Equalizing Payments for Medical Care

Uwe E. Reinhardt is an economics professor at Princeton. He has some financial interests in the health care field.

For some time now, health policy makers around the world and the analysts who advise them have been exploring reforms of the methods by which the providers of health care are paid or, as the latter prefer to call it, are “reimbursed” – an unfortunate, mind-altering expression on which I have already commented in an earlier post.

Today’s Economist

Perspectives from expert contributors.

Several papers in the current issue of Health Affairs are devoted to that topic. They include one by me, another by David Miller that addresses large variations in Medicare payments for surgery and one by Peter Hussey about bundled payments for treatments of an entire episode of illness.

Perspectives from expert contributors.

My paper focuses on the fact that every private health insurer in this country pays different physicians, hospitals and other providers of health care different prices for identical services. The flip side of this practice is that a given provider charges different payers – insurers or patients – different prices for identical health service. Economists call that practice “price discrimination.”

Figure 1 below illustrates this phenomenon from the insurer’s perspective for colonoscopies in New Jersey. Figure 2 shows payments in 2007 by one large private insurer for appendectomies (then code DRG 107) and coronary bypass grafts with cardiac catheterization (code CABG, then DRG 107) in California at what are known as “tertiary hospitals” — those with the ability to support medical specialists in medicine, pediatrics, obstetrics and gynecology, surgery, their subspecialties and ancillary services.

While there evidently is pervasive price discrimination within the private health-care sector, there are also sizable price differentials between public payers on the one hand and private payers on the other. Figure 3 illustrates this phenomenon by means of the so-called payment-to-cost ratio paid to hospitals by Medicare, Medicaid and private health insurers. This ratio is calculated as a fraction of the full costs that hospitals report to have incurred for patients covered by these three payers.

We can see that in many years, hospital report that the two public payers have covered the full cost (including presumably allocated fixed-overhead costs) of the care for the patients covered by these programs. Private payers, on the other hand, pay a sizable margin on top of the full costs of treating their covered clients.

Private health insurers and their principals, private employers, deplore this phenomenon as a “cost shift” from public payers to them. Of course, by similar reasoning, private insurers and individual self-paying patients who pay relatively high prices for given services can lament that they are the victims of a cost shift from private insurers with stronger market power vis à vis hospitals, which enables them to bargain for lower prices for identical services.

Many economists do not buy into this contention, asserting that price discrimination can exist without a cost shift. Explaining how economists arrive at that conclusion goes beyond the limit of this post. Interested readers, however, might consult my previously cited paper in Health Affairs, or, if they are not daunted by more formal economic analysis, read Austin Frakt’s critique of the cost-shift theory.

Whether or not one accepts the cost-shift premise, the question arises of whether price discrimination in health care has served the United States well. On this point, the business school professors Michael Porter and Elizabeth Teisberg have this to say in their book “Redefining Health Care”:

This administrative complexity of dealing with multiple prices [for the same service] adds costs with no benefit. The dysfunctional competition that has been created by price discrimination far outweighs any short-term advantages individual system participants gain from it, even for those participants who currently enjoy the biggest discounts. The lesson is simple: skewed incentives motivate activities that push costs higher. All these incentives and distortions reinforce zero-sum competition and work against value creation.

Similarly, in commenting critically in The New England Journal of Medicine on another study of administrative costs of Canadian and American health care, Henry Aaron of the Brookings Institution offered this preamble to his critique:

I look at the U.S. health care system and see an administrative monstrosity, a truly bizarre mélange of thousands of payers with payment systems that differ for no socially beneficial reason, as well as staggeringly complex public systems with mind-boggling administered prices and other rules expressing distinctions that can only be regarded as weird.

Other nations with multiple insurance carriers – for example, Germany and Switzerland – avoid price discrimination in health care through negotiations over prices between regional associations of health insurers and counterpart associations of health care providers, subject to some overall budget constraint informed by macroeconomic conditions (e.g., growth of the payroll on which premiums are based or per capita income). The negotiated prices then apply uniformly to all insurers and all providers in a region (states in Germany and cantons in Switzerland). In the United States, Maryland has operated such an “all payer” system for hospitals for several decades.

An all payer system has the potential to reduce health care costs in several ways, including the discipline of a fee schedule on providers, the schedule to be negotiated with providers on a regional basis, and a reduction in the enormous complexity and high administrative costs of the current system.

If it is desired, an all payer system can also serve as a way to constrain the future growth of health care to some desired path – e.g., with total national health spending growing annually only 0.5 percentage points faster than the growth of the rest of gross the domestic product, rather than the traditional two percentage points faster that prevailed over the last four decades. A two percentage point differential is simply not sustainable.

In my above-cited paper, I advocate an all payer system for the United States to eliminate the pervasive price discrimination inherent in American health care and, to the extent it exists, the much-lamented cost shift. For readers of this blog, Health Affairs has graciously provided access to the paper until Nov. 16. I invite readers to take a look at my argument for an all-payer approach and share with us their reaction to it.