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The Question of Cost-Shifting

If you want to see what a good communications strategy can get you, consider this Milliman report commissioned by the insurance industry trade group AHIP. The report found that Medicare and Medicaid used their bargaining power to negotiate prices far lower than private insurers could match. Examining payment rates for 2006 and 2007, Milliman estimated that if Medicare and Medicaid paid the same rates as private insurers, they would have spent $88.8 billion more.

At this point, you might imagine the insurance industry would ruefully clap its hands before the superior efficiency demonstrated by Medicare and Medicaid and wander home. Quite the opposite. This report, they said, just proves the existence of the dreaded "cost-shifting." They said this just proved that the public sector was making life harder for the private sector. They did some long division and decided that "cost-shifting" was adding $1,512 to the average cost of a family policy. "The existence of the private sector allows that shift,” explained Karen Ignagni, the head of AHIP. “If you clamp down on one side of a balloon, the other side just gets bigger.”

Health economist Austin Frakt has been fighting a lonely war against this basic economy fallacy. "Price differentials, which [the report] describes, do not support the conclusions reached," writes Frakt. "Just because payers A and B pay different prices does not mean that if payer A paid more payer B would pay less." Think of Wal-Mart and CVS. It's cheaper to buy razors at Wal-Mart. But that's not why it's more expensive to buy razors at CVS.

This is a place where you can argue that the private insurance industry has accelerated the growth of health-care costs because it is too weak to hold fast against price increases from providers. But imagine, for a minute, a world in which the other side of the balloon did not distend. The current health-care system needs current spending plus the current rate of growth in spending to survive in its current form. If Medicare lowers payments, it will attempt to make up the money elsewhere. If Medicare doesn't lower payments, it will attempt to make more money elsewhere. The system would like as much money as it can possibly get.

But if the rate of growth flattens because Medicare and Medicaid and private payers decide to hold down rates, the system will settle on a new and lower equilibrium. You can argue whether that's good thing or a bad thing. I think the health-care system spends too much money for not enough return, and so I think it's a good thing. Other people can argue other points. But it is, in any case, a possible thing. And it's one vision of what cost control looks like.

Indeed, no matter how you think about it, cost control means that the system is going to be taking in less revenue than it currently projects. That might be because prices get bargained down or people stop using unnecessary care or no one can afford insurance. But that's the future. The argument being made by Ignani, conversely, is that the system's rate of spending and rate of spending growth are both immutable, like some terrible law of physics. That's a brief for national bankruptcy, and it should be ignored.

By Ezra Klein  |  October 7, 2009; 1:27 PM ET
Categories:  Health Reform  
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The magic of numbers is that they can be used inappropriately in support of the most fallacious arguments. For example, we know from Medicare audits that taxpayers pay $4,018 for a standard wheelchair, while the private sector pays $1,048. We also know that Medicare is subject to considerable "waste, fraud, and abuse" -- billions more than citizen businesses would tolerate.

So, if we believe Medicare's own audit reports and reports from the CBO, we must question the origin of Medicare "savings". Is it possible that cost-shifting is indeed a factor in the equation?? Or is Medicare simply a sub-standard provider of health care services??

Posted by: rmgregory | October 7, 2009 2:27 PM | Report abuse

Ezra, you are falling into the same fallacious argument that Austin Frakt and others have made, analogizing an actual competitive marketplace to public vs. private health care reimbursement. No, razors being cheap at Walmart are not the reason they cost more at CVS. But if the gov't was buying half the countries razors and dictating the price they would pay to Gillete and Schick, a price that was below marginal cost, then everyone else would have to pay more for razors, or else Gillette and Schick would go out of business.

Posted by: ab13 | October 7, 2009 2:39 PM | Report abuse

You also ought to address the findings of the Milliman report rather than just implying bad faith on the part of Fox and Pickering.

Posted by: ab13 | October 7, 2009 2:41 PM | Report abuse

But what about the argument (supported by MedPac figures) that there is no correlation between the number of Medicare patients a hosipital has and the amounts it charges private insurers. Surely if there were "cost-shifting", you would expect to see such correlation. It does hosipital A with a lot of medicare patients no good if hospital B gets more from private insurers.

I'm not sure about this, but I think there actually is a small amount of anti-correlation which makes sense if it is the power and prestige of the hosipital that dicitate how much they get since one would assume, in general, that the most prestigous ones are not located in slums.

Posted by: lensch | October 7, 2009 2:55 PM | Report abuse

Sorry, to make my last Paragraph make a little more sense, you have to replace "Medicare" in my first patagraph with "Medicare and Medicaid."

Posted by: lensch | October 7, 2009 3:11 PM | Report abuse

Like I said in an earlier comment, cost shifting does exist. cf. Dranove. Also, a theoretical basis exists vis-a-vis presence of not-for-profit hospitals. Anyway, nothing in this healthcare reform drastically changes incentives for physicians and other providers.

We should be honest and admit that the government can't afford Medicare or Medicaid. For those who are in their twenties, do you really think you will get Medicare benefits anywhere near what today's seniors get when you turn 65?

Posted by: RandomWalk1 | October 7, 2009 4:06 PM | Report abuse

Lazy thinking on the price of razors at CVS vs Wal-Mart. A more apt analogy would imagine a scenario where the gov't buys 50% of all airline tickets (a high fixed cost industry like hospitals). If the airline needs to charge and avergae of $300 per ticket to make a return or else go bankrupt, but the government only pays $100 then the private sector must pay $500. It's that simple. The airlines will accept prices below their average cost because it helps offset their fixed costs.

And even suggesting that Medicare, much less Medicaid is efficient is laughable.

Now i wouldn't argue that if Medicare and Medicaid spent $88 B more it would mean a reduction in private payments of $88 B. Surely hospitals would keep some amount of the difference. But in markets with multiple hospitals commercial rates would go down to a lower equilibrium.

Posted by: mbp3 | October 7, 2009 4:06 PM | Report abuse

For RandomWalk from Uwe Reinhardt:

"If economic sustainability," then exactly what do people have in mind with that phrase? During the past 4 decades or so, the long-run, smoothed average annual growth rate in real (inflation-adjusted) GDP per capita has been about 2%. Suppose that fell to only 1.5% for the next four decades. The current average real GDP per capita of about $40,000 would then grow to about $72,500 by 2050 in constant-dollar terms. Medicare now absorbs about 3% of GDP, leaving a non-Medicare real per capita GDP of $38,800. It was estimated by the CBO about a year ago that Medicare will absorb about 9% of GDP by 2050. Let’s make that 10%. At these numbers, the non-Medicare real GDP per capita available to today’s little critters who will run America in 2050 will still be close to 70% larger than is our current non-Medicare GDP per capita."

Posted by: lensch | October 7, 2009 4:10 PM | Report abuse

lensch, from one health economist to another.

See Health Affairs (2006)
Evidence Of Cost Shifting In California Hospitals
Jack Zwanziger and Anil Bamezai

I win. Game, set, match. Just kidding. I'm open to further discussion. Ezra just shouldn't call cost shifting an economic fallacy.

Posted by: RandomWalk1 | October 7, 2009 4:17 PM | Report abuse

Ezra- I read you your blog every day. Typically we agree, but not on cost shifting. For context I am a retired healthcare insurance contracting VP for a major insurer and I support a public option. No problem there. Here's my take on medical cost shifting after many a hospital system contract negotiation. Private insurers are routinely confronted with hospitals making up their losses on government products by expecting more from the private insurers. If you look at publically available unaudited financials for hospital systems you can see this empirically. Private insurer while they have many millions of members don't have the same leaway that government agenices have in negotiations. Here's the difference. The private insurer can't walk away from a deal with no ill effect where the government sponsored plans have no down side. Once that hospital system throws down a termination notice the damage is done to the insurers' customer relationships and the competition has a leg up. Now one thing I still wonder about is how well do hospitals really understand their cost structure. Cost to charge rations are squishy.

Posted by: reddog3 | October 7, 2009 4:44 PM | Report abuse

The public sector is not a legitimate player in the market. If you can use taxpayer funds at will and don't have to worry about going out of business then you are not a legitimate presence.

In normal market situations cost shifting does not occur because companies have to focus on their own margins and the competitiveness of their pricing. If Wal-mart's razors are cheaper than CVS's then CVS has to make sure their pricing doesn't alienate them from their target market or they will go out of business.

If Wal-Mart and CVS only sold razors to people with Government credit cards at a fixed low price then everyone who did not have that Government Credit card would have to pay higher prices to make up for the losses that Wal-Mart and CVS would be taking on the Government brokered razors. That is called cost shifting.

I can't believe you actually think the Government is more efficient than the private sector. You should make at least a token effort to become informed about basic business and economic concepts.

If I had the unconditional backing of the US Government I could sell cars for $500 and still stay in business. Would that make me the most efficient car dealer in the country?

Posted by: fallsmeadjc | October 7, 2009 4:44 PM | Report abuse

RandomWalk - Thanks. That article is a bit complicated, but I gather that is a hospital by hospital study and it shows that on average when Medicare reimbursement went down, charges to private insurers went up although the relationship was not strong. Good evidence, but it still does not explain the lack of correlation between the number of Medicare and Medicaid patients and charges to private insurers.

BTW my comment to you was not about cost-shifting, but about the sustainability of Medicare.

PS I am only a mthatmatcican, unfortunately not an economist.

Posted by: lensch | October 7, 2009 5:00 PM | Report abuse

The key question about cost shifting is not whether Medicare pays less than the average paid by private insurance -- it does -- or whether, ignoring for the moment the lower billing costs associated with Medicare, it pays less than hospitals' costs -- it does in the case of about 55% of hospitals and about 25% of patients.

The key question is "what are appropriate hospital costs?" Hospitals spend a great deal of money for "costs" that have nothing to do with health care, ranging from advertising to the medical arms race to overbuilding to elaborate decor features to high salaries for executives. These more than account for the reported average "losses" on Medicare. The added costs of billing private insurers almost accounts for the "losses" by itself, and better quality control would more than cancel out the difference.

Should we design and maintain a health care system that pays for all of these things, or should we encourage all insurers, not just Medicare, to put some brakes on this process before we are bankrupt?

Posted by: PatS2 | October 7, 2009 5:02 PM | Report abuse

Let me get this straight:

Health insurance has become really expensive.

Healthcare reform is needed to reduce the number of the uninsured.

Basic logic says that cost shifting makes private insurance more expensive.

This insight should be completely ignored as a potential way to reduce the cost of insurance in the private market.


Posted by: fallsmeadjc | October 7, 2009 5:04 PM | Report abuse

In case you wondered, a "mthatmatcican" is a mathematician who can't type.

Posted by: lensch | October 7, 2009 5:04 PM | Report abuse

Basically, healthcare providers are offering a senior citizen discount. Any business that does this covers its costs by building higher prices into what it charges other customers. Ezra's off base.

Posted by: tomtildrum | October 7, 2009 5:29 PM | Report abuse

Klein perfectly illustrates what Richard Epstein calls the "Principal of Invincible Ignorance".

Case in point, as other commenters to this post have pointed out, Frakt and Klein are just plain wrong. What the government does with Medicare pricing is nothing at all like the two scenarios they offer as comparable. Frakt is slightly more disingenuous than Klein (though it was Klein who selected that particular quote for the post, so... ), but Klein's twist on it makes no sense at all. See comments above by ab13 and mbp3. They are correct. Frakt and Klein are wrong.

And yet, as ignorant as Klein is, he is proportionally confident that he is correct. He makes simple mistakes in logic and economics regularly, and shows no sign of learning, or even of recognizing that he's made a mistake. It's the "Principle of Invincible Ignorance", which may be related to my old favorite, the "Dunning-Kruger effect".

And Richard Epstein has GOT to be flying miles above Klein's head, so I don't expect a coherent critique by Klein of this most worthwhile half hour health care reform lecture:

Posted by: msoja | October 7, 2009 7:42 PM | Report abuse

What providers charge has absolutely nothing to do with actual cost most of the time.

Therefore, any claim that Medicare is paying this or that % under what the hospital charges is meaningless noise.

Posted by: evangeline135 | October 8, 2009 6:06 AM | Report abuse

evangeline135 -- Upon what criteria do you think providers base their charges?

Or perhaps it should be asked, what components that make up the price a hospital charges are you asserting are meaningless (or frivolous, or non-essential), and unnecessary to one's overall health care bill?

Posted by: msoja | October 8, 2009 8:58 AM | Report abuse

evangeline, nice straw man. This is not comparing what Medicare pays to what doctors charge, it is comparing what they pay to what it costs to provide the care.

Posted by: ab13 | October 8, 2009 11:27 AM | Report abuse

Talk to hospital administrators? They will scream about how we're killing them while building a new billion dollar annex.

TheIncidentalEconomist is right -- hospitals negotiate for as much money as they can get. Insurance companies negotiate to pay as little as possible. The final price depends on the relative market power of the hospital and insurance company.

A hospital may think it's underpaid by Medicare and want to make it up from the insurance company but that doesn't mean the hospital will get what it wants. Also, if Medicare pays more the hospital is not going to cut its request from the insurance company the next year. Again, it will negotiate for as much as possible.

As MedPAC has shown, wealthy hospitals have a stronger negotiating position so they get higher rates from private insurers. The hospital then uses that money to install waterfalls, plasma televisions, and MRI machines that make coffee and it will claim that costs have increased. The more those costs increase the more the hospital "loses" from Medicare.

Posted by: hype1 | October 8, 2009 1:04 PM | Report abuse

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