The annual contracting process between purchasers and providers at the heart of the recent NHS internal market reforms has significant drawbacks. According to research by Martin Chalkley and James Malcomson, published in the latest issue of the Economic Journal, health authorities and GPs are likely to end up actually paying more than they need to for the same standard of service. What''s more, one way for hospitals to cut costs is to reduce standards of service: ways of countering this may result in hospitals investing less in future services.
Under the reformed system, health authorities and GP fundholders contract with hospitals to provide health services for their patients. They have come under pressure from the NHS Executive to use contracts in which the amount paid to a hospital depends only on the number of patients treated, not on whether the patients it receives are more or less expensive to treat. The attractions of such contracts are obvious: if hospitals are paid the same whatever their costs turn out to be, they have strong incentives to keep costs down and so contain the overall costs of health care.
But there are two reasons why health authorities and GPs may end up paying more than they need to under this contracting system. First, because NHS trust hospitals must break even year by year, they can only take on contracts that cover costs even if the costs of treatment turn out high: hence prices specified in contracts also need to be high. Second, even if a hospital knows costs will be low, the health authority may not have access to this information and may thus end up paying more than it should.
In addition, with health services, it is virtually impossible to specify in a contract all aspects of standards of service: waiting times, quality of medical care, friendliness of staff, etc. As a result, with pressure to reduce costs, standards of service may suffer. There are some circumstances in which competition between hospitals can be relied on to maintain standards, for example, where GPs have a realistic choice about where to refer patients and are well-informed about standards of service in different hospitals. In other cases, health authorities must use other means of maintaining standards.
One alternative is that, because NHS contracts typically run for one year, hospitals may have their contract renewed on less favourable terms, or in extreme cases not renewed at all, if they do not maintain quality standards. The problem here is that contracts that can be renewed on less favourable terms because standards of service are low can also be renewed on less favourable terms for other reasons. In particular, health authorities will negotiate for lower prices if a hospital shows that it really can deliver services at low costs. This again weakens the pressure to reduce costs.
Health authorities will also negotiate for lower prices, or higher standards for the same prices, if a hospital invests in equipment that enables it to treat patients more cheaply or more effectively. If hospitals anticipate this (and Chalkley and Malcomson know from talking to them that some of them certainly do), they will invest less in future services because they anticipate lower revenues in the future with which to pay for those investments.
Getting the right balance between all these factors requires contracts carefully tailored to each specific type of health service. Chalkley and Malcomson''s research explains how this can be done. In particular, they note that it is not sensible to adopt a simple policy prescription that contracts for all types of health services should last for only one year and have the amount paid to a hospital depend only on the number of patients treated. Contracts with prices that are adjusted in the light of cost variations will average out cheaper in the long run even though they weaken the pressure to reduce costs.
''Contracts for the National Health Service'' by Martin Chalkley and James M. Malcomson is published in the November 1996 issue of the Economic Journal. Chalkley and Malcomson are at the University of Southampton. Their work on the NHS forms part of the Economic and Social Research Council''s research programme on Contracts and Competition.
