The NHS financial crisis was not caused by too much reform too quickly, but by too little too late, argues Keith Palmer. Efforts to restore balance should not be allowed to delay it further

The NHS financial crisis was not caused by too much reform too quickly, but by too little too late, argues Keith Palmer. Efforts to restore balance should not be allowed to delay it further

In recent years the NHS has seen the most sustained period of rapid funding growth ever. In spite of this, in 2005-06 trusts incurred an aggregate deficit of more than£1.2bn and the NHS as a whole incurred a net deficit of more than£500m.

There has been much debate about what lies behind the pervasive sense of financial crises. In fact there are three inter-related causes. The first is the failure to anticipate and manage the rapid growth of demand for hospital care. Emergency hospital admissions have grown by about 6 per cent a year over the last three years. In some regions, notably London, they grew by more than 10 per cent a year.

The second is rapid cost inflation, particularly of pay and drug costs. Average annual pay costs per NHS employee has grown by about 7 per cent over the past three years. They were under-estimated and under-funded but trusts had to pay them in full.

The third cause is the declining productivity of trusts. More staff, equipment and funding were needed to serve a given volume of patients before taking account of cost inflation and activity growth. The NHS funded the higher level of demand at much higher cost per patient.

The failure to achieve NHS-wide financial balance should not have been a surprise; there were no adequate mechanisms in place to ensure that the cost of meeting aggregate demand remained within budget. The result is that for the last two years it did not.

Why did more than 60 trusts incur deficits in 2005-06 while many others were able to achieve financial balance? Some trusts were hit harder than others by the staged introduction of the reforms, particularly payment by results. The cost of meeting access targets and responding to the growth in demand for emergency care was much higher for some trusts than others. There was bound to be a need for adjustment with the emergence in the short term of 'winners' and 'losers'.

Winners would find it easier to achieve financial balance, even if relatively inefficient. Losers would be more likely to incur deficits even if relatively efficient. The financial regime that required all trusts to maintain precise income-expenditure balance in every year was a mistake. It turned a period of necessary adjustment into a perceived financial crisis.

The financial crisis was not caused by too much reform too quickly, as some would have it. This is clear because key reforms, such as payment by results, practice-based commissioning and patient choice only began to 'bite' in earnest in 2006-07. The real cause of the financial crisis is better described as too little reform, too late - the result of rapid growth in funding before putting in place sufficiently robust levers to manage demand, control cost inflation and induce improvements in productivity.

PCTs' ability to pay for services

In early 2006 the Department of Health introduced tough rules intended to restore financial balance. Three factors - the requirement for some trusts to budget for a surplus, top-slicing of primary care trust allocations in deficit regions and halving of the purchaser parity adjustment (PPA) - all reduce PCTs' ability to pay for services. PCTs affected by top-slicing and halving of the PPA are particularly hard hit.

All PCTs will have to manage hospital demand very aggressively to keep it within affordable limits. The hardest hit will not be able to afford to pay for the activity growth that is needed if the 18-week wait target is to be met.

Efforts to achieve financial balance are already causing those PCTs to cut back community care, mental healthcare and public health programmes. If they fail to contain demand to what is affordable they will incur deficits. If they succeed, then patient services will be reduced and hospital trusts will be more likely to incur deficits.

The extension of payment by results to two-thirds of hospital activity and the 5 per cent cut in the average real tariff sharply strengthen the pressure on hospital trusts to improve productivity. Hospital trusts will have to reduce unit costs this year by 4-5 per cent on average, and some by more than 10 per cent, if they are to achieve or restore financial balance.

They will no longer be able to trade their way out of deficits, as in the past, because PCTs will not have the funds to pay for more activity. There will be greater risks to the quality of patient care, particularly at trusts with large deficits.

Trusts will have to streamline clinical services, increase capacity use and reduce the time patients spend in hospital. They will have to provide more care for patients with fewer wards, beds and some categories of staff. There will be more 'stranded capacity', available to provide services for patients but unable to find a PCT able to pay for them.

Payment by results is a vital piece of the reform armoury. Well-designed tariffs can bring about better and cheaper patient care. Unfortunately as currently designed the tariffs have two major failings that are causing unintended and undesirable effects. First, they systematically over-fund some trusts at the expense of others. As a result some relatively efficient trusts will incur deficits because they are under-funded. Other less efficient trusts may achieve financial balance because they are over-funded.

Second, the tariffs generate strong perverse incentives for each hospital trust to maximise hospital admissions. If they support actions to shift activity out of hospital and closer to home or to minimise inappropriate hospital admissions for patients with long-term conditions it makes their task of achieving financial balance much more difficult.

The right direction?

With the new rules and tariffs in place, can we expect the government's healthcare objectives to be realised?

By the end of 2006-07 NHS-wide financial balance may well be restored. The reserves created by measures such as the top-slicing of PCT allocations should be sufficient to finance the aggregate trust deficit at year-end. However, many PCTs and trusts will remain in deficit.

The largest deficits will be focused on those trusts that are particularly hard-hit by the system rules and the unintended funding effects of the tariffs. Whether a trust incurs a deficit or achieves financial balance will not necessarily be a valid indicator of whether it is efficient or well managed.

The addition of new independent sector services will increase choice for patients, but will further increase the amount of NHS stranded capacity. The need to reconfigure services to provide better and cheaper care will become more urgent.

Progress in shifting care out of hospital and closer to home is likely to be slow. PCTs have weak levers to make it happen. Hospital trusts are unlikely to support creation of new networks of care providers, even if good for patients and cheaper overall, if they lose out as a result. The absence of rules to manage and finance service reconfiguration will act as a further brake on progress.

Beyond 2006-07 there is likely to be a continuing need for top-slicing of PCT allocations to create reserves to fund deficits and finance service reconfiguration.

As the growth rate of NHS funding slows sharply, sufficient resources to fund activity growth and further service improvement will only be available if NHS cost inflation is contained and all providers, not just hospital trusts, achieve sustained productivity improvements. PCTs will need stronger tools to target scarce additional resources on achieving national and locally agreed healthcare priorities.

Instruments of reform

There are three key areas where improvements to the reform instruments are needed if the government's objectives are to be more fully achieved.

The first is a stronger strategic commissioning regime that enables PCTs to shape more effectively the pattern of health services to address national and local healthcare priorities. The problem for PCTs at present is that they have only weak influence over the demand for hospital services and must pay the full tariff for almost all elective hospital activity. It is therefore difficult for them to avoid resources being sucked into hospital care at the expense of care in the community. PCTs need more influence over the share of their budgets that is spent on hospital care.

To achieve this they need to be able to contract for hospital services on the basis that they pay the full tariff for planned activity levels but a lower price for activity in excess of planned levels. A stronger commissioning regime would enable PCTs to perform more effectively the role envisaged for them in the commissioning framework.

The second area where major improvements are needed is in the design of the tariffs to eliminate the undesirable funding effects and to improve incentives on hospital providers to support desired service reconfigurations. New thinking is needed about ways to establish payment systems for chronic conditions and mental health that eliminate the current perverse incentives to maximise hospital admissions.

Third, clarification is needed of the rules that will apply to regulate the new NHS provider market and, in particular, to manage and finance desired service reconfigurations. Restructuring costs money in the short term but saves much more in the medium term. Without access to restructuring, finance trusts will not be able to implement desirable service reconfigurations. Currently there are no clear rules to govern whether and on what conditions proposed local agreements to reconfigure trusts, for example mergers, takeovers, strategic alliances etc will be permitted. Until the rules are clarified progress forging such local agreements will be stymied.

Adopting these policy improvements would facilitate progress in reconfiguring services to provide patients with better and cheaper patient care in the medium term. They would increase the range of services to which GP practices could refer and from which patients could choose. They would mitigate the financial destabilisation of trusts and improve the likelihood that NHS-wide financial balance is permanently restored.

Keith Palmer is a senior associate at the King's Fund, a non-executive director at Guy's and St Thomas' foundation trust and previously held senior positions at investment bank Rothschild. He writes here in a personal capacity. This article is based on NHS Reform: getting back on track, published today by the King's Fund.