Activity-based hospital funding healthy way to go

Six Australian public hospitals do more than 200 hip replacements a year. In one, the cost of a hip replacement is $9700 a patient. In another it is $23,400, nearly 2 ½ times higher.

Similarly, the cost of a common treatment for gallstones – laparoscopic cholecystectomy – ranges from $4100 to $7900 a patient, depending on the hospital.

Grattan Institute's new report, Controlling costly care: a billion-dollar hospital opportunity, reveals substantial differences in costs among Australia's public hospitals. Much of this cost can be avoided. If it is, nearly $1 billion will be freed up to address other needs every year.

When state finances are tight, such large differences cry out for attention. There is also a moral imperative: it is unethical to ration services or shift costs to consumers when there is inefficiency in the system that, with better management, could be reduced and the savings used to address unmet needs or future cost pressures.

The opportunity to free up this money comes because all states and territories are implementing activity-based funding for their public hospitals. Under this system, hospitals are funded on the basis of what they do – their activity – not in block grants or on the basis of previous funding arrangements, as used to be the case.

The costs of patients vary for a host of legitimate reasons, even after taking their illnesses into account. Some people may respond better to treatment; social factors such as homelessness also may affect treatment plans. The idea with activity-based funding is that these types of variation among patients will even out, with some costing more than average and some less.

Among hospitals, you'd also expect some variation. But the difference among Australian hospitals is far greater than is reasonable. Activity-based funding changes the incentives for public hospitals as the payment they get from state governments and the commonwealth is based on the average costs of similar patients nationally for commonwealth payments and in their state for state funding.

The big weakness of this approach is that it implicitly legitimises the existing distribution of costs. That is, the average takes into account the costs of all public hospitals, irrespective of whether they are delivering care in an efficient manner.

Grattan Institute's report recommends that states take out avoidable costs before setting the prices they pay hospitals. Avoidable costs are those that are substantially above the costs in the benchmark hospital in each state.

The policy shift isn't a simple matter of setting new prices. Other changes are also required.

Hospital managements need to be given information about their relative performance so they can identify savings opportunities. They need to be able to identify whether their cost problem is in cardiology or orthopedic surgery, whether it's about supplies or staffing. Different hospitals will have different problems that require different solutions. But hospital managements need to be given a strong incentive to fix their problem.

States also need to tighten up on their governance: reduce bail-outs to poorly performing hospitals and improve their ability to intervene when there are early indicators of things going wrong.

Hospital spending is the fastest growing area of government spending. Costs are projected to continue to grow as we introduce new technologies and respond to the impact of population growth and ageing.

We must keep healthcare affordable and the health budget in control. Rooting out inefficiencies in public hospital systems is a good place to start.