Bad Debts and Hospital Rate-Setting

This paper examines the economic foundations for mandatory discounts for insurers based on differences in bad debts experience. It considers critically the arguments Blue Cross plans use in several states. On both equity and efficiency grounds, discounts for actual bad debts are shown to be inappropriate. In contrast, it is shown that there are equity and efficiency reasons to grant a discount for insurance policies which avert bad debt, but that the appropriate discount is less than the amount of bad debt averted. The appropriate discount depends on the size of the subsidy needed to bring about purchase of debt-averting coverage. In some circumstances, this subsidy equals the underwriting loss on the coverage minus any tax subsidy the insurer receives.