Vertical Integration and Optimal Reimbursement Policy

Health care providers may vertically integrate not only to facilitate coordination of care, but also for strategic reasons that may not be in patients' best interests. Optimal Medicare reimbursement policy depends upon the extent to which each of these explanations is correct. To investigate, we compare the consequences of the 1997 adoption of prospective payment for skilled nursing facilities (SNF PPS) in geographic areas with high versus low levels of hospital/SNF integration. We find that SNF PPS decreased spending more in high integration areas, with no measurable consequences for patient health outcomes. Our findings suggest that subjecting integrated providers to higher-powered reimbursement incentives, i.e., less cost-sharing, may enhance medical productivity. More generally, we conclude that it may be efficient for purchasers of health services (and other services subject to agency problems) to consider the organizational form of their suppliers when choosing a reimbursement mechanism.