CBO’s Analysis of Financial Pressures Facing Hospitals Identifies Need for Additional Research on Hospitals’ Productivity and Responses

Posted by
Tamara Hayford
Lyle Nelson
September 8, 2016

Changes in laws and regulations stemming mostly from the Affordable Care Act (ACA) could have significant effects on hospitals’ finances. In particular, the ACA reduces Medicare’s payment updates for hospitals but also expands insurance coverage, which should reduce the amount of uncompensated care hospitals provide. To examine the effects of those and other provisions of federal law, the working paper that CBO released today calculated hospitals’ profit margins and the share of hospitals that might lose money in 2025 under several illustrative scenarios. Because of the substantial uncertainty surrounding the analysis, the paper presented a range of estimates corresponding to different assumptions about how hospitals’ costs might grow relative to their revenues. Those estimates are intended to reflect the financial pressures that hospitals will face in the future but are not a projection of actual outcomes, because Congressional Budget Office was not able to predict how hospitals will respond to those pressures.

Key Findings and Limitations of This Analysis

Our analysis of hospitals’ profit margins incorporates the effects of the cuts in Medicare’s hospital payment updates specified in the ACA, other reductions in federal payments to hospitals specified in the ACA and in other recent laws, and demographic changes (which will put downward pressure on hospitals’ margins as more patients shift from higher-paying commercial insurance to lower-paying Medicare coverage). The analysis also incorporates the effects of the expansion of insurance coverage under the ACA, which will improve hospitals’ finances by reducing the number of patients who are uninsured. The analysis focuses on about 3,000 hospitals that provide acute care to the general population and are subject to the reductions in Medicare’s payment updates; it thus excludes most rural hospitals and all of Medicare’s “critical access” hospitals.

As a starting point, we estimated that the average profit margin of the hospitals included in the analysis was 6.0 percent in 2011 and that 27 percent of them had negative profit margins (in other words, they lost money) in that year. That share may be surprisingly high but is similar to the shares of hospitals with a negative annual profit margin over the past two decades. Although some hospitals have closed over that period, others have opened, overall access to care remains good (as measured by indicators such as service use and hospital capacity), and the quality of care may have improved.

Findings About Profit Margins
Our results indicate that the magnitude of the financial challenges hospitals will face in the future depends crucially on whether and to what extent they can improve their productivity over time—that is, whether they can produce the same output (treatments and procedures) at the same level of quality with fewer inputs. In general, hospitals could use improvements in their productivity to increase the quality of care they provide (and some evidence suggests that they have done so in the past). For this analysis, however, we assumed that increases in hospitals’ productivity would be used instead to limit the growth of their costs.

Using that approach, we projected hospitals’ profit margins under different assumptions about their productivity growth that reflect a range of plausible outcomes, and we obtained the following results:

  • If the hospitals we examined were able to improve their productivity in line with productivity growth in the economy as a whole—by about 0.8 percent per year, on average, through 2025, according to CBO’s estimate—then the share of them with negative profit margins would increase to 41 percent in 2025, and their average profit margin would fall to 3.3 percent.
  • If, instead, those hospitals were able to improve their productivity by 0.4 percent per year, the share of them with negative profit margins would increase to 51 percent in 2025, and their average profit margin would fall to 1.6 percent.
  • If those hospitals were unable to increase their productivity (or to reduce cost growth in some other way), then the share of them with negative profit margins would increase to 60 percent in 2025, and their average profit margin would fall to negative 0.2 percent.

Those findings reflect the fact that Medicare’s payment updates for those hospitals now depend on the overall rate of productivity growth in the economy. The ACA generally specified that their payment update each year equal the estimated percentage change in the average price of hospitals’ inputs minus the estimated growth in productivity in the economy overall. (The ACA imposed additional reductions through 2019 that vary by year but are, on average, smaller than the productivity-related reductions; subsequent legislation has further reduced those payments.) Consequently, if those hospitals were not able to increase their productivity by enough to fully offset those reductions in payment updates—or did not use those productivity gains to reduce the growth of their costs—then Medicare’s payments would not keep pace with their costs of treating those patients, and profit margins for those hospitals would decline (holding all other factors equal).

To hold their aggregate profit margins in 2025 at about the 2011 level of 6.0 percent, the hospitals that we examined would have to increase total revenues (without increasing costs), reduce total costs (without reducing revenues), or achieve a combination of revenue increases and cost reductions. If they can increase productivity at the economywide rate, then the additional growth in revenues or reduction in costs would have to average 0.2 percent per year. If, instead, they are unable to reduce costs through higher productivity, then the additional growth in revenues or reduction in costs would have to average 0.5 percent per year (see figure below). (In our analysis, those changes in revenues and costs applied to all patients, whereas productivity growth had differential effects on Medicare, Medicaid, and private patients—as discussed in the paper.)

Recent data show that hospitals’ margins have continued to increase between 2011 and 2014—contrary to what our calculations would indicate. Hospitals may have responded to the financial pressures we have analyzed by changing revenues and costs, but other factors may have also affected their margins during those years. Because the reasons underlying the recent experience are not known, it remains unclear how difficult it will be for hospitals to maintain their margins over the longer term.

Limitations of This Analysis
At a minimum, the wide range of our results highlights the need for additional research on past and projected productivity growth for hospitals. Another crucial limitation of this analysis, however, is that we cannot account for hospitals’ responses to those financial pressures. Consequently, the calculations are not a projection of what will happen under current law, and we cannot estimate whether access to care or quality of care would suffer as a result, or whether and how spending on health care and the federal budget would be affected by those pressures and responses. In our judgment, there is insufficient evidence from the research literature and other sources to provide a basis for estimating how hospitals would respond or what the effects of those responses would be. In the remainder of this blog post, we highlight areas for additional research that would enhance the capabilities of CBO and other agencies to analyze hospitals’ profitability, their responses to financial pressures, and other factors affecting their finances.

Areas for Additional Research

CBO identified three major areas for future research into hospitals’ productivity and profit margins. The following questions highlight those areas.

How Well Are Hospitals’ Profit Margins Measured?
The estimates and projections of hospitals’ profit margins that CBO developed for this paper—and similar analyses from the actuaries at the Centers for Medicare & Medicaid Services (CMS)—are based on data from cost reports that hospitals are required to submit annually to CMS. Those data are also consistent with financial data summarized by the American Hospital Association. Those sources all indicate that, on average, about a quarter of hospitals lose money in a given year (see figure below). Although those hospitals are more likely to close or be purchased in the future, our analysis of the cost report data revealed that many hospitals are able to continue operating despite having negative margins over multiple years—a result that is somewhat surprising.

Those findings raise questions about whether the available data on hospitals’ costs and revenues are complete and accurate. Although the cost reports are the best source of detailed and publicly available data on hospitals’ finances, only certain fields are audited. If some types of revenues (such as charitable contributions and government transfers) are unreported for some hospitals, profits for those hospitals would be underestimated. Given the importance of the cost report data for assessing the effects of federal policies and other factors on hospitals’ finances, additional analyses to assess the reliability and completeness of the data would be useful. In addition, further analyses could provide insights about how hospitals that appear to be unprofitable are able to remain in operation for extended periods.

How Much Can Hospitals Limit Cost Growth by Improving Their Productivity?
As discussed in the paper, considerable uncertainty surrounds the extent to which hospitals have increased their productivity in the past or could do so in the future—so more research in this area would be especially useful. The main challenge that arises in measuring past productivity for the hospital industry (and for the health care sector more broadly) is accounting for any improvements in the quality of care. Looking ahead, a primary question is whether and to what extent hospitals can use productivity gains to control the growth of their costs.

The evidence base on those questions is limited. Two recent studies have found that the rate of hospitals’ productivity growth has increased over time but has still remained substantially lower than that of the economy as a whole; however, those studies did not account for improvements in the quality of care. By contrast, another recent study found much higher rates of productivity growth over the 2002–2011 period—but only after it accounted for quality improvements. However, that study examined hospital care for only three common conditions. Still other evidence suggests that hospitals may have achieved substantial productivity gains in the past and been able to control their costs in the process. In particular, between 1991 and 2011, Medicare’s payment rates grew about one percentage point more slowly than hospitals’ input prices, and private payments apparently grew at comparable rates (on average), and yet aggregate profit margins for hospitals rose over that period with no obvious deterioration in care quality. Taken together, those findings suggest that, on average, hospitals were able to restrain their cost growth through improvements in their productivity.

As noted by the CMS actuaries in their own projections of hospitals’ profit margins, “behavioral changes by hospitals (for instance, efforts to improve efficiency in lower-performing hospitals) could mitigate some of the impact of the ACA payment provisions, though there is considerable uncertainty regarding these types of changes.” Given the limited available evidence, CBO’s paper presents scenarios that use a range of plausible assumptions about the extent to which hospitals will be able to control their cost growth through improvements in productivity. Additional research and analysis would be useful for understanding the amount of productivity growth hospitals have achieved in the past and whether hospitals will be able to respond to financial pressures in the future by channeling their productivity improvements into reductions in cost growth—and what those developments might imply for spending on, access to, and quality of care.

A related question of interest is whether and to what extent productivity growth may vary across hospitals; for simplicity, and in the absence of other evidence, we assumed that productivity growth would occur at the same rate across all hospitals. But if differences in productivity growth are related to other factors affecting hospitals’ finances, the pressures facing hospitals could differ (in either direction) from the results we have presented.

What Effects Would Other Responses by Hospitals Have?
If hospitals cannot maintain sufficient profit margins by controlling the growth of their costs through improvements in their productivity, they would need to increase revenues or reduce costs in other ways; and if those efforts did not succeed, some hospitals might ultimately be forced to close or merge with another hospital or system. Because the evidence regarding those responses is also limited and sometimes conflicting, more research about them and their effects would be useful.

Increases in Revenues. As discussed in the paper, one way hospitals might increase revenues is by raising prices, particularly for privately insured patients. However, a recent review of the research literature on such cost shifting concluded that the evidence is mixed and that, at most, a small fraction of Medicare’s payment cuts is shifted to private payers through higher prices. More recently, two studies found that, contrary to the cost-shifting hypothesis, reductions in Medicare’s payment rates have led to lower rates for private payers. In that light, it may be difficult for hospitals to offset the reductions in Medicare’s payment updates by raising their private payment rates significantly. However, additional research on this question might still be useful. (The paper discusses several other ways in which hospitals might try to increase their revenues in response to financial pressures.)

Reductions in Costs. Hospitals also could seek to reduce or limit the growth of their costs in various ways. Existing research has found that hospitals have historically responded to financial pressures by reducing costs through the following channels:

  • Reducing the number of staff they employ or their costs per employee,
  • Decreasing other operating expenses,
  • Eliminating or shrinking unprofitable departments, or
  • Curtailing or delaying capital improvements or other investments.

Although such efforts to control costs could reflect hospitals’ attempts to improve their productivity, pursuing cost reductions through those channels might not have the desired result and could have adverse effects on the quality of care hospitals provide or on patients’ access to care. Additional research about such cost-control methods and their effects would thus be useful. One consideration going forward is that hospitals’ payments from Medicare and other insurers may be tied increasingly to measures of care quality (such as readmission rates); whether those payment arrangements will constrain hospitals’ cost-reduction efforts or could limit the resulting improvements in hospitals’ finances merits further analysis.

Adoption of New Payment Models. Another broad approach that hospitals could take to improve their finances is to participate in new payment models, such as accountable care organizations or bundled payments. Such models may allow participating providers to share in the savings if they are able to keep the total costs of care (for a given patient or for a particular episode of care) below a target level. If hospitals participate in those payment models, they might be able to reduce their costs by more than their revenues fall and thus could improve their financial position. However, other providers participating in such models could also seek to generate savings by avoiding or limiting hospital admissions, which could affect hospitals’ finances adversely. It would therefore be helpful if research about such payment models included analysis of their effects on different providers as well as their impact on overall spending and other metrics.

Closures and Consolidations. Finally, if hospitals are unable to respond effectively to the increased financial pressures, some hospitals may close or consolidate with another hospital or hospital system. However, we do not currently have a basis for estimating the share of hospitals that might close or merge with another hospital from simple projections of hospitals’ profit margins. Additional research on the effects of hospital closures and mergers on spending, access to care, and quality of care would be useful, because there is limited evidence available and it has yielded mixed results. Although there is considerable evidence that mergers lead to higher prices for private payers, there is less evidence on the effect of closures. Additional research on the effect of closures on prices and utilization would be useful as well.

Tamara Hayford is an analyst in the Heath, Retirement, and Long-Term Analysis Division at CBO, and Lyle Nelson is a senior adviser in that division.