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Numerous measures designed to control health care expenditures have been proposed or attempted over the years. There has been much controversy, first, whether such controls were necessary; second, which factor leading to increased expenditures was the most significant and therefore should be controlled; and third, whether the controls would do more harm than good. There are several reasons why controls have been an issue. The intervention of government into the affairs of the health care industry have been viewed by some with suspicion. Regulation of any kind has been thought by others to interfere with the "free market" operation of the medical economy and to compromise the independence and freedom of action of the providers that would be affected. Another debate has centered around the issue of whether cost controls would result in a reduced quality of health care. However, the increase in health care expenditures has significantly strengthened interest in examining measures to curb rising health expenditures.

A. Economic Stabilization Program

The Economic Stabilization Program (ESP) was a series of economy-wide wage and price controls which were designed to reduce inflation by about one-half in the economy as a whole. The program began with a freeze on wages and prices in August, 1971 (Phase I). The freeze was replaced in December, 1971 with control programs for each major sector of the economy (Phase II), including health.

For the health care industry, Phase II consisted of a ceiling for hospitals and other institutions of 6 percent per year (adjusted for changes in volume of services) on increases in prices and revenues per inpatient day. In no case could there be more than a 1.7 percent increase in expenditures for new technology, a 5.5 percent increase for non-wage-related expenses or a 2.5 percent increase for wage-related expenses. Noninstitutional providers, such as physicians and dentists, were allowed a 2.5 percent increase per year in their fees.

Phase III, which lasted from January 11, 1973, to June 13, 1973, was an extension of Phase II for many areas of the economy, including the health care industry. On June 13, 1973, another freeze on the prices of all commodities and services began and lasted until July 1, 1973, when it was superseded by Phase IV. Phase IV covered many industries including health until April 30, 1974, when ESP authority expired, and the program ended.

The stated goals of the hospital controls under Phase IV were to reduce the excessive rate of increase in the cost of hospital stays; to moderate increases in new services and to selectively control capital expenditures; to provide economic incentives for the substitution of less expensive ambulatory care for inpatient hospital care; to provide for the development of State, rather than Federal, administration

of health care controls; to allow internal flexibility and incentives for health care managers to improve productivity; and to be responsive to cost-saving innovations, such as health maintenance organizations.

For the health care industry, Phase IV established a limitation of 7.5 percent on increases in hospital charges and costs per inpatient admission, with adjustments for volume of services, and made provision for reimbursing the institution for new operating costs resulting from new and approved capital expansions. Also, a 6 percent increase limit was set for outpatient charges per procedure.

A 4 percent increase limit was placed on medical practitioners' aggregate annual fees, with a 10 percent increase limit for individual fees over $10 and a $1 increase limit for fees under $10. Also, a 6.5 percent increase limit was set for long-term care institutions' average realized revenues per day. This limit was applied separately for the various classes purchasers (e.g. Medicare, Medicaid, all other).

The Phase IV controls differed from Phases II and III in their emphasis on the total cost of a hospital stay rather than the individual price per day. In addition, Phase IV treated separately increased operating costs due to capital expenditures and placed controls on hospital outpatient services.

Before ESP went into effect, the annualized rates of increase in prices of medical care and of hospital charges (semi-private room) exceeded that of prices in the economy as a whole. During the various phases of ESP (August 1971 to April 1974), not only were the rates of increase for medical care and hospital charges reduced, but the rates of increase dropped below prices in the economy as a whole. In the post-ESP period, after the controls were lifted, the rates of increase for medical care and hospital charges rose above the pre-ESP levels and once again exceeded prices in the economy as a whole (see table on Page 8). This temporary effect in lowering prices is due in part to the fact that ESP was a cost containment program which did not attempt to address the underlying problems in the process of health care delivery, some of which are the unusual system of supply and demand where the users of health care usually pay only a small portion of the costs they incur; the maldistribution of manpower; and the high costs of medical and technological advances.

B. Efforts to Limit Reimbursement to Providers

1. Hospitals. Dissatisfaction with rising hospital costs has lead to considerable discussion of and experimentation with new approaches to paying for hospital care. Alternatives to present retrospective cost-based reimbursement systems include many approaches which are frequently described as "prospective reimbursement." The Social Security Administration defines these approaches as "the financial remuneration of health care providers whereby the amount or rate to be

paid is established prior to the period over which the rate is to be applied." The amount or rate to be paid may be determined through a number of methods such as prospective budget review and approval, rate review or rate setting, or the use of formulas to determine rates of payment or to limit payments under current reimbursement practices.

The proponents of prospective reimbursement argue that if a hospital could know its payment rate before it renders its services, it would have more motivation to see that these services were produced in the most efficient manner, since its solvency would depend on keeping its spending within the limits of its anticipated revenues. The hospital would have positive incentives for efficiency as well because, if it could produce its services more cheaply than the predetermined rate allowed, it could pocket all or some of the difference.

follow below:

The major examples of efforts to limit hospital costs

a. Hospital reimbursement limits under Medicare and Medicaid. The 1972 amendments to the Social Security Act authorized the Secretary of Health, Education, and Welfare to establish limits on the costs to be reimbursed under the Medicare program. The Secretary was given broad discretion in the selection of the institutions and kinds of costs to which the limits are applied and in the method of setting the limits.

Under present policy, cost limits are established each year for the routine cost portion of hospital costs--essentially, the cost related to bed and board. Individual hospitals are assigned to groups, depending on the hospital's size and the per capita income of the area where it is located. The cost limit for the hospitals in each group is set by a formula that establishes the limit high enough to permit the routine costs of well over 80 percent of the hospitals to be covered in full.

In FY 1975, the first full year of implementation, approximately 345 hospitals were reported to be in excess of the limit by a total of $35 million. Fiscal year 1976 data are not yet complete, but thus far 334 hospitals have been reported to be in excess of the limit; it is expected the total will increase above the FY 1975 number when all reports are in.

The objective of the cost-limits provision is to establish ceilings that reasonably prudent and cost-conscious hospitals can be expected to live within. By setting the limits in advance, it was intended that high-cost hospitals could, if they wished, undertake cost reduction measures to avoid loss of reimbursement. Where a hospital exceeds the limit and wishes to make up the lost income by imposing a special charge on patients, the patients must be advised of the situation in advance.

b. Federal experimentation and State programs. The Social Security Amendments of 1967 and 1972, and Section 1526 of the National Health Planning and Resources Development Act of 1974, authorize broad programs of experimentation in prospective reimbursement and other alternative reimbursement and rate setting methods. Under its authority, the Social Security Administration evaluated State and local systems which were already operating with Federal funding, and began supporting demonstrations, evaluations, and developmental projects in other States.

Three principal prospective reimbursement methodologies have been identified which are generally used in some combination:

-- Budget review approach, involving setting or approval of reimbursement rates based on a detailed review of the projected budgets of individual hospitals and their departments. This approach is used in Maryland in its rate setting, and is used in New Jersey and Connecticut in combination with a formula approach. Budget review can be done by exception, involving review only of those portions of an institution's budget exceeding established screens.


Formula methods, involving the use of formulas to determine rates of payment, or to determine ceilings or target rates under current reimbursement practices. New York uses a formula approach, and other States use this approach in combination with the other methods.


Negotiated rates, involving joint decision-making by the hospital and the rate setter. Rhode Island uses a negotiated budget methodology.

The Social Security Administration has identified five elements which it believes are essential in a prospective rate setting system:




All hospitals within a given system should submit accounting and reporting data based on uniform systems.

Health planning and rate setting should be closely coordinated.

Prospective rate-setting systems should focus on total hospital expenditures including utilization factors.

Prospective rate-setting systems should cover all payors.

Hospital participation in prospective rate-setting systems should be mandatory.

In addition to evaluations of ongoing activities, the Social Security Administration is funding a number of demonstration and

developmental activities to gather further information on rate-setting systems.

A recent American Hospital Association survey identified rate-regulation programs operating in 25 States, including several Blue Cross prospective reimbursement plans. Budget review was the principal method used but often in combination with other methods. A total of 2,070 hospitals and 1,407 nursing homes participated in the programs surveyed. In addition to the 25 programs currently in effect, the survey identified 13 States as contemplating some form of program.

c. Legislative proposals in the 95th Congress. Two bills were introduced in the 95th Congress which contain provisions to control hospital costs. One was the Carter Administration's proposal (H.R. 6575/ S. 1391), a temporary hospital cost-containment program which establishes a limit on increases in hospital revenues from each class of payor for inpatient services, pending the development of a permanent program. The other, initially introduced by Senator Talmadge (S. 1470/H.R. 7079), proposes a new method of reimbursement for hospital routine operating costs under the Medicare and Medicaid programs by providing incentives to hospitals to keep their costs below the average costs of similar hospitals and by establishing reimbursement ceilings.

2. Physicians. As noted above, the office-based physician takes a number of considerations into account in setting his fees. Factors such as the prevailing fee level in the community or the ability of patients to pay for a given service have served to determine the rate of growth of these fees. With public and private third-party payors assuming greater responsibility for payment of the physician's fee, these implicit constraints have been formalized in fee schedules and reimbursement policies.

Traditionally, the insurer has listed the maximum amounts payable for individual services in a published fee schedule. However, health insurance plans with fixed fee schedules offer no assurance to purchasers that the allowable fees will adequately cover their medical expenses. Some fee schedules, in fact, have fallen far behind prevailing fee levels.

In response to the demand for better protection, insurance organizations developed health benefit plans in the 1960's that set upper limits on the physician fees they would reimburse, but limits that were believed high enough so that a physician's billed charge would be paid in full so long as it met the "usual, customary, and reasonable" (UCR) criteria mentioned above.

The UCR plans developed by Blue Shield have usually set the upper limit on the fees they normally allow at the 90th percentile; so that either 90 percent of the fees being billed in the area are allowed in full or 90 percent of the physicians in the area will have their charges allowed in full. Other plans set their allowable charge limits high enough to satisfy both of the foregoing requirements.

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