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DO NONPROFIT HOSPITALS BEHAVE DIFFERENTLY THAN FOR-PROFIT HOSPITALS?

Hospitals initially cared for the poor, the mentally ill, and those with con- tagious diseases, such as tuberculosis. Many hospitals were started by religious organizations and local communities as charitable institutions.

More affluent patients were treated in their own homes. Things began to change with the development of ether in the mid-1800s, which allowed operations to be conducted under anesthesia. By the late 1800s, antiseptic procedures began to increase the chances of surviving surgery. The introduction of the X-ray machine around the beginning of the twentieth century enabled surgeons to become more effective by improving their ability to determine the precise loca- tion for the surgery, and some exploratory surgery was eliminated.

Because of these improvements, hospitals became the physician’s work- shop. Similarly, the type of patients served by the hospital changed. Hospitals were no longer places in which to die or be incarcerated, but rather places in which paying patients could be treated and then returned to society. The development of drugs and improved living conditions reduced the demand for mental and tuberculosis hospitals, and the demand for short-term general hospitals grew.

The control of private nonprofit hospitals also changed. As more of the hospital’s income came from paying patients, reliance on trustees to raise philanthropic funds declined. Physicians, who admitted and treated patients, became more important to the hospital. Because they were responsible for gen- erating the hospital’s revenue, physicians’ control over the hospital increased.

Most hospitals in the United States are nonprofit, either nongovernmental institutions or controlled by religious organizations. Together, these are referred to as private nonprofit hospitals. As exhibit 15.1 shows, the ownership of the majority of hospitals (2,849 of the 4,850 hospitals in 2016) is voluntary, mean- ing private nonprofit. In 2016, 956 state and local government and 199 federal hospitals were in operation. Investor-owned (for-profit) institutions accounted for 1,035 hospitals. Together, private nonprofit and for-profit hospitals admitted 83.5 percent of patients (68.5 percent and 15.0 percent, respectively).

The main legal distinctions between nonprofit and for-profit hospitals are that nonprofits cannot distribute profits to shareholders, and their earnings and property are exempt from federal and state taxes. They also may receive donations.

Since the mid-1980s, when managed care competition started, debate has ensued over whether nonprofit hospitals are really different from for-profit

15

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Health Pol icy Issues: An Economic Perspect ive236

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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 237

hospitals. The issues surrounding this debate center on the following questions: Do nonprofits charge lower prices than for-profits? Do nonprofits provide a higher level of quality than for-profits? Do nonprofits provide more charity care than for-profits? Or, as some critics of nonprofits maintain, is there no difference between the two other than the tax-exempt status of nonprofits’ surpluses? If the latter position is correct, is continuing nonprofit hospitals’ tax advantages and government subsidies justified? Alternatively, if nonprofits provide more charity care and higher-quality service and charge lower prices, will eliminating for-profits enable nonprofits to better serve their communities?

Why Are Hospitals Predominantly Nonprofit?

Several hypotheses have been offered to explain the existence of nonprofit hospitals. The most obvious is that when hospitals were used predominantly as institutions to serve the poor, they depended on donations for funding. However, the possibility of receiving donations does not explain why the majority of hospitals continue to be nonprofit. Donations account for a small percentage of hospital revenue. As public and private health insurance became the dominant source of hospital revenue, the potential for profit increased, as did the number of for-profit hospitals.

Although both public and private insurance have increased, many people remain uninsured. Some believe that only nonprofit hospitals provide uncom- pensated care to those who are unable to pay. Nonprofit hospitals presumably are willing to use their surplus funds to subsidize both the poor and money- losing services.

A related explanation is the issue of trust. A relationship based on trust is needed in markets in which information is lacking. Patients are not sure what services they need. They depend on the provider for diagnoses and treatment recommendations, and they are not knowledgeable about the skill of the sur- geon. The quality of medical and surgical treatments is difficult for patients to judge, and they cannot tell whether the hospital failed to provide care to save costs. In such situations, patients are more likely to rely on nonprofit provid- ers, believing that because they are not motivated by profit, they will not take advantage of a patient who lacks information and is seriously ill.1

Another explanation for the predominance of nonprofit status is that the hospital’s managers and board of directors want to be part of a nonprofit hospital, where their activities are subject to limited community oversight. The managers and board have greater flexibility to pursue policies that reflect their own preferences, such as offering prestigious but money-losing services even if these services are provided by other hospitals in the community.

Furthermore, nonprofit hospitals are in physicians’ financial interest. Being associated with nonprofit organizations allows physicians to exercise

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Health Pol icy Issues: An Economic Perspect ive238

greater control over the hospital’s policies, services offered, and investments in facilities and equipment. In a for-profit hospital, physicians have less money avail- able for facilities and equipment of their choosing, because surpluses must be distributed to shareholders and the government through payment of dividends and taxes. The hospital’s physicians also benefit from the hospital’s ability to receive donations and from the trust placed in the hospital by the community.

The importance of trust, the provision of community benefits, and the financial interests of physicians appear to be key reasons for the nonprofit status of hospitals.2

Performance of Nonprofit and For-Profit Hospitals

For-profit hospitals have a more precise organizational goal—namely profit— than do nonprofit hospitals. A concern of any organization is monitoring its managers’ success in achieving the firm’s goals. In a for-profit firm, the objec- tive is straightforward, and the shareholders have an incentive to monitor the performance of managers and replace them if their performance is lacking.

A nonprofit firm has multiple objectives, making it more difficult to monitor its managers. The various stakeholders of the nonprofit hospital— medical staff, board members, managers, employees, and the community—have different and sometimes conflicting objectives as to how the hospital’s surplus should be distributed. Should profits be used to subsidize the poor, increase compensation for managers, raise wages for employees, establish prestige facili- ties, or provide benefits (e.g., low office rent and resources) to medical staff? The board of directors has less incentive to monitor a nonprofit hospital, as it has less financial interest in the hospital’s performance and must rely on the managers for information about achieving the hospital’s multiple goals. Furthermore, if the nonprofit hospital is not performing efficiently, it may be able to survive on community donations.

Given the differing goals and incentive-monitoring mechanisms of for- profit and nonprofit hospitals, it is important to examine how the behavior of nonprofits differs from that of for-profits.

Pricing For-profit hospitals attempt to set prices to maximize their profits.3 Do nonprofit hospitals set lower prices than for-profit hospitals? Three aspects of hospital pricing shed light on how nonprofit hospitals set prices.

Many people believe that nonprofit hospitals set prices to earn sufficient revenues to cover their costs. Nonprofits set prices for private insurers that are below their profit-maximizing prices, but raise those prices when the gov- ernment lowers the price it pays for Medicare or Medicaid patients. For cost

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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 239

shifting to occur, a hospital (1) must have market power—that is, be able to profitably raise its price and (2) must decide not to exploit that market power before the government reduces its price. (A more complete discussion of cost shifting is provided in chapter 18.)

Evidence of hospital cost shifting is based on data from before the mid- 1980s (before managed care competition). With the start of intense price com- petition among hospitals, insurers became more sensitive to the prices charged by hospitals. Hospitals’ market power declined because insurers were willing to shift their volume to hospitals offering lower prices. Any ability of nonprofit hospitals to shift cost disappeared with hospital competition for managed care contracts. Instead, as the government reduced the prices it paid for Medicare and Medicaid patients, hospitals experienced greater pressure to lower their prices to be included in an insurer’s provider network.

Second, the pricing practices of nonprofit hospitals regarding uninsured patients have received a great deal of media publicity recently. Large purchasers of hospital services (e.g., health insurers, Medicare, Medicaid) receive deep discounts from a hospital’s billed charges—often as high as 50 percent. Unin- sured patients were asked to pay 100 percent of the hospital’s billed charges. Newspaper articles have described the hardship faced by many patients who do not have the resources to pay their hospital bills. Several lawsuits were filed on behalf of the uninsured against nonprofit hospitals because the hospitals charged the highest prices to those least able to pay and hounded patients for unpaid debts. These lawsuits (several of which have been settled by hospitals) claimed that nonprofit hospitals violated their charitable mission by overcharging the uninsured and sought to have these hospitals’ tax-exempt status revoked. The pricing practices of nonprofits with respect to the uninsured appear to be no different from those of for-profits. (New federal rules for hospitals have modified their pricing practices for the uninsured [Pear 2015].)

Third, do nonprofit hospitals increase prices if they merge with other nonprofit hospitals? The number of hospital mergers has grown in recent years. Consolidation of for-profit firms or hospitals in a market causes concern that competition will decline, enabling the hospitals to raise prices. Would a merger of nonprofit hospitals similarly result in higher hospital prices, or are nonprofit hospitals different?

In early court cases in which the merger of nonprofit hospitals was con- tested by federal antitrust agencies, the presiding judges ruled that nonprofit mergers are different from for-profit mergers. The judges believed that nonprofit mergers were unlikely to result in price increases—even if the hospitals acquired monopoly power—because the boards of directors are themselves local citizens and would not take advantage of their neighbors. Empirical studies, however, contradict the judges’ belief that nonprofit ownership limits price increases after a merger (Capps and Dranove 2004; Melnick, Keeler, and Zwanziger 1999).

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Health Pol icy Issues: An Economic Perspect ive240

Researchers found that nonprofits with great market power charge significantly higher prices than do nonprofits in competitive markets. These results suggest that some nonprofit hospitals merge simply to increase their market power and to negotiate higher prices with managed care plans. This type of behavior is no different from the behavior expected of for-profit hospitals.

In October 2005, the Federal Trade Commission (FTC) won an antitrust suit against nonprofit Northwestern Healthcare for a previously consummated hospital merger. The FTC claimed that a hospital merger that occurred in 2000 violated federal antitrust law because the newly created three-hospital system sufficiently boosted its market power to illegally control hospital prices in its market. The FTC’s decision was upheld on appeal, and the system hos- pitals were ordered to negotiate independently with insurers, rather than have Northwestern Healthcare divest itself of one hospital, as the initial decision recommended.

Mergers of nonprofit hospitals are no longer likely to be viewed as dif- ferent from mergers of for-profit hospitals (Morse et al. 2007).

The FTC (2006) claimed that, as a result of the merger, Northwest- ern Healthcare used its postmerger market power to impose huge price increases—40 to 60 percent and, in one case, even 190 percent—on insurers and employers.

Quality of Care Sloan (2000) reviewed several large-scale empirical studies of quality of care received by Medicare beneficiaries in nonprofit and for-profit hospitals. The studies examined various measures of quality, such as the overall care process and the extent to which medical charts showed that specific diagnostic and therapeutic procedures were performed competently. The studies assessed dif- ferent hospital admissions (e.g., hip fracture, stroke, coronary heart disease, congestive heart failure) and outcome measures (e.g., survival, functional status, cognitive status, probability of living in a nursing home). The study findings showed that teaching hospitals performed better; however, no statisti- cally significant differences were found between nonteaching private nonprofit hospitals and for-profit hospitals.

In an extensive study, McClellan and Staiger (2000) compared patient outcomes for all elderly Medicare beneficiaries hospitalized with heart disease (more than 350,000 per year) in for-profit and nonprofit hospitals between 1984 and 1994. McClellan and Staiger (2000, 4) found that

[o]n average, for-profit hospitals have higher mortality among elderly patients with

heart disease, and . . . this difference has grown over the last decade. However, much

of the difference appears to be associated with the location of for-profit hospitals.

Within specific markets, for-profit ownership appears if anything to be associated

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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 241

with better quality care. Moreover, the small average difference in mortality between

nonprofit and for-profit hospitals masks an enormous amount of variation in mortal-

ity within each of these ownership types. Overall, these results suggest that factors

other than for-profit status per se may be the main determinants of quality of care

in hospitals.

Charity Care Nonprofit hospitals have a long tradition of caring for the medically indigent. They were given tax-exempt status and community donations in the belief that they would provide charity care. However, the advent of price competition in the mid-1980s changed their ability to provide the level of charity care some believe is necessary to justify their tax-exempt status. Researchers have exam- ined the extent of charity care provided in terms of (1) hospital conversions (a nonprofit becomes a for-profit) and (2) the effect of greater competitive pressures from managed care.

Concern has arisen that once a hospital converts to for-profit status, its charity care will decline as the profit motive becomes dominant. Various studies, however, have found no difference in provision of uncompensated care once a hospital converts from nonprofit to for-profit status. Norton and Staiger (1994) found that for-profit hospitals are often located in areas with a high degree of health insurance (Medicare, Medicaid, and private). However, once differences in location are accounted for—such as by examining nonprofit and for-profit hospitals in the same market—no difference was found in the volume of uninsured patients treated by the two types of hospitals.

Price competition is expected to negatively affect a nonprofit hospital’s ability to provide charity care by decreasing the “profits” or surplus available for such care. As competition reduces the prices charged to privately insured patients, profits decline and, thus, fewer funds are available for charity care. Gruber (1994) found that increased competition among hospitals in California from 1984 to 1988 led to decreased revenues from private payers, decreased net income, and, consequently, less provision of uncompensated care. David Walker (2005), the-then comptroller general of the United States, stated that in four of the five states studied in 2003, state and locally owned hospitals provided an average of twice as much uncompensated care as did nonprofit or for-profit hospitals. In Florida, Georgia, Indiana, and Texas, nonprofits delivered more uncompensated care than did for-profits, but the difference was small. In California, for-profits delivered more uncompensated care than did nonprofits. In a study of uncompensated care in five states, the Congres- sional Budget Office (2006, 2) found that the cost of uncompensated care as a percentage of hospital operating expenses was much larger in government or public institutions (13 percent) than in nonprofit (4.7 percent) or for-profit (4.2 percent) institutions.

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Health Pol icy Issues: An Economic Perspect ive242

Individual nonprofit and for-profit hospitals, however, varied widely in the amount of uncompensated care they provided. Capps, Carlton, and David (2017) compared the provision of charity care between nonprofit and for-profit hospitals under different competitive conditions. They found that when both types of hospitals achieve greater market power, the amount of charity care or unprofitable services provided is not increased. Both types of hospitals exhibit a similar response to financial incentives.

Overall, competitive pressures result in lower income available for charity care in nonprofit and for-profit hospitals, whereas public hospitals experience higher uncompensated care costs.

The Question of Tax-Exempt Status

Nonprofit hospitals have received tax advantages that obligate them to serve the uninsured. Nonprofits, however, vary greatly in the amount of care they provide to the uninsured. In some cases, the value of the hospital’s tax exemp- tion exceeds the value of charity care provided. Consequently, it has been proposed that, in return for their tax-exempt status, nonprofit hospitals should be required to deliver a minimum amount of charity care.

If the tax exemption is to be tied to the value of charity care or com- munity benefits, the measure to be used and the amount of care to be provided must be defined. The following are proposed possible measures:

• Pure charity care: care for which payment is not expected and patients are not billed

• Bad debt: value of care delivered and billed to patients believed to be able to pay, but from whom the hospital is unable to collect

• Uncompensated care: the sum of bad debt and charity care • Medicaid and Medicare shortfalls: the difference between charges and

the amount reimbursed by Medicare and Medicaid • Community benefits: the previous items plus patient education,

prevention programs, medical research, and provision of money-losing services (e.g., burn units, trauma centers)

Deciding which definition should be used and what percentage of a nonprofit hospital’s revenue should be devoted to that measure is an important public policy issue being debated by state and federal governments. For example, if the charity care definition is used, is the amount of free care measured by the hospital’s full charges (which few payers actually pay) or the lower prices a health maintenance organization would pay? Further, using the broadest

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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 243

definition of community benefits may result in a hospital’s delivering no charity care but relying instead on Medicare and Medicaid shortfalls and some com- munity prevention programs, which also may be viewed as a marketing effort by the hospital.4 If such a broad definition were used, little difference would be found between many nonprofit and for-profit hospitals.

Many states have begun to engage in limited monitoring of the uncom- pensated care provided by nonprofit hospitals (see, for example, Day 2006; Reece 2011). Stringent requirements have not been imposed on hospitals to maintain their tax-exempt status. Included as part of the Affordable Care Act is the requirement that nonprofits conduct and submit a community needs assessment, after which their progress toward meeting those needs will be measured every three years. Those nonprofits that achieve little or no progress toward meeting the identified needs in their community will risk losing their tax-exempt status. Nonprofits also are required to ensure that their patients are aware when free or discounted care is available. These conditions are less severe than requiring nonprofits to spend a given percentage of their surplus on charity or uncompensated care.

Summary

In examining whether the behavior of nonprofit hospitals is different from that of for-profit hospitals, one must keep in mind that wide variations in behavior exist within both types of hospitals. Although little difference has been found between ownership type in pricing behavior, quality of care delivered, or even the amount of uncompensated care provided, these comparisons are based on averages.

As price competition among hospitals increases, ownership differences become less important in determining a hospital’s behavior regarding pricing, quality of care, and even charity care. In a price-competitive environment, nonprofit and for-profit hospitals must behave similarly to survive; nonprofits will have a smaller surplus with which to pursue other goals.

Ideally, the poor and uninsured should not have to rely on nonprofit or for-profit hospitals for charity care. Expanding health insurance to the unin- sured—either through private insurance refundable tax credits or Medicaid—will more directly solve the problem of providing care to the medically indigent. As more people obtain some form of coverage, the tax-exempt status of many nonprofit hospitals is likely to be questioned. Although certain nonprofits, such as teaching hospitals, will continue to provide care to those who remain uninsured, the majority of nonprofit hospitals will have to justify their role in society.

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Health Pol icy Issues: An Economic Perspect ive244

Discussion Questions

1. Discuss the differences and similarities among theories on why many hospitals are nonprofit.

2. Do you agree with the ruling by a federal judge that mergers of nonprofit hospitals should not be subject to the same antitrust laws as mergers of for-profit hospitals?

3. How has price competition affected the ability of nonprofit hospitals to achieve their mission?

4. What conditions should be imposed on nonprofit hospitals to retain their tax-exempt status?

5. In what ways, if any, are nonprofit hospitals different from for-profit hospitals?

Notes

1. The trust relationship between the patient and provider, however, applies more strongly to the patient–physician relationship. The physician diagnoses the illness, recommends treatment, refers the patient to specialists, and monitors the care the patient receives from different providers. Yet, physicians practice on a for-profit basis.

2. An additional explanation for the existence of nonprofit status is that the stochastic nature of the demand for medical services requires hospitals to maintain excess capacity for certain services. It can be very costly for patients if they cannot access hospital care when needed. For- profit hospitals, some believe, would be unwilling to bear the cost of idle hospital capacity. Further, certain hospital services (e.g., emergency departments; trauma centers; neonatal intensive care units; and teaching, research, and care for certain groups [such as drug addicts] that benefit the community) generally lose money and would otherwise not be provided.

3. Lakdawalla and Philipson (2006) claimed that the traditional for- profit analysis of a firm can be used to explain nonprofit hospitals, but with a lower cost structure because of their nonprofit status. The type of services a hospital chooses to offer (in addition to the pricing strategy) will also affect its profitability. Horwitz and Nichols (2009) found that nonprofit hospitals’ services vary according to the relative market share of nonprofit, for-profit, and government hospitals in a market. Nonprofits in markets with high for-profit market share were more likely to offer relatively profitable services and less likely to offer

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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 245

unprofitable services compared with nonprofits in markets with low for- profit penetration.

4. Young and colleagues (2013) surveyed nonprofit hospitals to determine how much they spent on Internal Revenue Service–defined measures of community benefit. They found that hospitals spent, on average, 7.5 percent of their operating expenses on community benefits. On average, more than 85 percent of these expenditures went toward patient care, and almost 50 percent of the 85 percent was used to supplement the low prices paid by government for services provided to Medicaid and other means-tested patients. Community benefit spending not related to patient care was devoted to community health improvement activities and health professions education. Only 1.9 percent of the study hospitals’ operating expenditures was spent, on average, on charity care.

References

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Capps, C., and D. Dranove. 2004. “Hospital Consolidation and Negotiated PPO Prices.” Health Affairs 23 (2): 175–81.

Congressional Budget Office. 2006. “Nonprofit Hospitals and the Provision of Com- munity Benefit.” Published December. www.cbo.gov/sites/default/files/cbo files/ftpdocs/76xx/doc7695/12-06-nonprofit.pdf.

Day, K. 2006. “Hospital Charity Care Is Probed.” Washington Post. Published Septem- ber 13. www.washingtonpost.com/wp-dyn/content/article/2006/09/12/ AR2006091201409.html.

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McClellan, M., and D. Staiger. 2000. “Comparing Hospital Quality at For-Profit and Not-for-Profit Hospitals.” In The Changing Hospital Industry: Comparing Not- for-Profit and For-Profit Institutions, edited by D. Cutler, 93–112. Chicago: University of Chicago Press.

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Morse, M., B. Kevin, R. McCann, and L. Bryant Jr. 2007. “Federal Trade Commission Finds Evanston Northwestern Healthcare Merger Unlawful but Orders ‘Separate and Independent Negotiating Teams’ Rather Than Divestiture.” Published August 17. www.lexology.com/library/detail.aspx?g=a1132f 5c-4483-41e5-a31d-dc832f51f1ea.

Norton, E., and D. Staiger. 1994. “How Hospital Ownership Affects Access to Care for the Uninsured.” RAND Journal of Economics 25 (1): 171–85.

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