(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.)

Why Doesn’t the Healthcare Industry Evolve Like Other Industries?

If you think about almost any industry and how it changes over time, you can see an obvious shift from high cost, low quality to lower cost, higher quality (and, thus, greater access to the product/service). Think about computers, or portable music players, or cars, or flat-screen TVs, or indoor plumbing, or airline flights. . . .

Average yearly productivity growth of industries is estimated to be about 2.4%. But healthcare is different–it receives negative estimates year after year. So what’s the cause of this? Why doesn’t healthcare evolve toward higher productivity over time? If we can figure this out, then maybe we’ll know what we should work on changing with how the industry is structured. And then we’ll be able to permanently solve this crazy trend of healthcare spending, which has been increasing at a rate of 2 – 4% faster than the rest of our economy for a long, long time.

People often blame the lack of evolution (toward lower cost, at least) on healthcare providers not having an incentive to compete on price. Patients don’t price shop, so why would they compete on price? And patients don’t price shop because insurance just covers everything for them, even the small, routine things.  We’re all contributing to this because, no matter which doctor we choose, we still have a $15 co-pay, so why would we waste our time finding out which provider will send the cheapest bill to our insurer? It’s reasonable, this argument, which says that the insurance structure is the reason healthcare providers don’t have to compete on price, and that that is causing the industry not to evolve like it should.

Are there any solutions to this?

The most commonly proposed solution is high-deductible insurance plans. It makes sense. If nothing is covered until you surpass a $1,000 or $2,000 or $5,000 deductible, price starts to really matter unless you’ve already surpassed that deductible for the year (which would be unusual for healthy people). The hard part about this is actually being able to find out prices from providers, but we’ll ignore that with the assumption that if enough people start requesting prices, providers will start making them more readily available. So the result would be that providers finally have to compete on price, they now have an incentive to find ways to reduce prices, and problem solved!

Not so fast.

Did anyone ever consider that providers already do compete on price? No, they don’t compete on prices for patients, but they do compete on price to win insurance contracts. How do you think insurance companies choose which doctors will be in their network? By price! Yes, providers definitely compete on price already. They do it to win insurance contracts, which then guarantees them a steady flow of patients and revenue.

But why doesn’t price competition for insurer contracts provide enough of an incentive for providers to find ways to cut costs and help the healthcare industry to evolve like almost every other industry?

I don’t know. But here’s my guess:

Management is in charge of negotiations to win insurance contracts, so they feel the pressure to find ways to lower costs, but that pressure isn’t conveyed strongly down to the people who have the knowledge required to actually recommend cost-cutting changes: doctors and nurses. If management isn’t working with the current business model’s routines and processes day in and day out, they aren’t going to see the inefficiencies in how things run. Doctors and nurses need to do that, so maybe most healthcare organizations aren’t giving doctors and nurses enough/any incentives to do that.

But, management’s specialty is figuring out completely new processes, routines, and business models that can achieve the same job for the patient but at a way lower cost. So why aren’t healthcare management people figuring out and experimenting with those in an effort to secure more insurance contracts (and, thus, market share and higher profitability)? You’d think the price competition for insurance contracts would at least motivate those kinds of experiments.

The answer may lie in the fact that healthcare provider organizations are known as some of the most complex organizations conceived by man. Possibly this complexity deters innovations like that. They’d be so hard to predict financial outcomes and market response! And with fewer ideas being tested, the evolution of healthcare will necessarily be slower than most industries. I’d love to see some research comparing the complexity of organizations with their speed of productivity growth. And I’m also interested to see the results of all sorts of government-funded “pilot programs” that allow providers to test new ideas out.

So, those are my conjectures, that price competition for insurance contracts isn’t enough because doctors and nurses aren’t given enough incentives to root out inefficiencies and because healthcare organizations are so complex that they deter business model innovations. Maybe I’m way off. Ideas?

UPDATE: I’m wrong. Providers don’t compete on price to convince insurers to add them to their networks. I’ve since learned that prices between insurers and providers are pretty much decided by Medicare prices as an anchor and adjusted up or down depending on bargaining power. This means prices will stay the same even if providers find lower-cost ways to deliver care. So, the question remains: Why aren’t providers finding all sorts of ways to lower costs if any cost reduction would not be followed by price reductions and, therefore, go straight to their bottom line? I still haven’t figured this one out, but Clay Christensen seems to think providers need to encompass the whole value chain to be successful at it, so maybe that has something to do with it.