This is a letter I sent to Gary Cohn, appointed by President Trump to head the National Economic Council and, among other things, come up with a plan for reforming healthcare. Formerly president of Goldman Sachs, Cohn may be a wizard at finance, but healthcare economics are wildly different and famously opaque.

So I thought I would help him out. As things are going with the Republicans’ health plan on Capitol Hill, Trump may need a Plan B.]

Healthcare economics are weird, opaque, and convoluted. The business of healthcare is unlike any other business. The politicians and pundits arguing about how to fix healthcare in the United States don’t understand what they are trying to fix. Neither do you, probably, because almost no one does.

So let me help with this explainer. Here’s the promise: This will be non-partisan, factual, and some parts at least will be different from anything you have heard before. This is a version of a letter I sent to the White House economists charged with coming up the new, better replacement for the Affordable Care Act.

Subject: Your best eight minutes on healthcare economics.

  • Why healthcare economics are different.
  • What would work

Who I am: An independent healthcare author and analyst since Jimmy Carter’s administration, speaker, consultant across the industry at all levels, including insurers, hospitals, device manufacturers, employers, the Veterans Administration, the pharmaceutical industry, the World Health Organization, the Department of Defense, a real insider.

Core problem: The core problem in fixing healthcare is the actual cost of medical care.

  • Healthcare in the U.S. by any measure costs about twice what it should and is twice more than in most other countries.
  • Medical prices are completely disconnected from the cost of production.
  • Few medical providers even know the true cost of their products, their tests, therapies, and surgeries because they reverse-engineer their prices based on reimbursements
  • By a number of highly respected analyses at least one third of that (well over $1 trillion this year) is waste, paying for things that we don’t need and that don’t help and often hurt.
  • Solving just the federal part of this would completely wipe out the deficit.

Trying to “take care of everybody” will always be impossible politically and economically as long as healthcare costs twice what it should and wastes trillions of dollars.

Solvable: This is a solvable problem. If we manage to stop paying for waste, over $1 trillion per year in unneeded overtreatment will disappear. Prices will drop to something like a true market price. This will not happen overnight, but it could happen over five years with vigorous implementation.


Why does it cost so much? 

No price signals: The structure of the U.S. healthcare market since the early 1980s has made it opaque to price signals. Customers in healthcare ask a different question than customers in most markets. Whether they are hospitals (as customers of suppliers) or individuals needing an operation, healthcare customers mostly don’t ask, “Can we afford it?” Or even, “What’s the best value for the money?” They ask, “Is it covered? Can we get reimbursed for this?” And the reimbursement or coverage is set by complex non-market mechanisms that in most parts of the market are themselves opaque to the customer. So there is no real customer and no real price signal in most relationships throughout the market.

Why health plan competition doesn’t help: The Affordable Care Act and the various Republican proposals all attempt to lower the cost of medical care through increased competition among health plans. The strategy is: Plans will compete to offer lower premiums, and in turn demand lower prices from doctors, clinics, and hospitals, driving pricing demands into the market. Doesn’t work. Won’t work. Here’s why:

In health insurance markets there is no advantage to being the least expensive offering. You’ll increase your market share, yes, but:

  • The customers have to renew every year. The customers you gain at the bottom will leave you as soon as you are not the cheapest. The market share you gain will evaporate.
  • The bottom of the market is typically sicker, requiring more of the premium dollar to pay for their medical care.
  • If you priced yourself lower than anyone else on the market, your rivals are more likely to have a sustainable price than you are: You will likely spend 100% or more of that low premium servicing those patients. Without ample funding from the “risk corridors” established under the ACA (and then defunded by Congress), you will go bankrupt — as many did in the last two years.

The sweet spot? The median premium price or a little below it. Even being a bit above it is not bad. So greater competition among health plans will not drive real price competition into the healthcare market.

Health plans’ incentives: Health plans’ profit (or margin) comes as percentage of the cost of healthcare (a percentage that is capped under the ACA). Any health plan that disrupted the market by truly devising a way to provide healthcare for half as much would be cutting their profit (margin) per account in half. So health plans actually have no incentive to seriously drive the cost of medical care lower.

Government programs such as Medicare and Medicaid do try to drive costs lower, but their attempt is blunted by the need to offer everyone meaningful coverage, which means they have to entice providers to accept these lower payments, without the power to force providers to take them.

Consolidation: In addition, private health plans’ ability to drive price signals into the market is quite limited, because the strongest providers in any given market have some immunity to demands for seriously lower prices. If you are selling a health plan in New York and you can’t offer your customers access to (for instance) NYU Langone, or the Northwell system, your health plan is going to lose market share. This is the main reason why the healthcare system has been undergoing rapid consolidation in recent years and will continue to: Stronger market presence allows them to resist the price demands of insurers.

Fee for service: What’s the question that defines a “customer”? We can consider an individual customer or, for instance, an employer as a proxy customer paying for its employees’ healthcare. Any true customer would ask (for instance) “How much will this new knee cost me, all in?” But most of healthcare is not sold bundled that way, it is sold per item, with each test and procedure billed separately, each surgeon and anesthesiologist and radiologist billing separately, according to negotiated billing codes. Most typically the customer or payer cannot know the cost until they see the bill.

This creates a powerful incentive for the hospital to do more billable items, to do more complex items, and to bill for everything possible at the highest price possible. Examples: I have seen hospitals bills with a $40 charge for handing a mother her brand-new baby, or a $600 line item for “NaCl .01 infusion therapy” which is actually a bag of water with a teaspoon of salt whose wholesale cost is 69 cents.

The fee-for-service payment system is the core of the problem. It incentives the wrong economic behaviors and punishes the right ones.

“Selling insurance across state lines:” Won’t help. Health plans already can and do sell nationally: Aetna, United, Anthem … This phrase is really a call to gut states’ ability to regulate health insurance within their boundaries. But regulation is not what keeps health plans from competing in state markets. The most heavily regulated states, such as California, New York, and Massachusetts, are also the states with the most health plan competition.

Health plans hesitate to go into competition in a new state because it is a difficult, expensive, and risky business proposition. You have to build networks of providers across the state, build considerable infrastructure, woo major accounts (such as employers) away from their traditional relationships, and set aside capital to service the accounts. If you’re a for-profit business, the question often is, “Why bother?”

Vouchers and tax credits: Speaker Ryan’s proposed tax credits, like other Republican proposals for Medicare as well as an ACA replacement, in effect turn the government’s involvement into a “defined contribution” program: “We’ll give each individual X dollars per year to buy health insurance. That will automatically set a price point that all health plans will compete to hit, and that will bring health premiums down.”

But health plans have to set their premiums high enough to pay for medical care, regardless of the size of the voucher. In a code-driven, fee-for-service payment system their price signals will still have a very weak effect on the industry costs. The main effect of such vouchers and tax credits will be to transfer much more of the cost of healthcare to the individual, which will drive many of them out of the market. That in turn will drive premiums even higher, because of adverse selection: The only people getting health insurance will be those who feel they both need it and can afford the premiums and deductibles — not only higher income people but sicker and older people.

So: The attempt to drive price signals through health plan competition will not work to lower the cost of healthcare in aggregate or for individuals.

What will work?

There exist many other models of actually paying for medical care beyond the fee-for-service model. These models drive value competition directly between medical providers and drive both individuals and payers (such as employers) into customer-like behaviors, and so drive strong price signals into the market. What is needed is not one model, but a variety of payment models supporting different business models across the system. To mention a few: bundled payments, medical tourism, direct-pay primary care, reference pricing, on-site clinics, capitation, mini-capitation, risk contracts.

These models exist, and their use is spreading, it’s a new movement mostly in the private markets. Medicare is pushing what I consider “lite” versions of them on the industry. The healthcare industry’s name for this new movement is “volume to value” or “value-based purchasing.”

What will work: Keeping an ACA-like system alive while reforming payment models to drive the market into customer-like behavior; that is, changing what we pay for from stuff we do to people (volume) to making people healthy (the value we want).

Recommended strategies:

1) Preserve the ACA (or an ACA-like system) and expand Medicaid. This would require more than just not repealing the ACA immediately. The ACA needs shoring up and patching or it will implode quite soon, as more health plans exit more markets and premiums for the rest rise rapidly. Letting the ACA fail by continuing to cripple it will not only be a political morass, it will also do serious damage to the healthcare industry, which will lose tens of millions of paying customers.

2) Reformulate the ACA (or its replacement) at the same time to require health plans to offer and support the numerous ways of paying for healthcare that are not fee-for-service but are value-based and that promote competition among healthcare providers.

3) Use Medicare funding to be far more aggressive in pushing the industry off the fee-for-service model and into the numerous other payment models that are appearing.

4) Negotiate drug prices. Easiest model: Allow large buyers of drugs (such as health systems) to buy on the world market through any nation or company that meets FDA standards for production and importation (as most advanced countries do). Peg U.S. government prices to prices in Canada and the EU.

By the way, pharmaceutical companies make a profit in those other markets. They claim high development cost, but seriously, this is much like Hollywood financing, where even blockbusters are often claimed to make no above-the-line profit. Next step: Fund most fundamental and translational drug development federally, then license drug companies to formulate and market the drugs.

5) Expand Medicaid but with non-fee-for-service models such as those that have grown up recently (particularly in Republican-governed states) that seem to be successful in providing lower-cost but more effective healthcare. These risk-based “population health” programs are good for the patients, profitable for the insurance companies (because they can lower the cost of good care and eliminate waste), and good for the healthcare providers, because they greatly lower the burden of uncompensated care.

6) Streamline the regulatory burden on healthcare providers, which has multiplied many times in recent years. The most rapidly-growing part of the hospital sector is the compliance department.

Political support

Politically, the main problem for this strategy is that it will not drop costs overnight. Market-based reforms such as these are more effective at dropping the actual costs of healthcare but take longer.

The main political advantage is that Republicans can claim to have supplanted Obamacare with something better, with a different, new idea — and Democrats can claim to have preserved coverage for everyone while eventually lowering costs. Healthcare reform has become a quagmire for both parties, with little hope of declaring victory for either side. This strategy offers a way out of that quagmire.

Some of these points would be very difficult for many Congressional conservatives to vote for (such as allocating more money for the ACA to make it truly affordable for lower income people). On the other hand, any replacement for the ACA will require some Democratic support, especially in the Senate. Any solution in this Congress must be at least somewhat bipartisan.

Other points would be very welcome to a market-oriented conservative, as they are all about driving true market competition rather than dictating prices from above.

Some points would be fiercely opposed by some portions of the industry, especially setting drug prices. But the pharmaceutical sector has very little support among the public for its prices. Any politician who can claim to have helped drive down drug prices would be a hero to the voters, especially the AARP voter.

The bulk of the healthcare sector (such as health plans, healthcare providers, device manufacturers and other suppliers) could deal with most of these points, as they already have been dealing with milder versions of them these past eight years, and adjusting rapidly.

I believe from my long experience that the medical providers (such as the American Medical Association and the American Hospital Association) would not oppose them, especially if regulation streamlining were strongly implemented. The American Hospital Association’s strategic plan for the next five years, for instance, touts “volume to value” and business model innovation as strategic goals for the industry.

Strategy summary:

Keep an ACA-like system alive while reforming payment models to drive the market into customer-like behavior.