Here’s a strange paradox: Health-care costs have increased by an unsustainable rate of about 8.5% each year over the past decade, according to PwC’s Health Research Institute. Already, the average employer-based family health insurance plans costs more than $18,000 annually.
But Medicare spending has been relatively stable. Over the past three years, the program’s payouts to hospitals have increased by only 1% to 3% a year, roughly even with inflation. The prices paid for some core services, such as ambulance transportation, have actually gone down.
To see what’s happening, we can start by pulling back the curtain on how preferred provider organizations do business. A PPO is a network of preferred health-care providers such as doctors and hospitals, typically assembled by an insurance carrier. In theory, the insurer can save money for its customers by persuading providers in the network to discount their services in exchange for driving volume to their facilities.
UnitedHealthcare Choice Plus, for instance, boasts that its PPO—a network of more than 780,000 professionals—cuts the cost of typical doctor visits by 52%, while saving 69% on MRIs. Pull back the curtain, and you’ll see these discounts are an accounting trick. To allow PPOs to advertise big discounts, providers simply inflate their billed charges on a whole range of services and treatments.
Don’t insurers have a natural incentive to keep provider prices down, even if they don’t end up paying the list price?
In fact, no—at least not since the Affordable Care Act took effect. That law established a “medical loss ratio,” which requires insurers covering individuals and small businesses to spend at least 80 cents of every premium dollar on medical expenses. Only 20 cents can go toward administrative costs and profit. (For insurers offering large group plans, the MLR rises to 85%.)
If a provider raises the cost of a blood test or medical procedure, insurers can charge higher premiums, while also boosting the value of their 20% share. Insurers can make more money only if they lower their administrative expenses or charge higher premiums.
In this way, the MLR rule encourages insurers to ignore providers’ artificial price hikes. Insurers can continue to attract customers with the promise of steep discounts through their PPO plans—and providers can continue to ratchet up their prices. By hoodwinking their customers, both insurers and providers make more money. Since insurance costs are merely a derivative of health-care costs, the result has been a steady rise in insurance costs for millions of working families.
For employers caught in this price spiral, there is a way out: partial or full self-insurance. When businesses self-insure, they pay employee health claims directly. That creates an incentive for businesses to question—and push back on—providers’ price increases. Self-insuring businesses can strengthen their leverage by using “reference-based pricing,” which caps payments for “shoppable”—nonemergency—services at the average price in a local market. Members who use providers with prices below the limit receive full coverage. If they use a provider that charges more than the limit, they pay the difference out-of-pocket.
This setup creates a strong incentive to control costs: Patients have a reason to shop around for the best value, while providers are pressured to keep their prices below the cap. The most expensive doctor is not always the doctor with the best outcomes.
That’s what happened when the California Public Employees’ Retirement System adopted a reference-pricing approach a few years ago. The agency had noticed that provider charges for hip and knee replacements varied from $15,000 to $110,000. In 2010, Calpers established a reference price of $30,000 for the procedures. Predictably, patients flocked to providers charging that price or less and shunned higher-cost facilities. Over the next couple of years, the number of California hospitals charging below $30,000 for a hip replacement jumped by more than 50%. In the first year Calpers saved an estimated $2.8 million on joint replacements.
What worked for Calpers can work just as effectively for small and midsize businesses. Today’s medical inflation is exactly what one would expect from health policies that reward insurers and providers for raising prices. Employers shouldn’t accept this status quo. By self-insuring and setting their own reference-based reimbursement, businesses can sidestep the traditional insurance model that continues to bleed them dry.
Mr. Lemer is CEO of The WellNet Healthcare Plan, a health-care services company.
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