0 CONGRESS OF THE UNITED STATES 

CONGRESSIONAL BUDGET OFFICE 

ACBOSTUDY 

APRIL 1991 
CBO Publication 

CONGRESSIONAL 

BUDGI!.T OFFICE 

Second 1111d D Strtets. S. W. 

Wa.t!JintiVII. D.C 205/S 

s u M M A R y 

April1991 

CBO STUDY OF RISING HEALTH CARE COSTS 

Although the United States is capable of providing the highest quality health care, 

the cost of this care is high and rising. Moreover, the United States spends much 

more on health care, relative to national income, than do other industrialized 

countries. Health care spending not only accounts for 14 percent of the federal 

budget and about 12 percent of gross national product, but it is accelerating in 

comparison with the national income. The real per capita rate of increase in health 

spending rose from 4.3 percent annually during the 1980-1985 period to 4.6 percent 

annually from 1985 to 1989. CBO's study, Rising Health Care Costs: Causes, 

Implications, and Strategies, describes the factors in our economy that contribute to 

the growth in spending for health and examines what is known about the 

effectiveness of different strategies for achieving greater control over costs. 

The five strategies for controlling health care costs examined in the CBO 

study are: cost-sharing by consumers; managed care that limits the freedom of 

health care providers and consumers; price controls; efforts to increase competition 

among insurers and providers; and regulation of the market for health services, 

including controls on capital and uniform payment systems that encompass all 

payers. With the exception of greater cost-sharing, each of these strategies bas been 

pursued in the past decade. Although some strategies seem to be effective when 

applied to subgroups of the population. none of them has had much effect on overall 

health care spending in the nation. 

The study suggests that efforts to control health spending may be frustrated 

by our fragmented financing system, under which providers who face constraints on 

prices and amounts of services for one set of patients may be able to compensate 

by increasing the prices they charge and the services they extend to other patients. 

Gaining control over health care costs would apparently require a significant 

restructuring of our health care system. To achieve greater control over costs we 

would have to make certain concessions. For example, there would probably be less 

spending on research and development, longer waiting times for use of new 

technologies, and limitations on our choices of providers and health care coverage. 

Questions regarding the study should be directed to Kathryn Langwell and 

Terri Menke of CBO's Human Resources and Community Development Division 

at (202)226-2653. The Office of Intergovernmental Relations is CBO's 

Congressional liaison office and can be reached at 226-2600. For additional copies 

of the report, please call the Publications Office at 226-2809. 
RISING HEALTH CARE COSTS: 

CAUSES, IMPLICATIONS, AND STRATEGIES 

The Congress of the United Ststes 

Congressional Budget Office 

For .. 1e by the Superintendent of Document•. U S. Govenunent Printing Office 

Waohington, D.C. 21)402 
LJL
PREFACE 

This study is the second part of the Congressional Budget Office's 

(CBO's) response to a request from the Senate Committee on Finance 

for a study of trends in spending on health and the effectiveness of strategies for controlling these costs. The study describes the characteristics of the health care sector--including the market for health insurance and the market for health services--that affect the level and rate 

of increase of health spending. It also ~examines various cost containment strategies and the extent to which they have been effective. The 

earlier paper, "Trends in Health Expenditures by Medicare and the 

Nation" (January 1991), provided information on national spending for 

health since 1965 and compared Medicare's spending with the overall 

pattern. In keeping with CBO's mandate to provide objective and impartial analysis, neither that paper nor this study contains recommendations. 

The study was prepared by Kathryn Langwell and Terri Menke, of 

CBO's Human Resources and Community Development Division, 

under the direction of Nancy M. Gordon. Terri Menke also provided 

Appendix A on the composition of national health expenditures and 

Appendix C on the health care systems of several other countries. 

Sandra Christensen was responsible for Appendix B, which examines 

the reasons some people are uninsured, based largely on an analysis 

conducted by Jack Rodgers using data from the Current Population 

Survey. Bryan Sayer was the programmer for the analysis of the 

uninsured. 

Francis S. Pierce edited the manuscript, Nancy H. Brooks provided 

editorial assistance, Julia Jacobson provided research assistance 

during the final stages of the paper, and Sharon Corbin-Jallow typed 

the numerous drafts. Kathryn Quattrone prepared the report for publication. 

April1991 

-- ---,-----

Robert D. Reischauer 

Director 
_ _ __ j LID 1 1; I - ___ L _______ _ 
CONTENTS 

I 

II 

III 

IV 

SUMMARY 

INTRODUCTION 

Trends in Spending and Prices 

for Health Services 2 

Implications of High and Rising 

Health Care Costs 5 

CHARACTERISTICS OF THE 

HEALTH SECTOR 

Characteristics of Economic Markets 7 

The Market for Health Insurance 10 

The Market for Health Services 20 

Performance of the Health Sector 28 

POLICIES DESIGNED TO CONTROL 

HEALTH CARE COSTS 

Cost Sharing 34 

Managed Care/Utilization Controls 36 

Price Controls 40 

Competition 45 

Regulation of the Market for 

Health Services 4 7 

THE POTENTIAL FORCONTROLLING 

RISING HEALTH CARE COSTS 

IN THE UNITED STATES 

ix 

1 

7 

33 

55 
____ __ l L JIJlillllll - _ _:_'1_ - --- -

vi RISING HEALTH CARE COSTS 

APPENDIXES 

A 

B 

c 

Composition of National Health 

Expenditur'es and Trends in 

Spending by Payer and 

Type of Service 61 

Reasons for Lack of Health 

Insurance 67 

Overview of Health Services 

in Other Countries 81 

April 1991 
CONTENTS vii 

TABLES 

A-1. Real National Health Expenditures 

by Payer and Type of Service, Selected 

Years 1965-1989 62 

A-2. Share of Personal Health Expenditures 

by Type of Service, Selecioed Years 

1965-1989 64 

A-3. Share of National Health Expenditures 

by Payer, Selected Years 1960-1989 65 

B-1. Health Insurance Coverage 

by Age,1990 68 

B-2. Sources of Health Insurance Coverage 

for the Population Under 65, 1990 69 

B-3. Work Force Connections of the Uninsured 

Population Under 65, 1990 70 

B-4. Availability of Employment-Based 

Insurance Plans, by Size ofFirm,1989 72 

B-5. Sources of Health InsuraLnce for Workers 

Under 65, by Size ofFirm,1990 73 

B-6. Uninsured Workers Under 65, 

by Size of Firm, 1990 74 

B-7. Workers Responses to Health Insurance 

Offers by Firms, 1988 75 

B-8. Percentage afFirms Citing Particular 

Reasons for Not Offering Health 

Insurance, 1989 76 

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__ _llHill ,.l ---~ -------

viii RISING HEALTH CARE COSTS 

B-9. 

B-10. 

FIGURE 

Wage Distribution for Firms, by Size of 

Firm and Whether It Offers Health 

Benefits, 1989 

Breakdown of Administrative Expenses 

for Conventionally Insured Plans, 1988 

Health Expenditures as a Percentage of 

Gross Domestk Product, United States 

and Selected Countries, 1965-1987 

April 1991 

77 

78 

4 
SUMMARY 

Although the United States is a leader in medical research and has the 

capability to deliver the highest quality health care, criticisms of its 

health care system have been growing over the past decade. These 

criticisms have focused on two principal features of our system. 

o Spending per person for health care in the United States is 

very high compared with other industrialized countries, and 

total national spending for health is increasing more rapidly 

than national income; and 

o Many people in the United States lack financial access to 

health care--that is, they are uninsured and ineligible for 

existing public health care programs. 

The United States spends much more per capita for health care 

than other industrialized countries. In 1987, the United States spent 

11.2 percent of gross domestic product (GDP) on health care, compared 

with 8.8 percent in Canada, 8.1 percent in West Germany, 6.8 percent 

in Japan, and 6.1 percent in the United Kingdom. Moreover, the differential between the United States and other countries' spending on 

health care as a share of GDP has increased dramatically since 1965. 

This increase in health spending also has significant implications for 

the federal budget. In 1980, 11 percent of the federal budget went to 

health care. CBO projects that health spending will be nearly 20 percent of the budget by 1996. 

THE HEALTH SECTOR 

Many factors contribute to the high and rapidly rising costs of health 

care per capita, including an aging population and more effective and 

costly medical technologies that are being developed on a continuing 

basis. Many observers, however, suggest that a major reason for high 

and rapidly rising health costs is the failure of the normal discipline of 

the marketplace to limit the quantity of services supplied, resulting in 

-- --- --,--- -
x RISING HEALTH CARE COSTS April 1991 

part from the fact that consumers pay less than the full price of the 

services they purchase. 

In the health services market, the conditions necessary for the 

existence of a fully competitive market are not met. In particular: 

o Uncertainty with res]pect to the occurrence of illness has led 

to the development of extensive insurance of a type that encourages consumers to purchase more and higher quality services than they would in the absence of insurance; 

o The complexity and rapid technological change in medical 

services and uncertainty about the efficacy of treatment have 

led consumers to delegate much decisionmaking to providers; 

and 

o Entry by providers into the industry is severely regulated, 

knowledge about differences among providers is not commonplace, and in many cases there are few competing sellers. 

The role of insurance in the health sector is critical to understanding the imperfections in the market for health services that contribute to high and rapidly rising costs. Thus, the characteristics of 

these two markets, and recent trends that affect their performance, 

provide background for the examination of the effectiveness of strategies for controlling costs. 

The Market for Health Insurance 

In 1990, about 70 percent of the population under the age of 65 had 

health insurance through some employment-based group. The growth 

in employment-based health insurance since the 1940s has been influenced by the lower premiums that can be charged for group health 

insurance compared with those for individual policies. These lower 

premiums are possible becaUS4:;! risks are more predictable for larger 

groups and because administrative costs are lower as a share of benefits for groups. An additional factor in the growth of employmentbased insurance is that employer-paid fringe benefits are excluded 
SUMMARY 

from the taxable income of employees. This exclusion will save individuals an estimated $56 billion to $58 billion in federal, state, and 

local taxes in 1991. 

Although employment continues to be the principal source of 

health insurance, the availability of employment-based coverage has 

been reduced by changes in the private insurance market over the past 

decade. Many of these changes occurred in response to rapid increases 

in the costs of health care. A related impetus for change was the 

development of policies intended to control rising health care costs that 

encouraged competition among health insurers and increased choices 

of insurance arrangements available to consumers. 

First, between 1980 and 1990, enrollment in health maintenance 

organizations (HMOs)--that is, combined insurance-service delivery 

systems--has risen nearly fourfold to 35 million people. HMOs offer a 

defined network of providers to their members, and are able to exert 

substantial control over the practice patterns of these providers. As a 

result, they have the potential to provide comprehensive health services for lower premiums than those of traditional insurers. 

Second, traditional insurers have moved away from community 

rating, using experience rating instead. Under community rating, 

premiums are based upon the expected costs per person of providing 

insurance in a geographic area, averaged over the entire insured population. When experience rating is used, insurers base the premium for 

a given group on the average expected costs of insuring that group 

alone. Experience-rated premiums are lower--relative to communityrated premiums--for groups that are expected to have fewer health 

problems than the average in the community. The other side of the 

coin, however, is that premiums are higher for those that are expected 

to have more health problems than average, compared with community-rated premiums. 

Third, rapid increases in the cost of health care have also affected 

the level of premiums for health insurance. Between 1977 and 1987, 

the average real premium paid by employers rose from $1,111 to 

$1,656 (in 1987 dollars), or by 49 percent. Because the costs of health 

insurance are a larger share of compensation for lower-wage workers, 

--,----- nunr-, r----
------ -- J LlJLIIJLI. ___ 'L_ ___ -

xii RISING HEALTH CARE COSTS April 1991 

the dramatic rise in premiums has reduced employment-based coverage for them more than for higher-wage workers. 

The Market for Health Services 

Several characteristics of the market for health services are important 

in explaining the level and trends in health spending. One change that 

has affected the market is the increase in the supply of physicians 

relative to the population over the past two decades--from 1.6 per 1,000 

population in 1970 to 2.4 per 1,000 in 1990. The availability of more 

physicians has improved access to health services in areas that were 

previously less well served and has made ·physicians more willing to 

participate in managed care arrangements and to negotiate discounts 

on pnces. 

Since physicians can influence the demand for medical services, 

however, the greater prevalence of negotiated discounts has not resulted in a decline in physicians' incomes. Instead, as prices have been 

constrained, the volume of services provided has risen. This increase 

may have resulted, in part, because consumers are likely to want more 

at the lower price, but it also resulted because physicians can increase 

the number of services they provide or change the way in which their 

services are counted or billed. Evidence from the experience under 

Medicare indicates that, when prices decline, the volume of services 

increases sufficiently to offset about half of the potential reduction in 

spending that would otherwise have resulted from the price decrease. 

In addition, some analysts believe that rapid technological change 

explains a significant portion of the increase in real health care spending per capita that has occurred over the past two decades. The present 

financing system for health care encourages the rapid dissemination of 

new technologies--access is available quickly for those with insurance 

or who can afford to pay directly--but excess capacity can easily develop. Excess capacity can then lead to overuse of these technologies, with 

higher costs resulting and with potential for harm to patients because 

of side effects or other complications associated with medical interventions. 
SUMMARY xiii 

The market for health services has also been influenced by the 

continuous decline over time in the out-of-pocket costs for health services paid by consumers. Although consumers partially pay for their 

health services through insurance premiums, taxes, and lower direct 

wages, their decision to use a specific health service is influenced by 

the direct out-of-pocket cost for that additional service. The decline in 

the proportion of costs paid out of pocket--from 46 percent in 1965 to 23 

percent in 1980 and to 21 percent in 1989--has led to a rise in the 

quantity and quality of services consumers have purchased over the 

past decade, perhaps obscuring some of the effects of policies aimed at 

reducing the rate of increase in health spending over that period. 

Finally, the medical malpractice environment has been cited as 

contributing to rising health costs. Although only about $5 billion--or 

0.9 percent of all spending for health--was spent on medical malpractice premiums by all types of medical providers in 1988, the malpractice climate may also affect patterns of practice in ways that indirectly raise costs. For example, physicians may increase testing beyond the medically necessary level in the face of potential liability 

lawsuits and in the absence of agreed-upon practice guidelines. 

Performance of the Health Sector 

The characteristics of the markets for health insurance and health 

services combine to create a number of outcomes in the health care sector that are perceived to be problems. 'I'hree major problems are: 

o The proportion of people without health insurance coverage 

has been growing over time--from 12.2 percent in 1978 to 

15.7 percent in 1989--and the proportion of workers with insurance has been falling. 

o Administrative costs associated with health care spending 

account for a high proportion of the costs of health care in the 

United States because of our multiple payer system, which 

requires tracking eligibility, marketing, risk assessment, 

monitoring of individual patient encounters, and a unique 

set of prices for each payer. In 1987, insurers' administrative 

---- -~----
~~ J L JIUJUiiU -~-~---~ 

xiv RISING HEALTH CARE COSTS April 1991 

costs were $23.9 billion, or 4.9 percent of spending in the 

United States, compared with 2.5 percent in Canada and 2.6 

percent in the United Kingdom. 

o Despite the exceptionally high level of spending for health 

care in the United States, health outcomes such as infant 

mortality rates and life expectancy at birth are no better here 

than in other industrialized countries. 

Although the United States spends more than other industrialized 

countries, some specific aspects of our system that contribute to these 

higher per capita costs are perceived by many people to be desirable. 

For example, we value speed and accuracy of diagnosis and a short 

length of time between diagnosis and treatment. We also devote significant resources to basic medical research that yields improvements 

in diagnosis and treatment. Moreover, the current financing system 

permits rapid dissemination of new technologies, extending the benefits of research to the insured population with minimal waiting times. 

POLICIES TO CONTROL HE:ALTH CARE COSTS 

In response to concerns about rising health care spending and prices, 

many strategies for controlling health care costs have been developed 

and carried out during the past two decades, especially during the 

1980s. Despite these efforts, spending on health has continued to rise 

at a dramatic rate. The variety of approaches adopted reflects the fact 

that controlling costs is a complex problem and that, in the United 

States, the market for health services is a diverse and uncoordinated 

system. 

Cost Sharing 

Although cost sharing by consumers has often been discussed as a 

potentially effective strategy for controlling health care costs, out~of~ 

pocket spending for health care declined from 23 percent of total costs 

in 1980 to 21 percent in 1989. Even so, the United States remains 

significantly different from most other countries. For example, out-of~ 
SUMMARY xv 

pocket costs are 7 percent in West Germany and 3 percent in the 

United Kingdom. 

Evidence from studies of the effect of cost sharing on spending for 

health services does, however, suggest that if the average coinsurance 

rate in 1989 had been increased from :!1 percent to 31 percent, a decrease in spending of between 1 percent and 2 percent would have 

occurred--or about $6 billion to $12 billion in 1989. This reduction in 

spending would probably result from fewer initial visits to ambulatory 

providers and would have more impact on the poor than on other consumers. 

Managed Care/Controls on Use 

Because there is evidence that many of the health services provided to 

consumers are unnecessary or inappropriate, managed care has been 

widely advocated in the United States since the early 1970s as a 

strategy for controlling costs. Managed care includes third-party 

payers' review and intervention in decisions about health services to be 

provided, and limitations on patients' choices of providers. Studies of 

its effectiveness suggest that managed care has a potential to reduce 

health care spending--although its effe·ctiveness varies depending on 

the strength of the controls employed. The impact on health care 

spending is achieved through a one-time reduction in levels of use; 

managed care does not appear to affect the rate of increase in spending 

overtime. 

Effective managed care for one group of patients, however, does 

not necessarily slow the growth in total expenditures for all patients. 

Our fragmented system of financing makes it possible for providers to 

expand services and raise prices for other patients not getting managed care. The substantial administrative costs of managed care also 

offset some of the savings from using fewer services. 

In contrast to the approaches to controlling use of services employed in the United States, several other industrialized countries 

monitor and review providers, rather than individual patients and 

procedures. This process is applied uniformly and comprehensively to 
----~- --------

xvi RISING HEALTH CARE COSTS April 1991 

all physicians, to identify those whose service patterns deviate from 

their peers. When indicators such as referral patterns, numbers of 

procedures and tests performed, and numbers of repeat visits deviate 

from the norm, committees monitoring regional health systems then 

review these physicians and, if warranted, penalize them. 

Price Controls 

Price controls on medical care have been imposed several times in the 

United States. Overall, the evidence from the Medicare experience of 

the potential effect of price controls on health care costs suggests that 

more services are provided when prices are reduced across the board; 

price controls on one type of service create incentives for providers to 

substitute other services for the controlled one; price controls established for a specific population group (such as Medicaid enrollees) may 

result in higher prices charged. to other population groups; and, when 

prices are controlled for only some groups, they may have less access to 

care. Thus, unless price controls are combined with systematic monitoring and review of all providers to prevent the volume of services 

from rising, their potential to solve the problem of health care costs is 

limited. 

Competition 

Competition among insurers and. providers has increased over the past 

decade. The number of insuring organizations has grown, and many 

employees are offered a choice among several insurance packages--

sometimes with financial incentives to choose lower-cost, more efficient plans. The number of physicians relative to the population has 

grown, and physicians are now less able to control competition from 

other providers who perform st~rvices that overlap with those of physicians--and who generally charge lower prices than physicians for these 

services. Advertising by physicians, hospitals, dentists, and other providers--which was prohibited by medical ethics and state regulations 

in the past--has now become an accepted practice. 
SUMMARY xvii 

If competition were an effective strategy for controlling costs, 

health care costs--particularly in areas that have become much more 

competitive--should have risen more slowly over the past decade than 

they have. This outcome would not necessarily occur, however, if 

nonprice competition was the predominant response to changes in this 

market. Some research suggests that greater competition has led to 

product differentiation and higher costs in the health care market, 

rather than to lower prices and greater efficiency. The competition 

strategy, however, has not been fully put into place. Moreover, approaches to cost containment that rely on changing the conduct of 

markets may require substantial passage of time before the full effects 

are evident. 

Regulation of the Market for Health Services 

Because past efforts to control costs have had limited effect, some 

people have concluded that greater regulation of the market for health 

services is necessary. Regulatory strategies attempted in the United 

States include the federal health planning and certificate-of-need programs and the state all-payer rate-setting programs for hospitals. In 

addition, strategies used in other countries--global budgeting and expenditure targets--might be effective here. 

Health Planning and Certificate-of-Need Prol!fams. The Health 

Planning and Resource Development Act of 1974 required that all 

states receiving federal health resources enact certificate-of-need 

(CON) laws--providing for state review and approval of planned capital 

investments of health care institutions. By 1980, all states except 

Louisiana had enacted CON laws. Subsequent research on their effectiveness consistently found that they did not restrain hospital spending and, in 1986, CON requirements for states to receive federal funds 

were dropped. Those who support health planning and CON requirements suggest, however, that CON in most states was applied in an 

erratic and politically motivated way that was not consistent with 

cost-consciousness and the orderly adoption of new technologies. 

The governments of some other countries control the capital acquisitions of hospitals. In Canada and the former West Germany, for 

II I! 1111~ lit' r -
--- _l 

x:viii RISING HEALTH CARE COSTS April 1991 

example, hospitals apply to the regional government for capital expenditures and the regional government provides funding only for 

approved investments. In Great Britain, the central government 

determines the national budget for capital costs, and decisions about 

capital acquisition are made at varying geographic levels depending on 

the type of expenditure. These restrictions on capital acquisition, 

which keep costs down but also tend to limit access to new technologies 

and treatments, appear to have led to a lower rate of technological 

diffusion than in the United States. 

State All-oaver Rate-setting Programs. During the past two decades, 

four states put in place statewide all-payer hospital rate regulation 

programs. Under these programs, the state establishes the reimbursement methodology under which hospitals in the state receive uniform 

payments for specific services from all third-party and direct payers. 

Results of nearly all of the studies of these systems find that they initially lowered costs by from 2 percent to 13 percent, and that they cut 

the rate of growth in hospital spending substantially below what would 

be expected in the absence of an all-payer system. 

Controls on Expenditure Levell?_. Another regulatory mechanism for 

controlling health care costs is to set limits on spending prospectively. 

This can be done through global budgeting, under which the government sets the operating budget in advance for specific providers--most 

commonly hospitals. Or it can be done through caps on expenditures, 

under which the government sets either a fixed budget that absolutely 

controls spending levels or a target that triggers penalties if it is exceeded. While other countries have relied extensively on expenditure 

targets to influence physician spending, the Medicare volume performance standards for physicians put into effect in 1990 is the first such 

attempt in the United States. Some other industrialized countries 

combine expenditure targets for physicians' services with ongoing 

monitoring of the practice patterns of individual physicians, in order to 

reduce the potential for some physicians to increase their incomes at 

the expense of others. 

If they are strictly applied, global budgeting and expenditure caps 

for overall spending or for types of services can limit the level and rate 
SUMMARY xix 

of growth of health care spending. Depending on how tightly they are 

set, however, they could adversely affect quality or access to care. 

THE POTENTIAL FOR CONTROLLING RISING 

HEALTH CARE COSTS IN THE UNITED STATES 

Control of health care costs--through either a one-time drop in spending or a lower rate of increase~-is much more difficult to achieve in the 

United States than in countries that have chosen to develop a coor~ 

dinated national health care policy or a national health system. In the 

United States, attempts to control health spending in one segment of 

the market or for specific groups of consumers may sometimes be successful for the part of the market affected. The impact on overall 

health spending in the nation may be much less, however, since pro~ 

viders may compensate for lower revenues from one segment of the 

market by increasing prices for, or the quantity of services provided to, 

other groups. 

During the 1980s, a number of strategies to control health care 

costs were carried out. Although it is difficult to quantify the overall 

effect of each change separately, there appears to have been little im~ 

pact on the growth in total health spending. The average annual rate 

of increase in real health spending per person was 4.3 percent between 

1980 and 1985 and 4.6 percent between 1985 and 1989. In addition, 

the share of GDP devoted to health spending rose from 9.2 percent in 

1980 to 11.7 percent in 1989. 

Evidence from other countries, and from research, suggests that it 

may be possible to achieve greater control over health care spending in 

the United States than has been apparent over the past decade. It 

would be necessary, however, to make changes in the financing and 

delivery of health care. Several policies, used in combination, could 

substantially increase our ability to control health care spending. 

These policies include: elimination of first-do1lar coverage under insurance policies; uniform utilization monitoring and review applied to 

all physicians rather than to individual patients and specific procedures; uniform payment levels that encompass all payers (including a 

prohibition against billing patients for any additional amounts); 
- - - l ._l_lilll 'I i I _____ J_ __ . 

xx RISING HEALTH CARE COSTS April 1991 

health planning that establishes capital and technology targets relative to population at national and regional levels, and that does notre~ 

irnburse for services provided through unapproved purchases; and effective national and regional budgets for overall spending or expenditure targets for specific types of spending. 

Without significant changes, the United States is unlikely to 

achieve much greater control over health care spending than it has in 

the 1980s. Moreover, the cons.,quences offailure to obtain the benefits 

of effective cost containment will be many, including making it more 

difficult to address the other major failure of our health care system--

the large and growing number of people in the United States without 

health insurance coverage. 

To change the present system, however, we would have to make 

some concessions. Greater control over health care spending would 

probably mean less spending on research and development, longer 

waiting times for use of new technologies, and limitations on our 

existing choices of providers, health care coverage, and alternatives for 

treatment. Whether these trade-offs are desirable depends on the 

priority the nation places on controlling costs as against maintaining 

other characteristics of the current health care system. 
CHAPTER I 

INTRODUCTION 

Although the United States is a leader in medical research and has the 

resources to provide the highest quality health care, criticisms of its 

health care system have been growing over the past decade. These 

criticisms have focused on two principal features of the system: 

o Spending per person for health care in the United States is 

very high compared with other industrialized countries, and 

is increasing more rapidly than national income; and 

o Many people in the United States lack financial access to 

health care--that is, they are uninsured and ineligible for 

existing public health care programs. 

A number of policies have bee.n proposed--and some implemented--with the goal of reducing the level of health spending and/or 

its rate of growth. These policies include consumer cost sharing, managed care, competition among providE~rs and insurers, price controls, 

and regulation of the market for health services. Despite the attention 

directed to this issue, national health care spending has continued to 

rise faster than the gross national product (GNP)--reaching 11.6 percent of GNP in 1989. The Health Care Financing Administration has 

estimated that spending for health will reach 15 percent of GNP by the 

year 2000. In addition, the cost of health care has implications for the 

federal budget. In 1990, health spending accounted for 14 percent of 

the budget, and the Congressional Budget Office has projected that 

19.5 percent of the federal budget will1~0 to health spending by 1996. 

The apparent inability of the United States to control spending for 

health is of particular concern at a time when about 33 million people 

have no health insurance coverage, since rising health care costs exac· 

erbate that problem. In the private sector, increasing health care costs 

have led to rapid rises in the health insurance premiums offered to em-

- --· -.----- -
__ _ _ _ _JLILild 

2 RISING HEALTH CARE COSTS April 1991 

ployment-based groups, and to increased competition among insurers 

to write policies for the healthiest groups that offer the lowest financial 

risk. Large groups can spread costs over a substantial number of individuals and families, while small groups do not have enough members to spread these risks if some members of the group have serious 

health problems. Consequently, small groups face premiums that are 

prohibitive or find it difficult to {)btain insurance at alL 

Many factors contribute to the high and rapidly rising costs of 

health care per capita in the United States, including an aging population and the continued development of more effective and costly 

medical technologies. However, a major reason for high and rapidly 

rising health costs may be the failure of the normal discipline of the 

marketplace. 

TRENDS IN SPENDING AND PRICES 

FOR HEALTH SERVICES 

In 1989, the United States spent $604 billion on health care. This 

amount was nearly three times the $204 billion (in 1989 dollars) spent 

in 1970. Real health care spending per capita in the United States rose 

from $950 to $2,354 (in 1989 dollars) between 1970 and 1989--an 

average annual real growth rate of 4.9 percent over the 19-year period. 

This growth rate reflects increases in quantity of services per capita, 

changes in quality, and increases in the price of medical services above 

general inflation in the economy) 

The United States spends much more per capita on health care 

than other industrial countries. While direct comparisons among 

countries are always difficult and need to be treated with caution, the 

United States' per capita spending on health is approximately onethird more than Canada's, double the spending of Japan and the 

1. Evidence in this section is drawn from the Congressional Budget Office paper, '"!'rends in Health 

Spending by Medicare and the Nation" (January 1991). The major components of national health 

expenditures are described in Appendix A, which also examines health spending by aource of 

payment and how these sources have changed over time. 
CHAPTER I INTRODUCTION 3 

former West Germany, and nearly three· times the amount spent in the 

United Kingdom. 

This higher spending per capita also is reflected in the proportion 

of gross domestic product (GDP) spent by each of these five countries on 

health care in 1987. The United States spent 11.2 percent of its GDP 

on health care in that year, while Canada spent 8.8 percent, former 

West Germany 8.1 percent, Japan 6.8 percent, and the United Kingdom 6.1 percent (see the Figure). In contrast, the share ofGDP spent 

on health in 1965, and the differences among these countries, were 

more modest--6 percent in the United States, 6.1 percent in Canada, 

5.1 percent in former West Germany, 4.3 percent in Japan, and 4.2 

percent in the United Kingdom. 

This higher level of per capita spending in the United States is, in 

large part, the result of considerably faster growth in spending during 

the 1980s than occurred in the other countries, with the exception of 

Canada. Real per capita health spending in the United States rose 33 

percent between 1980 and 1987. By comparison, the increase over this 

period was 38 percent in Canada, 13 percent in former West Germany, 

31 percent in Japan, and 22 percent in the United Kingdom. 

Within the United States, medical care prices increased much 

more rapidly between 1980 and 1988 than did prices of other major 

categories of expenditures. During the 1980-1988 period, the consumer price index for all urban consumers increased 36 percent for 

food, 44 percent for entertainment, a11Ld 57 percent for shelter, compared with 85 percent for medical care. 

Providers of medical care in the United States appear to have 

gained substantially from the rapid growth in per capita spending and 

from the increases in prices that have occurred. Hospital margins on 

total revenues began rising in the early 1970s. From previous levels · 

below 2.5 percent, they rose to 5.9 percent in 1985, declining to 4.8 

percent by 1990.2 

2. Hospital margins on total revenues are defined as the ratio of total revenues minus total costs to 

total revenues. 

nnnnr ·--- - -· - ·-·· 
_UIJ 

4 RISING HE:ALTll CARE COSTS April 1991 

Health Expenditures as a Percentage of Gross Domestic 

Product, United States and Selected Countries, 1965-1987 

Percent 

12 

" 

10 

• 

• 

7 

' 

6 

5 

- - 4 

' 

2 

0 

1965 

' 

1969 

West 

Germany_.· 

/ 

1973 

United 

States 

··-. ···- .·· 

~ 

J~~..-. "'--"'u;,;,,;;,.;.,..-----1 

Kingdom 

1977 , .. , 1985 

SOURCE: Congressional Budget Office calculations based on data from the Organization for Economic Cooperation and Developm,~nt, Health Data File, 1989, as reported in Health Care 

Financing Review, 1989 Annual Supplement. 

NOTE; Gross domestic product is equal to gross national product less net property income from 

abroad. Use of GOP for international comparisons of health spending eliminates variations 

arising from differences in the role of foreign transactions in different economies. 
CHAPTER I INTRODUCTION 5 

Physicians' incomes have also increased relative to the average 

compensation of all workers in the United States. In 1980, the ratio of 

the average physician's earnings to the average worker's earnings in 

the United States was 5.0. This ratio had increased to 5.4 by 1987. In 

1986, the last year for which data are available for all countries, the 

ratio of physicians' earnings to the average worker's earnings was 5.1 

for the United States, 4.3 for former West Germany, 3.7 for Canada, 2.5 

for Japan, and 2.4 for the United Kingdom. 

IMPLICATIONS OF HIGH AND 

RISING HEALTH CARE COSTS 

The United States health care system is able to provide the highest 

quality care, without delays in access, to those who have health insurance or can otherwise afford it. In addition, the United States devotes 

considerable resources to medical research and provides support for the 

rapid dissemination of new medical technologies throughout the 

nation. United States consumers also have more freedom to choose 

providers, service delivery systems, treatment methods, and insurance 

coverage levels than do residents of most other industrial countries. 

At the same time, the disadvantages of high and growing spending 

for heath care are also evident. The ffil[)re the nation spends on health 

care, the less income--both private and public--is available to spend on 

other goods and services. And continuing increases in health care 

spending per capita make it more difficult to address the problems of 

the uninsured population--since most remedies would result in even 

higher private and public spending. 

A decision to adopt effective strategies to control costs will require 

weighing the advantages of the current system against the disadvantages of a continuing increase in health spending relative to income. This paper provides background and information on the tradeotis that such a decision would imply. 

J,, 
··--1----

11: 
CHAPTER II 

CHARACTERISTICS OF THJ<~ 

HEALTH SECTOR 

Although rapid increases in expenditures and dramatic growth in 

prices can occur under a variety of conditions, the persistence of these 

phenomena in the market for health se:rvices is often cited as evidence 

that the market is not functioning weU in comparison with the markets for other goods and services. This chapter, therefore, begins by 

contrasting the market for health services with those for other goods. 

This background is provided for readers who are interested in how 

markets function generally, in order to have a better understanding of 

the problems of the health care sector. Readers who already have this 

background may go directly to the next section of this chapter. 

CHARACTERISTICS OF ECONOMIC MARKETS 

A properly functioning competitive market is one in which supply and 

demand cause prices to tend toward the lowest level at which sellers 

are willing to produce and offer those goods and services desired by 

consumers. Competitive markets are considered desirable because 

they use scarce resources more efficiently as firms seek to produce each 

unit of goods at the lowest possible cost, and because the set of products 

that is most valued by consumers is produced. Consumers benefit because, at any income level, they are able to acquire more goods and services than in a market in which competition does not operate effectively. Under these conditions, sellers receive a sufficient, but not excessive, return on their investment. And, in a competitive market, incentives are present for firms to seek and adopt cost-saving technological innovations. 

For a market to be effectively competitive, consumers and producers must have sufficient knowledge to make informed decisions; the 

number of buyers and sellers should be large; each seller's goods should 

be satisfactory substitutes for all other sellers' goods; and a change in 

liTmrT- ---
"J"ll '. --- -- __ l illlli.l. 

8 RISING HEALTH CARE COSTS 

,, i I - _ ____i_ __ 

April 1991 

the quantity of goods available should not swing the balance of power 

toward either buyers or sellers. 

While the ideal market structure, which would lead to perfectly 

competitive actions of buyers and sellers, does not exist, economists 

have debated the conditions necessary for effective competition. It has 

been argued that some departures from the perfectly competitive norm 

are not a barrier to achieving the long-nm benefits of competition. 

Effective competition has been described as requiring that consumers 

act independently and knowledgeably, that there be many sellers and 

easy entry for more of them, and that products have close substitutes 

available. 

If a market is functioning under relatively noncompetitive conditions, one might suppose that some people would benefit if changes 

were made that increased the degree of competition in that market. 

But economists hold that the effects of increased competition would depend upon the underlying factors causing the noncompetitive conditions in the market. Even if competition, under ideal conditions, leads 

to the most desirable outcomes for consumers, obtaining a closer approximation to competitive conditions does not always improve the 

outcomes. In fact, a partially competitive market, under some circumstances, may yield less beneficial results than a fully regulated market.l 

The "Special" Economic Problems of the Health Care Market 

In the health services market, the conditions necessary for the existence of a competitive market are not fully met. It departs from those 

conditions in the following ways: 

o Uncertainty with respect to the occurrence of illness has led 

to extensive medical insurance of a type that encourages consumers to purchase more and higher-quality services than 

they would in the absence of insurance; 

1. See R.G. Lipsey and K. Lancaster, "The General Theory of Second Best," Reuiew of Eeonom1c 

Studies, vol. 24 (1956), pp. 11·32, for a more detaileddiscuaaion of this issue. 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 9 

o The complexity of medical services, rapid technological 

change, and uncertainty about the efficacy of treatment have 

led consumers to delegate much decisionmaking to providers; 

and 

o Entry into the industry is severely regulated, knowledge 

about the differences among providers is hard to acquire, and 

in many cases there are few competing sellers. 

Economists argue that uncertainty about the incidence of disease 

and about the efficacy of treatment are the prime determinants of the 

special economic problems in the health <:are market, and that many of 

the institutional characteristics of medical practice appear to have 

evolved as ways to provide measures of certainty to this market. Thus, 

medical education and strict licensure restrictions guarantee that the 

physician has at least a minimal level of competence--an evaluation 

not possible for the consumer to make i.n advance of treatment. The 

inability of the consumer to be fully knowledgeable in choosing medical services leads to the delegation of decisionmaking authority to the 

physician. The physician, in this role, may feel a social responsibility 

to provide the best possible care without regard to cost. Finally, the 

uncertainty about the incidence of illness--and the potentially very 

high costs associated with treatment--lead to the purchase of health 

insurance that substantially reduces the role of price in consumers' 

decisions about the quantity and types of medical care to purchase. 

As a result of programs such as Medicare and Medicaid, as well as 

private health insurance, substantial numbers of people face a low or 

zero out-of-pocket price for services. In addition, governmentally set 

prices for services provided to those eligible result in different prices 

for identical services provided to different populations. Government 

policy toward health care is also reflected in the tax subsidies of health 

insurance and health expenditures, whilch result in lower after-tax 

costs of these products to consumers. 

Insurance is present in a number of markets and appears to have 

relatively less effect on behavior than in the market for health 

services. Automobile insurance and household insurance are widespread. These types of insurance, however, are designed to protect 

---r---
-- _lJ]l ,,. I - -~------

10 RISING HEALTH CARE COSTS April 1991 

against random, potentially very expensive events of a specific nature. 

Health insurance has evolved to provide financial protection against 

low-cost, predictable requirements for health services, as well as 

against the costs of random catastrophically expensive illness. The 

result of health insurance coverage that pays for routine and elective 

health services is that these services are used more than they would be 

in the absence of insurance. While few people would burn down their 

own homes because fire insurance offsets the cost of replac~ment, 

many people will visit the doctor more often or agree to elective surgical procedures of limited value to their health, if the out-of-pocket cost 

of doing so is so small that even minimal improvement in health sta· 

tus, functioning, or quality oflife seems worthwhile to the consumer. 

Recent trends both in the market for health insurance and the 

market for health services suggest that the consequences of market 

failure will continue to present a problem for the U.S. health care system. The characteristics of these two markets, and recent trends that 

affect their performance, provide background for the examination of 

the effectiveness of strategies for controlling costs. 

THE MARKET FOR HEALTH INSURANCE 

The market for health insurance has been changing in a number of 

ways over the past decade. These changes have been in response to the 

regulatory environment and to the many concurrent changes occurring 

in the market for health services, including rapid increases in health 

care costs. In turn, health insurance changes have implications for the 

overall performance of the health sector. 2 

2. Appendix B presents information on the extent of health insurance coverage in the United States 

and the major reasons for lack of health insurance. 
CHAPTER 11 CHARACTERISTICS OF THE HEALTH SECTOR 11 

The History of Health Insurance 

Until the early years of this century, people had little concern about 

the costs of health care. Medical knowledge was limited, and most 

treatment occurred in the home. Hospitals were used primarily to 

provide services to those who had no one at home to care for them. 

While the patient might die, it was unlikely that the patient's family 

would have to declare bankruptcy as a result of the illness. Consequently, health insurance was generally unavailable before World 

War I. Only a few small commercial insurance companies offered acci· 

dent and health protection, paying a cash indemnity to the individual 

if an accident or illness occurred.3 

During the 1930s, many people found themselves for the first time 

unable to pay for routine health care. Hospitals and physicians ex· 

perienced both reduced demand for their services and an increase in 

the number of patients unable to pay for services received. The 

response to this crisis was the development, with the assistance of 

hospital and physician organizations, of Blue Cross and Blue Shield 

insurance coverage for hospital and physician services, respectively. 

Unlike commercial insurers of the time, Blue Cross offered insur· 

ance coverage that reimbursed the hospital directly for services pro· 

vided (service benefits) rather than paying the patient a flat amount 

not directly related to the actual costs of the health care used--as insurance providing indemnity benefits had done. Blue Shield initially 

offered service benefits to low·income E~nrollees and indemnity coverage to higher·income enrollees. Over time, however, Blue Shield 

moved to service benefits for all its members. Some have argued that 

the development of service benefits coverage shifted control over 

health care financing from the patient to the provider. 

Commercial insurance began to develop during the 1940s, 

prompted by the trend to employment-based health insurance that 

began during World War II. The purchase of health insurance through 

employment-based groups permitted health insurance premiums to be 

3. Much of the information in thia section is drawn from Congressional Research Service, Health 

Insurance and the Uninsured: Background Data and Analysis (May 1988). 

Ill n11 T~· - -· -·----
.... ~lllJI ,, II ----~---

12 RISING HEALTH CARE COSTS April 1991 

lower than was possible for individual insurance policies. Within any 

large group formed for a purpose other than the purchase of health 

insurance, the insurer can assume that the risk of high-cost illness is 

randomly distributed. Therefore, insurance can be provided for a 

premium that represents the average expected cost of health care in 

the group or geographical area. In addition, administrative costs of insurance include a substantial fixed component that is a smaller proportion of insurance costs as the group increases in size. The financial 

advantages of employment-based group insurance to employees were 

reinforced, during World War II, when wages were frozen but fringe 

benefits were not. In 1942, only 37 companies were writing group 

health insurance; by 1951, this number had risen to 212 companies. 

By 1990, about 70 percent of the population under the age of 65 had 

health insurance through some employment-based group. 

A strong, additional impetus to the spread of employment-based 

health insurance was the exclusion of employer-paid fringe benefits 

from the taxable income of the employee. For an employee with a 

marginal income tax rate of 15 percent, a federal payroll tax rate of 

about 8 percent, and a state income tax rate of 5 percent, this tax 

exclusion means that $1 spent by the employer generates $1 of health 

insurance at a cost to the employee equivalent to 72 cents of after-tax 

cash income. As a result, employees have considerable incentive to 

negotiate for generous health insurance benefits, with the employer 

paying for a substantial proportion of them. In fact, the average 

employer contribution was about 83 percent of the total premium cost 

in 1987.4 This exclusion will save individuals and businesses about 

$56 billion to $58 billion in federal, state, and local taxes in 1991. 

Yet another aspect of the market for health insurance that may 

have considerable impact on its operation is the extensive regulation of 

the industry. Insurance regulation is performed at the state level and 

has differential effects on Blue Cross and Blue Shield plans, commercial insurers, and health maintenance organizations (HMOs). State 

regulation of insurance organizations has many features: 

4. SeeS. DiCarlo and J. Gabel, "Conventional Health Insurance: A Decade Later," Health Care 

Financing Review, vol.lO (Spring 1989), pp.77-88. 
CHAPTER II CHARACTERISTICS OF THE HEALm SECTOR 13 

o Companies must meet (and continue to meet) certain standards with respect to assets, reserves, and investments in 

order to be licensed--that is, permitted to operate in the state; 

o Each company must file annual financial statements, and 

permit periodic detailed examinations by state insurance 

departments; 

o Individual and group policy forms and, in some states, premium rates must be filed for review and approval with the state 

insurance commlSSlon; 

o Arbitrary discriminatory differences in premium rates are 

prohibited under state fair trade practices acts; 

o All states have adopted the Uniform Individual Accident and 

Sickness Policy Provisions of the National Association of Insurance Commissioners, which protect consumers through 

regulation of such factors as grace periods, proof of loss, cancellations, and claims procedures. 

o All states have laws requiring insurers to provide particular 

benefits in their policies, although the specific mandated 

benefits vary. 

In addition to regulations that affect the financial dealings of organizations that provide health insurance and that protect consumers, 

states also assess premium taxes on most types of insurance. This particular state practice has often distinguished between the Blue Cross/ 

Blue Shield plans and commercial insurance plans, with the former 

exempted or assessed a lower tax. In many states, the Blue Cross and 

Blue Shield plans also gain from other differential regulation that 

applies, for example, less stringent asset requirements to those plans. 

In return for these advantages, they are often required by state law to 

have open enrollment periods and to offer individual and group policies, as are HMOs in some states. HMOs also may be subject to regulation of their service delivery systems under state agencies that oversee medical practice. 

292-851 0 - 91 - 2 

----- - ---.--;--;----- II 1!!1111 T- ---
__ _ _ _ -~--LlJil_,_. -- --~_!_L__ -- -

14 RISING HEALTH CARE COSTS April 1991 

Federal regulation that affects health insurers derives primarily 

from the Employee Retirement Income Security Act of 1974 (ERISA). 

ERISA preempts state laws affecting employer-provided plans when 

the employer chooses to self-insure--that is, to assume the risk of 

paying health claims directly rather than purchase health insurance 

for employees. Self-insured employers are exempt from state-mandated benefit laws, state taxes on insurance premiums, and other regulations that increase the cost of group health insurance. The exemptions, combined with the minimal requirements under ERISA, 

have encouraged self-insurance particularly among large employers. 

Recent Trends in the Health Insurance Market 

Over the past decade, there have been many changes in the market for 

health insurance affecting its structure and operations and, as a 

consequence, the availability of employment-based insurance. Many 

of these changes have been a response to rapid increases in the costs of 

health care over a relatively short time. A related impetus for change 

is the encouragement given to competition among health insurers and 

to increasing the choices of insurance arrangements available to consumers. These latter phenomena were the direct result of policies intended to control rising health care costs. 

Alternative Insurance-Delivery Systems. The development and spread 

of combined insurance-service delivery systems, or HMOs, has had a 

substantial effect on the health insurance market. Because these insurers require that enrollees obtain services only from providers with 

whom the HMO contracts, and because they exert control over the decisions of contracted providers, HMOs have the potential to provide comprehensive health services for lower premiums than traditional insurers. 

HMOs, in their current form, developed and gradually spread 

during the 1930s and 1940s, particularly on the West Coast. Their 

growth was slow, however, until the 1970s. In 1973, in response to a 

perception that HMOs were a more cost-effective means of delivering 

health care, federal legislation was passed that encouraged their 

growth. In 1980 there were 236 HMOs providing services to over 9 
CHAPTER II CHARACTEHISTICS OF THE HEALTH SECTOR 15 

million people. By December 1989, there were 591 HMOs with nearly 

35 million members. 

To the extent that HMOs are better able to control the quantity 

and the costs of health services provided to their members than are 

traditional insurers, the increasing presence of HMOs may have encouraged traditional insurers to develop mechanisms that would allow 

them to compete with HMOs. Some of these mechanisms may be highly desirable--for example, adopting computer technologies for tracking 

enrollment and claims payments--in that they reduce costs of insurance without changing the product. Other responses may be less desirable, however. Traditional insurers may have become more selective about the insurance that they write, avoiding groups and individuals with characteristics that may indicate high risk, in order to 

offer lower premiums that are competitive with HMO premium levels. 

Methods for Setting Premiums. A major factor in the success of commercial insurers during the 1940s and 1950s was their use of experience rating to set premiums for large !:,JTOups. The use of information 

on the previous health care experience of large groups, particularly 

those that were composed of relatively young, healthy workers, generally resulted in premium levels that were lower than premiums 

based on community rating. 

Community rating sets premiums based upon the expected spending within a community (defined as a geographic area) for a defined set 

of benefits, divided by the number of people in the community. Thus, 

community rating does not distinguish among individuals with respect 

to characteristics that may be reasonably expected to affect their 

health status. 

As health care costs have risen, and as competition among health 

insurers has increased in response to policies intended to slow these 

cost increases, insurers have increasingly turned away from community rating and toward experience rating. Experience rating permits the insurer to set premiums for healthy groups at attractive 

levels, relative to premiums charged by HMOs and many Blue Cross 

and Blue Shield plans that use community rating methods for setting 

premiums. In addition to the competitive advantage offered by ex-

---- --.-;-, ---
- " 1_111_] -- - -li..J.Jl ,.Ill ------ -- ------

16 RISING HEALTH CARE COSTS April 1991 

perience rating, the practice makes it possible for insurers to attract 

healthier risks into their insurance pool and, by setting high premiums 

for less healthy groups, to discourage provision of insurance through 

employment groups with high expected costs. 

Another response to the higher costs of health care that affects the 

availability of health insurance is the practice of underwriting. Underwriting involves the setting of premiums, particularly for small 

employers and for individual applicants, based upon the insurer's assessment of specific risk factors for the group or person to be insured. 

Underwriting may include use of various sources of information (perhaps even including a medical examination) to assess the individual's 

health status, financial condition, and other risk factors. On the basis 

of underwriting, individuals and small employment groups may be 

denied coverage, charged a higher premium, or offered coverage only if 

high·risk employees are excluded or a waiting period (varying from six 

months to two years) is imposed before coverage begins for preexisting 

conditions. 

Self-Insurance by Employers. The health insurance market has also 

experienced a recent shift toward self·insurance by larger employers. 

Self·insurance reduces employers' expenses for health benefits since 

they are exempted from state regulations, such as premium taxes and 

mandated benefits, that increase costs. Self· insurance also allows em· 

ployers to avoid paying insurers a profit on the group policy (although 

they may continue to pay an insurer to serve as the administrative 

agent}. In addition, self-insured firms retain control over the funds 

budgeted for health costs until claims are paid. In 1979, 19 percent of 

medium and large employers were self.insured. By 1987, 40 percent 

were self-insured.5 

5. See Congressional Research Service, Health Insurance and the Uninsured. The data on 

self·iilllurance are obtained from the annual Hay/Huggins Benefits Report, an annual ~urvey of 

medium and larger firms. Of the 896 fll"IIls surveyed in 1987, 3 percent had fewer than 100 

employees, and 84 percent had 500 or more employees. 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 17 

Rising Premiums for Health Insurance. The rapid rise in real spending per person for health in the United States is also reflected in increasing health insurance premiums. Be-tween 1977 and 1987, the 

average real premium paid by employers rose from $1,111 to $1,656 (in 

1987 dollars), or by 49 percent. 

The relevant measure of compensation, for both workers and businesses, is the total of wages and salaries plus the cost of fringe benefits. 

If the cost of fringe benefits grows faster than wages because of rising 

health insurance premiums, workers will receive a greater share of 

total compensation as fringe benefits and a lesser share as wages and 

salaries. Recent data indicate that business spending for health grew 

from 5 percent to 7 percent of total labor compensation between 1980 

and 1989. Health benefits were 33 percent of total fringe benefits in 

1980 and 46 percent in 1989.6 

Because the costs of health insurance are a larger share of compensation for lower-wage workers, the dramatic rise in health insurance 

premiums has reduced employment-based coverage for them more 

than it has affected coverage for higher-wage workers. Some businesses with a high proportion of low-wage workers are apparently 

choosing not to provide health insurance at all because its cost would 

represent such a substantial addition to wages. In firms that do not 

offer health insurance, a high proportion of workers earn less than 

$10,000 per year. For example, in firms with 100 or more employees 

that do not offer health insurance, 52 percent of employees earn less 

than $10,000. In comparably sized firms that do offer insurance, only 

13 percent of workers earn less than $10,000.7 

A recent study examines trends in the percent of employees with 

employer-sponsored insurance, by earnings, over the 1979 to 1989 

period.8 Among workers who were not self-employed, not covered as a 

dependent on a private insurance policy, and not covered by a public 

program, the percent uninsured increased from 1979 to 1984, was 

6. See K. Levit and C. Cowan, ''The Burden of Health Care Costa: Business, Houaeholds, and 

Governments," Health Care Financing Reuiew, vol.12 (Winter 1990), pp.127-138. 

7. See Health Insurance Association of America, Source Book of Health Insurance Data, 1990 

(Washington, D.C.: 1990). 

-------r-.-:----
---~---

18 RISING HEALTH CARE COSTS April 1991 

stable from 1984 through 1987, and then rose again from 1987 to 1988. 

For low-wage workers (those earning less than $12,500 in 1989 dollars) 

the decline in the percent with employer-sponsored insurance was 10 

percentage points or more over the 1979 to 1989 period--with the great· 

est decrease experienced by lowest-wage workers. By comparison, the 

percent of workers earning $20,000 or more with employer-sponsored 

insurance remained at 90 percent to 95 percent over the entire period. 

These trends suggest that, if health care and health insurance 

costs continue to rise much faster than wages and salaries, the number 

of workers--particularly low-wage workers--not offered health insurance as a fringe benefit can also be expected to rise. 

Consequences of Health Insurance for the Market for Health Services 

Insurance performs the function of spreading risk across large groups, 

but also reduces the price consciousness of consumers in their decisions 

about the amount and type of insured services they purchase. This is 

particularly the case for health insurance, since it has evolved to include coverage for both routine health care services, with a significant 

elective component, and random, infrequent, catastrophic occurrences. 

One consequence of lower price consciousness and the resulting 

increased use of health services in the presence of insurance is rising 

prices for services. Higher prices, in turn, create greater incentives to 

insure against the possibility of incurring substantial costs when 

health care is needed, as well as higher health insurance premiums. 

The consequences of rising health care costs and their impact on 

the market for health insurance are reduced availability of insurance 

for employers with high-risk workers or in industries considered to be 

high-risk, premium levels that are sufficiently high that some employers choose not to offer health insurance, and exclusion of high-risk 

workers from group insurance coverage. These consequences appear to 

be most severe for small businesses with few workers among whom the 

8. See R. Kronick, "Health lnsUl'ance in the United States, 1979·1989: The Frayed Connection 

Between Employment and Insurance" {proressed), University of California, San Diego, La Jolla, 

California. 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 19 

risk can be spread and for businesses with a high proportion of lowwage workers. 

The increased competition among insurers, in response to policies 

intended to control health care costs, may also have resulted in higher 

administrative costs in the health insurance market. Every employer 

that offers multiple insurance options in effect creates several smaller 

insurance groups within the firm. The smaller the insured group, the 

higher are administrative costs as a share of the total premium. For 

firms with 1 to 4 employees, administrative costs are 40 percent of total 

benefit costs; for firms with 20 to 49 employees, administrative costs 

are 25 percent of benefits; but for firms with over 10,000 or more 

employees, administrative costs are only 5.5 percent of benefits.9 

Thus, smaller groups face a higher premium per worker for a standard 

insurance package. For example, to purchase $100 worth of health 

benefits for its employees, an insurance group with 10,000 employees 

would pay $105.50; to obtain the same level of benefits, an insurance 

group with fewer than five employees would pay $140.00. 

In fact, administrative costs in the private sector are rising even 

more rapidly than the cost of health care benefits--229 percent compared with 110 percent between 1980 and 1989. By comparison, administrative costs for the Medicare program rose 104 percent over this 

period, while spending for benefits rose 172 percent. This continuing 

increase in administrative costs in the private sector is exacerbating 

the problems already facing small employers in obtaining and affording health insurance coverage for their employees. 

THE MARKET FOR HEALTH SERVICES 

The existence of widespread insurance against health care costs has 

contributed to the health care cost problem, through reductions in the 

price consumers pay for health services, and has interacted with 

9. See Congressional Research Service, Private Health insurance: Options for Reform I September 

1990l. Large firms, however, may undertake some of the administrative activities of insurance in 

order W obtain lower premiums from the insurer. If smaUfirms are less likely to do so, then 

insurer-reported administrative costs may overstate the real relationship between firm size and 

costs. 
" 11'1 I ---JL J...1Jt _jl_ 

20 RISING HEALTH CARE COSTS 

__ _ll:l __ _ 

April 1991 

several characteristics of the market for health services to have a 

pervasive impact on the provision of health care in the United States. 

Several characteristics of the market for health services that are 

important in explaining the level and trends in the health sector are: 

growth in the supply of physicians, physician-induced demand for 

medical services, the medical malpractice environment, cross-subsidization across services and payers, and technological change. In addition, the share of the cost of health care services paid directly by 

consumers over the past decade has declined. 

Growth in the Supply of Physicians 

The supply of physicians relative to population has grown rapidly over 

the past two decades--from 1.6 per 1,000 population in 1970 to 2.4 per 

1,000 population in 1990. It is projected that, by the year 2000, there 

will be 2.6 physicians for every 1,000 persons in the United States. 

This growth was the result of policies implemented in the 1960s and 

1970s that expanded medical school capacity. These policies were 

based upon a perception that there were not enough physicians to meet 

the needs of the population and that, because of the undersupply, some 

geographic areas and population groups were substantially underserved. Some advocates of increasing the supply of physicians also 

argued that organized medicine had deliberately restricted the number 

and size of medical schools to obtain greater market power and increase the incomes of physicians. 

Several consequences of the increase in the supply of physicians 

have been noted. More physicians have chosen to locate in small towns 

and rural areas, resulting in better access to care for areas that were 

previously less well served. Physicians have also become more willing 

to participate in health maintenance organizations and other managed 

care arrangements, and negotiated price discounts between physicians 

and insurers have become common. 

The increased supply of physicians has not, however, led to lower 

incomes for physicians. In 1970, physicians earned, on average, 

$113,192 (in 1987 dollars) after expenses but before taxes. By 1987, 

average net earnings had risen to $132,300. The American Medical 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 21 

Association reports that incomes increased another 9 percent in 1988 

and 8 percent in 1989--far more than the underlying inflation rate in 

the economy or the average growth in wages that year. 

Physician-Induced Demand for Services 

Physicians can influence the demand for medical services because 

patients have imperfect information about the potential benefits of 

various medical procedures and, therefore, delegate substantial decisionmaking power to physicians. In addition, insured patients are not 

particularly conscious of costs. Studies show that, when physicians' 

fees are controlled, spending does not fall by the difference between the 

unconstrained fee and the controlled fee times the quantity of services 

previously provided. Instead, evidence from the Medicare experience 

suggests that when fees are constrained, the volume of services increases, offsetting some of the savings that would otherwise have occurred.lO While some of the observed response in volume to constrained fees is accounted for by consumers choosing to purchase more 

services at lower prices, the extensive degree of insurance in this market suggests that a substantial proportion of volume increases are the 

result of physicians' actions that increase the number of services or 

that change the way in which services are counted and billed. 

Since each physician can generate demand for his or her own services, some observers suggest that the implications for policy decisions 

in this market are significant. Policies to control health care costs may 

be designed to affect the demand side of the market, under an assumption that consumers are able to affect providers' behavior through 

their decisions about what services they purchase and from whom. 

Physician-induced demand, however, suggests that demand-side strategies may be largely ineffective since physicians are able to offset consumers' decisions, at least partially. In that case, cost control may be 

10. See Congressional Budget Office, Physician Payment Reform Under Medicare (April 1990!; 

J. Holahan and others, "Understanding the Recent Growth in Physicians' Expenditures," Journal 

of the American Medical Assocmiion, vol. 263, no. 12, p. 1660; and J. Gabel and T. Rice, "Reducing 

Public Expenditw-es for Physician Services: The Price of Paying Leas," Journal of Health Pohtics, 

Policy and Law, vol. 9 (Winter 1985), pp. 595·609. 

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1' I' rnr --
llllllj. ---- -- - ~ JLJJ{ PI, --~-t. --- --

22 RISING HEALTH CARE COSTS April 1991 

more effective if applied through regulatory controls on the supply 

side. 

The Medical Malpractice Environment 

Medical malpractice is the term used to refer to any deviation from 

accepted medical standards of care that causes injury to a patient. The 

legal system in the United States provides compensation to patients 

who are found to have suffered injury resulting from medical malpractice. II 

The insurance industry offers insurance to physicians and other 

providers of medical services against the possibility of a legal judgment 

that medical malpractice has occurred, with an award of compensation. 

In 1988, the average malpractice insurance premium paid by selfemployed physicians was $15,900. The premium level varied by specialty, however, from $35,300 for obstetricians/gynecologists to $4,400 

for psychiatrists. 

The perception that the medical malpractice environment is an 

important factor in the performance of the market for health services is 

based upon two concerns: 

o Malpractice premiums are one component of providers' costs 

and, even though they are a small share of costs for most 

specialties, if they rise rapidly they will cause the prices of 

services to increase; and 

o To avoid malpractice suits, providers may change their practice patterns in ways that reduce the probability of lawsuits 

and provide documentation that helps them to defend against 

suits that are filed. 

lL Much of the information in this section is drawn £rom U.S. Congress, Committee on Ways and 

Means, Medical Malpractice, Committee Print 101-26, prepared by the Congressional Research 

Service, April26, 1990. 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 23 

Malpractice premiums have, in fact, risen dramatically over the 

years. Between 1982 and 1988, the AMA reports that malpractice 

premiums for self-employed physicians rose at an average annual rate 

of 18.3 percent. The share of practice revenues devoted to malpractice 

premiums increased from 3.1 percent in 1982 to 5.6 percent in 1988. 

Overall in the United States, $5 billion was spent on medical malpractice premiums by all types of medical providers in 1988. Thus, 

medical malpractice premiums directly accounted for 0.9 percent of all 

spending for health that year. 

The practice of "defensive medicine" by physicians to protect themselves from medical malpractice suits may take the form of ordering 

additional tests, spending more time with patients, and maintaining 

more extensive medical records. Each of these responses has the potential to increase spending for health services over the level that would 

have prevailed in the absence of the current malpractice environment. 

It is possible, of course, that these responses also result in higher 

quality care and fewer injuries to patients from improper treatment. 

But defensive medicine may take a different form. Physicians may 

cease to perform high-risk procedures, only treat low-risk patients, refuse to accept some types of patients at all, or retire from practice. 

These responses could reduce access to care for some individuals, depending on whether other physicians who responded differently were 

available in the same area. They could also, however, change the 

quality of care, depending on the relative competence of physicians 

who are most likely to restrict their activities. 

The medical malpractice environment makes it more difficult to 

implement effective cost containment strategies. Physicians may be 

reluctant to incorporate consideration of costs into their practice decisions, in the face of potential liability lawsuits. From this perspective, 

the development of practice guidelines and results from research on 

the outcomes of different treatments may provide a foundation of 

knowledge that will enable physicians to make more appropriate and 

cost-effective decisions. 

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- __ lj]jl 111 1 -- ____ t._._ --. 

24 RISING HEALTH CARE COSTS April 1991 

The Ability to Cross-Subsidize 

The market for heath services has a substantial nonprofit segment. 

Over 85 percent of community hospitals and nearly 30 percent of nursing homes are either nonprofit or government-operated. As a consequence of the nonprofit nature of much of this market, combined 

with the presence of multiple third-party payers and the low level of 

consumer price-consciousness, some of these providers appear to subsidize some patients and services by setting higher prices for other 

categories of payers and services. Similarly, physicians can charge 

some patients--such as those without insurance--less or choose not to 

collect the balance of their bills. The implication of the ability to crosssubsidize is that insurers and patients with less market power may 

face higher prices and higher health insurance premiums that reflect, 

in part, the losses from third-party payers and patients whose payments are below the costs of the services. 

If providers can cross-subsidize and set prices for some--but not 

all--patients, then attempts to control use of services and costs by one 

payer may result in higher spending by other payers. For example, the 

imposition of utilization controls by an HMO may lower hospital admissions and the number of days of hospitalization for members of that 

HMO relative to what would occur in the absence of the controls. This 

lower use does not, however, necessarily lead to a corresponding reduction in the nation's total spending for hospital services, since hospitals 

may be able to increase the prices or the amounts of services provided 

to non-HMO patients in order to compensate for their lost revenues. 

Technological Change 

The United States spends a substantial amount each year on medical 

research--about $10.2 billion in public funds alone in 1989. This basic 

research yields new diagnostic tools and treatments that increase the 

effectiveness of medical care--and their rapid dissemination is encouraged by the present arrangements for financing health care in the 

United States. But the system for reimbursing providers makes it 

possible for excess capacity to develop. Excess capacity can then lead 

to overuse of these technologies, raising health care costs and possibly 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 25 

resulting in harm to patients from side effects or other complications 

associated with medical intervention. To date, however, for lack of 

data and in the absence of guidelines for establishing the clinically 

necessary supply of specific technologies, it has been difficult to quantify the general perception that excess capacity is a problem. Overuse of 

some technologies, however, is strongly suggested by studies showing 

that a substantial proportion of selected medical procedures performed are not clinically indicated. 

In fact, there have been few attempts by third-party payers in the 

United States to limit the diffusion of new technologies. The current 

financing system for health care in the United States ordinarily reimburses for any diagnostic tests or procedures that are generally accepted as proven and not experimentaL This open-ended financing, 

combined with the absence of any type of control on diffusion, results in 

much more rapid adoption of new technologies in the United States 

than in other countries. A recent comparison of the availability of six 

technologies in the United States, Canada, and former West Germany 

shows much greater capacity in the United States. For example, the 

numbers of open-heart surgical units per million persons were 0. 7 in 

former West Germany, 1.2 in Canada, and 3.3 in the United States. 

Similarly, the United States had 3.7 magnetic resonance imagers 

(MRis) per million persons compared with 0.9 in former West Germany 

and 0.5 in Canada.12 

Some limited evidence suggests that the Canadian government 

has sometimes chosen to make use of the United States' investment in 

various technologies, rather than to increase its own capital investment. For example, one hospital in Buffalo, New York, reports that 50 

of 100 patients receiving monthly lithotripsy treatments were doing so 

under a formal agreement with the province of Ontario. Patients in 

western Ontario who need cardiac surgery have been sent to a hospital 

in Detroit under an agreement initiated by physicians in Windsor, 

Ontario, and accepted by the provincial health insurance plan.13 

12. See Dale A. Rublee, "Medical Technology in CII.Il8da, Germany, and the United States," Health 

Affairs, vol. 8 (Fall1989l, pp. 178-181. 

13. See J. Iglehart, "Canada's Health Care System Faces Its Problems," New England Journal of 

Medicine, vol. 322(February 22, 1990), pp. 562-568. 

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____ _tl Ill II --~--·· 

26 RISING HEALTH CARE COSTS April 1991 

The United States health care system, as it is currently configured, ensures rapid diffusion of new technologies and access to those 

technologies without a waiting period for those who have the ability to 

pay. It may also result in use that exceeds the appropriate levels, 

leading to higher costs and potential harm to some patients. Some 

observers have suggested that a substantial degree of control of health 

spending may only be achieved through efforts to restrict the rate of 

technological change and diffusion of new technologies, and to ration 

access to new treatments. 

The Decreasing Role of Consumer Cost Sharing 

In 1965, Americans paid nearly half of national health expenditures 

out of pocket, but by 1989 the consumers' out-of-pocket share had 

declined to 21 percent.14 The expansion of private health insurance 

and of public programs that provide third-party payment on behalf of 

the elderly, severely disabled, and some of the poor have made it possible for consumers to purchase more services and higher-quality services while paying directly a smaller share of the costs associated with 

those services. 

The share paid by consumers varies by type of service purchased, 

however. Out-of-pocket payments were 5.5 percent of total spending 

for hospital services and 19 percent of total spending for physicians' 

services in 1989. Third-party coverage of some other types of services 

is not so complete: consumers paid 44 percent of the costs of nursing 

home care and 58 percent of the costs of prescription drugs. 

Coverage also varies by third-party payer. Medicaid pays essentially all the costs of health care needed by most beneficiaries, while 

Medicare pays only 45 percent of total health care costs of its aged and 

14. Out-of-pocket cos!:$ are defined as those costs directly related to the use of health services--

deductible amounts, coinsurance, and other copayment amounts--that are the responsibility of the 

consumer. Consumers also pay for health care indirectly through their health insurance premiums. 

Total household spending for health care is the combination of out-of-pocket costa and the 

household's share o£ health inaurance premiums, but only out-of-p-ocket coste directly influence 

consumers' decisions about use of health services. 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 27 

disabled enrollees.l5 In addition, out-of-pocket costs are open-ended 

under the Medicare program, unlike the provisions of most private 

health insurance policies that limit annual out-of-pocket costs. As a 

result, Medicare enrollees are at greater financial risk for high health 

care costs than are people covered by many other third-party payers. 

This financial vulnerability, however, does not cause most Medicare 

enrollees to become more price-conscious than other consumers because a market for supplementary insurance has developed to provide 

additional financial protection against their health care costs. About 

80 percent of Medicare enrollees have Medicare supplementary coverage through a retiree health plan or through an individual medigap 

policy or are eligible for full or qualified Medicaid assistance. 

Although consumers pay for their health care through insurance 

premiums, taxes, and lower direct wages, the decision to purchase a 

specific health service is influenced only by the direct out-of-pocket 

costs to the consumer for that additional service. The substantial reduction in the out-of-pocket price paid by consumers for health care 

means that consumers do not make decisions about purchases in this 

market based upon the full price of services. Thus, continuing decline 

in out-of-pocket spending as a proportion of total spending over the 

past decade probably lessened the impact of policies to reduce the rate 

of increase in health care spending over that period. 

PERFORMANCE OF THE HEALTH SECTOR 

In addition to the high and rising costs of health care, which were 

discussed in Chapter I, several other indications suggest that there are 

problems in the functioning of the health sector. These indications 

include: the substantial number of uninsured people, inefficiency in 

the provision of services, and health outcomes that seem poor relative 

to the level of national health spending. 

15. Categorically eligible Medicaid beneficiaries are not required to pay any of their coats, with the 

exception in some statel! of minimum copayments. Those who are eligible for Medicaid under a medically needy program incur out-of-pocket costs in most states. 

---~- -- JITJIT.- --- - -- - --
_ _l1L_ ... 

28 RISING HEALTH CARE COSTS April 1991 

Number of Uninsured People 

Despite the substantial spending for health care in the United States, a 

portion of its population is without imancial access to medical services. 

In March 1990, over 33 million people under age 65 were without 

health insurance coverage. 

The proportion of the population without insurance also has been 

growing over time··With the most substantial increase occurring 

between 1980 and 1984. In 1980, 12.5 percent of people under age 65 

did not have health insurance, according to data from the Health 

Interview Survey. By 1982, the percent uninsured had risen to 14.7 

with a further increase to 15.4 in 1984. Since 1984, the proportion of 

the population uninsured has increased only slightly to 15.7 percent in 

1989. While some of the increase may reflect the loss of health 

insurance resulting from high unemployment during the recession of 

the early 1980s, the proportion of the population without insurance 

continued to grow through the economic recovery. 

Most of the increase in the number of uninsured can be attributed 

to a decline in private insurance coverage--which fell from 78.8 percent 

in 1980 to 76.6 percent in 1989. Data from the Current Population 

Survey show that the percentage of workers covered by insurance 

through their own employers peaked in 1982, when 77.2 percent of 

full-time workers and 24 percent of part-time workers were insured. 

By 1987, the percentages of full-time and part-time workers with 

insurance through their own employers had declined to 73.8 percent 

and 21.4 percent, respectively. The proportion covered by insurance 

dropped in each major industrial category--in other words, the gradual 

shift of employment to the service sector explains only a small portion 

of this reduction in employment-based coverage. 

Those without health insurance are, in general, least able to afford 

to pay for health care, and they use fewer physicians' and inpatient 

hospital services than do the insured. The groups most likely to be 

uninsured in 1990 were young adults, part-time workers, those with 

low incomes, and members of single-parent families. One study estimated that nonelderly adults who were without insurance for a full 

year were 25 percent less likely than the insured to use any physicians' 
CHAPTER II CHARACTERISTICS OF THE HEALTH SECTOR 29 

services and 54 percent less likely to use inpatient hospital services. 

Even when some services were used, the uninsured used fewer than 

the insured: 16 percent fewer physicians' Services and 33 percent fewer 

hospital services.16 

While some of the services forgone may be discretionary or of 

limited value, it appears that important medical services also are not 

obtained. A recent study indicates that, among those who were 

hospitalized, people without insurance were sicker when they arrived 

and were 29 percent to 75 percent less likely to undergo each of five 

medical procedures that are expensive and have a substantial discretionary element. Uninsured patients were significantly more likely 

to die in the hospital, even after allowing for the fact that they were 

sicker when initially hospitalized and other factors.17 

Efficiency in Providing Health Care 

Costs of health services are, in part, dependent upon the efficiency of 

the market. In an efficient market, the value ofthe marginal services 

received by consumers approximately equals the marginal cost of those 

services. In addition, health services are produced using the least 

costly combination of resources. The pervasive presence of health insurance in this market, combined with the delegation of much of the 

decisionmaking to providers, gives reason to believe there may be substantial inefficiencies in the health sector. These inefficiencies may 

lead to a greater quantity of services being produced, and to higher 

price levels, than would occur otherwise. 

The presence of insurance that covers some services to a greater 

extent than others affects the quantity and mix of services that consumers obtain. For example, full coverage of inpatient care for psychiatric conditions, but limited coverage of outpatient psychiatric 

visits, creates incentives to use inpatient care rather than less costly 

16. SeeS. Long and J. Rodgers, The Effects of Belfl.g (!nin.sured on llealth Care Service Use Estimates 

from the Survey of Income and Program Participation, Bureau of the Census, SIPP Working Paper 

#9012(1990). 

17. See J. Hadley. E. Steinberg, and J. Feder, "Comparison of Uninsured and Privately Insured 

Hospital Patients,'' Journal of the American Med1cal Association, voL 265, pp. 374-379. 

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30 RISING HEALTH CARE COSTS April 1991 

and less intensive ambulatory care visits to a psychiatrist. Similarly, 

the exclusion of preventive services from insurance coverage may 

cause consumers to put off obtaining them, thereby developing illnesses that require costly treatment and result in loss of productive 

time for the patient. 

Another potential source of inefficiency in this market occurs 

when prices are set by third-party payers and physicians respond by 

altering the quantity and mix of services they provide to consumers. 

To the extent that limiting physicians' fees results in their providing 

more services to consumers, for example, some waste is occurring unless the consumer was receiving too few services before the fee reduction, which seems unlikely. 

Yet another concern, as discussed earlier, is that administrative 

costs account for a high proportion of the costs of health care. In 1987, 

administrative costs of third-party payers were $23.9 billion, or 4.9 

percent of spending in the United States, compared with 2.5 percent in 

Canada, and 2.6 percent in Great Britain. Higher administrative costs 

of insurance in the United States are, in part, accounted for by the 

costs of determining eligibility for coverage, risk assessment, marketing, and coordination of benefits. In addition, the presence of multiple payers, negotiated prices, and the need for eligibility determination imposes significant administrative costs on providers who must 

collect payments from multiple sources, each with different procedures 

and paperwork requirements. These costs are reflected in higher 

prices for health services and for health insurance. 

Health Outcomes 

Other countries appear to spend less per person while ensuring that 

virtually all of their populations have access to health care. Even 

though they spend less per capita, health status indicators such as 

infant mortality and life expectancy at birth in these countries are 

comparable to, or better than, in the United States. In 1986, infant 

mortality as a percent of live births was .52 in Japan, .79 in Canada, 

.87 in former West Germany, and .95 in the United Kingdom, compared with 1.04 in the United States. Life expectancy of female new-
CHAPTER II CHARACTERISTICS OF mE HEALTH SECTOR 31 

horns for these five countries varied in 1986 from a high of 80.9 years 

in Japan to a low of 77.5 in the United Kingdom--with the United 

States in the middle at 78.3 years. For male newborns, life expectancy 

at birth in 1986 ranged from 75.2 years in Japan to 71.3 years in the 

United States, with both former West Germany and the United Kingdom only slightly above the United States. 

While differentials in these measures may be the result of factors 

other than health care spending, it appears that higher spending for 

health in the United States does not result in better outcomes--at least 

for those broad measures of health--for the U.S. population. A number 

of reasons may account for this. First, other countries provide financial access to care for their entire populations. The U.S. system includes a large group of people without any insurance coverage at all. 

In addition, U.S. health insurance coverage typically does not pay for 

routine examinations and preventive care, which may result in lowerincome people not obtaining these services. 

Other considerations, such as speed and accuracy of diagnosis, and 

the length of time until treatment, may also be of importance to the 

U.S. population. The United States devotes significant resources to 

basic medical research that yields improvements in diagnosis and 

treatment. And the current financing system permits rapid diffusion 

of technologies, making the benefits of research available to the insured population with minimal waiting times. In addition, consumers 

in the United States have substantial freedom to choose among providers, insurance packages, and treatment alternatives. Some of the 

higher spending in the United States probably reflects preferences for 

these outcomes. 

-- -,-;-:----
___ jll_ __ 
CHAPTER III 

POLICIES DESIGNED TO CONTROL 

HEALTH CARE COSTS 

Many strategies intended to control health care costs have been put 

into effect during the past two decades, especially during the 1980s.l 

The variety of approaches reflects the fact that controlling costs is a 

complex problem, and that the market for health services in the United 

States is diverse and uncoordinated. When there is only limited price 

competition among providers, and when consumers delegate much of 

the decisionmaking about the services they purchase to providers, 

substantial inefficiencies appear to result. In consequence, health 

spending has continued to be much higher than in other countries and 

to rise at a dramatic rate.2 

Among the strategies invoked to address the complex causes of 

rising health spending are: 

o Policies to reduce the use of services by increasing the outof-pocket price to consumers; 

o Policies to limit the freedom of providers to determine the 

services that will be offered to consumers and the freedom of 

consumers to choose any provider, including organizations 

that provide managed care and controls instituted by thirdparty payers over the utilization of services. 

o Direct controls over the prices of services; 

1. This study addresses strategies to control health care ooats that have been put in place or oonaidered 

for implementation in the health ~tor. Other policiee external to the health sector may also affect 

the level and rate of increase of health spending. For example, during the 1980!1 changes in the 

Internal Revenue Code reduced the marginal inoome tax rate for virtually all taxpayers. To the 

e.xtent that the tall subsidy to empJoym.ent-baaediD&urance alfectB cleciaiona aboutbealtb insurance 

coverage, the change in tax policy may have led to Ieee erlenaive inaUI"ance ooverage. 

2. Appendix C contains descriptions of the health care systems of selected other countries whose c011t 

containment strategies are compared in the text with policies used in the United States. 
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34 RISING HEALTH CARE COSTS April 1991 

o Policies to encourage increased competition in the markets 

for health insurance and for health services; and 

o Regulatory policies to affect the market for health services 

within defined geographic areas--for example, the all-payer 

systems for hospitals in several states. 

COST SHARING 

Many observers have cited the declining share of costs paid by 

consumers as a major cause of the rapid increase in spending for health 

services over the past two decades. The reduction in price consciousness of consumers leads them to purchase both more and higherquality services. In addition, the modest cost sharing required for 

some services fails to provide consumers with adequate incentives to 

search for providers who charge less, and makes them relatively insensitive to price increases. 

The most comprehensive study examining the response to varying 

cost-sharing provisions of insurance plans has been the RAND Health 

Insurance Experiment (HIEJ, conducted during the late 1970s and 

early 1980s. The study found a significant relationship between the 

use of medical services and the amount paid out of pocket. Spending 

per person was 45 percent higher in a plan that required no cost 

sharing compared with a plan that required 95 percent cost sharing up 

to an annual maximum of $1,000. The greatest decline in use of outpatient services occurred between a free (no out-of-pocket costs) plan 

and a plan with 25 percent coinsurance, however. Smaller changes in 

use of services occurred between the 25 percent coinsurance plan and 

the 95 percent plan. More specifically, analysis of the HIE data suggests that a 1 percent increase in the coinsurance rate would produce a 

decrease in expenditures of between 0.1 percent and 0.2 percent, for an 

insurance policy with a maximum out-of-pocket cap of$1,000. 

Cost sharing did not affect all services and all consumers uniformly, however. For example, while cost sharing caused consumers to 

initiate fewer contacts with medical providers, there was little difference by plan in the number of services used once a contact was ini-
CHAPTER III POUCIES DESIGNED TO CONTROL HEALTH CARE COSTS 35 

tiated.3 Effects also differed by type of service: nearly all the impact of 

cost sharing occurred in outpatient services, and there were no significant differences in hospital admissions or in spending for hospitalized people enrolled in the different insurance plans. This may, in 

part, be the result of the maximum out-of-pocket liability being limited 

to $1,000. 

Cost sharing clearly has the potential to reduce spending for 

health services. Had the average coinsurance rate for all U.S. consumers been 10 percentage points higher in 1989, health expenditures 

would have been 1 percent to 2 percent lower--roughly $6 billion to $12 

billion less. The effects of a substantial increase in cost sharing, however, would vary among types of services and by characteristics of consumers. Ambulatory care services would be more responsive than 

others to increased cost sharing, with consumers seeking fewer initial 

visits rather than receiving less intensive visits. In addition, an 

across-the-board increase in cost sharing would have more impact on 

the poor than on other consumers--an outcome that might have adverse consequences for health status and access to care. 

For increased cost sharing to affect health care costs would also require that a supplementary market for health insurance be prohibited. 

The experience with Medicare enrollees indicates that without such a 

prohibition a new layer of insurance complexity and administrative 

costs might develop on top of the already fragmented existing system. 4 

Although cost sharing is an effective strategy for reducing expenditures for health care, most other industrial countries impose only 

nominal or no cost sharing requirements. Only France imposes cost 

sharing that approaches the level in the United States. In that 

country, out-of-pocket payments make up 20 percent of national health 

expenditures. In Canada's health system, provinces may impose user 

fees or allow providers to bill patients directly for amounts greater 

than the government-set payments on covered services, but none do so 

3. See Manning and others, "Health Insurance and the Demand for Medical Care: Evidence from a 

Randomized Experiment," American Economic Review, vol. 77 (June 1987),pp. 251·273. 

4. In addition, coordination of insurance coverage would be required ~o that families with more than one earner would not avoid cost sharing through multiple inaurance policies. 

!T-1: -- r11-,.,- · I 111 ... 
- ~·-·-'-"lL - - . 

36 RISING HEALTH CARE COSTS April 1991 

because federal funding is reduced dollar-for-dollar for such amounts. 

The exception is that patients can be billed for room and board in 

long-term care facilities. In former West Germany, out-of-pocket costs 

represent 7 percent of total health care expenditures. Patients pay 

primarily for over-the-counter drugs and to obtain better medical 

equipment than the sickness funds provide. In Great Britain, patient 

cost sharing represents about 3 percent of the cost of the National 

Health Service. Despite the lower levels of cost sharing in these other 

countries, each spends substantially less per capita on health tban does 

the United States. 

MANAGED CARE/UTILIZATION CONTROLS 

Managed care has been widely advocated since the early 1970s as a 

strategy for controlling costs. The principal impetus to managed care 

is evidence that many of the health services provided to consumers are 

unnecessary or inappropriate. Managed care is directed toward intervening in the decisions made by providers of care in order to ensure 

that only appropriate and necessary services are provided. Managed 

care organizations base this intervention on information that is not 

generally available to consumers, and thus act on consumers' behalf. 

Recent studies suggest that a high proportion of medical procedures performed are inappropriate. For example, one study of selected 

medical procedures provided to Medicare beneficiaries in eight states 

found that 17 percent of coronary angiographies, 32 percent of carotid 

endarectomies, and 17 percent of upper gastrointestinal tract endoscopies performed were inappropriate.5 To the extent that these patterns persist across all medical services, the loss to society from provision of unnecessary and inappropriate services may b~ substantial. 

Managed care, based on guidelines for appropriate care and employing 

utilization review and feedback to physicians about appropriate care, 

is expected to reduce this loss. 

5. SeeM. Chaasin a.nd others. "Does Inappropriate Use Explain Geographic Variations in the Use of 

Health Care Services?" Journal of the ArMrnan Medical AssociatWn, vol. 258 (November 13, 1987), 

pp. 1-5. 
CHAPTER Ill POUCIES DESIGNED TO CONTROL HEALTH CARE COSTS 37 

In addition, some managed care organizations negotiate with providers to obtain the lowest price available for services. If this negotiated price leads to higher efficiency in providing services, then managed care may also reduce waste. 

The term "managed care" encompasses a variety of interventions 

in health care delivery and financing. The major dimensions of managed care include: 

o Reviewing and intervening in decisions about health services 

to be provided--either prospectively or retrospectively; 

o Limiting or influencing patients' choice of providers: and 

o Negotiating different payment terms with providers. 

Each of these dimensions of managed care, however, is defined broadly 

and not all managed care organizations employ all of them. 

Managed care is provided through Health Maintenance Organizations (HMOs), Preferred Provider Organizations (PPOs), and "managed" fee-for-service insurance plans that require utilization controls 

and review. Each of these approaches manages care in a different way, 

although the distinctions among them are not always clearcut. HMOs 

provide the greatest degree of intervention in health care decisionmaking through an integrated delivery and financing system. There 

is, however, great diversity among HMOs, with some offering completely integrated systems with provider networks that serve only 

HMO members and others offering insurance arrangements coupled 

with limitations on consumers' choices among fee-for-service providers 

in the community. PPOs attempt to influence patients' choice of providers through offering differential cost sharing that rewards the 

patient who selects a provider from the PPO network. What is characterized as "managed fee-for-service" ordinarily involves utilization review overlaid on a traditional insurance package. 

During the 1980s, managed care--defined broadly--grew dramatically. The number ofHMOs more than doubled after 1980, with nearly 

35 million enrollees in 1989. Growth in the population covered by 

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38 RISING HEALTH CARE COSTS April 1991 

PPOs was also substantial during the 1980s. In 1984, only 1.3 million 

households were eligible to use PPOs; by January 1989, over 18 million 

households were eligible to use PPO plans. Blue Cross and Blue Shield 

plans reported 52 percent of enrollees in managed care in 1989, in' 

eluding 6 percent in HMOs, 15 percent in PPOs, and 31 percent in 

managed fee-for-service plans. 

Evidence as to the effectiveness of managed care in reducing expenditures for health care is limited, and much of the research was conducted in HMOs with fully integrated financing and delivery systems 

that are quite different from the majority of today's managed care organizations. These types ofHMOs have been found to reduce hospital 

use by over 20 percent, after allowing for differences in the characteristics of HMO enrollees and nonenrollees. HMOs that are more 

loosely structured--and PPOs and managed fee-for-service plans--have 

much less effect on utilization, with research studies reporting impacts 

ranging from zero to about an 8 percent reduction in utilization.6 

Managed care's principal impact appears to be on hospital use, with 

ambulatory care either unaffected or increasing as services are shifted 

from inpatient settings to outpatient sites. 

The actual reduction in spending for health services in managed 

care organizations is less than the reduction in use because the administrative costs of managed care are higher than those of unmanaged insurance plans. In addition, managed care, when it is successful 

in reducing spending, appears to have a one-time effect with no impact 

on rates of growth of health spending over time. 7 

Since it has been estimated that about half of the people in the 

United States with private insurance coverage were in managed care 

arrangements by 1989, health care spending could have been substantially lower by then if all managed care arrangements were as 

6. See W. Manning and others, "Health lnaurance and the Demand ror Medical Care"; R. Brown, 

Biased Selection in Medicare HMOs, Mathematic& Policy Research, Plainsboro, N.J. 1Apri11987); P. 

Feldatein and others. "Private Cost Containment: The Effects of Utilization Review Programs on 

Health Care Use and Expenditures," New Englc.nd JourTUll of Medicine, vol. 318 (1988), pp. 

1310..1314. 

7. See J. Newhouse and others. "Are Fee-ror-Service Costs Increasing Faater Than HMO Costa?" 

Medical Care, vol. 23 {August 1985), pp. 960-966. 
CHAPTER III POUCIES DESIGNED TO CONTROL HEALTH CARE COSTS 39 

effective as the fully integrated service and delivery systems that appear to have the greatest success in affecting utilization. There are a 

number of reasons, however, why the growth of managed care may not 

have produced such a noticeable drop in health spending over this 

period: 

o Not all managed care arrangements are equally effective~~ in 

fact, there is little evidence that loosely organized managed 

care produces any savings, and much of the growth in enroll~ 

ment in managed care organizations has been among loosely 

organized types of arrangements. 

o Substantial administrative costs are associated with managed care, and these costs may be sufficiently high to offset 

savings generated by modest reductions in hospital admis~ 

sions or length of stay. In addition, administrative costs are 

higher, the smaller the insured group. Since HMOs tend to 

enroll a relatively small proportion of the employees from 

any one employer, their per capita administrative costs are 

high. 

o The fragmented system of health care financing in the 

United States may make it possible for providers to expand 

the number of services and increase prices for other types of 

patients when managed care is successful in reducing utilization and expenditures for some groups of patients. 

Other countries appear to monitor and review providers, rather 

than individual patients and procedures. In addition, they apply this 

process uniformly and comprehensively to all physicians in large 

geographic areas, unlike the uncoordinated review in the United 

States. For example, all Canadian provinces have systems to monitor 

physicians' practice patterns. These systems identify physicians who 

bring patients back when not clearly medically necessary, who order 

more laboratory work than other physicians, and who deviate in other 

ways from the expected pattern of care. In British Columbia, for 

example, physicians with statistical profiles more than two standard 

deviations from the average for the physicians' peer group (defined by 

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I 
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40 RISING HEALTH CARE COSTS April 1991 

specialty and geographic area) are reviewed by a committee that can 

recommend penalties for cause. 

Former West Germany, like Canada, monitors on a subnational 

level. Each region maintains a data system that has the capability to 

create profiles of physicians' practices with respect to services provided, patient mix, and the profiles of costs of the services provided. 

Physicians whose profiles deviate from their peer group may be reviewed by the regional committees and, if warranted, penalized. 

In contrast, because comprehensive data on physicians' entire 

practices are not available to any one insurer in the United States, 

most utilization review and managed care involves review of specific 

patients' care and individual treatment decisions--for example, requirements for a second opinion before elective surgery is approved for 

payment.8 This type of review requires substantial resources to 

identify cases for examination and considerable clinical knowledge to 

assess the appropriateness of the decision. Moreover, the review standards vary from insurer to insurer. A physician may have patients 

who are subject to utilization review processes that differ greatly, depending on the rules of their particular payer. Further, because providers are subject to varying standards, they may not respond by 

changing overall practice patterns. 

PRICE CONTROLS 

Expenditures for health care are determined jointly by the quantity 

and by the price of services used. Setting limits on prices that may be 

charged for services is another strategy for cost control that has been 

implemented in the U.S. health care system. Most recently, the Medicare program imposed a freeze on physicians' fees during the mid1980s. 

B. Some HMOs aru:l PPOa monitor physicians. rather than reviewing individuel patients and 

procedures. Thia appears to be moat common in HMOa that pay contracted phyaiciana a fixed 

amount per HMO enrollee. In these caaes. the primary purpose of physician monitoring is to a88ure 

that the physician doe a not reapond to the HMO's payment system by undertreating patienta. 
CHAPTER III POUCIES DESIGNED TO CONTROL HEALTH CARE COSTS 41 

In the absence of any changes in the quantity or mix of services, a 

reduction in the price of a service should lead to lower total expenditures for that service, but changes in the quantity or mix of services 

typically do occur. For example: 

o More services may be provided when prices are reduced; 

o Price controls on one type of service create incentives for providers to substitute other services for the controlled one; 

o Price controls implemented for a specific population group 

(such as Medicaid or Medicare enrollees) may result in higher prices charged to other population groups; and 

o When prices are controlled for only some groups, those 

groups may have less access to health care than others. 

Studies of the effects of fee freezes or controls on physicians' prices 

indicate that they result in a pronounced volume offset that substantially reduces the anticipated savings from these policies. Under 

the Economic Stabilization Program <ESP) in the early 1970s, for 

example, the number of services delivered to Medicare patients increased by about 10 percent during the first year of the ESP and by 8 

percent to 15 percent (depending upon physician specialty) during the 

second year. As a result, the ESP was not effective in curbing increases in Medicare's program costs.9 Similarly, increases in the 

volume of physicians' services during the Medicare physician fee freeze 

in 1984 to 1986 were associated with a continuing rate of increase in 

physician expenditures per enrollee of 10 per cent or more during each 

of the years that fees were frozen. tO 

Most states limit reimbursement to hospitals and physicians under the Medicaid program. Before the Omnibus Budget Reconciliation 

Act of 1981, states were required to pay hospitals according to Medi9. See J. Gabel and T. Rice, "Reducing Public Expenditures for Physician Services." 

10. See J. Mitchell et al. Impact of the Medicare Fee Freeze on Physician E:qxnditures and Vol11me: 

Final Report, December 1988. HCFA Cooperative Agreement t 7-C-9875811-03. 
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oi2 RISING HEALTH CARE COSTS April 1991 

care rules, which relied on a reasonable cost methodology. The 1981 

act allowed states to pay hospitals an amount that would cover only the 

costs of economically and efficiently operated hospitals. The typical 

Medicaid hospital payment per day is about 80 percent of the average 

per diem cost for Medicaid patients. Physician reimbursement under 

Medicaid has also been restricted. In 1989, Medicaid paid physicians 

about 69 percent of Medicare rates. 

There is general agreement that these relatively low reimbursement rates have helped to reduce access to care for Medicaid beneficiaries, but less access does not necessarily mean that total costs are 

lower. Only about 75 percent of physicians are willing to treat Medicaid patients, whereas nearly all physicians treat Medicare enrollees. 

For some specialties, the Medicaid participation rates are even lower. 

For example, one survey showed that only about 55 percent of physicians providing reproductive health services treat Medicaid patients. 

Some physicians have reported that hospitals have discouraged them 

from admitting Medicaid patients. Partly as a result of limited access 

to services in physicians' offices, Medicaid patients seek care in hospital emergency departments and outpatient departments--which typically are more expensive--to a greater extent than patients with other 

types of health insurance. 

The effect of Medicare's Prospective Payment System (PPS) for reimbursing hospitals on spending for hospital services appears to 

indicate that price controls may be an effective strategy for controlling 

spending in the hospital sector, particularly in combination with increased monitoring of use. The PPS offers hospitals a fixed payment, 

related to expected costs of treatment for specific diagnoses, for each 

hospital admission. The fixed payment creates incentives for hospitals 

to operate more efficiently and to discharge patients at the earliest 

time that is medically permissible. 

During the first five years of the PPS, the average length of stay 

for Medicare enrollees declined 10 percent. Over the same period, partly because of the Medicare hospital utilization review process introduced concurrently with the PPS, admissions of Medicare enrollees fell 

12 percent. Despite these dramatic declines in use of services, the 

average annual rate of increase of real Medicare spending for hospital 
CHAPTER III POUCIES DESIGNED TO CONTROL HEALTH CARE COSTS 43 

services per enrollee was about 1.3 percent per year between 1983 and 

1988. This was, however, considerably lower than the 6.9 percent annual rate of growth per enrollee between 1980 and 1983. 

A related issue is the impact of the PPS on spending for other 

health care services. Since hospital and physician services have a 

strong complementary relationship, the initial impact of the PPS was 

to reduce spending for physicians' services as fewer hospital days required fewer hospital visits by physicians. Subsequently, however, as 

physicians and hospitals adjusted to the new system, more services 

may have been moved out of the hospital and into ambulatory 

settings--leading to an increase in spending for physician and other 

outpatient services.ll 

Although the Medicare program sets hospital payment levels 

prospectively and, beginning in 1992, will use a fee schedule to reimburse physicians, reimbursement of providers in the United States has 

primarily been based on costs or charges. In addition, every provider 

has a unique set of charges and each payer may negotiate a discount on 

these charges with individual providers. One consequence of these 

pricing arrangements is that vastly different prices can be paid for the 

same service, even when that service is performed by the same provider. In addition, substantial administrative costs are incurred by 

third-party payers and by providers in the effort to keep track of all the 

different price arrangements. 

Some other industrial countries rely on negotiations to establish 

prices for specific services. In former West Germany, for example, reimbursement for ambulatory care physician services is fee-for-service, 

based on a national relative value scale determined through negotiations between national associations of physicians and sickness funds. 

A conversion factor that translates the relative value scale into mane11. See J. Holahan. A. Dor, and S. Zuckerman, "Understanding the Recent Growth in Medicare 

Pbyeician ExpenditUJ"es," Journ.a/ of the American Medical AssociatWn., vol. 263, no. 12 (March 

23/30, 1990l. pp. 1658·1661: andJ. Mitchell, G. Wedig, and J. Cromwell, [mpactofthe Medicare Fee 

Freeze on Physician Expenditures and Volume: Fin.al Report, HCFA Cooperative Agreement 

17-C-98758/1-03 (December 1988). The best estimate from the Holahan study is that the net effect 

of the PPS on phyt~ician spending was to increase it by 18 percent. The best estimate from the 

Mitchell study would imply a 14 percent increase in physician spending because of the PPS. For 

both studies, however, this estimated effect is statistically insignificant. 

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_ _lli __ _ 

44 RISING HEALTH CARE COSTS April 1991 

tary terms is negotiated between regional associations of physicians 

and sickness funds in order to establish the fee that all physicians in 

the region will receive from the sickness funds for performing each procedure. 

In Canada, physicians are also reimbursed on a fee-for-service 

basis, with payment rates established by a fee schedule negotiated by 

the provinces and physicians' associations. Similarly, in France, ambulatory care physicians are reimbursed on a fee-for-service basis, with 

the fees set by the government. In former West Germany, France, and 

Great Britain, physicians who provide services as part of a public hospital episode are paid a salary, rather than under fee-for-service arrangements.12 

In some countries, these price controls for physicians' services are 

combined with utilization review mechanisms, as described earlier, 

that permit the identification of physicians and other providers generating more services than the norm. In former West Germany, the 

relation between price and volume is even more direct--when expenditures rise above the negotiated aggregate ceiling, fees paid to 

physicians are reduced proportionately. 

Price controls may have greater potential for reducing health care 

costs when applied uniformly to the whole health care system, because 

cost shifting among services and payers is less likely to be an issue. In 

addition, access to care is not differentially affected if price controls are 

applied uniformly within a geographic area. Volume responses, however, would still be possible even within a national system of contro11ed 

prices and could be large enough to reduce potential savings substantially unless price controls were combined with systematic utilization 

monitoring and review of all providers. 

12. In Canada, radiologist<!, aneethesiologiet<l and pathologists providing care in hospital settings are also paid on salary. Other speeialists receive fee-for-service payment. 
CHAPTER III POUCIES DESIGNED 0 CONTROL HEALTH CARE COSTS 45 

COMPETITION 

In the latter half of the 1970s, concer about the imperfections of the 

market for health services and the co sequences for total and public 

expenditures for health care produced number of proposals that were 

expected, if implemented, to increase ompetition among insurers and 

among providers. Increased competi ion, in turn, was expected to 

result in downward pressures on pric s and greater efficiency in the 

provision of health services. 

In the years since the concept of a competitive strategy for controlling health care costs was introd ced, a number of changes have 

occurred in the market for health serv ces. The growth in the number 

of HMOs, partly in response to federa law that required employers to 

offer an HMO option, has increased t e competitiveness of the health 

insurance market. Employees, if the are offered health insurance, 

typically have more than one plan to choose among, sometimes with 

financial incentives to choose lower- ost, more efficient insurer-provider arrangements. 

Competition among providers of ealth care has also increased 

over the past decade. The number of hysicians relative to population 

has grown, and physicians are now ss able to control competition 

from other providers who perform ser ices that overlap with those of 

physicians--and who generally charge ower prices than physicians for 

these services. Optometrists now ca perform diagnostic tests for a 

number of eye diseases and can pro ide follow-up care for cataract 

surgery and other medical condition under the Medicare program. 

Chiropractors have been successful in many areas in achieving an established role in health care, and in obtaining reimbursement from 

third-party payers. The corporate pr ctice of medicine--in HMOs, urgent care centers, walk-in clinics, a retail store dentistry--is now 

widespread. Advertising by physicia s, hospitals, dentists, and other 

providers now is an accepted phenome on that was prohibited by medical ethics and state regulations in the ast. 

In contrast, competition among h alth plans has not developed as 

was originally envisioned, with heal h insurers contracting with a 

unique set of providers that serve only the insurers' enrollees. Instead, 

292-851 0 - 91 - 3 

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46 RISING HEALTH CARE COSTS April 1991 

most of the rapid expansion in alternative insurer/delivery systems 

has occurred through PPOs and loosely structured HMOs that offer 

overlapping networks of providers that do not compete with one 

another. To achieve greater competition, some observers argue it 

would be necessary to establish discrete, non-overlapping provider 

networks so that consumers would be offered choices that are clearly 

different. 

Other proposals to increase the competitiveness of the health care 

market, through increasing the cost consciousness of consumers, also 

have not been implemented. In particular, the share of health insurance premiums paid by employers remains fully untaxed, and without 

dollar limitations.l3 In fact, the development of cafeteria plans for 

fringe benefits now permits many employees to pay their own share of 

the insurance premium and other health expenses from pre-tax dollars. 

Changes in the competitive nature of the market for health services would suggest that, if competition were an effective strategy, the 

rate of increase in health care costs in the United States would have 

declined during the 1980s, particularly in areas that have become 

more highly competitive. Although the number of studies on the impact of competition is limited, the findings suggest that:14 

13. A widely discussed propoaal 00 change that tax treatment of employer-paid health insurance would 

cap the tax deduction at a specified annual amo1mt, with employees incurring tu liability for 

employer-paid amounts above the cap. Employees would then have greater incentives 00 shop for 

the most coat-effective health plan. Even if the tax subsidy was entirely eliminated, group health 

imurance would tend to be less expensive than individual insurance and, therefore, groups would 

tend 00 be the principal insurance arrangement. These groups, however, might not form around 

employment but could instead result in additional fragmentation of the group health insurance 

market, particuhu:ly ifill!lurers tended to group by health status. 

14. See J. Merrill and C. McLaughlin "Competition versus !Wgulation: Some Empirical Evidence," 

Journal of Health Politics, Poltcy, and Law, vol. 10 !Winter 1986), pp. 613-623; J. Hadley and K. 

Swartz, ''The Impacts of Hospital Costs Between 1980 and 1984 of Hospital Rate Regulation, 

Competition. and Changes in Health Insurance Coverage." Inquiry, vol. 26 (Spring 1989), pp. 35-47; 

J. Robimon and H. Luft, "Competition, Regulation, and Hospital Costs, 1982-1986," Journal of the 

American Medical Association, vol. 260 (November 11, 1988). pp. 2676-2681; C. McLaughlin, ''The 

Effect of HMOs on Overall Hospital EJq>ensee: 19 Anything Left After Correding for Simultaneity 

and Selectivity?" Health Seruices Research, vol. 23 {August 1988). pp. 421-440; G. Melnick and J. 

Danziger, "Hospital Behavior Under Competition and Cost Containment Policies," Journal of the 

American Medical Association, vol. 260 (November 11, 1988), pp. 2669-2675. 
CHAPTER Ill POLICIES DESIGNED TO CONTROL HEALTH CARE COSTS 47 

o The effect of competition on hospital costs is uncertain, with 

some studies suggesting competition lowers costs and others 

indicating costs are unaffected or higher in more competitive 

markets; 

o Competition can lead to product differentiation and higher 

costs, rather than to price competition and greater efficiency; 

and 

o A higher HMO market share may not be associated with 

lower hospital expenses per capita in a market area, even if 

per capita hospital expenses for HMO members are lower, 

apparently because of offsetting increases in hospital expenses for patients not enrolled in HMOs. 

The evidence on the growth rate in per capita spending for health 

care over the past two decades also suggests that the competitive 

strategy, to the extent it has been attempted, has had, at best, only a 

small impact on health care costs. 

REGULATION OF THE MARKET FOR HEALTH SERVICES 

Economists generally justify regulation of an industry under several 

conditions: if the industry is a natural monopoly, if the industry is 

essential to the growth of other industries and the economy, or if for 

some reason competition does not work well in the industry. In addition, there is an assumption that regulation is only justified when 

the expected benefits of the regulation, such as improved performance 

of the industry, are greater than the expected costs. Using this logic, 

some policymakers have argued that greater regulation of the market 

for health services is necessary, because this market is not functioning 

properly in the United States and strategies to increase competition 

among insurers and among providers are ineffective or lead to even 

less desirable outcomes. 

Only some of the generic elements of regulation--control of entry, 

price regulation, prescription of conditions and quality of services, and 

the imposition of an obligation to serve all applicants under specified 

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48 RISING HEALTH CARE COSTS April 1991 

conditions--have been used in the United States in attempts to deal 

with the entire market for health services, rather than only the component of the market that is publicly financed. They include the federal health planning and certificate-of-need programs and the state 

all-payer rate-setting programs for hospitals. In addition to examining 

these two regulatory programs, this section also examines the global 

budgeting and related expenditure target strategies used in other 

countries. 

Health Planning and Certificate-of-Need Programs 

The Health Planning and Resource Development Act of 1974 required 

that all states receiving federal health resources enact certificate-ofneed (CON) laws--providing for state review and approval of capital 

investments of health care institutions. Health planning, particularly 

with respect to capital investment in hospitals, was believed to be an 

important component of any effort to control rising health care costs. 

Research in the 1960s had shown a statistical relationship between the 

supply of hospital beds and the use of hospital beds. By 1980, all states 

except Louisiana had enacted CON laws. 

Subsequent research on the effectiveness of CON consistently 

found that it was not effective in restraining per diem, per case, or per 

capita hospital costs.l5 At the same time, concern was expressed about 

the new distortions of the market that were introduced by CON activities, particularly with the impact of CON on the potential entry of new 

competitors into the market. Since CON was applied primarily to hospital investment decisions, there also was a perception that it caused 

investment to shift from hospitals to other health care providers to 

which CON did not apply. 

In 1986, federal CON requirements for states to receive funds were 

dropped. Those who support health planning and certificate-of-need 

requirements, however, suggest that the experience of the 1970s and 

early 1980s did not reflect the full potential for health planning and 

Hi. See L. Brown, "Common Sense Meets Implementation: Certificate-of-Need Regulation in the 

States," Journal of Health Politics, Policy and Law, vol. 8 (Falll983), pp. 80.494. 
CHAPTER Ill POUCIES DESIGNED TO CONTROL HEALTH CARE COSTS 49 

CON as a strategy for cost containment. They argue that CON was applied in most states in an erratic and politically motivated process that 

resulted in decisions about capital proposals that were not consistent 

with cost-conscious expansion of health facilities and orderly adoption 

of new technologies. In the few states where CON has been linked to 

hospital rate-setting and to statewide (rather than local area) health 

planning, proponents of CON suggest it has been much more effective 

in reducing growth in health care costs. 

The governments of many other countries control the capital acquisition of hospitals. In Canada, hospitals must make separate applications to the provincial ministry of health for capital expenditures, 

including facilities, equipment, and renovations. While the provinces 

provide most of the financing for capital acquisition, hospitals must 

provide some funding themselves. Although hospitals may acquire 

enough private money for capital investments, the provinces can refuse to provide the associated operating costs for capital purchased 

without provincial approval. 

In former West Germany, hospitals must submit a certificate-ofneed application to the state government for capital spending, and 

state and local governments provide the funding. In France, the 

investment decisions of public hospitals are publicly controlled. While 

private facilities can make their own investment decisions, prices are 

set by the government, which indirectly influences the amount of capital that can be acquired. 

In Great Britain, the central government determines a national 

budget for capital costs. Decisions about capital acquisition are made 

at varying geographic levels, depending on the type of expenditure. 

For example, decisions about facilities or equipment that would be 

used by patients from a wide area, such as CT scanners or a new hospital, are made at a regional or national level. 

The restrictions on capital acquisition in other countries have led 

to lower rates of technological diffusion of medical equipment compared with the United States--as was noted in Chapter II--which keeps 

costs down, but also tends to limit access to new technologies and treatments. 

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50 RISING HEALTH CARE COSTS April 1991 

State All-Payer Rate-Setting Programs 

Four states implemented statewide all-payer hospital reimbursement 

programs during the 1970s and 1980s. Under these programs, the 

states established the reimbursement methodology and the actual 

rates that hospitals were paid in the state. All third-party and direct 

consumer payments to hospitals were then based on those rates. Hospitals operating in states with all-payer rate-setting systems received 

uniform payments for specific services. These regulatory programs 

offered the opportunity to examine the effectiveness of regulation 

when applied to all payers in a defined geographic area. 

Maryland, New Jersey, New York, and Massachusetts had allpayer systems for hospitals in place for a period of years. The effectiveness of these state all-payer systems has been examined by anumber of researchers. Results of nearly all of these studies find that allpayer rate-setting is associated with lower costs, ranging from 2 percent to 13 percent lower, and with reduced rates of increase in hospital 

costs over time compared with the increases projected in the absence of 

an all-payer system.16 

Because of the perception that all-payer systems are an effective 

mechanism for controlling hospital costs, the federal government has 

allowed states to receive a waiver from the Medicare PPS if all payers 

are subject to regulation in the state and if Medicare outlays to hospitals in the state are less than or equal to what the expenditures 

would have been under the PPS. Initially, 14 states considered adopting all-payer systems in response to the waiver option. Only Maryland, New Jersey, Massachusetts, and New York, however, actually received waivers. New York and Massachusetts withdrew from the 

Medicare waiver program in 1985; New Jersey allowed its Medicare 

waiver to expire in 1989. At present, only Maryland continues to operate an all-payer system that includes Medicare under its rate-setting 

program. 

16. See J. Hadley and K. Swartz, "The [mpacts of Hoapital Costs"; C. Schramm, S. Renn, and B. Biles, 

"Controlling Hospital C~t Inflation: New Perspective~ on State Rate Setting," Heo.lth Affo.irs, vol. 

5 fFalll986), pp. 22-33; M. Rosko," A Comparison of Hospital Performance Under the Partial-Payer 

Medicare PPS and State All-Payer Rate-Setting Systems," lnquiry /Spring 1989), pp. 48·61; J. 

Hadley and S. Zuckerman, Hospital Cost Variations Under- PPS: Fino.! Report (Auguat 1990), 

Contract No. T-56950489 for the Pr~pective Payment Assessment Commission. 
CHAPTER III POLICIES DESIGNED TO CONTROL HEALTH CARE COSTS 51 

Controls on Expenditure Levels 

Another mechanism for controlling health care costs, within a regulatory framework, is to set prospective limits on spending. This may be 

done through global budgeting, under which the government sets in 

advance the operating budget for specific providers--most commonly 

hospitals--and through expenditure controls, under which the government sets a target for aggregate spending for health services. Expenditure targets have been used in some industrial countries to control spending for physician services. If these targets are exceeded, 

physicians are paid less per unit in the current period or the future. 

Expenditure caps are a stronger version of this approach, with spending absolutely limited in the time period to the amount defined by the 

cap. 

The United States, to date, has not used either global budgeting or 

expenditure targets for cost containment, either at the federal or state 

level, with one exception. Under the Omnibus Budget Reconciliation 

Act of 1989, target rates of increase in physician spending under the 

Medicare program were implemented beginning in 1990. If the rate of 

increase in spending exceeds the target, physicians' fees under the 

Medicare program will be lower in subsequent years (beginning in 

1992). Preliminary data for the first half of 1990 suggest that the rate 

of growth was 12.4 percent, substantially above the 9.1 percent target 

for 1990. 

Even if Medicare's physician targets are successful in constraining 

the rate of increase in that program, the impact it would have on 

physician spending in the nation is uncertain. The imposition of targets only for Medicare, which accounts for about 30 percent of physicians' revenues, may result in changes in physicians' practice patterns that result in more--or more costly--services being provided to 

non-Medicare patients. In other words, Medicare could achieve savings at the expense of other third-party payers and individual consumers with less market power. 
···~~1 lli . 

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52 RISING HEALm CARE COSTS April 1991 

Unlike the United States, some other industrial countries have 

relied extensively on controls on expenditure levels, including national 

or area expenditure targets, annual global budgets for hospitals, and 

expenditure targets for physician services. Five of the Canadian 

provinces have established expenditure targets for physicians' services 

which, if exceeded, lead to lower fees in the next round of fee negotiations. Quebec caps physicians' incomes for each quarter; if the income limit is exceeded, payments are greatly reduced during the rest of 

the quarter. 

Operating costs for hospitals in Canada are reimbursed with 

global annual budgets which are negotiated between the provinces and 

individual hospitals. These global budgets vary with the number of 

hospital beds per capita, the ratio of hospital staff to patients, and the 

amount and types of services provided. Hospital administrators then 

allocate these funds at their discretion. However, these global budgets 

have not always been applied as intended, because cost overruns have 

often been paid by the provinces. 

The Canadian federal government has also capped its contribution 

to national health spending. Until 1977, the federal government 

matched provincial spending dollar for dollar. Since 1977, the federal 

government has limited the growth in its contribution to health care 

costs by using a formula based on growth in the gross national product. 

Per capita payments are made to the provinces, regardless of the individual province's health care expenditures. This formula has forced 

the provinces to bear an increasing share of health care costs, since 

health expenditures have generally grown faster than gross national 

product. 

Former West Germany's Health Care Cost Containment Act of 

1977 established an annual assembly of health care providers, statutory and commercial insurance carriers, labor unions, employers, and 

state and local governments, which sets ceilings on the growth rates in 

national health care spending by type of service. A unique feature of 

the system is a negotiated expenditure cap that has been applied to 

spending for ambulatory physician services since 1985. If expenditures rise faster than expected, the fees for physician services are 
CHAPTER III POLICIES DESIGNED TO CONTROL HEALTH CARE COSTS 53 

reduced to prevent total spending from exceeding the cap. Such global 

budgeting is not applied to hospital reimbursement. 

Expenditures for hospital services in Britain's National Health 

Service are flxed by the national government within the framework of 

the entire government budget. Annual funding is allocated to the 

regions based on a formula that accounts for population size and the 

region's mortality rate. If a region overspends its allocation, less 

money is provided the next year. Generally, a hospital receives the 

same budget as the previous year, increased by an inflation factor, 

although individual hospitals can lobby for increased funding. France 

also instituted global budgeting for hospitals in 1983. Before that, the 

government reimbursed hospitals with pre-set per diem rates. 

Global budgeting for hospitals' operating costs and expenditure 

caps for overall spending or specific types of spending will limit the 

level and rate of growth of health care spending, if they are strictly applied. If a specified amount of money is allocated, and no other source 

of funding is available, then the health care system is constrained to 

cost only that amount. Setting the budget or cap, however, requires 

careful planning in order to avoid detrimental effects on quality and 

access to care. 

Expenditure targets for physicians' services may also be an effective mechanism for controlling health care ·costs, particularly if the 

system responds rapidly when it appears those targets will be exceeded. Immediate reductions in fees, when volume rises, to bring 

total spending down to the target is one effective approach. Similarly, 

a target associated with a substantial reduction in fees in future periods, or income limits tied to annual per physician targets, may be effective. In general, though, expenditure targets are applied less rigidly 

than expenditure caps, and, therefore, produce less definite outcomes. 

Some countries also combine expenditure targets with ongoing monitoring of individual physician practice patterns, in order to reduce the 

potential for some physicians to increase their incomes at the expense 

of other physicians under the target. 

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lLJ __ HI __ . 
CHAPTER IV 

THE POTENTIAL FOR CONTROLLING 

RISING HEALTH CARE COSTS IN THE 

UNITED STATES 

Control of health care costs--through either a one-time drop in spending or a lower rate of increase--is much more difficult to achieve in the 

United States than it is in countries that have chosen to develop a 

coordinated health care policy nationwide or have implemented a 

national health system. In the United States, attempts to control 

health spending in one segment of the market or for specific groups of 

consumers may be successful for the segment of the market affected. 

The impact on overall health spending may be much less, however, 

since providers and insurers may compensate for lower revenues from 

one segment of the market by increasing prices for, or the quantity of 

services provided to, other groups. 

During the 1980s, a number of strategies to control health care 

costs were implemented. Managed care and utilization review requirements spread rapidly to encompass a substantial portion of the population. Price controls were imposed on physicians under the Medicare 

program for an extended period. A new hospital payment system was 

imposed under the Medicare program that created incentives for greater efficiency in the provision of hospital services. Competition among 

providers and insurers increased. Although it is difficult to quantify 

the overall effects of each change separately, it appears that these efforts to contain costs have had little impact on total spending. The 

average annual rate of increase in real health spending per person was 

4.3 percent between 1980 and 1985 and 4.6 percent between 1985 and 

1989. And the share of GDP devoted to health spending rose from 9.2 

percent in 1980 to 11.7 percent in 1989. 

Evidence from other countries, and from research, suggests that it 

may be possible to achieve greater control over health care spending in 

the United States than has been achieved in the past decade. It would 

be necessary, however, to make changes in the financing and delivery 

of health care. Several policies used in combination could substan-

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56 RISING HEALTH CARE COSTS April 1991 

tially increase our ability to control health care spending. These policies include: elimination of first-dollar coverage under insurance policies; uniform utilization monitoring and review applied to all physicians rather than to individual patients and specific procedures; uniform payment levels for services that apply to all payers (including a 

prohibition on additional billing by providers); health planning that 

establishes capital and technology targets relative to population at 

national and regional levels and that does not reimburse for services 

provided through unapproved purchases; and effective national and 

regional budgets for overall spending or expenditure targets for specific types of spending. 

In the absence of these significant changes in the structure of the 

health care system, it is unlikely that the United States will be able to 

achieve much greater control over health care spending than was evident in the 1980s. The consequences of failure to obtain the benefits 

from effective cost containment are many. Health care spending will 

grow as a share of national income. Workers will receive a greater 

share of compensation as health insurance coverage, and less in the 

form of direct wages and salaries. As health care costs continue to rise 

at a rate that exceeds the rate of increase in wages and salaries, fewer 

workers--particularly lower-wage workers--will have employmentbased group insurance. Governments, both federal and state, will 

spend a larger amount in order to maintain current health programs, 

exerting pressure on government budgets and potentially crowding out 

funds for other programs in the absence of higher taxation. Finally, 

not controlling health care spending will make it more difficult to 

address the other major failure of the health care system--the large and 

growing number of people in the United States without health insurance coverage. 

In the process of changing the present health care system to 

achieve greater control over costs, however, some of the desirable features of the current health care system would be adversely affected. In 

particular, such a restructuring of the present system would probably 

mean less spending on research and development, longer waiting times 

for access to new technologies, and limitations on our existing choices 

of providers, health insurance coverage, and treatment alternatives. 

Whether these trade-offs are desirable depends upon the priority the 
CHAPTER IV POTENTIAL FOR CONTROLLUNG RISING HEALTH CARE COSTS 57 

nation places on controlling costs as against maintaining other characteristics of the health care system. 

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APPENDIXES 

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-- __ _]j ___ liL __ . 
APPENDIX A 

COMPOSITION OF NATIONAL HEALTH 

EXPENDITURES AND TRENDS IN SPENDING 

BY PAYER AND TYPE OF SERVICE 

National health expenditures in the United States are defined as total 

spending on all health care activities during the year. They include 

expenditures for hospital care; physician, dental, and other professional services; home health care; drugs and other nondurable products; vision products and other durable medical products; nursing 

home and other personal care; administrative costs; health services research; and construction or renovation of hospitals and nursing homes. 

Spending for health services and supplies is, therefore, total national 

health expenditures minus spending for research and construction. 

Personal health spending consists of health services and supplies 

minus administrative costs, research, and construction; it measures 

the services provided directly to consumers of health care. In 1989, 

national health expenditures were $604.1 billion, health services and 

supplies totaled $583.5 billion, and personal health care spending was 

$530.7 billion. 

After adjusting for inflation by expressing each year's spending in 

1989 dollars, national health expenditures rose from $134.4 billion in 

1965 to $604.1 billion in 1989 (see Table A-1). This increase represented an average annual real growth rate of 6.5 percent. 

The distribution of personal health expenditures by type of service 

has not changed much since 1965 (see Table A-2). The largest share of 

spending has consistently been for hospital services, which represented 

34 percent of total spending in 1965 and 39 percent in 1989. This was 

followed by spending for other services, physician services, nursing 

home care, and prescription drugs. The only shift in the rank order of 

service categories has been between nursing home spending and expenditures for prescription drugs. 

292-851 0 - 91 - 4 
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62 RISING HEALTH CARE COSTS April 1991 

TABLE A-1. REAL NATIONAL H LTH EXPENDITURES 

BY PAYER AND TY OF SERVICE, SELECTED 

YEARS 1965-1989 (In illions of1989 dollars) 

Type of Service 1965 1970 1975 1980 1985 1989 

All P yers 

Hospitals 45.3 76.6 109.8 154.0 194.4 232.8 

Physicians 26.5 37.3 48.8 63.0 85.6 117.6 

Nursing Homes 5.5 13.4 20.8 30.1 39.5 47.9 

Drugs and Other 

Nondurables 19.0 24.2 27.3 30.3 37.3 44.6 

Other 38.1 52.6 71.9 97.3 129.4 161.2 

Total 134.4 204.1 278.6 374.6 486.1 604.1 

Federal G vemment 

Hospitals 7.0 26.9 41.6 62.2 82.8 92.9 

Physicians 0.4 5.9 9.8 14.5 22.2 31.8 

Nursing Homes 0.7 3.8 6.4 9.2 11.3 16.2 

Drugs and Other 

Nondurables 0.2 0.7 Ll 1.2 1.7 2.5 

Other 7.3 11.5 17.5 21.1 25.0 31.1 

Total 15.6 48.7 76.3 108.3 143.0 174.4 

State and Loc 1 Governments 

Hospitals 10.1 14.0 18.2 19.9 23.1 31.6 

Physicians 1.4 2.3 3.8 4.5 5.7 7.4 

Nursing Homes 0.9 2.5 4.5 6.6 7.9 9.0 

Drugs and Other 

Nondurables 0.3 0.7 1.0 1.3 1.8 2.8 

Other 5.0 7.8 11.7 17.7 21.1 28.0 

Total 17.7 27.2 39.2 49.9 59.6 78.8 ~-----. --------------------------------------------------------------- (Continued) 

SOURCE: Congressional Budget Office, from the eoJth Care Financing Administration. 
APPENDIX A COMPOSITION OF NATIONAL HEALTH EXPENDITURES 63 

TABLE A-1. Continued 

Type of Service 1965 1970 1975 1980 1985 1989 

Private Health Insurance 

Hospitals 18.5 26.4 37.8 56.3 68.8 84.2 

Physicians 8.6 13.1 19.2 27.0 39.0 56.1 

Nursing Homes • • 0.2 0.3 0.4 0.5 

Drugs and Other 

Nondurables 0.4 0.9 1.8 3.8 6.0 7.0 

Other 4.8 5.5 10.1 23.0 40.9 52.0 

Total 32.3 45.9 69.0 110.4 155.1 199.7 

Consumer Out-of-Pocket Spending 

Hospitals 8.9 6.9 9.2 8.0 10.2 12.7 

Physicians 16.0 15.9 16.0 16.9 18.6 22.4 

Nursing Homes 3.5 6.4 8.8 13.0 19.2 21.3 

Drugs and Other 

Nondurables 18.2 21.9 23.4 24.0 27.8 32.3 

Other 14.7 19.1 23.4 25.9 30.2 36.2 

Total 61.4 70.3 80.8 87.9 106.1 124.8 

Other Private Payers 

Hospitals 0.9 2.5 3.0 7.5 9.5 11.4 

Physicians ' • • • • • 

Nursing Homes 0.3 0.7 1.0 0.9 0.8 0.9 

Drugs and Other 

Nondurables 0 0 0 0 0 0 

Other 6.2 8.8 9.2 9.6 12.1 14.0 

Total 7.4 11.9 13.3 18.1 22.4 26.3 

•• Less than $100 million . 
64 RISING HEALTH CARE COSTS April 1991 

In contrast, the distribution of national health expenditures by 

payer has changed considerably over time (see Table A-3). In 1960, 

out-of-pocket payments by consumers represented almost half of all 

spending for health care. Private health insurance contributed slightly less than one-quarter of the total, and spending by federal and by 

state and local governments contributed one-quarter. The picture was 

much different in 1989. Private health insurance represented the largest share, 33 percent. This was followed by federal spending (29 percent), out-of-pocket payments (21 percent), state and local government 

spending (13 percent), and other private payments (4 percent). 

The increase in health spending can be decomposed into the contributions of general economywide inflation, health services prices, 

population growth, and the volume and complexity of services, where 

complexity includes technological advances as well as the mix of 

services provided. These factors have had differential effects on health 

spending over time. Increases in volume and complexity accounted for 

the largest share of growth in health spending during the 1960s, 

explaining about half of the growth, but their relative importance has 

TABLE A-2. 

Type of Service 

Hospitals 

Physicians 

Nursing Homes 

Drugs and Other 

Nondurables 

Other a 

Total 

SHARE OF PERSONAL HEALTH EXPENDITURES 

BY TYPE OF SERVICE, SELECTED YEARS 

1965-1989 (In percent) 

1965 1970 1975 1980 1985 

33.7 37.6 39.4 41.1 40.0 

19.7 18.3 17.5 16.8 17.6 

4.1 6.5 7.5 8.0 8.1 

14.2 11.8 9.8 8.1 7.7 

28.3 25.8 25.8 26.0 26.6 

100.0 100.0 100.0 100.0 100.0 

1989 

38.5 

19.5 

7.9 

7.4 

26.7 

100.0 

SOURCE: Congressional Budget Office tabulations based on data from the Health Care Financing 

Administration. 

•• Includes horne health care, dental and other professional services, durable medical equipment, nondurable products e~~:cept drugs. other personal health care. administration, and research. 
APPENDIX A COMPOSITION OF NATIONAL HEALTH EXPENDITURES 65 

TABLE A-3. SHARE OF NATIONAL HEALTH EXPENDITURES BY 

PAYER, SELECTED YEARS 1960-1989 (In percent) 

Payer 1980 1970 1980 

Federal 11 24 29 

State/Local 14 13 13 

Out-of-Pocket Payments 49 34 23 

Private Health Insurance 22 22 29 

Other Private Sources __Q _J1 __Q 

Total 100 100 100 

1989 

29 

13 

21 

33 

...1 

100 

SOURCE: Congressional Budget Office tabulations baaed on data from the Health Care Financing 

Administration. 

declined over time. Since the mid-1970s, general inflation has explained most of the rise in health care spending. Volume and complexity increases were the second most important factor until the early 

1980s. Since the early 1980s, the contributions of volume and complexity of health care services and of health services prices have been 

comparable. For example, between 1988 and 1989, the contributions to 

the growth in health care spending were: 42 percent from general inflation, 32 percent from volume and complexity increases, 17 percent 

from increases in health services prices, and 9 percent from population 

growth. 

II 1 lr~l ----
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APPENDIX B 

REASONS FOR LACK 

OF HEALTH INSURANCE 

In March of 1990, an estimated 33.4 million people, or 13.6 percent of 

the population, were without health insurance coverage (Table B-1). 

People age 65 or more are the least likely to lack insurance, with only 1 

percent of them uninsured. Because all people 65 or over are eligible 

for insurance under Medicare, this group is excluded from subsequent 

tables and discussion. 

This appendix examines the reasons for lack of insurance among 

the population under 65. The number of uninsured among this population was 33.1 million in 1990, or 15.3 percent of the total. Young 

adults age 18 to 24 are the group most likely to lack insurance; 25.1 

percent of this age group were without insurance in 1990, nearly twice 

the incidence nationwide. 

The appendix relies throughout on estimates of insurance coverage at a single point in time, but it should be remembered that this 

may understate the problem of inadequate coverage. Estimates for 

1987 indicate that the number who were uninsured at some time during the year was 30 percent higher than the number who were uninsured during the first quarter. If the same was true for 1990, then 

about 20 percent of the population under 65 were uninsured at some 

time during the year, and about 10 percent were uninsured for the 

whole year.l Further, the proportion of the population without insurance has been growing. It is currently nearly 30 percent higher than it 

was in the late 1970s.2 

l. P. Short, EstirruJUs of the Uninsured Population, Co.len.dar Yeor 1987, DHHS Publication No. (PHSl 

90-3469, National Medical Expenditure Survey Data Summary 2 (September 1990), Agency for 

Health Care Policy and Research, Public Health Service. 

2. Trends in rates for the uninsured were calculated from Health Interview Survey <HIS) data for 

selected years because inauranee coverage is not accurately reported in the annual Current 

Population Surveys prior to 1988. According to HIS data, 12.2 percent of the population under 65 

wu uninsured in 1978, compared with 15.7 percent in 1989. 

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68 RISING REALm CARE COSTS April 1991 

TABLE B-1. HEALTH INSURANCE COVERAGE 

BY AGE, 1990 (In millions! 

Insured Uninsured 

Number Number as 

as Percentage Percentage of: 

Total of People People Total 

Group Population Number in Group Number in Group Uninsured 

Total 

Population 246.2 212.8 86.4 33.4 13.6 100.0 

65 or over 29.6 29.3 99.0 0.3 1.0 0.9 

Under65 216.6 183.5 84.7 33.1 15.3 99.1 

Under65 

by Age of 

Individual 

Under 18 64.3 55.8 86.7 8.5 13.3 25.6 

18 to 24 25.3 19.0 74.9 6.4 25.1 19.0 

25 to 44 80.4 67.9 84.4 12.6 15.6 37.6 

45 to 64 46.5 40.9 88.0 5.6 12.0 16.8 

SOURCE: Congressional Budget Office, from the March t990 Current Population Survey. 

Insurance among the population under 65 in the United States is 

largely employment-based, accounting for 69.5 percent of coverage for 

this group (Table B-2). About 8.5 percent of the population under 65 

benefits from public insurance programs (Medicaid, Medicare, and 

veterans health benefits), while 6.7 percent of this group has some private coverage that is not employment-based. 

There are two fundamental reasons for lack of private insurance 

coverage: either coverage is not available at any price, or the offer 

price is higher than the uninsured person is willing and able to pay. 

The latter appears to be a more important factor than the former, 

especially for those with some work force connection. 

THOSE WITH NO WORK FORCE CONNECTION 

Nearly one-fifth (or 19.4 percent) of the uninsured population have no 

connection with the work force, either through their own employment 
APPENDIX B REASONS FOR LACK OF HEALTH INSURANCE 69 

or that of a relative (Table B-3). Among those with no work force connection, 21.6 percent are uninsured. Unless eligible for Medicare, 

Medicaid, or a retiree health plan, members of this group must either 

purchase private coverage as individuals or do without. Some choose 

to do without because the coverage offered to them is unattractive. Insurance policies offered to individual applicants are typically more restrictive and more expensive than employment-based group coverage, 

as a result of insurers' attempts to guard against high-risk applicants. 

Most insurers will "underwrite" the individual applicant. This 

means they use various sources of information (perhaps including a 

medical examination) to assess the individual's health, financial 

status, and other risk factors. On the basis of this assessment, the individual is classified as either a standard risk, a substandard risk, or uninsurable. A person found to be a standard risk will generally be able 

to purchase insurance without special limitations for the standard 

premium. For any given benefit package, however, the standard 

premium for an individual policy will be higher than it would be under 

a group policy because of higher administrative costs. A person found 

TABLE B-2. SOURCES OF HEALTH INSURANCE COVERAGE 

FOR THE POPULATION UNDER 65, 1990 (In millions) 

Number 

as Percentage 

Source of of Population 

Primary Coverage Number Under 65 

Employment· based 150.6 69.5 

Medicare 3.0 1.4 

Medicaid 14.6 6.7 

Veterans 0.8 0.4 

Other Private 14.6 ~ 

Insured Total 183.5 84.7 

Uninsured Population 33.1 15.3 

SOURCE: Congressional Budget Office, from the March 1990 Current Population SUTVey. 

1'----- --
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70 RISING HEALTH CARE COSTS April 1991 

to be an insurable but substandard risk will typically face an even 

higher, above-standard premium. Further, there may be either a temporary or permanent exclusion waiver attached to the policy, which 

means that the insurer will not pay for services provided to treat 

specified medical conditions. 

Some individuals are denied insurance coverage altogether. For 

example, insurers often deny coverage to people with AIDS, alcoholism, diabetes, coronary artery disease, or cancer. Even in the absence 

of some preexisting medical condition, coverage may be denied to 

TABLE B-3. 

Group 

Workers 

Full-time 

Part-time 

Subtotal 

WORK FORCE CONNECTIONS OF THE UNINSURED 

POPULATION UNDER 65, 1990 (In millions) 

Number as 

Percentage of Percentage of People 

Uninsured in GrouQ Who Are: 

Number Under 65 Uninsured Insured 

13.4 40.4 12.6 87.4 

2.7 8.2 34.2 65.8 

16.1 48.7 14.2 85.8 

Nonworking Dependents 

of Workers 

Full-time 9.0 27.2 13.3 86.7 

Part-time 1.6 4.7 28.7 71.3 

Subtotal 10.6 31.9 14.4 85.6 

No Connection to 

Labor Market 6.4 19.4 21.6 78.4 

Total 33.1 100.0 15.3 84.7 

SOURCE: Congressional Budget Office, from the March 1990Current Population Survey. 

NOTES: Workers are all those reporting that they were employed during the survey week, including 

those not at work. 

The allocation among workers, dependents of workers, and those with no conneetion to the 

work force is based on the status of the individuaL However, for those with a work force 

conne<:tion, the connection is classified as full time if anyone in the family works run time. 
APPENDIX B REASONS FOR LACK OF HEALTH INSURANCE 71 

people in high-risk categories, such as drug abusers, older people, and 

those in high-risk occupations. Other factors, such as financial status, 

the area in which a person lives, and sexual preference may also influence an insurer's decision to deny coverage.3 

Not all insurers use underwriting for all applicants in the individual market. A third of Blue Cross/Blue Shield plans--serving 11 

states and the District of Columbia--offer open enrollment at some 

time during the year, which means that they will cover anyone who applies regardless ofhealthstatus and without medical screening.4 However, these plans often provide fewer benefits, impose higher costsharing requirements, and charge higher premiums to those who apply 

during the open enrollment period. Further, they usually impose 

waiting periods before benefits will be paid for preexisting conditions, 

or they may exclude coverage for such conditions altogether. Federally 

qualified health maintenance organizations (HMOs) may deny coverage altogether to a high-risk applicant, but they are required to 

charge a uniform rate (by class I to any individual applicant they accept. Further, they are not permitted to impose exclusion waivers or 

waiting periods for coverage. Some states have similar requirements 

governing HMOs that are not federally qualified. 

THOSE WITH A WORK FORCE CONNECTION 

About 80.6 percent of the (under 65) uninsured population is composed 

of those who have some connection to the work force (Table B-3). An 

estimated 48.7 percent of the uninsured population are employed, and 

another 31.9 percent are dependents of workers. About half of this 

group of uninsured are connected to the work force through a small employer (defined here as fewer than 25 employees), while the other half 

is connected through a larger employer.5 

3. U.S. Congress, Office of Technology Aaaessment, Medical Testing and Health Insurance !August 

1988). 

4. Congressional Researeh Service, Health insurance and the Uninsured: Background lJo;t.a and 

Analysis I May 1988). J). 29. 

5. The Bureau of Labor Statistics defines any employer with fewer than 100 employees as a small 

employer. A different definition is uaed here in order to focua on the firm size differences that 

correlate with differences in their provision of insurance. 

-- --n~·-- --
HI 

72 RISING HEALTH CARE COSTS April 1991 

TABLE B-4. AVAILABILITY OF EMPLOYMENT-BASED 

INSUBANCE PLANS, BY SIZE OF FIRM, 1989 

Percentage Percentage of 

Size of Firm of Firms Employees in 

(By number of employees) Offering Firms Offering 

Under 25 39 55 

Under 10 33 42 

10 to 24 72 70 

25to 99 94 94 

100to499 99 97 

500 to999 100 100 

1,000 and Over 100 100 

All Firms 43 77 

SOURCE: Congressional Budget Office, from 1989 Employer Survey by Health Insurance Association 

of America. 

Nonworking dependents are only slightly more likely to be uninsured than are workers (14.4 percent versus 14.2 percent), even though 

firms often require workers to contribute a larger share toward the 

premium for their dependents than for themselves. In one employer 

survey for 1989, the average employee share for individual coverage 

was 14 percent, while it was 26 percent for family coverage. About 57 

percent of employees contributed nothing toward the premium for individual coverage, compared with 36 percent for family coverage.6 

Among employees, those in families with only part-time workers 

are more likely to be uninsured than those in families with at least one 

member who works full time (34.2 percent versus 12.6 percent). Most 

firms do not provide health insurance coverage for part-time employees even when they offer coverage to full-time employees, and many 

6. Health Insurance Association of America, Providing Employee Health Benefits: How Finns Differ 

(1990), p. 59. 
APPENDIX B 

TABLE B-5. 

Size of Firm 

(By number 

of employees! 

Under25 

25 to 99 

100 to 499 

500 to 999 

1,000 and Over 

All Firms 

REASONS FOR LACK OF HEALTH INSURANCE 73 

SOURCES OF HEALTH INSURANCE FOR WORKERS 

UNDER 65, BY SIZE OF FIRM, 1990 

Number Percentage Insured by PrimaiT Source 

of Workers Own Other Other All 

(Jn millions) Employer Employer Public Private Sources 

32.9 30.7 24.6 2.5 17.2 75.0 

14.9 58.2 17.3 2.1 6.3 83.8 

16.0 67.7 14.6 1.9 4.4 88.7 

6.5 71.7 14.7 1.3 4.6 92.3 

43.5 73.9 12.9 1.6 4.2 92.7 

113.7 58.4 17.2 2.0 8.3 85.8 

SOURCE: Congressional Budget Office, from the March 1990 Current Population Survey. 

smaller firms do not provide health insurance to their employees at 

al1.7 

Overall, about 43 percent of firms--employing 77 percent of all 

workers--provide insurance coverage to their employees, at least to 

those who work full time (Table B-4). Virtually all firms with 100 or 

more employees offer insurance, and 94 percent of firms with 25 to 99 

employees do so. By contrast, only 39 percent of firms with fewer than 

25 employees offer insurance. Among small firms, insurance is less 

likely to be offered the smaller the firm. Only a third of firms with 

fewer than 10 employees provide insurance, while 72 percent of firms 

with 10 to 24 employees do so. 

Among all workers, 85.8 percent are insured (Table B-5). About 

58.4 percent of workers are insured by their own employers, and 

another 17.2 percent are insured by a relative's employer. The larger 

the size of the worker's firm, the more likely it is that the worker has 

7. In «~~~ults from a number of employer surveys conducted in the late 1980s, the proportion of firlllll 

that did not offer coverage to part-time employees ranged from 68 percent to 80 percent. 

Congressional Research Service, Insuring the Uninsured: OptU:ms and Analysis (October 1988) 

p.U3. 

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74 RISING HEALTH CARE COSTS 

TABLE B-6. 

Size of Firm 

(By number of 

of employees) 

Under25 

25to 99 

100 to 499 

500 to 999 

1,000 and Over 

All Firms 

UNINSURED WORKERS UNDER 65, 

BY SIZE OF FIRM, 1990 

Number as 

Percentage 

of Total 

Number Uninsured 

(In millions) Workers 

8.2 51.1 

2.4 14.9 

1.8 11.2 

0.5 3.1 

3.2 19.7 

16.1 100.0 

April 1991 

Percentage 

of People 

in Group 

Who Are 

Uninsured 

25.0 

16.2 

11.3 

7.7 

7.3 

14.2 

SOURCE: Congressional Budget Office, from the March 1990Current Population Survey. 

insurance and that the insurance is provided by the worker's employer.8 

About 14.2 percent of all workers--or one-third of workers who do 

not obtain coverage from their own employers--are uninsured. The 

other two-thirds of workers who do not obtain coverage from their own 

employers have coverage from some other source. The other sources 

include (in order of importance) employment-based coverage obtained 

through a relative, private coverage that is not employment-based, and 

coverage through a public program. 

Workers in Larger Firms 

Nearly half of uninsured workers are in firms with 25 or more employees, and a third are in firms with 100 or more employees--firms 

that usually offer insurance coverage to their employees (Table B-6). A 

number of factors explain the existence of uninsured workers in these 

8. The pattern of insurance for dependents ie similar to that shown for workers. 
APPENDIX 8 REASONS FOR LACK OF HEALTH INSURANCE 75 

TABLE B-7. WORKER RESPONSES TO HEALTH INSURANCE 

OFFERS BY FIRMS, 1988 (In percent) 

As Percentage 

Response of All Workers 

Insurance Offered to Worker and: 

Worker accepted 65.8 

Worker refused and was: 

Covered by spouse's firm 4.6 

Not covered by spouse's firm 5.5 

Insurance Not Offered to Worker Because: 

Worker was ineligible 5.8 

Firm did not provide 18.3 

SOURCE: Congressional Budget Office, from May 1988Current Population Survey. 

larger firms. First, part-time workers (who make up about 20 percent 

of the work force) are often not offered employment-based coverage. 

Second, some new employees are temporarily ineligible at any given 

time because of waiting periods imposed by employers. Third, an estimated 13 percent of workers eligible for employment-based coverage 

(or 10 percent of all workers) refuse it, and fewer than half of these 

have employment-based coverage through a spouse (Table B-7). 

Workers in Small Firms 

Slightly more than half of uninsured workers are in firms with fewer 

than 25 employees--firms that are relatively unlikely to offer group 

coverage.9 These firms experience a number of problems in the insurance market that distinguish them from larger employers. In fact, 

many of the problems faced by small employers are similar to those 

faced by individuals seeking insurance. 

9. The small group market is usually defined as the market applicable to firms with fewer than 25 

employees becalL':Ie this is the smallest category identified in the March Current Population Survey. 

The appropriate firm size to defme the small employer's insurance problem is debatable. however. 

It is lll08t common to use medical underwriting for groups of under 15. but there is evidence that 

imurers are beginning to underwrite groups with as many as 99 workers. See Richard Donahue, 

"Group Underwriters Seek Profit," National Underwnter(November28, 1988), p. 3. 

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___ __il 111111 

76 RISING HEALTH CARE COSTS 

TABLE B-8. PERCENTAGE OF FIRMS CITING PARTICULAR 

REASONS FOR NOT OFFERING HEALTH 

INSURANCE, 1989 

April 1991 

Reason Important Not Important 

Expense 

Low or Unstable Profits 

Future Cost 

Low Employee Interest 

No Acceptable Plan 

Not Needed to Attract Employees 

High Turnover 

86 

76 

70 

52 

46 

42 

32 

14 

24 

30 

48 

54 

58 

68 

SOURCE: Congressional Budget Office, from 1989 Employer Survey by Healtb Insw-ance Assodation 

of America. 

In a 1989 survey of employers by the Health Insurance Association 

of America, cost was the reason most frequently mentioned by employers who did not offer health insurance (Table B-8). About 86 percent of employers cited premium expense, while 76 percent reported 

that their profits were either too low or too unstable to support health 

insurance benefits (more than one reason could be cited). Less than 

half the employers surveyed reported that they were unable to find an 

acceptable plan (this includes those who were offered coverage but at a 

higher price than they were willing to pay).lO 

The availability of insurance does not appear to be the major 

problem for small employers. In a 1987 survey of small employers, 

fewer than 20 percent cited unavailability as the reason they did not 

provide health insurance. In fact, two-thirds of employers who did not 

provide insurance had never sought it.ll In later surveys conducted 

10. Health Insurance Association of America, Providing Employee Health Benefits: How Firms Differ 

(1990), p. 32. 

11. Small Business Administration, Health CllFe Cowrage and Costs in Small and Large Firms {April 

1987). 
APPENDIX 8 

TABLE B-9. 

Size of Firm 

(By number 

of employees) 

Under 10 

10to24 

25 to99 

tOO andOver 

All Firms 

REASONS FOR LACK OF HEALTH INSURANCE 77 

WAGE DISTRIBUTION FOR FIRMS, BY SIZE OF FIRM 

AND WHETHER IT OFFERS HEALTH BENEFITS, 1989 

Firms With Fir!Il8 Without 

All Firma Health Benefits Health Benefits 

Percentage of Percentage of Percentage of 

EmQloyees Earning EmJ;!IO:tees Earni!!K: EmQloyees Earning; 

Under $10,000- Om Under $10,000- Om Under $10,000 Over 

$10,000 $30,000 $30,000 $10,000 $30,000 $30,000 $10,000 $30.000 $30,000 

24 55 21 11 60 28 30 53 18 

24 56 19 16 62 22 47 41 12 

13 67 19 11 69 20 a a a 

14 65 22 13 65 22 a a a 

23 56 21 12 62 26 31 52 17 

SOURCE: Congressional Budget Office, from 1989 Employer Survey by Health Insurance Association 

of America. 

a. Numbers in theBe categories are too small to yield reliable estimates. 

in selected cities, the proportion of firms citing unavailability ranged 

from 10 percent to 36 percent.12 

Even if the costs of insurance were the same for small firms and 

large ones, small firms would be more likely to find coverage too expensive because they are more likely to be relatively low-wage enterprises. In 1989, less than 14 percent of employees earned less than 

$10,000 annually in firms with 25 or more employees, compared with 

24 percent in smaller firms (Table B-9). In firms that offered health 

benefits, about 12 percent of employees earned less than $10,000 a 

year. In firms that did not offer health benefits, 31 percent of employees earned less than $10,000. 

In fact, however, the costs of any given kind of coverage are typically higher for small firms than for larger ones. This result occurs because of higher administrative costs, and because of less favorable 

treatment under tax law. 

12. Alpha Center, "Summuy of Surveys of Small Employen Conducted by Health Care for the 

Uninsured Program Projects" (1990). 
__ _l .11.1111 

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78 RISING HEALTH CARE COSTS April 1991 

By one estimate, administrative expenses are 40 percent of benefit 

costs for firms with fewer than 5 employees, compared with 16 percent 

for firms with 100 to 499 employees and 5.5 percent for firms employing 10,000 people or more (Table B-10). One reason administrative costs per person covered are so much higher for small firms is that 

some of those costs are relatively fixed, regardless of the number of 

people covered under the policy. This is true for most general administrative expenses, such as advertising, billing, and general operating overhead. It may be true for sales commissions as well, depending on how the commission is determined. In addition, often the 

insurer must perform some services (such as member communications) 

for small groups that large employers would undertake themselves. 

The costs of medical underwriting are typically only relevant for small 

employers. And insurers commonly retain a higher proportion of small 

group premiums as reserves, reflecting the greater unpredictability of 

benefit costs for small groups. 

TABLE B-10. BREAKDOWN OF ADMINISTRATIVE EXPENSES FOR 

CONVENTIONALLY INSURED PLANS, 1988 

(As a percentage of benefit cost) 

General Sales Claims Risk 

Admin- Commis- Admin- and Premium Interest 

Employees istration sion istration Profit Taxes Credit Total 

1 to 4 12.5 8.4 9.3 8.5 2.8 -1.5 40.0 

5 to 9 11.2 6.0 8.6 8.0 2 7 -1.5 35.0 

10 to 19 9.2 5.0 7.2 7.5 2.6 -1.5 30.0 

20 to 49 7.6 3.3 6.3 6.8 2.5 -1.5 25.0 

50 to 99 4.8 2.0 4.3 6.0 2.4 -1.5 18.0 

100 to 499 4.0 1.6 4.1 5.5 2.3 -1.5 16.0 

500 to 2,499 3.2 0.7 3.9 3.5 2.2 -1.5 12.0 

2,500 to 9,999 1.4 0.3 3.8 1.8 2.2 -1.5 8.0 

10,000 or More 0.7 0.1 3.0 1.1 2.1 -1.5 5.5 

SOURCE: Estimates by Hay-HuggiM Company based on underwriting practices of major insurers. 

Reprinted from U.S. Houae of Representatives, Committee on Ways and Means, Subcommittee on Health, Private Health Insurance: Opticms for Reform (September 20, 1990l, p. 

12. 
APPENDIX 8 REASONS FOR LACK OF HEALTH INSURANCE 79 

Another factor behind the higher costs of health insurance for 

small employers is the less generous tax treatment afforded unincorporated firms. Corporations can deduct 100 percent of premium 

costs as a business expense when calculating taxable income, not only 

for employees but also for owners and their dependents. By contrast, 

while self-employed individuals, partnerships, and owners of other unincorporated ftrms may deduct 100 percent of premium costs for unrelated employees, they may deduct only 25 percent of premium costs 

for themselves and their dependents. Further, this deduction is scheduled to expire at the end of 1991. 

Not only are the costs of any given coverage higher for small ftrms, 

but the quality of the coverage offered is typically lower.13 Most insurers now subject small employers to underwriting, requiring medical 

information about each employee. If some employees are determined 

by the insurer to be high risk, the insurer may deny coverage to the 

whole group; offer to cover the group only if the high-risk employees 

are excluded; or offer to cover the entire group at higher rates.14 

Further, insurers typically impose a waiting period (varying from 6 

months to 2 years) before coverage begins for preexisting conditions 

among the insured group. 

Another undesirable feature of the coverage offered to small employers is that insurers may not guarantee continuation of coverage 

beyond the initial contract period. While most insurers cancel groups 

only with cause (such as misrepresentation), some insurers may deny 

renewal to eliminate groups with poor experience or groups for which 

the waiver on coverage for preexisting conditions is about to expire. 

When coverage is continued in the latter case, premiums are likely to 

increase sharply, often inducing employers to switch to a new insurer 

who offers lower rates but imposes a new waiting period on preexisting 

conditions. As a result, the exclusion for preexisting conditions is 

13. United States House of Representatives, Committee on Ways and Means. Subcommittee on Health, 

Priuate Health Insurance: Options for Reform (September 20, 1990), pp. 7-9. 

14. The Americans with Disabilities Act of 1990 (P.L. 101-336) will, when fully effective in 1992, 

prohibit employers with 15 or more workers from excluding any employee from a health plan. The 

plan may still exclude coverage for preexisting conditions or contain other provisioM baaed on 

standard underWTiting or risk classification practices. 

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80 RISING HEALTH CARE COSTS April 1991 

effectively permanent for employees in firms who change insurers frequently in search oflower premiums. 

Finally, insurers may require minimum participation rates for 

small employers to guard against the possibility that only those employees who foresee a need for expensive health care will enroll. For 

very small employers, insurers may require 75 percent to 100 percent 

participation. To achieve these participation rates, employers must 

typically pay most of the premium costs, and insurers may require that 

very small employers pay the entire premium rather than requiring an 

employee contribution. 

Although cost is the primary reason why small employers choose 

not to provide health insurance, results from surveys in selected cities 

suggest that there is a core of small employers who would never buy insurance in a voluntary system--probably because they can hire a suitable work force without it. In Denver, one-third of small employers not 

already providing insurance were unwilling to pay anything for it. In 

Birmingham, Alabama, one-fourth of those surveyed would contribute 

nothing toward insurance.15 

15. United States House of Representatives, Committee on Ways and Means, Subcommittee on Health, 

Prioot€ Health Insurance: Options for Reform (September 20, 1990), p. 42. 
APPENDIX C 

OVERVIEW OF HEALTH SERVICES 

IN OTHER COUNTRIES 

This appendix provides an overview of the health care systems in four 

other countries--the former West Germany, Canada, Great Britain, 

and France--and describes several strategies that have been used by 

these countries to contain health care costs. 

OVERVIEW OF HEALTH CARE 

SYSTEMS IN OTHER COUNTRIES 

All four countries examined here have health care systems that cover 

all, or almost all, of their population either through the public sl!ctor or 

through private insurance funds that are centrally regulated. 

In the former West Germany, over 99.7 percent of the population 

has health insurance that covers hospital care, physician and dental 

services, prescription drugs, and medical equipment. Long-term care 

is not covered by health insurance, although local welfare expenditures are used to subsidize those who cannot afford such care. About 90 

percent of the population is covered by the "Statutory Health Insurance" system, which consists of 1,200 nonprofit, privately run sickness 

funds that are regulated by the central government. About 8. 7 percent 

of the population is covered by commercial insurance policies, and 

about 1 percent is covered by governmental programs. About 0.3 per· 

cent is uninsured. 

Those with incomes below a specified level, students, and the 

majority of those who are retired must belong to the Statutory Health 

Insurance system. All others can elect to join a sickness fund, obtain 

commercial insurance, or remain uninsured. When workers join sickness funds, their dependents are also covered. About three-quarters of 

the membership in the sickness funds is compulsory. Membership in a 

sickness fund is generally determined by geography, the worker's 

Ill v---
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82 RISING HEALTH COSTS April 1991 

craft, or the worker's place of employment. Most workers do not have a 

choice among sickness funds, and remain in the same one for life. The 

exception is that white·collar workers can also choose a nationwide 

fund. 

Canada's health insurance system has provided universal cover· 

age since 1972. Each province administers its own health plan under 

federal regulations specifying minimum standards and federal finan· 

cial contributions. The plans must provide coverage for physician services and inpatient and outpatient hospital services. Notably absent 

from required coverage are prescription drugs and long·term care. 

Most Canadian provinces do provide prescription drug coverage at 

least for the elderly and those on public assistance. Some provinces 

also provide long-term care coverage. A private insurance industry 

exists in Canada, but benefits can only be provided for services not 

covered by the provincial plans. 

Unlike Canada and the former West Germany, the government in 

Britain both operates the health care system and funds it. Britain's 

National Health Service (NHS) provides universal coverage for physi· 

cian and hospital services, long· term care, and prescription drugs. A 

private insurance system operates alongside the NHS. Individuals 

purchase private insurance primarily for elective surgery and nursing 

home care, two services to which access is restricted under the NHS. 

France's public health care system provides nearly uriiversal coverage, covering 100 percent of the population for hospital care and 99 

percent of the population for physician services and prescription drugs. 

Like the former West German system, the French national health 

system is composed of sickness funds that cover both the worker and 

dependents and are regulated by the central government. It differs 

from the German system in that more than 80 percent of the French 

population belong to the general fund, which is a network of over 100 

local sickness funds operated under the authority of the central govermnent. France is attempting to expand membership of the general 

fund so that eventually the entire health care system will be under the 

control of the national government. Private insurance exists in France 

but plays a relatively minor role, funding only about 6 percent of 

health care expenditures. Some employers and some unions purchase 
APPENDIX C OVERVIEW OF HEALTH SERVICES IN OTHER COUNTRIES 83 

private insurance that is fmanced by a compulsory payroll deduction. 

The purchase of private insurance by individuals is uncommon. 

The tax structures used to finance these health care systems also 

vary among countries. The sickness funds in former West Germany 

are entitled to levy payroll taxes that vary with the employee's income 

but not with family size or health status. Employers and employees 

each contribute half of the total payroll tax levied. Since average 

health care costs per enrollee vary among the sickness funds, payroll 

taxes vary among the funds from about 8 percent to 16 percent. Sickness funds with financial problems sometimes receive cross~subsidies 

from other funds. Like the former West Germany, France finances its 

health care costs through compulsory payroll taxes. 

The federal share of health care spending in Canada is financed by 

a progressive income tax. The provinces are permitted to use any 

taxation method that they choose to finance their portion of health care 

costs. Most of the provinces pay these costs primarily from general tax 

revenues, but Alberta and British Columbia also charge health insurance premiums. 

Britain's NHS is funded mainly through general taxation, which 

finances 85 percent of the total NHS spending. Payroll taxes fund 

about 12 percent of the NHS, and patients pay about 3 percent of NHS 

costs. 

Despite the greater regulation of the health care sector in other 

countries, most allow patients some degree of choice of health care providers. In Canada, patients may choose freely from among general 

practitioners, but need a referral to see a specialist in some provinces. 

Access to health care providers is more restricted in the former 

West Germany and Great Britain. In former West Germany, patients 

may freely choose from among ambulatory physicians, but these 

physicians do not treat their patients once they have been admitted to 

a hospital. Only hospital-based physicians, who are salaried employees of the hospital, can treat inpatients. In Great Britain, choice 

among providers is even more restricted. Each British citizen registers 

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84 RISING HEALTH COSTS April 1991 

with a general practitioner (GP) who has an opening, and the GP 

serves as the initial contact point with the health care system. GPs can 

then refer patients to specialists, if needed, and the specialists can 

order complex tests and determine if patients require hospitalization. 

Once admitted to a hospital, patients are treated by specialists. 

APPROACHES TO COST CONTAINMENT 

IN OTHER COUNTRIES 

The countries examined here have used several methods to control 

their health care spending, some of which have not been tried in the 

United States. They include: 

o Global budgeting, whereby targets or caps on total spending 

are established; 

o Limitations on the supply of health care providers or medical 

equipment; and 

o Utilization review systems, which monitor the appropriateness of medical care provided. 

While cost sharing is used in the United States as a method of containing health care costs, it has had limited application in other 

countries. 

Global Budgeting 

All four of the countries discussed here have implemented some form of 

global budgeting. These include national expenditure targets, annual 

global budgets for hospitals, expenditure caps for physician services, 

and the incorporation of physicians' reimbursement for inpatient 

services into hospital payments. 

Former West Germany's Health Care Cost Containment Act of 

1977 established an annual assembly of health care providers, statutory and commercial insurance carriers, labor unions, employers, and 
APPENDIX C OVERVIEW OF HEALTH SERVICES IN OrnER COUNTRIES S5 

state and local governments that proposes ceilings on the growth rates 

in national health care spending by type of service. While these 

ceilings are not binding, they act as guidelines in negotiations between 

insurers and providers over the level of reimbursement for each 

medical service. 

A unique feature of the West German system is a negotiated expenditure cap that has been applied to spending for physician services 

since 1985. If expenditures rise faster than expected, the fees for 

physician services are reduced to prevent total spending from exceeding the cap. Within this framework, reimbursement for ambulatory care physician services under the Statutory Health Insurance 

system is fee-for-service and is based on a national relative-value scale 

determined through negotiations between national associations of 

physicians and sickness funds. A conversion factor that translates the 

relative-value scale into monetary values is negotiated between regional associations of physicians and sickness funds. Reimbursement 

of physicians by commercial insurance companies is based on a separate fee schedule set by the federal government. 

Such global budgeting is not applied to hospital reimbursement in 

former West Germany, but the hospital payments include reimbursement for inpatient physician services. Under the Statutory Health 

Insurance system, hospitals are reimbursed by predetermined per 

diem payments which do not vary according to the patient's illness or 

length of stay. These per diems are negotiated between each individual hospital and regional associations of sickness funds. These payments cover not only the hospital's operating costs but also payments 

for inpatient physician services, since physicians who treat patients on 

an inpatient basis are paid a salary by the hospitaL Private insurance 

carriers also pay hospitals per diem payments, but their rates are 

lower than for Statutory Health Insurance patients, because they also 

make separate payments for inpatient physician services. 

Reimbursement for physician services in Canada is similar to the 

West German system. Five provinces have established expenditure 

targets which, if exceeded, lead to lower fees in the next round offee 

negotiations. For example, Quebec caps physician incomes on a quarterly basis; if the income limit is exceeded, payments are greatly 

-- - -lllf--- v-----
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86 RISING HEALTH COSTS April 1991 

reduced during the rest of the quarter. Physicians are reimbursed on a 

fee-for-service basis, and the payment rates are established by a fee 

schedule negotiated by the provinces and physician associations. 

Hospitals in Canada are paid under global annual budgets that are 

negotiated between the provinces and individual hospitals. These 

global budgets vary with the number of hospital beds per capita, the 

ratio of hospital staff to patients, and the amount and types of services 

provided. Hospital administrators then allocate these funds at their 

discretion. However, cost overruns have often been paid by the provmces. 

The Canadian federal government has also capped its contribution 

to national health spending. Before 1977, the federal government 

matched provincial spending dollar for dollar. Since 1977, the federal 

government has limited the growth in its contribution to health care 

costs by using a formula based on growth in the gross national product. 

Per capita payments are made to the provinces, regardless of the individual province's health care expenditures. This formula has forced 

the provinces to bear an increasing share of health care costs, since 

health expenditures have generally grown faster than GNP. 

Expenditures for hospital services in Britain's NHS are fixed by 

the national government within the framework of the entire government budget. Annual funding is allocated to the regions based on a 

formula that takes account of population size and the region's mortality rate. If a region overspends its allocation, less money is provided 

the next year. Generally, a hospital receives the same budget as in the 

previous year, increased by an inflation factor, although individual 

hospitals can lobby for increased funding. In addition, hospitals 

receive some funding from charities, endowments, and private-pay 

patients. 

Expenditures for physician services in Britain are controlled in 

several ways. About half of physicians' incomes from the provision of 

ambulatory services come from capita ted payments--they receive a 

fixed amount per patient enrolled in their practice. These general 

practitioners serve as the primary contact points for patients under the 

NHS. Patients who require inpatient care are referred to NHS spe-
APPENDIX C OVERVIEW OF EALTH SERVICES IN OTHER COUNTRIES 87 

cialists, most of whom are sala ied employees of the regional health 

authority. Nevertheless, there is still a sizable fee-for-service component. Ambulatory physicians are paid on a fee-for-service basis for 

some services, such as certai preventive procedures and family 

planning services. Hospikl-bas d physicians in private hospitals are 

also paid on a fee-for-service bas· 

France instituted global ho ita! budgeting in 1983. Before that, 

the government reimbursed h spitals with preset per diem rates. 

Global budgeting is not applied o physician services, but spending is 

somewhat controlled through o her means. Ambulatory care physicians are reimbursed on a fee-fo -service basis, with the fees set by the 

government. Hospital-based ph sicians in public hospitals are paid a 

salary, but those employed by ivate hospitals are paid on a fee-forservice basis. 

Limitations on the Su 1 ofSer ices 

The governments of all four cou tries control the capital acquisition of 

hospitals. Several of these cou ries have also attempted to limit the 

number of physicians, which m y help to control health care costs if 

fewer providers translate into fe er services provided. 

In Canada, hospitals' capita costs are not included in their global 

budgets. Rather, hospitals mus make separate application to the provincial ministry of health for ca ital expenditures, including facilities, 

equipment, and renovations. he provinces provide most of the financing for capital acquisitio , but hospitals must provide some 

funding themselves. While ho pitals may acquire enough private 

money for capital investments, he provinces can refuse to provide the 

associated operating costs for pital purchased without provincial 

approval. 

In former West Germany, 

need to the state government fo 

governments provide the fundin 

of public hospitals are publicly 

make their own investment de 

-- --~--

ospitals must submit a certificate of 

capital spending, and state and local 

. In France, the investment decisions 

ntrolled. While private facilities can 

isions, prices are set by the governv----· 
'111111 

88 RISING HEAL m COSTS April 1991 

ment, which indirectly influences the amount of capital that can be 

acquired. 

In Great Britain, the central government determines a national 

budget for capital costs. Decisions about capital acquisition are made 

at various geographic levels, depending on the type of expenditure. 

For example, decisions about facilities or equipment that would be 

used by patients from a wide area, such as CT scanners or a new hospital, are made at a regional or national level. 

Some provinces in Canada, such as Quebec and Ontario, have tried 

to limit the number of medical school graduates. The Canadian federal 

government also limits the number of foreign medical school graduates 

who can practice there. France attempted to restrict the number of 

physicians by lengthening the duration of medical school. Britain explicitly controls the number of hospital-based physicians by requiring 

regional approval for new positions. 

Restrictions on capital acquisition have led to lower rates of 

technological diffusion of medical equipment in other countries than in 

the United States. A comparison of the availability of six technologies 

in the United States, Canada, and former West Germany shows much 

greater capacity in the United States than in the other two countries. 

For example, the numbers of open-heart surgical units per million 

persons were 1.2 in Canada, 0.7 in former West Germany, and 3.3 in 

the United States. The United States had 3.7 magnetic resonance 

imagers per million persons compared with 0.5 in Canada and 0.9 in 

former West Germany. 

These smaller supplies of capital equipment have led to the 

rationing of medical care in some countries. In Canada, there are 

waiting lists for some kinds of elective procedures and equipment, 

although rationing varies by province. In Newfoundland in 1989 there 

was a two-month wait for a CT scan, a two·and-one-half month wait for 

a mammogram, and a six- to ten-month wait for a hip replacement. 

Waits of several months for cardiac surgery occur in Ontario. However, Alberta does not appear to have such rationing. 
APPENDIX C OVERVIEW OF HEALTH SERVICES IN OTHER COUNTRIES 89 

In Great Britain, there is no wait for emergency care, but other 

cases may have to wait weeks or months to see a specialist. Patients 

waiting for admission to a hospital are classified as urgent or nonurgent, with most cases on the waiting lists being for elective surgery. 

The wait for patients with an urgent medical condition is supposed to 

be not more than one month and for non urgent cases not more than one 

year, although reports indicate that these waiting times are often 

exceeded. 

Utilization Review 

Two of these countries have instituted utilization review mechanisms 

as a cost containment strategy. The systems have in common the focus 

on identifying care that deviates from the norm, rather than applying 

objectively determined practice standards. Only one imposes penalties 

on physicians through financial sanctions for unneeded medical care. 

All Canadian provinces have committees that monitor physician 

practice patterns. They only identify physicians whose practice patterns deviate greatly from the average, however, and attempt to uncover fraud and incompetence. No objective standards of care are applied. 

Former West Germany has a system for monitoring physician 

costs that focuses on outpatient utilization. The sickness fund physician associations compare the costs per patient within type of service 

among physicians with the same experience, staff and equipment, and 

patient mix, and then review physicians whose practice costs are much 

higher than average. The penalty for exceeding average costs by more 

than 40 percent within a type of service is a reduction in fees for that 

type of service. 

Cost Sharing and Taxation 

Cost sharing--that is, requiring patients to pay part of the costs of the 

medical care that they consume--has been associated with lower health 

care utilization and thus lower costs. Nevertheless, cost sharing is not 

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90 RISING HEALTH COSTS April 1991 

used extensively in most countries except France, where out-of-pocket 

payments by patients amount to about 20 percent of national health 

expenditures, and the United States, where they are about 21 percent 

of total spending. 

Enrollees in _other countries pay for their health care through 

taxes levied to finance the health care systems. This reliance on taxes 

rather than cost sharing may increase the utilization of medical services and contribute to increased costs because there is no direct penalty for using more, rather than fewer, services. 

Most OECD countries other than France and the United States impose only nominal or no cost-sharing requirements, and prohibit balance billing. In Canada's public health system patients can be billed 

for room and board in long-term care facilities. Under federal law, 

provinces may impose user fees or balance billing for other services, 

but none do because federal funding is reduced dollar-for-dollar for 

such amounts. 

In the former West Germany, out-of-pocket costs represent 7 percent of total health care expenditures. Patients pay primarily for over· 

the-counter drugs and to obtain better medical equipment than the 

sickness funds provide. In Great Britain, patient cost sharing repre· 

sents about 3 percent of the cost of the NHS.