A new approach to hospital cost functions and some issues in revenue regulation.

An important aspect of hospital revenue regulation at the State level is the use of retroactive allowances for changes in the volume of service. Arguments favoring non-proportional allowances have been based on statistical studies of marginal cost, together with concerns about fairness toward non-profit enterprises or concerns about various inflationary biases in hospital management. This article attempts to review and clarify the regulatory issues and choices, with the aid of new econometric work that explicitly allows for the effects of transitory as well as expected demand changes on hospital expense. The present analysis is also novel in treating length of stay as an endogenous variable in cost functions. We analyzed cost variation for a panel of over 800 hospitals that reported monthly to Hospital Administrative Services between 1973 and 1978. The central results are that marginal cost of unexpected admissions is about half of average cost, while marginal cost of forecasted admissions is about equal to average cost. We obtained relatively low estimates of the cost of an "empty bed." The study tends to support proportional volume allowances in revenue regulation programs, with perhaps a residual role for selective case review.