An Economic Look at Healthcare - Part I

Healthcare reform is certainly a very hot topic. Emotions run very high on this issue on both sides of the debate. This issue seems to capture all the hot-button issues: liberty, economics, religion, politics, the proper role for government, compassion, interest groups, capitalism, socialism… the list goes on and on.

In such a cacophony of opinions and debates, very rarely do people address the root issue of rising costs. They bemoan high prices and seek to “teach the robber baron insurance companies a lesson!” Well, we must ask ourselves: what is the actual cause of rising healthcare costs? Why are prices rising? People and insurance companies play by the rules they’re given, that is, they respond to the incentives they are presented with.

As such, we must look deeper, we must find out why insurance companies don’t accept pre-existing conditions and why premiums keep rising. It’s not just that they’re evil and they want to exploit the sick and dying patient to line their pockets with money. That argument is far too simplistic and contributes nothing to the debate.

If we truly want healthcare reform, if we truly want to reduce costs, if we truly want to make healthcare available and affordable to everyone, we must roll up our sleeves and dive in. I wish it were as easy as saying “the government will fix it.” Unfortunately, if we want to fix the problem, real work must be done to peel back the layers until we find out what’s actually causing the problem. For too long we’ve sought to only address the symptoms.

This is the first of a two part series on health-care reform. This part will look at the major cause in the distortion of the healthcare market, Medicare and Medicaid, and show exactly how they contribute to rising healthcare costs.
Step one in reforming healthcare should be to get the government out of it. Its two major healthcare programs, Medicare and Medicaid, create most of the problems a government-run healthcare plan is meant to fix.

The following is a straight-forward explanation of how Medicare and Medicaid actually work. I will insert commentary from time to time, but I assure you, the way these government programs work and the resulting economic consequences is presented truthfully, with no fabrication. This can be found in any economics textbook. It is neither complicated nor a secret.

The bulk (71%) of government healthcare spending is to Medicare and Medicaid as of 2004. This money mostly goes to direct payments to physicians, hospitals and other health care provided through Medicare and Medicaid.

In 2004 Medicare cost the government $309 Billion and Medicaid cost $290 Billion.
What do we get for our money? Medicare benefits are subject to strict limits that are less generous that most private health insurance programs. Medicare does not cover long-term care for the elderly in nursing homes and provides only optional and limited prescription drug coverage. Many people over 65 in the US have private insurance plans to cover the things Medicare misses. All this funding for “free” healthcare and people STILL buy private insurance.

Because our population is rapidly aging, leading to an inverted population pyramid, we have less people in the work force (taxes) and more people receiving Medicare benefits. Because of this (and many other things as we’ll see) the cost of administering Medicare is spiraling upwards.

In order to try to keep an unsustainable program going, Medicare started limited payments to physicians in what’s known as the Medicare Fee Schedule (MFS) that sets payments according to time, skill, and the intensity of the services rendered. It’s a complicated formula designed to limit payments.

The fact is that anytime you have a committee trying to work out a complicated formula, the price won’t be accurate and at the very least will lag behind the true market cost of the procedures. As a result physicians are vastly underpaid by Medicare and it’s leading some to refuse to accept Medicare patients or offer them lower-quality care in an attempt to re-coup costs. This system turns patients into a liability for the doctors, creating the incentive to NOT treat them. Something you never want to see.

Medicare limits payments for specific hospital providers to certain amounts independent of the actual costs of the procedures. The current law pays hospitals a flat fee for illnesses classified into Diagnosis Related Groups (DRGs). Under the DRG system, payment for a medical procedure is the same regardless of any complications that might develop during the medical procedures.

For example, a hospital treating a heart-attack patient will be eligible for a certain flat fee no matter how much is actually spent caring for the patient. This obviously can work both ways, but it can create the incentive for the hospitals to “cut-corners” in order to maximize profit by reducing the quality of medical care provided to the elderly.

The payment for each DRG is based on the average cost of treatment for the illness in all US hospitals, adjusted for differences in local wage costs, the greater cost of providing care for Medicare patients in hospitals with teaching programs, and higher costs related to treating a disproportionately large share of low-income patients.

At the extreme, this system could lead to some hospitals shutting down if they have a high proportion of elderly patients.

The MFS and DRG amount to nothing more than committees, review panels and complex formulas. Can you imagine the administrative costs of such a system? All this central planning and extra time and costs to try to accomplish something the market does automatically and much much more effectively.

As with any insurance system, Medicare encourages the consumption of medical services beyond the efficient level (prices are seen as lower resulting in a higher quantity demanded). The government has chosen to limit overconsumption by placing limits on reimbursement to medical providers.

Medicare increases the quantity of medical services demanded by the elderly. The DRG system acts to limit the quantity of medical services supplied to the elderly by capping the price per unit of service to medical providers. Clearly a backwards policy as far as economics is concerned.

Despite these attempts by the government to limit costs, spending on Medicare has risen faster than the average rate of cost increases in healthcare spending for the nation as a whole. Private sector spending increased by 2.9% while Medicare spending increased by 8.7%.

In 1997 congress passed legislation that sharply reduced payments to healthcare providers for most medical procedures and encouraged those covered by Medicare to enroll in managed care programs. This is clearly and band-aid solution and yet another example of government intervention that only makes a bad problem worse.

The sad fact of Medicare is that it’s unsustainable. To keep it going the government must do either: cut benefits, raise taxes or limit eligibility. All bad options.

It is crucial to control spending per beneficiary under the program in the future as the number of beneficiaries begins to swell due to the aging of the US population. Since Medicare constitutes such a large share of demand for medical services in the United States, its policies affect both medical service prices and the use of those services. In other words, Medicare has monopoly power to in effect become a price setter. The rising costs of healthcare are largely due to Medicare itself! And by expanding the idea of it through similar programs we’re supposed to reduce costs? Does that make any sense?

The Medicare payment system, in some cases, has perverse effects that actually increase spending. For example, the prospective payment system limits the amounts that Medicare pays for hospital stays. In doing so it has encouraged hospitals to transfer patients quickly to skilled nursing facilities or to long-term facilities where Medicare is obligated to pay on a fee-for-service basis, thereby contributing to increased costs.

Costs could be reduced sharply by increasing deductibles and coinsurance payments for those covered by Medicare. This would increase the portion of medical expenses borne by patients themselves, and as I will discuss later, would decrease the quantity of such services demanded. Medicare combined with medigap often reduces the out-of-pocket cost per service to zero, thereby encouraging consumption beyond the point at which marginal benefit falls to marginal cost.

The current legislation wants to cap and reduce coinsurance payments and deductibles! EXACTLY the wrong idea! You couldn’t be more backwards if you tried. Yet another example of a government intervention that does nothing but make a bad problem worse.

In regards to prescription drugs Medicare also contributes to the rising prices. Medicare subsidizes spending on medicine for the elderly which provides incentives to increase total expenditure on prescription drugs. It is also increases the incentive for health care providers to prescribe drugs for the elderly. The increase in demand for pharmaceuticals puts upward pressure on prices.

Okay. On to Medicaid.

The biggest difference between Medicaid and Medicare, besides the people they target (Medicare is for the elderly, Medicaid is for the poor), is that Medicaid is primarily administered by state governments.

Much of the problems are the same – soaring prices, limits on reimbursements which changes incentives, and unsustainable structure.

Medicaid is the insurance of last resort- it takes many patients with no other insurance programs like crack-addicted babies, the homeless with disabilities and AIDS patients who run out of private insurance and exhaust all other financial means of paying medical bills. It’s also pays for long-term care for the elderly who have run out of their savings. Definitely a noble program, unfortunately it’s flawed.

Medicaid has created the incentive for many elderly people to conceal their financial assets from the government so they can get their nursing home and medical expenses paid through Medicaid instead of spending their own money.

Because of reduced reimbursement rates, many physicians are refusing to treat Medicaid patients. Even though spending for Medicaid is constantly increasing, many poor patients are finding it harder to obtain medical care from physicians and must resort to hospital emergency rooms for routine medical care.

This increases the demand for medical services in the emergency room, extends wait times and leads to those who do have insurance being charged extra for the patients who theoretically should be covered under Medicaid. It is easy to see how a program meant to help poor people actually hurts them and everybody else by driving up medical costs and leading to declining coverage.

What are states doing to try to control medical costs? A common strategy has been to reduce reimbursement rates to Medicaid providers. Because pharmaceuticals are a major factor in higher costs, many states are restricting reimbursement rates to providers of prescription drugs and even requiring Medicaid recipients to pay some of the costs. Healthcare only works when people pay something. Even state-run “free” programs like Medicaid realize that their patients have to pay at least something.

Some states are actually placing limits on how much they will pay for Medicaid recipients’ medical costs. Other states are making it more difficult for low-income people to qualify for Medicaid, and as a result hundreds of thousands of individuals are losing their Medicaid health insurance. These cut have been especially severe in Florida, Vermont, and Tennessee. As we can see, it’s the STATE (not private insurance) that is refusing to cover these people. It’s the state that is dropping coverage.

These distortions we see in the private sector arise and are a necessary response to backward government policy. It’s not that the private sector created their perverse policies and the benevolent government must come along and save us poor people from the evil insurance industry. Clearly the private sector has had no choice but to respond in a similar way because government policies have tied their hands where they have no other choice. Don’t you see how government intervention leads to the exact opposite effect it’s meant for? Don’t you see that continuing down this road will NEVER fix anything?

Just a few final thoughts on Medicaid and Medicare.

During the period from 1984-1986, Medicare actually froze payments to physicians, but the cost of treating those patients increased at a rate of about 10%. During that time physicians were able to increase the volume of patients they saw in order to offset the price freeze. Clearly just capping fees is not an adequate solution to the problem.

Medicare, in an attempt at reform, tried using the Prospective Payment System which pays hospitals a fixed amount per patient regardless of the length of stay. These fixed payments or DRGs (discussed earlier) have the intended goal of physicians not over-treating patients and discharging them from the hospital efficiently. Again, a noble goal that unfortunately misses the mark. The result is physicians are paid too little, which forces them to over-treat privately insured patients to try to make up the difference. Combine that with lower quality care for those that need it most and I’d say that’s another example of a lose-lose situation caused by government policy.

State governments tried the same approach with Medicaid. They limited their reimbursement to hospitals for Medicaid patients to covering the minimum possible average cost of hospital services. The average reimbursement rate under Medicaid is about 80 percent less than hospital cost of services.

Unfortunately, low rates of reimbursement under Medicaid have reduced access to medical care for those enrolled under the program. Many doctors are unwilling to accept Medicaid patients and some hospitals are reluctant to admit them. Because of difficulties in finding physicians to treat them, Medicaid patients often seek treatment at hospital emergency rooms, where costs of treatment are more expensive.

There are no easy solutions to the healthcare crisis. But continuing down the same road that caused the crisis in the first place is just plainly a short-sighted bad idea. If the MANY government interventions in healthcare are lifted, the market can and will work like it’s supposed to and you’d find that everybody is able to afford coverage, perhaps even without insurance at all.

The economic consequences of government intervention in healthcare are clear. Why would we think that any politician would know the answer? Why would we trust them with an issue as big as this? We need to listen to economists. We need to follow sound economic policy if we’re to solve the problem. I wish it were as easy as just saying, “the government will fix it,” but the sad truth is it’s not. Don’t be willing to settle for the easy answer just because it seems easy.