The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Nursing Homes

  • Edward C. Norton
Reference work entry


Nursing homes are healthcare providers for persons, often elderly, who need assistance living with chronic illness. This article describes the main economic issues of supply and demand for nursing home care, including quality of care and long-term care insurance.

Nursing home care is an important area for health economics because it represents the largest share of long-term care expenditure. The potential for needing nursing home care affects economic decisions for individuals over a lifetime and across generations (Norton 2000). For example, an elderly widow anticipating a need for long-term care may decrease her savings or increase her bequests to qualify for means-tested public insurance, or may demand informal care from a working daughter, even though she ultimately never enters a nursing home.

Long-term care differs from acute medical care in four fundamental ways (Norton 2000). First, long-term care is care for chronic illness or disability instead of treatment of an acute illness. Medical expenses accumulate unrelentingly. Second, the nursing home industry is dominated by for-profit facilities sometimes facing excess demand, in contrast to the hospital industry which is dominated by non-profit facilities with an excess supply of beds. Third, nursing homes have many close substitutes, including informal care. Informal care may affect the caregiver’s labour supply or may influence bequests, if such bequests are used to elicit attention and informal caregiving by children. Fourth, in contrast to relatively comprehensive acute care insurance for elderly, few people purchase private long-term care insurance and most public insurance is means-tested, with high co-payments. Thus, long-term care is usually the greatest out-of-pocket expenditure risk faced by the elderly.

This article summarises the theoretical and empirical economic research on nursing homes and long-term care. In addition to discussing supply and demand, particular attention is focused on quality of care and the market for long-term care insurance.


Aging Assisted living Chronic care Elderly Informal care Insurance Long-term care Nursing homes 

JEL Classifications

I110 I130 


Long-term care covers a continuous spectrum, from infrequent informal care provided by a neighbour to institutional care with around-the-clock nursing. The nursing home industry is an appropriate starting point for a review of long-term care because of its size and cost. Many elderly, and a few disabled nonelderly, people enter a nursing home when they are no longer able to live independently. In the USA, on any given day 5% of persons aged 65 and older are nursing home residents. Lengths of stay in nursing homes vary widely, from short stays of a day or two, to lengthy stays of several decades. Nursing home care is expensive, and insurance is far from complete.

There are many imperfect substitutes for nursing homes for long-term care. The choice depends on the individual’s physical and mental health, finances, and family situation. Despite the visibility of nursing homes, most care for the elderly is provided informally. Informal care is most often provided by spouses and children. Informal care can reduce nursing home use and expenditures because it is a substitute (Van Houtven and Norton 2004, 2008). Other forms of long-term care that are partial substitutes for nursing home care include home healthcare, board and care homes, adult foster care, adult day care, hospice care (Hamilton 1993) and continuing care retirement communities (CCRC). In summary, the market has developed a variety of solutions to the problem of giving care to chronically ill persons with widely varying physical and mental health status, finances and family situations.

For research on long-term care outside the USA, see Carmichael and Charles (2003), Forder and Netten (2000), Laine et al. (2005), Lindeboom et al. (2002), Noguchi and Shimizutani (2006), O’Neill et al. (2000), and Portrait et al. (2000).


The nursing home market has many properties of a competitive market (Bishop 1988). Barriers to entry are low, capital costs per bed are much lower for a nursing home than for a hospital, and new nursing homes can enter with little owner equity. Nursing homes hire relatively unskilled labour and do not need highly specialised equipment. Administrative and licensing costs are also low. Furthermore, there are few, if any, economies of scale. Nursing homes can enter with few beds. Therefore, barring regulation of entry, nursing homes of all sizes should be able to enter the market easily, based on entry costs.

Despite these attributes of a competitive market, the nursing home market is not competitive in many ways. Many nursing homes have waiting lists and operate at, or near, full capacity. The waiting lists may imply that demand exceeds supply, which would not happen in a freely competitive market in equilibrium. Part of the constraint on the market in the USA is that a majority of residents are covered by Medicaid or Medicare and pay regulated rates. Medicare covers short-term stays for persons expected to recover. Another reason may be due to direct constraints on supply due to Certificate-of-Need (CON) regulations. Although data from the late 1960s through the early 1980s argued that CON was a binding constraint for Medicaid beds (Scanlon 1980), recent research has shown different results. Grabowski et al. (2003) found that states that repealed CON and moratoria laws did not experience an increase in Medicaid expenditures relative to states that did not repeal these laws. Similarly, Gulley and Santerre (2003) found that the CON laws did not affect access to nursing home care. The national trend towards lower occupancy rates is consistent with the idea that CON and moratoria are no longer binding constraints in most nursing home markets.

A competitive market also requires informed consumers. Unlike acute medical care, the demand for nursing home care is often not time-sensitive. Potential residents may have days or weeks in which to search. Potential residents can obtain help from hospital discharge planners, relatives and social workers. Nursing home services are not technical and can be evaluated more easily by consumers than, say, surgical skill. There is a wide range of close substitutes, creating competition. However, in practice most consumers are not well informed. Elderly people who need nursing home care are disproportionately the ones with no close family to help them search, and end up in a nursing home because they have fewer options than other elderly. Those with close family often postpone searching for a nursing home because the thought of institutionalisation is unpleasant. Then, when a decision becomes necessary, location is often the overriding criterion. Elderly persons may have no choice if there are waiting lists and they are covered by Medicaid.

Quality of Care

The early literature on nursing home quality of care was largely based on Scanlon’s model (1980), in which nursing homes face two markets. One market is for private residents with downward sloping demand, and the other is for Medicaid residents who are insensitive to price. Scanlon presented evidence that the Medicaid residents faced excess demand nationally. Certificate-of-Need regulations and construction moratoria policies had constrained growth in the supply of nursing home beds, and nursing homes preferred to admit higher-paying private patients. As a result, when a bed shortage existed, it was the Medicaid patients who would be excluded.

Many policymakers argued that nursing home quality could be improved by raising Medicaid reimbursement rates. By incorporating a quality variable into Scanlon’s model, Nyman (1985) showed that raising Medicaid rates in a market with excess demand would result in nursing homes facing a reduced incentive to use quality of care to compete for the private patients. Several papers confirmed this inverse relationship between Medicaid reimbursement level and quality of care (Nyman 1985; Gertler 1989; Dusansky 1989; Gertler 1992). Nyman (1988, 1989) proposed that this outcome would be spurious if tight markets eliminated an observable measure of quality – the occupancy rate – to inform consumers. Norton (1992) showed that cost-mix adjusted reimbursement with incentives for quality improvement lead to improved health outcomes.

More recently the market has changed due to the decline in nursing home occupancy rates and the repeal of CON laws in some states. Recent studies have generally found a modest positive relationship between state Medicaid payment rates and nursing home quality, unlike the earlier research. Higher payment rates have been found to be associated with fewer pressure ulcers (Grabowski and Angelelli 2004), more staffing (Grabowski 2001b), fewer hospitalisations (Intrator and Mor 2004), fewer physical restraints (Grabowski et al. 2004), less feeding tube use and fewer government-cited deficiencies (Grabowski 2004). In terms of the size of the effect, these studies indicate a payment–quality elasticity in the range 0.1–0.7, depending on the quality measure. Importantly, the most recent studies provide little support for a negative relationship between the Medicaid payment level and quality.

In an attempt to bridge the two generations of this literature, Grabowski (2001a) replicated the data, methods and quality measures from Gertler (1989) to identify the underlying source of the different findings. When the methods and quality measures from the earlier study were applied to more recent data, Medicaid payment was found to be positively associated with quality. Changes in the marketplace – not alternative data or methods – explain the different findings across the two generations of studies. However, using national data from the earlier time period, Grabowski also found that Gertler’s New York results did not generalise to the entire USA. Thus, the earlier result may have been only been relevant for a minority of states or markets where CON laws were particularly binding.

Public Quality Information

Economists have long studied the problem of asymmetric information in the healthcare market (Arrow 1963). Without accurate information on nursing home quality, the market matching patients to providers will result in poor matches. Healthcare is partly an experience good. In principle, a patient could eventually discern a nursing home’s quality, but most patients only seek care once or a few times.

There are now published report cards and performance measures in the USA for nursing homes (and also for physicians, hospitals and home healthcare providers). The idea of Nursing Home Compare is to pool information on the experience of recent patients and make that information available to all potential patients. By pooling collective experience, healthcare can be an experience good.

Clearly, accurate timely information could help consumers choose higher-quality providers and induce providers to compete on quality (Werner and Asch. 2005). Even with good information, there are many potential problems and unintended effects (Werner and Asch 2005). These problems may be exacerbated with elderly patients, who are usually less able to handle complex comparative information.

Empirical results are quite mixed on the effect of Nursing Home Compare on quality of care. Werner et al. (2009) found that two of three published quality measures improved, while a third, no delirium, did not improve significantly but was already at high levels. The unreported measure of hospitalisation, however, worsened. Hospitalisations are not merely an indication of a poor health outcome. They can also be used strategically to improve a nursing home’s score (Konetzka et al. 2013). In contrast to CABG patients, where all patients are included in quality outcomes, for nursing homes only patients who stay at least 14 days are included. Konetzka et al. (2013) explain that this gives nursing homes a different kind of selection mechanism. They can discharge sicker patients back to the hospital just prior to the 14-day limit to keep poor-prognosis patients from adversely affecting their scores. Konetzka and colleagues find evidence of the hypothesised behaviour. This indicates that the concern about selection in performance measures is complicated in nursing homes.

A key assumption for advocates of report cards is that consumers will respond to quality information. If consumers are not responsive, then the case for publicly provided information falls. Therefore it is important to show that consumers respond to quality information (Werner et al. 2012). Werner and colleagues lay out the argument on both sides of the debate for how response to web-based information may differ by education. On the one hand, those with more education may be better able to process the complex information and use it to make decisions. On the other hand, people with more resources may always have been able to find out about quality of care, so providing it publicly may actually level the playing field, especially with social workers and discharge planners offering advice. Werner et al. (2012) found that nursing homes with higher reported quality of care for pain control increased their market share for post-acute care, indicating that consumers are responsive to information about certain kinds of quality, although the magnitude of the effect was small. For education, they found that those with higher education had a slightly higher response, and the difference was statistically significant.

Quality of care also depends on the market conditions. Building moratoria and Certificate-of-Need restrictions reduce supply from free market levels, leading to excess demand in the nursing home market. In these cases, nursing homes may not compete as well on quality of care. Not surprisingly, nursing homes in competitive markets responded more to quality incentives by improving quality after Nursing Home Compare than nursing homes with greater market power (Grabowski and Town 2011). Previous work by Grabowski (2002) showed that in excess demand markets more dependent residents had access problems, but that quality of care remained unchanged with the introduction of case-mix reimbursement.

Ownership Type

In contrast to the hospital industry, two-thirds of all nursing homes are for-profit. In both industries, the mix of for-profit and non-profit firms has led to studies of how ownership affects costs, quality and access to care. In nursing homes, the primary concern is the existence of asymmetric information about quality. Arrow (1963) hypothesised that non-profit providers are common in markets for complex personal services because they have less incentive than for-profit providers to under-provide quality to poorly informed consumers (see also Hirth 1999). Consumers, especially frail elderly people with no close family support, may have trouble discerning quality within a nursing home, and may not have the ability to shop among nursing homes (Spector et al. 1998).

Several papers promote the idea that non-profit status is a signal of quality. Chou (2002) looked at differences in quality of care, measured by death and adverse health outcomes, between for-profit and non-profit nursing homes and between residents who had close family. She found that the differences between ownership types were greater when there was asymmetric information, meaning that no spouse or child visited within 1 month of admission. Grabowski and Hirth (2003) looked at the related issue of how the share of non-profit nursing homes in the market affected quality of care. They argue that a greater percentage of non-profit nursing homes would have competitive spillover effects, which is what they found after controlling for the endogeneity of non-profit market share.


Demand for nursing home care depends primarily on health status and the out-of-pocket price relative to the price of close substitutes. Those in worse health demand more long-term care. Those with fewer substitutes, or whose substitutes are higher-priced, demand more long-term care. Demand curves slope downward, and health shocks shift the demand curve outward.

The primary determinant of demand for nursing home care is health status – both physical and mental health. Persons in worse health status are more likely to go to a nursing home. As physical or mental health deteriorates, a person is less able to live independently and less able to perform the basic activities that most persons take for granted. Demand for long-term care is also related to other demographic characteristics, such as age, gender and race, because these variables are proxies for health status. Health status generally declines with age. Gender is related to nursing home use, but much of the effect of gender is due to health status and marital status. Married persons are more likely to receive informal care from their spouse. Married persons are also more likely to have children, another important source of informal care. Because women tend to outlive their husbands, women near the end of their life are less likely to be married and therefore are more likely to demand nursing home care. Another consequence is that men have worse health status at admission than women because they are more likely to have been able to stay at home with a spouse.

Race is significant in nearly every empirical study of nursing home use. Whites are more likely to use nursing home care than black, Hispanic or Asian people. Black people are more likely than white people to be on Medicaid, have severe illness and not have long-term care insurance coverage – all factors that hinder admission to a for-profit nursing home (White-Means 1997). Differences persist in empirical work, even after controlling for observable differences in insurance and health status. The difference in nursing home use may be related to cultural differences in preference for location of care, differences in health status or differences in access due to racial discrimination (Headen 1992). Race encompasses social, psychological, biological and genetic influences (White-Means 1995). Race therefore pervades socioeconomic status, attitudes and family culture, implying that empirical work should include not merely a dummy variable for race but a fully interacted model. The effect of race may also be related to the opportunity cost of informal care and nursing home care (Headen 1992). For example, if the wage rates of black people are lower than for white people, and the nursing home price is the same, then the opportunity cost of informal care is lower for black people. Headen (1992) found evidence that the opportunity cost of time – measured by labour force participation, education, age and social support – is lower for black informal caregivers than white informal caregivers.

The financial determinants of nursing home demand are the price, the relative price of close substitutes, and the person’s income and assets. Nursing home demand will increase when the price falls or when the price of close substitutes rises. Private insurance lowers the out-of-pocket cost of nursing home care, but few elderly people have private insurance, and those who do may still face substantial co-payments and deductibles. Income and assets do not affect nursing home demand in a straightforward way.

The expected rapid rise in the number of elderly persons over the next few decades will greatly increase demand for all types of long-term care. However, two demographic trends may mitigate the problem. The mortality rate has fallen by about 1% per year since 1950, so elderly people are living longer (Cutler 2001). The longevity gender gap has narrowed because the mortality rate for elderly men is falling even faster than for women. In addition, disability rates among the elderly are declining. Therefore, people are living longer and living healthier (Manton and Gu 2001). Lakdawalla and Philipson (2002) argue that these trends help explain much of the decline in the relative growth in nursing home use seen since 1970. Still, overall demand is expected to increase as Baby Boomers enter the prime age for nursing home care.


A risk-averse person facing an uncertain and expensive risk of needing long-term care should demand insurance. Indeed, the greatest financial uncertainty for elderly is long-term care expenditures (Norton et al. 2006). It is not food, pharmaceuticals or even inpatient care. In the USA, Medicare insurance is quite complete for inpatient care, outpatient care and pharmaceuticals, especially when considering Medigap and Medicaid policies that help pay co-payments and deductibles. But Medicare coverage of long-term care is quite limited. Medicare not only requires a prior inpatient stay, but requires substantial cost sharing after 20 days, and pays nothing after 100 days. Medicaid coverage of long-term care also requires substantial cost sharing. Roughly speaking, the deductible is most of a person’s non-housing wealth and the co-pay is most of her income (Norton 1995). This leaves long-term care as the greatest expenditure risk. In addition to reducing financial risk, the desire to leave a bequest to spouse and children may be a major motive for purchasing long-term care insurance (Bernheim et al. 1985; Hurd 1987, 1989; Bernheim 1991).

Despite the apparent demand for long-term care insurance for the elderly there are many reasons why there is little private long-term care insurance sold. This has been discussed extensively in the literature (for reviews, see Norton (2000) and Brown and Finkelstein (2007, 2011)). Here is a summary of the most important reasons why the private insurance market is small. Adverse selection means that those who are most likely to need long-term care are most likely to want to buy it; insurance companies may target individuals who statistically are least likely to need it. Moral hazard is often a problem in insurance markets. For long-term care there is both standard moral hazard and a version proposed by Pauly (1990) in which elderly people do not buy insurance so that their children, the presumed future decision makers, will not put them in a nursing home. Loading (administrative) costs are high because most sales are made to individuals and because adverse selection requires background and health checks. The load for private long-term care insurance has been estimated to be about 32% (Brown and Finkelstein 2011). It is high because it is mostly sold to individuals and because of the high commission fees paid to the brokers. The high overhead raises the premium and lowers demand.

Medicaid is a close substitute for part of the population who would qualify for Medicaid quickly (Hubbard et al. 1995). But a major reason why there is low demand for private insurance is that the benefit is low. Insurance companies now offer capped daily benefits, instead of paying a fraction of the cost (like most other health insurance), because of the difficulty in predicting future nursing home costs (Cutler 1996). Some policies are limited in the number of days of coverage. People who lapse in their insurance payments forfeit their coverage. These policies all reduce the insurance value of the product and lower its desirability. Some elderly people greatly underestimate their own risk of needing long-term care, again lowering demand. Given all these reasons combined, it is perhaps a wonder anyone buys long-term care insurance.


Nursing homes are an important part of the spectrum of long-term care providers. They are the most expensive form of long-term care and are used extensively by persons unable to live independently. The market is not as competitive as one would expect from an industry with low barriers to entry. Regulated prices and poorly informed consumers make the market less competitive and contribute to the poor overall level of quality of care. Attempts to improve quality of care have recently focused on publicly provided information on quality. Demand for nursing homes is predominantly driven by poor physical and mental health, but also depends on the relative price of close substitutes. The market for private long-term care insurance is hampered not only by the usual problems of adverse selection and moral hazard, but also high loading and poor benefits. The economic issues surrounding nursing homes will continue to be important as the population ages over the next several decades.

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Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Edward C. Norton
    • 1
  1. 1.