2011 December 13 Tuesday
Why Did US Medical Costs Surge In 1980s?

Reihan Salam says during the 1980s the US pulled away from other developed countries in terms of medical costs. So what caused this trend? He points to a hypothesis that a change in the Medicare formula for setting treatment costs incentivized physicians to choose treatments that cost more. Reihan makes a number of other interesting observations worth reading.

This raises the question of what exactly changed in the 1980s. Daeho Kim, a graduate student at Brown University, offers a provocative hypothesis in a new working paper. As Kim explains, a 1983 Medicare reform created the prospective payment system, or PPS, which offered fixed reimbursements for the use of a medical technology. If a physician decides to use bypass surgery as a cardiac treatment, she wont be paid on the basis of what it cost her to perform the surgery. Instead, shell be paid the national average cost. This way, there is a strong incentive to beat the national average cost of performing bypass surgeries, thus lowering, in theory, systemwide costs.

Kim argues that physicians responded to this new pricing environment by focusing on treatments where they could provide services where they could get their costs well below the national Medicare price. These preferred treatments tended to have high average national costs. PPS backfired.

If this is true then government distortions of the market created the high prices which today are used to justify even bigger government interventions in the market.

We need to get more market incentives back into health care. It is far too expensive and medical care costs are lowering living standards. We need people to want to shop around and more visible market prices. Incentives need to work on patients and not just on medical service providers.

Share |      By Randall Parker at 2011 December 13 08:47 PM  Economics Health

MikeCLT said at December 14, 2011 5:24 AM:

Health costs are out of control. A friend of mine, age 48, had knee surgery to repair a torn ACL. The hospital bill was $32,000. The surgeon's bill was $7,000. He did not even stay overnight in the hospital. The surgery was less than 3 hours. A fairly routine surgery cost 80% of the the median family income of about $50,000. This is not sustainable.

AMac said at December 14, 2011 8:03 AM:

Anecdotes like MikeCLT's are the norm not the exception in the U.S. Two more:

1. This fall, my wife had a likely-benign mole removed from her leg. Her longstanding doc just retired; he'd done this at his office for about $150. The youngish replacement scheduled it as an outpatient procedure. Hospital bill: $1,200. Physicians' services bill yet to come. This doc was unaware of the cost consequences of her style of practice, and puzzled that we care (answer: super-high-deductible insurance policy, so we pay everything).

2. I have tried to figure out reimbursement rates for colon cancer screening by colonoscopy. Under Medicare, this has three parts -- physician's fee, facilities fee, and anaesthesiologist's fee. After a couple hours' reading and a connection with a friendly expert, I got some estimates (~$800 to $1,000, depending). Then I moved to private payers' reimbursements, starting with my own insurer. So far, I've spent about an hour on hold and an hour in various conversations with representative from the "Customer Service" call center, their managers, and the "Escalation Team." My conclusion so far: it is impossible to determine what Aetna pays for this heavily-promoted cancer screen. It seems that the company's reps can't tell me, because they don't know. More than that, none of them seemed to understand the question. "Sirrrr, let me say this once again. In-network, authorized colonoscopy will be covered, there will be no deductible to meet and you will not be responsible for a co-pay."

Mthson said at December 14, 2011 2:30 PM:

Coming from a tech management background, the medical industry seems to have incredibly inefficient division of labor.

I had a benign mole removed, and they had a highly intelligent dermatologist with several years of specialized education & training do the simplistic manual tasks required.

They're off by 3 orders of magnitude. It should take 10 hours, not 10,000 hours, to train an intelligent person how to make a simple incision, put in a few stitches, and be aware of all the complications to watch out for.

Randall Parker said at December 14, 2011 8:34 PM:


Agreed. Totally unsustainable.


Do you think she could have gotten the mole removed done far cheaper by going to a dermatologist?

Shopping around for colonoscopy: I really would want to know both the cost and the performance of multiple choices for getting it done. There are different rates at which doctors spot polyps. They are not all equally good at it. The performance varies over a wide range.

We really need access to more pricing information as well as more performance information.

Kaz said at December 14, 2011 10:52 PM:


Are those costs your friend actually had to pay out of pocket or was that the cost covered by the insurance? Hospitals often charge depending on how much they can not how much it actually costs with a bit of it being marked up. It's to make up the costs for people who don't have insurance or just straight up don't pay.

AMac said at December 15, 2011 8:31 AM:

> Do you think she could have gotten the mole removed done far cheaper by going to a dermatologist?

Yes. I'm actually sympathetic to my employer and Aetna for this recent move to a super-high-deductible policy, as it gives me (the consumer) a stake in pricing. Bad for me but good for society. That said, a road not taken in the Affordable Care Act was one you've often promoted here -- steps to promote pricing transparency. Had there been a discussion of what this doc's methods would cost (would cost us), my wife would have declined. In the kooky world of medical economics, it seems typical to me that this conversation didn't happen. Lesson learned.

sestamibi said at December 15, 2011 7:21 PM:

I like that: "If a physician decides to use bypass surgery as a cardiac treatment, SHE wont be paid on the basis of what it cost her to perform the surgery."

Note that Reihan Salam, who purports to be a conservative of some sort, reveals himself for the mangina he is (he did write a piece called "The Death of Macho" a while back), and carefully observes the fashionable new practice of exclusive use of feminine pronouns--particularly in reference to positions of authority, leadership, and expertise. Note also that the likelihood of a cardiac surgeon being a "she" is less than minimal, even in our enLIGHTened age in which women outnumber men even in medical schools, but choose far less demanding specialties. That is, if they don't waste the $300K investment in their education by dropping out of the work force to raise children.

California kid said at December 16, 2011 10:15 AM:

Partly it's caused by Physicians doing what is convenient for them rather than looking at things from a cost perspective. A specialist, when interviewing a new patient, will often order a complete suite of tests costing $3000. But these could be broken up into 3 suites costing $1000 each. The first suite could be chosen (based on Dr's experience) so that it will allow diagnosis of 80% of incoming new patients. The 2nd suite (for another $1000) could be used to find the next 15%. Finally, if both previous test suites didn't diagnose the condition, the final increment (for $1000 more)could be ordered.

But docs don't want to do this. They want it all up-front. That's a huge reason for the cost increases.

ANSWER ONE said at December 16, 2011 10:39 AM:

The answer to the question is: Neoliberalism. That's when governments are for sale and subjects to the rich fat ones.

ANSWER ONE said at December 16, 2011 10:42 AM:


Randall Parker said at December 19, 2011 7:16 PM:

California kid,

You bring up an interesting point. Makes me think there's another reason to what diagnostic expert systems: To let patients see what potential diagnoses a doctor is considering and to then sequence their own diagnosis in a way that minimizes costs.

Patients really need computer systems to enable them basically do battle with care providers who have an incentive to run up costs. They need this not just for price shopping for procedures. They even need it for making diagnostic and treatment choices between different options.

Black Death said at December 20, 2011 2:16 PM:

Medicare DRG's apply to hospitals, not physicians. The Kim paper makes that clear. but I'm not sure Salam understands that. Medicare pays physicians on a fee-for-service basis according to a national schedule with local modifications. If a patient is admitted to a hospital with a chest pain DRG and ends up getting a cardiac bypass, the hospital is paid a flat fee. The doctors all bill separately for their services.

Ross Noble said at December 24, 2011 7:45 PM:

Markets are elastic, inelastic, or mixed. Medical care is a mixed market, which means it has both inelastic and elastic elements. Between these two definitions, predators lurk.

Elastic markets self regulate by definition. For example, if I go to the store to buy Bayer aspirin, and they are out, I can buy a competing brand. In this way, elastic markets use the market mechanism to keep supply and pricing in control. Inelastic markets are those that cannot have easy competition. Roads, sewers, water, the military, are examples of inelasticity. Inelastic markets should be regulated or government owned.

Enron is an example of applying elastic methodologies to an inelastic market. In this case, Enron was predatory by pretending that elastic methods will bring efficiencies to an inelastic market; this is a confusion of concepts designed to manipulate the market for predatory gain. Liberals also conflate market mechansims, and try to apply inelastic mechanisms improperly. This is done because Liberals belive statist type government control is the panacea that heals all ills. An example of using elasticity improperly would be the nuclear power plants in Japan. The bonus and profits of private owners were put ahead of the safety of Japan's population. Does anybody believe the inelastic U.S. Navy would have done a worse job? Nuclear power is inelastic, especially given the risks involved.

Medical care, since it is a mixture of both elastic and inelastic, is ripe for predators to hide in the cracks and apply confusion and misdefinition.

Our medical care situation, when properly defined, has reasonable solutions. For example, where medical care is elastic, such as the elective choice of doctors, the patient should pay. When a scenario unfolds where the patient is unconcious, or is unable to make rational decisions, then medical care becomes inelastic.

Liberals would have us believe that all medical care should be under the purview of the government, hence all medical is 100% inelastic. Conservatives would suggest that medical care is 100% elastic - also untrue.

The answers are somewhere in between and are better seen when the definitions are clear. Rules should be agreed upon and codified into law. Those laws should understand what markets are, and what defines the markets. My statement to conservatives; markets are not God and they operate within a Law framework.

With regards to insurance, the law also regulates this market. Insurance spreads risk over a larger population sample. For inelastic type care, insurance should kick in.

We could also save money in the medical field by going back to having some charity hospitals. In the case of charity, the people seeking care, would be inelastic. That is, they would not have the money to get elastic care elsewhere. Segregating this population out by using charity hospitals would prevent Liberals from using the poor as a wedge toward their goal of politcal statism. From a conservative viewpoint, charity hospitals should use the tax code, such that Doctors volunteer and get a reduction in their taxes. This would make the cost of doctors in Charity hospitals be about 40 cents on the dollar.

Lawyers are in the way, where they want confusion in the definitions, so they can continue to make money by attacking hospitals and the medical care industry. Lawyers can be counted on to resist the idea of charity hospitals.

Ross Noble said at December 24, 2011 10:40 PM:

The answer to your question about the 80's increase in medical costs, is in the law changes, and misdefinitions that occured during that period.

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