BY DAVID HANSEN

Most in the current health reform debate agree on the need to curtail health care costs. Despite this, few discuss directly how health services are priced, though clearly this a central issue. Prices have both immediate impacts and longer term impacts. Immediate impacts include dividing up who pays what burden of current costs. However, I’d like to focus below on what should be a longer term impact of price mechanisms: driving inefficiency out of business.

An economic sector, to stay healthy, needs mechanisms to kill inefficient business approaches, while either prodding efficiency improvements or moving customers and staff to better performing entities. In most sectors, lower prices adequately incent customers to drop inefficient suppliers.  In medical care, however, suppliers seem to have too much power over prices, and thereby price loses effectiveness as the sector’s cleansing agent.

Evidence of pricing’s ineffectiveness for health services is found in the huge price variations that can be observed for similar services. Where markets function well, pricing variation across suppliers reflects quality or feature differences. For example, cars of similar attributes, such as the Honda Accord vs. the Toyota Camry, are priced approximately the same. In medical care, however, prices for services vary inexplicably widely. The State of California recently published price information by hospital for a couple dozen common surgeries.  This information was for average gross (pre-discount) charges, which, when combined with previously available data on discount levels, can be used to estimate average net (post discount) charges paid by customers. The net charges for coronary bypass surgeries (CABG), as an example, vary by twentyfold between the hospitals with the lowest and highest charges. The average charge for the highest quartile of hospitals is twice that of the lowest quartile of hospitals. This pricing pattern is similar across all surgical procedures included in the California data. Note that there is no relationship between charge levels and hospitals’ apparent quality. Some hospitals with good objective ratings for CABG surgeries and excellent reputations, such as UCLA Medical Center, charge little, while lesser known hospitals nearby with no or average ratings charge several multiples more.

That hospitals offer discounts of 70%+ for large health plans, with individuals paying far more for that same service, is another issue. Price discrimination for less essential services like vacation travel is one thing, but charging multiples more when a dying individual has no market clout: Can we as a society accept the morality of such practices?

But back to my main issue: A market that functioned well would transfer patients from hospitals in the expensive quartile to hospitals of equivalent quality in the least expensive quartile. In most markets, consumers would make the decision to change to better value vendors, but consumers in medical care lack both sufficient information and incentives to do so. Most privately insured Americans are insensitive to prices paid for expensive health services, such as medical care received in years with surgeries or other major medical events. Once annual costs for a patient reach the tens of thousands—and most hospitalizations quickly bring charges over ten thousand dollars—few insured patients face additional costs. Even patients with high-deductible plans linked to medical savings accounts carry no share of medical expenses for charges at such levels. This customer insensitivity to fees gives hospitals price setting powers that vendors in most other sectors would envy, and they use this power to keep prices high and inefficient operations on life support.

There was once hope among policy wonks that managed care would have both the incentives and market clout to funnel services to the most efficient suppliers. During the last dozen years, however, health providers have effectively countered managed care’s market power by leveraging local monopolies and the stickiness of patients’ relationships with specific physicians. One useful strategy for a hospital chain, for example, is to secure a “must-have” hospital for a health plan, such as the premier hospital in a wealthy suburb to which the spouses of executives for health plans’ clients insist on having access. Access to this hospital can then be leveraged in negotiations to attain higher prices for all hospitals across the chain.

For Medicare and Medicaid, the government has used its legislative and monopsony powers to attain advantageous prices. Service fees are stipulated by the government, rather than being subject to negotiations with individual hospitals.  The result is fees that, for a given procedure, are lower than private payers are typically offered. Liberals are proposing a new government health plan available to all, and some proposals provide for such a plan to take advantage of low Medicare’s payment levels. However, a new government plan will, unlike Medicare, face competition; thus, a new government plan’s ability to dictate pricing will be reduced by competitive pressures, just as it is for existing health plans. Besides, even if a new government plan is able to attain Medicare pricing, this won’t help the rest of the market with the bulk of the currently insured population.

However, there is an alternative set of policy options that could benefit all patients: government stipulation of fee ceilings that would apply across the board. Where the market functions inadequately to determine minimum acceptable efficiency levels from care providers, the government should step in if it can and enable better market performance. Government already has a price system set up for Medicare, so limited new administrative requirements would be called for. A maximum permitted price can be set initially at, for example, 30% above Medicare rates. This ceiling would be a maximum for all payers, whether self-pay patients or insurance companies. Medicare rules would apply in terms of defining care incidents, so that providers would have difficulty tacking on charges for peripheral services to make up for revenue losses resulting from price ceilings.

Providers will universally object to a price ceiling proposal, as an effective ceiling would threaten their market power. However, only the weakest links among providers would actually see revenue reductions.  More efficient providers would gain market share as the less efficient withdraw from what is for them, as opposed to efficient providers, unprofitable service lines. By policy intent, price ceilings would push every provider toward service lines where they excel and out of others.

Another advantage of price ceilings for all in the market is to decrease barriers to entry for new health plans, such as ones started by regional physician groups or local cooperatives. Negotiating with hospitals and other care providers is expensive, and a large market share is needed before good deals are won. Ceilings on fees would reduce an advantage for large health plans, and thus many reformers’ goal of increasing competition among payers would be advanced.

An objection to price ceilings is that they would discourage innovation of medical technologies. In theory ceilings could create disincentives for new medical procedures that are of higher quality, but more expensive than those already approved for payment by Medicare for the same disease. However, this issue plagues the existing system already, as most payers refuse to pay for medical procedures with yet unproven merit. Thus, the addition of price ceilings would not create the problem. In fact, it might make it easier to address the issue, since it a standard approach could be established readily. A single approval process could be initiated for medical procedures with promising, if not yet fully convincing, evidence of better quality at higher cost.

If the health sector is to remain market based and keep costs down, price mechanisms must work to cleanse the sector of inefficiency. However, neither patients nor health plans are in a position to make price a driver of who succeeds and who fails in the sector. Government, on the other hand, could make price more of a factor in the sector, and the policy complexity for doing so is relatively low. The result would be more pruning of the inefficient and prodding of the efficient, and the health sector would be set on a significantly lower cost curve.

David Hansen has aided organizations with health care strategy, IT planning, and new venture development for a couple decades, both in Scandinavia and in the USA. He holds graduate degrees in Economics and Business Administration from the University of Bergen, Norway and the University of California. He, like thousands of other health economists, has dreamed of significant health care reform in his lifetime.

More by this author:

• A Social Democrat Weighs In On A Government Health Plan
• The Stimulus Package and Health Data Exchange