Why Are Share of Charges Contracts Long-Lived?

Abstract

Auto-renew clauses, wherein contracts automatically renew until terminated by either party, are a common practice. Within the American healthcare system, auto-renew contracts between hospitals and private insurers are often share of charges contracts, wherein prices are calculated as a fixed multiple of provider-set charges. I document that in West Virginia, auto-renew share of charges contracts were standard for all but the largest insurer and would often remain in place for a decade or more. Hospitals practiced persistent and rapid increases in charges, seemingly making these contracts principally advantageous for the hospitals. I demonstrate that under certain conditions, these contracts can lead to Pareto improvements. With a share of charges contract, a hospital can use charges to adjust ex-post prices in response to changing conditions, while the negotiators can adjust the starting share of charges downwards to achieve the same expected payment in net present value terms. The key feature of these contracts is the renewal process, which enables the insurer to discipline hospital charges with the threat of contract termination and renegotiation.