CHAPTER
37
AN OVERVIEW OF THE HEALTHCARE 3
FINANCING SYSTEM
Learning Objectives
After reading this chapter, students will be able to
• explain why health insurance is common,
• use standard health insurance terminology,
• identify major trends in health insurance,
• describe the major problems faced by the current insurance system, and
• find current information about health insurance.
Key Concepts
• Insurance pools the risks of high costs.
• Moral hazard and adverse selection complicate risk pooling.
• About 91 percent of the US population has medical insurance.
• Consumers pay for most medical care indirectly, through taxes and
insurance premiums.
• Most consumers obtain coverage through an employer- or governmentsponsored plan.
• Managed care has largely replaced traditional insurance.
• Managed care plans differ widely.
3.1 Introduction
3.1.1 Paying for Medical Care
Consumers pay for most medical care indirectly, through insurance. In 2016
insurance paid for 78 percent of healthcare spending (Centers for Medicare
& Medicaid Services [CMS] 2017). Healthcare managers must therefore
understand the structure of private and public insurance programs because
much of their organizations’ revenues are shaped by insurance.
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38 Economics for Healthcare Managers
Managers must also be aware that consumers ultimately pay for
healthcare products, a key fact obscured by the complex structure of the
US healthcare financing system. When healthcare spending invokes higher
premiums or taxes, consumers are forced to spend less on other goods and
services. Some consumers may drop coverage, some employers may reduce
benefits, and some plans may reduce payments. This reaction need not occur
if a consensus has emerged in support of increased spending, but even then,
managers should be wary of the profound effects that changes to insurance
plans can cause for their firms. Finally, managers must consider more than
insurance payments. Even though the bulk of healthcare firms’ revenue
comes from insurers, consumers pay directly for some products. Consumers
directly spent more than $352 billion on healthcare products in 2016 (CMS
2017). No firm should ignore this huge market.
3.1.2 Direct Spending
Despite its large amount, direct consumer spending accounts for only a fraction of total healthcare spending. Exhibit 3.1 depicts a healthcare market in
which consumers directly pay the full cost of some services and part of the
costs of other services. Consumers’ direct payments are often called out-ofpocket payments. For example, a consumer’s payment for the full cost of a
pharmaceutical product, her 20 percent coinsurance payment to her dentist,
and her $25 copayment to her son’s pediatrician are all considered out-ofpocket payments. Insurance beneficiaries make out-of-pocket payments for
out-of-pocket
payment
Money a consumer
directly pays for a
good or service.
coinsurance
A form of cost
sharing in which
a patient pays a
share of the bill,
not a set fee.
copayment
A fee the patient
must pay in
addition to the
amount paid by
insurance.
Consumers Providers
Third parties
Premiums and taxes
Out-of-pocket payments
EXHIBIT 3.1
The Flow
of Funds in
Healthcare
Markets
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Chapter 3: An Overview of the Healthcare Financing System 39
services that are not covered, for services in excess of their policy’s coverage
limits, and for deductibles (amounts consumers are required to spend before
their plan pays anything). Another name for out-of-pocket payments is cost
sharing. Economics teaches us that a well-designed insurance plan usually
incorporates some cost sharing. We will explore this concept in detail in the
discussion of demand in chapter 7.
Insurance payments continue to be the largest source of revenue for
most healthcare providers. In 2016, they represented 88 percent of payments to hospitals, 81 percent of payments to physicians, and 66 percent of
payments to nursing homes (CMS 2017). Because insurance affects most
healthcare purchases, its structure has a profound influence on the healthcare
system and healthcare organizations.
The extent of insurance distinguishes the healthcare market from most
other markets. Insurance has three important effects on patients:
• It protects them against high healthcare expenses, which is the main
goal.
• It encourages them to use more healthcare services, which is a side
effect.
• It limits their autonomy in healthcare decision making, which is not a
goal.
Nonetheless, the advantages of insurance continue to exceed its disadvantages. As discussed in chapter 2, the share of direct payments for healthcare has steadily fallen during the past 15 years.
3.1.3 Sources of Insurance
Nearly 300 million Americans had some health insurance coverage in 2016
(US Census Bureau 2017). Only 1 percent of those older than 65 lacked coverage, only 5 percent of those younger than 18 lacked coverage, and 12 percent of those aged 18 to 64 lacked coverage. Although 27 percent of those
older than age 65 had employment-based insurance, 93 percent had Medicare coverage (meaning that many had duplicate coverage). Employmentbased insurance was the most common form of coverage for those younger
than 65. Fifty-six percent of children had employment-based insurance, and
39 percent had Medicaid. Sixty-three percent of those aged 18 to 64 had
employment-based insurance, and only 15 percent had Medicaid. In section
3.2 we will explore why employment-based insurance is so prevalent.
3.1.4 The Uninsured
For many years the share of the population without medical insurance rose
steadily, even as insurance payments rose as a share of total spending. Since
deductible
The amount a
consumer must
pay before
insurance covers
any healthcare
costs.
cost sharing
The general
term for direct
payments
to providers
by insurance
beneficiaries.
(Deductibles,
copayments, and
coinsurance are
forms of cost
sharing.)
Medicare
An insurance
program for
the elderly and
disabled, run
by the Centers
for Medicare &
Medicaid Services.
Medicaid
A collection
of state-run
insurance
programs that
meet standards
set by the Centers
for Medicare &
Medicaid Services
and serve those
with incomes low
enough to qualify
for their state’s
program. Medicaid
enrollment has
increased by more
than 20 percent
as a result of state
expansions under
the Affordable
Care Act.
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40 Economics for Healthcare Managers
the enactment of the Affordable Care Act (ACA), the percentage of the
population without health insurance has fallen sharply. The share of those
younger than age 65 without insurance was 18.2 percent in 2010. By 2016
it was 10.1 percent (US Census Bureau 2017).
Uninsured consumers enter healthcare markets with three significant
disadvantages. First, they must finance their needs from their own resources
or the resources of family, friends, and well-wishers. If these funds are not
adequate, they must do without care or rely on charity care. The uninsured
do not have access to the vast resources of modern insurance companies
when large healthcare bills arrive. Second, unlike most insured customers,
uninsured customers may be expected to pay list prices for services. Most
insured consumers are covered by plans that have secured discounts from
providers. None of the major government insurance plans and few private
insurance plans pay list prices for care. Although uninsured patients could
negotiate discounts, this practice is not routine. Third, the uninsured tend
to have low incomes. In 2016, 11.9 percent of those with annual household
incomes below $25,000 did not have health insurance, compared with only
5.5 percent of those with annual household incomes above $75,000 (US
Census Bureau 2017).
The combination of low income and no insurance often creates access
problems. For example, in 2016, 23 percent of uninsured adults reported
going without care when they had a medical problem (Kaiser Family Foundation 2017a). This rate was more than six times that of well-insured adults.
Delaying or forgoing care can lead to worse health outcomes.
3.2 What Is Insurance, and Why Is It So Prevalent?
3.2.1 What Insurance Does
Insurance pools the risks of healthcare costs, which have a skewed distribution. Most consumers have modest healthcare costs, but a few incur
crushing sums. For example, in 2014, 1 percent of the noninstitutionalized
population spent 23 percent of the total, averaging more than $107,000
(Berk and Fang 2017). Insurance addresses this problem. Suppose that one
person in a hundred has the misfortune to run up $100,000 in healthcare
bills and no one else spends anything. Consumers cannot predict whether
they will be lucky or unlucky, so they may buy insurance. If a private firm
offers insurance for an annual premium of $1,040, many consumers would
gladly buy insurance to eliminate a 1 percent chance of a $100,000 bill.
(The insurer gets $4,000 per 100 people to cover its selling costs, claims
processing costs, and profits.)
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Chapter 3: An Overview of the Healthcare Financing System 41
3.2.2 Adverse Selection and Moral Hazard
Alas, the world is more complex than the preceding scenario, and such a simple plan probably would not work. To begin with, insurance tends to change
the purchasing decisions of consumers. Insured consumers are more likely to
use services, and providers no longer feel compelled to limit their diagnosis
and treatment recommendations to amounts that individual consumers can
afford. The increase in spending that occurs as a result of insurance coverage is known as moral hazard. Moral hazard can be substantially reduced
if consumers face cost-sharing requirements, and most contemporary plans
have this provision.
Another, less tractable problem remains. Some consumers, notably
older people with chronic illnesses, are much more likely than average to
face large bills. Such consumers would be especially eager to buy insurance.
On the other hand, some consumers, notably younger people with healthy
ancestors and no chronic illnesses, are much less likely than average to face
large bills. Such consumers would not be especially eager to buy insurance.
This situation illustrates adverse selection: People with high risk are apt to
be eager to buy insurance, but people with low risk may not be. Wary of this
phenomenon, insurance firms have tried to assess the risks that individual
consumers pose and base their premiums on those risks, a process known
as underwriting. Of course underwriting drives up costs, making coverage
more expensive, which further reduces the share of consumers who are willing to pay for insurance. In the worst case, no private firm would be willing
to offer insurance to the general public.
In the United States, three mechanisms reduce the effects of adverse
selection: employment-sponsored medical insurance, government-sponsored
medical insurance, and health insurance subsidies. In 2016, 91 percent of
the population had health insurance. About 37 percent had governmentsponsored medical insurance, and 56 percent had employer-sponsored insurance (US Census Bureau 2017). Ninety-four percent of Americans aged 65
years or older have coverage through Medicare or Medicaid. Ninety percent
of those younger than 65 years have coverage, with 63 percent having
employer-sponsored coverage and 27 percent having government-sponsored
coverage (14% of these younger Americans bought insurance themselves, but
for some this purchase was in addition to other insurance).
Why is the link between employment and medical insurance so
strong? First, insurers are able to offer lower prices on employment-based
insurance because they reduce their sales costs and adverse selection risks by
selling to groups. Selling a policy to a group of 1,000 people costs only a
little more than selling a policy to an individual; thus the sales cost is much
lower. And because few people take jobs or stay in them just because of the
medical insurance benefits, adverse selection rarely occurs (i.e., most of the
moral hazard
The incentive to
use additional
care that having
insurance creates.
adverse selection
A situation that
occurs when
buyers have
better information
than sellers. For
example, highrisk consumers
are willing to pay
more for insurance
than low-risk
consumers are.
(Organizations
that have difficulty
distinguishing
high-risk from lowrisk consumers
are unlikely to be
profitable.)
underwriting
The process of
assessing the
risks associated
with an insurance
policy and setting
the premium
accordingly.
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42 Economics for Healthcare Managers
employees get the insurance, regardless of whether they think they’ll need
it soon). Second, insurance can benefit employers. If coverage improves the
health of employees or their dependents, workers will be more productive,
thereby improving profits for the company. Companies also benefit because
workers with employment-based medical insurance are less likely to quit. The
costs of hiring and training employees are high, so firms do not want to lose
employees unnecessarily. Third, employers’ contributions to insurance premiums are excluded from their employees’ Social Security taxes, Medicare taxes,
federal income taxes, and most state and local income taxes. Earning $5,000
in cash instead of a $5,000 medical insurance benefit could easily increase an
employee’s tax bill by $2,500.
This system is clearly advantageous for insurers, employers, and
employees. From the perspective of society as a whole, however, its desirability is less clear. The subsidies built into the tax code tend to force tax
rates higher, may encourage the use of insurance for costs such as eyeglasses
and routine dental checkups, and give employees an unrealistic sense of how
much insurance costs.
3.2.3 Medicare as an Example of Complexity
The health insurance system in the United States is so complex that only a
few specialists understand it. Exhibit 3.2 illustrates the complexity of healthcare financing by examining the flow of funds in traditional Medicare. Many
Understanding Health Risks and Insurance
Adverse selection is one reason for governments to intervene in health
insurance markets. A persistent fear is that people with low risks will
not buy insurance, pushing up premiums for people with higher risks.
Once premiums go up, additional people with low risks will drop out.
This sequence is called a death spiral because it will ultimately result
in no one buying insurance. To prevent this outcome, governments
subsidize insurance or mandate that it be bought.
Little evidence suggests that people understand health risks or
insurance well. Yet to make a good choice, consumers must compare
many different products with varying attributes and forecast what
their risks will be (Ericson and Starc 2016). Not surprisingly, many
find insurance choices difficult. A recent survey of Americans who
might seek insurance through the ACA marketplace found that many
struggled to understand basic concepts, such as a premium, a provider
network, or covered services (Long et al. 2014).
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Chapter 3: An Overview of the Healthcare Financing System 43
Medicare beneficiaries pay for supplemental policies that cover deductibles,
coinsurance, and other expenses that Medicare does not cover. Like many
insurers, Medicare requires a deductible. In 2017, the Medicare Part A
deductible was $1,316 per year, and the Medicare Part B deductible was
$183. The most common coinsurance payments spring from the 20 percent
of allowed fees Medicare beneficiaries must pay for most Part B services. For
simplicity, exhibit 3.2 focuses on supplemental policies that reimburse beneficiaries rather than pay providers directly. Beneficiaries with these sorts of
policies (and many without supplemental coverage) must make required outof-pocket payments directly to providers. Beneficiaries must also pay the Part
B premiums that fund 25 percent of this Medicare component. Like other
taxpayers, beneficiaries must also pay income taxes, which cover the other 75
percent of Part B costs.
Medicare Part A
Coverage for
inpatient hospital,
skilled nursing,
hospice, and home
health services.
Medicare Part B
Coverage for
outpatient services
and medical
equipment.
Medicare
beneficiaries
Premiums
Part B
premiums and
income taxes
Providers
Government
Employees
Wages
Employers
Payroll and
income taxes
Medicare payments
Supplemental
insurers
Out-of-pocket payments
EXHIBIT 3.2
The Flow
of Funds in
Medicare
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44 Economics for Healthcare Managers
Employers and employees also pay taxes to fund the Medicare system.
The most visible of these taxes is the Medicare payroll tax, which is levied on
wages to fund Part A (which covers hospital, home health, skilled nursing,
and hospice services). In addition, corporation and individual income taxes
help fund the 75 percent of Part B costs that premiums do not cover. CMS,
the federal agency that operates Medicare, combines these tax and premium
funds to pay providers. Not surprisingly, few taxpayers, beneficiaries, or public officials understand how Medicare is financed.
3.3 The Changing Nature of Health Insurance
Traditional, open-ended fee-for-service (FFS) plans (of which pre-1984
Medicare was a classic example) have three basic problems. First, they
encourage providers and consumers to use covered services as long as the
direct cost to consumers is less than the direct benefit. Because the actual
cost of care is much greater than the amount consumers pay, some consumers may use services that are worth less than they actually cost. In addition,
open-ended FFS plans discourage consumers from using services that are not
covered, even highly effective ones. Finally, much of the system is unplanned,
in that the prices paid by consumers and the prices received by providers do
not reflect actual provider costs or consumer valuations.
Given the origins of traditional medical insurance, this inattention to
efficiency makes sense. Medical insurance was started by providers, largely
in response to consumers’ inability to afford expensive services and the
unwillingness of some consumers to pay their bills after services had been
rendered. The goal was to cover the costs of services, not to provide care in
the most efficient manner possible nor to improve the health of the covered
population.
Managed care is a varied collection of insurance plans with only one
common denominator: They are different from FFS insurance plans. Traditionally, FFS plans covered all services if they were included in the contract
and if a provider, typically a physician, was willing to certify that they were
medically necessary. The FFS plans had no features that tried to influence
the decisions of patients or physicians (aside from the effects of subsidizing
higher spending).
Currently, insurance takes five basic forms: FFS plans, PPOs (preferred provider organizations), HMOs (health maintenance organizations), point-of-service (POS) plans, and high-deductible (HD) plans.
We will briefly describe each of the alternatives to FFS plans.
fee-for-service
(FFS)
An insurance plan
that pays providers
on the basis of
their charges for
services.
managed care
A loosely defined
term that includes
all plans except
open-ended
fee-for-service.
It is sometimes
used to describe
the techniques
insurance
companies use.
PPO (preferred
provider
organization)
Plan that contracts
with a network
of providers.
(Network providers
may be chosen
for a variety of
reasons, but a
willingness to
discount fees is
usually required.)
HMO (health
maintenance
organization)
Plan that provides
comprehensive
benefits to
enrollees in
exchange for
a premium.
(Originally, HMOs
were distinct from
other insurance
plans because
providers were
not paid on a
fee-for-service
basis and because
enrollees faced
no cost-sharing
requirements.)
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Chapter 3: An Overview of the Healthcare Financing System 45
point-of-service
(POS) plan
Plan that allows
members to see
any physician
but increases
cost sharing for
physicians outside
the plan’s network.
(This arrangement
has become so
common that POS
plans may not be
labeled as such.)
high-deductible
(HD) plan
Plan that has a
deductible of at
least $1,000 and
may be combined
with a health
savings account.
Oregon’s Coordinated Care
Organizations
In 2012 Oregon launched an ambitious redesign of its Medicaid program. It created a statewide network of coordinated care organizations,
which are similar in some respects to accountable care organizations,
but these coordinated care organizations get global, risk-adjusted
budgets from the state, are responsible for a broad range of services
(behavioral, dental, and physical), and are governed by a broad range
of local stakeholders. The coordinated care organizations have implemented a number of innovations, including the following:
• Locating behavioral health specialists in primary care settings
• Using community health workers
• Using emergency department navigators to connect patients with
primary care
• Emphasizing identification and brief treatment of substance
abusers
How has this program worked? Per-member per-month spending
for hospital care decreased sharply, and spending on primary care
increased sharply. Most of the quality measures with incentives
attached have improved. Most without incentives have not.
Discussion Questions
• Why should a state provide Medicaid to its citizens?
• Who is eligible for Medicaid in Oregon?
• How does this situation differ from eligibility in your state?
• How is Oregon’s Medicaid different from your health insurance?
From Medicare?
• What type of insurance is Oregon Medicaid?
• Why might community health workers improve outcomes and save
money?
• Why does Medicare not pay for community health workers?
• How might linking behavioral health and primary care improve
outcomes and save money?
accountable care
organization
Network of
providers that have
financial incentives
to reduce spending
and improve
outcomes.
global, riskadjusted budget
Payment of a fixed
amount per person
to the organization
responsible for
providing care to
a population. Risk
adjustment means
that the amount per
person is higher for
people with higher
risk of expensive
illnesses.
community health
workers
Local, nonclinical
workers who
help patients live
healthier lives and
help providers
understand
patients’ needs.
Case 3.1
(continued)
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46 Economics for Healthcare Managers
PPOs are the most common form of managed care organization. All
PPOs negotiate discounts with a panel of hospitals, physicians, and other
providers, but their similarities end there. Some PPOs have small panels; others have large panels. Some PPOs require that care be approved by a primary
care physician; some do not.
PPOs are far less diverse than HMOs, however. Some HMOs are
structured around large medical group practices and are called group model
HMOs. Group model HMOs typically make a flat payment per consumer
enrolled with the group. This practice is called capitation. Other HMOs,
called staff model HMOs, employ physicians directly and pay them salaries.
Both staff and group model HMOs still exist, but they are expensive to set
up and make sense only for large numbers of enrollees (because small HMOs
cannot negotiate favorable prices with hospitals).
HMO expansion largely has been fueled by the growth of independent practice association (IPA) HMOs. These plans contract with large
groups of physicians, small groups of physicians, and solo-practice physicians.
These contracts assume many forms. Physicians can be paid per service (as
PPOs usually operate) or per enrollee (as group model HMOs usually operate). IPAs also pay hospitals and other providers in varied ways.
POS plans are another form of HMO. These plans are a combination
of PPO and IPA models. Unlike IPA HMOs, they cover nonemergency services provided by nonnetwork providers, but copayments are higher. Unlike
PPOs, they pay some providers using methods other than discounted FFS
payments.
HD plans have a deductible of at least $1,000. These plans may be
combined with health savings accounts, which are nontaxable accounts that
employees and employers can contribute to and employees can use to pay
medical bills.
group model HMO
A plan that
contracts with a
physician group to
provide services.
capitation
Payment per
person. (The
payment does not
depend on the
amount or type of
services provided.)
staff model HMO
A plan that
employs staff
physicians to
provide services.
independent
practice
association (IPA)
HMO
A plan that
contracts with
independent
practice
associations,
which in turn
contract with
physician groups.
health savings
account
An account that
employees and
employers can
contribute to and
employees can
use to pay medical
bills. Employees’
contributions and
payments are not
taxable.
• How might connecting patients with primary
care improve outcomes and save money?
• Is there evidence that good primary care
improves outcomes and saves money?
• How might increasing treatment of substance abusers improve
outcomes and save money?
• Is reducing the hospitalization rate a good thing?
• Is reducing use of emergency departments a good thing?
Case 3.1
(continued)
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Chapter 3: An Overview of the Healthcare Financing System 47
Health insurance continues to evolve in a disorderly fashion. Where
this development will lead is not clear. The belief that health insurance is
changing rapidly is widespread, and exhibit 3.3 seems to confirm this belief.
Since 2007, FFS plans have all but disappeared, and the market share of PPO
plans has fallen from 57 percent to 48 percent. HMO plans (which include
POS plans in exhibit 3.3) have fallen from 34 percent of the employer-based
market to 24 percent. HD plans have risen from 5 percent of the market in
2007 to 28 percent in 2017.
The patterns in other sectors differ from those in the employersponsored market. More than 60 percent of Medicare Advantage beneficiaries are in HMOs (Kaiser Family Foundation 2017b). Likewise, more than
70 percent of Medicaid beneficiaries are in HMOs, and about half of those
buying ACA plans are as well.
Complicating this already complex picture are recent changes in
Medicare, Medicaid, ACA marketplace plans, and employment-based plans.
These innovations could have widespread effects, although only preliminary
evidence is available for most of them. We will explore these changes in detail
in chapter 6.
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
0%
10%
20%
30%
40%
50%
60%
70% PPO
60%
HD
8%
HMO
24%
FFS
1%
PPO
48%
HD
29%
EXHIBIT 3.3
Enrollment
Patterns in
EmployerSponsored
Insurance
Source: Kaiser Family Foundation and Health Research & Educational Trust (2017).
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48 Economics for Healthcare Managers
3.4 Payment Systems
In the past, most healthcare providers were paid on the basis of volume.
Today, insurers have begun to experiment with alternative payment models.
Geisinger’s Transformation
The conflicting incentives of FFS and capitation
present significant problems for integrated health
systems like Geisinger Health System of central Pennsylvania. Indeed,
after its merger with Penn State Health collapsed, many were concerned about its viability. Geisinger faced losses in its hospitals and
physician group, and its health plan was not doing well (Goldsmith
2017).
Geisinger’s turnaround involved two strategies: increasing the
share of physician compensation in the form of FFS payments and
implementing a robust network of patient-centered medical homes to
limit low-value care (healthcare offering little or no clinical value or
even having potential harms greater than its benefits). The change in
physician compensation allowed the creation of a broader network and
rewarded higher volumes. In essence, Geisinger became a network
HMO (an HMO having a variety of contracts with physician groups,
IPAs, and individual physicians; it may also own hospitals and employ
physicians).
Geisinger had two major advantages. Its Medicare Advantage plan
was profitable, and its strong market position allowed it to negotiate
good rates with local insurance plans. Those high rates gave it the
resources necessary to transform its primary care practices.
Discussion Questions
• Why would it make sense to become a network HMO?
• Did it make sense for Geisinger to support the patient-centered
medical home transition?
• Could an independent practice afford to become a patient-centered
medical home?
• Why is Medicare sponsoring patient-centered medical home
demonstrations?
• How would a 6 percent reduction in hospitalization rates affect
hospitals?
low-value care
Care that has
been scientifically
evaluated and
found to be of
little or no clinical
value or to have
potential harms
greater than its
benefits.
network HMO
An insurance
plan that has a
variety of contracts
with physician
groups, IPAs,
and individual
physicians. A
network HMO
may also own the
hospitals that it
uses and employ
physicians.
Case 3.2
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Chapter 3: An Overview of the Healthcare Financing System 49
These alternative payment models can change providers’ incentives, which
can change patterns of care. The power of changing incentives should not
be underestimated, and managers need to be wary of getting what they
pay for rather than getting what they want. When contracting with insurers
or providers, managers need to recognize the strengths and weaknesses of
different systems. The four basic payment methods—salary, volume-based,
value-based, and capitation—can be modified by the addition of incentive
payments, increasing the number of possible payment methods.
A salary is fixed compensation paid per defined period. As such, it is
not directly linked to output. Typically, physicians are paid a salary when their
productivity is difficult to measure (e.g., in the case of academic physicians)
or when the incentives created by payments per service are seen as undesirable (e.g., an incentive to overtreat that increases costs). As noted earlier,
most physicians in the United States have traditionally been paid on the basis
of volume, meaning providing more services increases revenue.
Volume-based payments can take a number of forms. Per-service
payments entail a payment for each separate service. For example, a physician
visit that involved 10 minutes talking to the doctor, an X-ray, and a laboratory test would result in a bill for three services. Case-based payments are
single payments for all covered services associated with an episode of care.
Medicare’s diagnosis-related group (DRG) system is a case-based system
for hospital care, although it does not include physicians’ services or posthospital care. In essence, case-based payments are volume-based payments for a
bundle of services rather than separate payments for each individual service.
Value-based payments add a quality bonus or penalty to volume-based
payments. For example, Medicare reduces DRG payments to hospitals with
above-average 30-day readmission rates for pneumonia patients. Capitation is
compensation paid per beneficiary enrolled with a physician or an organization. Capitation is similar to a salary but varies according to the number of
customers.
Each of the four basic payment methods has advantages and disadvantages. Salaries are straightforward and incorporate no incentives to provide
more care than necessary, but they do not encourage efficiency or reward
exemplary service. In addition, salaries give providers incentives to use
resources other than their time and effort to meet their customers’ needs.
In the absence of incentives not to refer patients to other providers, salaried
providers may well seek to refer substantial numbers of patients to specialists,
urgent care clinics, or other sources of care.
Capitation incorporates many of the same incentives as a salary, with
two important differences. One is that capitation payments drop if customers
leave the practice, so physicians have more incentive to serve patients well.
The other is that capitation creates incentives to undertreat. Providing a
salary
Fixed
compensation per
period.
volume-based
payment
Payment that
increases if a
provider delivers
more services.
per-service
payment
Payment for each
billable service.
Providing an
additional service
increases the bill.
case-based
payment
A single payment
for an episode of
care, regardless
of the number of
services.
diagnosis-related
group (DRG)
The basis of
Medicare’s casebased payment
system for
hospitals.
value-based
payment
Payment adjusted
on the basis of
quality measures.
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50 Economics for Healthcare Managers
service increases costs but does not increase revenue, so profits rise if service
levels drop.
Volume-based payment encourages productivity and efficiency but
may create incentives to overtreat (especially for services with prices that
are much higher than production costs). Services that offer limited benefits
to patients can be profitable in volume-based payment systems as long as
the benefits exceed the consumer’s out-of-pocket cost. On the other hand,
incentives to undertreat can emerge if services are unprofitable. Getting
prices right is vital in volume-based payment.
Case-based payment combines features of per-service payment and
capitation. It is a form of volume-based payment, so it rewards productivity
and efficiency. However, case-based payment may encourage providers to
treat patients with highly profitable cases who should not be treated, or it
may create incentives for providers not to treat patients with less profitable
cases who should be treated. Like capitation, it can create incentives to skimp
on care. Costs can be reduced by improving efficiency, shifting responsibility
for therapy to other sources (e.g., the health department), avoiding complex
patients, and narrowing the definition of a case. The challenge is to keep
providers focused on improving efficiency, not on gaming the system.
Any of these four basic methods can be modified by including bonuses
and penalties, as value-based payment does. A base salary plus a bonus for
reducing inpatient days in selected cases is not a straight salary contract.
Similarly, a capitation plan with bonuses or penalties for exceeding or not
meeting customer service standards (e.g., a bonus for returning more than
75% of after-hours calls within 15 minutes) would not generate the same
incentives a plain capitation plan would. Most insurers are moving away from
volume-based payments toward value-based payments; however, insurers are
trying a variety of approaches because the best way to implement value-based
payment is not yet clear.
Capitation was previously expected to become the dominant method
of payment. Experience with capitation suggests, however, that few providers
(or insurers, for that matter) have the administrative skills or data that capitation demands. In addition, the financial risks of capitation can be substantial.
Few providers have enough capitated patients for variations in average costs
to cease being worrisome, and capitation payments are seldom risk adjusted
(i.e., increased when spending can be expected to be higher than average).
These considerations have dampened most providers’ enthusiasm for capitation. Insurers also have realized that capitation is not a panacea, recognizing
that providers have ways other than becoming more efficient to reduce their
costs. Volume-based payments remain the norm, but most major insurers are
seeking to switch to value-based payments (which include careful monitoring
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Chapter 3: An Overview of the Healthcare Financing System 51
of quality). What compensation arrangements will look like in ten years
remains to be seen.
3.5 Conclusion
Health insurance is common because of the risks of unexpected costs, but the
days of traditional, open-ended insurance plans are over. Despite the ubiquity
of managed care and much discussion of value-based payment systems, most
consumers are enrolled in plans that are minimally managed, such as PPOs or
POS plans that pay providers in familiar ways. But more than half of the providers who responded to a recent survey are deeply involved with value-based
payment, and most expect to be shortly (KPMG 2017). Medicare, Medicaid,
and most private insurers have already begun to change how they pay providers. Changes in payment systems substantially increase the risks that managers
must face. The next chapter will introduce strategies for managing these risks.
The central challenge of cost remains. In 2016 median household
income was $59,039, meaning that half of the households in the country
made less than $59,039. The Milliman Medical Index, which tracks all
healthcare costs, shows that an average family of four spent $25,824 in 2016
(Girod, Weltz, and Hart 2016). Many families simply cannot afford this level
of spending.
Exercises
3.1 Why is health insurance necessary?
3.2 Explain how adverse selection and moral hazard differ, and give an
example of each.
3.3 Some consumers are overinsured, yet some are underinsured.
Millions are clearly uninsured. What do you think these concepts
mean?
3.4 Should health insurance continue to be employment-based for most
Americans?
3.5 A radiology firm charges $2,000 per exam. Uninsured patients are
expected to pay list price. How much do they pay?
3.6 A radiology firm charges $2,000 per exam. An insurer’s allowed
fee is 80 percent of charges. Its beneficiaries pay 25 percent of the
allowed fee. How much does the insurer pay? How much does the
beneficiary pay?
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52 Economics for Healthcare Managers
3.7 If the radiology firm in exercise 3.6 raised its charge to $3,000,
how much would the insurer pay? How much would the beneficiary
pay?
3.8 A surgeon charges $2,400 for hernia surgery. The surgeon contracts
with an insurer that allows a fee of $800. Patients pay 20 percent of
the allowed fee. How much does the insurer pay? How much does
the patient pay?
3.9 You have incurred a medical bill of $10,000. Your plan has a
deductible of $1,000 and coinsurance of 20 percent. How much of
this bill will you have to pay directly?
3.10 Why do employers provide health insurance coverage to their
employees?
3.11 Your practice offers only a PPO with a large deductible, high
coinsurance, and a limited network. You pay $400 per month for
single coverage. Some of your employees have been urging you to
offer a more generous plan. Who would you expect to choose the
more generous plan and pay any extra premium?
3.12 What are the fundamental differences between HMO and PPO
plans?
3.13 Suppose that your employer offered you $4,000 in cash instead
of health insurance coverage. Health insurance is excluded from
state income taxes and federal income taxes. (To keep the problem
simple, we will ignore Social Security and Medicare taxes.) The cash
would be subject to state income taxes (8%) and federal income
taxes (28%). How much would your after-tax income go up if you
took the cash rather than the insurance?
3.14 How would the calculation in exercise 3.13 differ for a worker who
earns $500,000 and lives in Vermont? This worker faces a state
income tax rate of 9.5 percent and a federal income tax rate of 35
percent.
References
Berk, M. L., and Z. Fang. 2017. “Most Americans Have Good Health, Little Unmet
Need, and Few Health Care Expenses.” Health Affairs 36 (4): 742–46.
Centers for Medicare & Medicaid Services (CMS). 2017. “National Health Expenditures by Type of Service and Source of Funds: Calendar Years 1960 to
2016.” Accessed November 3. www.cms.gov/Research-Statistics-Data-and
-Systems/Statistics-Trends-and-Reports/NationalHealthExpendData
/Downloads/NHE2016.zip.
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