Senator DOLE. I understand, Mr. Secretary, that Senator Talmadge has no further questions and I have no further questions.

We deeply appreciate your apperance. You may be excused. I will go over and vote.

We will stand in recess until Senator Talmadge returns. I look forward to seeing you again.

Secretary CALIFANO. I am sure that you will, Senator.

[The prepared statement of Secretary Califano follows:]

STATEMENT BY SECRETARY JOSEPH A. CALIFANO, JR., DEPARTMENT OF HEALTH, EDUCATION, AND WELFARE

Mr. Chairman, I appreciate the opportunity to appear before this distinguished Subcommittee on Health to discuss S. 1470, the proposed Medicare-Medicaid Administrative and Reimbursement Reform Act.

By introducing this legislation, you continue the Finance Committee's tradition as thoughtful critic and powerful force for reform in this nation's health care system.

Your Committee's concern with development of a comprehensive health care policy for all Americans-especially for those who are poor, or aged or disabled— dates to the 1930's and the original maternal and child health program.

Since then, you have been instrumental in health care innovation and policymaking with such measures as vendor payment programs supporting medical assistance to the poor and aged in the 1950's and early 1960's; the development and expansion of Medicare and Medicaid; and the design of other landmark health programs including Professional Standards Review Organizations.

Last session, the Finance Committee, through this Subcommittee, again provided leadership in identifying serious problems and devising needed reforms in the nation's health care system.

In less than six months in office, we in the new Administration have moved to support or to implement the most urgent of those reforms.

First, in the 94th Congress, you introduced legislation to remedy serious problems created by fraud and abuse in the Medicare and Medicaid programs. You recognized that fiscal integrity and sound management practices must characterize these programs if they are to enjoy the trust and cinfidence of the American people.

This year the fraud and abuse legislation has been introduced separately in both Houses of Congress, with strong endorsements from the President and from me. That legislation should soon pass the House and we look forward to the opportunity to urge its passage in the Senate.

Second, your health care reform legislation in the 94th Congress proposed establishment of an Inspector General for Health within the Department of Health, Education, and Welfare. That proposal-expanded so that the jurisdiction of the Inspector General includes all programs of HEW-became law last year, and we have acted quickly to implement it. The new Inspector General, Tom Morris, and Charles Ruff are men of superb qualifications who have been moving swiftly to organize this office and to begin the vital work of reducing fraud and abuse in HEW's programs, especially in the Department's health programs.

Third, you have proposed, both last session and in the present MedicareMedicaid Administrative and Reimbursement Reform Act, that the health care financing functions of the Department be consolidated into a single administrative structure.

President Carter endorsed this concept early in the presidential campaign. As you know, less than sixty days after assuming office, I effected this much needed reorganization through administrative action. As I noted at the time of the reorganization, we are deeply indebted to the work of this Subcommittee, and to the illuminating hearings that you held last year on the problems of health care financing.

We have high expectations for this element of the Department's reorganization. The Health Care Financing Administration should significantly improve the effectiveness, efficiency and responsiveness of Medicare and Medicaid by coordinating the policy and practices of the two programs and by eliminating, or reducing, unnecessary and costly duplication in their operations. By joining

these programs under one administrative structure, we should also realize important economies through reduction of fraud, abuse and leakage.

Under the leadership of Robert Derzon, one of this nation's outstanding hospital administrators, we are trying to make HCFA operational as soon as possible. In the short term, we must take the separate Medicare and Medicaid functions and employees and weld them into a cohesive unit.

We believe that the structure presently contemplated is an appropriate first step in the development of a sound HCFA organization that will be fully content with the intent of your health care financing proposal. At this time, it is essential that we continue to have fiexibility to adapt organizational structure to the programmatic needs that emerge from practical, day-to-day experience. We do not, therefore, believe that legislation establishing HCFA is necessary to achieve the desirable goals of consolidating Medicare and Medicaid administration.

HOSPITAL REIMBURSEMENT AND HOSPITAL COSTS

Mr. Chairman, there is another problem identified in the proposed legislation that the Administration views as being of the greatest urgency-the methods by which hospitals are reimbursed for services provided to Medicare and Medicaid beneficiaries and the skyrocketing increases in hospital costs that are caused, in substantial part, by present reimbursement methods.

I would like to devote much of my remaining testimony to this fundamental issue because it is a matter of signal importance and because the President has proposed legislation, the Hospital Cost Containment Act of 1977, that also addresses the problem. As you noted when introducing S. 1470, the Administration bill is a transitional measure that complements the long-term, structural reform contained in the Medicare-Medicaid Administrative and Reimbursement Act.

As this Subcommittee knows well, the Medicare and Medicaid programs presently reimburse hospitals for reasonable costs incurred in providing services to program beneficiaries. This retrospective payment method has proven to be highly inflationary because reimbursement simply covers rising hospital costs, however unnecessary or wasteful those costs may be. By reimbursing hospitals for most incurred costs, this method provides virtually no incentives for efficiency. As this Subcommittee also knows well, this method of reimbursement-which also applies in other health programs-has contributed to rampaging inflation in the hospital industry (which constitutes 40 percent of health care costs). If we take no action now, total health expenditures will double between 1975 and 1980; hospital costs paid by Medicare and Medicaid will double even sooner: total hospital spending could reach $220 billion by 1986; and the share of the federal budget that goes to hospitals will rise steeply above the present 9 cents of every Federal dollar.

Section Two of S. 1470 would establish a prospective reimbursement system for hospitals participating in Medicare and Medicaid. In essence, this is accomplished by classifying hospitals according to bed-size and type and by establishing prospective limits on per diem routine operating costs for hospitals in that group.

We believe that the concepts underlying Section Two of the proposed legislation are sound and another testament to this Subcommittee's foreight: reimbursement of hospitals must be shifted from retrospective to prospective: prospective limits on hospital costs should be based on different types of hospitals; and these limits should encourage efficiency and penalize inefficiency. These concepts, as the President has stated, must clearly be part of meaningful reform. But, although we support the concepts underlying Section Two's hospital reimbursement requirements, let me share with you some of the difficulties we have with that provision as presently drafted.

First, the provision applies only to Medicare and Medicaid payments, which constitute about one-third of hospital spending nationwide. Holding down Medicare and Medicaid payments alone could simply encourage hospitals to refuse these patients, to provide such patients with second-class care, or to transfer their costs to other payors.

Second, we do not yet have adequate data or methodologies to classify hospitals according to relevant cost-based characteristics-and such a classification is, of course, necessary for a sound long-run prospective reimbursement system.

Although Section Two significantly improves on the present method of classifying hospitals-which is required under Section 223 of the Social Security Amendments of 1972-by using local wage base data as an important variable, we simply do not have such data at present for most localities in the United States.

A sound classification system should take into account not just bed size and types of hospitals (as proposed in the bill) but also the types of patients in hospitals of equivalent size and type. Obviously a 200 bed short term general hospital with a large fraction of obstetrical patients will have different costs than a 200 bed short term general hospital with a large fraction of cardiac patients. Unfortunately, we presently lack the methodology to classify hospitals by types of patient (i.e. by the type of diagnostic patient case mix).

Similarly, the bill proposes that "teaching" hospitals constitute one of three "types" of hospitals (along with short term general and speciality hospitals). Again, we presently lack an agreed upon methodology for determining whether, and to what extent, an institution is a "teaching hospital."

We do not believe that these are insurmountable barriers to a sound prospective reimbursement classification system, and we look forward to working with you to develop such a system. But these difficulties are real obstacles in the short term.

Third, and related to the point immediately above, Section Two only covers about 35-40 percent of present hospital costs and does not include such critical expenditures as capital costs, education and training costs, malpractice insurance expenses, energy costs, and so-called "ancillary costs" (e.g. the costs for expensive operating rooms or high-priced x-ray machines). Hospitals may be able to circumvent Section Two's restraint on a limited proportion of their costs by shifting costs to other, uncovered areas (e.g. ancillary costs) or by increasing the lengths of patient stays.

Fourth, we seriously question whether a specific classification system should be actually written into a statute. Even when we are able to devise an adequate classification system for prospective hospital reimbursement, we will be continually refining our data and methodologies. Flexibility should be built into the statute to allow for improvements without additional legislation.

Fifth, Section Two does not place a limit on actual increases in hospital costs over time, but instead bases its limits on the average costs for types of hospitals. Thus, if all hospitals increase their costs substantially from one year to the next, this provision would permit reimbursement to rise accordingly.

Finally, Section Two, while pointing the way towards sensible changes in reimbursement techniques, will not, in our judgment, effectively control costs in the immediate future. Indeed, our preliminary, relatively conservative estimates indicate that Section Two could cost up to $50 million more in 1978-even if it could be fully implemented-than the present cost limiting provision already in law. Not only could Section Two add as much as $50 million to President Carter's fiscal year 1978 budget, but its costs appear to increase with time-to approximately $55 million in fiscal year 1979, $64 million in fiscal year 1980, and $75 million in fiscal year 1981. If modifications could be devised to meet the difficulties discussed above, however, then we would expect substantial long-term savings from Section Two.

For these reasons, Mr. Chairman, I share your views that the President's proposed Hospital Cost Containment Act of 1977 is complementary to S. 1470. The Administration's cost containment proposal is a transitional program, designed to restrain the intolerable current rate of increase in hospital costs and to gain the time necessary to work out some of the difficulties that we see in the present version of Section Two's hospital reimbursement reforms.

As you know, the President's bill limits increases in total hospital inpatient revenues to an annual rate of about nine percent, beginning in October 1977. The program would cover the inpatient revenues of about 6,000 acute care and speciality hospitals, but exclude long-term, chronic care and new hospitals.

The basic limit would be set by a formula reflecting general price trends in the economy with an increment for increases in services. Each cost-based third party payor would apply the limits in interim and final payments, and would monitor hospitals for compliance with respect to its own subscribers.

Under present estimates, the savings resulting from implementation of the Hospital Cost Containment Act would be approximately $1.9 billion in fiscal year 1978 including $657 million in Medicare and Federal Medicaid and $879 million in private funds. By fiscal year 1980, net savings would nearly triple to over

$5.5 billion, including $2.0 billion in Medicare and Federal Medicaid and $2.6 billion in private funds.

Thus, Mr. Chairman, as you stated on May 5, 1977, when introducing S. 1470, the Medicare-Medicaid Administrative and Reimbursement Reform Act "represents a long-term basic structural answer to the problem of rising hospital costs, whereas the Administration is calling for a short-term interim cap on revenues to be in place only until a long-term solution can be established." We recognize that our proposal is only a short-range measure, but it is no less necessary for being short-term and can serve the critical function of simply, quickly and effectively curbing the intolerable rise in hospital costs.

While I will not attempt to describe the Administration's cost containment proposal in any great detail at this time, Mr. Chairman, I would like to take this opportunity to respond to several specific questions and concerns you expressed about the Administration proposal in your statement introducing S. 1470.

You expressed concern that the administration proposal might establish a floor rather than a ceiling.

But I do not believe that hospitals will increase their revenues to the 9 percent allowable limit under our program. Experience with the Economic Stabilization Program indicates that a substantial fraction of hospitals kept costs and revenues within the limits imposed and did not automatically increase them to the maximum extent allowable. Similarly, approximately one-fifth of all hospitals now voluntarily keep their cost increases below 9 percent annually even though they are not required by law to do so. Moreover, under our plan, we have included provisions which would reward those hospitals coming in below the limit in any given year.

Mr. Chairman, you also indicated some concern that our exceptions are excessively generous.

We believe that we have restricted exceptions to only those conditions genuinely meriting some flexibility. There are only two basic grounds for exceptions— major changes in patient loads (more than a 15 percent increase in admissions) and major changes in new capital facilities or equipment. In both cases local health systems agencies would have to approve exceptions. The hospital would also have to demonstrate that it had current assets less than approximately twice its current liabilities, and therefore was in need of additional revenue to make those major changes.

We also permit an optional adjustment for increases in wages of nonsupervisory employees. Wages have not been the driving force in hospital costs increases. Historic trends in hourly increases have been 7.2 percent for hospital nonsupervisory workers for the past six years. Even assuming that these wages should increase at a rate of 9.5 percent, the allowable revenue limit would be increased by less than a percentage point. This provision is important to protect low-wage hospital workers from any adverse impact of cost constraints.

You also expressed some reservation about our program's differential impact on efficient and inefficient hospitals.

We do not believe our program penalizes efficient hospitals. Efficient low-cost hospitals should not need increases greater than 9 percent. It is true, however, that our program does not eliminate all of the waste and inefficiency in the system. As I indicated earlier, one of the major technical deterrents to doing so is the lack of an adequate classification system for distinguishing efficient and inefficient hospitals. But our plan would penalize those inefficient hospitals whose costs are currently rising at a greater than 9 percent rate, and put us in much better position to ferret out remaining inefficiency in a long-term solution along the lines you have proposed.

Furthermore, the Administration proposal does build in a number of rewards for hospitals which choose to become more efficient :

Hospitals that close unnecessary facilities or eliminate duplicative equipment would have revenues for these services retained in the base (if the HSA approved discontinuance of these services). Thus, the hospital would be permitted a greater than 9 percent increase on remaining services.

Hospitals that work with their medical staffs to eliminate unnecessary tests, admissions, or days of stay would be permitted higher allowable revenue per unit of service since our limit is on total revenue increases.

Mr. Chairman, you also indicated some concern about starting with a transitional cost containment program and then moving to a longer-term system. As noted, we feel strongly that the problem of rising costs is of such disastrous pro

portions that we simply cannot wait for a perfect solution before acting. It is important, however, to provide for an orderly evolution. We have designed our transitional program so that it will be compatible with a number of more fundamental structural reforms of reimbursement methods, including the type of incentives for improved efficiency contained in your bill.

Finally, I would like to respond to one other query about the administration's program-namely, that any slowing of the rate of increase in hospital costs can only be achieved by lowering the quality of patient care.

Mr. Chairman, your Subcommittee has contributed significantly to our understanding that more is not always better in the health care system. Unnecessary medication, hospitalization, testing, and surgery can be positively harmful to health and can constitute poor health care policy. Our program provides a strong economic incentive for hospitals to work with Professional Standards Review Organizations to curtail this unnecessary utilization. Unlike the current cost reimbursement system, our program would reward the hospital which chooses to reduce the length of patient stay or reduce unnecessary admissions.

Both Title I and Title II of our plan would provide strong incentives for hospitals to reduce unnecessary specialized facilities. For example, studies have shown that to maintain minimum standards of quality, a cardiac center should perform four to six cardiac operations weekly. Over 80 percent of all hospitals performing cardiac surgical procedures do not meet this requirement. In fact, an independent study of a Massachusetts hospital were 49% of open-heart surgery patients died during the period 1968-1975-an unusually high death rate-concluded that an inadequate number of open-heart operations at the hospital, and the resultant inexperience of the cardiovascualr team, contributed to the poor results. The Administration's proposal can help eliminate underutilized cardiac care facilities, promote regionalization, and thus improve patient care.

Another area where substantial cost savings would be achieved with an actual improvement in quality of patient care is inhalation therapy. Mr. Chairman, your staff has alerted the nation to alarming improper professional practices in this area. One study indicates that approximately $500 million could be saved by eliminating those inhalation therapy procedures which are of dubious benefit. In sum, with the help of this Subcommittee, we have identified over $5 billion in savings that can be achieved without harming patient care. A "fat list" of those wasteful or unnecessary items which could be trimmed back without affecting quality of care is appended to my statement.

For these, and for other reasons that I will hopefully detail before this Subcommittee when it considers the Hospital Cost Containment Act of 1977, we believe that the Administration proposal is a necessary precursor to the major, structural hospital reimbursement reforms set forth in S. 1470.

HOSPITAL CAPITAL CONSTRAINTS

The legislation you have introduced also contains important provisions for dealing with the problem of over-capitalization in the hospital industry. The Subcommittee's concern with elimination of unnecessary hospital beds, as reflected in Section 3 of S. 1470, and with strengthening sanction against institutions which provide services with unapproved capital facilities or equipment, as reflected in Section 4, is shared by the Administration.

In the Hospital Cost Containment Act of 1977, we have addressed these concerns in a slightly different fashion. We, too, are convinced that it is important to restrict Medicare, Medicaid, and Maternal and Child Health payments not only for the depreciation expenses of unapproved capital expenditures, but also for their associated operating expenses. Besides limiting the dollar amount of certificates of need that can be issued within each State, the provisions of our bill would use a ratio of $10 of operating expenses for every $1 of depreciation expenses in estimating the relevant operating expenses to be disallowed.

We would also encourage the closing, modification, or conversion of underutilized hospital beds by several methods. The Administration proposal permits hospitals to retain any discontinued beds, services, or facilities approved by the HSA in their revenue base. It also prohibits net additional bed investment in areas which are already overbedded.

I hope my staff can explore with yours the most effective and appropriate methods of eliminating unnecessary hospital capacity.