Rate Regulation Revisited:
Managing Regulatory Failure

and Regulatory Capture in
Health Care

 

OCTOBER 2022

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7 S
NOT

 
ABSTRACT

Concern over high and rapidly rising hospital prices has increased interest in government
regulation of health care prices. However, regulation of health care faces two potential weak-
nesses: regulatory failure (intrusive regulations that can increase an industry's cost both directly
and by reducing incentives to improve operating efficiency, pursue innovation, or address
equity and disparities) and regulatory capture (regulators serving the interests of the regulated
industry rather than the public interest). To investigate the threats posed by regulatory failure
and capture and to identify approaches that can minimize or ameliorate the effects of these two
phenomena, we conducted a review of published literature and consideration of past regulatory
strategies and structural features. We found that although the dangers of regulatory failure and
capture are real, they are manageable. The use of structural features that protect the indepen-
dence of regulatory agencies, coupled with development of fully transparent pricing systems
that are not overly complex, can help prevent or reduce the incidence of regulatory capture and
failure.

INTRODUCTION

Health care markets in the United States are characterized by various forms of so-called market
failure. Of all the imperfections in U.S. health care markets, one of the most important is the
consolidation of health care providers, particularly hospitals and health systems, which has
created noncompetitive conditions and given provider entities unprecedented levels of market
power to negotiate monopoly prices."

Due to the presence of market failures, particularly provider and insurer concentration, commer-
cial health care markets do not work efficiently, and prices are far higher than either the average
or marginal cost of production. Research shows that these dynamics are primarily responsible
for the rapid growth of commercial prices and spending in recent years, which has greatly erod-
ed the affordability of health care for individuals and households in recent decades.' The failure
of the market for health care services invites some form of government intervention.

While empirical evaluations of rate regulatory systems have shown that these approaches

can successfully constrain health care price growth and meet other policy objectives,*" many
economists are wary of such government intervention because of concerns that rate regulation
is vulnerable to regulatory failure and regulatory capture, which can create further inefficiencies
and market distortions that are not in the public interest.® Others point to a range of strategies
for minimizing the occurrence of these phenomena. States should adopt less complex, less
interventionist, and more targeted rate regulatory approaches to minimize regulatory failure and
institute structural remedies to help prevent regulatory capture.

Milbank Memorial Fund e www.milbank.org 2
REGULATORY FAILURE

The concept of regulatory failure is associated with the idea that, even if a particular
marketplace experiences market failure to some extent, government rate regulation may
make matters worse rather than better.®

Regulatory failure may include:
e alack of responsiveness by the regulating agency to changing market conditions,

* excessive complexity of regulatory methods that hampers the ability of the regulated
industry to respond to the incentives and achieve the goals of the regulated system,

e regulatory rules or incentives that result in industry performance that is not consistent
with the public interest, or

e the promulgation of regulations or governmental policies that result in prices that are
too high or low and/or widely varying prices.'

These circumstances, which are particularly prominent in the U.S. health care system, can
result in suboptimal allocations of resources and outcomes across the regulated industry.®

An example of regulatory failure in health care occurred in the New York Prospective Hospital
Reimbursement Methodology (NYPHRM) system (the first state-based hospital all-payer
rate-setting system in the nation), which was in place from 1971 to 1995. The state's rate
methods were dominated by a need to reduce Medicaid deficits, resulting in regulators
setting rates and annual rate updates at very low levels. This led some of the state's most
prestigious and critical hospitals to the brink of financial ruin in 1977 and 1978.8

During its latter years, NYPHRM was considered incomprehensibly complex, having un-
dergone five different legislative overhauls.'° When a regulated price system is both very
complex and modified frequently, and particularly when these changes are initiated and
influenced by powerful members of the regulated industry (an example of how regulatory
failure can contribute to regulatory capture), the rate-setting agency comes to be viewed as
arbitrary and politically driven rather than an unbiased policymaker that prioritizes the public
interest."Indeed, the methodology of the all-payer systems in New York became so complex
in the late 1980s that only a small group of regulators and hospitals fully understood it."

Another form of regulatory failure, which was prevalent in Washington State's failed attempt
to operate an all-payer hospital rate-setting system, is a regulatory agency's tendency to
micromanage the regulated entities and the entire regulatory process. While Washington's
enabling legislation was nearly identical to a statute adopted in Maryland, the two states
differed dramatically in how regulators chose to operate their systems, with Maryland opting
for a system that used well-understood formulas to update rates more or less automatically
each year. The Maryland system also attempted to minimize regulatory intrusions and regula-
tory micromanagement by focusing regulatory intervention only on outlier institutions (e.g.,
hospitals that deviated significantly from the cost standards established by the Maryland
Health Services Cost Review Commission[HSCRC)]).

Milbank Memorial Fund e www.milbank.org 3
By contrast, Washington's system relied on an excruciatingly detailed and highly contentious
annual budget review and approval processes for each hospital in establishing rates for each
year. Even though the approved annual updates provided by the Washington rate commission
were extremely generous and the rate of inflation in hospital costs in the state exceeded the
national average over the period of the regulation, the hospital industry was antagonistic
toward the regulatory system and in 1989 managed to bring it to an end. Such antagonism is
an almost inevitable outcome of a system of overly intrusive regulation. Excessively detailed
rate-setting interventions inappropriately substitute the judgment of regulators for the judg-
ment of hospital administrators regarding key resource allocation decisions and thus tend to
antagonize administrators who feel their authority is being undermined.* Such microman-
agement activities cause a regulator to lose sight of the larger goals of a regulatory system,
which is to meet its primary policy goals while minimizing the level of regulatory intervention.

REGULATORY CAPTURE

Although regulatory failure is perceived in the U.S. as a more pervasive phenomenon than
regulatory capture, much of the literature on rate regulation contains descriptions and
assessments of regulatory capture, along with prescriptions to help prevent or mitigate

its deleterious effects. Regulatory capture is the process through which regulated entities
successfully influence and even manipulate government agencies to enact policies that
advance their own special interests over the interests of the broader public. The motivation
for the capture of the regulatory agency is an industry's desire to use the regulatory process
as a vehicle for charging higher prices, restricting output, raising profits, raising executive
salaries, and/or protecting itself from competitors."

The most radical version of the regulatory capture theory posits that regulation is proposed
and supported by regulated industries as a mechanism for supplanting competition with

a legal, enforceable cartel.' Often-cited examples of this extreme form of capture are the
much-maligned Interstate Commerce Commission (ICC), which worked to protect the railroad
industry, and the Civil Aeronautics Commission, which was alleged to have set airline prices
and restricted entry such that the major airlines were against deregulation of the industry in
the late 1970s.'7"8

In health care, instances of regulatory capture are often associated with the influence of the
American Medical Association's Relative Value Scale Update Committee (RUC), which has
been criticized for enabling specialty medical societies to dominate Medicare's development
of physician payment levels to favor physician specialists and proceduralists."

Other examples are the all-payer hospital rate regulatory agencies in New York, New Jersey,
Massachusetts, and Maryland, which, after experiencing some early successes in containing
hospital price and expenditure growth in the late 1970s and early 1980s, came under signifi-
cant political pressure by hospital leaders to relax their cost constraints. This pressure led
to methodology changes that allowed hospital rates and revenues to increase more rapidly in

Milbank Memorial Fund e www.milbank.org 4
the late 1980s and early 1990s, which contributed to large increases in hospital profitability
during this period."

The Maryland hospital rate-setting system also shows evidence of some degree of regulatory
capture in recent years. Although the system has met the cost growth targets as required per
the terms of the state's waiver from the national Medicare reimbursement system, regulators
have set rates at levels allowing the hospital industry to generate operating profits hovering
around 8% on regulated services since 2015.7" This level is in excess of hospital profits nation-
ally, which have been at all-time highs in recent years."

PRIMARY TYPES AND CAUSES OF REGULATORY CAPTURE

The literature classifies regulatory capture as either "materialist" capture or "cognitive/
cultural' capture. Materialist capture can result from bribery or so-called revolving doors (the
practice whereby regulators eventually leave government positions to take jobs in the indus-
tries they regulated). Fortunately, cases of bribery are likely infrequent and can be easier to
uncover and punish, and the revolving door phenomenon can at least in theory be addressed
by placing restrictions on the ability of regulatory staff to work for regulated entities for a
period after leaving the agency."

Cognitive capture can be more difficult to detect because it does not require an explicit quid
pro quo between regulators and regulatees. Instead, the implicit prospect of a high-paying
industry job may subtly influence a regulator to favor industry positions and objectives."
Cognitive capture is perhaps the most concerning type of capture and may be more difficult
to prevent. It stems from the nature of personal interactions between members of the
regulated industry and the regulating agency, in which the regulated industry perpetually
attempts to persuade the regulator to adopt or modify existing methods that promote the
industry's financial interests. This type of capture is a function of both the way in which these
regulators and regulatees interact (e.g., in public or in private) and the frequency of their
interactions." It can also come as a result of an imbalance in the knowledge and expertise
of regulatory staff relative to the knowledge and expertise of industry participants. This
imbalance is particularly prevalent in highly technical industries such as financial services
and health care.

Frequent interactions between the regulator and the regulated industry may cause the
regulator to identify with the perspectives and preferences of the regulated industry.2®Such
regular exchanges between agency and industry can blur what should be a sharp line between
regulator and regulatee and can compromise independent regulatory judgment.?'

An example of cognitive capture may have been the development, at the request of the
Maryland Hospital Association in the early 1990s, of ongoing agency/industry work groups
on methodology development and major rate-setting decisions, including the magnitude of
the HSCRC's approved annual inflation increase to hospital rates or global budgets. These
work group activities were time-consuming for regulatory staff and made rate-setting staff
the focal point for attempts by hospital lobbying to influence policy.2® Such interactions

Milbank Memorial Fund e www.milbank.org 5
also caused frequent revisions to existing rate methodologies, adding to the complexity of
Maryland's rate-setting system. In recent years, the agency leadership expanded these work
groups to 16 in total.

While these work groups also included payer representatives, the overwhelming majority

of attendees were from the regulated hospital industry and arguably unduly influenced the
views of key rate-setting staff.2* Frequent modifications of rate methods in response to
ongoing lobbying of rate-setting staff by industry personnel usually add to the complexity of
already complex systems.*° Frequent changes to rate methods will add unneeded complexity
that can obscure the financial incentives of the rate-setting system for hospitals and payers,
and create inconsistencies in the rates applied to different hospitals, and open the door to
legal challenges by theregulated industry. All of these factors can undermine the transparen-
cy and effectiveness of the rate-setting process.

AVOIDING REGULATORY FAILURE AND CAPTURE

Given the significant data requirements, inherent complexity, and dangers of regulatory
capture and failure associated with state-based rate setting, some economists argue that
very few states have the ability to establish and maintain elaborate health care provider
rate-setting systems that will stand the test of time." Yet, the literature on regulated hospital
pricing systems documents the operations of several highly effective rate-setting systems
that did not experience significant failure or capture.** The Rochester Hospital Experimental
Payment Program (HEPP), an all-payer Medicare demonstration that ran fram 1980 to 1987
and covered nine hospitals in upstate New York, and the early Maryland all-payer rate regula-
tory system, which ran from 1976 to 1990, were examples of rate systems that largely avoided
the debilitating influences of regulatory capture and failure.*4*5

In the case of the Rochester HEPP, success occurred in part because the rate methods and
locus of regulatory control were focused on constraining aggregate hospital budgets, as
opposed to regulating the prices of individual hospital services. This system was also largely
formula driven and far less complex than other rate-setting systems. The literature on this
unique rate-setting demonstration - and conversations with those involved - indicate that
hospital global budgets were relatively easy to develop and administer, requiring a full-time
professional staff of only six to administer the system. This form of macro-oriented and
formula-based regulation made for a simpler regulatory system, which was easily under-
stood by hospital and payer personnel and more easily explained to legislators and other
policymakers.*®37

The early Maryland system also relied on macro-oriented rate-setting approaches involving
the heavy use of financial incentives, the establishment of attainable and well-understood
performance targets, minimized regulatory intervention, regulatory focus on the most costly
hospitals, the use of formula-based rate setting, and avoidance of frequent changes to

rate methods. Instead, it adopted a long-term regulatory perspective designed to address
Maryland's cost problems over the long haul without resorting to drastic and destabilizing
short-term regulatory action.®

Milbank Memorial Fund e www.milbank.org 6
Maryland's long-standing emphasis on its key regulatory principles and policy goals of
promoting patient access, payer equity, cost control, industry and regulator accountability,
and system financial stability and predictability also helped guide the HSCRC's policymaking
process and avoid the tendency of regulators to micromanage the system. Maryland's stat-
utory flexibility was also invaluable to regulators in the development of new and innovative
hospital payment systems and in adapting to the introduction of managed care in the late
1980s and early 1990s.** Thus, Maryland's flexible statute enabled the HSCRC to adapt its
system to accommodate managed care delivery system innovations and avoid the managed
care experiences of other rate-setting states."°

In addition to establishing systems with more flexibility and macro orientation, states can use
certain structural remedies to enhance the independence and transparency of regulatory
authorities, thereby limiting regulatory capture and failure. These structural remedies are
presented and discussed in Exhibit 1.

Exhibit 1: Features of a Regulatory Approach That Affect Risk of Capture or Failure

 

 

 

 

 

Category Lower Likelihood of Capture or Higher Likelihood of Capture or
Failure Failure
Agency type Advisory without rate enforcement Operational with rate
authority enforcement authority
Examples: MedPAC, Massachusetts Examples: previous all-payer
Health Policy Commission (HPC) hospital rate systems, Maryland
HSCRC
Advisory agencies/commissions that
do not have rate-setting authority Agencies/commissions with
are generally not subject to capture strong rate-setting authority will
attempts by the industry because they | be subject to repeated attempts
lack the authority to enforce rate/ by the regulated industry to
expenditure constraints. influence policy, methodology,
and rate-setting decisions.
Agency structure | Independent public or quasi-public Agency housed in state's

agency

Examples: Rochester Area Hospital
Corporation (RAHC), Maryland HSCRC

An agency that is largely independent
of state government may be less
subject to influences to elevate state
priorities over the priorities of the
general public. Agencies that report
to and are dependent on the executive
branch or legislative budget appropri-
ations may be more easily captured.
Independent agencies can be a source
of innovation - as was the case in
Maryland from 1976 to 1990.

 

Department of Health

Examples: New Jersey, New
York, or Massachusetts hospital
rate-setting agencies

Agencies housed in state govern-
ment may be more easily influ-
enced to prioritize state policy/
budgetary priorities.

 

 

Milbank Memorial Fund e www.milbank.org
 

Representation

Prohibition on agency leadership
affiliation/ties with regulated entities

Examples: Massachusetts HPC,
West Virginia Health Care Authority

Strict prohibitions on affiliations with
regulated entities can help ensure that
agency decision-making is not unduly
influenced by the priorities of the reg-
ulated industry and instead emphasize
the goal of protecting the broader
public interest over the interests and
goals of powerful regulated entities

or those of the regulated industry as a
whole. Regulatory agency leaders can
receive input from members of the
regulated industry by accepting public
testimony and comment letters from
industry representatives.

Mixed representation including
those with affiliation/ties with
regulated industry

Example: Maryland HSCRC?

While some may believe it is
useful to have industry represen-
tatives appointed to the leader-
ship of an agency to promote a
cooperative rule-making atmo-
sphere, some provider-based
appointees may work to influence
other leaders and staff to favor
industry interests.

This is particularly likely to occur
when industry representatives
have specialized knowledge

of hospital operations and the
rate-setting process itself,
relative to other appointed agency
leaders or agency staff.

 

Leadership
characteristics

 

 

Use of volunteer leaders/
commissioners

Examples: Maryland HSCRC,
Massachusetts HPC

The appointment of individuals with
strong health care policy backgrounds
and expertise (such as academic
health care economists) can assist
the agency in maintaining a priority of
protecting the broader public interest
and avoiding capture. The use of vol-
untary agency leaders/commissioners
as opposed to full-time employed
members can allow the agency to
attract high-caliber representation
from business, labor, academic,

or community/consumer-based
organizations.

 

Employment of full-time leaders/
commissioners

Examples: New Jersey, New York,
Massachusetts, and West Virginia
hospital rate-setting agencies

The use of full-time salaried
leaders/commissioners makes

it difficult to attract leaders with
sufficient public policy expertise
with an emphasis on civic duty
and a strong priority to protect
the public interest over the inter-
ests of the regulated industry or
more parochial priorities of state
government.

 

Milbank Memorial Fund e www.milbank.org

 
 

 

 

 

and frequent articulation of agency
principles and goals

Agency leaders that prioritize the
public interest over "deal making"

to placate influential industry rep-
resentatives are able meet their
objectives most effectively. Frequent
articulation of agency principles,
regulatory tenets, and policy goals can
help guide more consistent agency
decision-making over time.

 

Accountability Establishment of and adherence to Absence of performance
and disclosure clear performance metrics or targets | metrics or targets
The use of stringent but attainable The absence of clear perfor-
performance metrics (e.g., cost mance metrics or targets with
control, quality improvement, equity publication of the agency's
in payment) imposed by an external performance on these metrics on
authority (such as the federal gov- a regular basis obviously reduces
ernment) with periodic review of the accountability of the agency.
performance and the imposition of
significant penalties for nonperfor-
mance can galvanize support for the
agency's success and help immunize
it from capture or failure. Over time,
the agency should evaluate its overall
performance and revise its goals and
objectives accordingly.
Leadership Highly professionalized agencies Agencies that emphasize
strategy with strong independent leadership | balancing perspectives among

interests

A more passive approach to
leadership leads to compromises
among private interests that favor
the better-resourced parties
rather than the advancement of
the broader public interest. The
absence of clear and repeated
articulation of agency regulatory
principles and goals may facilitate
decision-making that favors
special interests over the broader
public interest.

 

Milbank Memorial Fund e www.milbank.org

 
 

 

 

 

Regulatory Emphasis on minimizing regulatory | Development of highly detailed,
approach intervention, adoption of more prescriptive and complex
macro-level methodologies, avoid- | rate methods with frequent
ance of frequent changes to regula- | changes to these methods in
tory methods/rules, and adoption response to industry criticism
of a long-term perspective
Agencies that implement highly
Agencies that take a more macro ap- | detailed and complex methods
proach to regulation (i.e., use of less | and change these methods
detailed and complex rate methods, | frequently risk obscuring the in-
applying regulatory focus primarily | centives of the rate system and
on the poorest industry performers, | making the rate-setting system
adoption of rate methods that subject to "insider" gaming and
minimize the scope of regulatory a lack of transparency to key
intrusions) and avoid frequent and interest groups and the public.
highly disruptive modifications to
rate methods are better able to
avoid capture and failure.
Funding and Well-funded agencies with a Underfunded/underresourced
salary structure | separate salary structure for staff | agencies that must rely on the

Agencies with funding that is
independent of a politicized budget
appropriation process (i.e., funding
through mandated "user fees") have
flexibility to perform necessary
duties, avoid regulatory gridlock
(e.g., excessive delays in regulatory
action), and hire an expert and pro-
fessional staff. Adequate funding is
also important to prevent the agency
from being vulnerable to information
asymmetry, whereby agency staff is
disadvantaged, relative to regulated
industry personnel, by a lack of tech-
nical knowledge.

 

normal state salary structure

Agencies dependent ona
potentially politicized budget
appropriation process in the
state legislature are at risk

of attempts by the regulated
industry to starve it of the
resources needed to perform
effectively and/or resist efforts
at industry capture.

 

 

Milbank Memorial Fund e www.milbank.org
 

Nature of

Broad statutory language that

Highly prescriptive authority

 

 

 

statutory provides the agency with some that embeds detailed rate-set-
authority discretion on the development of ting methods in statutes
rate methods
Example: New York Prospec-
Examples: Maryland HSCRC, Roch- | tive Hospital Rate Methodology
ester RAHC (NYPHRM)
Agencies with significant discretion | Rate systems that include
and flexibility to develop and modify | detailed rate-setting methods
key rate methods may be better able | in statutes have reduced ability
to avoid regulatory failure(inability | to respond to changes and
to adapt toachanging healthcare _| innovations in care delivery.
market and delivery system).? Needed modifications to rate
methods require the statutes to
be revised periodically, which
invites unfriendly amendments
by interested parties. Frequent
statutory revisions that are
subject to political manipula-
tions can produce rate systems
that favor politically powerful
entities and, in most cases, add
to the complexity and unintelli-
gibility of the rate system.
Transparency and | Strict adherence to a state's Minimal or loose adherence toa
agency autonomy | Administrative Procedures Act state's APA

(APA)

The APA can add to the transparency
of agency operations, reduce the
potential for conflicts of interest,
and help the agency maintain need-
ed distance from industry attempts
to influence its decisions. Strict ad-
herence to the requirements of the
APA can ensure appropriate balance
between adequate and transparent
communication with the regulated
industry while preserving sufficient
regulatory distance to allow for inde-
pendent decision-making by agency
staff and minimize the corrosive
effects of cognitive capture.

 

Agencies with no or only loose
adherence to the APA can
create circumstances where
representatives of the regulated
industry have repeated access
to agency personnel and lead-
ership and frequently engage

in private communications/
meetings. The absence of strict
requirements on industry/agen-
cy communications can result
in excessive agency exposure
to industry lobbying and under-
mine the due process of the
agency.

 

 

Milbank Memorial Fund e www.milbank.org
 

 

Development of Cultivation and use of independent | Exclusive reliance on regulato-
sources of diverse | expertise to supplement agency ry staff and agency leadership
andindependent | decision-making

expertise Exclusive reliance on the exper-

 

In the volume Preventing Regulatory
Capture," several essays emphasize
opportunities for reducing the risk
of capture by diversifying the sourc-
es of expertise in regulatory deci-
sion-making. These essays point to
the importance of engaging witha
diversity of interests and experts,
beyond the regulated industry itself.
Several mention the potential value
of independent academic adviso-

ry boards or individual academic
experts to review and comment on
agency data and methodologies. An-
other strategy to provide a counter-
weight to the influence of regulated
interests is to promote consumer
empowerment through the appoint-
ment of an official public advocate.

 

tise of agency staff, who may
be at a knowledge/expertise
disadvantage relative to rep-
resentatives of the regulated
industry, and agency leaders,
who themselves may be man-
agers and board members of
regulated entities, can create a
skewed and insulated regulatory
perspective that fails to consid-
er regulatory decisions in the
context of how they impact the
broader public at large (which
should be a key priority of any
regulatory agency).

 

 

@ Maryland's statute (which was originally drafted by the Maryland Hospital Association) authorized the appointment
of no more than three hospital industry representatives (of a total of seven commissioner slots) to the HSCRC.

' The development of a flexible statute that only articulates key goals and policy priorities and does not specify the
exact rate methods gives an agency flexibility to devise and adopt rate methods to meet these goals. However, this
type of regulatory discretion also can provide a captured agency with significant flexibility to meet the needs and
priorities of the regulated industry. Thus, while increasing the independence and autonomy of a regulated agency
does not necessarily increase the likelihood of capture, policymakers need to be aware that granting too much
discretion carries such a risk. See Hiriart Y, Martimort D. How Much Discretion for Risk Regulation? Working paper,

October 2009. http://idei.fr/doc/by/martimort/how_ much. discretion_octO9.pdf._

Sources: Review of the literature on regulatory capture and failure and the author's experience on the staff of the
Maryland HSCRC.

Although the use of structural features of regulation as discussed in Exhibit 1 can help reduce
the risk of capture and failure, a high level of professionalism, strong independent leader-
ship, and an emphasis on civic duty are also important resources for successful regulatory
agencies."

Milbank Memorial Fund «e www.milbank.org 12
A "DOOMSDAY MACHINE"

Related to the issue of accountability and system performance is a phenomenon in
Maryland that diluted the industry's attempts at regulatory capture and galvanized
support for rate setting from all parties, including the regulated industry. The terms

of the original Medicare waiver and its financial performance test created a sort of
"doomsday machine' (as portrayed in the film Dr. Strangelove) in which all parties stood
to suffer highly negative consequences should the rate system fail to meet its cost
containment goals.

When the system was first established, Medicare's payment levels to Maryland hospitals
in 1977 (the year the waiver was negotiated) were about 30% above the national average.
To the state's considerable benefit, Medicare allowed Maryland to retain this higher level
of payment if Medicare payment growth never exceeded this 30% excess level over the
life of the system.*?

By 2014, the value of these excess Medicare payments was estimated to be approximate-
ly $2.0 billion per year, or approximately 14% of total hospital revenue. Should Maryland
fail to meet its performance goals under the terms of its Medicare waiver, Maryland
hospitals would have been phased into the national Medicare Prospective Payment
System, which would reduce total hospital revenues by 14%. The threat of this "dooms-
day" scenario strongly motivated all parties to do whatever it took to perform at levels
sufficient to maintain the waiver and gave the rate-setting agency tremendous leverage
in applying rate constraints as necessary to meet its performance goals."

While this situation may not be completely replicable, it does illustrate the power of
stringent but attainable cost performance standards established by an external entity
(i.e., the federal government) and tied to significant penalties or other consequences for
nonperformance. Such a doomsday mechanism can ensure that the regulatory agency
remains vigilant in meeting its performance standards and that the regulated industry's
aspirations to capture the regulator are moderated.

 

LESSONS FOR FUTURE RATE-SETTING SYSTEMS

The demise of state-based rate setting has not been attributed to regulatory failure or
capture, but rather to a loss of interest group support due to political change, a partial
collision of rate setting with managed care, and the reduced effectiveness and the inability
of these systems to meet their original policy goals - particularly cost containment. This
reduced effectiveness, along with the perception that the rate-setting process had become
unintelligible and subject to insider manipulation, led to the erosion of support from poli-
ticians, insurers, and the business community. The emergence of managed care as anew
and effective "pro-market" cost control mechanism and changes in the political leadership

Milbank Memorial Fund e www.milbank.org 13
of these states (to parties favoring market-based solutions over regulatory solutions) led
directly to the repeal of rate-setting authority in these states in the early 1990s."

In the late 1990s, Harvard T.H. Chan School of Public Health's John McDonough rejected the
argument that capture was the primary reason for the demise of three of the four state-
based systems. Instead, he concluded that "these regulatory systems benefited consumers
more than they benefited the regulated hospitals" and "only in New Jersey could the capture
thesis be validated, and then only in the period between 1987 and 1992. The notion that elect-
ed and public officials play second fiddle to the agendas of interest groups is flatly rejected
by the evidence.""®

Many of McDonough's observations about the occurrence of capture in the context of state
hospital payment systems mirror the conclusions of a comprehensive review of the literature
on regulatory capture: (1) capture is often a misdiagnosis that is frequently motivated by
political ideology and not backed up by empirical evidence; (2) capture is not binary: while
there are examples of extreme capture, it is rarely pervasive or absolute, but instead exists in
varying degrees;**"' (3) in a world where capture varies, some regulatory systems and agen-
cies have done a better jab than others at resisting it; and(4) a number of structural features
of regulation can help insulate an agency from an industry's attempts at regulatory capture
(Figure 1).*8

Insum, debilitating levels of regulatory capture and regulatory failure are not inevitable.
Both can be largely prevented and, if they occur, minimized. Less complex and interven-
tionist regulatory systems, such as establishing price caps on out-of-network services or
developing flexible hospital global budgets, have the benefit of minimizing the danger of
failure and capture, while at the same time directly mitigating the pricing market power that
most hospitals now possess.*°

ACKNOWLEDGMENT

This research effort and article was generously funded by a grant to Global Health Payments
LLC by the Commonwealth Fund.

Milbank Memorial Fund e www.milbank.org 14
NOTES

'Fuse Brown EC. Resurrecting health care rate regulation. Hastings Law J. 2015;67:85-142.

? Cooper Z, Craig SV, Gaynor M, Van Reenen J. The price ain't right? hospital prices and health
spending on the privately insured. Q J Econ. 2019;134(1):51-107. https://doi.org/10.1093/qje/
qjy020.

3 Murray R, Berenson RA. Hospital Rate Setting Revisited: Dumb Price Fixing or a Smart Solu-
tion to Provider Pricing Power and Delivery Reform? Urban Institute; 2015. https://www.urban.
org/research/publication/hospital-rate-setting-revisited-dumb-price-fixing-or-smart-solu-
tion-provider-pricing-power-and-delivery-reform. Accessed June 28, 2021.

"Gaynor M. What to Do About Health-Care Markets? Policies to Make Health-Care Markets Work.
The Hamilton Project; 2020. https://www.hamiltonproject.org/papers/what_to_do_about_
health_care_markets_policies_to_make_health_care_markets_work. Accessed June 28,
2021.

5 Rose NL. Learning from the past: insights for the regulation of economic activity. In: Rose
NL, ed. Economic Regulation and Its Reform: What Have We Learned? University of Chicago
Press; 2014:1-23.

8 Orbach B. What is government failure to? Yale J Regul. 2013;30:44-56. Available at SSRN:
https://ssrn.com/abstract=2219709.

7Phang SY. Regulatory failures and regulatory capture. In: Housing Finance Systems.

Palgrave Macmillan; 2013:155-170.

8 Chernew ME. The role of market forces in U.S. health care. N Engl J Med. 2020;383(15):1401-
1404. https://www.nejm.org/doi/10.1056/ NEJMp2006097. Accessed June 30, 2021.

®Thorpe KE. Does all-payer rate setting work? the case of the New York Prospective Hospital
Reimbursement Methodology. J Health Polit Policy Law. 1987;12(3):391-408.

McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

"bid.

Ibid.

% Atkinson G. State Hospital Rate-Setting Revisited. The Commonwealth Fund; 2009. https://
www.commonwealthfund.org/publications/issue-briefs/2009/oct/state-hospital-rate-set-
ting-revisited.

"Carpenter D, Moss DA, eds. Preventing Regulatory Capture: Special Interest Influ-
ence and How to Limit It. Cambridge University Press; 2014. https://www.cambridge.
org/9781107646704. Accessed June 28, 2021.

® Ibid.

'® Bernstein MH. Regulating Business by Independent Commission. Princeton University Press;
1955:265.

"Carpenter D, Moss DA, eds. Preventing Regulatory Capture: Special Interest Influ-
ence and How to Limit It. Cambridge University Press; 2014. https://www.cambridge.
org/9781107646704. Accessed June 28, 2021.

Milbank Memorial Fund e www.milbank.org 15
8 Letter by Richard Olney to Charles Perkins, president, Chicago, Burlington & Quincy Rail-
road, December 28, 1892. The first federal regulatory agency, the ICC, was set up to regulate
railroad freight rates in the 1880s. Soon after, Richard Olney, a prominent railroad lawyer,
came to Washington to serve as attorney general. Olney was asked if he would help kill off
the hated ICC. His reply was a premonition of the dynamic that was to follow with the ICC:
"The Commission is, or can be made, of great use to the railroads. It satisfies the popular
clamor for a government supervision of the railroads, at the same time that it that supervi-
sion is almost entirely nominal. Further, the older such a Commission gets to be, the more
inclined it will be found to take the business and railroad view of things. The part of the
wisdom is not to destroy the Commission, but to utilize it."

® Calsyn M, Twomey M. Rethinking the RUC: Reforming How Medicare Pays for Doctors' Ser-
vices. Center for American Progress; July 2018. https://americanprogress.org/article/re-
thinking-the-ruc/.

20McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

21See the Health Services Cost Review Commission's Hospital Financial Condition Reports,
2014-2020. Available at: https://hscrc.maryland.gov/Pages/pdr-annual-reports.aspx.

22 Medicare Payment Advisory Commission. Report to the Congress: Medicare Payment Policy.
March 2021. https://www.medpac.gov/wp-content/uploads/import_data/scrape_files/
docs/default-source/reports/mar21.medpac_report_to_the_congress_sec.pdf. Accessed
November 18, 2021.

3 Revolving door prohibitions. National Conference of State Legislatures. Published August
24, 2021.

https://www.ncsl.org/research/ethics/50-state-table-revolving-door-prohibitions.aspx.

?4Carpenter D, Moss DA, eds. Preventing Regulatory Capture: Special Interest Influ-
ence and How to Limit It. Cambridge University Press; 2014. https://www.cambridge.
org/9781107646704. Accessed June 28, 2021.

25 Ibid.

76 Wren-Lewis L. Regulatory capture: risks and solutions. In: Emerging Issues in Competi-
tion, Collusion and Regulation of Network Industries. CEPR; 2011. Available at: https://www.
researchgate.net/publication/265962949_Regqulatory_Capture_Risks_and_Solutions/
link/54218dffOcf274a67fea98e6/download.

27Green M, Nader R. Economic regulation vs. competition: Uncle Sam the monopoly man.
Yale Law J. 1973;82(5): 871-889. https://doi.org/10.2307/795533.

78Murray R, Berenson RA. Hospital Rate Setting Revisited: Dumb Price Fixing or a Smart
Solution to Provider Pricing Power and Delivery Reform? Urban Institute; 2015. https://
www.urban.org/research/publication/hospital-rate-setting-revisited-dumb-price-fix-
ing-or-smart-solution-provider-pricing-power-and-delivery-reform. Accessed June 28,
2021.

28 Personal observation of Jack C. Keane, HSCRC commissioner, 2011-2019.

30 McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

Milbank Memorial Fund e www.milbank.org 16
31Pauly M, Town R. Maryland exceptionalism? all-payers regulation and health care system
efficiency. J Health Polit Policy Law. 2012;37(4):697-707. https://doi.org/10.1215/03616878-
1697502.

32 McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

33 Berenson RA, Murray RB. How price regulation is needed to advance market competition.
Health Aff (Millwood). 2022;41(1):26-34. https://doi.org/10.1377/hithaff.2021.01235.

34Murray R, Berenson RA. Hospital Rate Setting Revisited: Dumb Price Fixing or a Smart
Solution to Provider Pricing Power and Delivery Reform? Urban Institute; 2015. https://
www.urban.org/research/publication/hospital-rate-setting-revisited-dumb-price-fix-
ing-or-smart-solution-provider-pricing-power-and-delivery-reform. Accessed June 28,
2021.

35 McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

36 _iebschutz SF. Communities and Health Care: The Rochester, New York, Experiment.
Rochester. University of Rochester Press; 2011.

37Personal communication with Jack Cook, primary financial consultant to the RAHC.

38 Cohen HA. Maryland's All-Payor Hospital Payment System. 2011. https://hserc.maryland.gov/
documents/pdr/Generallnformation/MarylandAll-PayorHospitalSystem. pdf.

38 Murray R, Berenson RA. Hospital Rate Setting Revisited: Dumb Price Fixing or a Smart
Solution to Provider Pricing Power and Delivery Reform? Urban Institute; 2015. https://
www.urban.org/research/publication/hospital-rate-setting-revisited-dumb-price-fix-
ing-or-smart-solution-provider-pricing-power-and-delivery-reform. Accessed June 28,
2021.

"©McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

"Wu T. What really saved the republic from Trump? it wasn't our constitutional system of
checks and balances. The New York Times. December 10, 2020. https://www.nytimes.
com/2020/12/10/opinion/trump-constitution-norms.html.

"2 Murray R, Berenson RA. Hospital Rate Setting Revisited: Dumb Price Fixing or a Smart
Solution to Provider Pricing Power and Delivery Reform? Urban Institute; 2015. https://
www.urban.org/research/publication/hospital-rate-setting-revisited-dumb-price-fix-
ing-or-smart-solution-provider-pricing-power-and-delivery-reform. Accessed June 28,
2021.

*3 |bid.

"4Thorpe KE. Does all-payer rate setting work? the case of the New York Prospective
Hospital Reimbursement Methodology. J Health Polit Policy Law. 1987;12(3):391-408.
https://doi.org/10.1215/03616878-12-3-391.

"6 McDonough JE. Interests, Ideas, and Deregulation: The Fate of Hospital Rate Setting.
University of Michigan Press; 1997.

Milbank Memorial Fund e www.milbank.org 17
"8 Carpenter D, Moss DA, eds. Preventing Regulatory Capture: Special Interest Influ-
ence and How to Limit It. Cambridge University Press; 2014. https://www.cambridge.
org/9781107646704. Accessed June 28, 2021.

47Stigler GJ. The theory of economic regulation. Bell J Econ Manag Sci. 1971;2(1): 3-21.

"8 Carpenter D, Moss DA, eds. Preventing Regulatory Capture: Special Interest Influ-
ence and How to Limit It. Cambridge University Press; 2014. https://www.cambridge.
org/9781107646704. Accessed June 28, 20721.

"8 Berenson RA, Murray RB. How price regulation is needed to advance market competition.
Health Aff (Millwood). 2022;41(1):26-34. https://doi.org/10.1377/hithaff.2021.01235.

Milbank Memorial Fund e www.milbank.org 18
ABOUT THE AUTHORS

Robert Murray operates a management consulting firm specializing in the development of
hospital payment systems. He has written extensively on the history of hospital payment
systems in the United States and has proposed several payment models that could be
adopted by states to curb the growth in hospital prices and expenditures in the commercial
market. Prior to becoming a consultant, he served as the executive director of Maryland's
Health Services Cost Review Commission, the regulatory agency responsible for administer-
ing the state's all-payer hospital rate-setting program.

Milbank Memorial Fund e www.milbank.org 19
About the Milbank Memorial Fund

The Milbank Memorial Fund is an operating foundation that aims to improve population
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