Using hospital-specific costs to improve the fairness of prospective reimbursement.

Payment rates in Medicare's Prospective Payment System (PPS) are based on averages of historical hospital costs. Compared to reimbursing each hospital's own costs, pricing at the average of costs implies a massive redistribution of payments among hospitals. Because not all sources of hospital costs are accounted for in the PPS, some of this redistribution is 'unfair'. Information in hospital-specific costs on unmeasured patient severity and input prices can be exploited to reduce payment inequities. However, fully hospital-specific rates are not optimal because costs also reflect treatment intensity and efficiency differences among hospitals.