Month: January 2014

How to Change How Prices Are Set in Healthcare

Image credit: shutterstock.com
Image credit: shutterstock.com

In my previous post, I described the three ways prices can be set in healthcare: administrative pricing, bargaining power-based pricing, and competitive pricing. I also bemoaned the fact that the prices paid to providers by private insurers are determined more by relative market share than by anything else* . . . but this post explains how we can change all that.

I see two possible pathways from bargaining power-based pricing to competitive pricing, so here they are.

First Pathway

Let’s pretend a colonoscopy clinic is super innovative in how they do things, and they eventually are able to lower their costs by 20%. This is great for them because the prices they are paid by insurers has stayed the same (remember, those prices are determined primarily by relative market share, not costs), so now they have a really solid profit margin. And yet, the managers of this clinic still aren’t satisfied because they have excess capacity they want to fill.

One day, the managers come up with an idea. They say, “Up to this point, we’ve always maximally leveraged our bargaining power with insurers to win the highest prices we possibly can, but what if we do something radically different? What if we offer to lower our prices by 10% in exchange for the insurers putting us in a new, lower-copay tier? This would induce way more of their policy holders to choose us for their colonoscopies, so we’ll fill up our excess capacity. And, according to our calculations, our increased volume will more than make up for the lower prices. So everyone wins! Our profit increases, the insurer saves money with the lowered prices, and the patients are happy because their copays are less as well.”

Soon, some of the clinic’s competitors would figure out why their volume is starting to drop, so they would probably find a way to offer lower prices to get put into that lower-copay tier as well. Competitors who can’t or won’t lower prices will slowly lose market share until they, too, are forced to either lower price or improve quality enough to convince patients that going to them is worth the extra money.

Voila! Competitive pricing.

I have a friend who manages a large self-insured employer’s insurance plan, and I asked him what he would do if a clinic came to him offering lower prices in exchange for steering more employees to it. He said as long as the provider can show that quality won’t go down with the additional volume and that wait times for appointments won’t increase, he’d probably go for it.

Now, of course this wouldn’t work with every kind of healthcare service. I purposely chose a non-emergency service that already has pretty straightforward pricing. But as a priori quality and pricing information becomes more available, more services will be candidates for this pathway to competitive pricing.

One other point: Hospitals generally do a horrible job of cost accounting (they’re just such complex organizations!), so they usually have no idea if a proposed price reduction will still be profitable or not. Thus, they’ll be left behind in this game until they start to develop better cost accounting methods. If they have some foresight, they’ll start fixing that now.

Second Pathway

An insurer is despairing the fact that many of the providers in the region have combined into a single price-negotiating group, so now the insurer is stuck paying way higher prices than before. But then some health policy-savvy managers figure out a solution. They say, “Let’s implement reference pricing for a bunch of non-emergency, straightforward services. Let’s start with colonoscopies. This is how it works. We’ll tell our policy holders that we’ll put $1,200 toward a colonoscopy (the “reference price”). If a policy holder chooses a provider who charges more than that, they will pay everything over that price. A few clinics in the area offer prices that are lower than $1,200, so policy holders will still have a few options if they don’t want to pay a dime. But, (and here’s the best part) the price the providers in that huge price-negotiating group forced us to accept is $3,000, so they’re definitely going to lose a lot of volume, which will probably force them to lower their price.”

Soon other insurers jump on the reference pricing bandwagon and higher-priced providers who are losing tons of volume will be forced to price competitively.

In conclusion, shifting to competitive pricing is not immediately possible with most healthcare services. But the way to make more healthcare services amenable to competitive pricing is to improve a priori quality and pricing information: quality information needs to be standardized and more relevant to the factors patients should be considering when they’re choosing between providers, and the full price of an episode of care needs to be available beforehand so patients can compare them apples to apples. Only after these changes happen will we be able to rely more on competitive pricing, which, most importantly, will do more to stimulate value-improving innovations in our healthcare system than almost anything else.

* I also complained about how administrative prices don’t encourage (and actually stifle) innovation toward higher quality and lower prices. Check out the Uwe Reinhardt quote in this blog post and then think, “Uwe must have been reading Taylor’s blog.”

The Three Different Ways We Could Set Prices in Healthcare

Image credit: AP Photo/Damian Dovarganes
Image credit: AP Photo/Damian Dovarganes

Out of the three general ways we could set prices in our healthcare system, one is best. Too bad we’re using the other two.

First, I’ll describe each method:

  1. Administrative pricing: This one is very straightforward. The government says, “For procedure A, healthcare providers will be paid X dollars.” Usually the methods for coming up with that dollar amount are sophisticated and rely on the best available data, but not always because they are subject to various political influences and government budgets.
  2. Bargaining power-based pricing: This one is easiest to explain using an example. Think of a small town with only two family medicine docs. One, Dr. Awesome, treats 90% of the town’s residents; the other, Dr. Mediocre, treats the other 10%. All patients are insured by one of four different private insurers, each of which has approximately equal market share. Now think of Dr. Awesome sitting down at the bargaining table with one of the insurers to decide on prices. He says, “If you don’t pay me at least Medicare rates times 1.4, I won’t accept your insurance. I’m serious, I won’t accept anything less.” And the insurer says, “Hey, that’s a horrible deal, but if we stop covering care you provide then most of our policy holders in your town will just switch to one of our three competitors and we’d lose out on even more profit!” Now think of the conversation between Dr. Mediocre and that same insurer. Dr. Mediocre says, “Pay me Medicare rates times 1.4.” And the insurer responds, “No. We’ll pay you Medicare times 0.8. If you say no and we don’t have you listed as a provider in our network anymore, that’s okay because only a tiny percentage of our policy holders are your patients. And we know that you don’t have many patients, so you can’t afford to risk losing 1/4 of them by saying no to the price we offer.” Relative market share between the two parties is the primary determinant of bargaining power, so a bigger market share means you can get a better price.*
  3. Competitive pricing: This is the method used to determine prices in almost every other industry. Here’s basically how it plays out: Competitor A says, “Everyone knows that our product has similar quality to our competitor’s product, so we can’t price it higher than theirs without sacrificing quite a bit of market share. We could sell it for less than theirs to win more market share, but then the price is perilously close to our costs, so we’ll have to do some math to see what the profit-maximizing price/market share combination is likely to be.” Note the one huge condition that is required for this to work: Potential customers must be able to compare the price and quality of all their options, which is starting to happen more and more as better quality information is starting to become available and as prices are becoming more transparent.

Our healthcare system currently relies primarily on number 1 (think: Medicare and Medicaid) and number 2 (think: private insurers and providers setting prices with each other). But which method is best?

If you want to have the lowest possible prices, administrative pricing is the obvious best choice. But that’s only for the short term (as you’ll see), and it does nothing to encourage quality improvement unless you start getting into the treacherous area of performance incentives.

The only thing I’ll say about bargaining power-based pricing is that I don’t like it. I’d rather not have prices that are totally unrelated to costs or quality and instead are determined by relative market share.

Now let me tell you why I like competitive pricing so much. I want our healthcare system to deliver better value right now (Value = Quality / Price), and even more than that I want that value to go up over time as providers and insurers innovate in ways that allow them to decrease prices, increase quality, or both. Competitive pricing is the only method that provides an incentive for competitors to innovate because it rewards the highest-value offerings with increased market share and profit. The other two options don’t do that, which seems like a pretty big downside, don’t you think? I’d be willing to forgo short-term super-low administratively set prices in favor of stimulating innovation that will improve value way more over the long term.

In my next post, I’ll explain how we can shift from bargaining power-based pricing to competitive pricing.

* Do you ever hear those arguments that if public insurers lower their prices any more, providers will just raise their prices for private insurers? Well, now you know why those arguments are mostly hogwash. Providers are already leveraging their relative market share to get as high prices as possible from private insurers, and getting paid less by public insurers doesn’t change that relative market share.