266 May 10, 1983 MOBILIZING COMPETITION TO CU.T HEALTH COSTS INTRODUCTION Consumer prices have stopped soaring. For the twelve months ending in March, they rose just 3.6 percent. thro ughout the economy have begun to stabilize or even fall, the cost of health care continues its inexorable climb. In the same period, the health care component of the Consumer Price Index jumped 10.5 percent. The trouble is that most Americans may not be a w are of the vast and ever increasing sums they spend on medical care. Third parties, such as private health insurance companies and the government, pay most of the bill. Although medical costs may seem low to many Americans, they all pay enor mous sums for health care--either as taxpayers or purchasers of insurance The only way to restrain health costs is by a funda- mental restructuring of the system to allow market forces to play more of a role in determining prices and the amount of services used But whi l e prices When Ronald Reagan became president, he urged reforms aimed at creating a truly competitive health care insurance and delivery system. David Stockman and Richard Schweiker--to top cabinet jobs. Administration is now turning its rhetoric into a se t of proposals for consideration by the Congress. Union address, the President outlined an initiative that soon was translated into a'group of bills submitted for legislative action He appointed two of the leading advocates of the approach- The In his 1983 State of the The measures would put in place some of the key elements needed 'to create a truly competitive health industry,'enabling Americans to reap the savings of market pressure on health costs. A cap would be placed on the tax exemption of employer f inanced insurance; this would brake cost-increasing overinsurance. Modest copayments would be required for Medicare hospitalization reimbursement; this would not only introduce greater cost sensi tivity into the federal program, but would generate funds t o 2 finance a program for catastrophic hospital cost coverage under Medicare. encourage Medicare beneficiaries to shop around1# f6r more economi- cal private insurance.

And a voluntary voucher program would be introduced to These reforms are long overdue. They would change signifi- cantly the country's health care system, which now provides strong incentives for patients, physicians, and hospitals to ignore the cost of procedures and leads to ballooning medical costs. effectively in virtually every other a r ea of the economy an industry in which price is a factor in decisions, and incentives encourage competition and economy. By moving in this direction, the U.S. would be dealing with the problem of health cost escala- tion in a way that uses the marketplace to restrain costs. This would be more effective and equitable than the crude policy of price controls urged by proponents of a national health program In its place would emerge the kind of system that operates 1 BACKGROUND Expenditures on medical care ros e from $41.7 billion (6 percent of GNP) in 1965 to $286.6 billion (9.8 percent of GNP) in 19

81. This represents an increase of 587 percent in nominal dollars and 139 percent after adjusting for inflation. Annual per capita health expenditures also increas ed substantially, rising over the same period from 211 to $1,225, a rise of 481 percent, or nearly 100 percent after adjusting for inf1ation.l In 1982 health costs rose by 11 percent, while the general inflation rate dropped to less than 4 percent.

Medica re and.Medicaid have become increasingly costly to daintain. Between 1967 and 1982, the combined spending on these programs grew from 3.9 billion to $64 billion; outlays are projected to exceed 100 billion annually by 1986 unless cost- saving reforms are i mplemented A number of factors contribute to soaring health care costs: inflation, an aging population, greater affluence, a rising level of medical technology, increased utilization of health facilities, and factors enhancing the quality of medical care. fueled the surge in health costs more than the practice in America of third parties, such as insurance companies and governments, paying most medical expenses. Seldom do patients directly pay their own medical bills. These third-party payments, usually pr o vided on a group insurance basis, artificially inflate the demand for health care because the direct cost of services to covered patients is virtually zero. This drives up the price of medical care and leads to great inefficiencies by encouraging people t o use health care service options without regard to their Nothing has U.S. General Accounting Office Report A Primer on Competitive Strategies for Containing Health Care Costs HRD-82-92, September 24, 1982), p. 1 3 comDarative cost. Moreover, many of the m a rginal benefit to the patient 'and ,re 1 services are only of ndertaken largely beca Because of the group nature c a third party bears the expense most insurance, heavy utilization by an individual does not directly affect his premium-the extra costs are s hared by the group se Providers of health care, meanwhile, enjoy incentives to provide excessive care because they know that such services are generally cost-free to the patient. Explains Stanford economist Alain Enthoven The main cause of unnecessary and unjustified increase in costs is the complex of perverse incentives inherent in our dominant financing system for health care fee-for-service for the doctor, cost-reimbursement for the hospital, and third-party insurance to protect consumers, with premium s paid entirely or largely by employers or government. This system rewards providers of health care with more revenue for providing more and more costly care, whether or not more is necessary or beneficial to the patient It leaves insured consumers with li t tle or no incentive to seek a less costly health care financing delivery plan cost-increasing incentives and virutally no reward for economy 2 There are many Throughout the 1970s, the government tried to contain costs by imposing controls on prices, hospi t al capital expenditures and the utilization of health care services. These were ineffec tive and added to the misallocation problem an economist with the American Enterprise Institute These policies entrench inefficiency in the health care system and fost e r 'cost control' at the expense of consideration of the quality and availability of services.113 has pointed out, a policy of price controls is like trying to stop a pot boiling by cl.amping down hard on the lid--rather than reducing the heat Notes Jack M e yer And as Milton Friedman Studies have revealed that cost-sharing by the consumer through deductibles and copayments significantly reduces the use of medical services and promotes more economical use of resource In one test group, for instance, a copayme n t of 25 percent, in 2 Alain C. Enthoven, "Health Care Costs," National Journal, May 26, 1979 p. 885 Jack A. Meyer, "Health," in Eugene J. McAllister, ed., Agenda for Progress Examining Federal Spending (Washington, D.C The Heritage Foundation 1981 p. 242 F or a review of some of these studies, see GAO, op. cit pp. 8-21, and Congressional Budget Office Containing Medical Care Costs Through Market Forces," May 1982, pp. 11-16. 4 place of 100 percent insurance doverage for hospital and physician services, cut t otal health care expenditures by 19 percent hospital admission rates were 21 percent lower and spending on physician care was 20 percent lower, thanks mainly to a reduction in the number of office visits ment of 25 percent for all physician services resul t ed in a 24 percent decline in visits to physicians. Econometric studies yield similar results. One such study showed that 25 percent coinsurance, rather than full coverage, was estimated to reduce hospital spending by 17 percent In another experiment, a c o pay The evidence suggests strongly that wider application of Consumers would be more cost-sharing by the patient, leading to the more efficient utili zation of services, would result in lower expenditures and a downward pressure on medical prices sensitiv e to the prices of services they use, and this would force greater price competition between providers alternative health care financing and delivery systems to match the desires of the public, such as Health Maintenance Organizations HMOs HMOs avoid the p e rverse incentives associated with the fee-for-service and cost based reimbursement mechanisms by operat ing as prepaid group plans advance, they have financial incentives to minimize costs by curtailing unnecessary services, thereby rewarding efficient pr o viders and penalizing inefficient ones.5 evidence that shows these prepaid groups provide services of high quality at costs significantly lower than those of conventional insurance plans.6 Encouraging competition would also stimulate development of Becaus e these groups are paid in There is considerable THE REAGAN PROPOSALS Much of the Administration's health care budget focuses on encouraging competition. With greater coinsurance, the patient together with his physician, determines the amount of care he re c eives; with the HMO, it is the physician, rather than the patient, who makes the determination. Either approach promotes the competitive forces necessary to insure that resources are used efficiently. Four bills have been sent to the House (H.R 2574, H.R. 2575, H.R. 2576, and H.R. 2577) and four to the Senate S. 640, S. 641, S. 642, and S. 643)--a11 incorporating the Admini stration's proposals. Representative Barber Conable R-N.Y introduced the House bills, and Senator Robert Dole (R-Kan.) the Senate meas ures See GAO, op. cit pp. 22-31, and CBO, op. cit pp. 16-21.

Ibid I5 CHANGING THE TAX TREATMENT OF HEALTH BENEFITS (H.R. 2754, S. 640 The tax treatment of employer sponsored health insurance has been a major factpr in discouraging competition, tax code -do es not subsidize individual medical expenses, except in cases where the costs exceed a threshold based on adjusted gross income, it does subsidize employee health insurance benefits paid on their behalf by their employers the purchase of excessive health i nsurance coverage because it allows employers who offer employee health insurance plans to deduct their contributions as business expenses. meanwhile, receive these benefits tax free Although the The current law encourages Employees Consequently, the more of his income an employee can take in the form of health insurance benefits, the more of it is sheltered from taxation. This explains the growth of dental plans, family insurance and, above all, first dollar coverage. This growth of tax-sheltered group pl ans blinds the health consumer to the true cost of the services.

The Administration proposes to limit the tax-free treatment of employer health insurance premium contributions to 2,100 annually for family plans and $840 annually for individual plans. Any c ontribution exceeding this would be treated as taxable income for the employee 2.3 billion in federal revenues in 1984 and a total of $31 billion from 1984-1988.8 This change would raise an additional This proposed reform would promote a competitive envir o nment in the health care industry by making both employers'and employees more cost conscious when purchasing health insurance and medical care. The original rationale for tax relief for employee plans was to help people purchase insurance to protect thems elves and their families from large, unexpected medical expenses-not to provide tax exemption for income spent on very routine and inexpen- sive services.

Under the Reagan proposal, those with insurance premiums above the tax-free limit would have to choos e a less costly alternative or pay tax on the amount.over the limit. Those choosing the former course might select plans that have more deductibles and coinsurance, while still providing full coverage of catastrophic expenses. The evidence suggests that e v en modest deductibles and copayments could reduce dramatically excessive The Tax Equity and Fiscal Responsibility Act raised the floor under the itemized deduction for medical expenses for calendar year 1983 from 3 percent to 5 percent of adjusted gross i ncome.

Office of Managment and Budget, "Major Themes and Additional Budget Details Fiscal Year 1984 p. 67. 6 demand for health care services by increasing consumer awareness of costs. native delivery systems that provide quality care more cost-effect- ivel y Or they might choose some of the less expensive alter Objections to the Tax Cap The Poor: Opponents of the tax cap proposal argue that additional cost-sharing may be difficult for low income families, and that they may delay or forget the routine medica l services that keep them healthy and out of expensive hospitals. Among the cost effective services they fear would be dropped are outpatient and preventive care services, early diagnosis and treatment, dental, vision, mental, and home health services This argument would have some merit, were the cap were set at a very low level. high enough to leave unaffected the coverage of most low income employees insurance premiums would be difficult and costly to administer. These regulatory burdens, they argue, woul d be particularly onerous for small businesses, which cannot afford to hire the experts needed to monitor regulatory and tax changes. Winston, a consultant to the White House on health issues, how- ever, points out that the proposal only sets a limit on th e amount of health insurance that is tax deductible and that it should not impose an unreasonable accounting burden.

Others claim that a uniform limit would penalize people living in areas with exceptionally high medical costs. actuarial group. But this wo uld complicate administration and establish a precedent for regional variations in the tax code based on differences in costs of living. If the cap, moreover, introduces the greatest price constraint in high-cost areas, it is precisely there that downward pressure on prices is most needed In fact, the Administrationls ceiling is Administration: Some critics point out that a tax on health David High Cost Areas These critics propose that the limit vary by location and Tax Revenue: Other critics argue.that th e tax cap will.not have the.anticipated effect on tax revenues because employers will merely shift money spent on excess health insurance' into other nontaxed fringe benefits. While this may be true, it ignores that primary purpose of the cap is to restrai n the growth of health care costs due to. inappropriate demand. The aim is not to raise tax revenues I MEDICARE The present Medicare program has two parts. Part A is a hospital insurance (HI) program, which is financed from payroll taxes and covers inpatie n t hospital services, skilled nursing care, and home health services. It provides full coverage after 7 an annual deductible which represents the average daily cost of one day in a hospital ($350 in 1984 For the next 59 days it neither requires cost-sharin g by the beneficiary nor limits the total costs incurred. Coinsurance charges are not made until the 61st day, and in 1984 would be increased to $87.50 per day through the 90th day able lifetime reserve of 60 days, at a cost of $175 a day in 19

84. Beyond this point, the patient is' responsible for the full cost of hospitalization As only.0.6 percent of Medicare patients remain longer than 60 days, Part A coinsurance rarely applie Beyond 90 days, an individual can draw on a nonrenew Part B of Medicare, the Supplementary Medical Insurance SMI) program, is an optional supplement to those eligible for Part A, as well as for everyone over the age of

65. It is 75 percent financed from general revenues, with the rest coming from premium payments of beneficiaries It includes coverage for all other Medicare services, primarily physician services. There is an annual $75 deductible, after which the program reimburses 80 percent of Medicare approved charges for covered services leaving the patient to pay 20 percent ( though this share is largely o.ffset by private insurance purchased by about half of all Medi care beneficiaries).

The Medicare.program faces serious financial difficulties.

This February, the Congressional Budget Office projected that under current law t he HI trust fund would be depleted by 1988 and run a $400 billion deficit by 1995.1 Catastrophic Hospital Costs Protection and Cost Sharing 1H.R. 2575, S. 642 Under the present cost-sharing structure, individuals have little incentive to avoid unnecessary hospital services once they are admitted to a hospital and pay the deductible, since cost sharing only begins on the 61st day no incentives to seek hospitals with lower costs, because the deductible remains the same regardless of hospital costs ing a cost - per-day price equal to the $350 deductible in 1984 Medicare would pay $3,500 for the average stay of eleven days and $20,650 for the maximum 60-day stay, before the consumer begins to share any costs. Based on these figures, the Medicare patient's share o f the cost would be less than $32 per day for the average stay in the hospital, and less than $6 per day for a 60-day hospitalization. On the other hand, Medicare patients face virtually unlimited liability for the cost of their care after they use up thei r lifetime reserve days people requiring long hospitalization can face extremely high personal expenses. A five-month hospital stay in 1984, for In addition, patients have Assum Severely ill See Linda E. Demkovitch The Medicare Tradeoff--Many Would Pay Mor e So That a Few Could Save," National Journal, p. 545 lo m p. 544 8 example, would cost a Medicare patient over $13,000 according to the Administration, increasing by about 10,000 for each additional month 1 Some cost-sharing is needed to provide an incent i ve to minimize routine hospitalization. The elderly, however, must be protected from catastrophic hospital costs To achieve these two goals, the Administration has proposed adding a copayment equal to 8 percent of the hospital deductible ($28 in 1984) for the 2nd through 15th day and 5 percent ($17.50 in 1984) for the 1.6th through the 60th day of care. Beyond this, however, the benefi ciary would not be liable for any hospitalization costs.

The Administrationls plan, in other words, is to replace a system that provides practically free hospitalization for short stays--but provides no catastophic coverage--with one that requires a modest copayment and covers catastrophic hospital charges. In a ddition, beneficiaries would be liable for no more than two hospital deductibles a year, while daily coinsurance charges for the 21st through 100th day in a skilled nursing facility would be reduced from 12.5 percent to 5 percent of the inpatient hospital deductible fiscal 1984 and $6.7 billion through fiscal year 1988.12 1984, the anticipated savings due to increased cost-sharing are actually $1.6 billion, but these are partially offset by increased costs of $910 million for catastrophic coverage financin g catastrophic care within Medicare, but by introducing cost-sharing immediately after payment of the deductible, it hospital prices.13 Advancing the coinsurance rates would not impose an unduly large burden on most beneficiaries-it would raise the copayme nt for an average stay to just $2

80. On the other hand, patients requiring a five-month hospital stay would pay a maximum of $1,530 in 1984, a saving of $11,945 over present The proposal is expected to save $710 million in For Not only does the Administra tionls proposal provide self provides greater incentives to restrain consumption and therefore iaw.14 Increased copayments in the early stages of hospitalization of course, would mean an extra financial burden on most of those requiring hospitalization, s ince only a very small proportion of Medicare beneficiaries need catastrophic protection. Only those requiring hospitalization for 74 or more days would come out ahead under the Administration's proposals.

Of Medicare's 29 11 l2 Ibid.

OMB, op. cit., p. 57 l3 While coinsurance would'foster the more efficient use of hospital care the Administration's proposal would not do anything to encourage patients to look for less expensive hospitals, since the coinsurance rates are based on a percentage of the deducti ble rather than a particular hospital's average daily costs. Basing coinsurance rates on each hospital's own costs may provide even greater incentives to seek out low-cost hospitals as well as stimulating competition among hospitals.

OMB, op. cit p. 57. l4 9 million eligibles, about 170,000 actually spend that amount of time in a hospital annually.

Rubin, Assistant HHS Secretary for Planning and Evaluation, the additional 280 in costs faced by the average beneficiary I1will buy the peace of mind of having unlimited hospital coverage.'f15 And, of course, the downward pressure on prices resulting from copayments will reduce the possibility of a major disruption of Medicare the cause of runaway costs But as pointed out by Robert J VOLUNTARY VOUCHERS H.R. 2577 , S. 641 Medicare beneficiaries today cannot use their entitlement to purchase coverage under alternative delivery systems, even if an alternative provides a superior package at a reduced rate. To remedy this, the Administration proposes establishing a vol u ntary Medicare voucher that beneficiaries could use to enroll in private health insurance plans. The federal government would pay 95 percent of Medicare's average adjusted per capita cost (AAPCC) to individuals choosing private plans that offer coverage a t least as full as that provided by Medicare.

The AAPCC would be adjusted actuarially to take into account Medicare's true costs according to such personal characteristics as age, sex, and health status, and regional medical cost differ ences would be enti tled.to a cash rebate. In addition, anyone becoming dissatisfied with their private coverage would be permitted to rejoin the Medicare system beneficiaries to shop for alternatives to fee-for-service medicine incentive Beneficiaries choosing plans costing less than the voucher This voluntary voucher system would encourage Medicare such as prepaid groups like HMOs. Currently there is no such Vouchers have several advantages. They could reduce the cost of the Medicare program by effectively setting a limit o n the governmentfs financial responsibility for those accepting the voucher, since it would replace a system of open-ended reimburse ments with fixed premium payments. Savings would occur if the value of the voucher is less than would otherwise have been.s p ent on 'the Medicare recipient number and health status of Medicare beneficiaries selecting the voucher Total savings would depend on the A Medicare voucher also would allow Americans to shop for plans in the private sector they feel are better suited to t heir needs and desires. Enrollees may accept greater cost-sharing in return for the cash refund coverage than is available under Medicare and use the voucher to purchase private insurance Others may wish more comprehensive The voucher expands opportunitie s l5 See Demkovitch, op. cit p. 5

45. I r 10 Finally, an important part of the Administration's proposals is to stimulate competitive forces in Medicare and the entire health care system. By encouraging more competition among new kinds of delivery systems, the voucher should lead to downward pressure on costs and to private sector innovation in health care coverage and delivery.

The voucher concept, however, may create a few problems.

Private plans may have a difficult time competing with Medicare because of various cost advantages enjoyed by the federal system The Medicare program, for instance, is not subject to premium taxes, and it generally reimburses providers at a lower rate than most private insurers. These cost disadvantages can be consider able, and could explain the relatively little interest expressed by pr.ivate insurers in Medicare vouchers.

A second common criticism of vouchers is that they could This could drive up Medicare lead to adverse selection, i.e., that those people who are rela tiv ely low users of health care might opt for the vouchers leaving heavier users in the system costs, rather than reduce them as intended. The Administration partially addresses this problem by adjusting the value of the voucher to actuarial classes OTHER RE F ORMS H.R. 2576, S. 643 The Administration also proposes other reforms in the Medi care and Medicaid programs. The major provisions include a freeze on physician fees for Medicare and changes in the Supple mentary Medical Insurance program and modest copay ments for the Medicaid program.

Premiums and Deductibles for Supplementary Medical Insurance SMI The elderly participating in the SMI program now pay a monthly premium of $12.20 and a deductible of 75 tion proposes to delay the next annual Part B premium i ncrease for six months until January 1, 1984, and then begin annual adjustments to raise it from the current level of 23 percent of program costs to 33 percent by January 1, 19

88. The deductible would also be indexed to the annual increase in the price o f physician services. These reforms would actually raise outlays by about $100 million in fiscal 1984 but would save over $9 billion through fiscal 1988.16 was to be funded only half by general revenues, with beneficiary premiums paying the other half. Wh i le this was the case for the The Administra When the SMI program originally was introduced in 1966, it 16 OMB, op. cit p. 60. program's first five years, beneficiary decade have declined to just 23 percent determined by a formula that is inversely related to the per capita income of a state 50 to 78 percent. There is, however, considerable variation among states with respect to eligibility requirements and benefit levels.

Medicaid offers a number of services, such as inpatient' hospital care, outpatient care, skilled nursing and physician services. long-term institutional care (in contrast to Medicare, which aims Federal contribution rates range from The program is heavily weighted in favor of providing premiums in the past of program costs. The Administration's proposai should- be a first- step to raising the premium back to the full 50 percent.

Physician Payment Freeze Medicare currently reimburses physicians on a "reason able charge" basis. These are updated annually to reflect changes in. physician charges. charges' paid by Medicare during 1984,at the 1983 levels. The measure is expected to save 100 million in fiscal year.1984.and 5.2 billion over a five-year peri0d.l Th e Administration proposes freezing physician The physician freeze does not freeze what physicians can charge, only what Medicare pays. If physicians feel that the risk, of course, losing patients to other physicians who offer services at a lower rate. mark e t will bear a higher price, they can ch'arge more. They Medicaid Copayments l7 Ibid p. 59 l8 Thehigher copayments would apply to the "medically needy" beneficiaries of the program 2 12 CONCLUSION Public health care policy has long been based on a variety o f regulations and cost controls. These methods have failed to stem health care inflation and have caused the misallocation of resources attack on this problem reduce unnecessary use of and inappropriate demand for health care. in government programs and p romote more selective use of private insurance plans. It would increase.consumer awareness of health costs and stimulate competition among health care providers.

While some people would bear additional costs, all Americans would benefit from a restructured health care sector that lowers medical care costs by limiting excessive demand.

Medicare beneficiaries would be protected from the disastrously high expenses associated with prolonged illness.

While stronger measures may be needed, those offered by the Administration are an important reversal in the direction of federal health sector involvement competitive market to push down costs and ensure economical use of resources. The result health care services and lower costs to both taxpayers and patients The Reagan Administration is proposing a pragmatic It is trying to promote market forces to The President's plan is designed to expand consumer choice In addition They leave more room for a .A reduction in the use of unnecessary Peter G. Germanis Schultz Fell ow