The Impending End of Cross-Subsidization

For decades, American health systems have operated on an increasingly precarious regime of financial tradeoffs: commercially insured surgical patients cross-subsidize Medicare, Medicaid, and uninsured patients. Hospital outpatient fees underwrite employed physician losses. A few high-acuity service lines prop up entire portfolios of money-losing programs that their communities expect.

This precarious Jenga tower of healthcare financing is tottering. The most recent assault by CMS on July 2 threatens two of the pillars of this cross-subsidy regime – 340B Medicaid drug payments and Medicare’s so-called “site of service” payments for remote ambulatory care. These reductions are part of a continuing campaign by well-financed policy advocates that, if successful, would devastate hospital bottom lines.

The cross-subsidy regime underpinning hospitals has sustained them for decades. It financed portfolio expansion while diffusing responsibility for managing cost. Health systems used the proceeds to construct state-of-the-art infrastructure, build comprehensive service lines and, in many cases, become the largest employers in their communities.

Today hospitals’ cost-shifting machinery is seizing up. Recent data suggest the sector remains on fragile financial footing, with health system operating margins turning negative at the start of 2026. Some health systems with just the right mix of patients, payers, and service lines have flourished or survived in their markets. Many health systems that were not lucky geographically or were never able to achieve that balance either merged or closed.

Uncovering the funds flow: where cross-subsidy lives

Understanding the anatomy of cross subsidization is the first step toward restructuring it.

• Commercial payers subsidize government programs. This is the most foundational and most threatened cross-subsidy. Commercial insurance (e.g., employers and individuals) pays hospitals approximately 2.5 times Medicare rates on average for the same services. That mark-up enables health systems to offset losses incurred treating Medicare and Medicaid patients, who now represent the majority of most health system volume, as well as the cost of caring for those without coverage. As government payer mix increases, the uninsured rate rises, and commercial reimbursement is increasingly targeted by state cost control initiatives, this core cross-subsidy is increasingly imperiled.
• Hospital outpatient charges subsidize physician losses. This is the most volatile and most rapidly growing cross subsidy. Historically, health systems have invested approximately $256,000 per employed physician annually to offset the gap between practice revenue and operating expenses. Incurring these losses was viewed as essential for market positioning, referral capture, and care coordination. Thanks to the facility fees hospitals levied to offset these losses, physician time became more valuable in hospital employment than if they remained in independent practice, accelerating its collapse and increasing pressure on hospitals. 
• High-margin service lines subsidize community care. Oncology, cardiovascular, orthopedics, and neurosciences generate a disproportionate share of health system margins. In our experience, these service lines can account for the majority of hospital operating margins. They are also among the most resource-intensive, cost-driving services in medicine. Complex, high-acuity services carry the lion’s share of margin. Meanwhile, services that define a health system’s community mission and address gaps in the social safety net – behavioral health, obstetrics, and primary and emergency care – run persistent and widening deficits.
• Hospital outpatient departments (HOPDs) subsidize inpatient care. Many systems generate the vast majority of their operating margin from HOPD activity, through facility fees that are under attack through site-neutrality proposals. Inpatient care, meanwhile, represents a high-revenue, low-to-negative-margin enterprise for many systems. Some health systems have successfully recalibrated portfolios by tilting towards non-hospital ambulatory operations (e.g., see Tenet Health). Too many organizations are still clinging to “we get paid more at the hospital” strategies.

The flashing yellow light

Political forces on the left and right are attacking these cross-subsidies more aggressively than industry leadership teams are moving to address the problem.

• Site neutrality – Congressional and regulatory momentum toward site-neutral payment is growing. The policy logic is simple: if a knee replacement costs the same at a hospital outpatient department as at an ambulatory surgery center, why should Medicare pay more for the HOPD version?
• Franchise protection – States that have not already eliminated the competition-reducing protections of hospital franchises embodied by Certificate of Need laws are contemplating doing so. The Affordable Care Act’s provisions forbidding the establishment of new physician-owned hospitals could be repealed.
• Commercial price caps – An increasing number of states are either regulating hospital commercial rates as a percentage of Medicare, setting cost increase targets or else setting global hospital budgets directly. 

Kicking out the crutch

There is no single solution to the cross-subsidization problem. But there are strategic actions that can make a health system’s economics more sustainable. What will it take?

Committing to Medicare breakeven – seriously – Medicare payments were originally designed to reimburse hospitals for their costs of care for treating older Americans. Yet most health systems have accepted persistent and growing Medicare losses as a permanent feature of the payment landscape, rather than a serious management problem. Many hospital executives talk wistfully of “reimbursement,” implying that all their costs are fixed and Medicare “owes” them. That “reimbursement” mindset must disappear.

Breaking even on Medicare, including Medicare Advantage (now more than half the program), requires rigorous cost discipline, elimination of services that are not sustainably sized or staffed, thoughtful operating model redesign, and a willingness to completely restructure or exit underperforming Medicare Advantage contracts or poorly performing provider sponsored plans. It is time for organizations to rigorously manage the delivered cost of Medicare’s DRGs or APCs – thus reducing their dependence on commercial rates to offset Medicare losses.

• Understanding your actual costs – Healthcare is the only large industry in the US that routinely prices its services without a clear understanding of what those services actually cost (i.e., cost of goods sold). The result: a fatal diffusion of accountability for actually controlling cost and achieving sustainable margins. Health systems must have rigorous financial analytic tools that are real-time and, assisted by AI, recursive.
• Moving to profitable ambulatory growth – The shift toward efficient, convenient, consumer-oriented ambulatory care models is inevitable. It must be executed with operational discipline that matches strategic intent. Systems that win in ambulatory services will be those that redesign ambulatory operating models and workflows. Pushing care off the hospital campus and learning to manage the costs at much lower rates is inevitable.
• Not accepting the medical group as the loss leader – Physician enterprise losses are among the largest sources of financial drain in the health system income statement. They do not have to be. The pathway forward requires both tighter and more convenient scheduling; improving network performance against contracted rates; capturing value-based payment upside; and creating joint venture and partnership structures that work for clinicians and the health system. In some cases, it will mean shrinking overall physician employment. 
• Specializing and trading – The systems that will thrive in the next decade will make explicit choices – about service lines, geographies, and patient populations. This may require service line partnerships with competitors where appropriate or co-investment in shared infrastructure. It will also require aggressively consolidating or relocating service offerings of geographically proximate hospitals/facilities within a single enterprise. It will require willingness to refer out or cease to do that which you cannot do profitably or safely.

The path forward starts with honesty (and good data)

The cross-subsidization model evolved through decades of adaptation to government payment policies and market realities. The problem is those realities are changing dramatically, and the model has not. Leadership teams must create a more balanced economic model – and a supporting sustainable operating model – that allows the organization to serve its community over the long term.

Responsible stewardship often requires difficult decisions. The cross-subsidy crutch has served its purpose. It is time to learn to walk without it.

Photo: narvo vexar, Getty Images

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