Understanding the Goals of Nonprofit Hospitals

SUMR Blog

Understanding the Goals of Nonprofit Hospitals

Do nonprofit hospitals behave differently from their for-profit counterparts?  [Seven of the ten most profitable hospitals held the label “nonprofit,” according to a recent study. As the government affords these hospitals benefits, including tax breaks, it is important to question whether such privileges are warranted. The economic debate over the proper way to model the behavior of these nonprofit institutions began in the 1960s, as health care spending began its staggering increases, and has continued ever since.

Economic models have always been imperfect, many relying on assumptions that allow for relatively simple mathematics to predict firm and consumer behavior. For example, many models use basic calculus to determine the optimal price for a firm to set, given assumptions that simplify the behavior of other firms, consumer tastes, and the presence of other goods or services. As economists relax these assumptions, the math often becomes more complex and the answers become less intuitive.

A major assumption that gets little attention is that the firm’s goal is to maximize its profits. This makes sense when considering for-profit firms, but applying it to hospitals gets complicated. Most hospitals are nonprofit institutions, implying that their goals would be something other than profit maximization.

In 1970, Joseph P. Newhouse published a paper “Toward a Theory of Nonprofit Institutions: An Economic Model of a Hospital,” which claimed that the hospital’s incentives would be to maximize prestige, not profits. Within a budget constraint (including grants and charitable contributions), the hospital would maximize prestige by maximizing the quantity and quality of services delivered; Newhouse thought that these goals would also satisfy other motivations of hospital administrators, like showing “professional excellence” or “technical virtuosity.” The hospital would set prices so that the average revenue is equal to the average cost, ideally within each measure of quality, quantity, and revenue (such that the hospital is not net losing money on any operation). This would result in literally no profit, and is similar to the behavior of firms in a perfectly competitive market with no fixed costs. Newhouse felt that the hospital would exhibit this behavior regardless of competition, taking the potential for profits and instead applying that to increasing prestige.

However, over time, the landscape has changed. In his 2003 article “The Convergence between For-Profit and Nonprofit Hospitals in the United States,” Guy David noted that “In 1960, nonprofit hospitals maintained on average more than three times as many beds per hospital as their for-profit counterparts; following a monotonic decline in relative size, by 2000, the average nonprofit hospital was only 32% larger than the typical for-profit hospital.” He then posed and defended the idea that nonprofit hospitals have the same goals as for-profit hospitals, and that the label of “for-profit” versus “not-for-profit” served as simply a business strategy, with different options being optimal in different economic environments.

Nonprofit hospitals could be modeled as truly altruistic, looking to maximize social welfare rather than prestige or profit. The mission statements of non-profit hospitals are consistent with this theory, and it could be justified in that the most altruistic individuals sort into nonprofit hospitals instead of for-profit alternatives. Finally, it is possible that hospitals might maximize something other than prestige, profits or social welfare. Broadly referred to as perquisite maximization models, they include a variety of potential “perquisites,” such as physicians maximizing their individual income, rather than the hospital maximizing its income as an institution.

Several studies have extended this debate beyond theory. A survey of 60 hospitals in 1985, conducted by Alan Bauerschmidt and Philip Jacobs, found that hospitals listed the desire to serve all patients as the most influential factor in pricing services (of the options provided), followed closely by the desire to meet a net revenue goal. These goals are consistent with something between pure altruism and prestige or other perquisite maximization. In 2005, Jill Horwitz published a paper comparing different types of hospitals and found that “for-profits are most likely to offer relatively profitable medical services; government hospitals are most likely to offer relatively unprofitable services; nonprofits often fall in the middle.” For-profits are also more responsive to changes in service profitability than the other two types. This study indicates that non-profit hospitals seem to be focused on something other than profit maximization, but the profitability of services was generalized. For an individual hospital, there may be an abnormal economic environment or other preexisting characteristics that result in the most profitable service being one that is normally less profitable.

A 2010 quasi-experimental study by Tom Chang and Mireille Jacobson took advantage of a policy change in California to analyze how different hospitals responded to a “shock” to their fixed costs. California instituted a mandate that required hospitals to either improve or reconstruct their facilities to meet seismic safety standards. These standards varied across the state based primarily on seismic activity, and there was no correlation between the strength of these standards and whether hospitals held for profit or nonprofit status. The authors found that the mandate did indeed have an effect, and the variation in hospital response was instructive:

Hospitals with higher seismic risk are more likely to shut down, irrespective of ownership type, but not-for-profits alone increase their mix of profitable services such as NICU days and MRI minutes. These results are most consistent with not-for-profit hospitals as perquisite maximizers and allow us to reject two of the other leading theories of not-for-profit hospital behavior – ‘for-profits in disguise’ and ‘pure altruism.’

If the nonprofits were really for profits in disguise, they would have already maximized their profitable services. The mandate should not inherently increase the demand for NICU days and MRI minutes, and if it did, it should have increased the demand for the services across all hospitals. It appears that to account for the fixed cost, nonprofit hospitals shifted to services that were likely unnecessary but were profitable. This shift also argues against pure altruism – otherwise, they would not have shifted toward expensive and unnecessary procedures, which decrease “social welfare” but help the hospital do well financially.

However, this study does not end the debate. The results were based on California’s hospitals, which may not generalize to hospitals in other states or areas of the country. Additionally, the study analyzed the general response for the hospitals as a whole; the implications for not-for-profit goals do not mean that every nonprofit hospital is a perquisite maximizer. This category of “perquisite maximizer” is still broad and leaves significant room for debate about the specific perquisite that the hospitals are maximizing. There is much more room for debate and research, but it seems as though an answer is emerging, and the economic models are getting closer and closer to accurately representing firm behavior in the real world.