How hospitals work.
The comment of the day comes from our own unagidon, who offers the following tutorial in answer to the vexing question, “Why do hospitals charge so much for an aspirin?”
The reason that hospitals charge so much for an aspirin is a rather simple one, and if I tell you why they do it might help me make my point better. (I will talk about hospitals here, but what I say will more or less apply to doctors and other kinds of medical professionals.)
If we categorize them in terms of how and how much they pay, there are five kinds of people that go to hospital. These are Medicare patients, commercial insurance patients, self-pay patients, Medicaid patients, and indigent patients.
Like any business, hospitals have a cost structure, which is the sum total of how much it costs them to perform whatever it is that they perform. Any good enterprise will include in their cost structure a “profit”. (It’s a profit if it is a for profit concern and it is a surplus if it is a not for profit concern. But it’s the same thing.)
To cover its costs, any concern will have what is called a “cost to charge ratio”, which is simply what it charges against its own costs. So for example if some concern wanted to break even, it would charge precisely what its costs are. That is, for every dollar it pays out for salaries or equipment or whatever, it would charge a dollar. In this case, the cost to charge ratio would be 1:1.
The cost to charge ratio at a hospital in the United States is typically about 2:1 (they charge 2 dollars for every one they spend) to about 10:1 (they charge 10 dollars for every one they spend). In the case of your mother, she happened to go to a hospital with a high cost to charge ratio. But the thing is, with all of these high cost to charge ratios, hospitals only manage a profit margin (in general) of 1 to maybe 5 percent, with most of them at the lower end of the range. If they are charging at least double to ten times their cost, how can this be?
The real question is: “who pays what and why do they pay what they pay?”
Most of a hospitals business comes from Medicare patients. Medicare patients (and they are not all old, but they all tend to be sicker than everyone else) do account for most of the hospital work in this country. The government pays the hospitals from the Medicare taxes that most of us pay. But the government only pays 98 percent of charges. This means that most of the income that a hospital gets (think about 2/3 of its income) is paid to them below cost. There is a good reason why the government does this. The basic hospital rate (the “base rate”) is set by statute for the whole country each year. This rate is adjusted for each hospital based on location (New York has higher costs than Hope Arkansas, so its hospitals get paid more) and some other things, including volume of charity care, whether the hospital is a teaching hospital, etc. The reason that the government pays less than cost is that this is the only mechanism that it can use to create an incentive for the hospital to become more efficient and cut its own costs.
Now usually it would be the “free market” that would do this. Is the government displacing the Invisible Hand of Adam Smith here? It would seem so. But the government has to do this, in fact, because there is no free market for medical services in the United States. For a free market to work, one needs to have two things: 1) prices have to be transparent and 2) quality has to be transparent. In order for prices to move, one has to be able to compare prices between providers of a service. One also has to know which provider is better, because part of a price is the quality of the service. The consumer doesn’t just want the cheapest price, they want the cheapest price for the best service, so they have to measure this as well.
There is neither price nor quality transparency for medical costs in the US, so the market can’t act in the way that it does for the price of bread. There is a reason why this is that I won’t get into here. But you can’t comparison shop for your appendectomy nor is there an objective and reliable way to compare one doctor to another in terms of their abilities.
The point is, hospitals are paid below cost at the get go for most of their services. But they still have to break even or make a small profit. But the next group of patients are Medicaid patients. Medicaid patients are paid for basically by the state. The state pays for them at about 30 to 60 percent of cost. The state does this because our society thinks that we need to provide some minimum of medical service. The problem here is that state has one idea of what “minimum” means and the hospital has another idea. The hospital wants to treat a Medicaid patient like any other patient. So they just suck it off. Medicaid patients are a variable percentage of a hospital’s patient mix. Let’s pretend that it’s 10 percent. If Medicare patients are 66 percent and Medicaid patients are 10 percent of the patients, then 76 percent of patients are seen at below cost. The hospital now has to find a way to break even on a patient base of only 24 percent (100% – 76%).
But in this 24 percent is another group of patients. These are the ones that can’t pay for anything. This population consists of people who do not qualify for Medicaid (and states have been cutting more and more people out of the Medicaid pool over the last 10 – 20 years to save themselves money.) The hospital is required by state law to provide emergency care for these people and in some (rare) cases they will also provide other kinds of free care. (Emergency room care, by the way, is the most expensive form a care in general). But since all of this care is provided for free, if you add it to the 66% of patients who are paid below cost, you have a larger group of patients who are paid even more below cost. Let’s say that these people amount to 4% of the hospital census. This means that a full 80% of the patients are paying below hospital costs.
So in order for the hospital to even break even, it has to inflate, massively inflate what it charges for the last two categories of patients; those insured commercially and those (like your mother) who have no insurance and will have to pay out of pocket.
Now of these last two groups, those with commercial insurance pay different amounts depending on what insurance company (and product) they have. Insurance companies negotiate discounts from the massive mark-ups that a hospital has to make in order to break even. The size of the discount will depend in general on how much business the insurance company has with the hospital. The more business it has, the larger the discount it can command. Of course, this leads to two things. First, this means that the majority of a hospital’s commercial business will be at the highest discount rate. This discounted rate is (and has to be) at a more than 100 percent of cost, since insurance companies know that they have to cover the costs of (in this case) the 80% of patients who are paying below cost. Otherwise, the hospital would go out of business. But the largest insurer pays the least, followed by each payer in its turn by size. The irony here is that in a free market the largest one who pays the least will have the lower price in the market and end up with a higher market share, which means that the hospital’s reimbursement will continue to fall absolutely.
This leaves a single group of people left for the hospital to use to break even. This is people like your mother who don’t have insurance, but who aren’t on Medicare, Medicaid, or who aren’t indigent enough to get straight charity. So the hospital is bound to charge her a lot for even an aspirin. It has no choice.
Now for all of this to work in a “free market”, everyone would have to pay their appropriate share or else not get services; just like you do when you get your oil changed. You, the guy next to you in the Mercedes and the guy next to him in the beat up 20 year old pick up truck all pay exactly the same for the oil change. No one subsidizes anyone. But the market can’t work this way with medical care. First, because we as a society will not allow people to be turned away. Second, because the people who need the most care (the elderly) have no cash flow to pay full price as a rule. And in fact, since no one could have predicted that kinds of expensive medical advances would occur when these people were working and saving, even the good savers would not have been able to save enough. So the reason the market doesn’t work for the 50 million that don’t have insurance turns out to be very simple. The market works for people who can afford the service and 50 million people either can’t or won’t. The genius of American capitalism will never figure out a way to serve these people for free. Never.
The good news is that there is now just about enough money flowing through the system to fund the whole system, even before “Obamacare”. (The Right even admits this when they say the the US already has “universal” insurance because everyone gets to go to the ER when necessary.) The problem isn’t that there isn’t money enough in the system and not Uncle Sam has to pay for things through your tax dollars. The problem is that there is plenty of money in the system for everyone but it is not being allocated in a way to promote maximum efficiency. This is why the US has the best health care technology and the worst outcomes in the civilized world. The health care reform is not some socialist plot (if it was, the doctors and hospitals would be nationalized) to get the government to pay for everything. The health care reform is a plan (not a very good one, but better than nothing) to do the reallocation of resources that the market is unable to do. It is no more and no less than this.
People who think that their rights are being violated if they can’t opt out of a national health care system are simply disregarding the fact that they are already in a system that they can’t opt out of. Whatever they say or do, if they have an accident or a heart attack they WILL go and WILL be seen in an ER, although someone else will pay for it. From the point of view of we who are paying for it, people who want the right to “opt out” think they have a right to be paid for by people like me. So do I want you to be compelled to pay your share? Well, yes. Is this unjust? I don’t think so. If you think that you have conservative argument about why I should pay your hospital bill because you have some right not to have to, I would love to hear it.
Straightforward, reasonable, and CORRECT, as usual. Thanks, Unagidon.
Thanks to Unagidon. This was both clear and fascinating.
unagidon –
I think the country needs you to do an article about that for the AARP magazine. It would educate millions.
For the segment that is expected to make up the difference- the self-pays- how much of what they’re being charged is actually collectible? I’m doing foreclosure prevention/avoidance work right now; the stories just break your heart, and it seems like an awful lot of my clients say they are behind in their mortgage “because I got sick”. Are the hospitals truly able to make up the difference with folks who pay out of pocket?
Even with everyone covered by third party insurance, public or private, and with a cost-plus set of fees aren’t we almost guaranteed to continue getting very expensive aspirin? What is the incentive of a hospital or doctor under such a public utility type set of incentives a) to avoid treatments that are minimally beneficial but at exorbitant cost or b) to choose treatments that are slighlty less beneficial but at dramatically lower cost. Is there any reason to innovate?
Or do we think we can somehow provide Mayo Clinic type services to everyone without substantially increasing costs to the public? If we had eating insurance where a third party pays all food costs soon everyone would be eating at gourmet restaurants.
Dear Irene,
The people who make up the difference are the commercially insured. The self-pays are too small a segment to make up the difference. But since they fall outside of the four other discounted categories, they (initially) get the full unvarnished 400 percent of charge (or whatever it is) bill.
The hospital (or doctor) is willing and is probably expecting to be asked to give a personal discount. The bad news is that the discount is usually far less than the weakest insurance company would get. The hospital might cut the bill in half and only bill 200 percent of charges. (As an insurance guy, I sometimes laugh at people who negotiate these kinds of “discounts” and say that if everyone did this, there would be no need for insurance companies). A hospital or doctor might also be willing to come up with a steeper discount as a settlement on an otherwise un-payable bill. But at this point the lawyers are usually involved and the patient’s credit rating is shot. However, a settlement could involve a payment plan that will keep the patient’s nose just above water; it could be a very small amount over a very long period. And this could in turn prevent a foreclosure and other kinds of unpleasant stuff. The problem is, people who get sick and find themselves in this situation often get sick again and then they sink anyway.
Why would a hospital (maybe) make such a settlement? It’s a bit complicated and has to do with how we do accounting. If a hospital has an noncollectable bill, it can record the bill as a loss. In some ways it can be advantageous for the hospital to maximize this amount on their books and record the whole billed charge as the loss. On the other hand, with a settlement, the hospital can continue to claim at least part of the unpaid bill as a receivable, which is to say, as an asset on their books. The willingness of a hospital to make a deal will depend on whether it thinks it needs to write off a lot of debts or keep them on the books as (potential) assets. I know that this will be a bit too wonky for some people. But I mention this, because it is stuff like this that makes accounting rules and regulations such a sensitive topic for people in business. It’s not just about “too much regulation” as certain people like to claim. The regulations will create new channels of possible activity that businesses can then exploit. This is also why regulations must ALWAYS be reviewed, be adjusted, and be changed. Regulation is actually a dance between the public interest and capitalism’s ability to innovate in how it counts assets.
But I digress.
Perhaps too wonky, but…. there are items on our insurance reports (for doctor visits, tests, etc), such as co-insurance, co-pays, deductibles, and discount amounts. Somewhere there is probably a contract that will give amounts or percentages, but have never seen it. In any case, I am stunned by how much the provider charges and how little the insurance company winds up paying. There is often a big difference between the insurance payment and the item that says, “your responsibility.” And now and again, I have decided it’s not my responsibility because the medical provider vastly overcharged (e.g., a mammeogram). So far toughing this out has worked. Views? Opinions?
How about Commonweal doing a two-part article by unagidon about health care in the USA — one part about the easy stuff, one about the wonky stuff. It would be widely quoted, and Pres. Obama would appoint him Commissioner of Insurance, a new post that the Republicans would refuse to fund, but the people would support with voluntary contributions because most everyone is going bankrupt anyway. Of course, he’ll then have to tell us what the ideal system would be.
But seriously — until the voters understand how the system works there won’t be any sensible reform. There has to be enough voter understanding to counter the poison of the political hacks.
Patrick said: “Even with everyone covered by third party insurance, public or private, and with a cost-plus set of fees aren’t we almost guaranteed to continue getting very expensive aspirin? What is the incentive of a hospital or doctor under such a public utility type set of incentives a) to avoid treatments that are minimally beneficial but at exorbitant cost or b) to choose treatments that are slightly less beneficial but at dramatically lower cost. Is there any reason to innovate?
Or do we think we can somehow provide Mayo Clinic type services to everyone without substantially increasing costs to the public? If we had eating insurance where a third party pays all food costs soon everyone would be eating at gourmet restaurants.”
For mostly political reasons, health care reform concentrated on insurance companies and did not really address costs or quality at the provider level. Cost and quality are interrelated in that a health care service is not really improved in its cost efficiency unless the service quality is as good or better than it was before. This part has always been addressed by insurance companies (if only from the selfish view that cutting costs while reducing quality leads to higher costs in the long run). And if you are an insurance company executive looking at the reform statutes, you walk away with the idea that the core of cost and quality is to keep the insurance companies doing what they have been doing. The Feds help with this with various things relating to information gathering and exchange; as well they should. More information means or should mean higher quality and lower prices. This is really only a variation of what a free market should do with transparent information about price and quality; something we would NEVER get without regulatory involvement.
The other part of cost and quality is, as you mention, the consumer side. The consumer has come to expect a lot. It would be simple and cheap to build a national insurance system that covers all of the preventative stuff and all of the catastrophic stuff for absolutely everyone (including those illegal aliens who are ripping off the country by coming here and working very long hours at very low pay). But the big political football is that massive space in between the preventative and the catastrophic. People do not want to reduce their own expectations of what they themselves can get, especially if they think that it means diluting their own benefits to take care of the poor and the brown skinned.
What we would need to do is to reset the base of expectations. One could do this in theory rationally. But our political system is such that it makes more short term sense for political parties to pitch one interest against other interests. Since this is the case, the way that expectations are going to be reset is via some sort of collapse of the system. We are seeing this right now and it is going to get worse. American politicians are in general too short sighted to be doing this as some kind of long term strategy. But like everything else related to our individualist consumer ethics, we won’t see the light until someone hits us across the head with a frying pan. In the meantime we will waste tremendous resources trying to defend a vision of the world as it looked in the 1970′s.
Margaret said: “Perhaps too wonky, but…. there are items on our insurance reports (for doctor visits, tests, etc), such as co-insurance, co-pays, deductibles, and discount amounts. Somewhere there is probably a contract that will give amounts or percentages, but have never seen it. In any case, I am stunned by how much the provider charges and how little the insurance company winds up paying. There is often a big difference between the insurance payment and the item that says, “your responsibility.” And now and again, I have decided it’s not my responsibility because the medical provider vastly overcharged (e.g., a mammogram). So far toughing this out has worked. Views? Opinions?”
You should be pleased to hear that the health care reform legislation requires insurance companies and everyone else to make this crystal clear to you. Of course, without other kinds of changes it is sort of like getting the privilege of being able to read one’s own autopsy report. Still, it will be a start.
Co-pays, co-insurance and such have two functions; to reduce cost and to reduce utilization. They are not there to reduce costs to the insurance companies as much as reduce costs to the employer. Even with co-pays and such, because medical costs rise so much faster than inflation insurance costs rise much faster than inflation. If real underlying hospital costs rise, say, 13 percent a year (that is, at the level of billed charges), even with discounts hospital costs are probably rising 7 or 8 percent a year for the insurance company. For a company, the question is, are next year’s profits going to trend up 7 or 8 percent to offset the benefit plan that it has now. And in this economy (but really, in any economy that isn’t a bubble) the answer is no.
So companies want to reduce benefits and they can do this by passing on more costs to their workers. The insurance companies take the direct hit for this, because it is the insurance company that sends the reconciliation of the bill to the member. And in fact, it is part of the job of insurance companies to take part of the flack off the employer.
Co-pays and such also reduce utilization, but not in the way you might think. What insurance companies want to do is to make people think before they run to the doctor. Or, if they run to the doctor, to run to some cheaper medical solution than, say, the emergency room. On the other hand, the insurance company does NOT want people skipping treatments that they need because of co-pays. It is really a balancing act. I could go into how this works in action but it is a bit complicated so I won’t do it here. But I can say that because of our rotten economy and the general fear level of the American consumer (stoked, of course by our politics) medical utilization has fallen in the entire country over the past 12 – 18 months and we in the business are concerned that people are putting off things that they should not be and that when they finally have these things seen to, the treatments are going to be very expensive because they will be far sicker than they need to be.
As for price differences between hospitals, you are now entering the High Wonk realm of hospital and physician contract negotiation. Complicated and esoteric stuff, but (perhaps too) simply, here is what is going on.
Like any business, a hospital wants to increase next year’s margin by some percentage. Let’s say they want their margin to go up a very modest two percent. If they were a grocery store, they could raise each of their prices two percent and be done with it. But both commercial payers and Medicare want differential prices for services. Both constantly measure national average costs for things, so they will say that service X has to come DOWN in price, not go up two percent. So the hospital has to make a higher increase on some other service to get to an overall average of two percent. If the other thing is something they don’t do a lot of, they may have to raise the price of that thing VERY high to make up the difference. Since this has been going on for 20 or 30 years, you get generated all kinds of strange price disparities, even between hospitals that are across the street from each other. You look at your bill and say “The CAT SCAN I got last year has gone up by 75 percent!” The hospital can still say “Yes, but our prices have (in aggregate) gone up a measly two percent.”
And so it may look to you like you are getting screwed. Which you are. But it’s not personal. It’s the logic of our system.
unagidon: is the Kaiser Permanente model one of the better answers to this kind of problem?
I’m starting to feel pretty hopeful about health care refom. Uninsured people in NYS with pre-existing condiitons can get decent coverage now for about $420 a month. ($50 a month less upstate) I think that sounds pretty good. Or not?
http://www.ghi.com/nybridgeplan/faq.html
The Kaiser model is good. But there are lots of good things we can do. Our main problem is that we really don’t make much of an effort to understand how we spread risk and how we spread the consequences of our actions.
Part of this is in the way that capitalism is constructed. It creates the myth of the unattached human and this in the context of the most integrated economy that has ever existed in history. Part of this is the peculiar kind of Christianity that grew up in America, which fosters the idea that liberty allows one to make decisions without regard to anything or anyone else. I actually don’t mind if people try to pass on their risks to other people. Doing this is definitely not virtuous, but it is understandable and it can be defended against. What drives me nuts is that people generally don’t even look at the technical side of our social and economic integration. Without knowing this, one’s politics on the left and the right are bound to remain infantile, because effective action only comes from knowing what is actually going on.
What I still don’t understand is why my health insurance now costs more than twice what it did in 2002 and the deductible has gone from $500 to $3,500.