Administered Pricing and Vertical Integration in the Hospital Industry

This article investigates the influence of governmental payment mechanisms under the Medicare program on contractual relationships and vertical integration between hospitals and nursing homes. The "prospective payment system," implemented in 1983, created strong incentives for hospitals to reduce costs per admission by shortening average length of patient stays, which in turn created a new dependency of hospitals on nursing homes. In contrast to the bilateral contract negotiations which resolve analogous problems in other industries, the price paid to the nursing home to accept a hospital patient cannot be negotiated between the hospital and the nursing home but is established unilaterally be Medicare. However, Medicare does not determine the implicit transfer price governing patient flows between the hospital and nursing home divisions of vertically integrated health care organizations. The impact of administered pricing on vertical integration is confirmed empirically using 1982-90 data on acute care hospitals and skilled nursing facilities. Copyright 1996 by the University of Chicago.