Keeping Score

Why is it that Washington is spending so many hours over so many months — on top of two decades of prior conversation, analysis and debate — and is still failing to come up with a reasonable way to reform the health care system? Today I will slice through the Gordian Knot and give you a simple way to keep score.

There are four basic questions to be asked of any health care system. If you answer these questions the right way, the path to reform is rather easy and straightforward. But if you answer even one question the wrong way, you will get caught up in a cycle of complexity — with fix upon fix, each trying to patch up the problems created by the previous fix.

Hint: Right answers are the ones that give people socially good incentives. Those are incentives to meet your own needs without imposing external costs on others. Wrong answers are the ones that give people socially bad incentives. These are perverse incentives to impose external costs on others in the process of pursuing your own interests.

“1-2-3…that’s how elementary it’s going to be”

Note: An earlier version of this was published in National Review.

 1.       How is Health Insurance to be Subsidized?

Is the government subsidy to be uniform across all ways of obtaining insurance (as it is in most countries)? Or will the subsidies differ according to how insurance is acquired? Currently, we have the latter condition: The subsidies are heavily tilted toward employer-provided group insurance and away from individually acquired insurance. Every dollar of premium paid by an employer avoids a 15.3 percent FICA payroll tax and — in the case of a middle-income family — a 25 percent federal income tax and a 6 percent state income. Avoiding these taxes amounts to receiving a subsidy equal to almost half the cost of the insurance. People who must purchase their own insurance, by contrast, get virtually no tax relief. At the workplace, insurance is purchased with before-tax dollars. Away from the workplace, it must be purchased with after-tax dollars. The poor individual purchaser must earn twice as much money to be able to buy the same insurance.

The health-reform bills in Congress would create even more lopsided subsidies—this time tilted toward individual purchase in a “health insurance exchange,” and away from purchase through one’s employer. Under Sen. Edward Kennedy’s bill, the highest premium anyone would have to pay in the exchange would be 12.5 percent of his income. The additional cost would be paid by the taxpayers.  In the House bill, the highest premium would be as low as 3 percent of income for a family earning up to 150% of the poverty level ($33,000). That means a low-income worker would pay only $992 for a family plan whose actual cost is $13,000 (about average for employer-provided coverage). The net subsidy would be $12,008. By contrast, if an employer purchased this same insurance, the implicit subsidy would be only the amount of payroll tax he avoided, or $5,060.

You don’t have to be a math genius to figure out that the exchange is a better deal. Indeed, if a worker has been getting insurance from his employer, he and the employer could drop the plan at work, agree on higher wages instead of premiums, purchase the same plan in the exchange, and end up with almost $7,000 in extra take-home pay. Great deal for the worker. But that $7,000 gain will be at the expense of the taxpayers. And after millions of people do that, the taxpayers will end up paying billions of dollars in subsidies without any real change in health insurance coverage!

Nonuniform subsidies create havoc. Under the current system, they make portability — the ability to keep your health-insurance plan when you change jobs — virtually impossible. Under the bills in Congress, more than half the population will try to shift from group to individual coverage — creating an enormous taxpayer (subsidy) burden with no net reduction in the number of uninsured.

2.       How is Health Insurance to be Priced?

Are the premiums going to reflect expected costs, as they do in other insurance markets? Or are they going to be independent of expected costs? Under “community rating” (the pricing scheme preferred by congressional Democrats), insurers must charge the same premium to everyone, regardless of health condition. This creates perverse incentives for both buyers and sellers.

Buyers will tend to choose lean plans when they are healthy (and don’t expect to use many services) and rich plans when they are sick (and plan to use a lot). They will tend to choose HMO coverage when healthy (and choice of doctors does not seem very important) and fee-for-service insurance if they have a serious problem (and choice of doctors is critical). More generally, if the premium is the same for everyone, people will tend to underinsure themselves when they are healthy and overinsure themselves when sick.

Sellers of health plans will seek to attract the healthy (on whom they make a profit) and avoid the sick (from whom they incur losses). After enrollment, they will tend to overprovide to the healthy (in order to keep them and attract new enrollees) and underprovide to the sick (in order to encourage their exodus and discourage new enrollees like them).

Much regulation would be needed to try to keep insurers from acting on these incentives. But there is a better way: Let premiums reflect real risks. One out of five seniors is enrolled in a (private) Medicare Advantage plan that receives a risk-rated premium, calculated on the basis of up to 75 different variables. In this system, health plans will no longer want to drive the sickest enrollees away, because these patients will be paying higher premiums. Employers could do the same for their employees.

3.       How Much of Health Insurance is Third-Party Insurance?

Will a third party pay every bill (as in Britain and Canada)? Or will individuals be able to self-insure, managing some of their health-care dollars in an account they own and control? If the former, patients will have incentives to overconsume, using up health-care resources until their value at the margin (the value of the last unit purchased) is almost zero. And health plans will have to employ rationing devices to control demand. If patients are using their own money, however, they won’t spend a dollar on care unless the care is worth a dollar.

There is already a good model for this patient-centered alternative. In the Medicaid Cash and Counseling pilot program, homebound disabled patients manage their own budgets. They can pay market prices and hire and fire those who provide them with health services. Satisfaction rates approach 100 percent (something unheard of in health care anywhere else on the planet).

4.       How Do Providers Get Paid?

Are the packages and the prices dictated by the third-party payer — as they are in Canada, under US Medicare and under most private insurance in this country? Or, will providers have the freedom to repackage and reprice their services in order to better meet patient needs? More fundamentally, are the providers competing for patients based on price and, therefore, quality? Or, are the prices fixed independently of patient preferences and behavior?

Unlike the Cash and Counseling program, other Medicaid patients and Medicaid providers cannot recontract or make other mutually beneficial arrangements. For example, Medicaid patients cannot add to Medicaid reimbursement rates and pay market prices at walk-in clinics, surgicenters and urgent care centers. They cannot choose a doctor they like and pay his usual and customary fee. I have no idea what the satisfaction rate is in Medicaid generally. But since being in Medicaid is only marginally better than being uninsured, I suspect it is not very high.

Lessons for Reform

As noted, one wrong answer creates a nightmare. But with four out of four answers wrong (note: you could improve on that by choosing randomly), workable health reform is a metaphysical impossibility.

Comments (17)

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  1. Devon Herrick says:

    It never ceases to amaze me how oblivious public policy makers are to the role of incentives in health care. Several examples come to mind.

    In Massachusetts, New Jersey and New York (and elsewhere) politicians try to force healthy, young people to pay insurance rates much higher than their expected costs so older, less healthy people can get a huge discount. Yet policy makers cannot figure out why the only ones who want to join the (community rated) plans are the older, less healthy people – causing premiums to skyrocket.

    Policy makers cannot figure out why doctors and hospitals have not installed costly electronic medical record (EMR) systems and then used them to reduce the redundant medical tests that earn providers significant fees.

    Policy makers cannot figure out why health insurers don’t want to enroll sick people, who waited until they are ill to apply for coverage, at premiums well below the expected costs.

  2. David Rose says:

    I thought you might enjoy the following article in the Christian Science Monitor on health care reform:

  3. Chris Ewin, MD says:

    Nice article in the National Review Aug 24 with the above noted questions.

    How do providers get paid?
    In primary care, we should get paid directly from our patients. By cutting out the bean cutters, we (PCP’s) decrease our overhead and the overhead of the goverbnment and insurers. The result: less waste. More monies for the specialists and the hospitals…

  4. Bart Ingles says:

    In Massachusetts, New Jersey and New York (and elsewhere) politicians try to force healthy, young people to pay insurance rates much higher than their expected costs so older, less healthy people can get a huge discount. Yet policy makers cannot figure out why the only ones who want to join the (community rated) plans are the older, less healthy people – causing premiums to skyrocket.

    Devon, how much of the high cost in these states is due to excessive mandates for every kind of benefit imaginable?

    It seems to me that to look at a broad range of experiences involving community rating, one need only look at employer-sponsored coverage. Granted it’s more expensive than the best possible quote for a healthy individual, yet healthy individuals continue to get their coverage from work, preventing the runaway pricing you mention. And it’s obviously successful in that most Americans receive their coverage from this source, are not forced by any law to do so, and are always ready to turn out any politician who attempts to tamper with their benefits.

    As for the article above, I agree with 80-90% of N.C.P.A.’s positions, and of the remainder I also strongly agree on the importance of reforming the employer tax exclusion, but change has to start from a clear understanding of the status quo. And the status quo is that employer-sponsored coverage is by law community-rated. So a tax subsidy for employer-sponsored insurance is just as much a tax subsidy for community-rated insurance. You cannot, for example, receive employer-sponsored coverage that is individually underwritten.

    Glossing over this fact will only result in proposals that stand no chance of surviving public scrutiny, much less a hostile Congress.

  5. Bart Ingles says:


    You cannot, for example, receive employer-sponsored coverage that is individually underwritten…

    …therefore, there is no comparable tax subsidy for individually underwritten coverage.

    Note that I am ignoring the self-employment deduction as it appears to be a exception that tests the rule, able to exist only because it is limited to a few individuals disjoint from employees with benefits.

  6. Neil H. says:

    Here’s betting that Congress continues to get four out of four wrong.

  7. Dr. Bob Kramer says:


    One phrase that really bothers me is that healthy folks can choose any provider, “because it really doesn’t matter” I realize that the person who graduates last in his class at medical school is still called “Doctor” but there are differences when it comes to education, training, experience, knowledge, commitment, enthusiasm, etc. I didn’t accept my training at Yale at $25/mo to be put in the same category as anyone with a medical degree. I got the very finest medical education that was available so I could be a better physician, and by achieving this status, I could expect greater financial rewards. The insurance industry has reduced this aspect of health care to the lowest common denominator and I resent it.

  8. Alberto Benegas Lynch says:

    Excellent John!

  9. Dr. P says:

    What is the Gordian knot?

  10. John Goodman says:

    Greek legend has it that there was a very large knot of string, twine, or rope that was so complexly wound that no one could unravel it. Supposedly, Alexander solved the problem by slicing thru the knot with his sword.

  11. Ray Gitmo says:


    John, I ususlly agree with yoiur conclusions and I agree with most of the points you make in this article. I am having difficulty with the above section however. I work with a lot of Medicare Advantage plans, and they are all as community rated as any other Medicare plan. Some of these plans, specially the PPO’s, have an “out of pocket maximum”. I have many clients that hit their OOPM in moth 2 or 3 of the year. I know this when they sign up for the plan, yet I have no way to prevent their enrolling because to do so would be a violation of the law. For that matter, Medigap policies are also very community rated. I have clients who are on gamma globulin maintenance 2 to 4 times per month…these folks are creating yearly expense of $150k just on that one line item, and they pay $3,000 per year for the medigap policy. Perhaps I misunderstood your message here.

    I would like to hear your ideas on how we price insurance (specially Medicare ) to recognize the additional expenses caused by poor lifestyle choices eg: food, drug and alcohol abuse

  12. Ray Gitmo says:

    My previous comment addresses the paragrah below from your point #2…Dont know why it disappeard from my previous post.


  13. Ray Gitmo says:

    Last try…apparently putting the comment in brackets is making it not show up in my posting. Hopefully this will work. Your original comment is below.

    But there is a better way: Let premiums reflect real risks. One out of five seniors is enrolled in a (private) Medicare Advantage plan that receives a risk-rated premium, calculated on the basis of up to 75 different variables. In this system, health plans will no longer want to drive the sickest enrollees away, because these patients will be paying higher premiums

  14. Frank Timmins says:

    John, would it not be preferable to design a program that not only by-passes as much third party involvement as possible, but also by-passes any dirct government subsidizing of medical providers (subsidizing also means price control)? Is there not a way to bring all citizens into the free market system thereby allowing pricing and quality issues to be determined by the doctors and patients? I think so, and it does not involve “health insurance exchanges” or government sponsored “Co-ops”.

    Rather it means adoption of a McCain/Coburn style credit/voucher system that, along with regulatory based uniform liberalization of medical underwriting, would empower 98%(??) of all Americans to operate in the same system based upon their particular needs and preferences.

    In theory there would not even be a need for Medicare or Medicaid. Everyone could be able to fund healthcare through either tax credits or vouchers. They may choose HSAs, high deductible plans, low deductible plans, insurance carriers,etc. Is that not the optimum system?

    Of course there would have to also be some sort of risk safety valve for carriers (stop loss reinsurance) that protects them from unusual losses resulting from more liberal medical underwriting, but that is a relatively easy fix with the current insurance infrastructure. It could be an intra-carrier funded high risk pool. There would also be enrollment requirements (with penalties) to keep the moral hazard of opting out until sick a non issue.

    Why must we have this complicated smorgasbord of private/government programs of infinite complexity and funny number financing, corruption of bureaucrats, and provider system gaming when the simple solution is right under our noses?

  15. Richard Collins says:

    John, logic will get you nowhere…

    Great article John, keep them coming.


  16. Lynn Dietz says:

    My question is why should medical care providers be subsidized at all? The fact is, health insurance subsidizes physician’s and hospitals. If the medical community actually had to compete for patients, which they don’t under our current system of employer-provided health insurance regulated PPO’s & HMO’s, then there could be a chance for the “cost” of healthcare to go down, so that individuals could afford it. (Heaven forbid that the free market system enter the healthcare arena). The same thing goes for the health insurance companies–they don’t have to compete for employer premiums–every year my employer shops for health insurance and has the prices dictated to them–the only way for them to save on health insurance is to cut benefits. It has also always frustrated me that I cannot find out how much a medical procedure will cost because no one at the physician’s office or hospital knows, because there are different prices for different insurance companies, and the insurance companies have different reimbursement rates for different employers. As a fiscally conservative and responsible individual, I believe that the cost of healthcare should be as transparent as the cost of groceries at the market. Also, there shouldn’t be a “single-payer’ system in the form of insurance or government, but only the individual patient should be responsible for payment. Only then do I believe we would actually see a decrease in the “cost” of healthcare, as physicians and hospitals would actually have to compete for patients, and patients would be able to choose those that provide them with the quality of care that they want, not that is dictated to them. Likewise, health insurance companies should have to compete for an individual’s business–not an employer’s, and they should have to base their premiums on the entire market, not some employer group. I don’t want to have to depend on either the government or my employer for healthcare or health insurance, and I certainly do not trust our current government to resolve this issue; what they are doing is not in the best interest of the individual taxpayer, and is really only another disguised tax increase on all of us that Congress has become so adept at.

  17. […] for health care consumers to get what they want. At present, US government health spending distorts incentives for patients, physicians, insurers, hospitals, drug and device manufacturers, and […]