Payment levels and hospital response to prospective payment

Nearly ten years after the implementation of Medicare's Prospective Payment System (PPS), some of its major impacts remain hard to explain using existing economic models. We develop a simple model of the hospital's choice of intensity of care, which affects demand for admissions. The model suggests an important role for the level of prospective payment, independent of the effect of marginal incentives. Predictions from the model are compared first with aggregate utilization data from Medicare's PPS experience, and then with various hospital-level studies which control for interhospital differences in reimbursement rates.