Controlling Health Care Costs when Government Pays

Government, as a purchaser of health care, has sought ways to control health care costs. One of the more effective approaches that helped bring Medicare costs down was the prospective payment system (PPS). Instead of paying hospitals for the services that they provide, under PPS, the government pays them per case. Medicare began offering a fixed payment for each patient admitted to a hospital based on a diagnosis related group (DRG) that the patient was assigned to.

Offering a fixed payment per patient has both advantages and disadvantages. A big advantage is that it offsets the incentive of doctors to provide additional services to patients when the marginal benefit is below the marginal cost. When the government or insurance companies pay doctors and hospitals for the services they provide, patients will usually agree to additional treatment recommended by their doctors, even if it is not cost effective. Many patients would not agree to additional treatment if they had to pay out of pocket. The prospective payment system has been quite effective at reducing the average length of hospital stays without any evident decline in the health of those treated.

One problem with paying a fixed payment for each case is that it fails to account for differences between patients within each treatment category. Each patient will receive the treatment that the government deems necessary for the average patient with a given health problem. Some patients may need more than the average while others need less. Offering a fixed payment also reduces the incentive of hospitals to compete on quality. Hospitals will have an incentive to pursue quality improvements that are accounted for by the government’s payment formula (such as changes that hasten patients’ rate of recovery). If they cannot charge the extra cost of a quality improvement to the government or an insurance company, hospitals will only pursue it if patients are willing to pay extra for it out-of-pocket.

When government or insurance companies pay for health care and limit their payments via a PPS system, covered patients need not get too few health services or inferior quality services provided they have the freedom to choose their doctor or hospital and to pay whatever PPS does not pay. In this case, patients could pay extra out-of pocket to get extra services or superior quality care if they value either more than the additional cost. By contrast, government payment will lead to some patients getting more health care or higher quality than they are willing to pay for. As long as a third party pays most of the cost of a procedure, some people will consume more health care than is consistent with their preferences. Although paternalistic arguments can be made for this approach, government lacks the information to account for all the factors that might justify giving priority to some patients over others in using scarce health care resources.

It is a good thing when government takes steps to limit health care costs as they have done with the PPS system, as long as patients are permitted to pay extra to consume more than the limited quantity or quality of service covered by the insurance or government program. There is, however, a fundamental problem with this approach, which is part of the reason why Medicare costs continue to rise so fast that Medicare appears to be financially unsustainable.

No matter how carefully a hospital is at diagnosing a patient when he is first admitted, hospitals often do not know ahead of time what sequence of treatments will be most effective for each particular patient. As a result, Medicare allows retrospective cost sharing based on treatment decisions hospitals make long after the initial diagnosis. It is often unclear whether a certain treatment is appropriate for a given patient. The more that Medicare allows retrospective cost sharing the greater the incentive of hospitals to err on the side of more intensive and costly treatment. As technology improves, hospitals also have an incentive to use more expensive treatments, if they can get reimbursed for the additional cost, regardless of how large or small the marginal benefit actually is.

Lacking a profitability constraint or even much of a budget constraint, government Medicare adminstrators have inadequate incentives to compare the marginal benefits of a more intensive treatment regimen with the marginal costs.

By contrast, if patients or their families were the ones paying for the treatment, they would have an incentive to make treatment decisions based on a comparison of anticipated marginal benefits with marginal costs. This would provide a much more powerful incentive to control costs than PPS provides, as it is currently administered by the government. The best way to control the costs of medical care for the elderly is to have patients and their families bear a greater share of the costs of medical care, since they are the ones most likely to make choices that will promote a cost efficient level of treatment.