Tom: The proliferation of health maintenance organizations as a result of the HMO Act of 1973 was an attempt to reverse the upward trend in inpatient utilization that began with the introduction of Medicare and Medicaid in 1965. The concept of “managed competition” attempted to organize the market – both buyers and sellers – into groups with the assumption that classic economic principles like price-elastic demand and the consumer’s ability to understand quality and assess value applied to health care. HMOs combined the functions of insurance and health care provision into one entity. Some HMOs employed their physicians while others paid doctors based on a discounted fee-for-service schedule. A new payment methodology known as capitation gave physician groups a prospective budget per enrollee; if the physicians managed to hold total patient costs below the capitated budget, they kept the difference. At the outset, capitation was limited to physician services – initially primary care services, but later to include specialist physician services. In some instances, HMOs expanded the scope of the capitation to include hospital services. When capitation emerged in southern California and several other geographic areas, many assumed that the practice would spread nationally, creating an intense interest in the ownership of primary care practices in anticipation of controlling large portions of health care spending.
Tom: Ralph, why do you think that capitation, once thought to be headed for wide adoption nationally, never replaced fee-for-service as the dominant payment methodology?
Ralph: Outside of California and a handful of other markets, the limitations placed by HMOs on choice of provider proved too restrictive for most consumers. Patients were unwilling to disrupt physician relationships, even in exchange for increased benefits. Eventually it became clear that HMO penetration had stalled and with it, the potential for capitation to gain traction. Insurers introduced preferred provider organizations (PPOs) with broader networks and fewer restrictions on patient choice. With an increasing share of the spend occurring outside of a tightly controlled provider network, capitation proved to be impractical, and the prevailing method of payment remained discounted fee-for-service. There was renewed enthusiasm for managed care in the Clinton health care plan during the 1990s, once again leaning on managed competition and its underlying economic assumptions. Throughout the 1980s and 1990s, managed care plans had their biggest impacts negotiating lower unit prices with providers. Those negotiations were in turn aided by the assumption by providers that demand was price-elastic; when physicians and hospitals realized that managed care plans could not move market share to the extent once feared, bargaining power shifted back toward providers.
Tom: In retrospect, owning primary care practices was more economically complicated than it may have seemed; what “caveat emptor” lessons emerged?
Ralph: Those who invested heavily in primary care practices quickly realized that costs rose significantly when the infrastructure of a large organization was overlayed on what had been small businesses with minimal administrative overhead. When PCPs were no longer owning their own practices, productivity often dropped sharply. By the late 1990s, with capitation never having made a significant dent in fee-for-service payments, health systems realized that ownership of PCP practices did not guarantee success in attracting an incremental market share. Rather than gaining share, many health systems were heavily subsidizing PCP practices to retain what they already had. The subsidies needed to keep primary care practices solvent were considerable. In 1998, MedPartners, one of the two leading publicly traded firms specializing in PCP acquisition and management, was incurring heavy losses and divested its practice management activities, eventually rebranding as Caremark Rx – today one of the leading pharmacy benefit managers (PBMs). By 2002, Phycor, the other leading PCP firm, filed for bankruptcy, ending that period of PCP practice management.
Tom: As a hospital CEO, you were on both sides of the PCP acquisition scale; at Chicago, you were quite conservative, and at Penn, you inherited an organization that had encountered serious financial difficulty as a result of having been far more aggressive. What did you take from both experiences?
Ralph: The hospitals that fared best during those years were those that did not panic. Some recognized that patient loyalty to physicians and hospitals was stronger than managed care companies assumed, and that consumers inherently distrusted insurers. They resisted insurer demands for unprofitable pricing and focused instead on improving access and creating a more distributed model for patients, with a particular emphasis on multi-specialty ambulatory care. Hospitals with strong local brands were occasionally excluded from early insurer networks, but the exclusions were short-lived. Insurers struggled to remain competitive with highly restrictive networks and responded by contracting more broadly.
Hospitals that invested conservatively in PCP practices fared better financially than those that became highly leveraged in primary care. A considerable number of large hospitals and newly forming health systems – including Penn – incurred enormous financial losses stemming from aggressive PCP acquisition strategies. For those who moved more deliberately, scarce capital remained available to battle the federal funding cutbacks associated with the Balanced Budget Act of 1997. In the end, many of the PCP practices purchased at the height of the M&A cycle were eventually sold back to the physicians at considerable discounts, or in many cases were simply given back to the original owners.
Tom: If there is a takeaway for today’s world, it might be that the value of primary care practices is not what it was assumed to be 30-40 years ago. Back then, the belief was that PCPs were essential to amass “covered lives”. That was an expensive experiment. Over the last 15 years health systems consolidated, often in response to payer consolidation and in an effort by providers to retain bargaining leverage. Those efforts have been largely successful in preventing unit prices from falling as payers grew increasingly powerful. Looking forward, primary care practices represent an opportunity for health systems to more effectively manage longitudinal episodes of chronic illness. Having a clearer view of the underlying value of the practices will help calibrate the economics more effectively than what occurred in the 1980s.
2. We can reduce costs by aligning payer, hospital, and physician incentives.
Ralph: Aligning payer and provider incentives centers around reducing avoidable utilization and sharing the resulting savings in a way that all partners are better off economically than they were before the intervention. Tom, I remember your research early on cautioning that shared savings programs were not as straight-forward as they were being portrayed. What were some of the issues?
Tom: Savings to payers arising from avoided utilization are direct. The impact on providers is more complicated, and it centers around fixed costs. For hospitals, where fixed costs are approximately 50% of net revenue, the arithmetic does not work unless the provider share of savings exceeds 50% or if a subset of providers share in savings that accrue from lower utilization of other providers. Very few if any incentive programs allocate over half of the savings to providers. As a result, hospitals rarely recover foregone revenue profitably in the form of shared savings. Physician practices, with lower proportions of fixed costs, might have breakeven points slightly below a 50% share of savings, but not materially so. Given the cost structure of health care providers, at least 50% of savings arising from reduced utilization are required to create any financial incentive.
Ralph: So how did those factors come into play with the Affordable Care Act (ACA) and accountable care organizations (ACOs)?
Tom: Provider groups were encouraged to reduce the costs of an attributed population in exchange for a share of the resulting savings. Specifically, if an ACO reduced the expected spend of its attributed population by 4%, it would receive a 2% incentive bonus. The population to be measured was attributed to a health system based on historic utilization; they were already patients of those providers. As a result, any savings came at the expense of ACO provider revenue. The opportunity to recover 50% of that foregone revenue provided virtually no upside potential for the providers. The infrastructure required to establish and manage an ACO and the associated administrative costs were substantial. Over the years since the passage of the ACA, there has been negligible evidence of any material impact on overall health care spending, and the majority of early adopter ACOs have terminated their participation.
Tom: The high fixed costs in health care have created something of a “Catch-22” problem for anyone hoping to align incentives. The opportunity to share 50% of savings creates a virtually perfect point of economic indifference for providers, especially hospitals. For payers to share much more than 50% of savings with providers, unprecedented utilization reductions would be required for the payers to realize material net gains. What have you seen that does work in aligning payer and provider incentives?
Ralph: What has worked well is a more transactional alignment of incentives in the form of bundled prices. The concept was initially adopted for organ transplants and cardiovascular surgery over 30 years ago, then bundled prices were extended to major orthopedic procedures like joint replacements more recently. The mechanism draws its name from the bundling of services (typically before and after surgery) into longitudinal episode prices. Bundled prices create provider accountability for the efficiency of the procedure itself, for complications and readmissions, and for the utilization of post-acute resources such as rehabilitation facilities, and for skilled nursing care whether in a facility or at home. Allowing resources to be used for post-acute care, all the way to the home, is an important benefit of the payment mechanism. Of all efforts to align payer and provider incentives, bundled prices have the best measurable track record.
3. We should all be like Kaiser Permanente and vertically integrate.
Tom: I remember when I came into academic medicine back in 1994 after having been CEO of several HMOs, I discovered academic medical centers enthusiastically investing in their own health plans. When asked what I thought of the idea, I ruffled more than a few feathers by saying that I thought it was a particularly bad idea in general. Do you recall what the atmosphere was like back then, Ralph?
Ralph: During the first half of the 1990s, there was a prevailing belief by hospitals that they could dislodge insurers from the market by creating their own insurance vehicles and contracting directly with employers. The belief at the time was that by taking on the insurance risk directly from employers, hospitals could avoid the need for negotiating prices with insurers and eliminate a layer of overhead and insurer profit. The model many health care providers hoped to emulate was Kaiser Permanente. Since Kaiser had successfully achieved the vertical integration between insurer and provider, it naturally followed that other large health care providers should be able to do so as well.
Tom: That’s just when I made the transition from insurer to strategist for academic medicine. Between 1990 and 1995, there was significant growth in the number of provider-owned insurance products that competed head-to-head with large commercial insurers. Many of those efforts had worse than hoped for results. What do you think went wrong?
Ralph: It’s worth noting that Kaiser did not acquire an insurance arm, it was created as one. If anything, Kaiser was an insurance vehicle that acquired providers, not the other way around. It is also important to remember that Kaiser has been repeatedly unsuccessful in exporting its fully integrated business model to other parts of the country. A significant number of second- or third-generation Californians were born into the Kaiser system, creating a stable foundation of committed consumers. For many Californians, Kaiser is part of the landscape. It’s conceivable that if it wasn’t already a dominant force in the market, creating Kaiser today may not be possible.
Tom: At a time when huge insurance companies like Prudential, Metropolitan Life, John Hancock, and Travelers were divesting their medical lines of business to focus on less volatile property and casualty products, hospitals and health systems were entering a market that was already in the process of imploding. In addition to absorbing the financial losses arising from the inherent randomness that comes with small beneficiary pools, health care providers were unwittingly the victims of their own brand equity. A concept well-known to actuaries and insurance executives but not intuitively obvious to hospital executives at the time is selection bias. The stronger the brand of the parent medical center, the sicker the enrollees will be who choose its insurance product. An insurer that attracts a disproportionately infirm roster of beneficiaries has no hope of managing its way out of the problem. Premiums are based on average costs. If the health system’s insurance product experienced selection bias, its fate was sealed. Throughout the 1990s, provider-owned health plans lost hundreds of millions of dollars, not an insignificant portion of which resulted from the strength of their brands as providers.
Tom: In recent years, there have been more than a few examples of successful provider-owned health plans, but those successes have more often occurred in managed Medicare or Medicaid. Why the recent success in the public sector when there was such bad experience in the older private sector plans?
Ralph: There are significant differences between public and private sector insurance plans. With Medicaid, having a managed care plan improves cash flow by providing payments prospectively rather than lagging the provision of care by months or even a year or more. In both managed Medicaid and Medicare Advantage plans, the default price with other providers is traditional Medicaid or Medicare prices; in the private sector, provider-owned insurance plans were exposed to much higher variation in prices when care was provided by someone else. Medicare Advantage plans have attracted younger beneficiaries with favorable risk profiles, which has led to recent calls for premiums paid by CMS to be reduced. That contrasts with the adverse selection that provider-owned plans experienced in the 1990s. With few exceptions, hospitals and health systems that refrained from either launching their own commercial insurance products or partnering with insurers to market co-branded private sector offerings fared considerably better financially than those that did. Scarce capital was conserved for investment in clinical program development, improved access, and broader geographic reach for low-acuity services.
4. Bigger is always better.
Tom: We’re both old enough to remember when almost all hospitals were independent. There was a time when mergers and acquisitions in health care were big news events. Then it became so common that it was more surprising when any significant time went by without a merger being announced. What tipped over the dominoes, and have we seen the results that we thought we would?
Ralph: Partly in response to consolidation among insurers, which created pressure on a health system’s bargaining clout, and partly in an effort to solidify referral patterns and secure market share, hospitals undertook horizontal integration strategies involving mergers and acquisition among historic competitors. It was assumed that the resulting systems would realize economies of scale as a function of spreading fixed costs over a larger base. While bargaining clout with payers increased, there has been little evidence of transformative cost reductions, and when mergers involve disparate geographies with no contiguous service areas, there is little chance for care coordination, program rationalization, or referral capture.
The realization of material economies of scale has been more elusive than the achievement of incremental bargaining clout. One explanation for the difficulty might be the nature of health systems themselves. Fixed costs represent roughly half of total expenses, and community leaders are reticent toward closing facilities, so a large portion of potential savings – those that come from consolidation – are difficult to realize. Compounding the reluctance by systems to consolidate redundant clinical programs was the addition of expensive system level corporate overhead. Health system formation resulted in the elimination of some redundant lower paying jobs while adding much higher paying executive roles at the corporate level.
Tom: What has been your philosophy with respect to the “bigger is better” proposition?
Ralph: Our belief was always that you needed sufficient scale to support complex clinical programs and to be big enough to be excellent, but we did not pursue size for size’s sake. It’s also more difficult to manage an organization that grows inorganically. Cultural differences, people coming to the new entity with vastly different expectations, these all make it challenging to keep your eye on excellence. And if you are always merging, these distractions never subside – in fact, they get worse.
Tom: A hidden cost of growing a health system is the increase in clinical variation across the sites of care. Our research found greater variation in clinical practice within health systems than exists between health systems. More pointedly, intra-system variation increased with the size of the organization. As hospitals and physicians are added to a system, unless steps are taken to standardize care processes, variation naturally increases. Higher variation brings with it avoidable consumption of resources, and with that comes higher system costs. We were surprised to discover that two years after our initial examination, after being alerted to the variance in utilization, rather than reducing clinical variation over time via standardization, health systems exhibited even greater internal variation upon re-examination. There is substantial evidence that system formation and expansion has resulted in financial gains for providers. Evidence of any material savings for patients or any marked improvement in outcomes is much more difficult to find.
5. Market competition works in health care and results in lower costs and better outcomes.
Tom: One of the most sweeping and difficult to abandon assumptions is that the market is the most effective vehicle to distribute health care. This fundamental economic assumption is so tightly woven into the fabric of everything that we do that it is difficult for most folks to imagine that it is not the best way to deliver health care. Ralph, you have written extensively with colleagues at the Wharton School and others; why do you think we’ve been so slow to realize that health care is not a normal economic good?
Ralph: The higher rate of increase in health care costs compared to increases in other sectors of the economy has driven major policy initiatives over the last 50 years to reduce that inflationary trend. As we have discussed, fixing hospital prices through the introduction of DRGs in the 1980s, managed competition in the 1990s, and promoting ACOs in the Affordable Care Act in the last decade were all efforts to use traditional economic models to reduce costs to purchasers, and to the federal government. Each of these initiatives failed to materially dampen health care inflation as countervailing drivers – most notably higher utilization – more than offset price reductions. Health care costs are shaped more by providers than by patients, thus policy efforts that put more cost control in the choices of patients as consumers have come up short. The better cost controls have resulted when hospitals, doctors, and complementary professionals are given clear incentives to promote patient well-being by reducing unnecessary readmissions, using home care as an alternative to inpatient care, and integrating care processes through shared information. As most of the more expensive health care is concentrated in a small 5% to 10% of the population, efforts to optimize the care of those patients is critical to cost containment policy. In theory, ACOs were such an initiative, but in practice they were focused more on PCPs and the broad population rather than on the collective set of providers who were treating the relatively expensive cohort of patients. Cost containment policy should focus on organizing care, not just shaping prices paid by insurers/government.
Tom: Following similar logic, a considerable amount of attention in Washington has been devoted to provider price transparency. The rationale is that consumers will shop for lower prices if they are given more information. Nothing could be more central to classical economic theory, which makes it such a surprise to learn that it does not apply to health care. Simply stated, for anything other than the most minor of conditions, virtually everything in health care costs much more than any patient could hope to afford regardless of their knowledge of the price. Once the patient reaches their maximum out of pocket exposure, which is typically several thousand dollars in any year, insurance pays 100%, making price completely irrelevant. Almost nothing costs so little as to make its price relevant to the patient. For any insured population, our research found that only 11% of total spending is incurred by patients who spend enough but not too much to care about prices. Even if price sensitivity existed for individual services, it would be counter-productive in reducing overall health care costs. Savings that may accrue for a given test can be quickly offset by the cost of interrupting an episode of care. Patients in the midst of cancer episodes who received the preponderance of their care from a single health system were found to be 40% less expensive than those who divided their episodes between multiple systems.
Tom: High deductible health plans, first introduced a few years before but whose adoption was accelerated by the recession of 2008, were predicated on the assumption that patients would avoid spurious utilization if they were exposed to more front-end financial responsibility. Like other price sensitivity initiatives, high deductibles proved not to be a huge success. Why do you think they didn’t work as planned?
Ralph: An unintended consequence of higher deductibles is the dampening of appropriate demand. Introduced with the theoretical assumption that more financial responsibility by patients would reduce unnecessary utilization, high deductible health plans inadvertently discourage patients from accessing essential services like cancer screenings, vaccinations, or early detection. Research has shown that even when those essential services are excluded from the high deductibles, patients find it very difficult to distinguish between discretionary and essential services; they just avoid everything.
Tom: The emergence of health disparities as a national concern is cause for additional skepticism with respect to the role of the market. Markets do not correct for health disparities, they cause them. By their nature, markets pit buyers against each other in an effective auction, where consumers with greater means can afford to bid up the price and/or purchase additional goods or services. Disparities are an unavoidable byproduct of the market as a distribution vehicle.
Ralph: With Medicare and Medicaid prices falling far short of provider costs, hospitals and physicians have become economically dependent on private sector revenue to fund the public sector shortfall. As a result, health systems are under economic pressure to prioritize investments and business development efforts in geographies characterized by higher concentrations of privately insured patients. Portions of service areas disproportionately populated by Medicaid patients attract considerably less investment and often turn into veritable medical deserts. The wide gaps between public and private sector prices and the reliance on the market to govern distribution has led to the extensive disparities in access, experience, and outcomes that we have today.
Tom: In recent years, there have been a number of states that have significantly increased their Medicaid pricing, commonly through Section 1115 waivers. In many cases, Medicaid prices have even approximated prevailing private sector prices for those markets. Those steps have the potential to alleviate disparities in access to health care services as providers will find it affordable to expand capacity into what had previously been economically unsustainable medical deserts.
Closing Thoughts
The last forty years have been marked by strategies and policies that relied on the presumption that health care behaves like other economic goods, and that classic market dynamics apply. A look back over that period reveals that providers who questioned the seemingly obvious and those who were more conservative in their reactions to environmental shifts tended to fare better over the long run. Our reliance on the market to determine prices and to govern distribution has led to multiple false starts and the unintended exacerbation of health disparities. A crucial lesson from the last 40 years is the realization that it’s not just the things we get right that matter…it’s the things that we don’t get wrong.