Sources of hospital cost variation by urban-rural location

Under current law, Medicare's Prospective Payment System (PPS) recognizes a 25% differential in standardized average costs per admission between rural and urban areas. Using Medicare Part A and B claims data from four states across the country, this paper employs descriptive and multivariate techniques to explain the underlying sources of cost variation. DRG mix and within-DRG severity differences were found to contribute only 10-15% to the overall urban-rural variation compared to about one third for wage differences. Differences in procedure intensity for basically similar patients explained another 25-50% of the urban-rural difference depending on illness. Evidence was also found for systematic cost and procedure differences between core city versus suburban hospitals. If the urban-rural rate differential were eliminated, the impact on urban hospitals could have major effects on the intensive way in which physicians treat patients. Whether this would have demonstrable outcome effects is unknown, but initial severity differences alone do not justify the observed procedural differences.