The High Price of Health

by Uwe Reinhardt [Reinhardt is professor of health care economics, Princeton University. Copyright Uwe Reinhardt, Princeton University, 1998.]

If one had to compress an assessment of the managed-care industry in this decade into one paragraph, it might read as follows: In this decade, the managed-care industry achieved a lot more than it is given credit for. But it fell surprisingly short of the earlier expectations that many experts had of the industry, partly for reasons beyond its control. And partly because it shot itself in the foot.


Think back to the late 1980s. In those years the premiums private employers were charged for the health-insurance for their employees rose an average of 15% - 20% per year. In fact, throughout most of the 1980s, health-spending per capita in the private sector rose much more rapidly than did spending by Medicare per Medicare enrollee, which is one of the better kept secrets among the general public. Throughout the 1980s, corporate executivee wailed that "government was not paying its fair share" of health care costs. In fact, these executives were lamenting the fact that government was controlling health spending better than they did.

In the end, private sector health spending got so out of control that employers became desperate. After Governor Clinton was elected President, executives of major corporations jetted to Little Rock to beseech him for help in their fight with the health-care sector.

But not all of them did. Some had discovered the confluence of three independent factors that gave them a unique opportunity to tame the health-care cost monster:

(1) the general recession that began in the late 1980s and ran into about 1992;

(2) the general restructuring of corporate America, set off in part by the debt binge upon which corporate America had embarked earlier in the decade and that had put severe pressure on executives to cut costs; and

(3) an earlier decade's worth of experimentation with managed care techniques that now, in the early 1990s, lay on sundry shelves, ready to be used.

The first and second factors made the typical employee fear for his or her job, to which the family's health insurance was tied. Beset by this fear, employees accepted rather passively a proposition that had hitherto been anathema in America: that they should give up their freedom of choice among doctors and hospitals at time of illness in return for better cost control. Once that proposition had been crammed down the employees' throats, the private insurance carriers who provided health insurance to private employers were able to contract selectively with doctors and hospitals, and what is now referred to under the generic term "managed care" could take off in earnest.


Selective contracting is the central pillar of managed care, because it effectively converts self-employed physicians into quasi-employees who can be "fired" at will by the private insurance carriers, simply by canceling the carriers' contracts with individual physicians. Hospitals, too, became dependent on their survival for the selective contracts with insurance carriers, now rechristened as "managed-care companies." Selective contracting became the instrument that cash physicians and other providers of healthcare from their position of undisputed control over the content and cost of health care into an unaccustomed servitude. Put another way, American medicine slipped from what physicians remember as their Golden Age into what many of them now call the Dark Ages of the profession.

This shift of market power from the supply to the demand side enabled the managed-care industry to accomplish two tasks that hitherto had been unthinkable. First, insurance carriers could extract steep price discounts from the providers of health care, sometimes driving the fees they paid doctors and hospitals below the levels paid by Medicare. Second, the insurance carriers could foist upon doctors and hospitals externally administered practice guidelines that were enforced through pre-authorization of expensive procedures, concurrent review, and ex-post physician profiles that were used by insurers in decisions whether or not to renew contracts with particular physicians. Medicine began to be practiced in a statistical fishbowl.


There is no question that the managed-care industry was able to use this new-found market power to the overall economic advantage of the insured. The annual increase in premiums private employers had to pay for their employees' insurance coverage began to plummet, reaching a reported national average of -1% in 1994-95 (although there was a wide variance about this average). Although now there is talk of premium increases for 1998-99 in the range of 5% to 10%, even these increases are considerable below the norm of the late 1980s.

As late as June 1993 the Congressional Budget Office (CBO) had predicted that the US would be spending between 15% and 16% of its gross domestic produce (GDP) on health care by the mid 1990s and close to 20% by the year 2000. In fact, ever since 1992 that ratio has stabilized at slightly below 14 percent. The ratio is unlikely to reach 16% by the year 2000 and probably will not even reach 15%.

In terms of dollars, in 1996 American spent somewhere between $100 to $140 billion less on health care than the CBO had predicted only several years earlier. By the year 2000, that saving will amount to $300 billion a year. Surely a fair-minded person must call that an achievement for which some gratitude seems due.

Did anyone thank the leaders of the managed-care industry for this achievement? No one did, for at least two reasons.

First, these cost savings were, after all, purchased at the expense of less freedom of choice among providers and of considerable hassle visited upon doctors, hospitals, pharmacists and other providers of health care. In effect, the managed-care industry represents nothing other than the private regulation of health care. And no one likes to have their health care regulated by public or private regulators.

As part of the managed-care revolution, relatively gentle public regulators, who were forever scared of the political consequences of their actions (and whose bosses could be bought off with PAC money) were being replaced by tough, capitalistic and sometimes ruthless private regulators who took no prisoners and whose bosses (shareholders) could not be bought off with PAC money at all. To their chagrin, the providers of health care discovered that the shiny wing-tipped boot of a private regulator weighs much more heavily on the shoulder of the regulatee than do the hush-puppies of public regulators. For that very reason, physicians in particular have run in droves to politicians, there to seek succor from the heavy hand of the private health-care regulators. In the meantime, physicians have also sung a sad chorus into the ears of their patients, fueling the patient's anxiety over the strictures of managed care.

Second, while patients certainly are aware of the freedom they have lost--and are reminded of that loss daily in the media--they are not aware that the cost savings purchased with that limitation of choice ultimately benefits patients. The reason is that the typical employee is woefully ignorant of the ultimate incidence of "employer-paid" fringe benefits. For decades, private employers have nourished the myth that it is the "company," rather than the employees themselves, which pays for the employees' health insurance and other fringe benefits. Employer provided health insurance literally is being viewed by employees as an almost free lunch. Lulled into this myth, employees now believe that every penny of cost savings achieved through managed care has accrued fully to the firm's owners, not to the employees.

Economists believe to know better. Both economic theory and a considerable body of empirical research suggests that the bulk, if not all, of the fringe benefits bestowed by employers on their employees are paid for through reduction in the employees' own take-home pay. Thus, most economists would argue that whatever cost savings the managed care industry wrought from the providers of health care flowed through to employees in the form of added take-home pay or added jobs.

Economists are willing to thank the managed-care industry for this achievement . And they think that employees, too, should thank the industry. Alas, the ignorant masses--carefully left in the dark on this point by their employers--won't. And, thus, the managed-care industry ends up with a black eye as the only "thanks" for a major achievement.

Poor people on Medicaid also should thank the managed care industry for a new-found dignity accorded these patients. In the 1980s, the fees private insurers paid doctors and hospitals for health care were so enormously high that many providers simply refused to treat Medicaid patients at that program's low fees. In the economist's jargon, the physicians' and hospitals' economic opportunity costs of treating Medicaid patients were too high. In the meantime, the fees paid under managed care have been depressed to the point at which Medicaid patients look downright attractive by comparison. By depressing the fees paid for private patients, the managed-care industry actually has vested Medicaid patients with a new dignity in the eyes of doctors and hospitals. It is a major achievement that has gone almost unnoticed.

For more information on this topic, I'd be happy to share hard-copies of a recent speech entitled: "Would Jesus have Liked Managed Care?" The answer is: Probably yes, for Mary herself would be likely to have been a Medicaid mom in our age (while Joseph would have been uninsured).


At this time, the managed-care industry seems to be losing the tight grip it had gained over health care providers in the early 1990s. Since 1997, premiums for private health insurance have started to creep up. Current forecasts put premium increases for 1998-99 in the 5% to 10% range (depending on the size of the employer writing the contracts), although premium increases of 25% or more for small employers are not unheard of. Indeed, the Connecticut-based Oxford Health Plan recently announced that it would like to raise premiums for individually sold health-insurance policies by between 60 to 70%.

In addition, the managed care industry is now met with a pervasive backlash, certainly in the media and in the political arena, and apparently among the general public as well. Bashing and regulating the industry has become a favorite, even among Republican politicians, as is illustrated by the highly regulatory "consumer protection" bill recently introduced by the Republican Congressman Norwood and Senator D'Amato.

In part these developments are beyond the industry's control. In part, they are self-inflicted wounds whose infliction was triggered by a mental illness that the ancient Greeks called hubris.

As noted earlier, selective contracting is the central pillar upon which the power of the managed-care industry rests. That pillar, in turn, is anchored in the willingness of the insured to put up with limited choice of providers of health care at the time illness strikes. In its most concrete form, that limited choice model is the gate-keeper model, under which a primary-care physician effectively regulates the health care patients receive at the time of illness. As noted earlier as well, it took a recession and cowered employees to foist the principle of limited choice upon employees. In the meantime, however, the economy has been booming and labor markets have become tight. In such a market, generous fringe benefits are a come-on from which limited choice detracts. Thus, not surprisingly, the gate-keeper model in managed care has given way to point-of-service contracts (which allow procurement of care from outside the managed-care network of providers), direct access to specialists, and so on.

In short, boom times in the economy have eroded the power of selective contracting and, thereby, clipped the wings of managed care. That industry finds it difficult now to control its outlays on medical care--especially on prescription drugs--because the industry is slouching once again towards something resembling nothing so much as warmed-over, fee-for-service indemnity insurance.

In addition to this factor, which is truly beyond the industry's control, the industry itself has triggered a backlash through its clumsy techniques, some of which seem to be rooted in outright arrogance.

In principle, the idea of "managing care" had been to hold the providers of health care to high standards of clinical performance through well-researched practice guidelines. In practice, "managed care" has meant for the most part a fanatic and ill-considered search for the lowest average length of stay (ALOS) in hospitals. The effort is ill conceived, because the later days in a hospital stay actually cost much less in controllable costs than the flat per diems insurers pay for those days. Thus, insurers believe to be saving $ 1,000 to $ 1,500 when they kick mothers out of the hospital one day after a normal delivery, when in fact that second days could have added at most $200 or so in avoidable costs. After all, how much Jello can a mother really eat on that second day?

The thoughtless, indiscriminate hunt for ever more reductions in the ALOS of hospitalized patients is, in my view, one of the bullets the industry aimed at its own foot. The fact that earlier discharges are medically safe is really besides the point in what is supposed to be a "consumer-driven" health system. If consumers resent being discharged early, the proper policy would be to reeducate them, rather than to treat them as mere biological structures without a psyche. It is a safe bet that the industry will be able to turn off the current backlash against it only once it appreciates more fully the difference between mere biological structures in for repair and "consumers" who want a health-care experience that suits their own preferences.

Second, the managed-care industry has never really understood the theory of "managed competition" or, if it did, it has sabotaged the implementation of the idea deliberately. Although much touching lip service is paid on the conference circuit to the "new, customer driven" American health system, in truth most managed-care carriers consider their job done when they have pleased the employee-benefit manager.

Many health plans do not even have a flourishing website through which to distribute credible information on the satisfaction of enrollees already in the plan, on the background of its physicians, and so on. Most health plans still ask households to choose them without much relevant information. Taking too lightly the ultimate consumer of insurance coverage appears to have been borne by an untoward hubris the industry developed after the demise of the Clinton plan. The industry is now reaping what that hubris begot.

Third, related to the preceding factor, the leaders of the managed-care industry have allocated insufficient time and money to the information systems that are the sine qua non of a well functioning managed-care industry. The current plight of Oxford Health Plan, Inc. is a highly visible manifestation of this failure; but I believe the problem to be pervasive. Saving on information systems is penny wise and pound foolish. One would hope that the industry has learned from that failure. As a general rule, any health plan that pays its Chief Financial Officer more than its Chief Information Officer pays insufficient respect to the crucial role of information in managed care and managed competition.

Finally, some of the shortcomings in the managed-care industry must be laid at the doorstep of employers. Except for a few large companies, most private employers are simply not up to the task of implementing the theoretically elegant design of "managed competition," under which individual households would be well informed about the quality and cost of insurance protection of a whole host of competing health plans. About half of the nation's employees are offered but one plan by their employers and another 23 percent only two plans. Many employers do not offer their employees any health insurance at all.

History may well record one day that, after being the catalysts for managed care and managed competition in the early 1990s, America's private employers ultimately become the major obstacle to these innovative ideas. I have set forth my arguments on this proposition more fully in a recent paper entitled: "Employer-Provided Health Insurance: Rest in Peace." Perhaps the idea of employment-based health insurance has outlived its usefulness, and we should start thinking of its replacement in the decade ahead.


In thinking about the future of the American health care system, we should make a distinction between "managed care" and "managed competition." "Managed care" is a set of techniques designed to make the providers of health care more accountable for the quality of the health care they deliver, for the real resources they burn in the process and for the claims on the GDP they make to reward themselves for whatever health care they deliver to people. "Managed competition," on the other hand, is a carefully designed and regulated market structure in which health plans can be made to compete fairly for prospective enrollees. The two concepts are not at all the same thing, although "managed competition" usually does go hand in hand with "managed care."

While there has been some progress in introducing "managed care" into hitherto completely unmanaged and uncontrolled American health care system, the actual practice of "managed competition" is the rare exception, rather than the rule. To be sure, "managed competition" is being attempted by the Buyers Health Care Group in Minnesota, by the Pacific Health Care Group in San Francisco and by the California Personnel Retirement System (CalPERS) for employees of the California State government. It seems doubtful, however, that private employers elsewhere will ever succeed in practicing anything even resembling "managed competition."

It is more likely that the Medicare program will embark upon the full-fledged and proper implementation of "managed competition," as a result of the Medicare Choice plan passed into legislation as part of the Balance Budget Act of 1997 (BBA '97). While employees in the private sector seem willing to accept the haphazard market for health insurance being foisted upon them by their employers, it can be doubted that the elderly will be anywhere near as undemanding and passive. Medicare cannot afford to be anywhere near as cavalier toward the elderly as employers are toward their charges. It can be expected that, within a few years, Medicare will have develop a reasonably well functioning information infrastructure for its Medicare Choice program and that, in the end, it will be once again Medicare that will teach the private sector how to practice "managed competition," just as Medicare led the way in the development of the Resource Based Relative Value Scale (RBRVS) that is now being adopted everywhere by the private sector, and just as Medicare led in the development of the prospective DRG payment system for hospitals that is being copied around the world.

Medicare is likely soon to be a leader also in what is now called "direct contracting," that is, the assumption of full risk by integrated networks of health care providers who will take capitation directly from Medicare, without the traditional insurance intermediary. While that is being attempted now by a small group of private employers in Minnesota, it is likely to be the Medicare program that will give that development a major impetus. Within the next decade then, we should expect to see integrated provider networks compete head on with insurance-centered health plans, although in many areas the two may well cooperate, with insurance companies acting as patient brokers who, for 8 to 10 cents of the premium dollar, will channel insured lives to integrated providers systems that will take full risk for roughly 90 cents of the premium dollar. That model is already developing in some parts of the country--e.g. in California and in Massachusetts.


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