If we’re serious about reducing U.S. health care spending, then we need to focus on reigning in hospital prices for the same reason that Willie Sutton robbed banks. It’s where the money is. As a result, this post will explore the rapid rise in hospital prices that has occurred in the U.S. over the last 15 years.

When we look at global trends in health care expenditure, it turns out that the strongest predictor of variation in spending across countries (i.e., the factor that explains the variation across the U.S., France, and Germany) is the wealth of the nations. In short, wealthier countries, not surprisingly, spend more on health care. However, the variation in wealth across countries only explains roughly 50 percent of the variation in health care spending, and the U.S. still spends about half a trillion dollars more per year than its gross domestic product alone should explain.

However, once we adjust for wealth, variation in hospital spending is the single largest factor driving the difference in spending across Organisation for Economic Co-operation and Development (OECD) countries. This shouldn’t be terribly surprising either. The U.S. hospital sector is one of the largest industries in the United States. Indeed, it’s a $700 billion dollar industry, and there is twice as much money spent on hospital care than is spent on the purchase of new cars.

So what is driving the U.S. to spend more on hospital care than other nations?

Higher hospital spending in the U.S. could be driven by a host of factors. Perhaps, for example, hospital care in the U.S. was of higher quality, so while Americans were paying more for their care, they were also getting more quality. Likewise, an equally likely scenario could be that Americans are sicker and therefore require more care once they’re admitted to the hospital.

However, analysts at McKinsey came to the conclusion that higher hospital costs in the U.S. are not driven by differences in quality or the relative health of U.S. citizens. Instead, they found that they’re being driven by the differentially higher prices and higher input costs (i.e., doctors’ and nurses’ salaries) in the U.S. relative to what is observed in other nations. This McKinsey-price hypothesis echoes the conclusions of a 2003 study, led by Princeton economist Uwe Reinhardt, titled, It’s the Prices, Stupid: Why the United States is So Different from Other Countries.

Indeed, it turns out that when we examine the change in hospital prices over time and the variation in prices within markets, we see some very worrying trends. Indeed, from 1993 through 2001, U.S. hospital prices rose by 20 percent. Then, from 2001 through 2008, prices rose by over 40 percent. More recently in California from 2005 through 2009, the prices of appendix removals, cesarean delivery and hip replacements rose by 53 percent, 55 percent and 51 percent respectively.

Perhaps what’s even more worrying than the increase in prices over time is the variation in prices across hospitals within markets. Here, we observe that within hospital markets in the U.S., there tends to be between 200 to 800 percent variation in prices for the same procedure. These are worrying numbers for an economist. They suggest that the market for hospital care in the U.S. is ailing tremendously and is badly in need of improvements.

There are three possible explanations for this rise in prices over time and variation in prices across markets.

The first explanation is that these changes in price reflect improvements in care. So, for example, during this period of rapid price increases, hospitals could have made commensurate improvements in their clinical quality or improved their facilities. Indeed, there is some evidence that newly passed requirements for earthquake preparedness actually led to increases in prices.

However, it is unlikely that quality improvements explain all (or anywhere close to the majority) of the price increases. Here, most of the medical conditions that have had the steepest price increases (i.e., cesarean sections) are fairly routine, and have not changed dramatically over the last five years. Likewise, these increases in prices are visible across various states, which are each subject to different regulatory requirements (i.e., most hospitals that saw price increases did not need to increase their earthquake preparedness).

A second potential explanation for the increases in price is cost-shifting. This is a topic I discussed in an earlier post (http://healthpolicyforum.org/post/will-hospital-cost-shifting-blunt-impact-medicare-payment-reform). Here, the cost-shifting hypothesis suggests that falling Medicare and Medicaid reimbursement rates have prompted hospitals to raise prices more for privately funded patients.

While there are a number of proponents of this cost-shifting hypothesis, most economists dispute whether it is a realistic phenomenon and the extent to which it could be contributing to the overall rise in prices. Economists argue that for cost-shifting to occur, hospitals would have had to have been leaving money on the table in the past and not setting prices appropriately high. Nevertheless, with Medicare and Medicaid reimbursement rates set to fall over the next decade, it is going to be important for us to more fully consider the potential for and implications of cost shifting.

A third potential explanation for the rise in hospital prices is the huge consolidation that has occurred in the U.S. hospital industry over the last 15 years. During this period, hospital markets have become about 33 percent more consolidated and the average number of hospitals in a market has reduced from six to four. Right now, the majority of U.S. hospital markets are rated as ‘highly concentrated’ by the Federal Trade Commission. Indeed, while it’s difficult to estimate, the notable research in this area has found that hospital consolidation can dramatically raise prices, inducing increases of between 10 to 40 percent.

To be sure, chronic disease management is important, but if we’re serious about slowing health care spending, we need to continue to focus on hospital care. Hospital prices are increasing substantially faster than inflation and it’s clear that the U.S. hospital market is approaching dysfunction. Whether policymakers adopt a more regulatory approach, like an all-payer system or a more typically market oriented approach, like introducing reference prices for hospital care, it is clear that if we ignore rising hospital prices, it is at our peril.