Health Policy Issues: An Economic Perspective, Seventh Edition

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SEVENTH EDITION

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Library of Congress Cataloging-in-Publication Data

Names: Feldstein, Paul J., author.

Title: Health policy issues : an economic perspective / Paul J. Feldstein.

Description: Seventh edition. | Chicago, Illinois : Health Administration Press (HAP) : Washington, DC ; Association of University Programs in Health Administration (AUPHA), [2019] | Includes bibliographical references and index.

Identifiers: LCCN 2018034249 (print) | LCCN 2018035093 (ebook) | ISBN 9781640550117 (ebook) | ISBN 9781640550124 (xml) | ISBN 9781640550131 (epub) | ISBN 9781640550148 (mobi) | ISBN 9781640550100 (print : alk. paper)

Subjects: LCSH: Medical economics—United States. | Medical policy—Economic aspects—United States. | Medical care—United States—Cost control. | Medical care, Cost of—United States.

Classification: LCC RA410.53 (ebook) | LCC RA410.53 .F455 2019 (print) | DDC 338.4/736210973—dc23

LC record available at https://lccn.loc.gov/2018034249

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BRIEF CONTENTS

List of Exhibits

Preface

Chapter 1.The Rise of Medical Expenditures

Chapter 2.How Much Should We Spend on Medical Care?

Chapter 3.Do More Medical Expenditures Produce Better Health?

Chapter 4.In Whose Interest Does the Physician Act?

Chapter 5.Rationing Medical Services

Chapter 6.How Much Health Insurance Should Everyone Have?

Chapter 7.Why Are Those Who Most Need Health Insurance Least Able to Buy It?

Chapter 8.Medicare

Chapter 9.Medicaid

Chapter 10.How Does Medicare Pay Physicians?

Chapter 11.The Impending Shortage of Physicians

Chapter 12.Why Is Getting into Medical School So Difficult?

Chapter 13.The Changing Practice of Medicine

Chapter 14.Physician Malpractice Reform

Chapter 15.Do Nonprofit Hospitals Behave Differently Than For-Profit Hospitals?

Chapter 16.Competition Among Hospitals: Does It Raise or Lower Costs?

Chapter 17.The Future Role of Hospitals

Chapter 18.Cost Shifting

Chapter 19.Can Price Controls Limit Medical Expenditure Increases?

Chapter 20.The Evolution of Managed Care

Chapter 21.Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System?

Chapter 22.Comparative Effectiveness Research

Chapter 23.Who Bears the Cost of Employee Health Benefits?

Chapter 24.Will a Shortage of Registered Nurses Reoccur?

Chapter 25.The High Price of Prescription Drugs

Chapter 26.Ensuring Safety and Efficacy of New Drugs: Too Much of a Good Thing?

Chapter 27.Why Are Prescription Drugs Less Expensive Overseas?

Chapter 28.The Pharmaceutical Industry: A Public Policy Dilemma

Chapter 29.Should Kidneys and Other Organs Be Bought and Sold?

Chapter 30.Should Profits in Healthcare Be Prohibited?

Chapter 31.The Role of Government in Medical Care

Chapter 32.Health Associations and the Political Marketplace

Chapter 33.Medical Research, Medical Education, Alcohol Consumption, and Pollution: Who Should Pay?

Chapter 34.The Canadian Healthcare System

Chapter 35.Employer-Mandated National Health Insurance

Chapter 36.National Health Insurance: Which Approach and Why?

Chapter 37.Financing Long-Term Care

Chapter 38.The Affordable Care Act: Did It Achieve Its Goals?

Glossary

Index

About the Author

DETAILED CONTENTS

List of Exhibits

Preface

Chapter 1.The Rise of Medical Expenditures

Before Medicare and Medicaid

The Greater Role of Government in Healthcare

Changing Patient and Provider Incentives

Government Response to Rising Costs

The Affordable Care Act

Summary

Discussion Questions

Notes

References

Chapter 2.How Much Should We Spend on Medical Care?

Consumer Sovereignty

Economic Efficiency

Government and Employer Concerns over Rising Medical Expenditures

Approaches to Limiting Increases in Medical Expenditures

Summary

Discussion Questions

References

Chapter 3.Do More Medical Expenditures Produce Better Health?

Medical Services Versus Health

Health Production Function

Improving Health Status Cost-Effectively

Relationship of Medical Care to Health over Time

Summary

Discussion Questions

Notes

References

Chapter 4.In Whose Interest Does the Physician Act?

The Perfect Agent

Supplier-Induced Demand or the Imperfect Agent

Increase in Physician Supply

Insurers’ Response to Demand Inducement

HMO Incentives by Imperfect Agents

Informed Purchasers

Summary

Discussion Questions

Note

Additional Reading

References

Chapter 5.Rationing Medical Services

Government Rationing

Rationing by Ability to Pay the Market-Determined Price

Decision Making by Consumers of Medical Services

Marginal Benefit Curve

Price Sensitivity

Moral Hazard

Summary

Discussion Questions

References

Chapter 6.How Much Health Insurance Should Everyone Have?

Definitions of Insurance Terms

Insurance Purchase Decision Making

Tax-Free, Employer-Paid Health Insurance

Summary

Discussion Questions

Notes

References

Chapter 7.Why Are Those Who Most Need Health Insurance Least Able to Buy It?

The Different Private Health Insurance Markets

Determinants of Private Health Insurance Premiums

How Health Insurance Markets Work

The Affordable Care Act's Changes to the Individual Health Insurance Market

The Effect of the Affordable Care Act's Rules on Premiums in the Individual Market

Summary

Discussion Questions

Notes

Additional Readings

References

Chapter 8.Medicare

The Current State of Medicare

Part A: Hospital Insurance

Part B: Supplemental Medical Insurance

Part C: Medicare Advantage Plans

Part D: Prescription Drug Coverage

Medigap Supplementary Insurance

The Affordable Care Act's Approach to Reducing Rising Medicare Expenditures

Reductions in Regulated Provider Prices

Concerns About the Current Medicare System

Proposals for Medicare Reform

Politics of Medicare Reform

Summary

Discussion Questions

Notes

References

Chapter 9.Medicaid

Federally Mandated Medicaid Population Groups

An Illustration of Medicaid Eligibility

State Children's Health Insurance Program

Medicaid Enrollees and Medicaid Expenditures

Medicaid Concerns

The Affordable Care Act's Impact on Medicaid

Medicaid Reforms

Summary

Discussion Questions

Notes

References

Chapter 10.How Does Medicare Pay Physicians?

Initial Medicare Physician Payment

Reasons for Adopting the Resource-Based Relative Value Scale

Components of the RBRVS System

The Medicare Access and CHIP Reauthorization Act (MACRA)

Summary

Discussion Questions

Note

References

Chapter 11.The Impending Shortage of Physicians

Definitions of a Physician Shortage or Surplus

Consequences of an Imbalance in Physician Supply and Demand

Economic Evidence on Trends in Physician Demand and Supply

Long-Term Outlook for the Physician Shortage

Summary

Discussion Questions

Notes

References

Chapter 12.Why Is Getting into Medical School So Difficult?

The Market for Medical Education in Theory

The Market for Medical Education in Practice

Accreditation for Medical Schools

Recommended Changes

Summary

Discussion Questions

Notes

References

Chapter 13.The Changing Practice of Medicine

Types of Medical Groups

Changes in Size and Type of Medical Groups

Reversal of Fortunes of Large Multispecialty Groups

The Outlook for Medical Practice

Summary

Discussion Questions

Note

References

Chapter 14.Physician Malpractice Reform

How Malpractice Claims Vary Among Physicians and by Specialty Status

Objectives of the Malpractice System

Proposed Changes to the Malpractice System

Enterprise Liability

Disclosure, Apology, and Offer Programs

The Effects of Various Tort Reforms

Summary

Discussion Questions

Notes

References

Chapter 15.Do Nonprofit Hospitals Behave Differently Than For-Profit Hospitals?

Why Are Hospitals Predominantly Nonprofit?

Performance of Nonprofit and For-Profit Hospitals

The Question of Tax-Exempt Status

Summary

Discussion Questions

Notes

References

Chapter 16.Competition Among Hospitals: Does It Raise or Lower Costs?

Origins of Nonprice Competition

Transition to Price Competition

Price Competition in Theory

Price Competition in Practice

Summary

Discussion Questions

Notes

References

Chapter 17.The Future Role of Hospitals

From Medicare to the Present

Hospital Costs: The Public and Private Sectors

Hospital Revenues

The Current Hospital Outlook

Hospital Strategies

Summary

Discussion Questions

Notes

References

Chapter 18.Cost Shifting

Setting Prices to Maximize Profits

Origins of Claims of Cost Shifting

Price Discrimination

Conditions Under Which Cost Shifting Can Occur

The Direction of Causality

Summary

Discussion Questions

Notes

Additional Reading

References

Chapter 19.Can Price Controls Limit Medical Expenditure Increases?

Effect of Price Controls in Theory

Effect of Price Controls in Practice

Global Budgets

Summary

Discussion Questions

Notes

References

Chapter 20.The Evolution of Managed Care

Why Managed Care Came About

What Is Managed Care?

Types of Managed Care Plans

How Has Managed Care Performed?

The Change in Managed Care

Recent Developments in Managed Care

Accountable Care Organizations

Population Health

Summary

Discussion Questions

Note

Additional Reading

References

Chapter 21.Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System?

Criteria for Judging Performance of a Country's Medical Sector

How Medical Markets Differ from Competitive Markets

Demand-Side Market Failures

Supply-Side Market Failures

How Can Medical Markets Be More Competitive?

Are the Poor Disadvantaged in a Competitive Market?

Patient Incentives Drive Price Competition in Government and Private Markets

What Might Competitive Medical Markets Look Like?

Summary

Discussion Questions

Notes

References

Chapter 22.Comparative Effectiveness Research

CER and the Role of Government

Concerns over How CER Will Be Used

Cost-Effectiveness Analysis

Quality-Adjusted Life Years

The National Institute for Health and Care Excellence

Summary

Discussion Questions

Note

Additional Readings

References

Chapter 23.Who Bears the Cost of Employee Health Benefits?

How Labor Markets Function

Who Bears the Cost of Rising Employee Medical Costs?

The Growing Divergence Between Wages and Total Compensation

Who Pays for Retiree Medical Costs?

Reducing the Visibility of a Health Policy's Costs

Summary

Discussion Questions

Notes

References

Chapter 24.Will a Shortage of Registered Nurses Reoccur?

Measuring Nursing Shortages

Nursing Shortages in Theory

Nursing Shortages in Practice

The Outlook for Registered Nurses

Summary

Discussion Questions

Notes

References

Chapter 25.The High Price of Prescription Drugs

Reasons for the Increase in Pharmaceutical Expenditures

Pricing Practices of US Pharmaceutical Companies

The Shortage of Generic Drugs

Summary

Discussion Questions

Notes

References

Chapter 26.Ensuring Safety and Efficacy of New Drugs: Too Much of a Good Thing?

History of Regulation of Prescription Drugs

The FDA's Stringent Guidelines for Safety and Efficacy

Summary

Discussion Questions

Notes

References

Chapter 27.Why Are Prescription Drugs Less Expensive Overseas?

Accuracy of Studies on International Variations in Drug Prices

Why Prescription Drugs Are Expected to Be Priced Lower Overseas

Public Policy Issues

Summary

Discussion Questions

Notes

Additional Readings

References

Chapter 28.The Pharmaceutical Industry: A Public Policy Dilemma

Public Policy Dilemma

Structure of the Pharmaceutical Industry

Development of New Drugs by the US Pharmaceutical Industry

The Political Attractiveness of Price Controls on Prescription Drugs

Consequences of Price Controls on Prescription Drugs

Summary

Discussion Questions

References

Chapter 29.Should Kidneys and Other Organs Be Bought and Sold?

Sources of Organs for Transplantation

Donor Compensation Proposals

Opposition to Using Financial Incentives

Additional Considerations

Summary

Discussion Questions

Notes

Additional Readings

References

Chapter 30.Should Profits in Healthcare Be Prohibited?

Definition of Profits

Excess Profits (Economic Profit)

Do Not-for-Profit Hospitals and Insurers Generate Profits?

What Are the Consequences of Eliminating Profit from Healthcare?

Summary

Discussion Questions

Notes

References

Chapter 31.The Role of Government in Medical Care

Public-Interest Theory of Government

Economic Theory of Regulation

Political Markets Compared with Economic Markets

Summary

Discussion Questions

Note

References

Chapter 32.Health Associations and the Political Marketplace

The Role of Health Associations

The Five Types of Legislation Favored by Health Associations

Summary

Discussion Questions

Notes

References

Chapter 33.Medical Research, Medical Education, Alcohol Consumption, and Pollution: Who Should Pay?

External Costs and Benefits

Government Policies When Externalities Exist

Divergence Between Theoretical and Actual Government Policy

Summary

Discussion Questions

Notes

Additional Readings

References

Appendix: Inframarginal Externalities in Medical Education

Chapter 34.The Canadian Healthcare System

Comparing the Canadian System with the US System

Controlling Healthcare Costs in Canada

Consequences of Strict Limits on Per Capita Costs

Is Canada Abandoning Its Single-Payer System?

Should the United States Adopt the Canadian System?

Summary

Discussion Questions

Notes

References

Chapter 35.Employer-Mandated National Health Insurance

Why the Uninsured Do Not Have Health Insurance

Consequences of Employer-Mandated Health Insurance

Political Consequences of Employer-Mandated Health Insurance

Summary

Discussion Questions

Notes

Additional Reading

References

Chapter 36.National Health Insurance: Which Approach and Why?

Criteria for National Health Insurance

National Health Insurance Proposals

Fundamental Differences in Perspectives Regarding Government's Health Policy Role

Summary

Discussion Questions

Notes

Additional Readings

References

Chapter 37.Financing Long-Term Care

The Nature of Long-Term Care

Current State of Long-Term Care Financing

Why Do So Few Aged Buy Private Long-Term Care Insurance?

Approaches to Financing Long-Term Care

Summary

Discussion Questions

Notes

References

Chapter 38.The Affordable Care Act: Did It Achieve Its Goals?

Reducing the Number of Uninsured

Medicaid Eligibility Expansion

ACA-Mandated Benefits and Regulations

ACA's Employer Mandate

Small-Business Premium Tax Credit

ACA's Individual Mandate

Health Insurance Exchanges

Adverse Selection in the Health Insurance Exchanges

Consequences of the ACA Legislation on the Health Insurance Exchanges

Proposed Changes to the ACA to Further Reduce the Uninsured

Summary

Discussion Questions

Notes

References

Glossary

Index

About the Author

LIST OF EXHIBITS

PREFACE

Being an economist, I believe an economic approach is very useful, not only for understanding the forces pressing for change in healthcare, but also for explaining why the health system has evolved to its current state. Even the political issues surrounding the financing and delivery of health services can be better understood when viewed through an economic perspective—that is, the economic self-interest of participants.

For these reasons, I believe an issue-oriented book containing short discussions on each subject and using an economic perspective is needed. The economic perspective used throughout is that of a market economist—namely, one who believes markets (in which suppliers compete for customers on the basis of price and quality) are the most effective mechanisms for allocating resources. Of course, at times markets fail or lead to outcomes that are undesirable in terms of equity. Market economists generally believe that government economic interventions—no matter how well intentioned or carefully thought out—can neither replicate the efficiency with which markets allocate resources nor fully anticipate the behavioral responses of the economic agents affected by the intervention. In cases of market failure, market economists prefer solutions that fix the underlying problem while retaining basic market incentives rather than replacing the market altogether with government planning or provision.

Healthcare reform has been an ongoing process for decades. At times, legislation and regulation have brought about major changes in the financing and delivery of medical services. At other times, competitive forces have restructured the delivery system. Both legislative and market forces will continue to influence how the public pays for and receives its medical services. Any subject affecting the lives of so many and requiring such a large portion of our country's resources will continue to be a topic of debate, legislative change, and market restructuring. I hope this book will help to clarify some of the more significant issues underlying the politics and economics of healthcare.

Changes in the Seventh Edition

Many revisions and additions have been made in this seventh edition. The book consists of 38 chapters, a glossary, 116 exhibits, and extensive references lists. In addition to updating the exhibits (including several new exhibits) and adding recent references, the book has been revised (some sections rather extensively) and updated, using recent data, adding new research findings relevant to various sections, and including new sections in some chapters.

Three chapters have been added: chapter 30, Should Profits in Healthcare Be Prohibited?, chapter 32, Health Associations and the Political Marketplace, and chapter 38, The Affordable Care Act: Did It Achieve Its Goals?

The Affordable Care Act (ACA), the most significant health policy enacted in many years, affected all aspects of the healthcare financing and delivery system. Many people and institutions have been affected by this legislation, including physicians, hospitals, other healthcare providers, insurers, employers, employees, unions, the uninsured, and the states as well as the federal government. Any book on health policy must discuss the ACA.

The ACA, however, is so complex and its reach so extensive that it is impossible to cover it in one or two chapters. Instead, the ACA is discussed in those chapters in which particular aspects of the legislation are relevant. ACA policies and their implications are repeated in several chapters. The reason for this is twofold. First, instructors generally do not assign all 38 chapters to their students. Second, some chapters would be incomplete if particular aspects of the ACA were not included. For example, the ACA made important changes to the health insurance market and to Medicaid eligibility. Thus, these changes and their consequences are discussed in both chapter 7 and chapter 9.

The following chapters were significantly revised or include important new sections. The three new chapters for this seventh edition are also described below.

Chapter 10: How Does Medicare Pay Physicians?

Included in this chapter is a new section on MACRA (the Medicare Access and CHIP Reauthorization Act), which describes and analyzes the likely consequences of the new Medicare physician payment system starting in 2019.

Chapter 14: Physician Malpractice Reform

The emphasis in this chapter has been changed from a discussion of the recurrent malpractice crises and why malpractice premiums have risen to the objectives of the malpractice system, proposed reforms, and their likely effectiveness, including a new illustrative exhibit.

Chapter 23: Who Bears the Cost of Employee Health Benefits?

This chapter has been extensively revised and emphasizes how the costs of various mandates are shifted to employees.

Chapter 25: The High Price of Prescription Drugs

A new section is included that analyzes the shortage of generic drugs. It is surprising that the supply of generic drugs, inexpensive copies of drugs that have lost their patent protection, cannot be increased quickly when the demand for such drugs exceeds the available supply. The reasons for these recurrent shortages and appropriate public policies are discussed.

Chapter 30: Should Profits in Healthcare Be Prohibited?

This chapter is new. Many people have questioned the role of profits and the adverse incentive effects of making a profit in healthcare. The different definitions of profits used by accountants and economists are discussed, including when excess profits are beneficial to society, as well as appropriate government regulation when excess profits are generated by certain types of behavior. This chapter also examines why not-for-profit hospitals and insurers must earn a profit. Examples of the consequences of prohibiting profits are given, and the importance of profits in providing incentives for developing treatment and cost-reduction innovations is discussed.

Chapter 31: The Role of Government in Medical Care

A new section titled Political Markets Compared with Economic Markets discusses the similarities and differences between the two types of markets.

Chapter 32: Health Associations and the Political Marketplace

This new chapter discusses the types of legislation demanded by different health associations. Understanding the economic self-interest of association members and their policy preferences gives us insight into why the financing and delivery of medical services has evolved the way it has. Also discussed are the types of legislation and regulation favored (and opposed) by politically powerful health associations.

Chapter 33: Medical Research, Medical Education, Alcohol Consumption, and Pollution: Who Should Pay?

An appendix titled Inframarginal Externalities in Medical Education has been added to this chapter. The appendix describes the circumstances in which individuals receive sufficient private benefits from becoming physicians that medical education subsidies are unnecessary.

Chapter 35: Employer-Mandated National Health Insurance

In addition to various updates of exhibits, data, and commentary, this chapter includes a discussion of the ACA's employer mandate.

Chapter 38: The Affordable Care Act: Did It Achieve Its Goals?

This new chapter examines an important objective of the ACA: reducing the number of uninsured. The chapter elaborates on several ACA issues covered in other chapters and provides new materials and exhibits regarding the ACA's approaches for reducing the number of uninsured. Sufficient time has passed and data have become available to allow analyses of the effectiveness of these ACA approaches: Medicaid eligibility expansion, employer mandate, small-business tax credit, individual mandate, and subsidies within the health insurance exchanges. Suggested legislative changes are presented that could increase the number of insured. Bipartisan political support is essential to enacting legislation that expands insurance coverage.

Instructor Resources

This book's Instructor Resources include a test bank, PowerPoint slides, discussion points for the book's end-of-chapter discussion questions, additional questions and discussion points, teaching tips, chapter overviews, and a transition guide to the new edition. For the most up-to-date information about this book and its Instructor Resources, go to ache.org/HAP and browse for the book's title or author name. This book's Instructor Resources are available to instructors who adopt this book for use in their course. For access information, please email hapbooks@ache.org.

Acknowledgments

I thank Glenn Melnick, Thomas Wickizer, Jerry German, Jeff Hoch, and several anonymous reviewers for their comments. For this seventh edition, I also thank Elzbieta Kozlowski for all her assistance, particularly the collection of data and construction of the exhibits.

Paul J. Feldstein

Encinitas, California

CHAPTER

1

THE RISE OF MEDICAL EXPENDITURES

The rapid growth of medical expenditures since 1965 is as familiar as the increasing percentage of US gross domestic product (GDP) devoted to medical care. Less known are the reasons for this continual increase. The purpose of this introductory chapter is threefold: (1) to provide a historical perspective on the medical sector; (2) to explain the rise of medical expenditures in an economic context; and (3) to set forth criteria for evaluating the Patient Protection and Affordable Care Act (ACA), which has been the most significant healthcare legislation since Medicare and Medicaid.

Before Medicare and Medicaid

Until 1965, spending in the medical sector was predominantly private—80 percent of all expenditures were paid by individuals out of pocket or by private health insurance on their behalf. The remaining expenditures (20 percent) were paid by the federal government (8 percent) and the states (12 percent) (see exhibit 1.1). Personal medical expenditures totaled $35 billion and accounted for approximately 6 percent of GDP—that is, six cents of every dollar spent went to medical services.

Two important trends are the increasing role of government in financing medical services and the declining portion of expenditures paid out of pocket by the public. As shown in exhibit 1.1, the government paid 47.8 percent of total medical expenditures in 2016; the federal share was 38.6 percent and the states contributed 9.2 percent. Meanwhile, the private share dropped to 52.2 percent (from 79.5 percent in 1965); of that amount, 12.4 percent was paid out of pocket (from 52.4 percent in 1965).

The Greater Role of Government in Healthcare

Medicare and Medicaid were enacted in 1965, dramatically expanding the role of government in financing medical care. Medicare, which covers the aged, initially consisted of two of its current four parts—Part A and Part B. Part A is for hospital care and is financed by a separate (Medicare) payroll tax on the working population. Part B covers physicians’ services and is financed by federal taxes (currently 75 percent) and by a premium paid by the aged (25 percent). Medicare Part C and Part D have since been added. Part C is a managed care option, and Part D is a prescription drug benefit—financed 75 percent by the federal government and 25 percent by the aged. Parts B, C, and D are all voluntary programs.

Medicaid is for the categorically or medically needy, including the indigent aged and families with dependent children who receive cash assistance. Each state administers its own program, and the federal government pays, on average, more than half of the costs. The ACA, enacted in 2010 and implemented in 2014, expanded Medicaid eligibility from 100 to 138 percent of the federal poverty level (FPL). The federal government reimburses states that choose to expand Medicaid for up to 90 percent of their costs for the newly eligible enrollees.

The rapid increase in total national health expenditures (NHE) is illustrated in exhibit 1.2, which shows spending on the different components of medical services over time. Since 2000, NHE per capita has risen from $4,884 to $10,365. During this time frame, hospital care and physician and clinical services—the two largest components of medical expenditures—surged from $416 billion to $1.083 trillion and from $291 billion to $665 billion, respectively. These data indicate the enormous amount of US resources flowing into healthcare.

In 2016, $3.338 trillion (or 17.9 percent of GDP) was spent on medical care in the United States.¹ From 2000 to 2016, these expenditures climbed by about 9 percent per year. Since peaking in the early part of the decade, the annual rate of increase in NHE has been declining, although it remains above the rate of inflation. These expenditures continue to rise as a percentage of GDP.

The Relationship Between NHE and GDP

The growth in medical expenditures over time can be illustrated by comparing the rate of increase in NHE per capita to the rate of change in GDP per capita. (To show the relationship between the two series more clearly, a five-year moving average of the rates of change is used.) If NHE per capita is rising faster than GDP per capita, the former is becoming a larger share of GDP. If the two series are moving together, then changes in the economy and health spending are closely related. Exhibit 1.3 shows the relationship between the two series from 1965 to 2016.

The only major divergence between NHE per capita and GDP per capita began in the mid-1990s. Medical expenditures increased at a slower rate because of the growth of managed care (which emphasized utilization management) and price competition among providers participating in managed care provider networks. By the end of the 1990s, managed care's cost-containment approaches lost support because of public dissatisfaction with managed care's restrictions on access to specialists, lawsuits against managed care organizations (MCOs) for denial of care, government legislation, and a tight labor market that led employers to offer their employees more health plan choices. As a result, medical expenditures rose at a more rapid rate.

The decline in the annual NHE rate increase from about 2008 to 2013 (exhibit 1.3) can be attributed to the Great Recession, slow economic recovery, high unemployment levels, a large number of uninsured, a decrease in the number of employers paying for employee health insurance, and the rapid spread of high-deductible health plans (Fuchs 2013).

NHE is likely to rise at a slightly faster rate in the coming years as the economy continues to recover; more baby boomers become eligible for Medicare; new technology and specialty drugs that improve the quality of life (but are higher in cost) are developed; and increased demand occurs as a result of the ACA's Medicaid eligibility expansion and subsidies for low-income enrollees on health insurance exchanges.

By 2025, federal, state, and local governments are expected to increase their share of total NHE, which is expected to reach $2.6 trillion (almost doubling from $1.5 trillion in 2016) and to consume an even greater portion of GDP (19.9 percent) (Centers for Medicare & Medicaid Services 2017c, table 16). Exhibit 1.4 shows where healthcare dollars come from and how they are distributed among different types of healthcare providers.

Changing Patient and Provider Incentives

Medical expenditures equal the prices of services provided multiplied by the quantity of services provided. The rise of expenditures can be explained by looking at the factors that prompt medical prices and quantities to change. In a market system, the prices and output of goods and services are determined by the interaction of buyers (the demand side) and sellers (the supply side). We can analyze price and output changes by examining how various interventions change the behavior of buyers and sellers. One such intervention was Medicare, which lowered the out-of-pocket price the aged had to pay for medical care. The demand for hospital and physician services went up dramatically after Medicare was enacted, spurring rapid price increases. Similarly, government payments on behalf of the poor under Medicaid stimulated demand for medical services among this population. Greater demand for services multiplied by higher prices for those services equals greater total expenditures.

Prices also go up when the costs of providing services increase. For example, to attract more nurses to care for the higher number of aged patients, hospitals raised nurses’ wages and then passed this increase on to payers in the form of more expensive services. Increased demand for care multiplied by higher costs of care equals greater expenditures.

While the government was subsidizing the demands of the aged and the poor, the demand for medical services by the employed population also was increasing. The growth of private health insurance during the late 1960s and 1970s was stimulated by income growth, high marginal (federal) income tax rates (up to 70 percent), and the high inflation rate in the economy. The high inflation rate threatened to push many people into higher marginal tax brackets. If an employee were pushed into a 50 percent marginal income tax bracket, half of his salary in that bracket would go to taxes. Instead of having that additional income taxed at 50 percent, employees often chose to have the employer spend those same dollars, before tax, on more comprehensive health insurance. Thus, employees could receive the full value of their raise, albeit in healthcare benefits. This tax subsidy for employer-paid health insurance stimulated the demand for medical services in the private sector and further boosted medical prices.

Demand increased most rapidly for medical services covered by government and private health insurance. As of 2016, only 3 percent of hospital care and 8.9 percent of physician services were paid out of pocket by the patient; the remainder was paid by a third party (Centers for Medicare & Medicaid Services 2017b). Patients had little incentive to be concerned about the price of a service when they were not responsible for paying a significant portion of the price. As the out-of-pocket price declined, the use of services increased.

The aged—who represent almost 16 percent of the population and use more medical services than any other age group—accounted for 35.4 percent of all hospital stays as of 2015 (Agency for Healthcare Research and Quality 2017). Use of physician services by the aged (Medicare), the poor (Medicaid), and those covered by tax-exempt employer-paid insurance also increased as patients became less concerned about the cost of their care. Historically, advances in medical technology have been another factor stimulating the demand for medical treatment. New methods of diagnosis and treatment were developed; those with previously untreatable diseases gained access to technology that offered the hope of recovery. New medical devices (e.g., imaging equipment) were introduced, and new treatments (e.g., organ transplantations) became available. New diseases (e.g., AIDS) also increased demand on the medical system. Reduced out-of-pocket costs and increased third-party payments (both public and private)—in addition to an aging population, new technologies, and new diseases—drove up prices and the quantity of medical services provided.

Providers (hospitals and physicians) responded to the increased demand for care, but the way they responded unnecessarily increased the cost of providing medical services. After Medicare was enacted, hospitals had few incentives to be efficient because Medicare reimbursed hospitals their costs plus 2 percent for serving Medicare patients. Hospitals, predominantly not-for-profit, consequently expanded their capacity, invested in the latest technology, and duplicated facilities and services offered by nearby hospitals. Hospital prices rose faster than the prices of any other medical service.

Similarly, physicians had little cause for concern over hospital costs. Physicians, who were paid on a fee-for-service basis, wanted their hospitals to have the latest equipment so they would not have to refer patients elsewhere (and possibly lose them). They would hospitalize patients for diagnostic workups and keep them in the hospital longer than necessary because it was less costly for patients covered by hospital insurance, and physicians would be sure to receive reimbursement. Outpatient services, which were less costly than hospital care, initially were not covered by third-party payers.

In addition to the lack of incentives for patients to be concerned with the cost of their care and the similar lack of incentives for providers to supply that care efficiently, the federal government imposed restrictions on the delivery of services that increased enrollees’ medical costs. Under Medicare and Medicaid, the government ruled that insurers must give enrollees free choice of provider. Insurers such as health maintenance organizations (HMOs) that precluded enrollees from choosing any physician in the community were violating the free choice of provider rule and, thus, were ineligible to receive capitation payments from the government. Instead, HMOs were paid fee-for-service, reducing their incentive to reduce the total costs of treating a patient. Numerous state restrictions on HMOs, such as prohibiting them from advertising, requiring HMOs to be not-for-profit (thereby limiting their access to capital), and requiring HMOs to be controlled by physicians, further inhibited their development. By imposing these restrictions on alternative delivery systems, however, the government reduced competition for Medicare and Medicaid patients, forgoing an opportunity to reduce government payments for Medicare and Medicaid services.

The effects of higher demand, limited patient and provider incentives to search for lower-cost approaches, and restrictions on the delivery of medical services were escalating prices, increasing use of services, and resulting in greater medical expenditures.

Government Response to Rising Costs

As expenditures under Medicare and Medicaid increased, the federal government faced limited options: (1) raise the Medicare payroll tax and income taxes on the working population to continue funding these programs; (2) require the aged to pay higher premiums for Medicare, and increase their deductibles and copayments; or (3) reduce payments to hospitals and physicians. Each of these approaches would cost successive administrations and Congress political support from some constituents, such as employees, the aged, and healthcare providers. The least politically costly options appeared to be number 1 (increase taxes on employees) and number 3 (reduce payments to hospitals and physicians). The aged have the highest voting participation rate of any age group, as well as the political support of their children, who are relieved of the financial responsibility to pay their parents’ medical expenses.

Federal and state governments used additional regulatory approaches to control these rapidly rising expenditures. Medicare utilization review programs were instituted, and controls were placed on hospital investments in new facilities and equipment. These government controls proved ineffective as hospital expenditures continued to escalate through the 1970s. The federal government then limited physician fee increases under Medicare and Medicaid; as a consequence, many physicians refused to participate in these programs, reducing access to care for the aged and the poor. As a result of providers’ refusal to participate in Medicare, many Medicare patients had to pay higher out-of-pocket fees to be seen by physicians.

In 1979, President Carter's highest domestic priority was to enact limits on Medicare hospital cost increases; a Congress controlled by his own political party defeated him.

The 1980s

By the beginning of the 1980s, political consensus was lacking on what should be done to control Medicare hospital and physician expenditures, and private health expenditures also continued to rise. By the mid-1980s, however, legislative changes and other events imposed heavy cost-containment pressures on Medicare, Medicaid, and the private sector.

Legislative and Government Changes

President Nixon wanted a health program that would not increase federal expenditures. The result was the Health Maintenance Organization Act of 1973, which legitimized HMOs and removed restrictive state laws impeding the development of federally approved HMOs. However, many HMOs decided not to seek federal qualification because imposed restrictions, such as having to offer more costly benefits, would have caused their premiums to be too high to be competitive with traditional health insurers’ premiums. These restrictions were removed by the late 1970s, and the growth of HMOs began in the early 1980s.

To achieve savings in Medicaid, the Reagan Administration removed the free-choice-of-provider rule in 1981, enabling states to enroll their Medicaid populations in closed provider panels. As a result, states were permitted to negotiate capitation payments with HMOs for care of Medicaid patients. The free choice rule continued for the aged; however, in the mid-1980s, Medicare patients were permitted to voluntarily join HMOs. The federal government agreed to pay HMOs a capitated amount for enrolling Medicare patients, but less than 10 percent of the aged voluntarily participated. (As of 2016, 34 percent of the 48 million aged were enrolled in Medicare HMOs, referred to as Medicare Advantage plans [Centers for Medicare & Medicaid Services 2017a].²)

Federal subsidies were provided to medical schools in 1964 to increase the number of students they could accommodate, and the supply of physicians expanded. The number of active physicians grew from 146 per 100,000 civilian population in 1965 to 195 per 100,000 in 1980; it reached 233 per 100,000 by 1990 and 321 per 100,000 in 2013 (American Medical Association 1991, 2015). The greater supply created excess capacity among physicians, dampened their fee hikes, and made attracting physicians—and therefore expanding—easier for HMOs.

A new Medicare hospital payment system was phased in during 1983. Under the new system, hospitals were no longer to be paid according to their costs. Fixed prices were established for each diagnostic admission (referred to as diagnosis-related groups [DRGs]), and each year Congress set an annual limit on the amount by which these fixed prices per admission could increase. DRG prices changed hospitals’ incentives. Because hospitals could keep the difference if the costs they incurred from an admission were less than the fixed DRG payment they received for that admission, they were motivated to reduce the cost of caring for Medicare patients and to discharge them earlier. Length of stay per admission fell, and occupancy rates declined. Hospitals also became concerned about inefficient physician practice behaviors that increased the hospitals’ costs of care.

In addition, in 1992 the federal government changed its method of paying physicians under Medicare. A national fee schedule (referred to as resource-based relative value system [RBRVS]) was implemented, and volume expenditure limits were established to cap the total rate of increase in physician Medicare payments. The RBRVS also prohibited physicians from charging their higher-income patients a higher fee and accepting the Medicare fee only for lower-income patients; they had to accept the fee for all or none of their Medicare patients. Medicare patients represent such a significant portion of a physician's practice that few physicians decided not to participate; consequently, they accepted Medicare fees for all patients.

To contain increases in Medicare expenditures during this period, the federal government imposed price controls and expenditure limits on hospital and physician payments for services provided to Medicare patients.

Private Sector Changes

In addition to the government policy changes of the early 1980s, important events were occurring in the private sector. The new decade started with a recession. To survive the recession and remain competitive internationally, the business sector looked to reduce labor costs. Because employer-paid health insurance was the fastest-growing labor expense, businesses pressured health insurers to better control the use and cost of medical services. Competitive pressures forced insurers to increase the efficiency of their benefit packages by including lower-cost substitutes for inpatient care, such as outpatient surgery. They raised deductibles and copayments, intensifying patients’ price sensitivity. Patients had to receive prior authorization from their insurer before being admitted to a hospital, and insurers reviewed patients’ length of stay while patients were in the hospital. These actions greatly reduced hospital admission rates and lengths of stay. In 1975, the number of admissions in community hospitals was 155 per 1,000 population. By 1990, it had fallen to 125 per 1,000 and continued to decline thereafter, dropping to 104 per 1,000 in 2015. The number of inpatient days per 1,000 population declined even more dramatically—from 1,302 in 1977 to 982 in 1990 to 565 in 2015 (American Hospital Association 2017).

Because of the implementation of the DRG payment system, the changes to private programs, and a shift to the outpatient sector facilitated by technological change (both anesthetic and surgical techniques), hospital occupancy rates decreased from 76 percent in 1980 to 63.5 percent in 2015 (American Hospital Association 2017).

Antitrust Laws

The preconditions for price competition were in place: Hospitals and physicians had excess capacity, and employers wanted to pay less for employee health insurance. The last necessary condition for price competition occurred in 1982, when the US Supreme Court upheld the applicability of antitrust laws to the medical sector. Successful antitrust cases were brought against the American Medical Association for its restrictions on advertising; against a medical society that threatened to boycott an insurer over physician fee increases; against a dental organization that boycotted an insurer's cost-containment program; against medical staffs that denied hospital privileges to physicians because they belonged to an HMO; and against hospitals whose mergers threatened to reduce price competition in their communities.

The applicability of antitrust laws, excess capacity among providers, and employer and insurer interest in lowering medical costs brought about profound changes in the medical marketplace. Traditional insurance plans lost market share as managed care plans, which controlled utilization and limited access to hospitals and physicians, grew. Preferred provider organizations (PPOs) were formed and included only physicians and hospitals willing to discount their prices. Employees and their families were offered price incentives in the form of lower out-of-pocket payments to use these less expensive providers. Large employers and health insurers began to select PPOs on the basis of their prices, use of services, and treatment outcomes.

Consequences of the 1980s Changes

The 1980s disrupted the traditional physician–patient relationship. Insurers and HMOs used utilization review to control patient demand, emphasize outcomes and appropriateness of care, and limit patients’ access to higher-priced physicians and hospitals by not including them in their provider networks. They also used case management for catastrophic illnesses, substituted less expensive settings for costlier inpatient care, and influenced patients’ choice of drugs through the use of formularies.

The use of cost-containment programs and the shift to outpatient care lowered hospital occupancy rates. The increasing supply of physicians—particularly specialists—created excess capacity. Hospitals in financial trouble closed, and others merged. Hospital consolidation increased. Hospitals’ excess capacity was not reduced until years later when the demand for care began to exceed the available supply of hospitals and physicians. Until then, hospitals and physicians continued to be subject to intense competitive pressures.

Employees’ incentive to reduce their insurance premiums also stimulated competition among HMOs and insurers. Employers required employees to pay the additional cost of more expensive health plans, so many employees chose the lowest-priced plan. Health insurance companies competed for enrollees primarily by offering lower premiums and provider networks with better reputations.

The 1990s

As managed care spread throughout the United States during the 1990s, the rate of increase in medical expenditures declined (see exhibit 1.3). Hospital use decreased dramatically, and hospitals and physicians agreed to large price discounts to be included in an insurer's provider panel. These cost-containment approaches contributed to the lower annual rate of increase. However, although price competition reduced medical costs, patients were dissatisfied. The public wanted greater access to care, particularly less restriction on referrals to specialists. Public backlash against HMOs emerged. HMOs lost several lawsuits for denying access to experimental treatments, and Congress and the states imposed restrictions on MCOs, such as mandating minimum lengths of hospital stays for normal deliveries. Consequently, cost-containment restrictions weakened, and increases in prices, use of services, and medical expenditures reaccelerated.

The 2000s

The excess capacity that weakened hospitals in their negotiations with insurers dried up during the 2000s. Financially weak hospitals had closed. Because consolidation reduces the number of competitors in an area, the number of hospital mergers—which enhance bargaining power—increased. As hospital prices rose, so did insurance premiums. Previous approaches, such as decreased hospital use and price discounts, could no longer achieve large cost reductions. Instead, insurers tried to develop more innovative, less costly ways of managing patient care.

Newer approaches to cost containment included high-deductible health plans, reliance on evidence-based medicine, and chronic disease management. Insurers’ method of shifting a larger share of medical costs to consumers is referred to as consumer-driven healthcare. In return for lower health insurance premiums, consumers pay higher deductibles and copayments. Consumers then presumably evaluate the costs and benefits of spending their own funds on healthcare. Another approach to lowering medical costs is to use evidence-based medicine, which relies on scientific evidence and analysis of large data sets to determine the effect of different physician practice patterns on costs and medical outcomes. Other insurers emphasize disease management to provide chronically ill patients, who incur the most medical expenditures, with preventive and continuous care. This approach not only improves the quality of care but reduces costly hospitalizations.

Pay-for-performance programs also have been developed to lower costs and improve care. Insurers pay higher amounts to physicians and other healthcare providers if they provide high-quality care, which is usually defined on the basis of process measures developed by medical experts. Insurers also make report cards available to their enrollees. Report cards are a means of describing hospitals and medical groups in the insurer's provider network according to medical outcomes, preventive services, and patient satisfaction scores to enable enrollees to make informed choices about the providers they use.

In the latter half of the decade, rising premiums and increased unemployment (resulting from the Great Recession) prompted people to drop their health insurance or switch to plans that charged lower premiums, such as high-deductible plans. Many Americans became concerned that premiums would continue increasing, making insurance even less affordable. The recession, a decrease in the number of insured, and the switch to high-deductible health plans slowed rising healthcare expenditures (see exhibit 1.3).

In 2015, Congress again revised Medicare payments to physicians with passage of The Medicare Access and CHIP Reauthorization Act (MACRA). The law's provisions are being phased in and will become fully effective for all physicians by 2019. MACRA is the most substantive change in physician reimbursement since Medicare was enacted. Congress had previously been reluctant to enforce the accumulated sustainable growth rate (SGR) cuts, which would have reduced Medicare payments to physicians. The SGR formula was eliminated with passage of MACRA. The new law attempts to change physician incentives by moving payments away from fee-for-service toward financial accountability for the care they provide. Another objective of MACRA is to move physicians into alternative payment systems that require them to bear financial risk. (MACRA is discussed more completely in chapter 10.)

It is too early to judge how physicians will adjust to the new Medicare payment system, which requires them to submit a great deal of data. This requirement may force many physicians to decide to become employees of hospitals and insurers.

The Affordable Care Act

The most significant health policy event of the current decade was the 2010 enactment and 2014 implementation of the ACA. Although implementation was fraught with website and enrollment problems, the legislation, which did not receive bipartisan support and has proved to be controversial, has led to important changes in the financing and delivery of medical services. Sufficient time has elapsed to examine the extent to which the ACA has achieved its stated objectives. Consequently, it should be judged according to three criteria.

The first criterion is whether it reduced the number of uninsured, presumably the major goal of the legislation. Before the ACA was enacted, about 50 million Americans did not have health insurance. Several approaches were used to decrease the number of uninsured. The ACA expanded Medicaid eligibility from 100 to 138 percent of the FPL. (However, not all states chose to expand their Medicaid eligibility levels.) Federal and state health insurance exchanges were established, primarily for those who purchase insurance in the individual market. In addition, premium tax credits and cost-sharing subsidies were provided on a declining scale to those with incomes between 138 and 400 percent of the FPL. The legislation included an individual mandate that required everyone to buy insurance or pay a penalty. An employer mandate was imposed that required employers to offer health insurance to their employees or pay a penalty of $2,000 per employee. Small employers (those with fewer than 50 full-time employees) were exempted from this mandate and, instead, were offered a tax credit for providing health insurance to their employees.

In 2010, when the ACA was enacted, the Congressional Budget Office estimated that these steps to increase insurance coverage, expand Medicaid, provide health insurance exchange subsidies, include individual and employer mandates, and provide tax credits for small employers would increase the number of insured by 23 million, leaving 21 million Americans uninsured by 2016. By 2016, however, only 16 million people gained insurance, leaving 28 million uninsured (Congressional Budget Office 2017, 9).

The second criterion relates to cost. The Obama administration and Congressional Democrats expected the ACA to increase the demand for health insurance and, consequently, the demand for medical services without raising the costs of care. In fact, the ACA was expected to bend the cost curve down, decrease premiums by $2,500 a year for a family of four, and not add a dime to the deficit. These promises were made by President Obama in promoting the legislation's benefits to the middle class. The Congressional Budget Office initially calculated the projected cost over a ten-year period and estimated that it would be budget neutral for this period. Budget neutrality was to be achieved by increasing ACA taxes for the entire ten-year period but delaying spending for several years (from 2010 to 2014). Whether the ACA succeeds in reducing the rate of increase in medical expenditures, reducing family premiums, and achieving budget neutrality at the end of the decade will determine if it has met this second objective.³

The third criterion is whether people who already had insurance were able to keep the coverage they had, as President Obama promised. He stated numerous times, If you like your healthcare plan, you can keep your healthcare plan and if you like your doctor, you can keep your doctor. What made these promises doubtful was that the ACA made numerous changes to the health insurance market, such as mandating essential (i.e., more comprehensive) health benefits, requiring a smaller difference in premiums between older and younger individuals on the health insurance exchanges, establishing gender equality in premium ratings, and initiating a new health insurance tax on premiums for those buying insurance on the