Here's Why Healthcare is so Damn Expensive

Blog Post - Here's Why Healthcare is so Damn Expensive

Due to rapidly increasing expenditures, the national healthcare debate largely focuses on the price of healthcare. Politicians make grandiose claims that they will “lower” the price of healthcare. To understand the current inflated price of healthcare, it is imperative to also understand the costs and price mechanisms of healthcare.

The general theory works like this: health insurance creates a third-party payor effect that saturates demand for healthcare by lowering the effective price to consumers (what you pay out of pocket); at the same time, a highly regulated supply-side has abnormally high costs of goods due to command-and-control policies. The inevitable outcome of restricted supply and saturated demand is a rise in the price level.

On the demand side, healthcare is no longer financed by out-out-pocket payments, but rather through third parties. This dilutes the price structure and removes disincentives to over-consume, thus increases in demand. Out-out-pocket payments decreased from 56% in 1950 to 14% in 2009 while third party payments increased from 44% to 86%. Almost all of healthcare spending is “someone else” (not consumers) making the transaction to pay for services.

The reason for this change, which coincides with large increases in per capita healthcare spending, is the expansion of insurance. It began during WW2 wage freezes when employers began offering fringe benefits to compete for labor - i.e. health insurance. About twenty years later, Medicare and Medicaid significantly expanded third-party insurance financing. Lastly, since 1950, a larger portion of employees have become eligible to pay income and payroll taxes. This growth made tax-exempt benefits attractive to both employers and employees.

In the private sector, health insurance companies have turned to managed care plans that contribute to supply restrictions. Enrollees may only see certain providers within a network and must pay an additional fee for out of the network coverage. The effective outcome is a higher switching cost for consumers, restricted supply, and less competition.

Moreover, the negotiated prices between payors and providers disrupts the price system by removing consumers as the decision maker. Managed care plans, which are the most popular type of private insurance, are essentially long term contracts between providers and insurance companies. They “set” prices with no input from consumers and essentially removes all their bargaining power. The feedback loop of typical price mechanisms is non-existent.

Also, Medicare and Medicaid account for over ⅓ of all health care spending. These public insurers have enormous amounts of buying power in the market. Thus, reimbursement rates are set through law - not negotiation - and they’re set lower than negotiated prices.

For example, combined underpayments were $51 billion in 2013. This includes a shortfall of $37.9 billion for Medicare and $13.2 billion for Medicaid. For Medicare, hospitals received payment of only 88 cents for every dollar spent by hospitals caring for Medicare patients in 2013. For Medicaid, hospitals received payment of only 90 cents for every dollar spent by hospitals caring for Medicaid patients in 2013. In 2013, 65 percent of hospitals received Medicare payments less than cost, while 62 percent of hospitals received Medicaid payments less than cost. To make up these losses, doctors push costs onto privately insured and fee-for-service patients.

On the supply-side, regulatory restrictions and command-control policy reduce our medical care capacity and drive up prices. They are so cumbersome that many doctors find a different career path or quit medicine to retire early.

Per the CMS, "9,539 physicians who had accepted Medicare opted out of the program in 2012, up from 3,700 in 2009." This is because, as previously mentioned, Medicare underpays doctors and medical facilities. The proportion of family doctors who accepted new Medicare patients also dropped to 81%, down from 83% in 2010. These all represent a decline in the supply of medical care.

Special interests also play a role in reducing the supply of medical care. For example, many states allow nurse practitioners to independently provide general and family medical services. Unsurprisingly, the largest physicians group opposes this practice and actively lobbies against it. As a result, people are forced to see higher-cost doctors for routine procedures.

Since Medicare has enormous market power, they can create industry standards at a whim - the most burdensome of which is their extensive coding system. The coding system was introduced as a means to reduce costs. In short, doctors and hospitals bill Medicare using codes that line up to treatments, which in turn mean reimbursements.

So why is this relevant to supply-side restrictions? The outcome was that hospitals and physicians developed enormous administrative wings to comply. Eventually, private insurers adopted a similar coding system since so many hospitals already used it. This diverts resources away from delivering health care so that providers can comply with this public/private bureaucracy. It becomes immediately clear when you look at any hospital budget: administrative costs are now 25% and also the fastest growing cost.

Of course, the coding system is deeply flawed as well. For example, according to the Department of Health and Human Services, nearly 42% of services are incorrectly coded. The Inspector General found that this amounted to 21% of Medicare payouts - or $6.7 billion. Medicare/Medicaid is also rife with fraudulent billing - racking up $177 billion in fraudulent payouts. There’s actually a law enforcement division that fights Medicare/Medicaid fraud.

These two bits of information are very important. For one, faulty billing requires administrators to go back and fix it all - which costs time and money. Fraudulent billing is not only a loss to taxpayers, but it is also a loss to public insurance programs. There are now considerable resources tied up in unproductive uses that instead could increase the supply of healthcare. This is not to say private insurers are immune from this expense, but rather to put it in perspective.

There are numerous proposals to address our high-price system, but we cannot “lower the price” of healthcare without first understanding why it costs so much. We cling to the idea that health insurance, whether private or public, is the best way to finance health care. For some, that might be the case, but simple trips to the doctors do not require the bureaucratic structure currently in place. We must establish a consumer-provider price structure that is open to the competitive market.

(NOTE: Yes, it is true that single-payer health insurance countries have lower medical care spending, but this is largely due to price controls that subsequently causing care rationing. See here for more info.)

Grant Phillips is a panelist on UA Live, an admin of We Are Capitalists, and founder of The Modern Libertarian. 


Comment list

  • Lucas
    19-Jul-2016 01:51 AM

    Even so called free market utopias, have universal healthcare. Singapore, Hong Kong, Chile. Your thesis would be true if the US didn't rank dead last compared to others in terms of healthcare.

  • Pat
    17-Feb-2017 02:44 PM

    Medical administrative fees like legislative fees consumes health care dollars like taxpayer dollars faster than they can get produced, and the consumer/citizen is left without adequate health care by willing and educated physicians who cannot get paid, or well enough to remain as components of an excellent health care system. Blame lobbyists?

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