A recent post made reference to the medical device industry, prompted by Ramesh Ponnuru’s latest column. The post’s larger concern was with barriers to new entrants in a wide range of industries, which have contributed to a dearth of exploratory, as opposed to exploitative, innovation. Conor Friedersdorf kindly sent along an article by Mariah Blake of the Washington Monthly on barriers to entry in the medical device industry itself.

As Blake explains, the medical supply market has long been dominated by a small handful of powerful incumbents. Medical providers thus banded together to form group purchasing organizations (GPOs) to gain leverage in their negotiations with the giants. While GPOs began as nonprofit collectives, for-profit GPOs entered the picture and, as for-profits tend to do, they spread quickly, achieving near-total penetration of the hospital market by the end of the 1970s. It is at this point that Congress, in its infinite wisdom, decided to lend a helping hand:

Then, in 1986 Congress passed a bill exempting GPOs from the anti-kickback provisions embedded in Medicare law. This meant that instead of collecting membership dues, GPOs could collect “fees”—in other industries they might be called kickbacks or bribes—from suppliers in the form of a share of sales revenue. (For example, in exchange for signing a contract with a given gauze maker, a GPO might get a percentage of whatever the company made selling gauze to members.) The idea was to help struggling hospitals by shifting the burden of funding GPOs’ operations to vendors. To prevent abuse, “fees” of more than 3 percent of sales were supposed to be reported to member hospitals and (upon request) the secretary of health and human services.
But, as with many well-intended laws, the shift had some ground-shaking unintended consequences. Most importantly, it turned the incentives for GPOs upside down. Instead of being tied to the dues paid by members, GPOs’ revenues were now tied to the profits of the suppliers they were supposed to be pressing for lower prices. This created an incentive to cater to the sellers rather than to the buyers—to big companies like Becton Dickinson rather than to member hospitals. Before long, large suppliers began using “fees”—sometimes very generous ones—along with tiered pricing to secure deals that locked GPO members into buying their products. In many cases, hospitals were obliged to buy virtually all of their bandages or scalpels or heart monitors from one company. GPOs also began offering package deals that bundled products together. To get the best price on stethoscopes, a hospital might have to agree to buy everything from pacemakers to cotton balls from the GPO’s preferred vendors. Hospitals went along because they got price breaks, usually in the form of rebates if they met buying quotas.
This situation only grew thornier in 1996, when the Justice Department and the Federal Trade Commission overhauled antitrust rules and granted the organizations protection from antitrust actions, except under “extraordinary circumstances.” Once again, the idea was to help struggling hospitals, this time by allowing the buying groups to grow big enough to negotiate the best deals for their members. But the decision led to a frenzy of consolidation. Within a few years, five GPOs controlled purchasing for 90 percent of the nation’s hospitals, which only amplified the clout of big suppliers.
As it turns out, Shaw’s retractable syringe hit just as these trends were converging. In fact, the year his product came onto the market, three of the nation’s largest GPOs merged to form a company called Premier, which managed buying for 1,700 hospitals, or about a third of all hospitals in the United States. Shortly thereafter, Premier signed a $1.8 billion, seven-and-a-half-year deal with Becton Dickinson. Under the agreement, member hospitals—among them Dallas-based Presbyterian, where Shaw would hit a brick wall—had to buy 90 percent of their syringes and blood collection tubes from the company. Over the next two years, BD landed similar deals with all but one major GPO. As a result, almost everywhere Shaw turned, he found hospital doors were closed to him.

There are many lessons we could take away. For example, we could decide that Medicare should have kept its anti-kickback regulation in place. One could also argue that Medicare itself has encouraged excessive homogenization in the U.S. health system, i.e., providers are reluctant to pursue alternative strategies as they might be punished by a rigid, slow-moving Medicare system for doing so.

Perhaps not surprisingly, the GPOs keep prices opaque:

The idea of hospitals outsourcing oversight of their supply budgets may seem hard to fathom. But the price of medical supplies is not always transparent. Makers of the costliest devices and equipment tend to be secretive about pricing and generally require buyers to sign gag clauses promising not to disclose what they’ve paid, which makes it difficult for hospitals to comparison shop. (In fact, this is one reason GPOs maintain their services are necessary.) Also, many larger hospitals hold stakes in GPOs, and even smaller ones have less incentive than outsiders might think to pour over cost reports, since insurance companies and government programs, like Medicare and Medicaid, are picking up the tab for much of their supplies and equipment.
As for independent assessment of GPOs’ effect on costs, they are hard to come by. But the little information that is available suggests that they may actually drive up the price of supplies. A 2002 pilot study by the Government Accountability Office found, for instance, that hospitals that went through GPOs paid more for safety needles and most models of pacemakers than those that negotiated prices on their own—for some pacemakers the median gap was as wide as 39 percent.
Even more unsettling are the findings of MEMdata, a Texas-based company that helps hospitals process their bids for new equipment and captures the quotes in a database, so that administrators can compare the prices they are offered to what others have paid. Shortly after the company opened for business, founder Bob Yancy says he discovered that bids hospitals got through their GPO contracts were substantially higher than the ones he or medical centers that weren’t locked into GPO pricing could get by negotiating directly with vendors for the same equipment. Yancy later had his staff add a field to their database to track just how GPO bids stacked up. Over the last seven years, his company, which serves more than 500 medical facilities, has collected tens of thousands of bids. On average, Yancy says, the GPOs’ prices are 22 percent higher than the ones that hospitals can get on their own. “The bottom line is that hospitals are being systematically overcharged,” he told me, when I met him at a Washington, D.C., restaurant. “GPOs are inflating the pricing.”

So why does nothing change? Blake offers a simple reply:

“Hospitals are a big constituency in every district,” explains one senior Senate staffer involved in the ongoing GPO investigation. “And hospitals support GPOs. Reform, on the other hand, doesn’t really have a lobby, which can make it difficult to take action.”

Notice, however, that medical providers will greet any proposed cuts in Medicaid and Medicare budgets with the vociferous insistence that it is the poor and the sick who will suffer — for whatever reason, hospitals don’t choose to defect from GPOs to lower expenditures; we don’t ease regulations that require physicians to do work that other medical workers could perform just as well; and the cost of the health system continues to increase.

One likely scenario is that we will see some half-competent effort to regulate the GPOs. The GPOs will then find their way around these regulations, perhaps by changing their names. Meanwhile, barriers to new medical providers that can bring a fresh look to purchasing will remain as high as ever. Or we could recognize that micro-managing the system won’t work, and that lowering barriers to entry is the key to reversing this toxic dynamic.