How Regulators Can Increase Price Competition in Health Care

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Scholars urge regulators to help level the playing field in contracting between health plans and hospitals.

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California is losing ground in the battle against rising hospital costs.

Once a successful model for controlling health care spending, the state is struggling to maintain price competition in its health care markets. According to researchers at the University of Southern California and the University of Illinois at Chicago, state regulatory decisions and hospital consolidation appear largely to blame.

The scholars—Glenn Melnick, Katya Fonkych, and Jack Zwanzigerfind that the regulation of access to emergency hospital services and the increase in multihospital systems, in which numerous hospitals are controlled by a central organization, have eroded the necessary conditions for price competition. These developments, explain Melnick and his coauthors, have made it more difficult for health plans to negotiate lower prices for their members and to exclude higher-cost hospitals from their networks.

As the birthplace of one of the earliest prepaid health plans in the nation early in the twentieth century, California has a long history of encouraging innovation in health plans. The state’s early adoption of managed care policies in the 1980s contributed to its success in controlling health care costs during the 1990s, write Melnick and his coauthors. Managed care plans help control health care costs, in part, by selectively contracting with smaller networks of health care providers where individuals covered by the health plan can receive care at negotiated lower rates.

But narrower networks and limited choice prompted a backlash by consumers. Patients and employers feared that managed care policies compromised access to health care, particularly emergency care, according to Melnick and his colleagues.

In response, California began regulating access to hospital emergency care. The “prudent layperson” rule, adopted in 1999, allows health plan members to go to the nearest emergency room and mandates that plans pay for the care provided—even if the hospital is out-of-network. In addition, the rule allows hospitals to bill health plans at higher rates than the prices in a negotiated contract.

Melnick and his coauthors explain that the prudent layperson rule means that hospitals still receive a portion of their local market’s medical emergencies, regardless of whether the hospital negotiated a contract with the health plan. For those out-of-network patients, the hospitals can and do charge above-market prices. The ability to charge high fees for a proportion of local emergencies gives hospitals significant leverage when contracting with health plans, argue Melnick and his colleagues. The rule makes it expensive for a health plan to exclude a local hospital from its network, and gives hospitals the ability to walk away from a negotiation and still get above-market rates for a portion of local medical emergencies.

Another response to managed care in California has been hospital consolidation, Melnick and his coauthors write. As providers competed for managed care contracts on price, some hospitals left the market, others merged, and some grew into multihospital systems. Notably, the expansion of multihospital systems likely included the addition of hospitals in different geographic markets, write Melnick and his colleagues. Because antitrust enforcement typically looks at limited geographic markets, this type of market consolidation over large areas generally falls outside the scope of laws that protect consumers by ensuring the existence of competition, write Melnick and his coauthors.

Consolidation in California has given hospital systems significant leverage when contracting with health plans, assert Melnick and his coauthors. Some hospital systems, for example, started requiring that their contract with a health plan cover all the hospitals in the system—known as all-or-nothing contracting. This contracting strategy is anticompetitive and drives up prices, argue Melnick and his colleagues. For example, a health plan may want to exclude a certain hospital because it is more expensive or provides lower-quality care than a local competitor. If the hospital is a member of a system that engages in all-or-nothing contracting, however, the health plan may have no ability to contract selectively.

Melnick and his coauthors offer several regulatory approaches for leveling the playing field and increasing competition in health care markets in order to lower prices.

First, states could make reimbursement for out-of-network emergency services less lucrative. Melnick and his coauthors suggest that regulators could limit what plans are required to pay for emergency services without requiring the patient to pay the difference, such as by capping fees at a fixed percentage of what Medicare pays for the service. Alternatively, payment could be linked to the negotiated, contract price of the service in the local market. These approaches would prevent hospitals from billing at above-market rates for emergency services, making it less expensive for a health plan to exclude a hospital from its network.

Second, antitrust regulators could expand their analysis to include hospital consolidations occurring across markets, rather than focusing on the impact in local markets. Melnick and his coauthors argue that it is especially important to adapt regulatory oversight in this way because hospital systems add hospitals in different geographic markets, which increases their leverage when contracting.

Finally, California lawmakers proposed a bill, SB-538, that sought to limit anticompetitive contracting practices in negotiations between health plans and large hospital systems. The bill was recently withdrawn, but Melnick and his coauthors point to such legislation as an option for eliminating all-or-nothing contracting. SB-538 would have prohibited hospital systems from requiring plans to include all its member hospitals in the contract.

These regulatory approaches and policy options could help to restore competitive conditions in California’s health care markets, write Melnick and his coauthors, allowing the state to once again control rising health care prices.

Melnick and his colleagues’ paper appears in the journal Health Affairs.