The Recent Rise In Health Care Inflation

In Medicare and Medicaid, which make up about 20% each of total U.S. health care spending, the prices paid by insurers are set either at the state (Medicaid) or federal (Medicare) level. Furthermore, recent research has shown that a substantial fraction of the private market follows Medicare prices.[3] As many of the prices paid by insurers to providers are either administratively set by Medicare and Medicaid or follow prices that are administratively set, price evolution in health care services has been influenced substantially by changes in policy over the last decade.

Understanding the evolution of prices paid to providers by Medicare is particularly important to understanding trends in health care service prices, given Medicare’s importance in market-wide price determination. The two largest components of total payments made by Medicare to providers are inpatient hospital (approximately 50%) and physician (approximately 20%) payments. As the bulk of the recent rebound in health care inflation has come through hospital prices, I focus here on the determination of prices paid by Medicare to hospitals.

While the fine details of price determination in Medicare’s Prospective Payment System (PPS) are quite complicated, at its core the system is straightforward. The starting point for determining how much Medicare pays providers is a base level of payment. This number is then adjusted based on a patient’s diagnosis (to take into account that some services are much more difficult and resource intensive than others), as well as the patient’s geographical location (to take into account that inputs are more expensive in some areas than others).

The factors that determine the evolution of Medicare prices over time come from two sources. The first is annual adjustments made by the Centers for Medicare and Medicaid Services (CMS) to the base payment level to account for changes in the costs of inputs. These adjustments are called “market basket updates," and are strictly formulaic. For hospitals, the most important component of the market basket update is the Employment Cost Index’s (ECI) measure of the rate of change to hospital wages and benefits; the ECI directly accounts for about 70% of the price index used to adjust hospital base payments rates.

The second component of Medicare hospital price evolution comes in the form of legislated adjustments, which are either added or (mostly) subtracted from the market basket update to determine the final payment updates. The first panel of figure 2 plots the update to Medicare hospital payments that was made after legislated adjustments, the initially proposed market basket update, and the difference. The requirements of various pieces of legislation, such as the American Taxpayer Relief Act (ATRA) of 2012 and the Affordable Care Act (ACA) of 2010, mean that the final payment update may bear little relation to the original market basket update.

2. Annual initial and effective Medicare payment update to hospitals

Annual initial and effective Medicare payment update to hospitals

Note: Does not include sequestration cuts from the Budget Control Act of 2011.

Source: Author’s calculations from CMS Hospital Inpatient Prospective Payment System (IPPS) final rules, fiscal years 2011 - 19.

Long-term factors

Health care services inflation was high during the early 2000s and then dropped sharply in late 2010. This drop reflects cuts to Medicare payments included in the ACA, which came into effect in fiscal year 2011. The second panel of figure 2 decomposes the difference between the effective update and the market basket update into components of specific pieces of legislation, the most important of which are various cuts required by the ACA. These cuts to Medicare hospital payment rate updates have been in effect every year since 2011, and while some components will eventually expire, the largest component (the “multi-factor productivity" adjustment) is set to continue indefinitely under current law.

These legislated cuts to Medicare payment growth can be an important restraining force on overall health care inflation, to the extent that the evolution of Medicare prices has both a large direct and indirect effect on overall health care prices - and one that will remain in place for the foreseeable future under current law. After the Medicare cuts from the Affordable Care Act were phased in, health care inflation dropped precipitously (figure 1). Inflation remained stable at the new lower level for several years, until prices were hit by a series of one-time policy shocks discussed in the next section. If we take the average inflation level over this stable period (the dashed line in figure 1) and consider this to be the post-ACA “new normal," we have just now returned to this level after years of very low inflation numbers.

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Disclaimer: Opinions expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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