Drgs, Costs and Quality of Care

DRGs, COSTS AND QUALITY OF CARE: AN AGENCYTHEORY PERSPECTIVE

DANA A. FORGIONE, THOMAS E. VERMEER, KRISHNAMURTHY SURYSEKAR,JOHN A. WRIEDEN AND CATHERINE C. PLANTE*

INTRODUCTION

Ever since Diagnosis Related Group (DRG)-based payment systems were first

introduced in the US in 1983, the medical community has expressed concern

about the potential impact of these price controls on the cost and quality of

healthcare services. Several research studies have examined the impact of DRG-

based payment systems on the cost and quality of care. In this paper, we extend

the research on the impact of DRG-based payments by applying an economic

Agency theory perspective. We present (1) an economic background of the basic

payment systems over the years, (2) provide an overview of the accounting and

economic research that uses Agency theory to study contracting behavior, (3)

apply an Agency perspective to help understand the costs and benefits of hospital

payment systems, (4) examine whether the Agency theory perspective helps to

explain the impact of DRG-based healthcare payment systems on the cost and

quality of healthcare services, and (5) determine if Agency theory helps to

generalize these implications to other Organization for Economic Cooperation

*The authors are respectively, Director and Professor of Accounting, Florida InternationalUniversity; Associate Professor of Accounting, University of Baltimore; Associate Professor ofAccounting, Florida International University; Distinguished Senior Lecturer, FloridaInternational University; and Associate Professor of Accounting, University of NewHampshire. Special thanks to those who assisted with suggestions and information for thispaper. Any errors in the work are, of course, the authors’ own. Akmal Bhatti, HBSConsulting, UK; Dana Burduja, National Health Insurance House, Romania; RosannaCoffey, The MEDSTAT Group, Inc., USA; Daniela Dobre, University of Groningen, TheNetherlands; F.H. Roger France, Universite Catholique de Louvain, Belgium; StefanHakansson, National Board of Health and Welfare and Stockholm University, Sweden;Rupert Houghton, HBS Consulting, UK; Daniel Louis, Jefferson Medical College, USA;Ceu Mateus, Universidade Nova de Lisboa, Portugal; Hayoung Park, Catholic University ofKorea, Korea; Karl Pfeiffer, Universitat Innsbruck, Austria; Jean Marie Rodrigues,Universite Jean Monnet Saint Etienne, France; Henner Schellschmidt, WissenschaftlichesInstitut der AOK, Germany; Miriam Wiley, The Economic and Social Research Institute,Ireland; and two anonymous referees. Earlier versions of this paper were presented at theEuropean Institute for Advanced Studies in Management, International Conference onAccounting, Auditing and Management in Public Sector Reforms, held on October 7–9,2004 in Oslo, Norway, and at the Patient Classification Systems/Europe, 20th InternationalWorking Conference, held on October 27–30, 2004 in Budapest, Hungary.

Address for correspondence: Dana A. Forgione, Director & Professor of Accounting, Schoolof Accounting, Florida International University, University Park, Miami, FL 33199 USA.e-mail: [email protected]

Financial Accountability & Management, 21(3), August 2005, 0267-4424

#Blackwell Publishing Ltd. 2005, 9600 Garsington Road, Oxford OX4 2DQ , UKand 350 Main Street, Malden, MA 02148, USA. 291

and Development (OECD) countries. In the healthcare industry, there is a

unique relationship between the consumer (the patient), the provider of the

service (the healthcare worker) and the payer of the services (the insurance

company and/or government). This provides an excellent setting to examine

how Agency theory can explain why a cost reimbursement system and the

prospective payment (DRG-based) system produce different incentive structures

among the participants.

RESEARCH CONTEXT

The state of fiscal deficit in healthcare systems around the world continues to

escalate. The problem is essentially the same in every country, regardless of its

economic system or perspective on social welfare: increasing, unlimited demand,

in the face of limited resources, combined with escalating costs. Because the users

of the services are generally not the payers, the usual rationing of services based

on price is absent. In addition, in the developing world, rapidly accelerating

population growth produces increasing demand for healthcare services. At the

same time, the western world is dying – the death rate in the western world now

exceeds its birth rate – and the number of US workers will drop from seven per

retiree down to three workers per retiree by the year 2020.

Starting about 1965 with the Kennedy-Johnson era and the introduction of

the Great Society philosophy of government, the US embarked on a massive

campaign of government spending on social services, including: social security,

employment security, Medicare, Medicaid, and education.1 Projected spending

on these services combined will approach $1.7 trillion by 2008 (see Table 1). At

the same time, we did not pay for those services out of current income, but

rather borrowed the money and will leave payment for these programs to our

children and grandchildren. Table 2 presents the corresponding exponential

Table 1

US Federal Health and Human Services Expenditures

(Billions of US dollars)

1960–2008

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2008

Education 1 2 9 16 32 29 37 51 54 85 89Medicaid – – 3 7 14 23 41 89 118 197 253Medicare – – 7 15 35 71 110 180 219 309 388Inc. Sec. 7 9 16 50 87 129 149 224 254 341 369Soc. Sec. 12 17 30 65 119 189 249 336 409 516 592Total 20 28 65 153 287 441 586 880 1,054 1,448 1,691

Source: US Federal Budget Historical Tables.

292 FORGIONE, VERMEER, SURYSEKAR, WRIEDEN AND PLANTE

# Blackwell Publishing Ltd 2005

growth in the US national debt, which will exceed $9.3 trillion by 2008. The

three workers per retiree of the younger generation will be expected to pay for

expenditures incurred by the current generation, when they will have less than

half the collective earning power available to service the debt.

In the US, medical, hospital and long term care utilization will continue to

escalate for the next 10 to 15 years. According to Heffler et al. (2003), as the US

population ages during the next few years, total healthcare spending alone will

likely more than double, exceeding $3 trillion by 2012. According to this study,

total healthcare spending is currently at 14.1 percent of the US Gross Domestic

Product (GDP), and is likely to increase to 17.7 percent of GDP by 2012, making

it a significant issue for policy makers.

The hospital payment systems have gone through three major approaches

during the last 30 years. In many countries, and from the inception of the

Medicare program under the US Social Security Amendments of 1965, hospitals

were reimbursed for their costs. Cost reimbursement came to include operating

costs, capital costs such as interest on debt, return on equity for shareholders,

depreciation, insurance and taxes on plant assets, and reimbursement for med-

ical education. Cost reimbursement led to massive expansion of healthcare

capacity, costs and incentives to develop the highest quality, state-of-the-art

medical services, in the greatest abundance possible. Over-treatment of patients

and excess hospital capacity became significant issues as healthcare expenditures

increased at an increasing rate (Forgione and Vermeer, 2003).

The Social Security Amendments of 1983 ushered in the era of the

Prospective Payment System (PPS) using DRGs – essentially fixed-fee transfer

price controls. This approach has been adopted in 19 countries around the

world, and imposed strong incentives to reduce cost per patient case by short-

ening the patient’s length of stay in the hospital. Some limited research studies

argued that this has resulted in patients being discharged from hospitals ‘quicker

and sicker’ (Kahn et al., 1993). However, data on the quality of care is very

limited, and no conclusive, generalizable evidence has been presented to docu-

ment reduced quality of care. The global cost savings from countries discharging

patients ‘quicker’ has been estimated in the multiple billions of dollars. Similar

payment systems are now being implemented across all sectors of the US

Table 2

US National Debt

(Billions of US dollars)

1905–2008

1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 2008

0 0 16 39 260 274 322 542 1,817 4,921 7,837 9,388

Source: US Federal Budget Historical Tables.

DRGS, COSTS AND QUALITY OF CARE: AN AGENCY PERSPECTIVE 293


healthcare industry, from ambulatory surgery centers, to nursing homes, home

health care, and others (Medicare Payment Advisory Commission, 2002).

However, as long as the fixed-fee payments are set higher than the marginal

cost of providing the services, hospitals continue to expand patient service

volumes, and national costs continue to grow.

The third phase, capitation, came about with the advent of health main-

tenance organizations (HMOs), preferred provider organizations (PPOs), and

other so-called managed care systems. Under capitation, provider payments are

based on fixed amounts per member per month (PMPM) for a given patient

member population, regardless of the quantity of health services required

(Forgione and Vermeer, 2003). With the mobility of the US population and

the frequency with which employers change health plans, the opportunity for a

provider to realize long-term cost savings by investing in a patient’s preventative

care is lost when the patient moves to another plan. Conversely, a provider who

defers treatment or under-treats a patient may not bear the long term cost of

poorer health status since the patient will likely move to another employer-based

health plan within a couple of years. Thus, the economic incentives under

capitation completely reversed the cost-reimbursement approach. Capitated

providers have the perverse financial incentive to profit more from deferred

care or under-treatment of a given patient member base, than from providing

expanded care or over-treatment, as with cost-reimbursement systems.

Figure 1, Panels A, B and C present these three payment systems graphically.

In Panel A, the cost reimbursement graph, revenues track costs, and increase

exponentially as costs are increased. In Panel B, under PPS the revenue line is

straightened by the fixed-fee price-controlled payments and the provider can lose

money if costs exceed revenues. In Panel C, under capitated payments the

revenue line is completely horizontal, and the provider increases profits by

reducing the volume and cost of care provided.

Previous research has examined the relationships between DRGs, costs and

quality to determine if DRGs have had an impact on costs and to examine

whether quality of treatment has changed under a DRG-based system.

The purpose of this research is to further examine the relationship between

DRGs and hospital costs and also DRGs and quality of care using an Agency

theory framework. The healthcare industry provides a rich context to use

Agency theory to examine incentive structures and relationships.

In the previous research on DRGs, the most difficult relationship to examine

is quality of care because quality is difficult to define and quantify. Kahn et al.

(1993) examined the impact of DRG-based payment systems on the quality of

care for hospitalized Medicare patients in the US. The authors found that (1)

patients were sicker at admission, (2) length of stay dropped, (3) process of care

improved, (4) patients were less stable after discharge, (5) in-hospital mortality

deceased, and (6) post-discharge mortality was unchanged after adoption of a

DRG-based payment system. They examined five clinical conditions on a total

of 16,758 patient discharges before and after adoption of a DRG-based payment



Figure 1

Healthcare Payment Systems

Volume

CostRevenue

Volume

Cost

Revenue

Volume

Cost

Revenue

Panel A: Cost Reimbursement

Panel B: Prospective Payment

Panel C: Capitation



system. This study was financed by the Health Care Financing Administration

(now renamed CMS).

Extending previous research, recent studies have begun to examine the

comparative impact of DRG-based payment systems across different countries.

Most studies have examined the impact of DRG-based payment systems within

a specific country, state, or local area. Brizioli et al. (1996) examined the impact

of a DRG-based payment system on the treatment of chronic heart failure in

Italy. The authors analyzed four hospitals in Central Italy and found that after

DRG introduction, length of stay was shorter, re-admission rates increased, and

average cost of service decreased mainly from the reduction in length of stay.

They found no reduction in the quality of care in terms of available diagnostics

and the amount of available resources.

Kroneman and Nagy (2001) examined the impact of DRG-based payment

systems in Hungary. The authors studied the effect of the financing system and

bed supply on average length of stay, admission rate, occupancy and patient

case-mix. They found that average length of stay was shorter, more patients were

admitted and case-mix intensity increased after the adoption of a DRG-based

payment system. Although the case-mix increased, no interaction effect was

found between bed supply and the financing system.

Forgione and Vermeer (2002) developed a preliminary international case-mix

index for cross-country comparisons, and used it to devise a standardized cost

per case and a standardized cost per day for several countries. The authors

found that DRG adopting countries experienced a greater decline in average

length of stay compared to non-adopting countries. Forgione et al. (2004) exam-

ined the impact of DRG-based payment systems on the quality of healthcare

across national and cultural boundaries. The authors found some evidence for

OECD countries that adoption of DRG-based payments systems was associated

with faster hospital case mix increases and slower quality gains with respect to

patient mortality from surgical and medical misadventures.

Although researchers have examined the impact of DRG-based payment

systems from many different perspectives, we have not identified any attempts

in the literature to study this issue from an Agency theory perspective. In this

paper, we provide an overview of the accounting and economics research that

uses Agency theory to study contracting behavior and we apply this perspective

to hospital payment systems.

THEORETICAL PROSPECTIVE

The economic principal-agent model provides an approach for analyzing the

decision making of individuals or organizations with conflicting objectives, and

with different available information and risk tolerance. Agency theory can be

used to examine relationships between parties. As Baiman (1982, p. 155) points

out, Agency theory research focuses on the optimal contractual relationships



among parties that act in their own best economic interests. In healthcare such

contractual relationships arise between the provider, the patient, and the payer.

Each party seeks to act in its own best economic interest. A payer like Medicare in

the US is interested in controlling costs. This is not necessarily in the best interests of

the patient, who demands quality care, and the provider who seeks to maximize

return for cost of care provided. In addition to acting in their own best interests,

contracting parties may also have different endowments of private information. For

instance a provider would have, based on its expertise, information on how much

laboratory investigation is needed for a given patient. The payer is interested in

writing a contract with the provider that contains incentives to limit the investiga-

tions to minimize overall costs. Thus, in the context of healthcare, decisions of

contracting parties can be examined using the perspective of Agency theory.

Agency Theory in Healthcare

Figure 2 provides a simple model of the four major constituents in healthcare

economic relationships: the patient, the provider, the employer, and the insur-

ance company or government agency. This is a generic model, and any specific

constituents may not appear in a given country, or for a particular health plan

within a country that has multiple health plans. The most commonly omitted

constituent is employers, who do not directly participate in the model when a

healthcare coverage plan is not employment-based.

Patient

Healthcare Provider

Employer

InsuranceCompany orGovernment

Service

Payment

Payment

Payment Paym

ent

Payment

Figure 2

US Healthcare Economic Constituents

Source: Adapted from M. Petersen (2002).



The patient receives a service from the provider, and the payment is typically

made by two parties. The major source of payment is either a private insurance

company or the federal/state government, and the minor source is the patient

who pays an out-of-pocket co-payment or fee. The insurance premiums are paid

by the patient’s employer, with an ever-increasing proportion of the premium

being deducted from the patient’s paycheck. The federal government also

plays the role of an insurance company in the case of Medicare beneficiaries,

and the US federal and state governments perform the same role for indigent

patients under Medicaid. The premiums are charged through their taxing author-

ity. A review of some of these constituent group relationships is provided in

Forgione (1999).

In this paper, we extend the literature by examining the individual constituent

incentives in greater detail. First, the patient is concerned with receiving the best

care for the least cost. The cost to the patient includes insurance premiums, the

related portion of taxes, and the out-of-pocket deductibles and co-payments – as well

as the indirect costs of searching for and obtaining an appropriate quality healthcare

provider. For patients with employment-based health benefits, the choices include

(a) the insurance companies participating in the employer’s health plan options, and

(b) the healthcare providers participating in the insurance company’s program

network. For the aged, disabled and end stage renal disease (ESRD) patients in

the US, there may be a timing consideration – they pay their Medicare and general

taxes first if previously working, then receive full or partial coverage for the cost of

health services when they become federal Medicare beneficiaries.

Healthcare providers are interested in recovering their costs and expanding

operations, or maximizing profits in the case of for-profit (FP) organizations,

while providing acceptable quality of care in the marketplace. Payments may

either be received as reimbursement for the cost of services, or a fixed fee for the

type of service provided, plus any deductibles or co-payments collected from

patients. The FP insurance company is interested in maximizing profits, and the

government is interested in meeting the needs of the voting constituency and

general public, while controlling costs relative to other demands on the public

budget. Obviously, these four constituents have different incentives.

Three key economic questions affecting healthcare are as follows:

1. How is the quality of care impacted by multiple economic incentives and

relationships under government payment policies?

2. What are the incentives for providers to minimize cost, when some of

their revenues increase as costs increase?

3. When indirect costs are allocated and reimbursed, what economic incen-

tives can be used by payers to deter inappropriate cost shifting?

Some examples of basic economic conflicts of interest for providers include the

following. For a baby delivery, if there are minor complications that arise during

the immediate pre-delivery period, the physician may decide to perform a

cesarean section, for which the provider can receive a much higher case-rate



payment than for a normal delivery. Thus, for the same outcome (baby delivery),

the physician can choose between different clinical processes and risk levels to

achieve the outcome. Podiatrists in the US tend to lose money on every patient

office visit. They make up for the losses when they perform a surgery. Typically

they may provide one surgery per every 100 office visits. The financial incentive

exists to assess surgeries as ‘necessary’ more often than may be in the patients’ or

payers best interests, in order to help recoup the podiatrist’s losses from office

visits. (Not to mention that keeping the podiatrist in business may be in society’s

long-run best interest as well.)

A healthcare provider may use fixed-cost facilities to treat two different types

of patients for the same service – one patient that generates fixed-fee payments

and another that generates cost-plus reimbursement. If the reimbursement on

behalf of the latter patient also includes reimbursement of allocated facility fixed

overhead costs, the provider has a financial incentive to ‘under-treat’ the former

(fixed-fee) patient, ‘over-treat’ the latter, and shift cost allocations to the cost-

reimbursed patients. Eldenburg and Kallapur (1997) and Eldenburg and

Soderstrom (1996), documented such accounting and cost-shifting practices in

hospitals that resulted from these incentives. Petersen (2002) also described other

studies that document how healthcare providers may act to increase profits

under the prevailing incentive systems.

In further examining the relationship between the patient and the provider in

the context of an Agency theory framework, it must be remembered that the

provider is considered an ‘expert’ – which has an impact on the relationship

between the patient and the ‘expert.’ The physician or hospital personnel are

experts, and the patient essentially hires the experts to act on their behalf –

which can result in economic conflicts with respect to due diligence. For exam-

ple, what is the appropriate number of additional diagnostic tests? The ordering

of excessive additional tests may be motivated by ‘defensive medicine’ practices

under our litigious medical malpractice liability environment in the US.

Providers are also restricted, on the other hand, by the physician self-referral

laws, which prohibit a physician from ordering tests from a clinical laboratory in

which the physician has a financial interest. Determining the appropriate num-

ber of tests and whether this is the number of tests a physician actually orders is a

topic for further research. However, most important to the above potential

conflicts of interests between providers and patients is the issue of quality.

It must be noted that quality is more immediately important to the patient

than to the major payer for the services (the insurance company or government).

The payer becomes economically concerned when the marginal cost of lower

quality exceeds the marginal benefits from cost-saving payment policies.

However, determining the marginal costs and benefits is problematic. One

stark example is the case of a managed care health plan in the Baltimore,

Maryland area which concluded that just because a woman had a caesarian

section one time, the dictates of good quality medicine did not require that she

always have a caesarian section for subsequent baby deliveries, and thus it set a



policy of not paying for second caesarian sections. Needless to say, a woman in

the plan who once before had a caesarian section was pregnant with a second

baby, her uterus ruptured, and her baby died. The managed care provider

quickly discovered that their policy was not the low-cost payment policy after

all. Similar events lead to considerable controversy and implementation of laws

prohibiting ‘drive-through’ baby deliveries (Salganik, 1998; and Hyman, 2001).

As previously discussed there is a relationship between quality and costs as

reflected in the procurement literature among others. This has essential applic-

ation to healthcare. Quality of care is a key issue under payment systems that

motivate discharging patients ‘quicker’ and potentially ‘sicker.’ In its March

2001 report, the Institute of Medicine Committee on Quality of

Healthcare (2001, p. 1) noted that ‘The U.S. health care delivery system

does not provide consistent, high-quality medical care to all people.’ This report

noted that when the following six criteria were met, a quality health care system

would be in place in the US: safe, effective, patient-centered, timely, efficient and

equitable. Stoecklein (2003) noted how the American Society for Quality

(ASQ) could help implement the above six objectives through working with

partner organizations and focusing on customer needs. The question remains,

how do certain payment systems and economic incentive relationships impact

the quality of healthcare?

For 20 years the global multi-billion dollar benefits of DRG-based pay-

ment systems have been reported based on the savings achieved from

discharging patients quicker. What has not typically been included is the

cost of discharging patients sicker. If the cost of reduced quality factors, such

as patient readmissions, nosocomial infections and mortality due to surgical

and medical misadventures of patients, were included, the measured cost per

patient case would likely increase substantially. That is, the costs of dischar-

ging patients sicker may considerably offset the savings from discharging them

quicker.

The role of compensation mechanisms in motivating quality has been studied

in Agency theory. Lambert (1986) studied a problem where an owner delegates

the choice of investing in a risky project or a risk-free project to an expert

manager. The manager’s decision must also include the cost of expending

research effort on the profitability potential of the two projects. This research

effort expended by the manager cannot be fully observed or contracted upon,

whereas the investment decision is observable. If the manager invests in the risk-

free project, the owner cannot determine if (1) the manager worked hard in the

research and determined that the owner’s best interest was served by the project,

or (2) the manager worked hard on the research, found that the owner was better

off with the risky project but chose the risk-free project because the manger’s

compensation scheme imposed too much risk on the manager if the risky project

were undertaken, or (3) the manager did not work hard on research, and chose

the risk-free project anyway. Lambert (1986) derived conditions when there will

be over-investment in the risky project.



A stream of research involving procurement contracting studies the incentives

of contractors to reduce costs when contract payments include some form of

reimbursement for actual costs. Rogerson (1992) documents the possibility of

cost shifting to a cost-reimbursed project by a contractor who is also providing

the product in a competitive market. Reichelstein (1992) suggests a budget-based

compensation scheme that was implemented in German defense contracting to

minimize cost overruns. Loeb and Surysekar (1997) study the same issue when

the cost-reimbursed payment is subject to a price ceiling. Wehrle-Einhorn (1994)

discussed the impact of the change in focus of the US federal government

procurement policy from process to product – giving increased importance to

the quality of product or service provided. The author commented on the

positive effects of Policy 91-2 of the Office of Federal Procurement Policy

(OFPP). In this Policy document OFPP advocated that federal agencies which

previously emphasized low price, with minimum acceptable quality, would need

to change to a policy where both quality performance and price matter in federal

contracting.

Overall, the above studies indicate that economic incentives are important

and predictable in determining quality of the service provided by an ‘expert.’

Since DRG-based healthcare payments were primarily designed to deal with

provider experts and economic incentives, it is essential to consider the way

quality of healthcare is affected by financial incentives inherent in the payment

systems. Such understanding will help policy makers and providers in assessing

the potential impact of proposed changes in payment systems on the quality and

efficiency of healthcare delivery.

RESULTS

This paper examines the relationships between DRGS, costs and quality to

examine the incentive structures previously discussed. We further illustrate the

application of the Agency theory perspective to hospital payment systems using

data from the 2002 OECD Health Data CD-ROM. The 2002 database includes

approximately 1,200 variables for the 30 member countries in the OECD (see

Table 3 for a list of these countries) from 1960 to 2002. We specifically use this

data to examine whether the Agency theory perspective can help explain the

impact of DRG-based payment systems on the cost and quality of healthcare

services.

As of the time frame for this study, 19 OECD countries adopted some form of

DRG-based price controls as a part of their healthcare payment systems (see

Table 4 for a list of these countries). Of the 11 OECD countries that did not

adopt any form of DRG-based price controls, many have since either adopted

some form of DRG-based price controls, or are at a very preliminary stage of

system development (see Table 5 for the 11 non-adopting countries and their

status). It should be noted that countries may phase-in the application of a



DRG-based payment system in different ways over time. A country may initially

focus on a specific region of the country and/or a specific type of healthcare

provider, and then expand implementation on a wider basis. In some instances a

country may adopt a DRG-based payment system in partial reimbursement, or

for reporting purposes, and then expand its use as an increasing part of reimburse-

ment. There are other countries that may adopt a DRG-based payment system

Table 4

The 19 DRG Adopting Countries

Country Phase-in Start Date

Australia ’93–’00Austria ’97Belgium Approx. ’95Canada Approx. ’83Denmark ’00Finland ’95–’01France ’99–’04Hungary ’93Ireland ’93Italy ’95Luxembourg ’95Norway ’93Poland ’99Portugal ’90Spain ’91–’98Sweden ’90–’96Switzerland ’96United Kingdom Approx. ’92United States ’83

Source: Adapted from Forgione et al. (2004).

Table 3

The 30 OECD Member Countries

Australia Hungary PolandAustria Iceland PortugalBelgium Ireland Slovak RepublicCanada Italy SpainCzech Republic Japan SwedenDenmark Korea SwitzerlandFinland Luxembourg The NetherlandsFrance Mexico TurkeyGermany New Zealand United KingdomGreece Norway United States



for a limited part of their healthcare system with no concurrent plans for

expansion of its use. Considering these issues, the observation of importance is

whether notable changes (in slope) occur in cost or quality measures on or about

the adoption phase-in starting date, rather than mean differences which may

incorporate country-specific biases in the measures.

To examine the relationship between DRGs and costs, we examined expen-

ditures on outpatient visits. As an ‘expert,’ a physician or hospital personnel can

move a patient from an inpatient facility to an outpatient facility because the

patient views the physician as an expert and thus relies on the physicians

instructions. The physician’s motivation for moving the patient from an inpa-

tient facility to an outpatient facility may in part be motivated by financial

interests as well as patient care interests. After DRG adoption, many physicians

had a financial motivation to move patients from inpatient facilities to outpatient

facilities because payments for inpatient procedures were limited by the price

controls while payments for most outpatient procedures were cost-reimbursed

and had not been capped. Figure 3 illustrates the trend of total expenditures on

outpatient care for OECD countries that adopted DRG-based price controls vs.

countries that did not adopt DRG-based price controls. The graph illustrates

that providers in OECD countries that adopted DRG-based price controls were

moving patients to outpatient care at a considerably faster rate (greater slope)

than their counterparts in OECD countries that had not adopted DRG-based

price controls. Many believe that a primary motivation for this switch was the

adoption of DRG-based price controls. Another significant factor may be a

disparity in the prevalence and availability of outpatient laparoscopic surgery

services across the two groups.

Table 5

11 Non-Adopting Countries

Country Expected Phase-inStart Date

Status

Czech Republic ’97 Pilot program due for data ’03Germany ’04–’07 DueGreeceIcelandJapan Embryonic stage of implementationKorea ’97–’02 Very early stage, limited scopeMexico Not implemented yet, seeks progressive

implementationNetherlands Began ’03New Zealand ’93–’00 Mixed system, uncertain adoption time frameSlovak RepublicTurkey




The challenge has been, and continues to be, the difficulty of obtaining

adequate data on the quality of care, especially in the international arena. The

2002 OECD Health Data CD-ROM provides very few measures that can proxy

for quality of care. As a proxy for quality of care, we examine time-trends in the

OECD variable, ‘Causes of Mortality: Surgical & Medical Misadventures of

Patients.’2 Although the rate of surgical and medical errors should indicate a

measure of quality of care, patient mortality subjects our analysis to a very

stringent test of the impact of DRG-based payment systems.

Figure 4 provides the trends in ‘case mix index adjusted causes of mortality:

surgical and medical misadventures of patients’ for OECD countries that have

adopted DRG-based payment systems, aligned on year of the first year of

adoption phase-in.3 Except for Spain and Canada which have notably large

changes around the adoption dates in opposite directions, there appears to be no

consistent trend in case mix adjusted causes of mortality: surgical and medical

misadventures of patients that can be observed from the data. As previously

mentioned, the use of causes of mortality as a proxy for quality of care limits the

sensitivity of this variable. The large increase in mortality for Canada, and the

large decrease for Spain pose interesting questions about why the changes were

in opposite directions, and why these changes were so large (see Figure 5). One

explanation is that mortality significantly changed in each of these two countries

as a consequence of adopting the price-control system. An alternative explan-

ation is that quality of data collection and reporting significantly improved in

Figure 3

Total Per-Capita Expenditure on Outpatient Care Adopters vs. Non-Adopters

$100

$250

$400

$550

$700

$850

$1,000

$1,150

$1,300

$1,450

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Year

US

exc

hang

e ra

te/p

er c

apita

AdoptersNon-Adopters



both countries, thus revealing a more accurate picture of their respective mor-

tality rates. Perhaps there was some combination of the two effects, although it is

interesting to note that Canada uses DRG information extensively in patient

case management, which may precipitate a quality of care effect.

As with any study examining quality of care issues, the major limitation of this

study is data. This limitation is exacerbated because of our extending the study

to include all OECD countries. Comparing any data across countries is proble-

matic because of different measures and interpretations on top of all the country

and cultural differences. Another problem with the data is trying to infer

individual decisions using macro level data. Surgical and medical misadventures

is a crude measure of quality but it does provide the most consistent measure

across countries. All of these data issues are a limitation to this study.

CONCLUSIONS

Over the last thirty years many studies have examined the impact of different

payment systems on the cost and quality of healthcare services. In this paper, we

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

–17–16–15–14–13–12–11–10 –9 –8 –7 –6 –5 –4 –3 –2 –1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year

Dea

ths

per

100,

000

popu

latio

n

AustriaCanadaFinlandSpainSwedenUnited States

Figure 4

Case Mix Adjusted Causes of Mortality: Surgical and Medical Misadventures of

Patients Adopters

(Year 0 ¼ DRG adoption date)




extended this research by applying an Agency theory perspective. Specifically,

we provided (1) a background of payment systems over the years, (2) provided

an overview of the accounting and economics research that uses Agency

theory to study contracting behavior, (3) applied the Agency theory perspective

to the costs and benefits of hospital payment systems, (4) examined how the

Agency theory perspective can help explain the impact of DRG-based payment

systems on the cost and quality of healthcare services, and (5) determined if

Agency theory helps to generalize these implications to other OECD countries.

We found that the Agency theory literature provides considerable insight into the

incentives present in healthcare payment policy that will assist national health

planning boards and international healthcare provider organization managers in

their prediction and assessments of payment system impact on the quality and

efficiency of healthcare services.

The incentive to shift costs and services to account for changes in payment

mechanisms is predicted by Agency theory. Our finding that OECD adopters of

DRG-based systems incur significantly higher outpatient costs than non-adopters

is consistent with this prediction. It is also consistent with the finding in

Eldenburg and Kallapur (1997) that used data from one state in the US.


0

0.25

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0.75

1

1.25

1.5

1.75

–17 –16 –15 –14 –13 –12 –11 –10 –9 –8 –7 –6 –5 –4 –3 –2 –1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year

Dea

th p

er 1

00,0

00 p

opul

atio

n

CanadaSpain

Figure 5

Case Mix Adjusted Causes of Mortality: Surgical and Medical Misadventures of

Patients Canada and Spain

(Year 0 ¼ DRG adoption date)



Healthcare provider managers can thus assess the impact on both their revenues

and costs, and make adjustments in their fiscal and clinical operations accord-

ingly. On the other hand, healthcare policy makers can predict such operational

shifts and assess their consistency with policy objectives, as well as any unin-

tended consequences of specific policy implementation.

In spite of data limitations, this exploratory study allows a more in-depth

understanding of the relationships between costs and quality in a DRG based

system. More importantly, however, this study gives a new perspective on the

sometimes conflicting incentives that the major constituents in the healthcare

system face. Relationships between DRGs, costs and quality were examined in

the US environment and in the context of Agency theory to explore the relation-

ships. This study also goes a step further and explores those relationships in a

multinational setting. Future research will require more detailed, country-

specific data on quality of care, as well as hospital costs by DRG. These data

will enable the construction of more refined international case mix adjustments

for cross-country comparisons of quality and cost of care. With the availability of

better and more complete data future researchers will be able to further explore

the impact of financial incentives on the cost and quality of healthcare service

throughout the world.

NOTES

1 In the US, social security is a government operated quasi-pension system, employment securityprovides income assistance to the unemployed, Medicare provides healthcare to the elderly,disabled and end-stage renal disease (ESRD) patients, and Medicaid provides healthcare to theindigent.

2 This variable is defined as the age-standardized death rate by cause, extracted from the WorldHealth Organization Mortality Data base. The causes of death are determined with reference tothe 10th revision of the International Classification of Diseases. Essentially this variable measuresthe patient death rates due to surgical and medical errors or mishaps.

3 See Forgione et al. (2004) for a more detailed discussion of the calculation of case mix indexadjusted causes of mortality: surgical and medical misadventures of patients.

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