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Cost Sharing: The Good, The Bad, And The Ugly

May 25th, 2010

Cost sharing in a fee-for-service health care system is almost universally recommended by health economists. The reason: When patients pay some part of the costs of their care, they are likely to be more conservative, prudent shoppers in the medical marketplace.

Under the recently enacted health reform, for example, the out-of-pocket exposure can be as high as $6,645 for individuals and $13,290 for families in 2014. (Estimate of the Medicare Actuary.)

Yet there are three major problems with the current practice of cost sharing:

  • Even under the best design, copayments and deductibles are a very inefficient way of sharing costs between patients and their insurers.
  • In the most common arrangements, cost sharing affects incentives weakly and often not at all.
  • All too often, cost-sharing arrangements are a facade — masking an underlying effort to shift costs from the healthy to the sick.

To make matters worse, all three problems are likely to escalate under the new law—especially in the health insurance exchanges.

The best way to think about cost sharing is to understand that there are two types of insurance: self-insurance—say, through a general bank account or a Health Savings Account (HSA)—and third-party insurance. The economic problem is to find the ideal division between the two. What bills (or what proportion of bills) should be paid by the patient directly and what should be paid by the third-party insurer?

Ideal Health Insurance. In my original paper on this subject, I argued that there are three types of medical care for which people should self-insure: when patients can exercise discretion; when patients should exercise discretion; and when the amount of money involved is not large.

A broken leg, a ruptured appendix, cardiac arrest, the onset of a stroke—all of these are cases where patients cannot exercise discretion; and, even if they could, they probably shouldn’t. In these instances, care decisions (including decisions about the resources needed for that care) need to be made by professionals.

On the other hand, almost all primary care—including general checkups and most diagnostic tests—fit the three criteria almost perfectly. Since experts disagree, for example, about when (and how frequently) people should get general checkups, mammograms, pap smears, PSA tests, etc., and since people differ a lot in their attitudes toward risk in general and medical care in particular, these are precisely the areas where individual decision making and individual purchase makes sense.

Ideal health insurance, then, would carve out entire areas of care, where it is appropriate and desirable for patients to make their own decisions and where it is understood and accepted that not all patients will make the same decisions. Patients would self-insure for these expenses through an HSA. Within this sphere of medicine, patients would bear the full costs and reap the full benefits of the decisions they make. (Think of this as the “live and let live” sector of medical practice.)

Where individual discretion is neither possible nor desirable, however, third-party insurance should be involved in the decisions and pay for their full cost. (Think of this as the “we’re all in this together” sector of medical practice.) Here, of necessity, insurers will legitimately intervene in the practice of medicine from time to time, because when a patient draws money from an insurance pool, every other member of the pool has a legitimate interest in how the money is spent.

A third category of care combines features of the first two. These involve procedures that need to be done but for which patients can legitimately exercise discretion over where, how, and when they are done. For expensive procedures of this type, a third party might make a lump sum available (calculated to cover almost all of the cost of an efficient doctor and an efficient care facility), leaving the patient free to make other choices and pay the marginal cost of those decisions from an HSA. (Think of this as the “casualty model” of insurance.)

The Roll of Deductibles and Copayments. Nothing in the preceding discussion required us at any point to bring up the topic of deductibles and copayments. In fact, the way these are ordinarily used is completely inconsistent with ideal health insurance, which assigns 100 percent of the cost of each decision to the decision maker. Certainly an across-the-board deductible, covering all procedures—both inpatient and outpatient—is completely inconsistent with ideal insurance. Ditto for across-the-board copayments (a percent of the provider fee), covering all procedures.

The Opposite of Ideal Health Insurance. Imagine an insurance plan that turns ideal insurance upside down. This is a plan in which the decision maker never pays the cost of his or her decisions. In particular, imagine a plan in which (1) whenever the patient is making decisions, the third-party payer pays, but (2) whenever decisions are being made by someone other than the patient, the patient often pays. Sound like something out of a Marx Brothers movie? Believe it or not, this describes the most common form of insurance sold in the market today.

Under a typical plan, for example, most primary care, most diagnostic tests, and most inexpensive drugs are available to the patient at no charge, or for a nominal fee. This means that where patients have the most discretion about care, they pay almost none of the cost directly. But these same plans often have high deductibles and hefty copayments above the deductible. This means a person could be hit by a truck and end up owing a hospital $5,000 or more in out-of-pocket payments, even though the patient exercised no discretion whatsoever over the care.

Perverse Reasons for Faulty Insurance Design. In my analysis of managed competition, I argued that when health plans are forced to community-rate their product and accept all comers, they will try to attract the healthy and avoid the sick; and, after enrollment, they will be tempted to overprovide care to the healthy and underprovide it to the sick. The reason why that observation is important is that (loosely speaking) you can think of the entire employer market as managed competition writ large.

The employer, for example, cannot refuse coverage or charge a higher premium based on health status. Employers can, however, manipulate the design of their health insurance in order to attract the healthy and repel the sick. Of course, this is terrible from the point of view of efficient cost control. But as everyone in the trade knows, there is no plan design known to humanity that can control costs better than hiring only healthy employees.

How Health Reform May Make Things Worse. For all the criticism one can level at current health insurance designs, there is one overwhelming virtue of the current system: The government is not telling you that you have to be in a poorly designed plan. However, that is about to change.

What I have described as the “opposite of ideal health insurance” is about to be forced on the entire private sector. Eventually, every plan will be required to provide first-dollar coverage for preventive care, and the only avenue left to keep premiums down will be to collect large deductibles and copayments from people who are sick enough to require hospital care.

To make matters worse, most other traditional methods of cost control (such as choosing a more limited package of benefits) are being taken off the table. So the pressure on employers to have plans that are unattractive to sick people will intensify. And, as I have explained elsewhere, the perverse incentives will be even more intense in the exchange.

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9 Responses to “Cost Sharing: The Good, The Bad, And The Ugly”

  1. Lauren_K Says:

    I disagree with the arguments that screening and primary care are bearing most of the cost to our health insurers. Increased visits to primary care physicians or preventative care such as screening has allowed many to identify disease at its onset thereby decreasing the cost to insurers if it were instead caught later in its progression. Additionally, the decrease in primary care physicians and GPs in the US, with an increase in specialists instead, are also responsible for the increased belief that these minor visits and screening procedures are costing a fortune. Maybe we should reconsider what it would be like for there to be more general practitioners and less specialists. Most physicians performing the screening procedures discussed (PSA and Pap smears are not diagnostic procedures) are specialists, OB/GYNs for example. If these tests could be performed by GPs perhaps they would not be as much of a cost concern. Additionally, we should be promoting regular visits to the general practitioner so that doctors have a more complete patient history so that, when the “nondiscretionary events” hit, the doctor does not need to run a complete set of diagnostics or delve through multiple medical records because they will more personally understand the individual they care for. Our health care system is inefficient and costly because we have established a system where people are able to see specialists before they see GPs, and rather than supporting the idea that these “discretionary” visits should be payed in complete by the patient, we should consider the alternative – that people should be encouraged to check in with their physicians often, so that they can identify problems as they arise, gain support to improve the lifestyle behaviors that are making them ill, and in the long term costing far less than the visits they choose to make to specialists when considerable illness does arise.

  2. John Goodman Says:

    This discussion seems to have gotten off track. The only patients who are “ideal” and “compliant” are the ones who are anesthetized and on the operating table. Were all patients “ideal” and “compliant” all the time, we would never have to worry about the appropriate division between self insurance and third party insurance.

    As it turns out, there are huge swathes of care for which self insurance is the most appropriate option – especially for people who do not intend to do everything they are told to do by some remote, impersonal bureaucracy. As Devon points out, a great deal of money can be spent in these areas. In fact, we could spend the entire national income on diagnostic tests alone – not in wasteful ways, but in ways that create some marginal value.

    I hope people choose not to spend all their income in that way, however.

  3. Robert Power Says:

    Devon, I assume that John G is referring to PPACA Section 1001. That section is hardly a recipe for runaway preventive/diagnostic costs, either within the new exchanges or elsewhere. Affected services must receive an “A” or “B” grade from the US Preventive Services Task Force USPSTF). Would that standard be met in your Cooper Clinic example? Certainly not.

    An older article by Filak et al. estimated the lifetime cost of USPSTF-recommended services. The result was very affordable for an idealized, perfectly-compliant patient, when compared to expected lifetime medical costs. This was a gross estimate, not net of savings. When balanced with any savings, the net cost of USPSTF-recommended care would be of little consequence


  4. Kenneth Artz Says:

    You say… the “opposite of ideal health insurance” is about to be forced on the entire private sector. Can I escape this with an HSA and/or flying to India or Costa Rica whenever I need high quality health care?

  5. Devon Herrick Says:

    Robert, Near my office in Dallas is the Cooper Clinic, which offers a comprehensive physical exam costing from $2,800 to $5,000 depending on which tests are requested. If all 300 million Americans took advantage of this, the nation’s health care bill would increase by about 50%. If we all just opted for $1,000 per year in additional screenings or primary care – that’s only a few extra visits and a handful of additional tests – our health expenditure would climb by 13%, or about $300 billion. This is not insignificant.

  6. JoeBarnett Says:

    Whether it is preventive care, primary care or emergency room care: if people have insurance coverage, they apparently will use more of the services than if they are uninsured. That may be because cost (however much it is — and patients seldom know in advance how much any of those services will cost) is much less a consideration, even if, at sometime in the future, the patient will be called upon to make that copayment or meet the deductible. The provider bills the insurer, and the patient is billed later for the residual. Only if the patient has to fork over some money (whatever amount) right then, is cost sharing likely to have any effect on the patient’s use of services.

  7. Robert Power Says:

    John, your core premise here is that preventive care will be over-used due to full coverage, and that such over-use will have a major impact on national costs. I just cannot buy that premise. First, preventive care is a tiny portion of all health care spending. Second, such care is just as often under-used now. Third, full-coverage preventive services are likely to be limited to those supported by actual evidence. Finally, the provider community is never going to get rich by churning evidence-based preventive services.

    At one point, you pull “diagnostic” services into your discussion, as if they too will receive full coverage due to benefit package requirements. I know of no such requirement.

  8. Brian R Williams Says:

    Like most other markets I know, people are more careful about spending their own money and less careful when they are spending someone else’s money. This same principle can carry over to the health care marketplace, as demonstrated by the way people manage their own Health Savings Accounts. I’ve never seen this explained any better than in this posting from John Goodman. But for reasons unknown, Congress and the President seem to think that heretofore unknown laws of economics will rise up and be discovered if we enact complicated revenue and spending streams (including subsidies for people who can’t afford, penalties for people who buy too much, and a mandate for everyong to buy something) to pay for everyone’s health care.

  9. Devon Herrick Says:

    The RAND Health Insurance Experiment found significant cost-sharing reduces medical spending by about 30%, without adversely impacting health for most people. Despite this, many public health advocates dismiss cost-sharing as a barrier to care that encourages people to forgo necessary care.

    In the long run we all pay for our care, albeit indirectly. I would rather pay more of my health care directly and have more control over how the funds are spent — and the types of services I can purchase.

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