Should We Regulate Prices of Hospitals? All-payer Rate Setting’s Allure

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Image credit: time.com

The Bitter Pill article has received a lot of press lately. People reading it have often turned to a simple solution: regulate prices. The most straightforward approach to this is called “all-payer rate setting,” which has been experimented with before in some places in the U.S. and is still used in Maryland. The basic idea is that the government says, “When any provider performs this certain service, he/she will be paid this much for it no matter who the payer is.” And they set prices for every single service. Think of how this would instantly make all chargemasters a thing of the past. And no more worrying about hospitals increasing their bargaining power as they join together to form ACOs. And all that administrative complexity that would be gone (thus decreasing costs a fair amount)!

But there are downsides, too, which are not as obvious and may lead people to jump on the bandwagon of all-payer rate setting ignorantly. First, back to basics:

Total spending on healthcare = price * quantity

Yes, we probably have some quantity problems (running too many scans, etc., which regional variation literature attests to quite thoroughly), but the main reason we spend so much more than other countries is because of the prices. So, here’s the prices equation:

Price = Cost + Profit

What’s making prices too high? Brill makes a strong case that, at least in a lot of hospitals, profit is part of the problem [Update: Turns out most hospitals lose money on average, so it’s not as big of a deal as we thought]. But what about costs? Is the actual cost of care too high as well? YES, costs are the major problem, as shown by looking at the average profitability of healthcare organizations. More evidence of this: even in countries that do a pretty good job minimizing unnecessary services and regulating profits to reasonable levels, healthcare spending growth is still unsustainable, which only leaves cost as the primary culprit. Therefore, any policy (whether it’s meant to regulate profits, improve access, improve quality, or whatever) that creates barriers to cost lowering should be reserved as a last resort.

So, would all-payer rate setting create a barrier to cost lowering? If yes, I don’t like it. If no, let’s consider it.

First, since I’m reading The Wealth of Nations lately, let’s ask Adam Smith what he thinks about the subject:

I shall conclude this long chapter with observing, that though anciently it was usual to rate wages, first by general laws extending over the whole kingdom, and afterwards by particular orders of the justices of peace in every particular county, both these practices have now gone entirely into disuse.

By the experience of above four hundred years [says Doctor Burn] it seems time to lay aside all endeavours to bring under strict regulations, what in its own nature seems incapable of minute limitation: for if all persons in the same kind of work were to receive equal wages, there would be no emulation, and no room left for industry or ingenuity.

Particular acts of parliament, however, still attempt sometimes to regulate wages in particular trades and in particular places. (Emphasis added)

What’s he trying to say? All-payer rate setting would leave “no room left for [cost-lowering] industry and ingenuity”? (If you’d like to see my explanation for why I assume innovations by providers are generally cost-lowering, see here.)

I’ve explained before how taking away the freedom to set your own prices also removes much of the rewards for cost-lowering industry and ingenuity. In short (and simplified), lowering costs without sacrificing quality means you can lower prices more than others and therefore offer higher value than others, and higher value will eventually be rewarded with market share and profits. (Another assumption I’m making: patients preferentially choose higher-value providers, which is starting to be more true, but there are still many barriers to it.)

Back to the big picture: All-payer rate setting reduces the potential rewards for cost-lowering innovations, which I can guarantee will reduce the amount of cost-lowering innovation that goes on. So, yes, all-payer rate setting will be a barrier to cost-lowering innovation. And that’s a huge problem, so let’s look for other ways to fix egregious profits and costs. More to come . . .

How to Make the Cost of Care Cheaper

I’ve been leading up to this for a long time. Lowering the cost of the actual provision of care is one of the most important things all countries with unsustainable health spending growth need. And, at the outset, I’ll say I don’t have all the answers. But here’s what I’ve got, explained in maybe a roundabout way, but hopefully it makes sense by the end.

Think about providers’ incentive to innovate. Do they have one? Hopefully your initial response is “yes,” because you’d be right (partially). Assuming this is a provider that operates as most in the country do, its prices are determined based on market power, not costs. So, with the assurance that prices will stay the same regardless of costs, providers have a great incentive to lower costs! Any cost decrease will go straight to their bottom line.

At this point, I picture in my head a little map of the United States with a vertical pin sticking out of it for each hospital, with the height of the pin representing that hospital’s costs of delivering care. The taller the pin, the higher the costs. So, the incentive for each hospital is to lower their costs as much as possible in order to maximize profits, and different hospitals succeed to varying degrees. The pins get pushed down with each successful cost-cutting initiative, some more than others.

Now let’s say there is a hospital that finds a really innovative way to deliver care, and their costs are way lower than everyone else’s. They want to get more customers in an effort to continue generating more wealth, but they’re stuck! Why are they stuck? Because even though their costs are so much lower, they don’t really get to set the prices the patients actually pay when choosing which hospital to go to for care. High-value providers can’t expand to new cities because they’d have to set their prices lower than existing providers’ prices, steal a whole bunch of the market share, and most likely force some of the lower-value incumbents out of business. But if they could, do you see what would happen to the pins? The one really low pin would start spreading, making the tallest pins get taken off the map completely with each market that it spreads to. It would be beautiful! Different kinds of cost-saving innovations would be spreading all over the country.

So, to repeat David Cutler’s question, Where are all the healthcare innovators? They’re out there, all over the country, but they’re stuck in their current markets; thus, we don’t see or even hear about most of them.

In summary, think of the two ways a company can make more money:

  1. Sell items at a higher margin
  2. Sell more items

Providers in our healthcare system can only do the first one. The second one is mostly not functioning, and thus we don’t have the harsh (and absolutely crucial) evolutionary force of putting lower-value providers out of business and lowering the cost of healthcare.

I’ll admit, the proliferation of high-deductible plans and new kinds of deals between providers and insurers are starting to overcome this. But there are probably other ways to increase the pace of the elimination of these barriers, and I would think the government should be focused on figuring out what they are if they want to solve this country’s budget problems. Or they could continue to argue over how to how to reduce volume and price while largely ignoring costs.

How to Think About a Healthcare Reform’s Impact on Total Spending

I know I left off my last post with a cliff-hanger about how to lower the cost of delivering care, but I realized I’m explaining this in an out-of-order way, so I’m going to back up a bit and lay the foundation.

I’ve posted before that there are actually three ways to lower health spending. Again, here’s the equation:

Total Spending = Volume x Price

To lower total spending, we could lower volume or lower price. And, again, we can only lower price so much without actually lowering costs of delivering care.

But what about the third way? A more complete equation would look like this:

Total Spending = Volumea x Pricea + Volumeb x Priceb + Volumec x Pricec + . . .

Get it? Our total spending is the total amount we’ve spent on hip replacements and on metformin and on office visits. . . .

So, the third way for us to lower total spending would be to adjust our mix of services so we’re choosing low-cost treatments instead of high-cost ones. Instead of buying brand-name drugs, we’d buy generics. Instead of full knee replacements, we’d opt for physical therapy.

Okay, good. Now, whenever you hear anything about a reform that’s aimed at lowering total health spending, you should be able to easily place it into one of those three categories.

So what about the Affordable Care Act? There are a zillion different provisions, all with different effects on total spending. Increasing insurance coverage = increased volume. Requiring preventive care coverage = changing services mix (more preventive services, fewer preventable complications we have to fix). Insurance exchanges = lower price through increased price competition among insurers. . . . To mention just a few.

(The Framing of) How to Solve the Healthcare Cost Problem

“The cost problem” in healthcare is referring to the fact that our country is making itself go bankrupt based on overspending on healthcare, and we’re not even getting amazing outcomes that justify that spending. I’ve blogged before about how this overspending problem can really be broken down into two separate problems:

Spending = Volume x Price

To really get a good solution, we need to both (1) lower the volume of care delivered and (2) lower the prices we’re paying for everything. Lowering the volume, I’ve already argued, would substantially be achieved by giving providers an incentive to profit from long-term wellness. People at Dartmouth say 30% of all care is unnecessary, so, if true, that would mean big savings. But I’ve never said much about how to lower price, so let’s talk about price now:

Price = Cost + Profit

If we want to substantially lower prices, we need to actually lower costs, and then make sure prices follow them down. What I’m saying is that any price-lowering reform needs two components:

  1. Costs to go down
  2. Prices to follow

We’ve actually seen people try to only lower costs (think: tort reform) and other people try to only lower prices (think: all-payer rate setting).

I’ve also explained before that we should expect providers to be the main drivers of cost-lowering innovations. But provider-driven, cost-lowering innovations don’t seem to be happening much in our (or anyone’s!) healthcare system, so why not? The answer to this question is what every health system in the world needs. So I’ll tell you. Next time.

Why Is Innovation the Main Driver of Healthcare Spending Increases?

I have this demand: Every weekday, I want to get from home to school and back again with as little travel time as possible. I could fulfill this desire in various ways: drive a car, ride a bike, walk, fly a helicopter. Let’s pretend my demand is currently being fulfilled by a helicopter because that’s the fastest way available. So, you could say that my demand to get to school as quickly as possible is being fulfilled to some extent, but it’s not being completely fulfilled, which would entail getting to school and back with zero total travel time. Technology is limiting my demand from being completely fulfilled.

I will call my fulfilled demand active, because I’m actively spending money to fulfill it, and my unfulfilled demand latent, because it exists but is not currently being fulfilled.

What does this have to do with innovation? Well, not much, except that it lays the background for understanding my next sentence. Innovation (which I will define as finding a new way to fulfill demand) comes in two varieties: (1) the variety that creates cheaper ways to fulfill active demand and (2) innovation that activates latent demand.

Let’s make this concrete. If a new helicopter company comes up with a cheaper way to sell a similar-quality helicopter as the one I have, then I could have gotten that one instead. This would be an example of fulfilling active demand in a cheaper way. And if a teleportation company comes along, then I could get one of those and all of my latent demand would be activated.

All of this assumes money is no object, which, when we’re talking about healthcare, it often isn’t. But this post isn’t about that.

So now you should understand that when innovation has the net effect of increasing total spending in an industry (like healthcare), it’s probably because a lot of latent demand is getting activated (i.e., we’re spending money to fulfill demands that weren’t previously being fulfilled). This is great! . . . Except when it bankrupts us. So we probably need to somehow ration (especially the high-cost-yet-marginally-better-outcome stuff) and encourage innovation of the cost-lowering kind.

Ignoring (for now) the rationing suggestion, here are my thoughts about who we can expect/encourage to provide the cost-lowering innovation.

Providers (doctors and hospitals). I don’t see providers as activating much latent demand in healthcare. They kind of have to just use what treatment techniques they’re provided and find the most cost-effective way to administer them to the right patients. So, provider innovation should be a major source of the cost-lowering variety (think about IHC or Mayo Clinic).

Suppliers (device manufacturers and pharmaceutical companies). When thinking about supplier innovation, they do both kinds. Often they are coming up with miracle drugs and devices that activate latent demand (think about insulin, which prolonged the life expectancy for diabetics from months to decades), and sometimes they are also coming up with devices that make it cheaper to fulfill already active demand (think about at-home dialysis machines).

One Way New Medical Knowledge and Technology Will Make Healthcare Cheaper

Here’s my way of explaining one cool way that healthcare will get cheaper. Picture a stack of papers. It’s maybe a few feet tall, and each paper represents some kind of healthcare-related service that could be delivered. For example, one of those sheets represents a triple bypass. Another represents a consultation about asthma. Another represents an MRI imaging. There are tons of them! Now picture that they are arranged in order of simplest procedure (at the bottom of the stack) to the most complex procedure (at the top of the stack). So we’ve got administering someone with a vaccine and stuff like that at the bottom of the stack, all the way up to, say, some crazy brain surgery at the very top of the stack.

Obviously only the most super-specialized physicians can do brain surgeries and other similarly complex services, while probably a technician or medical assistant could administer vaccines. Thus, we could draw lines on that stack of papers that look like this:

A physician could do anything in his section of papers, and he could probably also do (maybe with a little practice) anything that a nurse or technician could do. But he isn’t trained to do anything above his line–only specialists can do those things.

Now on to how healthcare will become cheaper. As our medical knowledge and technology increase, things that used to require great training become simpler. For example, hip replacements used to be so complex that only the most highly trained specialists could do them. Now, thanks to better man-made sockets and such, they are much simpler to perform, and probably any orthopedic surgeon could perform one and get outcomes that are better than in 1980. In short, the lines move up as technology and knowledge progresses.

This saves money mostly because a technician’s time is less costly than a nurse’s time, a nurse’s time is less costly than a physician’s time, and so forth.

And, I should probably mention two other things. First, there is another, lower cost, caregiver emerging: the patient himself. These days, who do you think primarily takes care of diabetic patients? The diabetic himself! Second, I don’t know if specialists will become extinct any time soon, since there are always papers being added to the stack as we find out we can do more and more things to heal people.

And one last thing: I said all this will make healthcare cheaper–meaning the actual cost of the provision of care will decrease for a lot of diseases–I didn’t say this will reduce our total spending on healthcare. Why not? Because as we learn how to do new, crazy surgeries and stuff, we’ll probably start spending lots of money on those, and that will likely more than outweigh the spending reductions we’ll get as a result of what I described above.

The Only Two Ways to Reduce Healthcare Spending

If you’ve graduated from elementary school, you have probably learned this formula:

Money Spent = Number of Units * Price per Unit

If we’re talking healthcare (and we are), the “Money Spent” part would be the approximately 18 percent of our GDP that goes to healthcare. The number of units would be the number of doctor visits, ER visits, x-rays, cardiac catheterizations, pills, MRIs, etc. that we buy each year. And the price per unit would be the actual cost of the provision of care plus some amount of profit.

So, if we are to solve our healthcare spending crisis, we need to either reduce the number of units we buy or the price per unit. Those are the only two ways.

It’s been interesting lately as I read/hear about healthcare reform ideas with this in mind. I’m not sure any of them have actually proposed something that will directly reduce the actual cost of the provision of care, which, in my mind, is what we need to be worrying about. Think about it: We can reduce the number of units by doing more preventive care and rationing; we can reduce healthcare organizations’ profits by having the government set prices lower; but healthcare will still cost a lot of money! The real money-saving potential lies in reducing the actual cost of the provision of care.

Is that possible? YES.

How? Evolution of the healthcare industry through better information, business model innovation, and technology. (See The Innovator’s Prescription by Christensen, Grossman, and Hwang, which doesn’t have all the answers, and the ones provided are disputed, but I think they’re on the right track.)

Our Healthcare Spending Trend and Why It’s Killing Us

I wrote a post a little while back explaining that there are two types of healthcare costs: care costs and non-care costs. Well, taking a step back, those are actually both related only to our level of spending. But there is another aspect of spending that is not talked about nearly as much, and about which I am much more concerned: trend.

The U.S. Department of Labor keeps track of the U.S. inflation rate, and they say it has been under 4 percent every year since 1991. Estimates of yearly health spending growth range from 5 to 15 percent, but most come in over the 10 percent mark. If you’ve done your math correctly, you probably figured out that healthcare spending is increasing faster than inflation.

So, is this bad? Well, as a country, we’re getting wealthier, and with more wealth comes more health spending, which is a great thing. There are tons of things that people choose to get healthcare-wise when they have more money. Maybe it’s plastic surgery, maybe it’s other cosmetic surgeries, maybe it’s eye surgery, maybe it’s weight-loss surgery, maybe it’s the more expensive treatment option for longtime joint or back pain, . . . you get the picture.

So yes, some spending increases are a good sign. But that crazy spending growth can’t all be attributed to wealth increases in our country. Two other big causes of spending growth can probably be labeled as (1) medical technology and (2) chronic diseases, and both of these are causing me some concern. First, a little explanation of each.

Medical technology causes spending growth because it allows us to spend tons of money saving someone or fixing someone when we used to have to just watch from the sidelines. It also allows us to treat things more effectively and more expensively. For example, a robot for use in surgeries is super expensive, but it reduces invasiveness and increases the range of things that are considered operable. These are positive things as well.

And as for chronic diseases, this refers to kidney disease, heart disease, diabetes, those sorts of things. And some estimates say that two thirds of our healthcare expenditures are generated by them. Crazy, I know.

So there’s a basic overview of why healthcare costs are increasing faster than our economy is growing. And here is why I’m concerned about it: it’s pricing low-income Americans out of healthcare insurance and contributing to a growing national debt.

As insurance companies have to deal with more expensive beneficiaries (especially the ones with chronic diseases), they have to raise insurance rates. And as new (more expensive) treatment options become available, they have to cover many of those (or risk losing beneficiaries), which means (again) raising insurance rates. All of this raising insurance rates business means it gets too expensive for people and employers, so they just make the decision to just get rid of health insurance and hope for the best.

And then there’s the government debt. Medicare and Medicaid are not immune to all the insurance cost increases. Yeah, they get to decide how much they pay providers, but they still have to decide what to do about new expensive treatments, and they also have to fork out more dough for people with chronic diseases, especially since the over-65 population is the main chronic-disease population. It’s just getting more expensive for the government to pay for healthcare!

So there you have it. Our spending trend is causing some major problems, and it is definitely exacerbating our quality and access problems. But never fear! There are some amazingly good solutions out there for all of this, but I’ll save those for another post, same bat time, same bat channel.

Innovation, Infrastructure, and a Bankrupt Government

Since I’m on the topic of healthcare costs lately (and will be for a while, probably), I’d like to talk about the potentiality of healthcare spending bankrupting our national government. Is it possible? I don’t really know, but that’s obviously the worst-case scenario with all this crazy spending we’re doing. I’ve heard a number of different quotes that say effective, cost-curve-flattening health reforms would solve virtually all of the federal government’s fiscal woes. At 18-ish percent of GDP, that’s not that hard to believe.

But there is a little-known upside and a somewhat-known upside to huge amounts of spending.

The somewhat-known upside: innovation. Yes, America’s health system is best known for more than just spending. It’s the source of more healthcare innovations than anywhere else. So maybe that means we’re just subsidizing the world’s cures to . . . everything. This aspect of our system is what I always think about when I wonder how we could reduce spending, because if we reduce spending at the expense of the strong incentive to innovate, is that a net positive or negative?

The little-known upside: infrastructure. Yes, investors follow the money, and why do you think the United States has the nicest hospital facilities and technologies in the world? There’s money in healthcare! This health infrastructure might be the best thing that ever happened to healthcare in the U.S., because it will keep on giving after we’ve found a way to spend less. Think of the internet bubble. Remember how this country spent tons and tons of money on the internet in the ’90s, and then there was that huge stock-market crash? Well, most people probably don’t know that, even after that huge crash, we now have tons and tons of fiber-optic cable all over our country. That infrastructure is said to be one of the leading factors that allowed the internet to grow as fast as it did in the U.S., probably helping us maintain a world-power economy in the midst of huge changes in the structure of business. So a long-term upside to crazy health spending is the infrastructure that it gives us.

I guess what I’m saying is, yes, we’re spending a ton of money on healthcare, but we are also reaping some benefits too, namely innovation and infrastructure. So here’s the final question: Do we think it’s better to have healthcare innovation and infrastructure or a fiscally solid federal government?

Kinds of Healthcare Costs

I learned that there are two kinds of medical costs, broadly categorized: care costs and managerial costs. They’re kind of self explanatory, don’t you think?

The interesting thing about the U.S. healthcare system is that I’ve never seen an aggregate percentage estimate of just how much of our total healthcare spending (you know, that 18-ish percent of GDP) goes to managerial costs. Maybe some health economist has come up with that number somewhere, but I haven’t seen it. Think about it–you would have to estimate and add the total managerial costs of Medicare, Medicaid, the private insurance sector, CHIP, the VA system, the system for congress and for those with kidney failure and for native Americans. . . . Sounds fun. Other countries have anywhere between 2 to 5 percent estimates for their total managerial costs.

What I have heard, though, are estimates for the total managerial costs of Medicare (2 percent) and the private insurance industry (20 percent). You’d think the 2 percent is awesome and the 20 percent is horrible. Well, the 20 percent is horrible, but not bad considering they’ve got to spend so much money on screening applicants and trying to find ways to deny claims and developing thousands of new compensation plans and payment schedules and paying awesome executives. (It is the private sector, after all.)

And as for the 2 percent, I think it might be a little too low. Maybe a little more spending on managerial stuff could go towards ways to prevent fraud, cause apparently that’s a pretty big thing with Medicare. So maybe every extra dollar of fraud prevention would save a few dollars of fake claims, up to a point. That would maybe leave the Medicare number up around 3 percent, which is still not too bad. Unless you don’t trust government’s estimates of their own efficiency. They want to look good, right? Number-fudging isn’t that hard to do, especially with something so complex as healthcare.