The last 20 years have seen a dramatic change in the way that hospitals are paid for services provided. Under the cost-plus system that existed in the 1980s, insurance firms and the government (in the form of Medicare and Medicaid payments) reimbursed hospitals for actual costs plus a reasonable profit. The current Prospective Payment System (PPS), however, classifies all diseases into Diagnostic Related Groups (DRGs). The hospital obtains a flat fee for each patient in a given DRG, independent of the hospital’s actual costs for treating that patient.

Required:

a. What are management’s incentives under the cost-plus regime? What information does management need to execute its strategy under the cost-plus regime? Assume management’s goals are the same as the hospital owners’ goals.

b. What are management’s incentives under the PPS regime? What information does management need to execute its strategy under the PPS regime? Again, assume management’s goals are the same as the hospital owners’ goals.

c. How does the change in the regime affect the change in the type of cost information provided to management?