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CHAPTER 14

Financing Health Care

OBJECTIVES

1. Identify alternative sources of healthcare funding in the United States.

2. Describe the effects of financing health care through insurance premiums, tax subsidies, and mandated benefits.

3. Compare the effects of financing by insurance premiums, payroll taxes, sales taxes, and income taxes.

4. Discuss the administrative cost of public and private financing mechanisms.

5. Describe the effects of alternative ways of reimbursing providers for services provided.

Hicks, Lanis. Economics of Health and Medical Care, Jones & Bartlett Learning, LLC, 2020. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/undip-ebooks/detail.action?docID=6031666. Created from undip-ebooks on 2021-04-12 20:40:11.

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14.1 Introduction

This chapter examines, conceptually and empirically, the growth in healthcare expenditures and the sources of financing of those expenditures. As spending on healthcare goods and services continues to increase, concerns are increasingly expressed about the increase. It is important to distinguish between absolute expenditures and the relative amount of expenditures on health care. Preliminary estimates indicate that in 2018, the United States spent $3.65 trillion on health care, an increase of 4.4% over 2017. This amount of spending translates into $11,212 per capita, and 17.8% of the gross domestic product (GDP).

The concern should not be focused on the absolute size of spending in the healthcare sector ($3.65 trillion), but rather on the increasing share of total output that the healthcare sector is consuming (17.8% of GDP). As a larger share of total output goes to the healthcare sector, there are fewer resources available for the production of other goods and services in the economy. As a healthcare sector’s percent of GDP increases, questions are increasingly being asked about the relative value of the goods and services produced and whether the population might be better off if the resources were reallocated to other sectors. While the United States spends more per capita and a higher percent of its GDP on healthcare goods and services than any other country, the health status of its population is far from the best. As a result, attention is focused on alternative ways of financing healthcare services in order to try to reduce the rate of increase in spending.

The growth in healthcare spending has implications for the financing of those expenditures and its sustainability. There are three major methods of financing healthcare services—out-of- pocket payments by the consumers, insurance premiums, and

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taxation—and within each category there are a number of different financing techniques. Out-of-pocket payments by consumers include amounts the insured population pays for deductibles, copayments, coinsurance, and payments for services not covered, and the uninsured are responsible for all services utilized, even though some of the costs of those services become uncompensated care by the providers. Insurance premiums can be paid directly by the consumer, employer, governments, or a combination. Also, taxes can be levied on income or on specific products or services to finance health care. Further, the different financing methods can interact: insurance premiums can be excluded from taxation (as is the case in the United States) or can be taxed; they can be part of a compensation package of employees, or purchased individually with after-tax dollars.

Each method of financing healthcare services will impact differently on groups of the population with different characteristics, such as income level or family size. Determining how the burden of each financing method will fall is not a simple or straightforward matter. To illustrate, the burden of insurance premiums that are paid out of pocket by consumers falls on the consumers directly, but income taxes can influence this burden. When insurance is obtained through the workplace (as is often the case in the United States), the burden of payment is far from clear. Furthermore, different kinds of taxes will have different impacts on different groups within the population, especially due to variations in income levels.

Economic analysis can be a very useful tool for assessing the effects of these various finance methods. The first part of this chapter examines how explanatory economics can be used to analyze the burden of the various financing methods. How these various financing methods can be assessed in terms of specific criteria or policy objectives is also discussed.

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Different financing methods can also have substantially different costs. In the case of private insurance, the insurance company will incur the costs of marketing, rating alternative consumer groups, paying providers, and monitoring and enforcing utilization. In the case of government financing, there are the costs of collecting taxes and administering public programs. A debate continues to occur in the United States over whether healthcare coverage for the population should be financed primarily through private markets (with appropriate subsidies when necessary) or through public financing. This chapter illustrates how economic analysis can be used to compare these options.

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14.2 Insurance Terminology

A brief discussion of basic insurance concepts and terminology is presented before analyzing the financing of health care. An understanding of these insurance concepts is important since these various concepts also have implications for the variety of methods for financing health care and the burden of healthcare costs.

When utilizing healthcare services, consumers may pay various amounts toward the medical bill associated with those services. Many insurance packages require the consumer to pay a deductible before insurance pays anything. This deductible is a flat, or fixed, amount that must be paid by the consumer before the insurance company begins to pay all or part of the remaining amount. To illustrate, an insurance package may require the beneficiary to pay the first $1000 of medical expenses each year before the insurance pays anything.

The use of deductibles has an impact on the administrative costs of the insurance company. Since a deductible eliminates the processing of claims for small amounts, the transaction costs associated with paying small claims are avoided. The higher the deductible the consumer must pay, the fewer the claims that will need to be processed by the insurance company. However, the use of deductibles, especially high deductibles, may be a deterrent to accessing needed medical care for some beneficiaries. In addition, the use of deductibles creates a greater burden on lower- income individuals than on higher-income individuals since the deductible represents a larger percentage of total income for the lower-income beneficiary. Also, if the only feature of the plan is the deductible, then the out-of-pocket cost to the beneficiary drops to zero once the deductible is met. This raises the possibility of

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overuse of healthcare services once the deductible is met since the consumer faces a zero price in the demand for health care.

Another common feature of insurance is the use of a copayment, which requires the beneficiary to pay a fixed amount each time a service is used. To illustrate, an insurance package may require the beneficiary to pay $20 each time a visit is made to a primary care physician, $50 each time a visit is made to a specialist, $75 each time a visit is made to an urgent care clinic, and $150 for each visit to an emergency room. A copayment places similar burdens on lower-income individuals as deductibles since they represent a larger portion of the individual’s income. A copayment would not have the same impact on administrative costs as deductibles to the insurer because copayments do not necessarily reduce the number of claims filed.

Coinsurance requires the beneficiary to pay a specified percentage of the price of the medical service, and the insurance company pays the balance. To illustrate, an insurance package may require the individual to pay 20% of the price after any deductible and the insurance company will pay 80%; the copayment amount is not included in the price of the service considered by the insurance company. Assuming that the price of the medical encounter was $1000, if the beneficiary had a $500 deductible and 20% coinsurance rate, then the beneficiary would have to pay $600 ($1000 − $500 + [$500 × 0.2] = $600) and the insurance company would pay $400 ($1000 − $500 − [$500 × 0.8]) = $400. Since the deductible is subtracted from the price of the service first, the insurance company does not pay the full stated percent of the price of the service.

A coinsurance feature lowers the price of the covered medical care by the percentage the insurance company pays; in this case, it lowers the price to the consumer by 80% after the deductible. A coinsurance feature reduces the price of the service, but still

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provides an incentive to be a cost-conscious consumer, because the consumer pays a percentage of whatever the price is. The actual impact will depend on the price elasticity of demand of the consumer—the more price elastic, the greater the impact on demand.

Many insurance plans included a “stop-loss” feature, which sets an upper limit on the amount the consumer will have to pay. This reduces the risk of a serious medical condition resulting in a catastrophic loss to the individual. To illustrate, an insurance package may contain the provision that once out-of-pocket expenditures of the individual reach a specified amount (e.g., $10,000), then the insurance company will pay all remaining medical expenses associated with covered services. The stop-loss feature is typically an annual condition.

While stop-loss features apply to beneficiaries, insurance companies seek protection by setting maximums and limits. To illustrate, the insurance package may specify a maximum annual amount it will cover, such as $250,000 of medical care or 60 days of hospital care. The policy may also contain lifetime limits that the insurance company will pay for medical expenses incurred by an individual, such as a limit of $5 million for covered services by the individual. These maximums and limits are not reached by most individuals. However, the presence of the feature can raise the fear that medical bankruptcy is a possibility, even for individuals with good health insurance coverage.

The two basic methods of establishing insurance premiums are community rating and experience rating. Under the community rating method, all enrollees in the plan are charged the same premium. Even community rating is usually separated into two rates—one covers individuals (single coverage) and the other provides family coverage. Under community rating, high users of healthcare services in the insurance plan are subsidized by low

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users of healthcare services. If the low users determine that the premiums are too high for the benefits they receive, these individuals may simply drop coverage and become uninsured. Also, the redistribution of resources from low users of healthcare services to high users may actually result in the transfer of income from low-income individuals to high-income individuals because income level is not considered in establishing the premium. This transfer of income from low-income to high-income individuals is in conflict with most income redistribution policies.

Experience rating relies upon the characteristics of groups of individuals or upon the prior experiences of those groups in establishing the premium to be charged. As a result, different groups within the plan are charged different rates depending upon their expected use of healthcare services. Under this method, individuals possessing characteristics associated with low risk are charged a lower premium for the same package of covered services than other groups with characteristics associated with higher use. Under the experience rating method, the medical loss ratio, benefits paid out divided by the premium for each of the groups, is close to 1.0. The loading fee charged for plans using the experience rating may be higher than plans using the community rating because of the administrative costs of determining into which group an individual will be classified. A loading fee is the amount above the pure premium (amount of medical claims paid) that the insurance company charges to cover such things as marketing expenses, administration, claims processing, reserves, and profits.

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14.3 Financing Means and Burdens in the United States

Currently, in the United States, a variety of financing mechanisms are used in health care. These mechanisms and the amounts raised through each are shown in Table 14-1. As can be seen, a total of $3.492 trillion was spent on health care in 2017. Of this amount, $365.55 billion (about 10.47%) was financed by out-of- pocket payments by consumers. In comparison, in 1965, consumers financed about 43.5% of expenditures out of pocket.

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Table 14-1 Sources of Funds for National Health Expenditures, 1965 and 2017

A total of $1.139 trillion (33.9%) was financed through private health insurance in 2017, compared to 23.8% in 1965. A reason

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for using 1965 as a comparative base is because that was the last full year before the two major government health insurance programs (Medicare and Medicaid) were implemented. Medicare coverage began in January 1966, covering most individuals age 65 and older. Medicaid coverage began in July 1966, covering certain low-income individuals. Medicaid provided coverage to pregnant women, young children, and certain individuals with disabilities with low income. Medicaid did not cover single individuals regardless of income level.

The percentage of the under-65 population covered by private health insurance declined between 2003 (at 68.9%) and 2010 (at 61.7%) but had increased again to 65.7% in 2017. The majority of the population with private health insurance receive coverage through employment-based insurance (58.2% of the under-65 population, or 88.6% of the privately insured population), with 11.4% of the privately insured purchasing individual policies (Cohen, 2018; DeNavas-Wait, Proctor, & Smith, 2011).

As illustrated in Table 14-2, for individuals with employer-based coverage, employers financed 82.8% of the $6896 of premiums for single coverage employees in 2018 and 71.7% of the $19,616 for family coverage. Between 1999 and 2018, both the premiums for insurance coverage and the percentage of premiums paid by the employee increased. As a result, the employee’s cost for single coverage increased from $318 in 1999 to $1186 in 2018, and the employee’s cost for family coverage increased from $1543 to $5547 during that period (Claxton, Rae, Long, Damico, & Whitmore, 2018).

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Table 14-2 Average Annual Premiums and Average Annual Worker Premium Contributions Paid by Covered Worker for

Single and Family Coverage, 1999–2018

As shown by the data presented in Table 14-2 with regard to health insurance provided through the workplace, the majority of the premiums are paid for by employers, with a smaller amount being paid for directly by employees. However, this does not mean that the employers bear the burden of the majority of the health insurance expenses. For one thing, premiums paid for by employers are workplace benefits that are not subject to income tax. Therefore, there is a sizable public subsidy given to employees who obtain their insurance in this way; their taxes will be lower than if their premiums were taxed at the same rate as their wages. In addition, there is considerable evidence that when

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all the wage effects are taken into account, the employees do indeed bear a major share of these premium costs through lower direct wages, even if it does not appear that way initially.

The third form of finance that is used is public finance, or programs funded through taxation. In 2017, over $1.94 trillion (55.3%) of total financing for health care involved public programs compared to 31.0% in 1965. Most of this 2017 amount (66.3%) went to pay for the federal Medicare program, which covers individuals 65 and over, those totally and permanently disabled, and those with certain diseases, and the joint federal- state Medicaid program, which is primarily for certain categories of lower-income groups. These two programs are largely, but not entirely, financed by taxation.

With regard to taxation, the major federal tax that pays for the hospital portion (Part A) of Medicare is a payroll tax of 2.9% of all wages, paid equally (1.45%) by employers and employees; self- employed individuals pay the full amount of 2.9%. As of January 2013, individuals filing jointly pay an additional 0.9% on income greater than $250,000 and single individuals pay the additional 0.9% on incomes over $200,000. The employers’ tax rate did not increase from 1.45%. In addition, there is a Medicare “premium” paid by enrolled beneficiaries for medical care (physician services) and health maintenance organization (Part B) coverage, which was $135.50 per month in 2019. This $135.50 is a base rate that applies to single individuals with an income of $85,000 or less and to beneficiaries filing jointly with income of $170,000 or less. Table 14-3 provides information on the premiums for individuals with incomes above these levels.

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Table 14-3 Total Medicare Part B Monthly Premiums, 2019

Most of the remainder of the federal portion of healthcare expenditures was raised through general taxation, the largest portion from direct income taxation. Of the $1.94 trillion spent by governments on health care, $335.0 billion was raised through state government taxation. Most state taxation is in the form of direct income and indirect sales taxes.

Table 14-1 provides an indication of the sources of the money spent on health care, but Table 14-1 cannot be used directly to assess the “burden” of healthcare financing (defined as the reduction in real income due to payments and taxes). The complexity of the situation and the prominent role played by each of the financing methods calls for a much more detailed analysis. Each financing method imposes different burdens on different groups of the population. The pattern of these burdens will be discussed after examining the burdens from a positive economic perspective.

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14.4 Economic Analysis of Alternative Payment Sources

This section presents economic analyses of alternative payment methods. The focus of the analyses is the economic impact of the payment methods on the resource owners (primarily employees and owners of companies). Insurance premiums (in particular, the impact of employer-paid premiums, taxation, and mandated benefits) and taxation (the impact of payroll and sales taxes) are examined.

A primary question relates to the economic impact of a tax, that is, who actually ends up bearing the economic burden. The group that bears the burden of the tax may not be the same group from which the tax was originally collected. To illustrate, a government tax on cigarettes may be collected from tobacco retailers (sellers). However, to the extent that prices of tobacco products are higher because of the tax, the economic burden is on the users of the tobacco, who pay the higher price.

14.4.1 Private Health Insurance

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14.4.1.1 Insurance Premiums Private health insurance can be obtained through the workplace or by direct individual purchase. Health insurance obtained in the workplace can be paid for directly by the employees (through payroll deductions from after-tax dollars), by the employers, or by a combination of employees and employers. There is no controversy over the burden of premiums paid by employees or by individuals; the purchasers bear the cost of their insurance purchases.

The economic burden of employer-paid premiums is more complicated. The cost of insurance benefit packages is viewed by employers as an expense, much like wages are. An employer has a demand curve for labor and will regard the costs of various forms of compensation as monetarily equivalent. To illustrate, if the marginal employee is worth (has a marginal value of) $100 to the employer, then the employer will be willing to pay up to $100 in compensation to the individual, whether the payment is in the form of wages or fringe benefits or a combination (Kreuger & Reinhardt, 1994). If benefits are increased, then the employer will reduce monetary wages. Thus, the economic burden of all health insurance benefits will fall on the employee, either directly (out of pocket) or indirectly (through a lower wage).

14.4.1.2 Taxation and Insurance Premiums Preferential tax treatment is provided for health insurance that is obtained through the workplace. Both the employer and the employee benefit from payments and contributions made in this system. When the employer pays all or part of the insurance premium for the employees, the employer’s payments are excluded from income and payroll taxes the employer pays. In most cases, the amount that the employees pay for their share of the premium is also excluded from income and payroll taxes. In addition, contributions that employers make to certain accounts for

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employees, such as flexible spending arrangements (FSAs), health reimbursement arrangements (HRAs), and health savings accounts (HSAs), to pay for employee healthcare costs are excluded from income and payroll taxes as well. On average, individuals that receive higher incomes and more expensive health insurance plans receive larger subsidies. It is estimated that the subsidy cost the federal government about $300 billion in foregone revenue in 2018 (CBO, 2018).

Health insurance benefits paid by the employer are exempt from personal income and the payroll taxes of the employee. This reduces the cost to the employee of employer-paid health insurance and increases the quantity demanded for health insurance. However, it cannot be assumed that once a subsidy is put into place, that the quantity demanded and supplied in the insurance market will remain the same. To see why, consider the analysis of a tax subsidy provided in the following illustration.

In Figure 14-1, the initial demand curve for health insurance (with no tax subsidies) is D . According to this curve, when the premium rate is $1000, a total of 75 individuals will be willing to shift their risks to health insurers. According to the supply curve for insurance (represented by S in Figure 14-1), insurers will be willing to supply 75 insurance policies to individuals at the rate of $1000, and the market is in equilibrium at a quantity of 75 and a price of $1000.

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Figure 14-1 Effects of a subsidy on quantity of health insurance. D represents the demand curve for insurance without a

subsidy; S represents the supply curve of insurance, and D represents the demand curve with a $500 subsidy for

purchasing insurance.

Assume that a 50% subsidy is introduced in the market. The effect of the subsidy is to lower the out-of-pocket price for insurance at every premium rate to potential demanders. Thus, at a premium rate of $1000, the out-of-pocket price to the consumer is now $500, and at this price an additional 25 individuals will be willing to shift their risks to the insurer and purchase an insurance policy, and so the quantity demanded will now be 100 policies. The market demand curve will shift out to D .

When demand shifts out to D , there is excess quantity demanded from the 25 additional individuals seeking insurance in the subsidized market. In this illustration, interactions will occur in the market forcing changes in the price until a new equilibrium is

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reached at which insurers are willing to supply 92 policies at a price of $1350 and 92 individuals are willing to pay their 50% of the new subsidized price. Generally, a higher supplier price will be required to induce the insurers to accept more risks.

A more detailed explanation of the changes that occur in the illustration is provided here. Initially, assume that there is no tax subsidy for the purchase of insurance. Then 75 risks will be shifted (or individuals insured) at a premium rate of $1000. This is the equilibrium price and quantity as shown in Figure 14-1. Using this position as a base point, a subsidy on premiums of 50% is introduced, reflecting that, the individuals are in a 50% income tax bracket and are allowed to deduct insurance premiums before calculating income taxes (for simplicity, the influence of the payroll taxes is ignored).

A preliminary analysis of the effects of the subsidy indicates that the premium price would remain the same ($1000), but half would be paid ($500) out of pocket by the consumer and the other half would fall on taxpayers (because the individual would get a subsidy of $500 lower taxable income so taxes would be decreased that could have been used to fund a public program). An economic analysis would result in a conclusion that the new quantity on which the subsidy will be based is not the old quantity demanded at a premium of $1000 nor the new quantity demanded at the $500 out-of-pocket cost.

As shown in Figure 14-1, the subsidy raises the quantity demanded at each price, and so more individuals will seek to shift risks at the subsidized premium rate of $1000. However, suppliers (insurers) will require higher premiums in order to accept more risks (issue more policies). The premium rate will rise, and fewer risks (policies issued) will be shifted than were originally indicated by demand conditions alone. In the illustration, the final premium

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rate will be $1350, and at this price, risks of 92 individuals will be shifted through insurance policies.

The cost of the new premium will be borne half by the consumer and half by the taxpayers under the 50% subsidy assumption. However, the amount of subsidy will be based on the new price of $1350. And the quantity of risks shifted will be the new equilibrium quantity. The final equilibrium (and the burden of the subsidy) will depend on the elasticities of demand and supply. In the extreme, if the supply curve were vertical, indicating no change in risks shifted, then the analysis would indicate that the premium would rise by the full amount of the subsidy. In this extreme case, the taxpayers would pay a subsidy of $1000 based on a new premium of $2000, with the risk of 75 individuals still being shifted. Alternatively, if the supply curve is horizontal, indicating an unlimited supply of risks accepted (policies issued) at a price of $1000, the consumer would get a full $500 subsidy paid for by the taxpayers; in this case, 100 risks would be shifted.

The analysis in this illustration does not take into account subsequent effects of the increased insurance coverage on the healthcare market. Nevertheless, even this simple analysis indicates that the demand-and-supply analysis should be considered when determining the full effects of a tax subsidy on health insurance premiums.

14.4.1.3 Mandated Benefits Mandated insurance benefits are government-required coverage benefits that individuals must privately purchase or employers must provide. Mandated benefits can have a considerable impact on labor markets depending on how they are viewed by consumers, and this impact will, in turn, affect the incidence of benefits. The Affordable Care Act of 2003 mandated health insurance coverage for individuals in the United States, and those

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individuals that did not purchase health insurance would be assessed a penalty. Certain individuals were excluded from the penalty if their income was below the threshold for filing a federal income tax return ($10,400 for an individual or $20,800 for a family in 2017), or if an individual or family had to pay more than 8.16% of income for health insurance in 2017 after taking into account any employer contributions or tax credits. Individuals were eligible for a hardship exemption if an application for Medicaid was filed but it was determined to be ineligible due to the state’s decision not to expand the program. As of 2019, the penalty would no longer be assessed although coverage is still mandated.

An illustration of an economic analysis of mandated benefits using a labor market analysis is presented in Figure 14-2. In the initial situation, there are no mandated benefits and the employer does not provide insurance benefits. In this situation, the demand for labor is shown as D , and the supply of labor is shown as S ; equilibrium wages are at $80, and equilibrium employment is at 300 workers.

1 v = 0

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Figure 14-2 The effect of mandated insurance coverage on the labor market. D represents the demand curve for labor without benefits. D represents the demand curve for labor with $20 of benefits. Supply curve S represents the supply of labor that places no value on benefits. Supply curve Sv b represents the supply of labor that values benefits and wages equally. Supply curve Sv b represents the supply of labor that places less than

$20 of value on the benefits.

Assume in the illustration that an initial wage of $60 was paid per worker and then mandated insurance benefits that cost $20 per worker are introduced. In terms of total compensation, the employer’s demand curve for labor will remain the same because the employer will still value each worker’s productivity the same. However, when expressed in terms of the wage rate, the demand curve will shift down by $20, because $20 is added to the wages for each worker to calculate total compensation paid by the employer. To adjust for the mandated benefits in terms of wages,

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the new demand curve for labor is shifted down by $20 for each quantity and becomes D .

An initial reaction might be to assume that the employees will bear the entire burden of the mandated benefits and be forced to take a $20 reduction in wages. In this situation employment would remain at the same level. This would be the case only if the workers fully value the benefits equally to wages (see curve S ). As shown, the new wage price in this situation would be $60, with total compensation valued at $80.

If the workers do not value the benefits at all, there will be a reduction in wages (but not by the full $20 of the benefit). In this illustration, it is assumed wages will decrease to $70 (or some amount, depending on the elasticity of labor supply). There will also be a reduction in employment because of the lower wage. The burden of the mandate will then fall, to some degree, on the workers who lose employment. If benefits are only partially valued (reflected in supply curve S ), the net result will be somewhere between these two situations.

In an extreme case, such as a vertical supply curve, there will be no employment effect, but a full wage effect. In fact, an earlier analysis of mandated benefits showed that this result is approximated in reality (Kreuger & Reinhardt, 1994), and so the workers bear the full burden of the mandate. In sum then, mandated benefits may have similar effects to those that might be concluded without a more formal economic analysis. However, this result is the case only if the supply curve of labor is, in reality, close to vertical (zero elasticity) in the relevant ranges.

14.4.2 Taxation Much health care (55.63%) is publicly funded, and much of the funding comes through taxation. Regardless of how taxes are configured, they can be regarded as reductions in income or

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wealth without any direct corresponding benefits. While it is true that benefits may come as a result of the use of the funds received from taxation, these benefits are not directly linked to payment of the taxes. It is not realistic to attempt to link the benefits resulting from the spending of taxes to the costs of the taxes themselves.

In terms of taxation, the taxing mechanisms can be either direct or indirect. Direct taxes are those that are specifically levied on the income of individuals and businesses. These direct taxes cannot therefore be shifted (i.e., the burden of the tax cannot be made to fall on someone other than the taxpayer). Indirect taxes that are placed on goods and services can be shifted (in essence, avoided) to some degree. Economic analysis is useful in determining the economic impact and burden of taxation. In the next section, the burden of two types of taxes commonly used to finance health care—payroll taxes and sales taxes—are analyzed.

14.4.2.1 Payroll Taxes A payroll tax is levied on wages. Medicare, for example, uses a payroll (social security) tax of 1.45% of total payroll (the rate is payable by both the employer and employee for a total of 2.9%) to finance the hospital (part A) portion of Medicare. Self-employed individuals are responsible for paying the full 2.9%. The burden of an employee-paid payroll tax is quite clear: it is paid by the worker. However, because it lowers take-home wages, some workers may decide not to supply labor at the lower wage. Employment in the economy will therefore be decreased. The burden of the payroll tax on employees is thus equally shared among workers. The economic effects resulting from the imposition of a payroll tax that is paid by employers is less clear and deserves closer attention.

In Figure 14-3, the analysis of the effect of a payroll tax on labor and wages is introduced. In the illustration assume there is a competitive labor market with a given supply of labor (S) and a

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given demand for labor (D ). The output measure is labor hours, and, in this market, equilibrium occurs with a wage rate of $40 per unit and a quantity of 300 labor hours. In this illustration a very steep supply curve for labor has been drawn. This steep curve indicates that workers will not change their work habits very much when wages increase or decrease. If the supply curve has been drawn as a vertical line, it would indicate that the workers would not change their employment habits at all. In an economy when many workers do not have the flexibility of reducing hours worked in small increments (e.g., they must either work full-time or only a set number of hours as part time) a vertical supply curve may be more applicable.

Figure 14-3 Effects of imposing an employer-paid payroll tax. S represents the initial supply of Labor. D represents demand

without the payroll tax. D represents demand with a payroll tax. The original equilibrium is 300 hours at $40. The new

equilibrium is 280 hours at $22.

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In this illustration, assume an employer-paid payroll tax of 100% of wages is introduced. If the employers are in a competitive industry, the price of their output cannot be increased. As a result, their demand-for-labor curve cannot be increased through offering higher prices. Therefore, the employers would have to either absorb the tax or lower wages paid to workers. An initial inclination might be to say that wages would stay at $40, the payroll taxes of $40 would be paid by the employer, and employment numbers would remain the same. This is a very unlikely outcome given the forces behind the employment of labor.

Figure 14-3 presents an economic analysis of what would be more likely to happen. The effect of an employer-based payroll tax is to shift down the demand-for-labor curve, which is based on the marginal revenue of the product that labor produces. In this illustration, at a wage of $20, each employer must pay a tax of $20 (which is 100% of the wage). Each worker now costs twice as much as previously to the firm. Therefore, where the employers formerly demanded 300 labor hours when the wage was $40, they will now demand 300 hours of labor at a wage of $20. This last condition occurs because the tax in this illustration is expressed as a percentage of wages. In this situation, the new demand-for-labor curve (in terms of wages) is a fixed percentage lower than the original one. Under this condition of a percentage of wages, the higher the wage, the greater the discrepancy between the original and new demand curves.

With the employers’ demand-for-labor curve (in terms of wages) shifting downward and to the left, employees will receive lower wages. In this illustration the new equilibrium volume of labor and the corresponding wage rate are just under 300 hours and just over $22. This means that the quantity of labor will have changed very little, but the wage rate will have fallen by almost the full amount of the tax. The workers have not substituted away from

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working (working fewer hours) and therefore have borne almost the entire burden of the tax through a reduction in their wage rate. In this case, the supply-of-labor curve is almost vertical, and workers would rather accept lower wages than lose employment.

Other situations in the market for labor are possible with the introduction of a payroll tax. To illustrate, if workers were very sensitive to the wage rates they receive, and the resulting supply- of-labor curve was close to horizontal, the labor supply would decrease when wages declined. In this instance, the workers would avoid the tax entirely by refusing to work at lower wages. At the new wage, the tax would have been shifted to the employers, who also would hire fewer workers because of the increased cost of production.

The effect of the payroll tax then will be to reduce employment and wages. How much of the payroll tax will be borne by the workers (through a decrease in wages) will depend on how much the workers are willing and able to adjust their wages and their work— information that is summarized by the supply-of-labor curve.

14.4.2.2 Sales Taxes A very similar analysis applies to the use of sales taxes as a mechanism to generate revenue. A sales tax is levied on a good or service sold in the market. Most states use sales taxes as a major source of revenue. Sales taxes can be general (the taxes placed on all items bought and sold in the market), a modified general sales tax (the taxes placed on most items except, for example, food sold in grocery stores, pharmaceutical products, and children’s clothes), or a very specific sales tax (the taxes placed on such items as gasoline, alcohol, tobacco products, etc.). In the case of tobacco and alcohol, these sales taxes may affect consumer behavior with regard to drinking and smoking and thus have an impact on health status (and healthcare demand). This

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was certainly the rationale provided for a large tobacco tax that the state of Maine imposed in order to pay for more publicly funded healthcare benefits in the 1980s.

In order to analyze the effects of sales taxes, a sales tax on prescription drugs will be used as an illustration. The initial situation, without the imposition of a sales tax, is shown in Figure 14-4. The demand for the prescription drugs is shown by the demand curve (D). This represents the demand by consumers for the prescription drugs. There is also a curve for the supply of prescription drugs without the sales tax (represented by S ). In a competitive market, equilibrium will occur in this illustration at a price of $40 and a quantity of 200 prescriptions filled (at the intersection of D and S ).

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Figure 14-4 The effects of a sales tax. D represents the demand curve for prescriptions. S represents the original

supply curve without a sales tax. S represents the new supply curve with supplier paying the tax. The original equilibrium is at

price of $40 and quantity of 200 prescriptions. The new equilibrium is at price of $50 and quantity at 150 prescriptions;

the tax is split between pharmacist and consumer.

In the illustration assume a sales tax of $20 on each prescription is imposed, to be paid by the pharmacists filling the prescriptions. The initial conclusion might be to assume the pharmacists will simply raise the price of each prescription to $60 and collect the tax on each of the 200 prescriptions filled. Such a result, however, would occur only if the demand curve for prescriptions was vertical and consumers would demand their prescriptions filled regardless of price. Such a situation is not a realistic scenario in the case of prescription drugs or most other goods and services. There is an

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elasticity of demand for prescription drugs, as indicated by the downward-sloping demand curve.

The sales tax on prescription drugs will cause the prices charged by the pharmacists to increase (if they pay the tax). At first the pharmacists might charge $60 for each prescription filled (although they would receive a net income of $40, as before since they must pay the $20 sales tax). But there is a limit to what consumers will pay for their prescription drugs. In this illustration, some consumers will refuse (or be unable) to fill their prescriptions, thus avoiding the sales tax entirely. In this illustration a new equilibrium will be reached at $50 per prescription filled, and only 150 prescriptions will be filled. The pharmacists will receive a net revenue of only $30 for each prescription and will supply fewer (150 at the net-after-tax price of $30).

In this illustration the market will have shifted part of the tax onto the pharmacists, who now pay one-half of it by receiving a lower price. The consumers end up paying $10 of the prescription tax by reducing the quantity they demand. The burden of the sales tax will thus be shared. It should be emphasized that other possible outcomes can occur, depending on the slopes of the supply and demand curves. However, it is not likely that all of the sales tax will be borne by the consumers.

As discussed earlier, sales taxes on a variety of products related to health are very common. Many states impose a tax on health insurance premiums. Such a tax will have an effect on the number of individuals who shift their risks (purchase a health insurance policy) to an insurer, and it can be analyzed using the basic sales tax model.

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14.5 The Implications of Alternative Types of Healthcare Financing

In this section, attention turns to the implications of alternative types of healthcare financing. The term implications does not have a precise meaning in this context. The term is used to denote the pattern of distribution of burdens of various financing methods (Due, 1957). The focus in this analysis will be on one key characteristic of individuals—their level of income—and four different types of financing: insurance premiums, income taxes, sales taxes, and payroll taxes. Although highly simplified, the analysis in this section is intended to provide a basic understanding of the major issues involved in using taxes to finance health care.

In evaluating the implications of taxes, the focus is on how regressive the tax is. A tax is considered to be regressive if it has a larger relative impact on the income of lower-income individuals than it has on the incomes of higher-income individuals. A tax is considered to be progressive if it has a larger relative impact on the incomes of higher-income individuals than on lower-income individuals. A tax is considered to be neutral if it has the same relative impact on all income cohorts. The impact of a tax on income is viewed as a relative burden on the various income cohorts.

Assume in this illustration that there are four income groups, and each group includes 100 families (see Table 14-4). Each family in the lowest income group has earnings of $20,000; in the next- lowest group, income of $40,000; in the third group, income of $60,000; and in the highest income group, an income of $80,000.

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Table 14-4 Income and Expenditures for Four Income Groups

Assume each family, regardless of income group, incurs healthcare expenditures of $5000. There are no differences in healthcare utilization by income level. However, all expenditures are financed by insurance, and the out-of-pocket cost to each family is zero. Total healthcare expenses for all groups is $2 million ($5000 × 400 families = $2,000,000).

Each family’s total consumption of goods and services, including food, utilities, etc., but not health care, is provided in column 5 of Table 14-4. The lowest income group spends all it earns on goods and services, the next group spends 90%, the third group spends 80%, and the highest income group spends 70%. The members of a group save what they do not spend. If they have to pay for health care, they will reduce other expenditures but will not reduce their savings. If they do pay for health care itself it will be paid for through the purchase of insurance.

The financing problem to be resolved is how to pay for the $2 million in healthcare expenses incurred by the population. There are four options available to finance the expenses: insurance premiums, a sales tax, a payroll tax, and an income tax. The task is to determine the impact of each type of financing on the different income groups. The conclusions reached in this illustration are summarized in Figure 14-5.

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Figure 14-5 Implications of different financing mechanisms. Premiums are the most regressive source of financing. Income tax is the most progressive source of financing. Sales tax and payroll tax fall in between. In this illustration payroll tax and

sales tax are still somewhat regressive.

Premiums. Each family in this illustration bears the same risk of incurring $5000 of health expenses, and so it might seem reasonable to simply charge every family the same premium rate (use a community rating). There are 400 families, and $2 million in healthcare funds must be raised (assume no loading fee is collected for simplicity). Therefore, each family will pay a premium of $5000 for insurance coverage.

The burden of this financing method on each family is calculated as the premium paid divided by the family income. This would result in a burden of 25% ($5000 / $20,000) for the lowest income families, 12.5% for the families earning $40,000, a total of 8.3% for the families earning $60,000, and 6.25% for the highest income

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families. The impact of community rate premiums is such that the burden decreases steadily as income increases.

Payroll Taxes. In the case of a payroll tax, a fixed percentage of wages is charged, but there is usually a cap above which income is not taxed. In this illustration, assume that this cap is $60,000. This means that all wages up to and including $60,000 are taxed. The members of the highest income group (those earning $80,000) will pay taxes on only the first $60,000 of their wages. Total taxable wages are therefore $18 million for all families since $20,000 of each of the 100 families in the highest income group is not taxed. In order to raise the required $2 million, a tax rate of 11.1% ($2 million / $18 million) must be levied on all wages up to $60,000.

The burden of the tax will be the same for the three groups whose members have incomes at or below $60,000; the amounts paid by each of these three groups vary, but the rate is the same at 11.1%. However, the highest income group pays only $6660 in payroll taxes per family, for an effective tax rate of 8.325%. As shown in Figure 14-5, the burden of the payroll tax is the same for the three lowest groups but decreases for the highest income group.

Sales Taxes. Sales taxes can be imposed on any of a variety of consumption expenditures. Assume in this illustration that sales taxes are imposed on all consumption expenditures. Sales taxes are also not imposed on savings, which, as mentioned earlier, vary by income cohort: no savings for families with incomes of $20,000, 10% savings for families with incomes of $40,000, 20% savings for families with incomes of $60,000, and 30% savings for families with incomes of $80,000 Total consumption expenditures for other goods and services for all families therefore equal $16 million. In order to raise the required $2 million in funds, the overall sales tax rate must be 12.5% ($2 million / 16 million). The lowest income group pays $250,000 on its $2 million in expenditures; the next

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group pays $450,000 on its $3.6 million in expenditures; the next group pays $600,000 on its $4.8 million in expenditures; and the highest income group pays $700,000 on its $5.6 million in expenditures.

Income Taxation. The burden of the income tax will depend on the actual tax rates, and these are subject to policy decisions by Congress. Assume in this illustration that the tax rates are such that the highest income class pays roughly four times the rate of the lowest group. This is very roughly the ratio in the United States today. Specifically, assume in this illustration that given an average overall rate, the lowest group will pay 40% of this rate (i.e., 0.4), the second group will pay 80% of the rate, the third-highest group will pay 120% of the rate, and the highest group will pay 160% of the rate. Let x stand for the overall tax rate. The overall rate can be determined by solving for x in this equation:

The $2 million is the amount to be collected by the income tax. If the equation is solved for x, the average overall rate is found to be 8.33%. Based on the ratios determined by “policy,” the four groups pay 3.33% (8.33 × 0.4), 6.64%, 9.99%, and 13.33% of income in income taxes, respectively.

The overall impact of the funding methods can be compared. Premiums are the most “regressive” and income taxes are the most “progressive.” The other two methods fall in between (under the assumptions in this illustration, the last two methods are mildly regressive).

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Omitted from the analysis in this illustration are out-of-pocket expenditures. The use of this type of financing will result in lower overall usage (because of the downward-sloping demand curve for health care). Thus, if families had to pay out of pocket for health care, total expenditures would likely fall below $2 million. The overall burden would depend on the response of each income group.

The assessment of financing options will depend on the policy goals. Much of the focus in evaluating types of financing is on considerations of equity. However, efficiency issues need to be addressed as well.

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14.6 The Administrative Cost of Alternative Types of Healthcare Financing

There has been a lively debate in recent years about administrative costs associated with the healthcare financing system in the United States. Much of the debate has been focused on the costs associated with the marketing of health insurance and hospital services; the monitoring of utilization and the regulating of payment by insurers; the billing of third parties by providers; and the collecting of deductibles, coinsurance, and copayments from patients by providers. Because of the complexity of the U.S. system of healthcare finance, more resources are devoted to these functions than in other healthcare systems, such as those of Canada and the United Kingdom. A study conducted using 1987 data estimated that between $96 billion and $120 billion were spent on administration in the United States, out of a total spent of $488 billion for all healthcare-related services (Woolhandler & Himmelstein, 1991). This study primarily added up the money costs of these functions.

Pozen and Cutler (2010) found that the largest difference in spending between the United States and Canada was in administrative costs, with 44% more administrative staff in the United States than in Canada. When all administrative costs were included, they found administrative costs accounted for 39% of the difference between the United States and Canada. Other authors (Blanchfield, Heffernan, Osgood, Sheehan, & Meyer, 2010; Davis et al., 2007; Luxembourg Income Study, 2011) have also found that the United States has many more administrative staff than do other countries. Cutler and Ly (2011) provide an excellent overview of comparative administrative findings.

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A paper by Pearson (2018) re-verified that not only does the United States spend more on direct patient care than other countries, but that the United States also spends more on healthcare administration. While it is difficult to identify exactly how much the United States spends on healthcare administration, the consensus is that it is substantial and continuing to grow.

One of the largest subcategories of health administration spending relates to billing and insurance-related (BIR) costs. The Center for American Progress estimated that United States payers and providers will spend $496 billion on billing and insurance-related administrative costs in 2019.

A 2014 study by Himmelstein et al. compared hospital administrative costs in eight nations and found that the costs in the United States exceeded all other countries. They found administrative costs in the United States accounted for 25.3% of the total hospital expenditures. The Netherlands had the next highest expense at 19.8% and England spent 15.5% on hospital administration.

Tseng, Kaplan, Richman, Shah, and Schulman (2018) found that administrative costs associated with physician billing and insurance-related activities in an academic health system accounted for $20 of a primary care visit and $215 for an inpatient surgical procedure. These physician-related administrative costs represented 3%–25% of all professional revenue in 2016–2017. Jiwani, Himmelstein, Woolhandler, and Kahn (2014) investigated BIR costs in the United States and found that these costs were between $330 and $597 billion in 2012. They concluded that the multi-payer system in the United States represented 80% of the difference in cost between the United States and a simplified financing system.

In examining the administrative costs in health care, it is important to keep in mind that sound administration is critical to a well-

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functioning organization or healthcare system. The United States has a very complex structure for its administration and so careful evaluation needs to be performed to determine the benefits that are associated with the costs. As efforts are undertaken to attempt to control rising costs in health care, the functioning of the administration of the system also needs to be considered. The multi-payer system in the United States adds to the complexity of its administration and providers often have to deal with insurance coverage, eligibility, and billing requirements that vary across payers, requiring additional administrative effort.

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14.7 Payment Mechanisms

The healthcare industry has been facing a number of changes in payment systems recently, and indications are that even more changes are looming in the future. A difficulty emerging in the implementation of different payment mechanisms is that there is a disconnect between the external payment systems being implemented and the internal methods that have been used to distribute resources within the organizations. Historically, the healthcare system has been a production-based system, receiving compensation for services produced. The incentive in any production-based system is simply to produce more units, as long as the cost of production is less than the market price received for the unit.

Complicating the production decisions in the healthcare system is the existence of health insurance programs that isolate production decisions from the cost of services utilized and the ability of insurance companies to simply pass the increased costs on to employers and governments, the purchasers of the majority of insurance plans. As healthcare costs began to impinge significantly on the other sectors of the economy, efforts emerged to change the payment incentives in the healthcare industry, especially as the increasing costs did not result in a concomitant improvement in the health status of the population. As attention has focused on controlling the rate of increase in healthcare expenditures, such alternative payment methods as pay for performance, shared savings, bundled payments, and global capitation have been introduced.

14.7.1 Pay for Performance Pay for performance was introduced to provide incentives to providers to improve the quality of care delivered. This occurred as

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evidence mounted regarding the underuse, overuse, and misuse of treatments within the healthcare system. The Committee on Redesigning Health Insurance Performance Measures, Payment, and Performance Improvement Programs (2007) defined pay for performance (P4P) as “the systematic and deliberate use of payment incentives that recognize and reward high levels of quality and quality improvement” (p. 5). Pay for performance is designed to offer incentives to encourage the healthcare system to move from its current volume-based structure toward different organizational and individual behaviors. The goal of P4P is to result in better quality and improved outcomes for patients in the population.

In most markets, incentives induce producers and/or consumers to behave or respond in predictable ways. These incentives focus on the identification of desired attributes and provide rewards or penalties in order to stimulate additional production of those attributes. The goal of the P4P model in health care is to motivate constructive change in the system by explicitly linking incentives to the quality and performance of the providers within the healthcare system. The difficulty in implementing P4P is in developing a framework that incorporates the complexity of the clinical situations to be included, the diversity of the environments in which care is provided, and the resources necessary to comply with the requirements of the system.

A critical and difficult issue in any P4P system is the selection of the priority quality dimensions and the establishment of the measures to be used to assess performance and quality. This is especially difficult in health care because focusing on one domain of quality may lead to reductions in other domains of quality. Another aspect to be considered in designing a P4P mechanism for health care is determining whether the focus should be on improvement in quality or on achieving a recognized threshold of

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desired quality, or both. The P4P system must also be capable of incorporating new measures as the healthcare system evolves; innovations and discoveries in health care should be encouraged. In addition, the incentive created should have a sufficient impact upon the revenues of the provider to influence their decisions, but not be so onerous as to compel providers to leave the system.

Pay-for-performance is a primary tool that has been used to achieve healthcare reform. In the development and implementation of P4P, a number of diverse types with heterogeneous incentives have been implemented, making evaluation of its effects somewhat difficult. In an evaluation by Van Herck et al. (2010) the effect domains assessed were: clinical- effectiveness, access and equity, coordination and continuity, patient-centeredness, and cost-effectiveness. In their review of 128 evaluation studies, the authors concluded that the effects achieved by P4P varied by the design choices and the characteristics of the context in which it was introduced. In their review of these studies, the authors found that process indicators generally yielded higher improvement rates than outcome measures, with intermediate outcome measures yielding rates in between process and outcome measures. The incentives that provided a financial reward appeared to generate more positive effects than did competitive incentives that resulted in winners and losers.

Figueroa, Tsugawa, Zheng, Orav, and Kjha (2016) examined the association between the value-based purchasing pay for performance incentive program introduced by Medicare and the 30-day mortality rate in U.S. hospitals for acute myocardial infarction, heart failure, and pneumonia. They did not find any subgroup of hospitals that implemented the program had better outcomes, including the poor-performing hospitals at baseline.

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These authors did not find any evidence that the value-based P4P program led to lower mortality rates.

Under the Medicare value-based program hospitals were rewarded or penalized based on their performance on a number of domains of care, including clinical processes and clinical outcomes of the three conditions evaluated as well as patient experiences and cost efficiency. Under this system, which is designed to be budget neutral, Medicare withholds a percentage of inpatient payments to prospectively paid hospitals and then redistributes the money back to hospitals based on their performance. In 2015, 1360 hospitals received penalties and 1700 hospitals received bonus payments.

Another program that has been introduced by Medicare is the hospital readmissions reduction program. This program implemented a financial penalty to reduce payment to hospitals with excessive 30-day inpatient readmissions for pneumonia, acute myocardial infarction, and heart failure. Lu, Huang, and Johnson (2016) found a significant reduction in excessive readmissions for these three conditions between 2013 and 2015, especially in small hospitals, public hospitals, and hospitals located in rural areas.

Medicare has undergone a number of changes in how it pays hospitals, especially since the Affordable Care Act introduced three programs that link Medicare payment to hospital performance in the areas of quality, efficiency, outcomes, and patient experiences. Earlier the 2003 Medicare Prescription Drug Improvement and Modernization Act initiated the hospital inpatient quality reporting program under which hospitals were required to report on a specified set of quality measures. If a hospital does not report the indicators, they receive a payment reduction. Aggregate hospital performance on required quality measures has improved since the requirement began. In 2012, Medicare began

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implementing the ACA-mandated Hospital Value-Based Purchasing Program and the Hospital Readmission Reduction Program. In 2015, the Hospital-Acquired Conditions Reduction Program began. With the introduction of these programs, by 2017 hospitals were at risk for losing as much as 6% of base operating payment, or 5% of total operating payments under these three programs. Under the Hospital Acquired Conditions Reduction Program, a 1% reduction in the total inpatient prospective payment system (IPPS) payments is levied against hospitals with scores (based on hospital infection rates and patient safety measures) in the worst-performing quartile of hospitals.

Kahn et al. (2015) evaluated the impact these three programs, taken together, had on hospital performance and payments during FY 2015. The authors concluded that these Medicare pay-for- performance programs have had a significant effect on hospital payments, particularly when the combined effects of the three programs are considered. The performance of hospitals where the various performance matrices are improving is consistent with the incentives created by the programs. The authors point out that appending quality programs to a payment system that is intended to cover the cost of an efficient provider of best care may create onerous outcomes for the providers. Including additional penalties on that payment system, especially with almost two-thirds of hospitals already experiencing negative Medicare patient margins, may be problematic. A more rational approach to aligning payment policy with quality outcomes needs to be considered at this time.

Shih, Nicholas, Thumma, Birkmeyer, and Dimick (2014) examined the incentive design of the second phase of the Medicare P4P program, the Premier Hospital Quality Incentive Demonstration Project, to determine if surgical mortality or complication rates in participating hospitals were reduced. This program, initiated in 2003, was designed to reward high-

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performing hospitals. Its incentive structure was redesigned in 2006 to also reward hospitals for achieving significant improvement. The authors found that there were lower risk- adjusted mortality rates for both cardiac and orthopedic patients after the incentives were restructured in 2006. However, mortality for CABG or joint replacement did not demonstrate significant improvements. Similarly, significant improvements in serious complications for CABG or joint replacement were not achieved. Also, the worst quintile hospitals targeted in the incentive structure changes did not show a change in mortality or serious complication rates. The authors concluded that significant redesign of the incentives in the program would need to be made in order for the P4P strategy to be successful.

14.7.2 Bundled Payments The generic term bundled payments is known by a variety of names, such as case rate, global payment, package pricing, episode-based payment, comprehensive care payment, and evidence-based case rate. Regardless of the term used, it is a payment method based on the costs expected to be incurred in the provision of a clinically defined episode of care, adjusted for the severity and complexity of a patient’s condition. Bundled payments are viewed as a blend of fee-for-service and capitation payments, discouraging the provision of unnecessary care and encouraging the coordination of care across providers, but not penalizing providers who care for sicker patients in their practice. The goal of bundled payment is to reduce fragmentation of care, thereby improving quality and reducing costs. The use of bundled payments should encourage providers within the system to reorganize how care is delivered so that it is coordinated and responsive to the needs of patients.

Under a bundled payment system, the services that are required by patients during a single illness or a course of treatment for a

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chronic disease are defined across providers and settings—the services are bundled into a single package of services. Once the required services are defined, a target price is established for the bundle. This target price reflects the total amount that will be paid for the episode of care, and all providers involved in the provision of services are covered under that price. This comprehensive price provides an incentive for the coordination of care in order to keep the costs of producing the services below the price established. Within the provider network, decisions have to be made on how to allocate the global revenue among the participating providers rendering services to the patient.

A number of barriers are encountered in the development of a bundled payment system. A major problem encountered is deciding just when an episode of care begins and ends. For an acute illness of limited duration, this is manageable. For chronic conditions lasting for extended periods of time, this is difficult to determine because, by definition, a chronic condition is a disease or illness that is persistent and long-lasting. Currently, an episode is typically defined for a specified period of time, such as 30–90 days after discharge from an acute care facility or after the first visit to a provider for the condition. The bundled payment is applied only to that particular illness or disease, which differs from capitation, which covers all illnesses experienced by an enrolled member for a specified period of time.

Because the target payment to be made is fixed, providers have an incentive to coordinate care and minimize the provision of any marginal or unnecessary care. A concern raised is that the incentive may encourage providers to underutilize services, negatively impacting the patient’s outcome. Careful monitoring is needed to ensure that quality is not negatively impacted and that patients receive necessary care.

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In January 2018, the Centers for Medicare and Medicaid (CMS) announced that 1547 providers and suppliers (823 acute care hospitals, 715 physician groups, and 9 “others”) had signed agreements to participate in the Bundled Payments for Care Improvement (BPCI)-Advanced model, which builds upon the earlier Bundled Payment for Care Initiative. Under this BPCI- Advanced program, participating hospitals and physician group practices will receive bundled payments for certain episodes of care as an alternative to the traditional fee-for-service payments. Under this BPCI-Advanced program, participants can earn additional payment if all expenditures for a beneficiary’s episode of care are less than a spending target. The spending target also incorporates measures of quality. Alternatively, if expenditures exceed the target price, then the participants must repay money to Medicare.

The BPCI-Advanced program expands the original BPCI program to include payments for additional clinical episodes, including outpatient episodes. The participants are provided the target price in advance, so they can plan more effectively how to manage episodes of care. BPCI-Advanced qualifies as an advanced alternative payment model, which means participating clinicians assume the risk for the cost of patient health care and for meeting quality thresholds, potentially qualifying them for other incentive programs and exempting them from the merit-based incentive payment system (MIPS). The stated goal of the program is to accelerate value-based transformation of the healthcare system by offering a range of new payment models so that providers can choose the approach that will work best for them. At this time, the program has not been implemented a sufficient amount of time to enable evaluation.

14.7.3 Value-Based Purchasing

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Value-based purchasing (VBP) programs are also sometimes known as shared-savings programs, the goals of which are similar to those of the bundled payment programs: to improve care coordination and redesign the processes of care to produce high- quality and efficient care delivery. Incentives are created within these programs to provide care that has higher value to the patient and to the system; these programs move away from paying providers based only on the volume of services provided to patients. Under these programs, if the provider is able to achieve savings and meet the quality performance standards, then the amount of the savings is shared between the providers and the payer. These programs focus on better care for individuals, better health for the population, and reducing the rate of growth in healthcare expenditures.

Similar to bundled payment systems, value-based purchasing (VBP) programs also require the establishment of clinical measures, measures of effective resource utilization, and incentives within the payment structure to link the two measures to the price paid for services. The focus on these systems is to foster joint clinical and financial accountability within the healthcare system. As with any of the performance-based payment systems, it is critical to have communication among the various providers in order to coordinate care. This communication requires electronic health records with interoperability (the ability to link to each other) capability.

VBP programs are demand-side strategies that impact the utilization of healthcare services by rewarding excellence in healthcare delivery by enhancing revenue through differential payment and by increasing market share by consumer selection. A key component of VBP is the development of standardized performance measures, including involving consumers in changing their lifestyle and self-managing their chronic diseases. The

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Institute of Medicine (2001) has established the STEEEP—Safe, Timely, Efficient, Effective, Equitable, and Patient-centered— typology of the dimensions of healthcare performance, which need to be incorporated into the system. To be effective, it is necessary to access and aggregate data on these dimensions from different sources and from different providers. As indicated, a key component of this model is patient-centeredness, which involves engaging the consumer in the process.

A number of pieces of legislation, such as the Patient Protection and Affordable Care Act and the Medicare Access and CHIP Reauthorization Act (MACRA) have reinforced the role of value- based purchasing payment in Medicare. In addition, many private insurers are following the lead of Medicare and adopting value- based payment mechanisms. Chee, Ryan, Wasfy, and Borden (2016) conducted a review, summarizing the current state of value-based payment programs and analyzed the strengths, weaknesses, and opportunities for the future. According to these authors, the opportunities to enhance the performance of the value-based payment programs include improving the quality measurement science, strengthening the size and design of incentives, reducing health disparities, choosing appropriate comparison targets, and determining the optimal role of value- based payment relative to alternative payment models. They also indicated that value-based payments serve as an opportunity for providers to build the infrastructure needed for value-oriented care.

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14.8 Consumer Engagement

As efforts continue to improve quality and control the costs of health care, attention is focused on ways of influencing consumers to be more informed decision makers. For consumers to become more engaged in the decision-making process, it is necessary for them to have a better understanding of the availability of alternatives and options, and of the quality of care offered, in order to demand and choose appropriate services. As outlined in Aligning Forces for Quality (AF4Q), sponsored by the Robert Wood Johnson Foundation, to be successful in transforming health care, a community-wide consumer-engagement strategy must help consumers to

Understand their risks or actual conditions, and take actions to manage them. Understand and make informed treatment choices. Understand the difference between good care and bad care, and demand good care. Advocate for public reporting by hospitals and doctors on nationally recognized indicators of quality care. Choose providers based on information about their ability to deliver effective care (http://www.rwjf.org/qualityequality/af4q/focusareas/consumer.jsp).

Basically, Aligning Forces for Quality invites the individuals who get care, give care, and pay for care to work together toward common, fundamental objectives that lead to better care. AF4Q showed that progress can be made locally when all stakeholders participate in the process. Effective consumer engagement builds and supports the capacity of consumers to manage their health and health conditions. This also involves the ability to understand, demand, and choose high-quality health care.

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For consumers to be informed decision makers in the healthcare system, literacy, and especially health literacy, is critical. A patient’s literacy skills are critical in interactions in the healthcare field, impacting the ability of the patient to navigate the services needed and the healthcare delivery system. Literacy skills are also important in enabling the patients to be advocates for their needs within the system, and the role of consumer self-advocacy is increasingly important. The complexity of the healthcare system and the incentives being created in many of the reform activities increasingly requires patients to take a proactive role in the utilization of healthcare services and in the self-management of medical conditions.

As increased emphasis is placed on consumer engagement and access to online information and health information technologies is becoming more widespread, care must be taken that the medically underserved and disadvantaged populations are not further disenfranchised from the system. Health disparities currently exist, and increased reliance on health information technologies for seeking and managing personal health conditions and for communicating between patients and providers may widen the disparity gap rather than solve it. The deployment of health information and health information technology is intended to impact the demand for healthcare services, but care must be taken that this doesn’t negatively impact various subgroups of the population.

Patient engagement is also a critical component of the patient- centered medical home model, which involves the provision of quality care that is coordinated, comprehensive, and cost- effective. The patient-centered medical home requires a strong patient–provider relationship through the use of a team approach to care that increases access to care and the continuity of the care provided. In addition to improving quality of care in order to

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improve health outcomes, the patient-centered medical home is expected to reduce demand for health services through the reduction of duplication of tests, procedures, emergency department visits, hospitalizations, and provider visits as care becomes coordinated across providers.

As the population becomes older and experiences escalating chronic conditions, it is critical that the healthcare delivery system becomes more effective in the management of chronic conditions. New streams of data are necessary to enable better self- management, improve shared decision making, and provide more virtual care. The importance of patient-generated health information, remote monitoring, non-visit-based care, and other innovative care approaches that foster more frequent contact with patients and better management of chronic conditions must become part of the adapting healthcare system (Sands & Wald, 2014).

A study by McFarland, Ornstein, and Holcombe (2015) examined the variation in patient satisfaction as determined by the Hospital Consumer Assessment of Healthcare Providers and Systems (HCAHPS) to determine the factors that predict patient satisfaction scores. The hospital value-based performance program provides incentives for quality performance-based health care and it links payments directly to patient satisfaction scores obtained from the HCAHPS surveys. The authors found that demographic and structural factors can predict patient satisfaction scores. More specifically, they found that hospital size (number of beds) and primary language (non-English-speaking) were the strongest predictors of unfavorable HCAHPS scores. Alternatively, education and white ethnicity were the strongest predictors of favorable HCAHPS scores. Without adjusting for such factors outside the control of hospitals, the value-based purchasing

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program may unfairly penalize some hospitals and unfairly reward others.

To assist in the improvement of consumer engagement, a new patient engagement measure, the Altarum Consumer Engagement (ACE) instrument, was developed and validated. This instrument was developed to increase the way patient engagement is measured and understood (Duke, Lynch, Smith, & Winstanley, 2015). If consumer engagement is to truly form a foundation for improving the healthcare delivery system and outcomes obtained in the delivery of care, then a mechanism for measuring consumer engagement is essential. Without the ability to measure consumer engagement, the ability to effectively incorporate it into the necessary changes in the healthcare delivery system is limited. To enable consumers to have a significant role in their care through such entities as patient-centered medical homes, coordinated care for chronic disease, and shared decision making, there needs to be a mechanism available for measuring and valuing that engagement. The goal is to lead to safer, more effective, and less expensive health care.

This discussion has served to highlight the fact that a healthcare financing system requires resources and that different systems have different costs. The Canadian system, for example, has lower administrative costs than does the U.S. system. However, the amount of administrative costs is not the only factor that needs to be taken into account when choosing a national healthcare “system.” Morra et al. (2011) found that physicians in the United States spend almost four times as much time interacting with payers as do physicians in Canada.

Marketing functions serve to inform potential customers about the characteristics of various health plans. Consumers can better select among health plans if they have more information. Regulation and payment functions serve to help ensure that the

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care provided is of a high quality and results in good outcomes. Although these functions are not always completely effective, nevertheless, when evaluating a financing system, the benefits of the various financing practices must be examined in addition to the costs.

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Exercises 1. What proportion of total health expenses were made by

out-of-pocket, government, and health insurance sources of finance in 2017?

2. An employee is worth $100 a week to her employer. The worker demands $20 in health insurance benefits, to be paid by the employer. What would the employer be willing to pay in terms of wages?

3. What is the effect on the market for health insurance of a government tax subsidy on health insurance premiums?

4. What will be the effect of mandated health insurance benefits on the market for labor if the workers do not place any value on these benefits? If they fully value the benefits?

5. What is a payroll tax? How will the imposition of a payroll tax affect the wage rate and the quantity of labor employed?

6. How will the imposition of a sales tax on a commodity affect the price and quantity sold of that commodity? Will the consumer usually bear the entire burden of the tax?

7. How does each of the following methods of financing the healthcare system impact on persons according to their income group? a. Income tax b. Sales tax c. Payroll tax d. Insurance premiums

8. Discuss the rationale for the introduction of pay-for- performance mechanisms in health care.

9. What are bundled payments and how are they being used in health care?

10. Why is consumer engagement so important in today’s healthcare system?

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