The Defined Contribution Health Benefit: A Practical Primer

Published August 1, 2001

A defined contribution approach to health care creates a new, more sustainable financial framework for an employer seeking to provide its employees with health benefits and purchase health plan coverage. This framework establishes clearly and predictably how much the employer will contribute to benefits.

In its fullest expression, the defined contribution also distances employers from health plan selection. It permits employees to directly control the range of health plans they may consider, producing a real sense of ownership over their eventual plan choice.

A defined contribution approach has the following main features:

  • Fixed employer contribution. The employer decides upon a fixed amount to pay for health plan coverage for all employees.
  • Many plan options. The employer presents employees with a choice of different health plans with varying deductibles, co-payments, health management styles (health maintenance organizations versus preferred provider organizations), and premiums.
  • Employee selects plan. Employees choose from the menu of health plans available and presented by the employer.
  • Employee pays difference. Employees pay the difference between the amount contributed by the employer and the cost of the coverage for the plan they select.
  • Employer pays health plan. The employer pays the premium for coverage directly to the health plan.
  • Employee controls coverage. Employees are free to remain with the health plan they initially selected or seek another health plan that better meets their needs.

In a defined contribution approach, employer contributions for health benefits are clearly labeled a part of total compensation for employees. Each employee is compensated with a fixed contribution. The fixed contribution generally is determined by the employer and can be based on a large number of considerations allowed under current law and regulations.

They can include the historical level of the health plan premium, a fixed annual percent increase such as 5 percent, a variable amount based on health cost increase trends, and/or any variation based on profitability, net revenue, productivity improvement, or other economic or performance-related measure.

Under the defined contribution approach, an employer can make the amount of the defined contribution equal for each employee or vary it based on a variety of factors such as number of family members, job classification, performance appraisal results, length of employment, divisional performance, or additional factors allowable under existing benefit laws and regulations.

When given a choice, some employees prefer to take a plan with higher co-pays or elect to change doctors or use their spouse’s health benefit plan. But employees rarely are given these options in the typical group plan offered by small employers. Instead, the employee must select one health plan with limited benefit coverage and point-of-use cost sharing—in addition to the inevitable, irritating administrative requirements. Employee choice of health plans consistently emerges as one of the most highly valued features of a benefit program.

Our current health benefits arrangements are contributing to the rapidly escalating cost of health plan coverage. Furthermore, the rate of increase for health coverage is far higher than all other cost increases for most employers. This rapidly growing component acts to reduce the funds available to pay cash compensation to employees or provide other benefits and, on a global level, reduces the competitiveness of the products and services of American companies. This situation is not sustainable over the long haul for either small employers or their employees and family members.

If employers and employees hope to maintain long-term satisfaction with their health coverage, a positive alternative in offering and paying for health insurance is badly needed. A “defined contribution” approach is a workable and positive solution. It involves employees more directly in the process of selecting and paying for health coverage, and it can be structured and implemented with considerable flexibility. With defined contribution, the employer may customize the company’s benefits-compensation strategy and offer a plan that meets its needs and employees’ needs.

Many Options

Employers have four options in providing employees a choice of plans. These include:

  • Group health plans
  • Individual health plans
  • Group and individual health plans
  • Allow individuals to find their own health plan

OPTION ONE: Group policies typically have more lenient underwriting provisions (that is, coverage is more readily available to employees with health problems), more generous contract provisions, and/or lower cost. Group policies usually require most if not all eligible employees to participate, and many insurance companies are not eager to give employees in small companies a choice of plans.

OPTION TWO: The employer provides access to a number of individual plans. The employer does not have to worry about participation requirements and can usually offer more choices to employees. Employees own the policies, so each policy is fully portable.

OPTION THREE: The employer offers both group and individual policies.

OPTION FOUR: The employer provides individual employees with the choice of finding their own health plan. Employees might select from among traditional indemnity plans, preferred provider organizations (PPOs), point-of-service (POS) plans, and health maintenance organizations (HMOs).

Employee Selects the Plan

Under a defined contribution approach, each employee can choose from the health plans offered by the employer the one that best fits his or her individual circumstances. The employer may decide to make information from a number of health plans available to employees in a standard format for comparison. Employees may select their health plan based on any number of criteria, such as those outlined in Figure One.

Employees are likely to be more satisfied once they have the ability to choose, especially when their decisions are supported by reliable and relevant information about the features and characteristics of each health plan. The company’s personnel compensation staff can coordinate the plan selections, insurance company billings, and monthly premium payments, or the company may choose to hire an outside administrator to manage the process.

Stephen Barchet, M.D. is manager of the Defined Contribution Project at the Evergreen Freedom Foundation. This summary is taken from his Defined Contribution Health Benefits: Enabling Employee Choice. A Practical Primer for Employers, published in April 2001 by Evergreen.

For more information . . . contact Lynn Harsh, executive director of the Evergreen Freedom Foundation, at 360/956-3482 or email [email protected]. The full text of Dr. Barchet’s report is available for a suggested contribution of $25; an online ordering form can be found at