Third party payment in health care (part 3): Technology drives cost growth

Imagine that Sony plans to bring to market a new TV that is twice as good as the old $500 TV but costs $200 more to produce. If instead it is twice as good but costs $2,000 more, they will probably hold off and look for a less expensive way to improve quality.

Now imagine that TV insurance covers 90% of the incremental cost, so the consumer only sees a price increment of $200 for a TV that costs $2,000 more to make. You, and many others, would demand this new TV, which is high quality but probably low value for you, since the true incremental cost is probably more than you’re willing to pay for that quality increase.

Knowing this, Sony will likely make lots of new high-tech TVs, and will expand their R&D programs to push the limits of TV quality improvement. They won’t care much about the higher costs, because demand for any new quality-improving technology is increased by the presence of TV insurance.

This is likely to be true even if you were also told that your TV insurance premium comes out of your wages, because the cost of that insurance depends mostly on how many of your work colleagues buy new and better TVs. In addition, that insurance premium is both hidden to you and distant when you’re at the store buying the TV.

Americans would have the best TVs in the world, and companies would compete based on who can produce the highest quality TVs, almost regardless of cost.

We don’t have TV insurance today, and yet TV quality improves fairly rapidly. The market, as an aggregated collection of individual purchasing preferences, determines a balance of improved quality and high cost that results in “high value technology improvements.” Sony and its competitors try to meet the demand for high value technology improvements, rather than for any technology improvements without regard to cost.

The hidden nature of employer-provided health insurance and the tax subsidy for that insurance distort people’s decisions so that they purchase health insurance with low deductibles and high premiums. This encourages us to use lots of health care without too much regard for the cost of that care.

In her testimony before the Senate Finance Committee, Kate Baicker explained why insurance causes greater consumption of health care:

Insurance, particularly insurance with low cost-sharing, means that patients do not bear the full cost of the health resources they use. … The RAND Health Insurance Experiment (HIE), one of the largest and most famous experiments in social science, measured people’s responsiveness to the price of health care. Contrary to the view of many non-economists that consuming health care is unpleasant and thus not likely to be responsive to prices, the HIE found otherwise: people who paid nothing for health care consumed 30 percent more care than those with high deductibles. This is not done in bad faith: patients and their physicians evaluate whether the care is of sufficient value to the patient to be worth the out-of-pocket costs.

This is why Kate (and I, having learned from Kate) talks about “high value health care.” As a policy matter, we should not want to encourage people to use either more or less health care. We should instead want people to be free to choose high value health care without distortion, in which each person decides how to get the greatest value per dollar spent and what is the right balance of improved quality and higher cost.

Everything that I have explained so far about third party payment in health care contributes primarily to a high level of health spending. None of these factors alone, however, explain the extraordinary growth of health spending. This is where we grasp the rose by the thorn: the primary driver of long-term health care cost is technology.¬†America spends more on health care each year primarily because we demand more and better health care each year. We just don’t know that we’re demanding it, because government policies push us toward high-premium low-deductible health insurance that increases our demand for high-quality but low-value technology improvements.

In January of 2008, the Congressional Budget Office reviewed three studies of the sources of cost growth in real per capita health care spending in the U.S. Here is their summary of two of the studies in chart form. (The third study had ranges and was too difficult to graph. It assigned a range for technology of between 38% and 62%.)

health cost growth graph

You can see that technology explains half to two-thirds of the long-term growth in real per capita health spending. Another 10-13% is the direct result of changes in third-party payment that further insulate us from the cost of the medical care we use (mostly the creation of Medicare and Medicaid).

There are two points here:

  1. Our employer-based health insurance system hides the cost of premiums and subsidizes those premiums. This encourages those with employer-provided health insurance to ignore some of the higher premium costs, and pushes us toward policies with low deductibles and copayments (at the expense of higher hidden subsidized premiums). These low deductible policies encourage us to use low value health care and result in unsustainably high and rapidly growing insurance premiums that crowd out wage growth.
  2. These low deductible policies also reduce our sensitivity to the costs of new medical technologies. We choose improved technology without proper regard for whether that technology is worth the higher cost, because government policies are distorting our decisions.

According to the two studies shown above, the interaction of these two factors is responsible for 2/3 to 3/4 of health care cost growth. This is where we get to the politically uncomfortable part.

  • Health care costs are on an unsustainable path. We must slow the growth of those costs.
  • 2/3 to 3/4 of health care cost growth comes from policies that push us toward low deductible policies and cause us to demand technology improvements without much consideration of the cost of those improvements.
  • Any solution that addresses the “change in third-party payment” source of cost growth will mean that people pay more out-of-pocket when they go to the doctor or hospital. In exchange they will get lower premiums. Still, this higher out-of-pocket spending is higher for some politicians to swallow (especially Democrats).
  • Any solution that addresses the technology source of health care cost growth will mean that new medical technologies will be developed less rapidly.

Nobody in Washington wants to tell you that last point. We argue about administrative costs, about medical liability costs, about insurance company profits, and about waste, fraud, and abuse. All of those are important contributing factors to high levels of health spending, and we should definitely make reforms that try to lower those levels. But our long-term problem is principally about the growth rate, and addressing the growth rate involves a real tradeoff. New medical technologies and drugs will still be developed, but not quite at the breakneck rate that we’re used to. This is grasping the rose by the thorn.

The only question left then becomes who will make those determinations. Should determinations of “high value health care”and “high value technology improvements” be made by the government, or as the result of the decisions of millions of Americans acting independently based on their own preferences?

You can probably guess my answer.

17 thoughts on “Third party payment in health care (part 3): Technology drives cost growth

  1. thebigo

    Hi Keith:

    Love your analysis. I own a small business and we’ve provided healthcare insurance to all our employees since we were launched 10 years ago. We had a traditional policy where our employees paid a nominal ($15) copay for just about all their coverage. Our premiums were climbing rapidly and had just about doubled within 7 years. Last year, we decided to bag that policy and adopted a policy tied to an Health Savings Account. Our employees pay the first $2,500 or $4,500 of expenses, then the policy kicks in. The company contributes a chunk of the deductible and employees have to contribute as well. We’re saving about half of our premium expenses and we’re all happy. If we don’t use what’s in our HSA, we keep it. It has forced our employees to be more judicious in their healthcare spending. No more going to the doctor for every little boo-boo.

  2. NormD

    Something is wrong with this analysis. Its too easy to just blame “technology”. Its a little like a teacher’s union saying that we spend so much money on education because we are purchasing “education” or a military contractor saying we are purchasing “defense”. If we ask them to spend less then we are told that we are going to get less education, defense or medical technology.

    Think about it. How has a office visit to a doctor changed in the past 20 years? Why does it cost so much more to talk to a doctor for 10 minutes? Most medical technology is rather dated: Statins? Xrays? CAT scans? MRIs? Blood tests? Stents? EKGs? Laperoptic surgery? These things have been around for decades. Technology, patent expiration and the learning curve should have been making them cheaper and better not more expensive.

    My wife had an appendectomy last year. The bill was $80K, reduced to $5K by insurance! They charged $12K for a 20 min CAT scan! The surgeon’s fee was a more reasonable $3K

    Something is desperately wrong with this industry and its not that they are using too much modern technology.

  3. Henry Bramlet

    Actually, NormD, you almost hit on a point I was going to make.

    Not only do the current incentives create an incentive for higher cost technologies, but they also form a DISINCENTIVE for lower cost technologies.

    Today, Samsung has an incentive to create a TV with future features for 60% cost of their standard models because doing so will open up new customers who don’t demand their product at the higher price point. Under the “TV Insurance” scenario, they have every incentive to pack features into ever more expensive TV’s because price is no longer a consideration.

    If you look at some of the most spectacular, market and industry changing successes in recent history, the ability to do things cheaper with technology has been a significant driver. WalMart wasn’t a paragon of service and excellence, but a master of technology in their supply chain that allowed them to cut prices to the bone. The success of computers has not only been their rapidly increasing power, but also their rapidly decreasing price.

    Technology could be driving down prices, but only if consumers become price sensitive.

  4. Chris

    No specific insights or anecdotes to offer here, but I did want to drop a “thank you.” As with all of yours posts, this is great analysis presented in a very easy-to-understand fashion. Washington (and now we) are very lucky to have you. Keep up the great work – this is a blog everyone (on both sides of the proverbial spectrum) should be reading.

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  6. leishman

    Speaking as a practicing physician for the last 35 years, I would offer the following regarding any new technology’s predictable evolution (MRI would be an example): Stage 1–remarkable breakthrough, with a few limited indications; Stage 2–expanded indications for use (other body areas, ability to diagnose/treat more conditions); Stage 3–standard of care (think of implementation of “routine” or “screening” mammography as an example); Stage 4–hmm…puzzling symptoms…let’s order an MRI; Stage 5–I don’t want to get sued for delay in diagnosis…better cover all the bases and order an MRI; Stage 6–patient demands an MRI based on something he/she saw on 60 Minutes. This pattern has continued unchanged for the last several decades; bone-marrow transplantation for cancer treatment (the “next best thing”, subsequently shown to be ineffective for many cancers) would be a more recent example of a long tradition of next-best-things such as leeches, gastric freezing, or chymopapain injections for lumbar disc herniation.
    That said, appropriate use of technology makes for better patient care, at least for some patients. I can write an order an MRI for a patient with a suspected brain tumor and diagnose it with greater accuracy and certainty than the world’s foremost pre-1980 neurologist. Of course, I may have to order brain MRI’s on 30 people to find one tumor. I can write an order for a mammogram and diagnose a small breast cancer that no surgeon could find with a careful breast examination. Of course, ten women may need biopsies for suspicious but benign lesions to find one actual breast cancer. But if I don’t order it and it’s found six months later, I’ll likely end up in court to explain the delay in diagnosis.
    On an unrelated matter, I’ve observed that those folks who decry “unnecessary” medical care for others (e.g., expensive and often futile treatment for what turns out to be end-of-life care, for example) are usually the same folks who, when faced with a serious medical condition for themselves or loved ones, never fail to demand “only the best” and that “everything must be done”. Go figure.
    And on a final unrelated matter, evidence-based treatment guidelines, including those likely to result from Pres. Obama’s proposed data-crunching in Washington, may be useful when looking at large groups of individuals, but have their limitations. If a form of treatment “only” helps 10% of people and is excluded from coverage, what happens if an individual is among the 10% who would have benefited?

  7. Andrew Biggs

    I have a strange fetish for the role of aging in driving overall health care and entitlement costs (see, so a quick note on the Cutler and Newhouse charts above. Aging isn’t a big cause of rising prices for private sector health care, which caters primarily to working age Americans. The average age of working age Americans is currently around 42 and will actually decline a little over the next 30 years or so as the Baby Boom bulge shifts into retirement and onto government health care rolls. However, for government funded health care it’s a different story. Those Baby Boomers will significantly increase the number of people receive Medicare benefits and the increase in the “oldest old” aged 85 and up will also raise costs as these folks simply use more health care. So it makes some sense to think of government provided health care as a somewhat different market than health provision for working age individuals.

  8. Darren

    I’ve been a radiologist for 11 years (plus four more in residency), and the changes in technology have been astounding. It’s one of the reasons I went into radiology.

    The CT scanners at my state-of-the-art hospital in 1994 took one slice every 8 seconds. The CT scanners available now, for no doubt the same purchase cost as the ones they replaced, take up to 192 slices per second, 64 per rotation with up to 3 rotations a second. The old CT scanners would take pictures 8-10mm thick. The new ones take slices 0.5mm thick, enabling reconstruction with full resolution in any plane. We’re looking at getting a new 64-slice scanner to replace a 2-slice in the hospital, they’re coming in at around $800,000. If price were no object, we could get a 320-slice scanner for about 2.5x more that would take 960 images in a second, scan a whole brain in one spin or a heart in one heartbeat.

    MRI scan times have come down, but not nearly as much as CT. MRIs are still expensive, because a magnet 30,000 times the Earth’s magnetic field is hard to build and insure uptime, and the environment makes normal equipment either useless, or if ferromagnetic, dangerous. Ultrasound is so much better than even 5 years ago that looking at old images makes me nauseous, and digital mammography is a significant leap forward in the detection of breast cancer.

    As a radiologist, I don’t order tests on people. I just read what is ordered, I may suggest a follow-up course of action but I don’t dictate what happens next. The cost savings of a CT scan to rule out appendicitis is that the CT, which costs $3,000 on the hospital bill, saves a laparotomy that costs $30,000. The rule used to be that surgeons were allowed to operate for appendicitis and be wrong (no appendicits) about 20% of the time. With CT, the miss rate is far lower, and fewer people are getting operations that they don’t need. My personal average for positive breast biopsies is 25%, but the majority of the breast biopsies that happen are done either with ultrasound or stereotactic biopsy, both outpatient and minimally-invasive procedures that cost far less than open biopsies. Imaging, properly used, gets fewer people into the OR and gives them more productive days of working rather than healing from surgery.

    That being true, I am opposed to medical imaging as entertainment. I promise you, if I put all the commenters on our 64-slice scanner, at 0.5mm resolution I will find something that is either pathology or a “normal variant” that doesn’t represent disease. That mass on your adrenal may be a nonfunctioning adenoma that won’t shorten your life by a day, or a metastatic lesion from another process. It may take another study or another study in a few months to tell the difference, but either way I agree with the American College of Radiology that unindicated, patient-driven imaging drives up cost with no increase in quality. I don’t tell people the gender of their child on a pregnancy ultrasound unless it’s germaine to a finding that may indicate something is wrong.

    Where technology is abused is when it makes it into a physician’s office, something the Stark laws still allow, even for something like a CT scanner or MRI. When you have one of those, you have a loan to pay and a service contract to pay, and it seems that whether or not the study happens has a lot to do with who owns the machine. This is a major point of contention between radiologists and the remainder of the medical field. There are physician-entrepeneurs who operate (and populate) imaging centers for profit, and this is probably not a good thing. The laws in this field are blunt tools, though — I wouldn’t want to deny a doctor in a small town an ultrasound machine or a CT when it would be a long trip to find either, but the cardiologist with a nuclear medicine camera and his own cath lab can be an exercise in abuse.

    Phil Gramm said years ago, during the HillaryCare debate (back when there was debate, remember that?) that “If I went to the grocery store and only paid 5% of the final bill, I’d eat differently and my dog would too.” The kabuki theater that is medical insurance billing is astounding. As a radiology group we would do equally well to bypass the billing and charge a flat $40 cash for everything we did, from finger films to the most complex interventional procedure, but that’s not an option on offer at this time. If you want to reform insurance, that’s a great thing. I just don’t see BHO doing so in a way that doesn’t create other unintended consequences, one of which may be my departure from medicine.

  9. Brad

    Couple of thoughts:

    1) RAND study had mixed findings–made equally bad choices when it came to all treatments. What you cite is true, but lower income folks had several suboptimal outcomes, ie, made poor choices.

    2) Technology choices not driven by demand side in many cases, it is on supply side by docs ordering tests. No data to say, regardless of type of plan you hold, technology costs would still not grow at obscene rates. May be dampened, but as you point out, that is source of evil.

    3) 80/20 rule, as I am sure you know. Small percent of folks use majority of resources. Even after deductibles, their costs are sky high, would not control.

    Could go on, but your analysis a bit myopic (although valid points, however, i disagree, SID and demand side is where issues are–supply side small potatoes). Also, see todays NEJM on market driven health solutions. Nice review of many of your points above.


  10. Jackson

    Speaking as a medical student, this sounds correct. Twenty years ago, HIV was a death sentence. Ten years ago, CML was a death sentence. Now both are chronic conditions. So the price of health care goes up, but you’re purchasing a different basket of goods. You’re not comparing apples to apples year over year.

    The analogy of a TV is not a very good one since in most cases (see HIV and CML above) the demand for the highest end medical services is very inelastic.

    However, I think you underestimate the extent to which doctors make treatment decisions instead of patients. By choosing the patients “menu” of options, the physician has already determined to a large extent which treatment the patient will choose. And most patients won’t go against their doctors recommendation anyway. They don’t have the information to make a medical decision, and are thus highly dependent on the physicians advice.

    From my perspective, two interventions that would slow cost growth is to increase the number of primary care physicians (pay off their medical school debt if they go into the field) and providing prescription drugs for free. Increasing the supply of primary care physicians would decrease cost growth because, although I don’t have data, I think there’s reason to believe that they are more likely to present their patients with a lower cost “menu” in aggregate than specialists. Providing free prescription drugs substitutes capital for labor. Drugs are to medicine what robots are to manufacturing, and in medicine, the price of labor is very high. People in our society eventually get treated, if it happens later in the process, the remedy is more labor intensive. I would love to hear your thoughts on this topic Mr. Hennessey.

  11. Jackson

    On a related note, and correct me if this is wrong, the statistics that tell us that health care spending increased by x amount and is now this much and this percentage of our economy are akin to GDP. It would be interesting to see a health care equivalent of the consumer price index.

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  15. kbh

    You’re not alone. Some state health insurance markets are so inefficient that you can find win-win opportunities with premiums that are so much lower that you can cover a lot of the out-of-pocket costs. I’m glad it’s working well for your business.

  16. Steven Hales

    NormD, Your experience is not unique. The root of the problem is with hospital chargemasters. The prices in the chargemaster are not aligned with costs. Items on your hospital bill reflect an arbitrary cost increase on individual line items that have taken place over the years to maximize hospital net revenues. The problem also has to do with Medicare mandated DRGs (Diagnosis Related Groups). These groupings have allowed hospital billing departments to game the system to receive payment. But overall because of a hospitals lack of true cost accounting efficiency improvements are not captured in prices. In fact hospitals have an incentive to hide efficiency improvements from payers. Their attitude is “why bother” I’m keeping the doors open with the current system. I am convinced that if we adopt a universal coding system, scrap chargemasters and DRGs, and put in place incentives for quality improvements hospitals would trim administrative costs and all payers would be aware of true costs. Once we have true market prices then high deductible policies make sense and the feedback loop is in place with consumers and payers fully aware of price. This feedback is what would continue to drive efficiency improvements and quality of care.

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