What proportion of hospital cost differences is justifiable?

In the Medicare Prospective Payment System (PPS), payments to hospitals for an admission are based on the national average cost per case for that diagnosis. The payments are adjusted for local labor costs, urban-rural location, treatment of a disproportionate share of Medicaid patients, amount of teaching, and outlier payments for unusually expensive or lengthy cases. Still, enormous variations in average hospital costs remain, and since 1988 hospital-specific costs have not been part of the payment formula. Two papers [Goodall ( 1990), Pope (1990)] in this issue argue that the transition from hospital-specific costs to adjusted national average costs has gone too far. They say it would be better to pay a blend of hospital-specific and adjusted national costs (as was done in the PPS phase-in period from 1984-1988). They argue: