In my last blog post I pointed out that larger hospitals responded to Medicare switching its reimbursements for capital costs to a prospective basis by implementing capital budgeting systems. The logic was that, given a fixed payment for capital, they could make more money if they could deliver health care with a more economical capital base. That’s what Medicare intended so the outcome sounds very favorable. After all, won't altering a system that pays for costs by going to one that gives an incentive to economize on capital assets work better?

Well, maybe and maybe not. The system that replaced the cost plus scheme was the DRG scheme. DRG (Diagnosis Related Group) is a payment made for the delivery of a specific hospital treatment or service. The idea, from above, was that Medicare would pay a certain fixed amount for, say, bypass surgery. This would give the hospital an incentive to perform the surgery as economically as possible. Sounds good so far, right? Naturally, Medicare found a way to screw it up.

Instead of allowing beneficiaries to buy private health care with Medicare dollars, Medicare simply determined what the DRG amount would be. Where as large private carriers would have an incentive to negotiate package prices for these services, Medicare uses a neat system of formulas to arrive at the value of bypass surgery in Cleveland or colon surgery in Dallas. I have to admit the methodology is, indeed, impressive. It’s also worthless since no government anywhere can possibly set market-clearing prices. Thus, we have a huge part of the medical system operating under a price control system. Anybody who passed Econ 101 knows that price controls produce shortages, surpluses and a significant deadweight loss on the economy. Any reform of health care needs to do in these price controls.