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Solution Framework of Market Forces

Third Party Payer versus Patient Pay

Growing reliance on third-party payers

Federal tax policies have long encouraged third-party, prepaid medical care over individual insurance or direct payment. Under current tax law, employers can deduct the cost of health insurance premiums from their employees’ pre-tax income, so one dollar of earned income buys one dollar’s worth of health insurance.

People without employer-provided health insurance, and people with insurance but paying out-of-pocket for expenses below the deductible or for required copayments, typically must use after tax dollars. This means one dollar of earned income may buy only 50 to 75 cents’ worth (depending on a person’s tax bracket) of health insurance or medical services. This encourages over-reliance on employer-provided insurance with low deductibles and copayments (Goodman and Musgrave 1992).

Government health care programs for the poor and elderly add greatly to the number of people who depend on third parties to pay for their health care. Government programs for the elderly (Medicare) cost $265 billion and for the poor (Medicaid) cost another $305 billion in 2004. (Kaiser 2005b, Kaiser 2007b). A recent study found that about half of the increase in health expenditures nationwide since 1965 was caused by the creation of Medicare and Medicaid (Finkelstein 2006).

As a result of tax policy and the expansion of Medicaid and Medicare, the amount Americans pay out-of-pocket for health care has fallen precipitously. In 1960 Americans paid about one-half (47 percent) of their medical bills out-of-pocket. By 2004, only 13 cents of every dollar was paid out-of-pocket. The remainder was paid by third parties—employers, insurance companies, and government agencies (CMS 2006).

Consequences of over-reliance on third parties

Because the party receiving service is not the one paying the bill, reliance on third-party payers reduces the financial incentive for patients to shop for the best deal and to limit their discretionary use of health services. This can be seen in the absence of comparative information about the quality and price of medical procedures now available to consumers. Prices for hospital procedures are rarely posted and bills bear little relationship to actual costs. Consumers seldom seek out such information because they aren’t paying the bill, and producers have little reason to provide it because it won’t affect whether a patient will choose them over other providers.

Managed care plans emerged in an effort by governments and businesses to combat the rising cost of health care due to these perverse incentives. Government regulations and Health Maintenance Organization (HMO) pre-authorization were substituted for market discipline, the privacy of patients and freedom of doctors were compromised, and a new layer of insurance bureaucracy was created. Since the underlying incentives to over-consume and over-spend were left unchanged, however, spending soon started to rise again.

The direct payment alternative If consumers paid a larger part of the cost of their care, consumption would fall significantly. The RAND Health Insurance Experiment, conducted during the 1970s, showed that when patients were exposed to greater cost-sharing their medical expenditures fell by about 30 percent with negligible health effects (Newhouse 1993). More recent research on consumers choosing high-deductible insurance and Health Savings Accounts shows significant reductions in spending without negative effects on health (Wharam et al. 2007).

While insurance is necessary and appropriate for expensive and unexpected care, nearly half of all health care spending is for relatively routine and inexpensive treatments best paid directly by patients. Recognizing this, hundreds of doctors have already arranged their practices to reduce their reliance on insurers by encouraging direct payment for services (Cherewatenko 2002, Meier 2001a). These practices accept only cash, checks, credit cards, or debit cards for Health Savings Accounts (see Principle 7 for more on HSAs).

Because they no longer require large staffs to process complex insurance claims or comply with price controls imposed by government programs, they are able to offer prices that are between 25 percent and 50 percent less than the reimbursement paid by Medicare and other insurers.

Direct payment for health care services also reduces the need for claims reviewers and “gatekeepers” who make up the bureaucracy created by managed care programs. Doctors and patients are once again allowed to determine appropriate care without interference.

Direct payment also ends the injustice present in the current system whereby households with the highest incomes, and therefore in higher tax brackets, get the largest tax benefits for employer-provided health insurance. John Goodman estimates that families in the wealthiest quintile of taxpayers get an annual tax subsidy of $1,560 a year, while families in the poorest quintile get only $250 (Thorpe and Goodman 2005).

Policies to promote direct payment

Elected officials can promote the movement away from overreliance on third-party payers by adopting the following policies: 

! End the tax preference for employer-provided health care by replacing it with a tax credit or standard deduction for health care that can be used to purchase individual insurance and make deposits into Health Savings Accounts (Bast, J. 2005);

! Make price information for hospital services more accessible and transparent (Kreit 2006);

! Repeal policies that slow the adoption of high-deductible plans with an HSA, such as mandated first-dollar coverage and state taxes on HSA deposits; and

! Include HSA-like accounts in government programs for the poor and elderly to ensure they have funds for direct payment of health care (Raniszewski Herrera 2006, Konig 2005).

By promoting direct payment, policymakers can reduce unnecessary health care spending, strengthen the doctor-patient relationship, end tax injustice, and reward the most efficient healthcare providers.

Suggested readings: Cannon, M., and Tanner, M., 2005, Healthy Competition: What’s Holding Back Health Care and How to Free It, Washington, DC: Cato Institute; Herrick, D., 2003, “Why Are Health Costs Rising?” National Center for Policy Analysis, Brief Analysis No. 437; McClaughry, J., 2003, “A Health Care Reform Agenda: Desirable State Changes,” Health Care News, March.