Addressing Government and Market Failures with Payment Incentives: Hospital Reimbursement Reform in Hainan, China

This paper examines the role of provider payment policy as an instrument for addressing government and market failures and controlling costs in the health sector, particularly in developing countries. We empirically evaluate the impact of provider payment reform in Hainan province, China, on expenditures for different categories of services that had been subject to distorted prices under fee-for-service. Using a pre-post study design with a control group, we analyze two years of claims data to assess the impact of a January 1997 change to prospective payment for a sub-sample of the hospitals. This difference-in-difference empirical strategy allows us to isolate the supply-side payment reform effects from demand-side policy interventions. We find that prepayment is associated with a slower increase in spending on expensive drugs and high technology services, compared to fee-for-service. The fact that payment reform is associated with reduced growth in spending on the most expensive drugs is particularly encouraging, given that drugs account for a remarkably high percentage of both the level and growth of aggregate health expenditure in China. Payment reform can be an effective policy instrument for correcting market failures and adverse side effects of government health sector interventions (such as distorted prices to assure access to basic services), both of which can lead to excessive health care expenditure growth. Such health spending growth can have a particularly high opportunity cost for developing countries.