The Art of Negotiation: Hospitals and Managed Care

The rising cost of healthcare is an ongoing concern for policymakers. Many observers in academia and the media have focused on insurance companies, doctors’ decisions, or the incentives to over-care in the system. In a recent paper, Mergers When Prices are Negotiated, Gautam Gowrisankaran, Aviv Nevo, and Robert Town use a game theoretical model as well as insurance claims data to examine the role of negotiations between Managed Care Organizations (MCOs) and hospital systems in setting prices for medical services.

Many employers who insure their workers delegate the management of their insurance pool to MCOs, which then negotiate with hospitals the terms of care and prices. Medicaid and Medicare, which together insured 30 percent of the population in 2009, use their market power to pay some of the lowest reimbursement rates to doctors and hospitals. Because of their large market share, MCOs similarly have more bargaining power than an individual employer, but hospitals may also merge to gain market power in negotiations.

The researchers construct a model of this dynamic, using a two-stage game where the MCOs and hospital systems negotiate a set of prices, after which an insured patient chooses a hospital based on the price incentives available to her. MCOs want to provide care at the lowest cost, consumers want the best and most convenient care subject to price incentives, and hospitals seek to maximize revenue. MCOs use price incentives to drive patients to lower-cost facilities, but insured patients often pay only a small share of their medical costs, weakening the effect of prices on their decisions. Critically, this model implies that the relative bargaining power of MCOs and systems of hospitals will affect prices; hospital systems that can corner a geographic market will be able to negotiate higher prices for medical services.

The authors use detailed administrative data to test their model in the context of a potential hospital merger in Northern Virginia between 2003 and 2006. They use administrative claims data from four large MCOs to determine the amount paid to hospitals under these claims as well as the demographic characteristics of patients. This data also includes the amount paid out-of-pocket from patients, which is important for constructing effective price sensitivities. The authors also use patient discharge data from Virginia Health Information, which provides data on the condition and demographics of every patient admitted to the hospitals of interest during the time period examined. Finally, data on hospital size and market concentration comes from the American Hospital Association Guide.

The 11 hospitals in the dataset varied greatly in size, type of patients admitted, and costs. The most expensive had base prices 36 percent higher than the most economical. Five belonged to INOVA Health Systems, which collectively had a dominant market share with 64 percent of all discharges. The patient choice model found that prices did affect patients’ decisions, but a 10 percent increase in prices would only yield a one percent fall in admissions for most hospitals. The bargaining model shows that MCOs are able to negotiate prices down and increase sensitivity of demand for hospital services to prices. The presence of MCOs increases effective sensitivity to prices in the market by constraining the ability of hospitals to set artificially high prices, thus finding a middle point between pure monopoly pricing and a situation where consumers pay all their own costs. For instance, the authors use their model to estimate the effect of the dominant INOVA hospital chain acquiring the smaller Prince William’s hospital. They find that this merger would raise prices by over three percent at both INOVA and rival hospitals, part of which is ultimately transferred to consumers.

This study shows that healthcare policy must take into account the relative bargaining power of hospitals, MCOs, and patients. When hospitals have market power and patients have insurance, the often-maligned Managed Care Organizations may play a critical role in moderating the ability of hospitals to set prices far above costs. Policymakers ought to carefully consider how to include MCOs in healthcare reform and how government programs like Medicare can continue to perform similar functions in negotiations with hospitals. 

Feature Photo: cc/(Alex Proimos)