Why Are Health Costs Rising?

Commentary by Devon Herrick

Mr. Chairman and members of the Subcommittee, please accept my comments for the record regarding the March 15, 2007, hearing about providing health insurance for the uninsured.  My comments focus specifically on the issue of health care prices.  As was pointed out by many of the witnesses during the hearing, the price of health care is a significant issue to consider as the Subcommittee discusses health care reform. 

Prices for medical services have been rising faster than prices of other goods and services for as long as anyone can remember. But the Subcommittee should consider that not all health care prices are rising. Although health care inflation is robust for those services paid by third-party insurance, prices are rising only moderately for services patients buy directly. For example, the real (inflation-adjusted) price of cosmetic surgery fell over the past decade - despite a huge increase in demand and considerable innovation.

Health Care Costs Rise When Others Pay. A primary reason why health care costs are soaring is that most of the time when people enter the medical marketplace, they are spending someone else's money. When patients pay their own medical bills, they are conservative consumers. Economic studies and common sense confirm that people are less likely to be prudent, careful shoppers if someone else is picking up the tab. Thus, the increase in spending has occurred because third parties - employers, insurance companies or government - pay almost all the bills.

The Extent of Third-Party Payment of Medical Bills. Although polls show that many people fear they will not be able to pay their medical bills from their own resources, the reality is that most people pay for only a small portion of their medical care:

  • For every $1 worth of hospital care consumed, the patient pays only about three cents out of pocket, on the average; 97 cents is paid by a third party.
  • For every $1 worth of physician services consumed, the patient pays less than 10 cents out of pocket, on the average.
  • For the health care system as a whole, every time patients consume $1 in services, they pay only 14 cents out of pocket.

Thus, from an economic point of view, the incentive for patients is to consume hospital services until they are worth only three cents on the dollar, on the average. The incentive is to consume physicians' services until they are worth only 10 cents on the dollar. And for the health care system as a whole, patients have an incentive to utilize everything modern medicine offers until the value to them is only 14 cents out of the last dollar spent.

Medical Inflation. Health care costs over the past 40 years have risen as the proportion of health care paid for by third parties has increased. Prior to the advent of Medicare and Medicaid in 1965, health care spending never exceeded 6 percent of gross domestic product. Today it is 16 percent. These two government programs unleashed a torrent of new spending and led to rising health care prices. For instance, a recent study by Amy Finkelstein of the Massachusetts Institute of Technology found that half the growth in health care expenditures was due to Medicare. There has also been an increase in tax-subsidized employer spending on health care. These two factors, rather than the cost of new technology and drugs, explain why health care costs outpace inflation.

Cosmetic Surgery Prices. Cosmetic surgery is one of the few types of medical care for which consumers pay almost exclusively out of pocket. Even so, the demand for cosmetic surgery exploded in recent years. Of the 10.2 million cosmetic procedures performed in 2005 that were tracked by the American Society of Plastic Surgeons, 1.8 million were surgical procedures. By comparison, in 1992 the American Society of Plastic Surgeons only tracked 413,208 cosmetic procedures - a fraction of those performed in 2005.

Despite this huge increase, cosmetic surgeons' fees remained relatively stable. The average increase in prices for medical services from 1992 through 2005 was 77 percent. [See the figure.] The increase in the price of all goods, as measured by the consumer price index (CPI), was 39 percent. Cosmetic surgery prices only went up about 22 percent. Thus, while the price of medical services generally rose almost twice as fast as the CPI, the price of cosmetic surgery went up slightly more than half as much. Put another way, while the real price of health care paid for by third parties rose, the real price of self-pay medicine fell.

Another example of price competition is the market for corrective eye surgery. In 1999, only a few years after LASIK was approved, the price was about $2,100 per eye, according to the ophthalmic market research firm MarketScope. Within a short time, competition drove the price down to a slightly more than $1,600. The cost per eye of the standard LASIK is now about 20 percent lower than six years earlier. Competition held prices in check until a new innovation arrived for which patients were willing to pay more. By 2003 surgeons began to perform a newer, more-advanced custom wavefront-guided LASIK procedure.

Keeping Costs Down. What explains this price stability?  One reason is patient behavior. When patients pay with their own money, they have an incentive to be savvy consumers. A second reason is supply. For instance, as more people demanded cosmetic surgery procedures, more surgeons began to provide them.  A third reason is efficiency.  Many providers are increasing their efficiency by locating operating rooms in their clinics, a less-expensive alternative to outpatient hospital surgery. And providers often adjust their fees to stay competitive and usually quote patients a package price. Absent are the gatekeepers, prior authorization and large medical office billing staffs needed when third-party insurance pays the fees. A fourth reason is innovation and the emergence of substitute products.

Fostering Competition.  When providers compete for business, the market fosters competition.  In competitive markets, producers seek to reduce costs and to offer products that meet customer demands. However, instead of a competitive national market for health insurance, we operate under a patchwork of 50 different sets of state regulations.  Since each state insurance market is protected from interstate competition, legislators often require insurers to cover services that drive up premiums.  For example, about one-fourth of states mandate benefit packages that cover acupuncture and marriage counseling. More than half require coverage for social workers and 60 percent for contraceptives. Seven states require coverage for hairpieces and nine, hearing aids.  Needless to say, these mandates drive up the cost of providing health insurance, often making it prohibitively expensive for an insurer licensed in one state to do business in another state.  As a result, consumers have little choice among plans. In many localities, only one insurance product is available, so the consumer is forced to buy an overpriced product, or forgo insurance altogether.

Fostering InnovationWhen patients directly control their health care dollars, not only do prices go down, medical providers begin to offer innovative services to meet the demand of empowered patients.  Telephone consultations, walk-in retail clinics, electronic medical records, and personalized care are among the innovative services provided by doctors.  These new physician services tend to have two characteristics: (a) they offer patients greater convenience and (b) they step outside normal reimbursement channels.  Furthermore, many of these innovations (such as electronic medical records) dramatically improve the delivery of quality health care.

Conclusion.  As the Subcommittee deliberates health care issues, I hope you will consider the relationship between the competitive healthcare marketplace and stable prices.  Thank you for the opportunity to comment.