Measuring hospital efficiency with frontier cost functions

This paper uses a stochastic frontier multiproduct cost function to derive hospital-specific measures of inefficiency. The cost function includes direct measures of illness severity, output quality, and patient outcomes to reduce the likelihood that the inefficiency estimates are capturing unmeasured differences in hospital outputs. Models are estimated using data from the AHA Annual Survey, Medicare Hospital Cost Reports, and MEDPAR. We explicitly test the assumption of output endogeneity and reject it in this application. We conclude that inefficiency accounts for 13.6 percent of total hospital costs. This estimate is robust with respect to model specification and approaches to pooling data across distinct groups of hospitals.