is, the value derived from putting the land to other uses—of the acres on which hospitals are built. Capital consists of the vast array of equipment in use at both hospitals and physician practices. Labor is the most important input both in the overall economy and for doctors and hospitals. Labor comprises 68.8 percent of the total cost of inputs that hospitals use to produce health care (CMS, 2010a) and 71.2 percent of the cost of physician inputs (CMS, 2010b).1

The costs of some inputs used in the production of health care vary geographically, whereas others do not. The price of the medical equipment that hospitals and physicians use is generally the same across all areas, and CMS does not adjust hospital or physician payment for any geographic differences in equipment costs (MaCurdy et al., 2011). For example, it costs a hospital in Des Moines, Iowa, about the same amount to purchase a computed tomography (CT) scanner as it does for a hospital in San Diego, California, and it costs a physician in Boise, Idaho, about the same amount to purchase a blood pressure monitor as it costs a doctor in New York City.

Prices for land and labor do vary from place to place, however. Per square foot, the cost of land in Boston, Massachusetts, is greater than the cost of the same type of land in Charlotte, North Carolina. Rent reflects the price of land, as well as the cost of construction. Rent per square foot of commercial space—the type of space that a physician practice might use—costs $28.72 in Boston and $17.60 in Charlotte (REIS unpublished data, 2010). Wages represent the price of labor. Per hour, the wage of a registered nurse (RN) in San Francisco, California, is greater than the wage of an RN in Springfield, Missouri—$48 in San Francisco and $25 in Springfield (RTI unpublished analysis of Bureau of Labor Statistics [BLS] data released in May 2010). CMS adjusts payments to both hospitals and physicians for geographic differences in the price of labor and it adjusts physician payment for differences in office rent. CMS also adjusts hospital payment for capital expenditures and depreciation, using the hospital wage index (HWI).

Because labor accounts for the majority of input costs for both hospitals and physicians, the committee uses the price of labor to define geographic boundaries for input markets. Moreover, because hospitals and physicians use the same types of labor inputs drawn from all employers in a similar geographic area, the committee proposes the use of one labor market definition for both sets of providers. The physical boundaries of these markets define the extent of geographic variations in input prices so that the same adjustment can be made to the payment made to all hospitals and physicians within the market boundaries (see Box 2-1 for an explanation of how the geographic adjustments work). Thus, payment areas should group together those providers facing comparable labor prices.

When geographic adjustments to payment are considered, an important question arises: how should Medicare recognize variations in the dollar value of inputs? Should Medicare adjust provider payments for the input costs that providers actually incur, or for the prevailing market price of inputs? When Medicare began in 1966, hospitals were reimbursed on the basis of their costs after they were incurred (retrospective cost reimbursement). In 1983, the program began a move to prospective payment. Hospitals were paid a set amount for similarly sick patients; no longer was payment tied to actual hospital costs. The goal was to hold down costs by encouraging hospitals to operate more efficiently (Mayes, 2006).

Subsequently, CMS has explained in the rules governing hospital payment (the Inpatient Prospective Payment System [IPPS]) that geographic adjustment is meant to reflect differences in input prices (CMS, 2010a). If CMS or the U.S. Congress meant geographic adjustment to reflect cost variation rather than input price variation, each hospital could be assigned its own


1 For hospitals with a wage index less than the national average, the labor-related share of input costs is set at 62 percent. For physicians, 18.7 percent of total input costs are office labor and 52.5 percent physician labor.

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