Teaching hospitals, as well as hospitals that treat a disproportionate share of poor patients, receive special subsidies from Medicare above and beyond the standard payments that other hospitals receive. In Medicare Hospital Subsidies (AEI Press, April 2002), Sean Nicholson of the University of Pennsylvania's Wharton School examines the payments that have often become vital to the financial health of many hospitals. These government subsidies were instituted because the cost of treating Medicare patients at teaching hospitals was believed to be higher than at nonteaching hospitals. The cost of treating poor Medicare patients also was thought to be higher than the cost of treating nonpoor Medicare patients. 

Although these subsidies were created to encourage hospitals to treat poor and uninsured patients, they may actually have the opposite effect, Nicholson tells us. These programs are now widely criticized both for raising health care costs and for failing to achieve the policy objectives used to justify them. The author explains that: 

The subsidies are poorly designed. Hospitals do not have to document how they use the subsidy payments. They are therefore free to use the funds for other objectives. 

The Medicare administrators calculate the Disproportionate Share Hospital subsidy by considering only the number of Medicaid patients treated by the hospital, instead of the number of uninsured patients. Empirical evidence shows that hospitals have responded to these incorrect incentives by treating fewer uninsured patients.

The size of the subsidies has grown rapidly over the past decade because of their ill-defined design. The payments are more generous than can be justified by quantitative analysis. Although estimates of the cost differences of teaching versus nonteaching hospitals and poor versus nonpoor Medicare patients have fallen substantially over time, the subsidy payments have not.  
The subsidies represent 12 percent of Medicare payments for inpatient hospital care. This comes at a time when the Medicare trust fund is already in trouble.

While the Balanced Budget Act of 1997 attempted to correct some of the flaws in the teaching hospital subsidy, hospitals still benefit from treating poor patients covered by Medicaid but not from treating poor patients who are not covered by Medicaid.

In addition, these subsidy payments have become vital to the financial health of many hospitals, so reducing them is politically difficult. For example, 6 percent of the revenue of urban teaching hospitals comes from Medicare subsidies. The payments exceed their total profit margin. 
After a detailed analysis of the rationale behind these Medicare subsidies, their legislative history, and the financial incentives of both types of hospital payments, Nicholson suggests alternative designs for these programs. Medicare Hospital Subsidies includes proposals that would curb the costs of these Medicare subsidies and would ensure the programs actually achieve the goals for which they were created.  

Sean Nicholson is an assistant professor in the health care systems department of the University of Pennsylvania's Wharton School. He has worked as a management consultant to the hospital industry and has written extensively on the economics of health care.