedures and a system of rigid price controls, originally developed by the military healthcare system Tricare, guarantee that market forces in medicine will be hobbled.

Take the Diagnostic Related Guidelines (DRG), a true nightmare for physicians and hospital administrators since their inception in 1983. Compliance with DRG has become a science of its own, with a booming consulting profession maneuvering hospitals through the jungle of rules. Hospitals are paid on a per-case basis regardless of the intensity of care provided to each patient, except for extraordinary outlier costs. Just consider the following formula for calculating the “threshold amount” to be plugged into the definition of “outlier payment”: Outlier Payment [= 80% of (Standard Cost – Threshold) x adjustment factor for children’s hospitals] = {[Fixed Loss Threshold x ((Labor-Related Share (.7110) x Applicable wage index) + Non-labor related share (.2890) x National Operating Standard Cost as a Share of Total Costs] + [DRG Base Payment (wage adjusted) x (1 + IDME)]}. All clear? This is how hospitals get reimbursed from Medicare, Medicaid – and from “private” health insurers. Oh, yes, and there are two tiers of DRGs, different for Medicare and Medicaid.

At present, hospitals can receive a reimbursement of $3,108.62 for treating a fractured femur (DRG 235) and $2,959.38 for a fractured hip and pelvis (DRG 236). Given the market power of the government programs, on which the majority of healthcare providers rely for revenue, even “private” insurers like Blue Cross or Aetna nearly always take the DRG as their price ceilings.

Add the fact that hospitals can increase their number of beds only if the state government certifies a need. In Michigan, beds can be transferred from one hospital to another belonging to the same organization only within a radius of two miles. Hospitals intending to start, replace or expand certain clinical services such as neonatal intensive care, open heart surgery, cardiac catheterization, lithotripsy, C.A.T. scan, M.R.I., air ambulance, and certain specialized psychiatric services, or those making capital expenditures in excess of $2,352,000 for a clinical service area or $3,528,000 or more for non-clinical service areas, must obtain a Certificate of Need from state government before proceeding.

Any possible economies of scale, which are naturally limited in a service-intensive business, are thus thwarted. Prices being largely fixed by government rules, and hospitals having a capacity fixed by government rules, the only flexibility at all for becoming profitable is in lowering the costs of supplies and of labor.

There is, of course, another way out: lowering the quality of medical services at given reimbursement rates. Hospitals themselves already must absorb the costs of patients staying longer than the time allotted under DRG. This imposes on hospitals a painful choice between financial survival and the medically best treatment of patients. Michigan hospitals have not yet reached that crisis point, but recent government strictures may push them over the edge.

As a result of the passage of the U. S. Needlestick Safety and Prevention Act in November 2000, one major Detroit-area healthcare organization saw the price of IV catheters skyrocket from $0.60 to $1.50 each, and the price of lancets for infants (“heelsticks”) from $500 to $11,000 a year. On another product line, extension sets, the new law costs this business, conservatively, an extra $500,000 a year. Hospitals must produce surpluses for reinvesting in equipment and training in a sector that is subject to rapid change of technology and medical knowledge, and all of this at largely fixed (because government-imposed) revenues.

Is it then not understandable that they try to buy as cheaply as they can? It is practically the only lever their management can still use short of making doctors and nurses spend less time on patients. Hospitals will hardly join a GPO if they do not reap a substantial benefit through cost savings. They are free to exit. Most hospitals buy parts of their supplies through GPOs, and the rest directly from suppliers. Why does government get involved at all?

Healthcare is a sad story. Governments at various levels first regulate healthcare providers by fixing both prices and possible output, and then attempt to dismantle self-help organizations of the industry – all under a guise of antitrust law and corporate ethics. And if hospitals merge in order to profit from any efficiencies larger businesses might still find, the FTC investigates them under antitrust rules. U. S. health care is a case study in policy failure – but not in market failure.

This most recent government incursion on health care is grandstanding and counterproductive at best, and most harmful for patients at worst. No new Hospital Advisory Commission instituted by Michigan’s governor will redress the calamity of overregulation. Politicians at all levels should leave healthcare to the institution that can provide it best: the free market.