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.

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 . . .