Hospital efficiency driven by price-setting

by Stephen Duckett

Published by The Australian, Wednesday 8 January 2014

In her recent column on health system sustainability, (The Weekend Australian, Dec 21-22) Judith Sloan conflates a system of administered prices for hospitals with “central planning” and assumes that best practice cannot be spread – or perhaps even achieved – in such a system.

Quoting from a piece written by economist Ludwig von Mises in the 1940s, she derides the whole prospect that setting prices could encourage efficiency. Economics has developed since then and there is now a body of theory on how to create efficiency incentives in regulated industries.

The role of the Independent Hospital Pricing Authority, her particular focus, is to establish the “National Efficient Price” for public hospital services. As Sloan notes, it currently does that by examining the distribution of costs for each type of care (say a hip replacement) and establishes the average cost as a fair and reasonable amount that ought to be paid to hospitals for providing that sort of care. There are minor adjustments to account for the additional costs associated with treating people from remote communities, indigenous people and for a handful of other factors.

Establishing a “National Efficient Price” sends a clear signal to hospitals about their relative efficiency. State hospital funding policies now generally follow a similar path designed to ensure that those hospitals that cost more than a state efficient price bring their costs down.

This system, now known as activity based funding, was introduced in Victoria 20 years ago under the Kennett Liberal government, spread to South Australia a year later and is now being rolled out nationally. From July, the commonwealth government will pay extra money to states for increases in hospital activity, but those payments will be based on the assumption that all the increased activity occurs efficiently. The additional payments will be paid at the “National Efficient Price”.

Market pricing, advocated by von Mises and Sloan, cannot work where there is no market.

Our shared commitment to equity has led Australians to vote time and time again for public hospital care to be provided outside a crude market. From an economist’s point of view, the next best thing is to introduce market-like mechanisms, not acting on consumers – because of the equity implications – but acting on providers, using price signals to drive efficiency.

This is where the “National Efficient Price” comes in. It was introduced as part of national health reforms endorsed by state and federal governments to increase the efficiency of the public hospital system. Sloan is right that setting the price at the average may introduce distortions, but not necessarily because of the “years of distorted decision-making” that have led to current practice. Setting the price at the average of current practice implicitly assumes that all those costs above average could be justified and ought to be averaged into the new price. But a far bigger challenge to average cost pricing comes from its acceptance that poor care ought to be rewarded.

The average cost includes the costs of adverse events that occur in hospital. It includes both the cost of the necessary treatment for which a person was admitted, and the cost of fixing anything that went wrong. The price established by the Independent Hospital Pricing Authority currently is based on that average, including elements of good and bad care.

An alternative approach is to set prices that exclude the incremental costs of adverse events. Hospitals with more than the average rate of adverse events would be penalised, hospitals with fewer would be rewarded. This would make it easier for advocates inside hospitals to mount a “business case for quality”, adding economic grounds to clinical ones to ensure good safety systems are in place to reduce the incidence of adverse events.

Activity based funding may not be perfect, but it is the best efficiency driver we have, consistent with ensuring equitable access to public hospital care. In the absence of the efficiency incentives that a properly administered system of price setting creates, the health system will become more expensive, putting further pressure on system sustainability.