The Restructuring of the Hospital Services Industry

By Reardon, Jack; Reardon, Laurie | Journal of Economic Issues, December 1995 | Go to article overview

The Restructuring of the Hospital Services Industry

Reardon, Jack, Reardon, Laurie, Journal of Economic Issues

As policymakers debate various health care proposals, the pace of structural change among hospitals is accelerating principally via mergers and acquisitions. This paper, after documenting the reasons for structural change, will empirically investigate the current structure of the industry.

The Current Merger Movement in Historical Perspective

Prior to 1870, hospitals were nonprofit institutions serving the poor, the homeless, and the insane [Starr 1982, 144]. Medicine was practiced outside of the hospital by peripatetic physicians attending patients at their home; hospitals served those without resources to pay for the services of a physician.(1)

During the period 1870-1910, hospitals were transformed from the periphery of health care to the center [Starr 1982, 144]. Several reasons account for this transformation [Temin 1988, 80-83]. First, improvements in hospital technologies and new surgery techniques made hospital visits more palatable for patients (and less life threatening). Second, the newly developed germ theory of disease created a need for doctors to work in laboratories in order to diagnose and treat disease. Third, increased urbanization divorced medical care from the home and led to an increased demand for hospital services by the urban middle and working class.(2)

Prior to this transformation, hospitals were nonprofit, operated either by religious denominations, charitable lay boards, municipal governments, or the federal government. As new surgery techniques made surgery profitable, and as the need for physicians to establish professional control over their work environment became more pronounced, proprietary hospitals - managed and operated by physicians for a profit - began to develop [Starr 1982, 157-165]. By 1910, 56 percent of the hospitals in the United States were proprietary [Starr 1982, 219].

The proprietary hospital was small and relied exclusively on the fee-paying middle and upper classes. Over time, however, proprietary hospitals dwindled in number and importance as they were typically converted to nonprofit organizations by their owners. By 1946, only 18 percent of the total hospitals were proprietary [Starr 1982, 219].

In 1945, Congress passed the Hill-Burton Act, which provided federal funds (and matching state and local funds) for the construction of new hospitals and the repair of aging hospitals. The Hill-Burton Act was successful in increasing the number of beds per capita [Temin 1988, 90]; however, it delayed consolidation in the industry since less economical hospitals were provided funds to continue operating [Starr 1982, 351].

The passage of Medicare/Medicaid in 1965 set in motion the forces responsible for the current merger wave. Desperate to win the support of the medical establishment for the passage of Medicare/Medicaid, the federal government promised a generous Medicare reimbursement policy on the basis of cost - to be determined by the hospital - and surrendered direct control of Medicare to Blue Cross and Blue Shield [Starr 1982, 375]. In addition, the federal government allowed hospitals to be reimbursed for a reasonable rate of return on equity capital and also allowed for depreciation to be calculated on the basis of current replacement cost rather than historical cost [Stevens 1989, 296-7].

Under such generous reimbursement conditions, it became very difficult for a hospital not to make a profit [Gray 1991, 33]. To take advantage of the new profit-making opportunities, investor-owned (IO) hospitals developed. Similar to the proprietary hospital, the objective of the IO hospital is to make a profit; however, unlike the proprietary hospital, the IO is largely owned by outside investors.

During the 1970s and the early 1980s, the profits of IO hospitals were relatively high-a dollar invested in an IO returned nearly 40 percent more in earnings than the average for all other industries [Stevens 1989, 337]. High profits facilitated the attainment of both debt and equity in the financial markets at a time when philanthropy and government aid grants to hospitals were declining. …

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