Theoretical Analysis of Hospitals’ Response to a Per Diem Prospective Payment System

Japan has one of the longest average length of stay in hospital (ALOS) among developed countries. To curb the high ALOS, the Ministry of Health, Labor and Welfare has launched a payment system reform where instead of the pre-reform fee-for-service system (FFS) a new per-diem prospective payment system (DPC/PDPS) has been gradually adopted. We develop a theoretical framework to model hospitals’ incentives under different payment systems and to study the impact of the reform on the ALOS. We show that hospitals with a longer (shorter) pre-reform ALOS shorten (lengthen) their post-reform ALOS. Furthermore, hospitals with longer prereform ALOS have stronger incentives to use planned readmission to decrease the post-reform length of stay associated with a single admission. The theoretical predictions of our model match empirical evidence from the literature.