Insurance principles and the design of prospective payment systems.

This paper applies insurance principles to the issues of optimal outlier payments and designation of peer groups in Medicare's case-based prospective payment system for hospital care. Arrow's principle that full insurance after a deductible is optimal implies that, to minimize hospital risk, outlier payments should be based on hospital average loss per case rather than, as at present, based on individual case-level losses. The principle of experience rating implies defining more homogenous peer groups for the purpose of figuring average cost. The empirical significance of these results is examined using a sample of 470,568 discharges from 469 hospitals.