My Latest Column: Why Exactly Did U.S. Health Costs Go Wild?

by Reihan Salam

Apologies for the light blogging. I’ve been finishing an essay that is long overdue. 

My latest column for The Daily is on a subject we often cover in this space, and I draw, once again, on a terrific post by Noah Millman and on a fascinating new paper by Brown University graduate student Daeho Kim. The following is from the column:

So if the real problem with U.S. health spending is that the U.S. diverged from its peer countries for a decade-long stretch, solving that problem isn’t quite as simple as mimicking the institutions and strategies of our peer countries, whether it’s Canada’s single-payer system or the hybrid models of France or Germany. Our peer countries are facing the same challenges we are, albeit with slightly more breathing room.

This raises the question of what exactly changed in the 1980s. Daeho Kim, a graduate student at Brown University, offers a provocative hypothesis in a new working paper. As Kim explains, a 1983 Medicare reform created the prospective payment system, or PPS, which offered fixed reimbursements for the use of a medical technology. If a physician decides to use bypass surgery as a cardiac treatment, she won’t be paid on the basis of what it cost her to perform the surgery. Instead, she’ll be paid the national average cost. This way, there is a strong incentive to beat the national average cost of performing bypass surgeries, thus lowering, in theory, systemwide costs.

But something quite different seems to have happened. A big part of the story is that providers can choose from a number of different cardiac treatments, some of which are more expensive than others. PPS encouraged them to focus on the treatments where the marginal cost — the cost of providing one more treatment, in this case — fell below the average cost, even if there are more cost-effective treatments available. Kim suggests that PPS may account for one of the most distinctive aspects of the U.S. health system — our extraordinary overreliance on costly treatments. If Kim is right, it is the failure of bureaucratic price-setting, not the failure of market competition, that may have supercharged health inflation in the 1980s and beyond. We could try to create better price-setting mechanisms. Or we could accept that centralized bureaucracies are just not very good at allocating resources.

Inevitably, I then make the case for Medicare premium support. Kim’s paper is obviously not going to be the last word on this subject. If he is right, however, the argument that Medicare has exacerbated cost growth across the health system will be strengthened enormously. Why? Well, the way to drive marginal cost below average cost for most medical technologies is to just ramp up the volume of procedures. If the goal is to maximize profit, which will be true whether or not the provider in question is avowedly “for-profit” or “non-profit,” the key thing will be to identify the most lucrative procedures, whether or not they are the most cost-effective procedures, and to do as many of them as possible, whether or not the patients are Medicare patients. Medicare premium support might help because competing on the basis of the cost of offering a defined benefit will foster spending discipline. Insurers will build provider networks that will use trial-and-error to settle on the best way to achieve cost savings rather than bureaucratic price-setting that encourages the use of some procedures over others on a mass scale. 

That’s the theory, at least. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.