Gaming the system has always been part and parcel of the federal Medicare program. At its inception, doctors discovered that by increasing their fees they would receive higher Medicare reimbursements in subsequent years. As lawmakers instituted price controls to thwart such tactics, new ways to game the system have arisen. Consider the case of Tenet Healthcare Corp., a large, for-profit hospital chain.

Tenet stands accused of overcharging Medicare and contributing to overall medical inflation by listing high retail prices. Yet this accusation doesn’t make sense because hospitals are rarely paid retail prices.

Akin to the manufacturer’s suggested retail price on automobiles, hospital retail charges are inflated prices that don’t reflect what they are actually paid. In fact, the differential is even greater for hospitals than for automobiles. Medicare and private insurers pay only a fraction of hospital charges.

For example, in May the New York Times highlighted a hospital bill for a bunion operation in which the (unnamed) hospital’s charges totaled $8,439. Medicare would have paid only $1,632 for that operation. Private insurers pay more than Medicare but still well below the hospital charge.

This pricing strategy also makes little sense for uninsured patients. Few can pay the full amount and at any rate uninsured patients are a very minor source of hospital revenue. So why do hospitals keep inflating their retail prices?

The answer lies in how Medicare pays for inpatient hospital stays and, in particular, “outliers” – patients who have significantly costlier hospital stays than the average patient.

In its early years, Medicare payments to hospitals soared from $3 billion in 1967 to $41 billion in 1983. That year, Medicare began imposing price controls with the creation of a new payment system for inpatient hospital stays. Hospitalizations have since been categorized into one of about 500 diagnosis-related groups (DRGs). Medicare then pays a fixed dollar amount for the hospital stay based on the patient’s DRG. As time has passed, this payment system has increasingly put the squeeze on hospitals. One way they have responded is by “upcoding” hospitalizations so they are assigned to the highest-paying DRG possible.

In practice, upcoding has run the gamut from questionable to outright fraud. Ferreting out the fraudulent cases from the borderline ones is a delicate task. In the late 1990s, however, federal regulators responded with a heavy hand. The 1996 HIPAA legislation gave investigators increased funding and a mandate to root out fraud and abuse. The resulting crackdown prompted some hospitals to downcode hospital stays for fear of triggering an investigation.

Fixed payments create another problem. The DRG payment is the same whether the hospital stay is two days or four days. Hospitals therefore have a strong incentive to discharge patients as soon as possible. But patients don’t always cooperate. Some require extended hospital stays with much higher costs. To compensate hospitals for these outliers, Congress added an escape clause to the DRG system. Patients who become outliers trigger additional payments from Medicare – and these extra payments are calculated using the hospital’s retail charges.

All hospitals inflate their retail prices to some degree in order to benefit from outlier payments. Discussing the issue recently, Centers for Medicare and Medicaid Services (CMS) administrator Tom Scully said, “Everyone is focusing on Tenet, but there are a number of others.” Tenet may be the boldest in pursuing large outlier payments, but it was inevitable that some hospital would eventually take full advantage of the system.

The Tenet story is currently being spun by the media as yet another tale of corporate greed. But the real story is that Medicare’s price control system is clumsy and easily manipulated. Hospitals and other providers will always be tempted to exploit its flaws. Tenet hasn’t been charged with doing anything illegal and it maintains that it was adhering to the letter of the law in obtaining the outlier payments.

But investigators are snooping around and seem intent on finding some way to make charging high prices a crime. According to Scully, they “need to be certain that other hospitals are not inappropriately gaming the system.” Clearly, hospitals are gaming Medicare. As the head of the Medicare bureaucracy, Scully is only doing his job, but Congress needs to do more than patch up another “loophole” and deploy investigators on another mission. Simply cracking down on outlier payments could easily end up reducing the quality of care for the sickest patients.

The continued gaming of Medicare’s bureaucrat-controlled price system provides one more reason to transform Medicare into a defined contribution program of competing private insurance plans. This would be quite similar to how 401(k) plans operate. Legislators would be doing the public a disservice if they pursue a drug benefit without this essential reform.

Chris Middleton is the Senior Health and Tax Policy Analyst for the Center For Entrepeneurship of the Pacific Research Institute in San Francisco. He can be reached via email at cmiddleton@pacificresearch.org.