The Sleeper in Health Care Payment Reform

Uwe E. Reinhardt is an economics professor at Princeton. He has some financial interests in the health care field.

In late June news organizations reported on a practical application in the United States of “reference pricing” for hospital care.

The concept has been well known for decades to health policy wonks and already applied to prescription drugs in many other countries, but it is still novel in the United States.

In the arsenal now being assembled on the payment side of health care to address rising costs, reference pricing may well turn out to be the sleeper, because it is a potentially powerful method of “putting the patient’s skin in the game,” the delicate phrase we use for “cost-sharing by patients.” As it is able to shift significant market power from the supply side to the payment side of the health sector, reference pricing is much feared by the providers - physicians, hospitals, pharmaceutical companies and others.

Reference pricing also leads to concerns that it could be used simply for rationing by income class in disguise, unless good care is taken to enforce high quality standards for the health care being delivered.

In theory, the concept of reference pricing is simple.

Consider any arrangement under which a third-party payer - a government program or a private insurer â€" protects individuals substantially from the cost of receiving a particular good or service, say, a drug aimed at a given therapeutic target or a hip replacement. Suppose different vendors of the good or service charge different prices for it.

Prices may vary for one or both of two reasons. First, vendors may differ in their efficiency and cost of producing the good or service. Second, there may be differences in quality, with higher quality costing more to produce. In the case of prescription drugs aimed at a given therapeutic target, some drugs with fewer side effects may be higher priced because they are still under patent protection.

The market power of reference pricing stems from the fact that the third-party payer covers only a low-priced version of the good or service in question - the “reference price,” leaving the recipient buying from a higher-priced vendor to pay out of pocket the entire difference between that higher price and the reference price. This cost-sharing method is thus more powerful in engaging patients in cost control than are co-payments or co-insurance.

Under co-payments, even those tiered by product or producer - e.g., a generic versus a brand-name drug, or services delivered in community hospitals versus those delivered in academic health centers - patients have no interest in the full price being charged. To them, drugs of all kinds have, say, three different prices - their tiered co-payments.

Under co-insurance, patients pay out of pocket a constant (or tiered) fraction of the full price of the good or service being covered, which does make them conscious of the full price being charged. But the third-party payer contributes more for a high-priced good or service than for a low-priced one.

Because prescription drugs, unlike most health-care services, are well-defined, standard products, it is not surprising that reference pricing was first widely applied to them, although mainly outside the United States. Germany’s statutory health insurance system introduced it as early as 1989, much to the consternation of the pharmaceutical industry, which sees in the raw market power it unleashes a threat to its revenues and profits and its capacity for research and development. In the meantime, many other nations have followed suit.

As Panos Kanavos and I noted in our 2001 paper “Reference Pricing for Drugs: Is It Compatible With U.S. Health Care?” a number of economists have shared the drug industry’s concerns. Their position is that patients are ill equipped to judge the relative clinical merits of different prices. Consequently, if on-patent brand-name drugs were pitted against generic drugs under reference pricing, the prices of on-patent drugs would inevitably collapse to the reference price. Some economists have even raised concerns over equity among patients.

While reference pricing for prescription drugs is now employed in many countries outside the United States, American insurers and pharmaceutical benefit managers have so far relied mainly on tiered co-payments or co-insurance as forms of cost-sharing by patients in drug therapy, probably because the American pharmaceutical industry strongly objects to reference pricing and the insured might as well.

In health care in the United States, the first proposed application of reference prices actually appeared in quite another context, namely, Prof. Alain Enthoven of Stanford’s concept of “managed competition.” He first developed it in 1977 for the Carter administration under the label Consumer Choice Health Plan.

At its core, the Enthoven plan is a defined-contribution plan for health insurance, pegged to the premium quoted for a relatively low-cost health plan - the reference price. Crucial to the design is a common, standard health benefit package and some mechanism for ensuring that the quality of the care rendered under each plan meets a satisfactory standard of quality in the eyes of the plan’s sponsors. The chart below illustrates the core of the idea.

The first three bars show the contributions for health maintenance organizations, the fourth and fifth for preferred provider organizations, which allow consumers to choose among participating providers, and the sixth for fee-for-service plans, which provide a separate payment to a health care provider for each service rendered.

Professor Enthoven’s design is now busily being reinvented under a new label, namely, “private exchanges.” But basically it is the same idea developed more than three decades ago and largely disregarded by the employers in the intervening years.

In the public sector, the idea of managed competition is now being reborn under the label of “premium support model.” But it, too, is basically the same reference-price proposal developed by Professor Enthoven more than three decades ago.

In fact, there really has not been any notable innovation in the market for private health insurance since 1977, besides inventing new labels for the same idea.

However, the application of reference pricing recently developed by the insurer WellPoint Inc. and the California Public Employees’ Retirement System is relatively novel, because it takes place at the nexus of patient and providers of health care (other employees and insurers have experimented with this approach as well). This approach to controlling the prices of health care in the private sector is likely to augur things to come.

Under WellPoint’s design, employees are to be provided, for well-defined medical procedures, user-friendly information on their total prices and their quality. If employees pick a provider charging more than the employer has set as the reference price, employees must pay the difference out of pocket.

This approach, more so than just bundled payments per episode of illness, has the potential of putting enormous price pressure on hospitals and physicians. WellPoint has reported that through this approach it has been able to reduce the cost (i.e., the price) of hip and knee replacements by 19 percent.

How quickly reference pricing of this genre will spread depends crucially two factors.

First, it depends, as noted, on the full transparency, in user-friendly fashion, of the prices and the quality of health care rendered by competing providers of health care.

Second, it depends on how receptive employees - the insured - will be to this innovation.

This second issue is another story, worthy of a separate post.