Using data from 1982 and 1984, we examined how Medicare's prospective payment system affected hospitals. The study showed that hospitals paid through the prospective payment system had significantly lower increases in Medicare costs and greater declines in Medicare use than did other hospitals. Unlike these other hospitals, for which Medicare costs approximately equaled Medicare revenues, hospitals receiving prospective payment kept Medicare costs from rising as fast as Medicare revenues, earning the profit that the prospective payment system allowed. The opportunity to earn a profit led hospitals to slow increases in Medicare costs, regardless of the level of revenue constraint. However, the more the prospective payment system constrained hospitals' revenues, the more hospitals slowed increases in Medicare costs. In the most constrained hospitals, slower increases in Medicare costs were accompanied by slower increases in total hospital spending. The least constrained hospitals slowed Medicare cost increases the least and did not show their overall spending. These hospitals nevertheless increased their profit margins the most, since the prospective payment system's federal rate paid them the highest rates relative to base-year costs. Since federal rates produced extra profits, not extra cost containment, their appropriateness is questionable. The prospective payment system should be modified to eliminate windfalls while continuing to promote cost containment.
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