Healthcare's Cost Problem: Lack of Price Elasticity of Demand

US Healthcare's cost problem is not the "Fee for Service" model. The root problem isn't even high healthcare prices… The root cause is “Price Inelasticity of Demand."


by David Gaines

Common wisdom is that US healthcare costs are too high because we pay based on the volume of services provided, rather than for positive health outcomes, and this creates powerful incentives for providers to perform too many services. Another popular train of thought states the costs are because of high prices. They correctly note that U.S. healthcare likely costs 60%+ more per unit relative to other countries, and those prices are driving costs.

This logic is tidy and both theories have parts that are correct, but it overlooks a more pernicious problem — a near-total lack of price elasticity.

"Price Elasticity of Demand" simply means that if someone sells something at a higher price, all else equal, people buy less of it. Conversely, if someone sells something at a lower quality but at the same price, people buy less of it.

This is a common feature of most well-functioning markets. For instance, if your local grocery store tries to sell a normal apple for $10, no one will buy it. We don't need value-based contracts for apples.

Now, I know your reaction: “Healthcare is different than groceries."

For patients, yes. But for payers and providers dealing with thousands of transactions a day, not really. Every day, Anthem and UHC buy and set the incentives for a lot more MRIs than a family (or several thousand families) buy apples. The key difference is that the families don’t buy the equivalent of $10 apples. If a store gets a reputation for worms in their apples (corollary to worse or excessive healthcare services), people stop buying them and go elsewhere!

But why are we getting it so wrong?

First, a provider won’t necessarily get more patient volume if they price their services well or if they deliver quantifiably better healthcare. In fact, if a provider manages to deliver care more efficiently, Medicare and commercial payers' reimbursement system will pay that provider less.

Second, payers are under tremendous pressure to offer broad networks to their members. Commercial plan sponsors are either unwilling to narrow their network, or unaware of their options to do so. This lack of dynamism occurs despite the vast majority of metros in the U.S. having 2+ healthcare systems that could compete against each other. This situation gives large provider groups (especially health systems that are thought of as "indispensable") significant leverage to negotiate favorable reimbursement rates. The lack of ability for a payer drive patient volume sets up a system where there is no reward for providers that lower their rates.

Third, patients are not incentivized to purchase healthcare efficiently. It costs a patient the same amount ($0) to get a screening colonoscopy at a hospital instead of an ambulatory surgery center (ASC), despite a hospital consistently costing 2x the ASC. There is often no clinical reason to receive the service at the hospital instead of the lower cost facility.  Similarly, the vast majority of health plans do not consistently have differing patient responsibilities for hospital based imaging versus office imaging, despite a hospital based image costing 2x as much.  Further still, most patients don't even have the option to opt-in to more efficient networks in exchange for lower premiums and patient payment responsibility.

Finally, healthcare claims data are opaque, which makes it very challenging for payers to analyze — and scrutinize — the services their in-network providers are providing, the prices they are charging for equivalent care, and the quality and appropriateness of those services. This opacity makes the information necessary for facilitating a competitive market largely absent.  (Shameless plug for my company, Careignition, which aims to inject transparency into this data and empower payers.)

If every provider group *has* to be in-network, if every screening colonoscopy has be fully reimbursed at the hospital when they don't need to happen there, and if payers (defined broadly) don’t have the tools to effectively police service costs or quality, then there is little stopping providers from setting high prices, raising them 10% a year, and growing their organizations — and doing cool, expensive things, like building beautiful buildings, starting corporate venture funds, donating to charity, organizing conferences, and buying other health systems.

We have a system where payers, employers, and patients reward providers with a much higher return on investment for building the prestige of an organization – moving higher in the rankings on U.S. News and Reports – than improving their prices and quality of care, making communities healthier and wealthier. Until these incentives are changed, short of a major government intervention, our healthcare system will continue to be the most expensive in the world.  

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