The Efficiency Incentives of Medicare's Rural Hospital Flexibility Program

Rationale: The Medicare Prospective Payment System (PPS) contains incentives for hospitals to improve efficiency by placing them at financial risk to earn a positive margin on services rendered to Medicare patients. Concerns about the financial viability of small rural hospitals led to the implementation of the Medicare Rural Hospital Flexibility Program that allowed facilities designated as Critical Access Hospitals (CAH) to be paid on a reasonable cost basis for inpatient and outpatient services. We compare the performance of CAH hospitals with non-CAH rural hospitals to examine the effects of payment incentives on cost-inefficiency. Methodology: Because it was important to control for variations in quality, the study was restricted to hospitals in 34 states that supplied administrative data (from which quality indicators were derived) to the Agency for Healthcare Research and Quality (AHRQ) Health Care Cost and Utilization Project (HCUP). The final analytical file included 267 CAHs and 521 non-CAH rural hospitals that reported complete data in 2004. We merged hospital-specific data from data files compiled by the American Hospital Association, the Center for Medicare and Medicaid Services, and county-level data from Solucient. Quality indicators came from the application of the AHRQ Quality Indicator (QI) software to HCUP data. We used the Battese-Coelli simultaneous stochastic frontier analysis model to estimate cost-inefficiency. The model included standard cost function variables such as admissions, outpatient visits, non-acute care patient days, and prices of capital and labor; as well variables for case-mix, service-mix and quality. Inefficiency-effects variables were used to represent a variety of internal and external environment pressures for efficiency including ownership, competition, and payment policies. Statistical tests indicated it was appropriate to: 1) estimate separate cost-inefficiency frontiers for CAH and non-CAH rural hospitals; 2) use a Cobb-Douglas cost function; and 3) assume a half-normal distribution for the inefficiency component of the residual. Results: The average estimated cost inefficiency was greater in CAHs (15.33%) than in other rural hospitals (11.29%). We also found that CAHs exhibited poorer values for a number of proxy measures for efficiency of patient management (average length of stay), facility utilization (occupancy rate), and labor productivity (FTE employees per outpatient adjusted admission). Non-CAH rural hospitals had a negative and significant (p < 0.01) correlation between cost-inefficiency and operating margin while CAH facilities did not. Conclusions: Consistent with expectations, rural hospitals, under a prospective payment regime, had less cost-inefficiency and better values for performance measures than CAH facilities under a cost-based reimbursement system. Further, inefficient rural hospitals tended to suffer financial consequences for their poor performance while CAH facilities did not. This highlights an important policy question - can we assure the viability of hospitals and provide incentives for efficiency at the same time?