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CHAPTER

3AN OVERVIEW OF THE HEALTHCARE FINANCING SYSTEM

Learning Objectives

After reading this chapter, students will be able to

• explain why health insurance is common, • use standard health insurance terminology, • identify major trends in health insurance, • describe the major problems faced by the current insurance system, and • find current information about health insurance.

Key Concepts

• Insurance pools the risks of high costs. • Moral hazard and adverse selection complicate risk pooling. • About 91 percent of the US population has medical insurance. • Consumers pay for most medical care indirectly, through taxes and

insurance premiums. • Most consumers obtain coverage through an employer- or government-

sponsored plan. • Managed care has largely replaced traditional insurance. • Managed care plans differ widely.

3.1 Introduction

3.1.1 Paying for Medical Care Consumers pay for most medical care indirectly, through insurance. In 2016 insurance paid for 78 percent of healthcare spending (Centers for Medicare & Medicaid Services [CMS] 2017). Healthcare managers must therefore understand the structure of private and public insurance programs because much of their organizations’ revenues are shaped by insurance.

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C o p y r i g h t 2 0 1 9 . H e a l t h A d m i n i s t r a t i o n P r e s s .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Economics for Healthcare Managers38

Managers must also be aware that consumers ultimately pay for healthcare products, a key fact obscured by the complex structure of the US healthcare financing system. When healthcare spending invokes higher premiums or taxes, consumers are forced to spend less on other goods and services. Some consumers may drop coverage, some employers may reduce benefits, and some plans may reduce payments. This reaction need not occur if a consensus has emerged in support of increased spending, but even then, managers should be wary of the profound effects that changes to insurance plans can cause for their firms. Finally, managers must consider more than insurance payments. Even though the bulk of healthcare firms’ revenue comes from insurers, consumers pay directly for some products. Consumers directly spent more than $352 billion on healthcare products in 2016 (CMS 2017). No firm should ignore this huge market.

3.1.2 Direct Spending Despite its large amount, direct consumer spending accounts for only a frac- tion of total healthcare spending. Exhibit 3.1 depicts a healthcare market in which consumers directly pay the full cost of some services and part of the costs of other services. Consumers’ direct payments are often called out-of- pocket payments. For example, a consumer’s payment for the full cost of a pharmaceutical product, her 20 percent coinsurance payment to her dentist, and her $25 copayment to her son’s pediatrician are all considered out-of- pocket payments. Insurance beneficiaries make out-of-pocket payments for

out-of-pocket payment Money a consumer directly pays for a good or service.

coinsurance A form of cost sharing in which a patient pays a share of the bill, not a set fee.

copayment A fee the patient must pay in addition to the amount paid by insurance.

Consumers Providers

Third parties

Premiums and taxes

Out-of-pocket payments

EXHIBIT 3.1 The Flow

of Funds in Healthcare

Markets

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Chapter 3: An Over view of the Healthcare F inancing System 39

services that are not covered, for services in excess of their policy’s coverage limits, and for deductibles (amounts consumers are required to spend before their plan pays anything). Another name for out-of-pocket payments is cost sharing. Economics teaches us that a well-designed insurance plan usually incorporates some cost sharing. We will explore this concept in detail in the discussion of demand in chapter 7.

Insurance payments continue to be the largest source of revenue for most healthcare providers. In 2016, they represented 88 percent of pay- ments to hospitals, 81 percent of payments to physicians, and 66 percent of payments to nursing homes (CMS 2017). Because insurance affects most healthcare purchases, its structure has a profound influence on the healthcare system and healthcare organizations.

The extent of insurance distinguishes the healthcare market from most other markets. Insurance has three important effects on patients:

• It protects them against high healthcare expenses, which is the main goal.

• It encourages them to use more healthcare services, which is a side effect.

• It limits their autonomy in healthcare decision making, which is not a goal.

Nonetheless, the advantages of insurance continue to exceed its disad- vantages. As discussed in chapter 2, the share of direct payments for health- care has steadily fallen during the past 15 years.

3.1.3 Sources of Insurance Nearly 300 million Americans had some health insurance coverage in 2016 (US Census Bureau 2017). Only 1 percent of those older than 65 lacked cov- erage, only 5 percent of those younger than 18 lacked coverage, and 12 per- cent of those aged 18 to 64 lacked coverage. Although 27 percent of those older than age 65 had employment-based insurance, 93 percent had Medi- care coverage (meaning that many had duplicate coverage). Employment- based insurance was the most common form of coverage for those younger than 65. Fifty-six percent of children had employment-based insurance, and 39 percent had Medicaid. Sixty-three percent of those aged 18 to 64 had employment-based insurance, and only 15 percent had Medicaid. In section 3.2 we will explore why employment-based insurance is so prevalent.

3.1.4 The Uninsured For many years the share of the population without medical insurance rose steadily, even as insurance payments rose as a share of total spending. Since

deductible The amount a consumer must pay before insurance covers any healthcare costs.

cost sharing The general term for direct payments to providers by insurance beneficiaries. (Deductibles, copayments, and coinsurance are forms of cost sharing.)

Medicare An insurance program for the elderly and disabled, run by the Centers for Medicare & Medicaid Services.

Medicaid A collection of state-run insurance programs that meet standards set by the Centers for Medicare & Medicaid Services and serve those with incomes low enough to qualify for their state’s program. Medicaid enrollment has increased by more than 20 percent as a result of state expansions under the Affordable Care Act.

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Economics for Healthcare Managers40

the enactment of the Affordable Care Act (ACA), the percentage of the population without health insurance has fallen sharply. The share of those younger than age 65 without insurance was 18.2 percent in 2010. By 2016 it was 10.1 percent (US Census Bureau 2017).

Uninsured consumers enter healthcare markets with three significant disadvantages. First, they must finance their needs from their own resources or the resources of family, friends, and well-wishers. If these funds are not adequate, they must do without care or rely on charity care. The uninsured do not have access to the vast resources of modern insurance companies when large healthcare bills arrive. Second, unlike most insured customers, uninsured customers may be expected to pay list prices for services. Most insured consumers are covered by plans that have secured discounts from providers. None of the major government insurance plans and few private insurance plans pay list prices for care. Although uninsured patients could negotiate discounts, this practice is not routine. Third, the uninsured tend to have low incomes. In 2016, 11.9 percent of those with annual household incomes below $25,000 did not have health insurance, compared with only 5.5 percent of those with annual household incomes above $75,000 (US Census Bureau 2017).

The combination of low income and no insurance often creates access problems. For example, in 2016, 23 percent of uninsured adults reported going without care when they had a medical problem (Kaiser Family Foun- dation 2017a). This rate was more than six times that of well-insured adults. Delaying or forgoing care can lead to worse health outcomes.

3.2 What Is Insurance, and Why Is It So Prevalent?

3.2.1 What Insurance Does Insurance pools the risks of healthcare costs, which have a skewed distri- bution. Most consumers have modest healthcare costs, but a few incur crushing sums. For example, in 2014, 1 percent of the noninstitutionalized population spent 23 percent of the total, averaging more than $107,000 (Berk and Fang 2017). Insurance addresses this problem. Suppose that one person in a hundred has the misfortune to run up $100,000 in healthcare bills and no one else spends anything. Consumers cannot predict whether they will be lucky or unlucky, so they may buy insurance. If a private firm offers insurance for an annual premium of $1,040, many consumers would gladly buy insurance to eliminate a 1 percent chance of a $100,000 bill. (The insurer gets $4,000 per 100 people to cover its selling costs, claims processing costs, and profits.)

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Chapter 3: An Over view of the Healthcare F inancing System 41

3.2.2 Adverse Selection and Moral Hazard Alas, the world is more complex than the preceding scenario, and such a sim- ple plan probably would not work. To begin with, insurance tends to change the purchasing decisions of consumers. Insured consumers are more likely to use services, and providers no longer feel compelled to limit their diagnosis and treatment recommendations to amounts that individual consumers can afford. The increase in spending that occurs as a result of insurance cover- age is known as moral hazard. Moral hazard can be substantially reduced if consumers face cost-sharing requirements, and most contemporary plans have this provision.

Another, less tractable problem remains. Some consumers, notably older people with chronic illnesses, are much more likely than average to face large bills. Such consumers would be especially eager to buy insurance. On the other hand, some consumers, notably younger people with healthy ancestors and no chronic illnesses, are much less likely than average to face large bills. Such consumers would not be especially eager to buy insurance. This situation illustrates adverse selection: People with high risk are apt to be eager to buy insurance, but people with low risk may not be. Wary of this phenomenon, insurance firms have tried to assess the risks that individual consumers pose and base their premiums on those risks, a process known as underwriting. Of course underwriting drives up costs, making coverage more expensive, which further reduces the share of consumers who are will- ing to pay for insurance. In the worst case, no private firm would be willing to offer insurance to the general public.

In the United States, three mechanisms reduce the effects of adverse selection: employment-sponsored medical insurance, government-sponsored medical insurance, and health insurance subsidies. In 2016, 91 percent of the population had health insurance. About 37 percent had government- sponsored medical insurance, and 56 percent had employer-sponsored insur- ance (US Census Bureau 2017). Ninety-four percent of Americans aged 65 years or older have coverage through Medicare or Medicaid. Ninety percent of those younger than 65 years have coverage, with 63 percent having employer-sponsored coverage and 27 percent having government-sponsored coverage (14% of these younger Americans bought insurance themselves, but for some this purchase was in addition to other insurance).

Why is the link between employment and medical insurance so strong? First, insurers are able to offer lower prices on employment-based insurance because they reduce their sales costs and adverse selection risks by selling to groups. Selling a policy to a group of 1,000 people costs only a little more than selling a policy to an individual; thus the sales cost is much lower. And because few people take jobs or stay in them just because of the medical insurance benefits, adverse selection rarely occurs (i.e., most of the

moral hazard The incentive to use additional care that having insurance creates.

adverse selection A situation that occurs when buyers have better information than sellers. For example, high- risk consumers are willing to pay more for insurance than low-risk consumers are. (Organizations that have difficulty distinguishing high-risk from low- risk consumers are unlikely to be profitable.)

underwriting The process of assessing the risks associated with an insurance policy and setting the premium accordingly.

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Economics for Healthcare Managers42

employees get the insurance, regardless of whether they think they’ll need it soon). Second, insurance can benefit employers. If coverage improves the health of employees or their dependents, workers will be more productive, thereby improving profits for the company. Companies also benefit because workers with employment-based medical insurance are less likely to quit. The costs of hiring and training employees are high, so firms do not want to lose employees unnecessarily. Third, employers’ contributions to insurance premi- ums are excluded from their employees’ Social Security taxes, Medicare taxes, federal income taxes, and most state and local income taxes. Earning $5,000 in cash instead of a $5,000 medical insurance benefit could easily increase an employee’s tax bill by $2,500.

This system is clearly advantageous for insurers, employers, and employees. From the perspective of society as a whole, however, its desir- ability is less clear. The subsidies built into the tax code tend to force tax rates higher, may encourage the use of insurance for costs such as eyeglasses and routine dental checkups, and give employees an unrealistic sense of how much insurance costs.

3.2.3 Medicare as an Example of Complexity The health insurance system in the United States is so complex that only a few specialists understand it. Exhibit 3.2 illustrates the complexity of health- care financing by examining the flow of funds in traditional Medicare. Many

Understanding Health Risks and Insurance

Adverse selection is one reason for governments to intervene in health insurance markets. A persistent fear is that people with low risks will not buy insurance, pushing up premiums for people with higher risks. Once premiums go up, additional people with low risks will drop out. This sequence is called a death spiral because it will ultimately result in no one buying insurance. To prevent this outcome, governments subsidize insurance or mandate that it be bought.

Little evidence suggests that people understand health risks or insurance well. Yet to make a good choice, consumers must compare many different products with varying attributes and forecast what their risks will be (Ericson and Starc 2016). Not surprisingly, many find insurance choices difficult. A recent survey of Americans who might seek insurance through the ACA marketplace found that many struggled to understand basic concepts, such as a premium, a provider network, or covered services (Long et al. 2014).

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Chapter 3: An Over view of the Healthcare F inancing System 43

Medicare beneficiaries pay for supplemental policies that cover deductibles, coinsurance, and other expenses that Medicare does not cover. Like many insurers, Medicare requires a deductible. In 2017, the Medicare Part A deductible was $1,316 per year, and the Medicare Part B deductible was $183. The most common coinsurance payments spring from the 20 percent of allowed fees Medicare beneficiaries must pay for most Part B services. For simplicity, exhibit 3.2 focuses on supplemental policies that reimburse ben- eficiaries rather than pay providers directly. Beneficiaries with these sorts of policies (and many without supplemental coverage) must make required out- of-pocket payments directly to providers. Beneficiaries must also pay the Part B premiums that fund 25 percent of this Medicare component. Like other taxpayers, beneficiaries must also pay income taxes, which cover the other 75 percent of Part B costs.

Medicare Part A Coverage for inpatient hospital, skilled nursing, hospice, and home health services.

Medicare Part B Coverage for outpatient services and medical equipment.

Medicare beneficiaries

Premiums

Part B premiums and income taxes

Providers

Government

Employees

Wages

Employers

Payroll and income taxes

Medicare payments

Supplemental insurers

Out-of-pocket payments

EXHIBIT 3.2 The Flow of Funds in Medicare

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Economics for Healthcare Managers44

Employers and employees also pay taxes to fund the Medicare system. The most visible of these taxes is the Medicare payroll tax, which is levied on wages to fund Part A (which covers hospital, home health, skilled nursing, and hospice services). In addition, corporation and individual income taxes help fund the 75 percent of Part B costs that premiums do not cover. CMS, the federal agency that operates Medicare, combines these tax and premium funds to pay providers. Not surprisingly, few taxpayers, beneficiaries, or pub- lic officials understand how Medicare is financed.

3.3 The Changing Nature of Health Insurance

Traditional, open-ended fee-for-service (FFS) plans (of which pre-1984 Medicare was a classic example) have three basic problems. First, they encourage providers and consumers to use covered services as long as the direct cost to consumers is less than the direct benefit. Because the actual cost of care is much greater than the amount consumers pay, some consum- ers may use services that are worth less than they actually cost. In addition, open-ended FFS plans discourage consumers from using services that are not covered, even highly effective ones. Finally, much of the system is unplanned, in that the prices paid by consumers and the prices received by providers do not reflect actual provider costs or consumer valuations.

Given the origins of traditional medical insurance, this inattention to efficiency makes sense. Medical insurance was started by providers, largely in response to consumers’ inability to afford expensive services and the unwillingness of some consumers to pay their bills after services had been rendered. The goal was to cover the costs of services, not to provide care in the most efficient manner possible nor to improve the health of the covered population.

Managed care is a varied collection of insurance plans with only one common denominator: They are different from FFS insurance plans. Tradi- tionally, FFS plans covered all services if they were included in the contract and if a provider, typically a physician, was willing to certify that they were medically necessary. The FFS plans had no features that tried to influence the decisions of patients or physicians (aside from the effects of subsidizing higher spending).

Currently, insurance takes five basic forms: FFS plans, PPOs (pre- ferred provider organizations), HMOs (health maintenance organiza- tions), point-of-service (POS) plans, and high-deductible (HD) plans. We will briefly describe each of the alternatives to FFS plans.

fee-for-service (FFS) An insurance plan that pays providers on the basis of their charges for services.

managed care A loosely defined term that includes all plans except open-ended fee-for-service. It is sometimes used to describe the techniques insurance companies use.

PPO (preferred provider organization) Plan that contracts with a network of providers. (Network providers may be chosen for a variety of reasons, but a willingness to discount fees is usually required.)

HMO (health maintenance organization) Plan that provides comprehensive benefits to enrollees in exchange for a premium. (Originally, HMOs were distinct from other insurance plans because providers were not paid on a fee-for-service basis and because enrollees faced no cost-sharing requirements.)

point-of-service (POS) plan Plan that allows members to see any physician but increases cost sharing for physicians outside the plan’s network. (This arrangement has become so common that POS plans may not be labeled as such.)

high-deductible (HD) plan Plan that has a deductible of at least $1,000 and may be combined with a health savings account.

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Chapter 3: An Over view of the Healthcare F inancing System 45

3.3 The Changing Nature of Health Insurance

fee-for-service (FFS) An insurance plan that pays providers on the basis of their charges for services.

managed care A loosely defined term that includes all plans except open-ended fee-for-service. It is sometimes used to describe the techniques insurance companies use.

high-deductible (HD) plan Plan that has a deductible of at least $1,000 and may be combined with a health savings account.

Oregon’s Coordinated Care Organizations

In 2012 Oregon launched an ambitious redesign of its Medicaid pro- gram. It created a statewide network of coordinated care organizations, which are similar in some respects to accountable care organizations, but these coordinated care organizations get global, risk-adjusted budgets from the state, are responsible for a broad range of services (behavioral, dental, and physical), and are governed by a broad range of local stakeholders. The coordinated care organizations have imple- mented a number of innovations, including the following:

• Locating behavioral health specialists in primary care settings

• Using community health workers

• Using emergency department navigators to connect patients with primary care

• Emphasizing identification and brief treatment of substance abusers

How has this program worked? Per-member per-month spending for hospital care decreased sharply, and spending on primary care increased sharply. Most of the quality measures with incentives attached have improved. Most without incentives have not.

Discussion Questions • Why should a state provide Medicaid to its citizens?

• Who is eligible for Medicaid in Oregon?

• How does this situation differ from eligibility in your state?

• How is Oregon’s Medicaid different from your health insurance? From Medicare?

• What type of insurance is Oregon Medicaid?

• Why might community health workers improve outcomes and save money?

• Why does Medicare not pay for community health workers?

• How might linking behavioral health and primary care improve outcomes and save money?

accountable care organization Network of providers that have financial incentives to reduce spending and improve outcomes.

global, risk- adjusted budget Payment of a fixed amount per person to the organization responsible for providing care to a population. Risk adjustment means that the amount per person is higher for people with higher risk of expensive illnesses.

community health workers Local, nonclinical workers who help patients live healthier lives and help providers understand patients’ needs.

Case 3.1

(continued)

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Economics for Healthcare Managers46

PPOs are the most common form of managed care organization. All PPOs negotiate discounts with a panel of hospitals, physicians, and other providers, but their similarities end there. Some PPOs have small panels; oth- ers have large panels. Some PPOs require that care be approved by a primary care physician; some do not.

PPOs are far less diverse than HMOs, however. Some HMOs are structured around large medical group practices and are called group model HMOs. Group model HMOs typically make a flat payment per consumer enrolled with the group. This practice is called capitation. Other HMOs, called staff model HMOs, employ physicians directly and pay them salaries. Both staff and group model HMOs still exist, but they are expensive to set up and make sense only for large numbers of enrollees (because small HMOs cannot negotiate favorable prices with hospitals).

HMO expansion largely has been fueled by the growth of indepen- dent practice association (IPA) HMOs. These plans contract with large groups of physicians, small groups of physicians, and solo-practice physicians. These contracts assume many forms. Physicians can be paid per service (as PPOs usually operate) or per enrollee (as group model HMOs usually oper- ate). IPAs also pay hospitals and other providers in varied ways.

POS plans are another form of HMO. These plans are a combination of PPO and IPA models. Unlike IPA HMOs, they cover nonemergency ser- vices provided by nonnetwork providers, but copayments are higher. Unlike PPOs, they pay some providers using methods other than discounted FFS payments.

HD plans have a deductible of at least $1,000. These plans may be combined with health savings accounts, which are nontaxable accounts that employees and employers can contribute to and employees can use to pay medical bills.

group model HMO A plan that contracts with a physician group to provide services.

capitation Payment per person. (The payment does not depend on the amount or type of services provided.)

staff model HMO A plan that employs staff physicians to provide services.

independent practice association (IPA) HMO A plan that contracts with independent practice associations, which in turn contract with physician groups.

health savings account An account that employees and employers can contribute to and employees can use to pay medical bills. Employees’ contributions and payments are not taxable.

• How might connecting patients with primary care improve outcomes and save money?

• Is there evidence that good primary care improves outcomes and saves money?

• How might increasing treatment of substance abusers improve outcomes and save money?

• Is reducing the hospitalization rate a good thing?

• Is reducing use of emergency departments a good thing?

Case 3.1 (continued)

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Chapter 3: An Over view of the Healthcare F inancing System 47

Health insurance continues to evolve in a disorderly fashion. Where this development will lead is not clear. The belief that health insurance is changing rapidly is widespread, and exhibit 3.3 seems to confirm this belief. Since 2007, FFS plans have all but disappeared, and the market share of PPO plans has fallen from 57 percent to 48 percent. HMO plans (which include POS plans in exhibit 3.3) have fallen from 34 percent of the employer-based market to 24 percent. HD plans have risen from 5 percent of the market in 2007 to 28 percent in 2017.

The patterns in other sectors differ from those in the employer- sponsored market. More than 60 percent of Medicare Advantage beneficia- ries are in HMOs (Kaiser Family Foundation 2017b). Likewise, more than 70 percent of Medicaid beneficiaries are in HMOs, and about half of those buying ACA plans are as well.

Complicating this already complex picture are recent changes in Medicare, Medicaid, ACA marketplace plans, and employment-based plans. These innovations could have widespread effects, although only preliminary evidence is available for most of them. We will explore these changes in detail in chapter 6.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0%

10%

20%

30%

40%

50%

60%

70% PPO 60%

HD 8%

HMO 24%

FFS 1%

PPO 48%

HD 29%

EXHIBIT 3.3 Enrollment Patterns in Employer- Sponsored Insurance

Source: Kaiser Family Foundation and Health Research & Educational Trust (2017).

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Economics for Healthcare Managers48

3.4 Payment Systems

In the past, most healthcare providers were paid on the basis of volume. Today, insurers have begun to experiment with alternative payment models.

Geisinger’s Transformation

The conflicting incentives of FFS and capitation present significant problems for integrated health

systems like Geisinger Health System of central Pennsylvania. Indeed, after its merger with Penn State Health collapsed, many were con- cerned about its viability. Geisinger faced losses in its hospitals and physician group, and its health plan was not doing well (Goldsmith 2017).

Geisinger’s turnaround involved two strategies: increasing the share of physician compensation in the form of FFS payments and implementing a robust network of patient-centered medical homes to limit low-value care (healthcare offering little or no clinical value or even having potential harms greater than its benefits). The change in physician compensation allowed the creation of a broader network and rewarded higher volumes. In essence, Geisinger became a network HMO (an HMO having a variety of contracts with physician groups, IPAs, and individual physicians; it may also own hospitals and employ physicians).

Geisinger had two major advantages. Its Medicare Advantage plan was profitable, and its strong market position allowed it to negotiate good rates with local insurance plans. Those high rates gave it the resources necessary to transform its primary care practices.

Discussion Questions • Why would it make sense to become a network HMO?

• Did it make sense for Geisinger to support the patient-centered medical home transition?

• Could an independent practice afford to become a patient-centered medical home?

• Why is Medicare sponsoring patient-centered medical home demonstrations?

• How would a 6 percent reduction in hospitalization rates affect hospitals?

low-value care Care that has been scientifically evaluated and found to be of little or no clinical value or to have potential harms greater than its benefits.

network HMO An insurance plan that has a variety of contracts with physician groups, IPAs, and individual physicians. A network HMO may also own the hospitals that it uses and employ physicians.

Case 3.2

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Chapter 3: An Over view of the Healthcare F inancing System 49

These alternative payment models can change providers’ incentives, which can change patterns of care. The power of changing incentives should not be underestimated, and managers need to be wary of getting what they pay for rather than getting what they want. When contracting with insurers or providers, managers need to recognize the strengths and weaknesses of different systems. The four basic payment methods—salary, volume-based, value-based, and capitation—can be modified by the addition of incentive payments, increasing the number of possible payment methods.

A salary is fixed compensation paid per defined period. As such, it is not directly linked to output. Typically, physicians are paid a salary when their productivity is difficult to measure (e.g., in the case of academic physicians) or when the incentives created by payments per service are seen as undesir- able (e.g., an incentive to overtreat that increases costs). As noted earlier, most physicians in the United States have traditionally been paid on the basis of volume, meaning providing more services increases revenue.

Volume-based payments can take a number of forms. Per-service payments entail a payment for each separate service. For example, a physician visit that involved 10 minutes talking to the doctor, an X-ray, and a labora- tory test would result in a bill for three services. Case-based payments are single payments for all covered services associated with an episode of care. Medicare’s diagnosis-related group (DRG) system is a case-based system for hospital care, although it does not include physicians’ services or posthos- pital care. In essence, case-based payments are volume-based payments for a bundle of services rather than separate payments for each individual service. Value-based payments add a quality bonus or penalty to volume-based payments. For example, Medicare reduces DRG payments to hospitals with above-average 30-day readmission rates for pneumonia patients. Capitation is compensation paid per beneficiary enrolled with a physician or an organiza- tion. Capitation is similar to a salary but varies according to the number of customers.

Each of the four basic payment methods has advantages and disadvan- tages. Salaries are straightforward and incorporate no incentives to provide more care than necessary, but they do not encourage efficiency or reward exemplary service. In addition, salaries give providers incentives to use resources other than their time and effort to meet their customers’ needs. In the absence of incentives not to refer patients to other providers, salaried providers may well seek to refer substantial numbers of patients to specialists, urgent care clinics, or other sources of care.

Capitation incorporates many of the same incentives as a salary, with two important differences. One is that capitation payments drop if customers leave the practice, so physicians have more incentive to serve patients well. The other is that capitation creates incentives to undertreat. Providing a

salary Fixed compensation per period.

volume-based payment Payment that increases if a provider delivers more services.

per-service payment Payment for each billable service. Providing an additional service increases the bill.

case-based payment A single payment for an episode of care, regardless of the number of services.

diagnosis-related group (DRG) The basis of Medicare’s case- based payment system for hospitals.

value-based payment Payment adjusted on the basis of quality measures.

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Economics for Healthcare Managers50

service increases costs but does not increase revenue, so profits rise if service levels drop.

Volume-based payment encourages productivity and efficiency but may create incentives to overtreat (especially for services with prices that are much higher than production costs). Services that offer limited benefits to patients can be profitable in volume-based payment systems as long as the benefits exceed the consumer’s out-of-pocket cost. On the other hand, incentives to undertreat can emerge if services are unprofitable. Getting prices right is vital in volume-based payment.

Case-based payment combines features of per-service payment and capitation. It is a form of volume-based payment, so it rewards productivity and efficiency. However, case-based payment may encourage providers to treat patients with highly profitable cases who should not be treated, or it may create incentives for providers not to treat patients with less profitable cases who should be treated. Like capitation, it can create incentives to skimp on care. Costs can be reduced by improving efficiency, shifting responsibility for therapy to other sources (e.g., the health department), avoiding complex patients, and narrowing the definition of a case. The challenge is to keep providers focused on improving efficiency, not on gaming the system.

Any of these four basic methods can be modified by including bonuses and penalties, as value-based payment does. A base salary plus a bonus for reducing inpatient days in selected cases is not a straight salary contract. Similarly, a capitation plan with bonuses or penalties for exceeding or not meeting customer service standards (e.g., a bonus for returning more than 75% of after-hours calls within 15 minutes) would not generate the same incentives a plain capitation plan would. Most insurers are moving away from volume-based payments toward value-based payments; however, insurers are trying a variety of approaches because the best way to implement value-based payment is not yet clear.

Capitation was previously expected to become the dominant method of payment. Experience with capitation suggests, however, that few providers (or insurers, for that matter) have the administrative skills or data that capita- tion demands. In addition, the financial risks of capitation can be substantial. Few providers have enough capitated patients for variations in average costs to cease being worrisome, and capitation payments are seldom risk adjusted (i.e., increased when spending can be expected to be higher than average). These considerations have dampened most providers’ enthusiasm for capita- tion. Insurers also have realized that capitation is not a panacea, recognizing that providers have ways other than becoming more efficient to reduce their costs. Volume-based payments remain the norm, but most major insurers are seeking to switch to value-based payments (which include careful monitoring

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Chapter 3: An Over view of the Healthcare F inancing System 51

of quality). What compensation arrangements will look like in ten years remains to be seen.

3.5 Conclusion

Health insurance is common because of the risks of unexpected costs, but the days of traditional, open-ended insurance plans are over. Despite the ubiquity of managed care and much discussion of value-based payment systems, most consumers are enrolled in plans that are minimally managed, such as PPOs or POS plans that pay providers in familiar ways. But more than half of the pro- viders who responded to a recent survey are deeply involved with value-based payment, and most expect to be shortly (KPMG 2017). Medicare, Medicaid, and most private insurers have already begun to change how they pay provid- ers. Changes in payment systems substantially increase the risks that managers must face. The next chapter will introduce strategies for managing these risks.

The central challenge of cost remains. In 2016 median household income was $59,039, meaning that half of the households in the country made less than $59,039. The Milliman Medical Index, which tracks all healthcare costs, shows that an average family of four spent $25,824 in 2016 (Girod, Weltz, and Hart 2016). Many families simply cannot afford this level of spending.

Exercises

3.1 Why is health insurance necessary? 3.2 Explain how adverse selection and moral hazard differ, and give an

example of each. 3.3 Some consumers are overinsured, yet some are underinsured.

Millions are clearly uninsured. What do you think these concepts mean?

3.4 Should health insurance continue to be employment-based for most Americans?

3.5 A radiology firm charges $2,000 per exam. Uninsured patients are expected to pay list price. How much do they pay?

3.6 A radiology firm charges $2,000 per exam. An insurer’s allowed fee is 80 percent of charges. Its beneficiaries pay 25 percent of the allowed fee. How much does the insurer pay? How much does the beneficiary pay?

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Economics for Healthcare Managers52

3.7 If the radiology firm in exercise 3.6 raised its charge to $3,000, how much would the insurer pay? How much would the beneficiary pay?

3.8 A surgeon charges $2,400 for hernia surgery. The surgeon contracts with an insurer that allows a fee of $800. Patients pay 20 percent of the allowed fee. How much does the insurer pay? How much does the patient pay?

3.9 You have incurred a medical bill of $10,000. Your plan has a deductible of $1,000 and coinsurance of 20 percent. How much of this bill will you have to pay directly?

3.10 Why do employers provide health insurance coverage to their employees?

3.11 Your practice offers only a PPO with a large deductible, high coinsurance, and a limited network. You pay $400 per month for single coverage. Some of your employees have been urging you to offer a more generous plan. Who would you expect to choose the more generous plan and pay any extra premium?

3.12 What are the fundamental differences between HMO and PPO plans?

3.13 Suppose that your employer offered you $4,000 in cash instead of health insurance coverage. Health insurance is excluded from state income taxes and federal income taxes. (To keep the problem simple, we will ignore Social Security and Medicare taxes.) The cash would be subject to state income taxes (8%) and federal income taxes (28%). How much would your after-tax income go up if you took the cash rather than the insurance?

3.14 How would the calculation in exercise 3.13 differ for a worker who earns $500,000 and lives in Vermont? This worker faces a state income tax rate of 9.5 percent and a federal income tax rate of 35 percent.

References

Berk, M. L., and Z. Fang. 2017. “Most Americans Have Good Health, Little Unmet Need, and Few Health Care Expenses.” Health Affairs 36 (4): 742–46.

Centers for Medicare & Medicaid Services (CMS). 2017. “National Health Expen- ditures by Type of Service and Source of Funds: Calendar Years 1960 to 2016.” Accessed November 3. www.cms.gov/Research-Statistics-Data-and -Systems/Statistics-Trends-and-Reports/NationalHealthExpendData /Downloads/NHE2016.zip.

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Chapter 3: An Over view of the Healthcare F inancing System 53

Ericson, K. M., and A. Starc. 2016. “How Product Standardization Affects Choice: Evidence from the Massachusetts Health Insurance Exchange.” Journal of Health Economics 50: 71–85.

Girod, C. S., S. A Weltz, and S. K. Hart. 2016. “2016 Milliman Medical Index.” Milli- man. Published May 24. www.milliman.com/insight/Periodicals/mmi/2016 -Milliman-Medical-Index/.

Goldsmith, J. 2017. “Geisinger’s Transformation: Balancing Growth and Risk.” Health Affairs Blog. Published March 8. http://healthaffairs.org/blog/2017 /03/08/geisingers -transformation -balancing-growth-and-risk/.

Kaiser Family Foundation. 2017a. “Key Facts About the Uninsured Population.” Updated November 29. www.kff.org/uninsured/fact-sheet/key-facts-about -the-uninsured-population/.

. 2017b. “Medicare Advantage.” Published October 10. www.kff.org /medicare/fact-sheet/medicare-advantage/.

Kaiser Family Foundation and Health Research & Educational Trust. 2017. Employer Health Benefits: 2017 Annual Survey. Published September. http://files.kff. org/attachment/Report-Employer-Health-Benefits-Annual-Survey-2017.

KPMG. 2017. “KPMG Value-Based Care.” Accessed September 10, 2018. https:// assets.kpmg.com/content/dam/kpmg/us/pdf/2017/01/VBC_Info graphic.pdf.

Long, S. K., G. M. Kenney, S. Zuckerman, D. E. Goin, D. Wissoker, F. Blavin, L. J. Blumberg, L. Clemans-Cope, J. Holahan, and K. Hempstead. 2014. “The Health Reform Monitoring Survey: Addressing Data Gaps to Provide Timely Insights into the Affordable Care Act.” Health Affairs 33 (1): 161–67.

US Census Bureau. 2017. “Annual Social and Economic Supplement (ASEC) of the Current Population Survey (CPS).” Revised May 8. www.census.gov /programs-surveys/saipe/guidance/model-input-data/cpsasec.html.

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