Time to Cut Out the Middle Man

Published October 1, 2001

During the last decade the health care industry, out of concern for growing health care costs, moved decisively away from traditional fee-for-service insurance to managed care. The rush was based on a fundamental misunderstanding of the causes of health care inflation.

The argument went that doctors were encouraged to perform unnecessary services because they were paid according to the number of services they delivered. The answer was to make physician compensation independent of the amount of service delivered, either by putting doctors on salary, or through using “capitation”—a per-patient payment that was blind to the amount of services delivered.

But fee-for-service wasn’t what caused inflation; third-party payment was. Consider all of the services that are purchased on a fee-for-service basis: auto repair, accountant’s services, barbering. None is subject to excessive inflation.

Third-Party Pay . . . for Haircuts?

One pays a fee for getting a haircut. That price may vary depending on the barber’s overhead, the market segment he’s targeting, etc. The mere fact that the barber is paid a fee does not mean he can charge an excessive fee, because you would take your business elsewhere. Nor does it mean he can force you to get your haircut weekly instead of monthly, even though he might want to. You would refuse to pay for needless visits.

Now consider how that would change if a third party was paying for your haircuts. You might go to the most expensive barber you could find, one that provided extras you valued: a shoulder massage, pleasant surroundings, interesting reading, a cup of cappuccino, or valet parking. And you would visit as often as you wanted.

The third party would look at the bill and say, “Geez, the price of haircuts has gone through the roof!” But, having agreed to pay a fee for the service, they would have little choice but to pay the bill.

Eventually, the third-party payer might decide to capitate the barber, paying him ten dollars per person per month. Suddenly, the dynamics have changed. The barber gets his ten bucks whether he cuts your hair or not. His incentive is to avoid cutting your hair. If you insist on getting a haircut, he certainly won’t provide you with any extras. And, of course, all barbers would get paid the same–whether they are Hollywood stylists or recent graduates of a Marine Corps chop shop.

The Problem with Third Parties

Health care is more serious than haircuts, of course, but the underlying economics are the same. Fee-for-service is inflationary only when a third party is paying the bill. If the consumer pays directly, there is a reluctance to part with money, and that controls the cost.

This is true regardless of the kind of third-party payer involved–employer, insurer, or government. No third-party payer is willing to write a blank check. They will all find a way to limit their costs by restricting the supply of services available to the consumer.

They might limit the number of licensed providers, use waiting lists, ration the kinds of services available, deny service based on medical necessity, or prevent certain groups–such as the elderly–from receiving certain services–such as transplants.

Such rationing, of course, results in unhappy consumers. In the United States, we are experiencing a “managed care backlash,” but people in other countries are not much happier. A survey of five English-speaking countries showed that, despite very different health care systems, the populations have remarkably similar levels of unhappiness with their systems.

Another consequence of third-party pay is that consumers have no idea what health care costs. The payers know, and employers, economists, and politicians are becoming alarmed that costs are rising by double digits again, but the American people are unaware and unconcerned. Surveys since 1973 consistently show that two-thirds of Americans think we spend too little on health care, while fewer than 10 percent think we spend too much.

Consumer-Driven Solution

As long as people are disconnected from the cost, as long as they think rising costs are someone else’s problem, there will never be the national consensus needed to change the system.

That’s why recent efforts to put more control of health care resources and responsibility in the hands of consumers are so important. The movement towards creating a “consumer-driven” health care system is taking many forms–medical savings accounts, defined contribution benefits, “premium support” or vouchers for Medicare, personal health accounts–but they all begin to merge the consumer and the payer, and reduce the role of third parties.

Ultimately, that’s how we will create the answers that managed care failed to find.

Greg Scandlen is senior fellow in health policy at the National Center for Policy Analysis and contributing editor to Health Care News.