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Confessions of a Price Controller

Saturday, October 30, 2010

The government price controls in America’s healthcare system always push prices up. Here’s why.

The Wall Street Journal reports that Medicare pays too much for specialist services and too little for primary care—even though doctors themselves decide how the money should be divvied up. That drives up the cost of the program and intensifies the shortage of primary-care doctors needed to care for the 32 million people who will get health coverage over the next few years.

This is neither surprising nor new, at least to me. I oversaw the study that created Medicare’s physician payment mechanism during the 1980s; I oversaw the implementation of that mechanism during the early 1990s; I am currently an appointed member of a state commission that sets prices for hospitals—and for those 25 years, I have been arguing that price controls are the wrong way to go.

Faulty Premise, Faulty Prices

Medicare’s physician payment system was developed by Harvard professor William Hsiao and put into place in 1992. The Resource-Based Relative Value System (RBRVS) is founded on the simple, but incorrect, view that higher payments are justified for services that require greater inputs—ignoring the consumer side of the market.

The problem for a government price controller is that he can never know when the price structure is ‘right.’ The bias is always to raise prices, not lower them.

The RBRVS makes sense, superficially. It pays more for services that require more physician work or that involve higher costs to maintain a practice. Compared with routine primary care, heart surgery is more physically demanding, with long hours in the operating room, more stressful since the patient’s life may depend on how well the surgeon does his job, and requires more advanced training. Heart surgeons also have higher practice costs, including more expensive medical liability coverage. Five minutes of a heart surgeon’s time requires greater resource use than five minutes with a pediatrician, and in a properly functioning market the surgeon would receive greater compensation.

But what happens if technology changes and heart disease can be cured with a pill? The need for heart surgery would disappear, but Medicare’s payment rate for the surgery would not change. Even though it is no longer needed, the input cost of heart surgery would remain unchanged at its high level, and that is what determines Medicare’s payment. Contrast that with a market without such price controls. If the demand for a service fell to zero, so would the price, providing a strong incentive for physicians to move into another line of medicine where their services were needed.

In a market without such price controls, if the demand for a service fell to zero, so would the price, providing a strong incentive for physicians to move into another line of medicine where their services were needed.

This is an exaggerated example, but it demonstrates the point. Prices must respond to both the supply and demand sides of the market to allocate resources to their best use. Medicare ignores the market, setting prices for physician services based on an academic theory with its roots in the Soviet Union and implemented by the American Medical Association. Those prices do not reflect the value patients receive from their care, and they do not reflect shifts in the demand for particular kinds of services (such as primary care) as the population ages or as more people have health insurance.

It’s Worse Than That

Medicare’s experience demonstrates how hard it is for a government agency to set physician payment rates that clear the market. Some prices are too low, requiring patients to wait for treatment or even go without as the demand for those services exceeds the supply. Some prices are too high, unnecessarily raising the cost of Medicare to the taxpayer as physicians respond to the incentive to use more expensive services—even when those services do not produce better outcomes for patients. If the prices are not right, the consequences are unavoidable.

The problem for a government price controller is that he can never know when the price structure is “right.” He can know when physicians are unhappy with their prices because they will complain, but that does not necessarily mean that those prices should be raised. He cannot know when prices are too high, because physicians benefiting from that mistaken generosity will not complain. The bias is always to raise prices, not lower them.

Medicare tries to solve that problem by limiting how much average prices may rise using the infamous sustainable growth rate (SGR) formula. That formula sets an arbitrary limit, unrelated to conditions in the market for physician services, on year-to-year increases in physician payment rates. Just as the price controller cannot know the “right” structure of relative prices, he also cannot know the “right” average price or its rate of growth. Again, the only signals come from those who want more, not less.

The inevitable result is that Congress breaks its own price control rules. In an annual rite of political contrition, Congress overrides the cuts in Medicare physician payment called for by the SGR. To maintain the fiction that someday we will take those reductions, they are pushed off to the next year—compounding both the amount to be cut and the political problem. As a result, Medicare is scheduled to reduce physician fees by 23 percent on December 1, and another 6.5 percent on January 1. Cuts of that magnitude are political suicide, and if imposed would cause millions of senior citizens to lose needed care.   

Going to Detox?

Price controls are like crack to an addict. You can’t live without them, but they will be the death of you. The recent healthcare overhaul legislation should have taken the first steps toward withdrawal, but did not. Let’s hope a Republican Congress will have the guts to start pulling the needle out of our arms.

Joseph Antos is the Wilson H. Taylor Scholar in Health Care and Retirement Policy at the American Enterprise Institute.

FURTHER READING: Antos also wrote, “Still No Good News for ObamaCare,” "A Mistaken Prognosis for Medicare,” “Reform Essentials,” “Rethinking Health Reform,” and, with Thomas Miller, “A Better Prescription” for healthcare reform.


Image by Darren Wamboldt/Bergman Group.


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