When government gets involved in things there tends to be the development of lots of alphabet soup descriptors for various aspects of what is being taxed, subsidized or regulated. This is true especially in medicine.

One of the more interesting abbreviations in medicine is DRG. This stand for Diagnosis Related Group. DRGs replaced a cost-plus reimbursement system for hospital procedures in 1983. Health spending in the U.S. exploded after the passage of Medicare in 1965. It occurred to those running the program that paying hospitals for their costs might actually give them an incentive to have lots of costs. So, to solve the problem, a “prospective payment” system using DRGs was developed.

The idea was simple. If you pay people to have costs, you get lots of costs. If you pay a hospital a fixed amount of money per patient, in theory they will have an incentive to provide services in a more economical manner. DRGs are determined by the medical condition of the patient, the procedure(s) for treatment, and the patient's age and sex. In addition, the possibility of complications is addressed in DRGs. The system was developed by Robert Fetter and John Thompson of Yale University (proving, once again, that many of the world’s stupidest ideas come from American Universities). In theory, the DRG for a bypass or an artery clean is set equal to the marginal cost of the procedure. Thus, we achieve the economically efficient outcome of Price = Marginal Cost.

Of course, it doesn’t work like that in the real world. The lack of real competition among hospitals means that many hospitals have no idea what the marginal cost of a procedure is at a point in time. Those that do have a huge incentive to provide procedures where Price > Marginal Cost and minimize those where Price < Marginal Cost. Of course, this won’t happen if Medicare sets the DRG rate exactly equal to that hospitals marginal cost.

You can see where this is headed. The bureaucrats at CMS (the bureaucracy that oversees Medicare and Medicaid) cannot possible calculate correct DRG rates. So the vast majority of the time Price does not equal Marginal Cost, rendering the whole system vastly inefficient. In Northeast Ohio, everybody from the Cleveland Clinic (which pioneered bypass surgery) to numerous community hospitals are trying to do heart surgery and procedures. Want to bet Price > Marginal Cost? In Northwest Ohio, it is almost impossible to get treated for Thyroid conditions at hospitals. Want to bet Price < Marginal Cost? In addition, many private plans copy DRG rates rather than negotiating with hospitals. Any reform of health care needs to start with the elimination of this alphabet price control system and its replacement with a real marketplace.