Building a Healthcare System from Scratch, Part 7: Concrete Descriptions of Some Optimal Systems

concrete
Image credit: Rattanachat

In Parts 1 through 6, I explained my framework for understanding the necessary ingredients of an optimal healthcare system. Those are the pre-requisite readings to understanding this post, and I will not fully summarize or provide the rationale for them here. But, just as a reminder, Parts 1 through 6 culminated in the goal of getting market share to flow to higher-value providers and insurers, which would be enabled through three critical inputs to decision makers/patients: (1) multiple options, (2) the ability to identify the highest-value option, and (3) incentives to choose the highest-value option. As barriers to those three inputs are minimized, any healthcare system will begin to evolve to deliver higher and higher value. This is the only way to unlock sustained value improvement in healthcare systems.

An important point about this framework is that it is, in a sense, welfare-spectrum neutral, meaning the principles apply to healthcare systems that sit at any point on the welfare spectrum, from libertarian-type systems to fully government-run systems.

Now let’s imagine up some concrete examples of what different types of systems might look like if we built them from scratch using the ingredients from that framework.

A Libertarian-type System

In this system, there are many private insurers all offering creative and innovative health insurance plans. Their efforts are focused on trying to maximize cost-saving prevention so they can lower their costs and then outprice their competitors. This has led to many ways of keeping people out of hospitals and emergency departments. But since health insurance is an inherently complex product, there are some standardized levels of coverage that have been agreed upon to help people compare those plans apples to apples. This standardization has been implemented in a way that maximally improves comparability with minimal limitation on plan design flexibility. Multiple health insurance comparison shopping websites have arisen, all highlighting those standardized coverage levels, differences between plans, and clear pricing.

An important aspect of these insurance plans is that most of them require the enrollee to pay some part of the price differential between providers; this did not need to be mandated because insurers found that they are able to price premiums more aggressively when they have implemented those cost-sharing characteristics. The plans that do not have this feature are much more expensive, but some people prefer them because they don’t ever need to worry about prices when choosing providers.

There is no requirement for people to buy health insurance, but because there is also no guarantee of care if someone without insurance has a catastrophic medical expense, many people are motivated to buy catastrophic coverage. The rest of their care they buy a la carte out of pocket.

Many of the poor, as well as people with chronic expensive medical conditions, are priced out of the insurance market, but private charities have cropped up that assist with this for most of them.

Looking at the provider side, nonprofits have played a leading role in establishing standards in provider quality metric tracking and reporting. These nonprofits also certify the quality information being reported by providers, so patients are able to compare the quality of different providers apples to apples. The quality metrics being reported and certified are determined by what patients find most relevant in helping them decide between providers for each service they are shopping for. Similar to the health insurance shopping websites, there are provider shopping websites presenting those standardized metrics alongside providers’ advertised prices.

Because providers are assured increased market share when their value goes up relative to competitors, there is a great variety of innovation toward crafting high-value care experiences for patients. Most of the value improvements are in the form of cost-lowering innovations because of the downward pressure on price exerted by the uninsured population and the price-sensitive insured population. Providers have particularly found that shifting the location of care to less expensive settings (including even the patient’s own home) and shifting to relying more on narrowly trained provider types (particularly for treatments that are relatively algorithmic) is very effective at lowering costs. Suppliers of healthcare devices have also found that they are more successful as they focus on developing lower-cost devices, even if that means sacrificing some amount of quality or features. And since government regulations have been kept to a minimum, all these innovations have been allowed to progress and flourish quickly. This occasionally results in unsafe practices and devices cropping up, and individuals have been hurt in the process, but people have felt that the rapidity of innovation that has improved so many lives has been worth that cost. And any practice that proves to be unsafe is exposed quickly in this marketplace.

Providers have also found that, when patients are shopping for a provider, they are looking for a specific well-defined service or bundle of services, such as a year’s worth of chronic disease management, a CT scan, a hip replacement (including all the pre-op workup and the post-op rehab), or a diagnostic evaluation. This has led to standardized bundles of services (also certified by those non-profits), which has made shopping for healthcare services easier and also enhanced the ability to compare the prices from one provider to another.

This system is not perfect. Some people choose not to buy insurance and then have to declare bankruptcy when they have an expensive care episode (or end up not getting care due to inability to pay), and some people want to buy insurance but are frustrated that they cannot afford it, although this number is decreasing each year. Providers face challenges dealing with multiple insurance plans with different reimbursement schemes and coverage rules. And unsafe practices or innovations crop up every so often that harm patients. But, overall, the value delivered by insurers and providers increases rapidly as insurers find new ways to prevent care episodes, and, for the care episodes that cannot be prevented, providers find ways to make care safer, more convenient, and more affordable.

A Single-payer System

With the government running the single insurance company for this system, they have been able to easily implement many of the needed aspects of an optimal healthcare system. They automatically cover all known cost-saving and cost-effective preventive services without copays, which includes population-based preventive services but also focuses more and more on targeting extra services to high-utilizing patients to prevent hospitalizations and ED visits. Their cradle-to-grave time horizon has helped this immensely.

The prices the insurer assigns to services are not firm but are rather considered to be the “maximum allowable reimbursement,” so any provider that wants to charge a lower price will have the freedom to do that. And providers who innovate and find ways to charge less win market share because the insurance plan’s cost-sharing policies require people to pay less out of pocket when selecting a less expensive provider. The insurer has also found that paying a single fee for standardized bundles of services has motivated a great deal of provider innovation and cooperation.

Together, all these reimbursement policies help to prevent as many care episodes as possible and minimize the cost of the episodes that are not preventable.

The insurer’s fee schedule also includes a multiplier to adjust for regional cost variations, and they leverage this to increase reimbursement in underserved areas as well, which has especially helped rural areas maintain enough providers.

As a condition of being accepted as in-network by the insurance plan, providers are required to use an electronic medical record that is able to decode and record to the patient’s secure cloud-based personal health record. Providers are also required to report specific quality metrics. These quality metrics are never used for giving bonuses, but they instead focus on the aspects of quality that patients find most relevant when they’re trying to decide between provider options. The insurer operates a single website that lists all in-network providers along with these risk-adjusted quality metrics and each provider’s prices (displayed as the amount the patient will be expected to pay out of pocket).

Providers appreciate this system for many reasons. They only deal with a single insurer, which minimizes insurance-related overhead expenses and gives them a single set of incentives to respond to. They are completely free to build hospitals and clinics wherever they think they will be most profitable. And they can organize care however they want provided they adhere to the safety and reporting regulations.

Now, having seen the main aspects of this system, let us consider the impact of not adhering to the framework’s requirement of having multiple insurer options. Recall that the jobs insurers are primarily responsible for are risk pooling and cost-saving prevention. And the reason having multiple options is desirable is because—assuming patients can identify and then choose the highest-value insurance plans—insurers will have a profit motive driving them to innovate to find ways to increase the value they deliver, which especially means finding ways to do more cost-saving prevention that will result in more care episodes being prevented, thus lowering the total cost of care and insurance prices. With a single government-run insurer, that innovation and its attendant benefits will be curtailed. Clearly there are many compensatory benefits, including simplicity, reduced administrative overhead, uniform incentives, and a straightforward way of achieving a society’s goal of universal access to insurance. Depending on the priorities of the country, these benefits may outweigh the costs. It is a question of values. But the decision becomes easier when the costs and benefits of each option are understood.

A Government-run System

This system, like the single-payer system described above, has a single insurer that is run by the government. But here the government also owns all the healthcare facilities and employs all the healthcare providers.

On the insurance side, reimbursement policies are familiar, with “maximum allowable reimbursements,” bundled pricing, differential cost-sharing for patients, and a website reporting the quality metrics and prices (out-of-pocket costs) of providers. The insurer also has a robust department working on preventing care episodes by finding innovative ways to keep people healthy.

But what about the provider side? Initially it may seem that patients only have a single healthcare provider option, but just because a single entity owns all the hospitals and clinics does not mean they are all the same. In this system, the government determines where healthcare facilities will be built and what services they will provide, but it allows great freedom in their operation. At every facility, providers are able to organize care however they like, and they are also free to charge any price as long as it is at or below the maximum allowable reimbursement for each service. They have great motivation to put in the effort required to find ways to lower costs (thereby enabling them to charge lower prices) and improve quality because they receive bonuses that are calculated based on the amount of money they saved the system (the number of patients treated multiplied by how much less than the maximum allowable reimbursement each of those patients was charged).

Because the insurer and providers are all operating under one roof, the billing in this system is particularly simple. Some specific requirements are in place for the purpose of accumulating data that will help track for problems in the healthcare system, but there are no complex billing codes or arcane documentation requirements. When providers document a patient encounter, they do so for the purpose of communicating to other providers what they thought and did.

Government healthcare expenditures in this system are sustainable mostly because providers are actively innovating to improve value—much of which results in them being able to lower prices so they can earn bonuses.

Overall, this system has been organized in a way that, despite the government ownership of providers, maintains the ability to reward value with market share, which drives value improvement. The insurance side also innovates to prevent care episodes by leveraging its cradle-to-grave time horizons and connections with other non-healthcare public health sectors.

There are barriers to provider innovation compared to other systems. Providers face the upside of potential bonuses for doing well, but there is not necessarily much downside risk in providers who are mediocre or worse and still getting paid their stable salary. In any other market, the risk of being forced out of business due to lost market share drives competitors to innovate to improve their value so they can become profitable, but in this system the worst-case scenario is that the government closes their clinic and relocates those providers elsewhere. Additionally, many innovations require new types of facilities or caregivers, or they require cooperation between multiple types of providers, which can be difficult when providers have limited control over facility design, placement, and reimbursement contracts.

The effects of these innovation barriers are difficult to quantify, but they need to be balanced with the benefits of a reduced documentation burden, a simpler billing system, and a more reliable dispersion of healthcare services across the country.

Conclusion

Policy makers overseeing any type of system need to understand their system’s current barriers to the three critical inputs: multiple options, ability to identify the highest-value option, and incentive to choose the highest-value option. (Many of the most common barriers to those three inputs are outlined in Part 6.) They need to understand that those barriers are the primary inhibitors of their healthcare system evolving to deliver increasingly higher value for patients over time. And as they enact policies that eliminate those barriers, they will see a predictable chain reaction of more patients choosing higher-value insurance plans and providers, those higher-value competitors earning more profit, and parties in the healthcare system beginning to innovate to deliver higher value, all of which will result in the healthcare system transformation that is sorely needed the world over. Policy makers who understand this framework are also empowered to propose and support policies that expand access in ways that do not create new barriers to those three critical inputs.

As healthcare reforms begin to take this focused direction, the innovations and value improvements will be exciting to watch!

In Part 8, I will conclude this series by imagining how the U.S. healthcare system might look with this framework fully implemented.

Building a Healthcare System from Scratch, Part 2: Parties

In Part 1, I enumerated the five jobs of a healthcare system:

  1. Treatment
  2. Cost-effective prevention
  3. Cost-saving prevention
  4. Risk pooling
  5. Equitable access

This time, I will look at which parties in a healthcare system have financial incentives to perform those jobs.

First, what are the different parties involved in providing services in a healthcare system? It’s not that complicated. There are providers. And there are insurers, which includes not only insurance companies but also large employers who are acting as the insurance company for their employees. And there’s also government, which is potentially available to step in and assist in fulfilling any of the jobs that wouldn’t otherwise be adequately fulfilled just strictly based on financial incentives.

Taking each problem one by one, let’s look at who has an incentive to fulfill them:

Treatment. Providers get paid for doing this, so it’s an easy one.

Cost-effective prevention. Again, providers have an incentive to do this because they get paid for performing the service. The problem is, patients are often unwilling to spend money on things that won’t benefit them immediately. We’re all a little short-sighted now and then. So this is a case where government intervention may be warranted, such as making a policy that all insurers need to cover certain cost-effective prevention services without a copay.

Cost-saving prevention. Providers are the ones getting paid to actually perform the services, but really it’s the insurer that stands to gain when a patient gets a service that ends up saving a lot more money down the road by preventing future care episodes. This assumes insurers have long enough time horizons to reap the benefits (long-term savings) of investing in cost-saving prevention.

Risk pooling. Again, this one is straightforward. Insurers get compensated for doing this one.

Equitable access. Do insurers or providers have a financial incentive to deliver care to people who cannot afford it? No. They definitely have cultural incentives to do this, but not financial incentives. So, if society believes that the cultural incentives are not enough to promote sufficient care provision to those who cannot afford it otherwise, this would be another potential role for government to somehow intervene.

jobs and parties

In Part 3, I will write about how these parties can have incentives not just to fulfill those jobs but to maximize the value they deliver when fulfilling them. Bear with me–the utility of the framework isn’t quite obvious yet, but it will come together quickly.

 

Does Supply and Demand Work in Healthcare? (Updated!)

This post is an update to my popular post, Does Supply and Demand Work in Healthcare? It explains the same things, but this version is shorter and clearer.

Supply and demand carry with them a few assumptions. When those assumptions are met, supply and demand works. When those assumptions are violated, supply and demand don’t work as we would expect. Healthcare is very different from most markets in the United States, especially in a couple key ways that violate the assumptions of supply and demand. The first violated assumption is that consumers have price and quality information. The second violated assumption is that consumers actually pay the price of what they buy. There are others, but these are the biggest ones, so let’s focus on them one at a time.

Assumption 1: Consumers Have Price and Quality Information

Think about how most markets work. People spend their own money to buy things they want. And because people don’t have unlimited dollars to spend, they’re weighing the value (Value = Quality/Price) of their different options–if something is higher quality but also higher priced, they have to decide if it’s worth it for them to spend that additional money to get that additional quality.

Think about how that impacts companies competing in a market. If one company makes a really high-value product, tons of people will buy it, and the company will increase supply so it won’t miss out on all those potential sales. If another company makes a dud of a product, it won’t get many sales, and it will decrease supply. (Yes I recognize that this is ignoring many complicating factors, but those factors don’t affect the point I’m trying to make here.)

Now, let’s look at how healthcare is different . . .

When patients choose a healthcare provider, they mostly aren’t using price and quality to make their decision. So even if a hospital is super high value, it won’t generally win the market share that it should, so it isn’t building additional wards like it would if it were competing in almost any other industry. Conversely, a low-value hospital will continually get more patients than it should, and it will keep its wards open.

Taking this one step further, a hospital will have a hard time investing in value-improving innovations if it’s not going to win more market share (i.e., additional profits) as a result. And, unfortunately, our current system often financially penalizes value-improving innovations. See here for more explanation on that.

Assumption 2: Consumers Actually Pay the Price of What They Buy

As I said above, a consumer in almost any other market will think carefully before buying a really expensive good or service. “This is way more expensive than the other one. Is it better enough to be worth it?” Same goes for deciding how much of something they’ll buy; people (usually) won’t buy more of a good or service than they think they can afford.

So, in other words, when customers actually have to fork out the dough for the thing they’re buying, their demand is appropriately limited. And, when demand is limited, that in turn constrains the quantity supplied–companies don’t want to spend a bunch of money making tons of goods that are unlikely to ever get sold without drastically reducing the price.

Now, let’s look at how healthcare is different . . .

The most obvious example I could bring up is end-of-life care. Think about a patient who had a massive stroke and is now in the ICU on life support, showing no signs of life for multiple days. There’s always the slightest chance they could recover some function, so it’s not unreasonable for families to cling to that hope and keep dragging it out. . . . Except that estimates of the cost for each additional day in the ICU run around the $5,000 mark. But, the family has probably already hit the out-of-pocket max for the year, so they won’t be paying a single cent more even if they drag the ICU stay on for another few days. My point is that demand is almost unlimited in a situation like this, and the hospital is happy to continue supplying the care as long as they’re getting paid for it. I’ve written elsewhere about the problems that arise when the party choosing how much care to get is not the same party that foots the bill.

These are just two examples of broken assumptions of supply and demand in healthcare. I am not saying that supply and demand will never work in healthcare; I’m just saying that the way our system is currently organized violates some of those assumptions. I’ve also written about how to fix that.

I’ll end with one other implication of all of this. Critics of “market-driven healthcare” abound because they say we’ve been trying it for a long time and look where it’s gotten us. But we actually haven’t truly tried it yet because we haven’t ever made the changes necessary to remove the barriers to supply and demand. Without explaining it fully here, I’ll assert that we can remove enough of those barriers for supply and demand to work well in healthcare. And the changes that would be required to accomplish that are compatible with any structure of healthcare system, be it a private system, a single-payer system, a fully government-run system, or whatever.

Why Drug Companies’ Medication Coupons Are Bad for the Healthcare System

Have you had the experience where you need a medication, and the brand name actually is cheaper for you because your doctor gives you a coupon for it? It’s great for you, but it’s bad for the healthcare system, and here’s why.

I have written before about the principle that is relevant to this, but it bears repeating: The party making a purchase decision must be the one who also bears the price differential between those options.

To understand why, let’s pretend you have a medium risk of heart attack or stroke in the next 10 years, so your doctor recommends you start a moderate-intensity statin medication. They’re all pretty close to equal in terms of efficacy and side effects, so the best money-saving decision would be to choose the cheapest one, right? Well, if your doctor says, “I’m happy to prescribe any of these for you. Which would you like?” You are the party who now gets to make a purchase decision. So you look at the monthly prices below (these are real prices):

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But then your doctor hands you a pitavastatin $100 off coupon some drug rep from Kowa Pharmaceuticals (the manufacturer) dropped off. You, a rational person, opt for that one since it’s now the cheapest (free)!

Now the monthly cost to the healthcare system for you to be on a statin totals $0.00 (your copay) + $101.36 (what your insurer has to cover) = $101.36. That’s about 20 times more expensive than it should have been!

What just happened here? The party making the purchase decision (you) did not bear the price differential between the options. Your insurer originally set it up so that you would pay more if you chose a more expensive statin, but the coupon interfered with that.

This same situation plays out over and over every day in our healthcare system with medications and with every other health service. It’s why I keep saying that we need to make the party who makes the purchase decision the same party who bears at least some part of the price differential between the options, which leads to a value-sensitive decision. Reference pricing does it, high-deductible insurance plans do it (for services below the deductible, at least), multi-tier prescription programs do it (when they’re not being subverted by manufacturer coupons). But these, collectively, are not influencing nearly enough of the purchase decisions being made in our healthcare system! And we waste money. Even worse, the higher value options are not rewarded with market share, the lower-value options are allowed to persist as is, and the overall value delivered by our healthcare system remains much lower than it could be.

So that’s why medication coupons–and any other thing that interferes with purchasers bearing the price differential between options–are bad.

The 3 (Actually, 2) Problems with the U.S. Healthcare System

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Image credit: Gary Larson

Before something can be fixed, the problem must be defined and the causes of that problem diagnosed.

The generally accepted problems with the U.S. healthcare system are that its prices are too high, its quality is too low/patchy, and not enough people have insurance coverage.

I’m going to change that a little bit. Since price and quality are the two variables that determine value, we could combine them into only two problems: suboptimal value and not enough insurance coverage.

The insurance coverage piece is kind of separate from the value piece because solving it primarily relies on government policies that subsidize the purchase of health insurance for those who wouldn’t be able to afford it otherwise. Those government policies are a (purposeful) distortion to the healthcare market. Distorting a market for a good reason is fine, but before you do it, you need to understand how the market should be structured to optimize value so you don’t accidentally ruin its potential to have higher value in the process.

And the nice thing is that value improvements will primarily come in the form of lower prices —> insurance coverage will become cheaper —> fewer people will be priced out of the market. Therefore, fixing value partially fixes the insurance coverage problem too!

What Is an ACO? What Is a Medical Home? What Is Bundled Billing? What Is P4P?

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

Our healthcare system is currently in experimentation mode–we are trying thousands of experiments to figure out how providers can be rewarded for “value instead of volume.” All the new terminology and reimbursement ideas accompanying these reforms can be hard to keep straight if you’re not steeped in this stuff every day, but guess what? There aren’t actually that many different ideas being tried; there are just a bunch of the same ideas being tried in various combinations. First I’ll describe those four basic ideas, and then I’ll show how they are the building blocks of all the main payment reform experiments out there.

Quality bonus: Give a provider more money when he hits performance targets on whatever quality metrics are important to the payer.

Utilization bonus: Utilization metrics and quality metrics are not usually separated, but they should be. Here’s the difference: improved performance on a quality metric increases spending; improved performance on a utilization metric decreases spending. They both improve quality, but they have different effects on total healthcare spending. So, for example, ED utilization rates and readmission rates would be considered utilization metrics. And childhood immunization rates and smoking cessation rates would also be considered utilization metrics because they tend to be cost saving. Insurers love giving providers bonuses on utilization metrics because they are stimulating providers to lower the amount being spent on healthcare.

Shared savings: If a provider can decrease spending for an episode of care (which could be defined as narrowly as all the care involved in performing a single surgery or as broadly as all the care a person needs for an entire year of chronic disease management), the insurer will share some of those savings with him.

Capitation: The amount a provider gets paid is prospectively determined and will not change regardless of how much or how little care that patient ends up receiving. Again, this could be defined narrowly, such as all the care involved in performing a single surgery (in which case it’s actually called a “bundled payment”), or it could be defined broadly, such as for all the care a person needs for an entire year.

By the way, did you notice that shared savings and capitation are almost the same thing? The only difference is who bears how much risk. In shared savings, the risk is shared, which means that if the costs of care come in lower than expected, the insurer gets some of the savings and the provider gets some of the savings. In capitation, the provider bears all the risk, which means that if the costs of care come in lower than expected, the provider gets all of the savings.

Okay, now that I have listed out those four ideas, take a look at the popular payment reforms of the day . . .

Medical Home

General idea:

  • Give a primary-care provider a per member per month “care management fee” (in addition to what he normally gets paid) for providing additional services (such as care coordination with specialists, after-hours access to care, care management plans for complex patients, and more)
  • Also give the primary-care provider bonuses when he meets cost and/or quality targets

Breaking down a medical home:

  • A care management fee is actually a utilization bonus (because the net effect of the provider offering all those services is to avoid a lot of care down the road)
  • A bonus for meeting quality targets is either a quality bonus or a utilization bonus depending on the specific metrics used
  • A bonus for meeting cost targets is shared savings

Accountable Care Organization (ACO)

General idea:

  • Give a group of providers bonuses when they lower the total cost of care of their patients (but the bonuses are contingent upon meeting quality targets).

Breaking down an ACO:

  • A bonus for lowering the total cost of care is shared savings
  • When a bonus is contingent upon meeting quality targets, that means it’s also a quality or utilization bonus (depending on the specific quality metrics used)

Pay for Performance (P4P)

General idea:

  • Give a provider bonuses when she meets quality targets.

Breaking down P4P:

  • This is either a quality or utilization bonus (depending on the specific quality metrics used), but it tends to be utilization bonuses because insurers especially like when providers decrease the amount of money they have to fork out

Bundled Payment/Episode-of-care Payment

General idea:

  • Give a group of providers a single payment for an episode of care regardless of the services provided.

Breaking down bundled payment:

  • A bundled payment is a narrow form of capitation

There you have it. They are all repetitions of the same ideas but combined in different ways.

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.