The Hospital Cost Crisis

This morning, we released a major new research paper, The Hospital Cost Crisis: How Government Policies Drive Consolidation, Undermine Competition, and Fuel Soaring Prices, authored by John R. Graham. It addresses one of the most important reasons why health care is increasingly unaffordable for Americans. Escalating hospital prices are the primary cause of rising health care costs—and largely result from counterproductive government policy.

Hospitals today do not operate in a competitive market that rewards efficiency and value. Instead, they operate within a system shaped by regulation, subsidies, and payment rules that systematically suppress competition, encourage consolidation, and weaken accountability.

Before today’s newsletter, which reviews the main arguments in the paper, I want to invite you to an in-person Paragon event featuring Centers for Medicare and Medicaid Services (CMS) Administrator Dr. Mehmet Oz, Senator Ron Johnson, and Representative John Joyce on waste, fraud, and abuse in government health programs and steps Washington can take to limit these problems. The event will be from 1:30 to 3:30 p.m. on Tuesday, April 28, at the National Press Club.

Hospital Prices Are Rising Rapidly

Hospital care is the largest component of U.S. health spending, accounting for roughly one-third of total expenditures. Americans spend more than $1.6 trillion annually on hospital care. The surge in hospital prices drives insurance premiums higher, strains family budgets, and contributes to the nation’s unsustainable fiscal trajectory.

Since 2000, hospital prices have risen three times faster than inflation and more than twice as fast as wages. That level of price growth is not just high—it is an extreme outlier across the economy. Even within health care, hospitals stand apart. Other medical services have seen far more modest price growth. The cost crisis is not evenly distributed across the system. It is concentrated in hospitals.

This is not what a functioning market looks like. In most sectors of the economy, technological advancement, productivity gains, and competition put downward pressure on prices. In the hospital sector, the opposite has occurred. Prices have risen rapidly even as technology has reduced the need for inpatient care and enabled services to move to lower-cost settings.

Government Policies Protect Incumbents from Competition

Government protections shield hospital systems from competitive pressure and keep prices high. Certificate-of-need laws and other anti-competitive practices in many states require providers to obtain government approval before opening or expanding facilities. In practice, these laws allow incumbent hospitals to block new entrants, increasing costs and harming access and quality of care. Paragon showed how states can execute these reforms in our 2021 book, Don’t Wait for Washington.

The Affordable Care Act restricted Medicare payments to physician-owned hospitals built after the law was passed. A key source of competition has largely been shut down by federal policy.

These barriers protect hospital systems from competitive pressure. Fewer competitors means fewer choices for patients and less incentive for providers to control costs or innovate.

Government Payment Programs Reward Higher Costs

Medicare, which plays a dominant role in hospital financing, sets prices through administrative formulas that are largely detached from market forces. Medicare’s introduction in the mid-1960s, with cost-based reimbursement, drove a sharp increase in payments to hospitals. Today, the formulas remain rooted in historical costs and updated through bureaucratic processes.

Hospitals now receive significant subsidies through Medicaid, driven by rapid growth in supplemental and state-directed payments. In most states, Medicaid pays more than Medicare, and in some states payment rates approach commercial rates, which average roughly 2.5 times Medicare rates. These higher payments are funded by the legalized Medicaid money laundering apparatus, which the One Big Beautiful Bill took steps to curb.

The 340B drug program allows qualifying hospitals to buy drugs from manufacturers at deep discounts, then bill insurers and patients at much higher prices, pocketing the difference. The program distorts the market and delivers large profits to wealthier hospital systems relative to rural and safety-net providers.

As a result of the government’s outsized role in hospital finances, hospitals increasingly devote resources to lobbying for higher payments and protection from competition. This means private payers are forced to compete against government programs in a distorted market where low-cost providers cannot enter freely. This drives up prices for everyone.

Government Policies Encourage Consolidation

The growth of large hospital systems is not a result of natural market evolution. In reality, consolidation is heavily influenced by government policy.

Payment differentials across settings create incentives for hospitals to acquire physician practices and outpatient facilities. By bringing these services under hospital ownership, systems can bill higher rates for the same care. Over time, this has led to widespread vertical consolidation. The 340B program has also driven consolidation, as hospitals acquire physician practices and outpatient clinics to expand the volume of 340B-eligible drugs. The share of physicians employed by hospitals has risen dramatically, reflecting the shift away from independent practice.

These changes have significant consequences. Consolidation reduces competition, limits patient choice and treatment options, and reinforces hospitals’ leverage to negotiate higher prices with private insurers. The result is higher spending without corresponding improvements in quality.

The Myth of Hospital Financial Distress

Hospitals frequently argue that they are financially strained and that government programs underpay for services. This claim is often used to justify higher prices and additional subsidies. In a previous Prognosis, Graham dissected why the cost-shifting claim—that hospitals need to charge private payers excessive amounts because of government underpayments—lacks theoretical support and is inconsistent with the evidence.

Most hospitals operate with solid margins, significant investment income, and strong balance sheets. Average operating margins in recent years have been positive. Total margins are often higher when investment income is included. More importantly, when examined on a marginal basis, Medicare patients are often profitable, and many hospitals also generate positive revenue from Medicaid.

The perception of losses often stems from how hospitals allocate costs, not from true financial distress. By assigning large portions of overhead to government payers, hospitals can present those programs as unprofitable even when incremental patients generate positive margins. The financial pressures described by hospitals are not primarily the result of inadequate payment, but rather of how the system encourages and sustains high-cost structures.

Government Policies Prop Up Inefficiency

One of the most striking aspects of the hospital sector is the lack of productivity improvement. Despite decades of technological advancement and organizational change, there is little evidence that hospitals have become more efficient. A large share of hospital spending is not tied directly to patient care. Administrative costs, overhead, and other non-clinical expenses account for a substantial portion of total spending.

Payment systems also contribute to this outcome. Medicare cost reporting and rate-setting processes accept rising costs as a baseline and incorporate them into future payments. Hospitals are reimbursed for capital investments and other expenditures in ways that reduce incentives to control costs.

In most industries, firms that fail to improve productivity are forced to adapt or exit the market. In the hospital sector, government policy cushions these pressures and allows inefficiencies to persist.

A System Built on Subsidies

Hospitals benefit from a wide range of government subsidies and payment programs, many of which are poorly targeted and not tied to performance.

These include direct payments through Medicare and Medicaid, supplemental and directed payments, tax advantages, and programs like the 340B drug discount program. Together, these funding streams represent hundreds of billions of dollars annually.

Rather than being structured to promote efficiency or competition, many of these subsidies reinforce existing incentives. They support expansion, consolidation, and higher spending while providing little accountability for outcomes.

Bottom Line

The paper’s central insight is that the hospital cost crisis is not a market failure—it is a policy failure. Government policies restrict competition, distort prices, reward inefficiency, and encourage consolidation.

The result is a system in which prices rise faster than wages and inflation, even as technological progress should be pushing costs down. For patients, this means high and unpredictable costs, forcing choices like delaying or forgoing care, soaring premiums, and, too often, crippling medical debt. For taxpayers, it means ever-increasing deficits and trillions added to our national debt.

If policymakers are serious about improving health care affordability, they must start with government policies that affect hospitals. Reforming the policies that suppress competition and reward consolidation and inefficiency would create a more competitive, transparent system that delivers better care at lower cost. Today’s paper concludes with 12 recommendations that would reform government policies and produce a more competitive, transparent, and efficient hospital sector.