Fee for Service Means Too Many Services

Imagine if, at the height of the Great Society, Lyndon Johnson had given older Americans a right to free economic advice — to help them plan for retirement, say — and paid for it on a fee-for-service basis.

Initially, the program would have provided modest and inexpensive advice to generally uninterested retirees. But over time, clever and ambitious economists would have created scores of expensive new consulting services, all paid for by the federal government. This payment system would have led to the constant creation of marginal services that trapped taxpayers in a spiraling circle of rising costs and excessive services.

Unfortunately, we did just this in health care. When Medicare and Medicaid were introduced in 1965, it seemed reasonable to pay providers on a fee-for-service basis. That’s how most private insurers worked, and there just weren’t that many procedures out there. But over time, a fee-for-service model creates huge incentives to produce expensive new services.

Doctors and hospitals might dispute the suggestion that financial considerations influence patient care. Yet the economic evidence is clear: When Medicare and other health care payers guarantee a fee for every service, patients will receive a lot of services.

A recent paper by economists Jeffrey Clemens and Joshua Gottlieb examined the impact of Medicare fees on service provision and health outcomes. (Note: I have served as an academic adviser to both authors.) Medicare reimbursement rates differ from place to place, so that providers in high-cost markets will receive higher rates than those in cheaper ones.

But in 1997, reimbursement maps were redrawn, so that some areas that once received low reimbursements — such as Cape Cod and the islands — were rezoned and began receiving higher payments. After looking at the services patients received before and after the price changes, Clemens and Gottlieb estimated that a 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} increase in rates led to a 5{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} increase in the amount of care that the typical patient received. Higher reimbursement rates particularly encourage the spread of new technologies, like the purchase of magnetic-resonance imaging machines by non-specialists.

Higher spending and more services would be a good thing if they led to dramatic health benefits. But Clemens and Gottlieb found no link between higher reimbursements and better health outcomes. Their finding joins a long list of papers finding little positive connection between medical spending and health outcomes; indeed, my colleagues Kate Baicker and Amitabh Chandra uncovered a distinctly negative correlation between Medicare spending per patient and health outcomes across states. The more Medicare spent on each patient, the worse the result.

While these findings are disturbing, they also suggest the possibility of reducing costs and improving outcomes simultaneously. That dramatic shift is exactly what the Massachusetts Legislature is groping for a way to encourage. Having found a way to extend coverage to nearly everyone, lawmakers need to insure that care is both effective and affordable.

Perhaps the boldest proposed solution is to provide medical care through so-called accountable-care organizations, or ACOs, which typically pay care providers a per-patient fee, not procedure by procedure. This eliminates the incentive to perform unnecessary but expensive procedures, but it creates the old HMO problem: a strong incentive to deny costly procedures.

To combat this tendency, ACOs have total responsibility for a patient’s care and can be paid based on the results. When financial incentives take patients’ health into account, providers have little incentive to deny necessary procedures. Meanwhile, hospitals and doctors — who resent second-guessing by HMOs and other insurers — should be more likely to hold back on unnecessary tests if the pressure to do so comes from within their own organizations.

I’m not sure accountable-care organizations will provide a perfect solution. But ever-increasing health costs pose a threat to America’s economic future, so the current situation has to change. That means changing the fee-for-service system. While health care decisions are sometimes life-or-death matters, and are often fraught with emotion, the health care industry is still subject to the laws of economics. v

Edward Glaeser is director of the Taubman Center for State and Local Government at Harvard Kennedy School, and author of the book “The Triumph of the City.”