Health Care Policy and Regulation

HEALTH CARE POLICY ANDREGULATION

Topics in Regulatory Economicsand Policy Series

Michael A. Crew, EditorSchool of Management-Rutgers UniversityNewark, New Jersey, U.S.A.

Previously published books in the series:

Rowley, C., R. Tollison, and G. Tullock:PoliticalEconomyofRen~Seekmg

Frantz, R.:X-Efficiency: Theory, Evidence and Applications

Crew, M.:Deregulation and Diversification of Utilities

Shogren, J.:The Political Economy of Govemment Regulation

Hillman, J., and R. Braeutigam:Price Level Regulation for Diversified Public Utilities

Einhorn, M.:Price Caps and Incentive Regulation in Telecommunications

Crew, M.:Competition and the Regulation of Utilities

Crew, M., and P. Kleindorfer:Competition and Innovation in Postal Services

Thompson, H.:Regulatory Finance: Financial Foundations of Rate of Return Regulation

Crew, M.:Economic Innovations in Public Utility Regulation

Crew, M., and P. Kleindorfer:The Economics of Postal Service

Crew, M., and P. Kleindorfer:Regulation and the Nature of Postal and Delivery Services

Oren, S., and S. Steven:Service Opportunities for Electric Utilities: Creating Differentiated Products

Kolbe, A.L., W.B. Tye, and S.C. Myers:Regulatory Risk: Economic Principles andApplications to Natrual Gas Pipelines

Pechman, C.:Regulating Power: The Economics of Electricity in the Information Age

Gordon, R.K.:Regulation and Economic Analysis: ACritique over Two Centuries

Blackmon, G.:Incentive Regulation and The Regulation of Incentives

Crew, M.A.:Incentive Regulation for Public Utilities

HEAL TH CARE POLICY AND REGULATION

edited by

Thomas A. Abbott, 111 Graduate School of Management Rutgers University Newark, New Jersey, U.S.A.

Springer Science+Business Media, LLC

ISBN 978-1-4613-5932-6 ISBN 978-1-4615-2219-5 (eBook) DOI 10.1007/978-1-4615-2219-5

Library of Congress Cataloging-in-Publication Data

A C.I.P. Catalogue record for this book is available from the Library of Congress.

Copyright<!:> 1995 by Springer Science+Business Media New York Originally published by Kluwer Academic Publishers in 1995 Softcover reprint ofthe hardcover 1st edition 1995 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo-copying, recording, or otherwise, without the prior written permission of the publisher, Springer Science+Business Media, LLC.

Printed on acid-free paper.

CONTENTS

Authors and Discussants vii

Preface and Acknowledgements ix

1 IntroductionThomas A. Abbott, III 1

PART I-HEALTH CARE REFORM 112 Lessons from Public Utility Regulation for the 13

Economic Regulation of Health Care Markets: AnOverviewThomas A. Abbott, III, and Michael A. Crew

Comments 38Warren Greenberg

Comments 41Geoffrey Liss

3 Regulatory Strategies Under Managed Competition 45Health Care ReformsMark Schlesinger

Comments 73John Ciccone

4 Health Care Cost Containment in Connecticut 81L. Spencer Cain

5 Health Care Reform in New Jersey 93Pamela S. Dickson

6 Health Security Act: Summary And Impact 97Ronald Rouse, Philip Vernon, Linda Stackman, andKeith Servis

v

vi HEALTH CARE POLICY AND REGULAnON

PART II-PRICE REGULATION 103

7 Regulating Pharmaceutical Prices 105Thomas A. Abbott, III

Comments 135Alison Keith

8 Hospital Price Regulation: Evidence and Implications 143for Health Care Reform

Jack Hadley

9 Paying Physicians as Agents: Fee-For-Service, 163Caption, Or Hybrids?Mark V. Pauly

Comments 175Beatrice E. Manning

Comments 177David W. Lee

PART III-QUALITY REGULATION 181

10 Medical Practice Guidelines and the Efficient 183Allocation of ResourcesJohn A. Rizzo and Jody L. Sindelar

Comments 200Kathleen A. Weis

11 Contending Views of Quality Management in Health 205Care: Implications for Competition and RegulationDavid Blumenthal and Richard Bohmer

Comments 222Malcolm G. Coblentz

Comments 224Martin Gaynor

12 Measuring and Improving Quality in Health Care 231Mark R. Chassin

Comments 236James F. Burgess, Jr.

Comments 240Paul M. Schyve

Glossary 243

AUTHORS AND DISCUSSANTS

Thomas A. Abbott, HI, Assistant Professor, Rutgers University

Robert Barnett, Assistant Director, Office of Health Systems Management,Division of Health Care Financing, New York Department of Health

P. George Benson, Dean, Rutgers University

David Blumenthal, MD, Massachusetts General Hospital

Richard Bohmer, MD, Clinical Director of Quality Improvement,Massachusetts General Hospital

James Burgess, Economist, Department of Veterans Affairs

L. Spencer Cain, Chief Analyst, Connecticut Legislative Program Review andInvestigations Committee

Mark Chassin, MD, Commissioner, New York Department of Health

John Ciccone, MD, President, Health Partnership for Quality Reform

Malcolm Coblentz, MD, St. Barnabas Medical Center

Michael A. Crew, Professor and Chair, Department of Finance-Economics,Rutgers University

Pamela S. Dickson, Assistant Commissioner, New Jersey Department of Health

Martin Gaynor, Assistant Professor, John Hopkins University

Gerry Goodrich, President and CEO, Irvington General Hospital

Warren Greenberg, Professor, George Washington University

Joseph Guy, Director, Bureau ofMedicaid Management Information Systems,New York Department of Health

Jack Hadley, Director, Institute for Health Care Research and Policy,Georgetown University

Michael Hoffman, Director of Research, Commission on Hospitals and HealthCare

Alison Keith, Director, Economic Analysis, Pfizer Pharmaceuticals

vii

viii HEALTH CARE POLICY AND REGULAnON

AI K1evorick, Deputy Dean, Cowles Foundation, Yale University

David Lee, Economist, American Medical Association

Geoffrey P. Liss, Executive Secretary, New Jersey State Department of Health

Beatrice Manning, MD, New Jersey Department of Health

Mark V. Pauly, Professor, University of Pennslyvania

John Rizzo, Assistant Professor of Public Health, Yale University

Mark Schlesinger, Associate Professor for Public Health, Yale University andRutgers University

Paul Schyve, MD, Senior Vice President, Joint Commission on Accreditation ofHealth Care Organizations

W. Robert Simons, Director, PRACON Consulting Services

Jody Sindelar, Associate Professor, Yale University

Kathleen Weis, Senior Epidemiologist, Agency For Health Care Policy andResearch

PREFACE AND ACKNOWLEDGEMENTS

This book is the result of three one-day Health Care Policy and RegulationWorkshops held at Rutgers-The State University ofNew Jersey during the Springof 1994 and sponsored by The Robert Wood Johnson Foundation. These workshops brought together over 70 academics, government health care regulators andadministrators, health care providers, and other health industry representatives todiscuss issues involved in health care reform and regulation. Although there weresome disagreements about how best to accomplish it, everyone at the workshopswas interested in putting aside self interest and improving health care delivery inAmerica. These discussions yielded many new insights into the complex issuesinvolved in reforming health care delivery and increased everyone's awareness ofthe struggles ahead of us. The views expressed in the following chapters andcomments are those of the authors and do not necessarily reflect those of the sponsoror the author's affiliated institutions.

There are a large number of people who played important roles in puttingtogether these workshops and this volume. In particular, I would like to thank themembers of the organizing committee, without whom's help the Health Care Policyand RegulationWorkshop would have remained just an idea in the back ofmy head.In particular, I would like to thank Joel Cantor of The Robert Wood JohnsonFoundation; Jody Sindelar, Donna Diers, and Bradford Gray of the Department ofEpidemiology and Public Health, Yale University; Robert Barnett ofthe New YorkDepartment of Health; Jack Croweak of Blue Cross-Blue Shield of Connecticut;Kenneth Raske of the Greater New York Hospital Association; Nancy Wolff of theInstitute for Health, Health Care Policy, and Aging Research at Rutgers University;and Michael Crew, Director of the Center for Research in Regulated Industries atRutgers University.Many thanks are also owed to the distinguished speakers and discussants who

took part in these workshops. A complete list can be found on pages vii-viii.Without their efforts and cooperation, neither the workshops nor this book wouldhave been possible.I would especially like to thank Michael Crew, Director, Linda Brennan, Administrative Assistant, and Kathleen Rutledge, Senior Clerk, at the Center for Researchin Regulated Industries. Without the Center's full support, the task organizing theworkshops would have been impossible. Not only did Linda provide excellenteditorial assistance, but she also prepared the final camera-ready manuscript which

ix

x HEALTH CARE POLICY AND REGULAnON

made speedy publication possible. Kathy's expert administrative assistance madeit possible to go from the concept of the workshop to the first meeting in less thanthree months. Moreover, it was her oversight that kept the workshops runningsmoothly despite the problems of inclement weather and missing speakers. Theusual disclaimers apply, none of the individuals named here is responsible for anyerrors. The views expressed are the views of the authors and not of their companiesor affiliations or of the sponsor.

THOMAS A. ABBOTT, III

1HEALTH CARE POLICY AND REGULATION:

INTRODUCTION

Thomas A. Abbott III

To say that Health Care in America is changing is to grossly understate therevolution which has overtaken the delivery, financing, and regulation ofAmericanhealth care services during the 1990s. These changes will continue as pressuresbuild from employers, citizens, and health care providers for changes which meetthe apparently conflicting goals of Security, Simplicity, Savings, Quality, Choice,and Responsibility and as Congress grapples with developing legislation which canpass both Houses. At the same time, many states are not waiting for Congress toact, but are going ahead with their own reforms, in an effort to meet the growinghealth care needs of their populations. Meanwhile, a number of important developments are taking place in the private sector, as employers shift more of the costof health benefits to employees; as managed care organizations grow larger anddevelop networks of associated providers; as the pharmaceutical industry undergoes a major structural change through mergers, alliances, and vertical integration;and as the hospital sector goes through a process of mergers and consolidations inan effort to resolve the problems of excess capacity and over investment intechnology. Thus, even without major legislation from Washington, Health Carein America will never be the same.This volume is an outgrowth of the Health Care Policy and Regulation Work

shops held at Rutgers University during the Spring of 1994. These workshopsattempted to do what the Clinton administration failed to do with its 500 memberHealth Reform Task Force-they brought together academics, government healthcare regulators and administrators, health care providers, and health industryrepresentatives to discuss issues involved in health care reform and regulation.Despite a few contentious moments, we found that there was a great deal ofagreement, and self interest did not reign. Although there were disagreementsabout how best to accomplish it, everyone wanted to improve health care deliveryfor everyone. Moreover, everyone realized that the rising costs of health care werecreating pressures to "do something" and that it was better to be involved in shapingthat something, than to allow self interest to lead them astray.Although no concrete proposals arose from these discussions, the papers and

comments in this volume illuminate some of the important issues involved in health

2 HEALTH CARE POLICY AND REGULAnON

care reform and frame the question of what is the proper role of public policy inthis area. This volume is divided into three main parts: Health Care Reform; PriceRegulation; and Quality Regulation.

Part I: Health Care Reform

The first part focuses on the issues of health care reform. It contains six chapters.In chapter two, Michael Crew and I examine the lessons from public utilityregulation for regulating health care markets. In chapter three, Mark Schlesingerexamines the role of health alliances in shaping the outcomes of managed competition. Current health care reforms in Connecticut, New Jersey, and New York arethe subject of chapters four through six.Part I begins with a chapter by Michael Crew and me on the lessons from public

utility regulation for the regulation of health care markets. While this may seemodd, we feel it is a natural place to begin. The objectives of public utility regulationare nearly identical to those ofHealth Care Reform: to promote universal (or nearlyuniversal) access while controlling overall costs. Moreover, the basic tools ofpublic utility regulation-price setting, quality controls, mandated services, andselective competition-are those available for health care reform.At the same time, there are fundamental differences between the markets for

health care services and public utilities. Foremost, the market for health careservices is much more complicated than that of traditional public utilities. It iscomplicated because the services are more complex and because of the existenceof incomplete information and health insurance, which lead to agency and moralhazard problems. Finally, in the case of public utilities, it is conditions of naturalmonopoly which provide the source of market power; while in health care, it is theexistence of incomplete information, insurance contracts, and moral hazard whichallow providers to charge prices in excess of marginal cost.Although, these differences exist, they should not be over stated. If current

trends in health care continue, the consolidation of purchasers and providers intolarger groups and the elimination of traditional indemnity insurance will transformthe health caremarket into one which more closely resembles that ofa public utility.In this case, we expect that the traditional sources of market power-the ability toswing large numbers of customers from one provider to another-will replace thecurrent ones in health care markets. In this new environment, there will be a needto channel these market forces in socially desirable directions, and regulators willundoubtedly rely on some of the traditional tools of public utility regulation toaccomplish this goal. As a result, our review of the lessons learned from publicutility regulation may foreshadow things to come.In chapter three, Mark Schlesinger examines the role of the health alliance in the

proposed managed competition environment. The central thesis of this chapter isthat the health alliance needs to take a much more active role in balancing theinterests of patients, providers, and society ifmanaged competition is to produce asocially desirable allocation of medical resources. He arrives at these conclusions

INTRODUcrION 3

after considering the effects of three key aspects of the health care market: 1) theeffect of moral hazard and benefit extranalities, 2) the complex relationshipsbetween patients, physicians, and plans, and 3) the existence of asymmetricinformation. Taken together, these features create a chain of principal-agentproblems (between patient-physician, physician-plan, and plan-society) which leadSchlesinger to conclude that the role of the health alliance must go beyond simplyorchestrating enrollment, collecting premiums, and disseminating information.Specifically, Schlesinger argues that in order to overcome these problems and

arrive at a socially-optimal outcome, the health alliance must take a pro-active rolein shaping the incentives and actions of patients, physicians, and health plans byaltering the balance of power between these groups using the concept of countervailing agency. That is, health plans, physicians, patients, and society all desiredifferent levels of treatment because of different financial incentives and differentvalues placed on the extranalities ofmedical treatment. In the managed competitionenvironment, the level of treatment for each condition will be determined bynegotiations between patients, physicians, and the health plan. By altering thebalance of power, the health alliance can act as an agent for society and move thetreatment level in the desired direction. Without such actions, the resulting treatment levels would depend on the characteristics of each market. In markets wherephysicians affiliate with many different health plans, they could exert market powerand push the treatment levels in their direction; while in markets where there areonly a few or one health plan, the health plan would dictate the treatment level. Byintervening in the market and altering the balance of power, the health alliance canshift treatment levels towards the socially desired levels.There are several mechanisms the alliance could use to influence the outcome

of these negotiations. First, the alliance could either make it more or less difficultfor patients to switch health plans or make health plans pay a penalty wheneversomeone left their plan. Such moves would shift the balance of power between thepatient and health plan and could more closely align the plan's financial interestswith those of the patient. Alternatively, taxes and subsidies could be used toinfluence the attractiveness ofcertain individuals or certain types of treatment (e.g.,preventive services). There are also several ways the alliance can shift the balanceof power between physicians and health plans. One way would be to restrict thefinancial incentives and other contractual arrangements that health plans use to alterphysician behavior-tighter restrictions on these practices would give the physicians relatively more power, while weaker restrictions would give the health planrelatively more power. A second method would be restrictions on the exclusivityarrangements. Passing "any willing provider" regulations and allowing physiciansto associate with multiple plans would give physicians relatively more power.Thus, rather than leave the negotiated outcomes to the vagaries of the marketstructure, by shifting the balance of power between patient, physicians, and healthplans, the health alliance can influence the level of treatment and improve socialwelfare.

In chapter four, L. Spencer Cain examines the changes under way in Connecti-

4 HEALTH CARE POLICY AND REGULATION

cut. He discusses several proposals made by the Legislative Program Review andInvestigations Committee and the legislation enacted during the 1994 session.Specifically, Connecticut has moved rapidly away from the rate regulation of the1980s and towards fully embracing managed competition. Many of the proposalsare directed at facilitating the development of integrated health plans and competitive health plan purchasing cooperatives. As part of this effort, legislation waspassed which eliminated the hospital rate regulation and permitted hospitals andhealth plans to negotiate rates-injecting competition into this formerly heavilyregulated sector. In addition, Public Act 94-3 centralized the regulatory authoritywhich was formerly spread across several state agencies into the Office of HealthCare Access. This new office is charged with developing policies to facilitatecompetition in the state, to consolidate heath regulation and financing in oneagency, and to achieve the goal of universal coverage for the state by 1997. Finally,legislation was passed to establish the Connecticut Health Data Institute. Thisinstitute is charged with creating a state-wide repository for centralized cost andquality data which can be used by both the public and private sectors to monitor,evaluate, and regulate the market for health care.In Chapter five, Pamela Dickson examines recent changes in health care regu

lation in New Jersey. In July 1991, the Health Care Cost Reduction Act was signed.The basic objective of this act was to try to control the runaway costs of uncompensated care in New Jersey by capping the surcharge paid by all hospital patientsat 19.7%. In November 1992, the Health Care Reform Act of 1992 was passed.Among other things, this act abolished the hospital rate setting structure in NewJersey and permitted hospitals to compete on the basis ofcharges. In addition, thesereforms dramatically altered the health insurance market in New Jersey by: 1)establishing standardized benefits packages every insurer must offer, 2) guaranteeing open enrollment with portable coverage for pre-existing conditions with aone-time, twelve-month waiting period, 3) mandating community rate for theseprograms, and 4) establishing subsidy programs for working people and thosetemporarily unemployed. The impact of these changes can already be seen throughout the state.In Chapter six, Ronald Rouse et al. discuss the impact of the Health Security Act

on New York state. Their analysis reveals a number of key areas where the HSAmight adversely affect the ongoing efforts ofNew York state to provide health carefor its citizens. Specifically, the authors raise issues concerning the equity of thefinancing mechanisms proposed within the HSA, as well as practical implementation issues. Can a single, high-quality standard of care be achieved? At what cost?And will managed competition actually be able to constrain costs, or will additionalmechanisms be needed? If adopted, the HSA would also force New York torestructure its current health care programs. What is the best way to conform tothe new legislation, while still serving the special needs of New York citizens? Iam sure that these, and many of the other concerns raised in this thought provokinganalysis, echo the concerns of officials in many other states when considering theimpact of the new and extensive federal mandates contained in the proposed health

INTRODUCTION

care reforms.

Part II: Price Regulation

5

The second part of this volume examines the role of price regulation in controllinghealth care costs. It contains three chapters. In chapter seven, I examine thealternatives for regulating pharmaceutical prices. In chapter eight, Jack Hadleyexamines the impact of various forms of hospital price regulation; while in chapternine, Mark Pauly examines the role ofprice regulation in controlling physician fees.Chapter seven focuses on the issue of regulating pharmaceutical prices. There

are two key issues examined in this paper. First, is there a clear need for priceregulation, and second, can price regulation work in this industry? In response tothe first question, I come to the conclusion that the proponents of price regulationhave not really proven their case. Although the financial returns in the pharmaceutical industry have been slightly higher than expected during the 1970s and 1980s,there is not overwhelming evidence of "price gouging" or excessive profits on thepart of the industry.In response to the second question, the answer is clearly no. The traditional

approaches to price regulation will not have the intended affect of eliminatingexcess profits from the industry while maintaining the incentives for research anddevelopment. First, rate-of-return regulation, the most natural approach, wouldresult in many adverse incentives-including excessive investment in research anddevelopment in order to inflate the rate base used to calculated the allowable returns.Second, price-cap regulation (PCR), the newest darling of regulatory economistsbecause of the built in incentives for productive efficiency, would also fail in thisindustry because of its dynamic nature. New products are always being introduced,and old products are replaced. Because PCR does not have a mechanism for settingthe introductory prices of new products, the rapid life cycle in the pharmaceuticalindustry would permit the firms to manipulate the index. Moreover, the price-capindex itself encourages firms to raise the launch prices of new drugs. This wouldhurt consumers in the short run and, depending on the discount rate, even in thelong run. Finally, although there is a natural appeal to using cost effectiveness asa pricing criterion, it is my opinion that the methodology behind these studies istoo easily distorted to provide a firm basis for these regulatory decisions. Thus,even if there were strong reasons for regulating prices, there is no firm foundationon which to rest price regulation of this industry.In chapter eight, Jack Hadley reviews the impact of hospital price regulation. In

particular, he examines three fundamental questions: what forms of hospital priceregulation are available? What is the evidence of their effectiveness? And shouldhospital price regulation be part of health care reform? In examining the firstquestion, Hadley reviews the history of hospital fee regulation under the Medicareprogram, starting with the early reasonable cost reimbursement and advancing tothe prospective payment system (PPS) currently in use. In examining the impactof PPS, Hadley observes that the rate of increase in Medicare spending slowed


dramatically after the introduction of PPS in 1983. At the same time, Hadleyexamines the issue ofcost shifting and concludes that the evidence that PPS inducedcost shifting is ambiguous. In addition to the Medicare PPS, a number of stateshave adopted rate regulation as a method of controlling hospital costs. Theevidence on these programs is fairly clear; they slowed the growth rate of expenditures. Finally, Hadley examines the role of competition in controlling hospitalcosts and finds that in California, where PPOs have been able to negotiate selectivecontracts with hospitals since 1982, competition between hospitals has also slowedthe growth of hospital costs. Thus, he concludes that both federal and stateregulation and market competition can have an effect on hospital costs.In discussing the role of rate regulation, Hadley observes that most health care

reform proposals continue the existing Medicare program and therefore wouldcontinue its current rate regulation-potentially extending it to fee-for-serviceplans. The Clinton proposal, however, would attempt to use managed competitionto control hospital costs for most of the population. In evaluating this approach,Hadley raises a number of potential flaws with the proposal. Specifically, hesuggests that the health plan may place financial interests ahead of the patientinterests, leading to under treatment. Second, under theClinton proposal, providerswould also consolidate by either merging or forming networks. These mergerswould alter the competitive dynamics of the industry and might interfere with theability of the competitive (i.e., monopsonistic?) pressures to lower prices. Andfinally, he concludes with the warning to "Hope for the best, but prepare for theworst." In this case, the best is that managed competition will be able to constrainhealth care costs while providing high quality care to its subscribers. The worst isthat managed care will fail to deliver on its promise of value. In this case, we needto be prepared to step in and address the remaining problems, whether they beregulating health plan premiums or the cost of services directly.In chapter nine, Mark V. Pauly examines alternative methods for paying physi

cians. He begins by observing that although much of the popular concern has todo with the level of physician income, the real issue from a policy perspective ishow physicians are paid at the margin and the incentives created by alternativearrangements. In particular, Pauly begins his analysis by examining the polar casesof fee-for-service and capitation. He goes on to propose that there exists afee-for-service payment that approaches the first-best outcome, provided thatphysicians have increasing marginal cost of providing services, that there is at leastsome concern about patient well-being, and that individual physicians have sufficiently large patient bases as to minimize variation in their aggregate treatmentneeds. Under these assumptions, he goes on to show how adjusting the fee-forservice component of a two-part payment mechanism leads physicians to producethe desired level ofservice. The fixed component may be used to expand or contractthe overall supply of physicians and to maintain an overall equilibrium in thephysician market.Pauly goes on to examine a number of complicating factors-such as: 1) the

existence of alternative plans, 2) variation in total desired services, 3) patient

INTRODUCTION 7

referral, and 4) uncertainty-demonstrating under which circumstances these couldbe overcome. Finally, he contrasts his fee-for-service component with the RBRVSMedicare Fee schedule-noting that both in theory and in practice they could bequite different.In concluding, Pauly argues that the fee-for-service mechanism creates a won

derful incentive to provide services in a cost efficient manner, if the fee is setcorrectly. However, there are strong reasons to suspect that current fee-for-sel viet:arrangements set the fee too high, inducing physicians to over treat patients andpreventing managed care organizations from achieving ideal outcomes. Althoughthere is a potential for public intervention to move the competitive market in thedirection of optimal physician fees, Pauly is skeptical of the government's abilityto do this correctly and therefore prefers to rely on the "more slowly but perhapsmore surely" evolutionary competitive process.

Part III: Quality Regulation

The final section of this volume examines issues involved in monitoring andimproving the quality of health care. In Chapter ten, John Rizzo and Jody Sindelarexamine the development and implementation of physician practice guidelines. Inchapter eleven, David Blumenthal and Richard Bohmer examine the application ofTotal Quality Management to health care, and in chapter twelve Mark Chassinexamines issues of measuring and improving quality of care.The central thesis of chapter ten, on physician practice guidelines, is that

although practice guidelines have become increasingly popular, not enough attention has been paid to guideline selection and implementation. In particular, howguidelines are presented to physicians has a great impact on whether the guidelinessucceed or fail at improving care-specifically, Rizzo and Sindelar examine theexpected impact of three alternative approaches to implementation: I) dissemination, 2) persuasion, and 3) regulation. Under the dissemination approach, theguidelines are simply distributed on an FYI basis to practicing physicians. Underthe persuasion model, community opinion leaders are used to convince practicingphysicians to adopt the new guidelines. Part of this process entails involving thesecommunity leaders at an early stage to help develop the guidelines. The thirdmodel, the regulatory approach, establishes "penalties" for non-adherence to theguidelines, which might include using the guideline as a defense in malpracticeactions.In examining the impact of these alternative approaches to guideline implemen

tation, Rizzo and Sindelar examine four key dimensions: 1) quality of care, 2) costof patient care, 3) the rate of innovation in medical practices, and 4) medicalmalpractice costs. In the case of the quality of care, Rizzo and Sindelar argue thatthe regulatory approach is likely to have the largest impact. In the context of patientcare costs, they again favor the regulatory approach as having the largest impacton patient care costs. They point out that, although in some instances the guidelinesmay actually increase costs, on balance, they expect them to decrease costs because


of the elimination of ineffective treatments. Rizzo and Sindelar argue that theimpact ofmedical guidelines on the rate of innovations is ambiguous. With respectto medical malpractice costs, they again favor the regulatory approach.They conclude their analysis with an examination of how areas are selected for

guideline development. In this section, they suggest that one should focus onseveral criteria for choosing which guidelines to develop. These criteria shouldinclude: I) the degree of uncertainty across physicians and the potential to reduceit, 2) the expectation that the guideline could be developed in a reasonable periodof time and would not become rapidly outdated, and 3) that the gain fromdeveloping a guideline in this area is sufficient to outweigh the costs.David Blumenthal and Richard Bohmer provide a provocative discussion of the

application of Total Quality Management (TQM) to health care in chapter eleven.They contrast it to the traditional, professional model approach to Quality Management, which attempts to weed out the "bad apples." The authors make a persuasivecase that, in the long run, TQM provides the best opportunity to improve healthcare delivery, however, it necessitates a dramatic change in the way health care isviewed-particularly on the part of physicians. In order to apply the principles ofTQM, one must visualize the provision of health care services as a process madeup of many different steps and provided by a team of health care providers, asopposed to a single unique event provided by a "lone ranger." Once one acceptsthe process interpretation, one begins to view a "bad outcome" as a failure of theprocess (and hence as an opportunity to improve it), rather than a failure of theindividual. At the same time, this new view also means that a success is a successof the process, not of the individual.Although American manufacturing has been slowly adopting this new philoso

phy, the rugged individualist nature of many American physicians suggests that itmight be a long uphill battle for acceptance by today's health care market-although JACHO has placed its full support behind the approach. Nonetheless,Blumenthal and Bohmer have begun to chip away at the professional model bypointing out that today's medical care system has become dominated by largeorganizations and the effective treatment of any single patient requires the coordinated actions of many skilled professionals-not just the attending physician.Moreover, the TQM approach is specifically developed to handle quality issuesthese kinds of situations, whereas the professional model is clearly not capable ofdealing with such complexity. Finally, one need not view the notion of health careservices as a process as being either de-humanizing or overly rigid; one of theprimary tenants of TQM is to first identify the customer needs and then identifyhow one can best meet these needs given the resources available to the firm.In the final chapter, Mark Chassin examines the issue ofmeasuring and improv

ing the quality of health care. In this chapter, he outlines three areas one should beconcerned with: overuse, underuse, and misuse of medical services. Moreover,each of these problems requires significantly different methods of measurement,intervention, and monitoring. With respect to the measurement issues, Chassinpoints out a number of dimensions to be considered when choosing a particular

INTRODUCTION 9

measure. Specifically, one should consider the sensitivity and specificity of themeasure. The sensitivity is the ability of the measure to detect a true qualityproblem, while the specificity is the ability of the measure to avoid false positives.In addition to these considerations, one must determine whether one wants to usean outcome measure or a process measure-in the case of the former, it is importantthat the outcomemeasure is related to the process one is attempting to control, whilein the latter case, it is important that the process measure is related to the outcomethat one is interested in.In attempting to use the selected quality measures to improve quality, there are

three alternative approaches which can be used: regulation, competition, andprofessionalism. Under the regulatory approach, standards are set and individualproviders' measures of quality are compared to these standards-with some formof "punishment" for failing to meet the established standards. Under the competitive approach, information on the quality measures are disseminated to consumersand payers, who in turn choose their health care providers on the basis of theirperformance. However, Chassin points out that to date, there is little evidence thatmanaged care organizations choose providers on the basis of quality measures.Under the professional strategy, these measures of quality are used as part of aContinuous Quality Improvement (CQI) program, which by any other name is stillTotal Quality Management.Overall, Chassin argues that there is no need to choose anyone of these

mechanisms, but that where possible each method should be used to improve thequality of care. The key ingredient is that one must build the necessary measuresof quality and collect the needed data. Moreover, he concludes that, in order tomeet the goals of universal access at an affordable cost, major improvements inquality (particularly with respect to overuse) will need to be achieved.

PART IHEALTH CARE REFORM

2Lessons from Public Utility Regulation for

the Economic Regulation ofHealth Care Markets: An Overview

Thomas A. Abbott, IIIMichael A. Crew

1. Background and Motivation

The Clinton health plan purports to offer a market, rather than government controlled system as a means of "reforming" health care delivery. As such, it aims to avoidbeing branded "socialized medicine," the kiss of death in this country! Although,the plan claims to be market driven, it, nevertheless, has provisions for developingexplicit rate regulation. In fact, medical care is currently highly regulated. It hasrate regulation for a major segment, Medicare and Medicaid, to say nothing of costcontainment efforts which fall just short of explicit regulation. Thus, in view ofthe fact that the door to rate regulation has already been opened, it seems quite likelythat, as the federal government becomes more involved in the delivery of medicalcare to all citizens, it may develop more comprehensive and explicit rate regulation.The principal aim of this paper is to ascertain if there are lessons from recentdevelopments in utility regulation that offer assistance in understanding the increased regulation of health care that can be expected to occur. We confine ourattention to health care delivery only and do not concern ourselves with rateregulation for ethical and OTC drugs, as one of us has examined this at some lengthelsewhere (Abbott 1993).Utility regulation has undergone major changes over recent years, with perhaps

the most important being a better understanding of the costs and benefits. Thisimproved understanding arises from a greater recognition of the effect of regulationon incentives. A second lesson concerns the role of cross subsidies as a device forredistribution. A third lesson involves the role of the rate regulator in monitoringand enforcing quality standards. The interaction between different types of regulations-for example, environmental and rate regulation-has become an increasingly important problem.All of these problems of utility regulation are present in abundance in the

regulation of health care delivery. Indeed, there are additional problems due to the


complex nature of medical care and the institutional arrangements involved inhealth care delivery which are not present in utilities. In particular, principal-agentand moral hazard problems are significant in medical care. Principal-agent problems arise from the information asymmetries involved in the doctor-patient relationship. Patients must rely on doctors to make therapeutic decisions on theirbehalf. In so doing, the doctor may have different objectives than the patient. Hemay prescribe a particular treatment regime because he can earn more money fromit, even though it could cost the patient more or may not be the most effectivemethod of treating the patient's condition. Moral hazard problems stem from thephysician-patient principal-agent problem and from the insurer-patient problem.As most health care is paid for by insurance, the patient (and doctor) have littleincentive for cost economy, since the patient is not paying the full costofthe service.These problems add significantly to the problem of regulating health care.This paper is divided into five sections. In section 2, we examine utility

regulation, including some recent experience and the lessons learned. In section 3,existing health care regulations are reviewed. Section 4 provides a summary anddiscussion of the Clinton Plan. Section 5 examines some of the lessons of utilityregulation for health care reform.

2. Review ofAnalysis of Public Utility Regulation

In reviewing the lessons of utility regulation, we employ the familiar efficiencyapproach in economics, namely the maximization of net benefits. We assume thatthe regulator has the following objective:

Maximize W,

whereW = Net Benefits = Total benefits less total costs

=TR+S-TC, (1)and TR =Total revenue (i.e., gross producer benefit),

TC =Total costs,S =Consumer's surplus (i.e., net consumer benefits).

The justification for regulating natural monopoly is ostensibly rather strong. Itis an attempt to avoid a tradeoff between apparently overwhelming scale economiesand market power.1 In figure 1, a highly simplified case is illustrated. The choiceis between organizing the industry as a single firm, in which case scale economiesare achieved and result in lower average costs ofACs, or organizing the industry asmultiple firms, where average costs would be higher at ACm. It follows from (l)that, in this case, unregulated monopoly would be preferred over multi-firm

Although this analysis is inspired by Williamson (1968), his analysis is directed at the mergerproblem rather than the natural monopoly problem.

LESSONS FROM PUBLIC UTILITY REGULATION

P

PsDead ~ight loss

~

PR Pes

0Q

Figure 1

15

organization, as the cost savings (the diagonally shaded rectangle) exceed the lossin consumer's surplus (the horizontally shaded triangle). Notice, however, that thissolution is not allocatively efficient because price exceeds marginal cost and thereis a deadweight loss equal to the triangle. Note also that the monopolist makesmonopoly profits, the sum of the vertical and the diagonally shaded rectangles. Thedeadweight loss and the monopoly profits provide the justification for regulation.If price were reduced by regulation, the deadweight loss could be eliminated andthe monopoly profits would disappear. In this diagram, if the price were set at PR,we would have apparently attained the holy grail of the efficiency of pure competition along with the scale economies of monopoly. Thus, rate regulation seems tooffer the prospect of not only eliminating inefficiency but also promoting equity.If only it were that easy! The underlying lesson from utility regulation is that it iscertainly not that easy! There are several problems with this analysis.First, this simple analysis assumes that there are no transactions or other costs

of operating the regulatory process. Regulators, like doctors, do not work fornothing! Traditionally, the effects of regulatory induced transactions costs havebeen mostly ignored. An investigation of regulatory transactions costs for NewJersey water companies revealed that such costs are not trivial, at least for smallercompanies (Crew and Kleindorfer 1985; 1987). The bottom line was that only


small amounts of such costs were needed to swamp the benefits of price controlprovided by rate regulation. In health care, where much of the actual delivery ofservices is provided by small firms or single entrepreneurs, the transactions costsof regulation could be enormous. So much for the easy elimination of deadweightloss!Second, this simple analysis ignores the consequences of rent-seeking behavior.

Much ahead of his time, Tullock (1967) saw the existence of monopoly rents, inthe form of the two shaded rectangles, as a potential source of inefficiency.Producers will not passively give up their rents, and indeed, they will find itprofitable to expend considerable resources on rent protection. In fact, they mustprotect these rents from many predators--eonsumers, labor unions, their ownmanagement employees, intervenors, and their regulatory commissions. WithTullock, the rent-seeking literature was born, but it took almost twenty years beforeits implications for regulation were well understood, as demonstrated in Crew andRowley (1988; 1989).2 The net result is that while regulation may be somewhatsuccessful in eliminating monopoly profits, it may not be able to capture the benefitsarising from scale economies for the consumers. There is some evidence to believethat recent changes in public utility regulation have shown some recognition of thisproblem.Finally, the above analysis ignores what have become regarded as important

information asymmetries. This problem arises because the firm's own management has a much better understanding of the firm and its market than outsiders,even well informed regulators. Given this superior information, management is ina position to either mislead the regulator, or extract a "rent" from the regulator inreturn for truthfully revealing the information (Crew and Frierman 1991). As aresult, a regulated firm must be permitted to earn extraordinary profits if it is toremain in the industry.This informational approach highlights the "mutual dependence" relationship

between the firm and its regulator. In return for the right to operate as a monopoly,the regulated firm gives up t".e right to set its prices and takes on an "obligation toserve.,,3 In setting prices, the regulator has three obligations: 1) protecting consumers from the abuse of monopoly power, 2) providing the firm with rates thatgave it the opportunity to earn a "fair" return on its assets, and 3) guaranteeing thefirm's monopoly franchise against entry. These obligations are highly inter-dependent, and the failure to achieve one ofthem may place the other two in jeopardy.

2.1. Rate-of-Return RegulationROR regulation provides a relatively straightforward, albeit naive, way of

2 A notable exception to this was Posner (1969,1975).3 This obligation was not absolute. Every individual is not entitled to a hook-up regardless of

cost. However, the typical utility must serve a significant number of its subscribers eventhough their revenues do not cover their costs.

LESSONS FROM PUBLIC UTILITY REGULAnON 17

trading off monopoly power and scale economies outlined in equation (1), whiletrying to achieve the three objectives outline above.4 This is accomplished bybasing rates on the firm's costs, and allowing it to make a fair ROR on its assets orrate base. The typical formula used is given by:

R= 0 +d+s(V - D), (2)

where R = Revenue Requirements

=PIXI +P2X2 + ... +PnXn;

o =operating expense;d =Current depreciation;s =allowed rate of return;V = gross value of rate base; andD =accumulated depreciation.

In this sense, it is similar to cost-based reimbursement approach used for non-profithospitals, except that there is a outside regulatory commission setting the pricesrather than the hospital board. Under ROR regulation, the regulatory commissionmust determine not only the amount of the revenue requirement, R, but also theindividual prices, Pi'S. In doing so, it must be diligent in the determination of costs.Regulatory commissions perform audits to monitor costs, including whether therate base is padded with unnecessary investments. To achieve this, the commissionmust become involved in micro management of the firm, second-guessing thedecisions of management. This requires a great deal of information, for which itmust rely heavily on the firm's management.5 It has taken many years for thenature, extent, and difficulty of this task to be appreciated. The task is compoundedby the fact that, in determining thePi'S, regulatory commissions have allowed crosssubsidies between different classes of consumers.6 These cross subsidies may bethe result of genuine equity concerns or political activities.There are several significant problems with ROR regulation which have corol

laries in regulating hospital fees. These problems include the following:

1. Because revenues are based on costs, the firm gets more revenues primarilyby getting the regulator to approve a higher cost number. This certainlyattenuates incentives for cost economy and leads to X-inefficiency.

2. The process of rate determination is quasi-judicial, involving lengthy hearingsspread over several months. If the utility wishes to change any of its prices,it has to go through this costly and lengthy process.

4 Some might argue that this was too complimentary a statement about ROR regulation. and thatit was just an argument about equity-a just price and a fair return. See Crew and Kleindorfer(1987. 93-119).

5 A similar situation arises at the hospital. where the hospital administrator must rely on thephysician to determine what resources are needed to treat an individual patient.

6 Hospitals again are quite similar, in that they may use prices to create a cross subsidy from onetype of patient to another.

18 HEALTH CARE POLlCY AND REGULATION

3. The process does not economize on transactions costs. Intervenors have anincentive to participate in the process, so they may be able to shift some ofthe costs attributable to them to other classes of customers.

4. Politicians view the regulatory process as an alternative redistribution mechanism to traditional taxes and subsidies. Not surprisingly utility rates havecome to embody significant cross subsidies. The presence ofcross subsidiesencourages the pursuit of rent-seeking and other deadweight-loss-inducingbehavior.

5. By requiring some kind of hearing before prices can be changed, RORregulation is very inflexible. This may not be a major problem when the firmis assured of its monopoly status, but it is a major problem when competitiveentry takes place.

6. Linking revenues to the rate base (V) encourages the firm to over invest incapital equipment, thereby inflating the rate base and resulting in excesscapacity. To counter this, regulatory commissions must become even moreinvolved in management decisions, and have adopted "Used and UsefulCriterion" for ex post determination of whether investment projects wereprudent.7

7. The treatment ofdepreciation results in excessively long lives for equipment.This is done with the intent of keeping current rates down in the short run.Where plant is very long-lived, like an aqueduct, it may be efficient. However, it is not so for high-tech industries, like telecommunications andmedical care, where optimal depreciation schedules should be front loaded.

The main advantages of the ROR regulation was that under certain conditionsit embodied procedural fairness and it provided incentives for high quality service.By incurring the increased costs of providing higher quality service, the firm wasable to increase its revenues. Assuring service quality was, therefore, not a problemunder ROR regulation. Quite the reverse, the concern was more with gold-plating.As long as the regulator guaranteed the utility's franchise from entry by competitorsthe process could operate and item 2 above was rather insignificant. However, onceregulators allowed entry, major problems arose. The regulated utility could notadjust its prices to meet the competition and was handicapped by additionalregulatory imposed costs.

2.2. Price-Cap RegulationPrice-cap regulation (PCR) is an attempt to address some of the problems of

rate-of-return (ROR) regulation. Its ostensible contribution is to break the linkagebetween revenues and costs. Under PCR, costs are decoupled from revenues.Incentives for cost economy are not attenuated nor are incentives for over-invest-

7 The parallels between the Used and Useful Criterion and Certificate-of-Need regulation inhealth care are examined in more detail below.

LESSONS FROM PUBLIC UTILITY REGULATION 19

ment in capital. This was at least implicitly recognized in the United Kingdomwhen, following the privatization of their network industries, the system of regulation adopted was not ROR regulation, but PeR. PeR establishes an index of thefirm's prices, which is allowed to increase each year by the rate of inflation lesssome percentage known as the X factor, as shown in equation (2).

N N

L PifJit-1 =(1 + CPI - X) L Pit-Iqit-I (2)i=1 ;=1

PeR came to the United States when the Federal Communications Commission(FCC) adopted a system of price caps for AT&T's inter-state traffic in 1984. Thisgave AT&T considerably more flexibility to compete with its aggressive rivals,notably MCI Communications. Hybrid forms of PeR have spread to local telephone companies. These involved a price cap, in the sense that some flexibility inchanging rates was allowed, but also an overall rate-of-return target. Above andbelow the target, the companies would share excesses or shortfalls.8

The decline of ROR and its increasing replacement by PeR in part reflect theabandonment by regulator of its obligation to protect the utility's franchise fromcompetitive entry. Implicitly, this is a recognition that the gains from scaleeconomies are not so great as to be worth the effort that full-fledged ROR requiresand that there may be other benefits to cost economy and dynamic efficiency fromallowing entry. Along with the demise of entry protection must go the crosssubsidies which ROR regulation embodied. Some progress has been made inreducing cross subsidies. Local telephone service continues to be sold predominantly on a flat-rate basis, with the major concession to this being the introductionof the FCC's subscriber line charge. This enabled the local companies to cut theaccess charges per minute of use paid to them by long-distance carriers, whocontinue to press for the reductions and seek other means of completing calls.Lessons from the changeover to PeR include:

1. PCR attempts to reduce the regulatory imposed disadvantages of the regulated firm once entry is permitted. This may involve imposing some regulation on competitors.

2. PCR may reduce the transactions costs of the regulatory process.

3. Some residual protection from entry still exists. For example, the shieldingof the local telephone company from intra-LATA competition in somejurisdictions and from local competition in almost all areas.

4. PeR provides the opposite incentives on quality compared to ROR. Indeed,BT initially had significant problems with quality, necessitating the interven-

8 A simple example would be that, if the target were 12 percent and the company earned 13percent, it would have to reduce its prices so as to get the rate of return down to 12.5 percent.


tion of the regulator. Therefore, PeR must be accompanied by some monitoring and regulation of service quality.

5. By allowing competitive entry, it becomes increasingly difficult for theregulator to maintain the same level of cross subsidies. This may have theeffect of inhibiting rent seeking.

6. IfPeR is implemented by means of a Laspeyre Index, there is the potentialfor regulatory induced distortions based upon differential growth ratesamongst products, as examined in Neu (1993) and Abbott and Crew (1993).These distortions are particularly apparent where new product introductionsare concerned, particularly if there are joint costs and interdependent demands. The dynamic issues associated with price caps are complex and notyet well understood.

The recognition amongst economists of the importance of asymmetric information, rent seeking, and transactions costs have led to an understanding that it is verydifficult to achieve the objectives of regulation. This has led to a reduction theexpectations of regulation and to consequent changes in implementation. Notably,regulation, in abandoning franchise protection, has moved away from micro-management and has increasingly favored market-based incentives. An example of thisis the system of emission trading permits that is now employed as a means ofcontrolling air pollution instead of traditional command and control mechanisms.Similarly, where entry protection is considered beneficial, alternatives to protectionby a regulator, such as franchise bidding, may be more efficient, as they usecompetition to strive for efficiency. (See Crew and Harstad 1992.)With this review of public utility regulation in mind, we turn to how these

methods might be applied to heath care markets. There appear to be several veryimportant differences between health care markets and the usual public utilitymarkets. First, in the public utility market, there is traditionally a single provider,for example, the local water company, while in health care markets most peoplepotentially have access to several hospitals and tens, if not hundreds, of doctors.9

Second, asymmetric information between consumers and suppliers, which is afundamental problem with respect to health care markets, is only indirectly relevantin the case of consumers and public utilities. IO Third, the role of third party payersand insurance is very important for understanding consumer behavior in the healthcare markets, but they are non-existent in the area of public utilities.Such differences between medical care and utilities create important problems

which need to be considered when applying the public utility model of regulationto health care markets. Most notably, the usual public utility framework isconcerned that the monopolist will raise prices above marginal cost, restricting the

9 This does not imply that doctors and hospitals do not have some market power.10 Of course, asymmetric information plays a major role between regulators and the regulated

firm.


amount of the service provided, and resulting in a deadweight loss to society.However, in the context of insurance, where individuals making the health caredecisions typically do not pay the "full price" of the service, there is a countervailingmoral hazard problem, which induces people to over consume these services. Thatis, it is generally argued that people consume medical services until their perceivedmarginal benefit is just equal to their marginal out-of-pocket costs. In the contextof hospital care, their marginal out-of-pocket costs is frequently zero, and so onewould expect to find that, relative to the efficient level, there is excess consumptionof hospital services. On the other hand, if one assumes that because of theasymmetric information between the doctor and patient, such decisions are madeprimarily by the attending physician, one must explore the extent to which physicians act as faithful agents for their patients. Is a physician acting as a faithfulagent ofthe patient if she equates marginal health benefits to 1) the marginal priceof the service, 2) the marginal social cost of the service, 3) the marginal cost to thepatient, or 4) zero? If the physician is not acting as a faithful agent, how are theybehaving, and what impact does this have on the nature of the treatment received?Pauly et al. (1992) discuss alternative models of physician behavior and theirimplications for monitoring and regulating their behavior.Such a discussion of the differences between health care and other public utilities

should not detract from some of the important similarities between these markets.In the United States, public utilities and health care are often viewed as goods whichindividual members of society have a right to receive. Such rights are not absolute.For example, every rural inhabitant does not have an absolute right to telephone orelectricity service. Similarly, as in the case of the British National Health Service,every individual is not entitled to whatever health care he wishes. He is entitled toemergency treatment as an absolute right. 11 As such, the objectives of regulatorsof both public utilities and health care markets are in many instances the same.These similarities include: 1) the belief that the regulated firm should provideuniversal (or nearly universal) service without undue discrimination; 2) the desireto induce the regulated firms to produce goods and services at the minimum costto society and avoid the dissipating effects of nonprice competition and rent-seeking; and 3) the desire to induce the regulated firms to produce services at the levelof quality demanded by the public. Moreover, the basic tools at the discretion ofthe regulator-licenses to operate and restrictions on entry, controls on investmentsin capital equipment, regulation of the prices charged, and restrictions on the qualityof the products produced-are essentially the same.

3. Existing Health Care Regulation

Health care in the United States is heavily regulated, with nearly every aspect of

11 For a discussion of economic rights, see Zajac (1978).


the health care delivery subject to public and private regulation. For example,insurance companies are regulated by the states, often requiring them to maintainsubstantial reserves and provide a wide range of services. Although physicians andother health professionals are licensed by states, access to the practice of specialtiesare controlled by hospitals (through their control of admitting privileges) andmedical societies (through their control of board certification). Physician reimbursements are regulated under both Medicare and Medicaid, and in some statesphysicians are prohibited from "balance billing" patients for the difference betweentheir fees and these reimbursements. Hospitals and other health care institutionsare licensed by the state; but must also receive "voluntary" accreditation from theJoint Commission for the Accreditation of Health Care Organizations (hospitals).Furthermore, nursing homes must be accredited by Medicare, and home health careinstitutions must be accredited by CHAP, if they intend to bill Medicare forservices. Under Medicare, hospital reimbursements are set using the ProspectivePaymentSystem (PPS), which some states have extended ormodified for all payers.In addition, in many states, hospitals that want to expand services or equipmentmust obtain a Certificate-of-Need (CON) from a state planning agency beforemaking new investments. The FDA tightly controls the introduction of new drugsand devices, as well as claims pharmaceutical companies make for their products.Prescribing privileges are granted by the states. Although this list is not complete,it is clear that health care delivery is regulated by a bewildering variety of federal,state, and local authorities.In this section, we examine how regulation has been employed to contain costs

in the health care sector. This examination focuses primarily on hospitals andphysicians, with a few remarks about pharmaceuticals and other aspects of healthcare delivery. It is intended to provide background and a basis for our laterdiscussion ofhow alternative regulatory mechanisms used to control public utilitiesmight apply to health care markets.

3.1. Cost Containment Efforts in the Hospital SectorThe Federal Government's efforts at cost containment in the hospital sector

began almost immediately after it accepted the financial responsibility for providing hospital care for all Americans over the age of 65 and partial responsibility forthe poor through theMedicare andMedicaid programs established in 1965. Almostimmediately, there were dramatic cost overruns which threatened the solvency ofthese programs. We will examine these efforts in three main areas: controlling newtechnologies, controlling prices, and controlling utilization. Initially, the focus ofthese cost containment efforts were on the expansion of new capital and technologies. The focus on technology is not surprising, since the time period was one ofrapid innovation and adoption ofnew, costly, technologies-such as theCT scannerand coronary artery bypass graft surgery. Although these technologies allowphysicians to treat some patients more effectively, they are very exr:ensive, andthere are weak incentives for the efficient use of these technologies. 2 However,rather than focus directly on the issue of when and where these technologies were


being used, and thereby interfering with the "doctor-patient" relationship (a majorfear in that time as well as today), legislators thought they could address this issueindirectly through regulation of capital investments. Further support for thisapproach existed because of a general belief that hospitals used these capitalinvestments as a means of nonprice competition, to attract "desirable" physicianswho would in turn attract patients. Thus, in addition to having rapid adoption ofnew, expensive technologies, there was a general consensus that there was an excesssupply and widespread duplication of such costly facilities.

In these circumstances, focusing on capital expenditures seemed reasonable,given that most hospital were nonprofit institutions with fees based on costs similarto the ROR regulated utility. Thus, controlling their acquisition of new technologies offered the prospect ofcontrolling the payments for hospital care by the federalgovernment. At the same time, the federal government had already fostered awide-spread, loose network of health planning agencies. These agencies were anoutgrowth of the Hospital Survey and Construction Act of 1946, better known asthe Hill-Burton Act. This program was designed to expand access to healthfacilities by providing matching grants to nonprofit institutions in exchange forpromises to provide care to the needy. It also required states to establish agenciesto survey its hospital needs and develop statewide plans for the construction ofpublic hospitals and health centers (Folland et al. 1993, 572). In the early years,this program focused on expanding the number of general hospital beds, but by theearly 1960s, the emphasis had changed to statewide facilities planning. However,these planning agencies were not concerned with cost control (Joskow 1981,77),but with making sure that federal funds were spent. As time progressed, and as thefederal government became more and more involved in the financing ofhealth carethrough the Medicare and Medicaid programs, these planning agencies began totake on a new role as agents used to control the expansion of health care facilitiesthrough Certificate-of-Need programs.

In 1966, the Comprehensive Health Planning Act (CHP) was passed. This actprovided modest funding for the creation of a single agency within each state withthe responsibility for organizing the state's health-planning activities of the variouslocal organizations within their state (Joskow 1981,77). Although this law fosteredthe idea of state wide planning, " ... unlike a formal Certificate-of-Need agency,hospitals could proceed with or without CHP agency approval even in states thathad review agreements with the federal government." (Joskow 1981, 79) Thus,overall, the CHP failed to stem the rising costs of hospital care in general, or thecosts of Medicare and Medicaid in particular, even though the Social SecurityAmendments of 1972 had stipulated that "capital costs associated with federalreimbursement for Medicare, Medicaid, and certain other federal programs couldbe denied if not approved by the state-designated planning agency." Although the

12 Recall the earlier discussion on information asymmetries and moral hazard.


threat of not paying the capital costs was credible, it had a minimal impact becausecapital averaged only 10 percent of total hospital expenditures (Joskow 1981).In 1974, the federal government enacted the National Health Planning and

Resources Development Act to overcome some of the problems with the CHPprogram. This law created a network of Health Systems Agencies (HSAs) whichwere required to collect and analyze data on utilization of facilities and to establishhealth system plans (HSPs) for their areas. In addition, these agencies wererequired to establish annual implementation plans to move towards a coordinatednetwork of health facilities. But, perhaps the most important requirement of theprogram was that states had to establish Certificate-of-Need (CON) programswhich restricted the construction of new facilities and met certain minimumstandards, or else sacrifice federal funds (Joskow 1981, 79). Finally, the federalgovernment had established a program which had the mandate and authority tocontrol the expansion of health care facilities. Unfortunately, although theseagencies were able to eliminate and prevent someduplication offacilities, they havenot been able to stem the rising demand for sophisticated services and technologiesdriven, in part, by the moral hazard aspects of modern health insurance contracts.Thus, one should view the use of CON programs as, at best, a qualified successand, at worse, an utter failure. In addition to the problems of rising demand, theCON programs also faced several other major hurdles. First, in some sense theCON emphasis on capital expenditures is misplaced. Although capital expenditures are substantial, they are in no means the major costs associated with adoptingnew technologies or techniques. Second, in many instances, focusing regulationon only one of the inputs results in additional inefficiencies as producers substituteother inputs for the constrained input. Third, establishing strict utilization criteriafor evaluating capital expenditures may result in perverse incentives to over treatin order to maintain an existing program or justify an expansion. Such incentivesmay exacerbate the existing agency problems embedded in the fee-for-serviceenvironment. And finally, Havighurst (1973) and Feldstein (1991) have suggestedthat it was fairly easy for existing hospitals to capture the CON agencies and usethe regulatory authority to restrict competitive entry and maintain their marketposition. Thus, although the CON program was intended to eliminate nonpricecompetition and insure that hospitals did not over invest in capital, thereby servingthe same function as the "Used and Useful" criteria for public utilities, it was notas successful. This was because, without comprehensive practice guidelines, it iswell nigh impossible for a regulator to determine if the use of the capital investmentis useful or if it is wasteful. This was an example of the tar-baby effect whichreferred to the tendency of regulation to increase the demand for new regulationsso that the existing regulation can be carried out more effectively, as discussed inMcKie (1970).

Controlling Hospital PricesDuring the 1970s, it became increasingly clear that the CON programs were not

able to control the rising costs of hospital care. During 1971, as part of the


Economic Stabilization Program, price controls were imposed on hospitals anddoctors, along with most other industries. However, although these broad-basedprice controls were lifted shortly later, the price controls on hospitals and doctorsremained in effect until April 1974 (Feldstein 1988). When these price controlswere finally lifted, and prices jumped upward, individual states faced increasingfinancial pressure from rising Medicaid costs and began to examine alternativemethods of regulating the hospital fees directly. A number of states set upregulatory commissions, which on the surface were quite similar to those used toregulate public utilities. These commissions reviewed the hospital fees, andsometimes overall hospital budgets, in an attempt to stem the rising cost of treatingpatients. Rate regulation introduced in these states varied widely, ranging fromvoluntary to mandatory programs with coverage ranging from only Medicaidpatients to all payers, and regulations focused on hospital charges, reimbursementrates, or total hospital expenditures. As one might expect, the success of theseprograms varied as well.New York was the first state to adopt mandatory reimbursement regulations in

1969, and there is a general perception that this program placed the greatestfinancial constraints on hospitals during the 1970s (Joskow 1981). New York doesnot have a single independent regulatory commission, but depends upon theactivities of several state agencies coordinated through the State Department ofHealth and administered through the Division of Health Care Financing. Thereimbursement rates are set using complicated formulas which adjust for teachingstatus, occupancy rates, inflation, and comparisons with other hospitals.New Jersey started effectively regulating hospital fees when the Health Care

Facilities Act of 1971 gave the commissioner of health broad powers. Previously,hospital budgets had been "routinely approved" by the state insurance commissioner (since 1938). Now these reviews would be conducted by the health commissioner, who was given the authority to scrutinize line items, coordinate thebudget reviews with CON applications, and the ability to set rates for both BlueCross and Medicaid (Widman and Light 1988). Even these controls, however, wereunable to stem the rising costs of hospital care, and, in 1978, New Jersey adopteda radically new approach of an all-payor, prospective payment system (PPS).Under this new system, instead of being paid a per diem rate for each patientretrospectively, hospitals would be paid a flat amount set in advance based on asystem of diagnosis-related groups (DRGs). This system continued until 1993,when a court ruled that the state could not set hospital rates for self-insuredcompanies under the exemptions provided by ERISA. Since January 1, 1993,hospitals in New Jersey have returned to a charges-based system, where individualhealth plans contract with hospitals over their charges.Connecticut adopted a public utility style regulatory model to control hospital

costs in the early 1970s, with the Commission on Hospitals and Health Care playingthe key role of regulator. A budget and rate review process, along with a CONprogram to control capital expenditures, were used by the Commission to containhospital costs (Legislative Program Review and Investigations Committee 1993,


hereafter LPRIC). Initially all budget changes from the previous year were reviewed, but, during the 1983-85 period, the Commission only reviewed thosebudgets which increased beyond the screen of the rate of inflation plus a 2 percentvolume offset (LPRIC 1993, 10). In 1985, the commission introduced a prospective payment system based on the DRG system. However, unlike the federalprogram, discussed below, this system followed the ROR approach and attemptedto set separate rates for each hospital based on their total revenue requirements.The prospective payment system ran into several difficulties which made it unworkable, and in 1990 it was replaced by a prospective budget review process. In 1993,the state legislature granted hospitals a 4.25 percent increase for gross revenues,and a 3.25 percent increase for net revenue (LPRIC 1993, 11).In 1983, the federal government instituted its own form of hospital rate regula

tion based on New Jersey's PPS. This approach paid hospitals prospectively, onthe basis of the average variable cost of treating a patient of that type on admission-even under PPS, capital costs were passed through to Medicare based on theproportion of admissions ofMedicare patients. By paying the hospital a fixed fee,regardless of the treatment received, the federal government hoped to break thelinkage between the hospitals own costs and the fee; thereby reducing the incentivesof the hospital to provide excessive services or lengthen the patient's stay. In asense, PPS aimed to provide incentives for efficiency to hospitals similar to thosePCR provided for utilities. However, just as PCR simultaneously provided theprospect of additional profits by reducing quality, DRGs provided incentives to thehospitals to under treat the patient, to deliberately miss-classify patients, and todischarge them before they are ready to go home (perhaps with a later re-admission). Thus, just as utility regulators recognized the need for additional regulationof quality under PCR, it is important for health care regulators to recognize theseadverse incentives and develop ways to monitor hospital behavior and insure thatpatients receive "appropriate" treatment.Prospective payment can also create equity problems. The basis behind pro

spective payment is that the hospital should receive only the average cost (acrossa wide range of hospitals) thereby removing the incentive to over treat. If the payoris large enough, they will essentially be indifferent, or even prefer the PPS approachif it succeeds in lowering average costs. However, for small groups or individualswho are trying to be cost conscious, there could be dramatic differences betweenthe costs built into the DRG and the actual resources used by the patient. Forexample, a patient who is self insured, might be asked to pay for 7 days in thehospital (the recommended stay for the DRG) even though they actually only stayedin the hospital 3 days. At an effective price of over $1000 per day, the discrepancycould be very large, and statements like "well on average it works out" are littlecomfort to those involved. These kinds of problems led Connecticut and NewJersey to abandon the all payor DRG approach. Similar cross subsidy issues arisein public utilities. Should rate payers in the central city be asked to subsidize thetelephone service in rural areas-where miles rather than feet of cable are requiredto provide service to each home?


Controlling UtilizationAs discussed above, one of the key problems facing any group interested in cost

containment is finding a way to overcome the incentives for over treatment builtinto the health care system. These incentives are pervasive, ranging from the wayin which insurance coverage shields the patient from the full cost of the treatmentreceived, inducing them to over consume services; to the physicians own code ofethics and financial incentives, which requires them to do everything they can tosave the patient, irrespective of costs; and to the way hospitals have been, and insome cases continue to be, paid which link prestige and profitability to having thelatest technology and to the provision of individual services. Early cost containment initiatives attempted to monitor and control the utilization ofhospital services.Utilization review programs seek to determine whether specific services are medically necessary, and whether they were delivered appropriately. Ermann (1988)outlines several types of utilization review programs. These include, preadmissionreview, which examines the appropriateness of the hospital admission beforeadmission occurs; concurrent review which determines if continued care is needed;and retrospective review which seeks to determine if there is an abnormal patternin the care given by a provider. During the first half of the century, utilizationreviews were limited to the self-policing activities of individual providers. In 1963,the Joint Commission on Accreditation of Hospitals (lCAH) recommended thathospitals implement DR committees. When Medicare was enacted in 1965, itrequired that participating hospitals establish UR programs (Ermann 1988). Despitethese efforts, the large annual increases in Medicare led to the establishment ofProfessional Standards Review Organizations in 1972. These organizations wereestablished to 1) monitor the admissions and length of stay of Medicare patients,2) identify areas of deficiency in the quality of care provided to Medicare patients,and 3) develop and analyze data systems profiling utilization patterns. During thelate 1970s, several studies showed that PSROs were not effective at reducing patientlength of stay or health care costs, and by 1980 most of the political and financialsupport for the program had eroded (Ermann 1988).By 1984, PSROs had been replaced by Peer Review Organizations (PROs), as

part of the movement towards prospective payment. There were a number ofsignificant differences between PROs and the earlier PSROs. First, there was onlyone PRO per state whereas the PSROs had been locally controlled. Second, PROsare either for-profit or non-profit corporations funded under performance-basedfederal contracts, whereas the PSROs had been physician-sponsored non-profitgroups with much looser grant-based funding. More significantly, while PSROshad largely delegated the reviewing authority to hospitals, PROs can only delegatequality reviews to the hospitals and must conduct their own appropriatenessevaluations. Finally, while PROs primarily use preadmission reviews as a costcontainment strategy, PSROs rarely utilized this approach (Ermann 1988).In addition to these federal programs, many private firms have entered the

Utilization Review business as third party payers have attempted to control theutilization of services and combat the moral hazard and informational problems.


In addition to pre-admission programs, these private firms offer catastrophic casemanagement, short-term disability review, second opinion surgery programs, andidentification and monitoring of mental health and substance abuse programs fortheir customers, typically insurance companies or self-insured corporations (Ermann 1988). Although Utilization Review has a certain conceptual appeal, eliminating the "unnecessary services" should reduce costs, it is quite difficult toimplement. Who decides what is unnecessary? Moreover, how does one measurethe outcome of the UR process? As a result, "the verdict on the overall usefulnessof utilization review has still to be delivered." (Pauly et al. 1992,98).

3.2. Cost Containment Efforts in the Physician MarketMany of the same issues ofmoral hazard and asymmetric information arise when

examining expenditures for physician services. However, there is a fundamentaldifference between the market for hospital services and the market for physicianservices. This difference is that whereas nearly 80 percent of the hospitals in theUnited States are nonprofit institutions, most physicians are in the for-profit sector.This has two immediate implications. First, over-investment in technology andX-inefficiency in physicians' offices are unlikely to be major problems. Second,there should be concern over whether physicians' prices are monopolistically setand other devices physicians might use to maximize their profits. Such concernstranslate into a demand for regulation.The above reasoning explains why Certificate-of-Need programs have not

applied to equipment placed in physicians' offices. Unfortunately, since the 1960swhen CON programs began to appear, developments in medical treatments havetended to blur the distinction between the hospital and the physicians office.Moreover, new institutions have been created to take advantage of the regulatorygaps. New outpatient surgical, diagnostic, and testing centers arose in situationswhere CON agencies succeeded in constraining the hospitals from expanding theirservices, and when PPS limited the amount they would receive for each admission(outpatient services are not included under PPS). In many instances, these facilitiesgrew out ofphysicians offices, and physicians had a financial interest in the facility.This created the entirely new problem of physician self referral. Now an unscrupulous physician could refer a patient to their own X-ray facility, and orderadditional, unnecessary, tests. Not only collecting from the patients' insurancecarrier for interpreting the tests, but also directly benefitting from the testing itself.Recently, theAMA adopted a new code ofethics which strictly prohibits physiciansfrom referring patients to facilities in which they have a financial interest.With respect to the physician market, there are three strategies which have been

developed to constrain costs. The first focuses on the utilization of physicianservices, in an attempt to control the quantity of services rendered by physicians.These include the utilization reviews discussed above, as well as the developmentof practice guidelines and the use of patient cost sharing. The second approachattempts to control physicians fees directly. This has been implemented primarilyby Medicare, Medicaid, and other large third party payers, which have developed


a variety of reimbursement methods-including the recently implemented Resources Based Relative Value Scale (RBRVS) for Medicare. The third approachhas been to fundamentally restructure the way in which physician services arerendered. This involves the development of alternatives to the Fee-for-Serviceenvironment, which include Preferred Provider Organizations (PPOs) and HealthMaintenance Organizations (HMOs). We examine developments in each oftheseareas in turn.

Controlling Utilization or Restricting DemandTurning first to the issue of utilization. Many of the programs discussed above

not only review hospital services, but also directly and indirectly, physicianservices. For example, if the pre-admission review determines that a patient doesnot need surgery, this affects surgeons services as well (although in some instanceit could merely move the procedure to an outpatient surgical center or a physiciansoffice which is not under the jurisdiction of the UR committee). However, for manythird party payers, UR activities extend to the physicians offices where pre-certification is now needed prior to undertaking major medical or surgical procedures,regardless of where the service is provided.Additional interest in utilization review and establishing practice guidelines

grew out of what has become known as the "small area variations" studies(Wennberg and Fowler 1977). These studies showed that there were widespreaddifferences in the utilization rates of common medical procedures without anyapparent differences in the underlying population or in medical outcomes. Oneexplanation for this is physician uncertainty. For many of the existing medicalprocedures, there is a great deal of uncertainty about both the probability of thevarious outcomes and the cost-effectiveness of the procedure. As a result, physicians base their medical decisions on their own experiences, not hard scientific data.Where there is a large degree of uncertainty, Wennberg and others have found thatthere is a wide variation in the utilization rates. One implication is that there couldbe widespread inappropriate use of existing technology. The savings from eliminating excessive utilization led Congress to establish the Agency for Health CarePolicy and Research in 1989. The agency's primary mission is "to determine whatworks and to develop practice guidelines and standards to assess and assure qualityof care." (Folland et aI. 1993,413).Pauly et aI. (1992) correctly point out that establishing practice guidelines simply

specifies what is appropriate care and does not provide a way of monitoring orenforcing that this care is provided to the patient. As Rizzo and Sindelar discuss,who develops the guideline and how it is developed affects the impact the guidelinehas on medical practice. Unfortunately, it is often in the areas where practiceguidelines would do the most good, that we have the least information on which tobase their development. Prematurely developing guidelines in these areas coulddo significant harm to current patients or interfere with the development of newerand better techniques (Pauly et aI. 1992,69.) Nevertheless, it would appear thatguidelines play an increasing role in constraining physician costs, as governments


and other third party payers demand and incorporate guidelines into their utilizationreview programs.

Controlling Physician FeesIn the fragmented market for physician services, most third party payers do not

have a large enough effect on a single physician to attempt to control their feesdirectly. Instead, most third party payers attempt to induce the patient into actingon their behalf either by establishing a fixed benefit schedule or by requiring thepatient to cost share. Under the indemnity approach, the patient pays the physiciandirectly, and then applies for reimbursement from the insurer, who pays thephysician's fee up to a maximum amount. Any amount above the cap is the patientsresponsibility. Usual cost sharing arrangements typically involve a deductible(generally $300-500 per individual or $800-1000 per family) and co-insurance(generally about 20% up to an out-of-pocket cap for some plans). There is strongempirical evidence that higher out-of-pocket payments are associated with lowertotal expenditures (Newhouse et al. 1981).With the adoption ofMedicare Part Bin 1965, the federal government became

directly involved in paying physicians for services provided to a large segment ofthe population. Although they anticipated some expenditure growth resulting fromthe new program, the dramatic rise in expenditures caught many by surprise. In itsfirst full year of operation, 1966, total expenditures for Medicare Part B were $1.2billion dollars; by 1990, this figure had increased to over $43 billion dollars.Changes in the volume and intensity of services accounted for over 50 percent ofthe real growth in these expenditures (Pauly et aI. 1992). Over the same time period,major changes were made in the way Medicare reimbursed physicians for theirservices, as policy makers tried to limit this growth and keep the Medicare TrustFund afloat.When Medicare was adopted, physicians were reimbursed using a system of

Customary, Prevailing, and Reasonable Charges (CPR). Under this system, thephysician would receive as payment the minimum of: 1) the actual charges billed,2) the customary charge, defined as the physician's median charge for that sameservice in the proceeding year, or 3) the prevailing charge, which was a predetermined percentile of the customary charges for that service by all physicians in ageographic area (Pauly et al. 1992, 21). In addition, physicians were prohibitedfrom billing Medicare a higher amount than they billed other third party payers. Itwas hoped that by restricting Medicare charges to other third party payers, theircost containment efforts would succeed in holding down Medicare expenditures.After the adoption of CPR by Medicare, other third party payers adopted a

similar approach called Usual, Customary, and Reasonable (UCR). Under UCR,the reimbursement is the lower of: 1) actual charges, 2) the usual charges, themedian of the doctor's own charges, or 3) the customary charges, based on apercentile of the distribution of charges by physicians in the area. In addition,higher charges may be "allowed" if they are deemed "reasonable" in light of anyunusual circumstances surrounding the case (Folland et al. 1993). The amount of


the charges above the reimbursement were the responsibility of the patient, unlessthe physician chose to accept assignment.Unfortunately, CPR and UCR have a built-in inflationary component. Although

increasing today's charges does not result in a higher reimbursement this year, itdoes increase the physician's customary charge for future years. Moreover, if allphysicians increase their charges, the prevailing charge rises as well. Thus, thedominant strategy for the physician is to increase their charges, but accept assignment and not balance bill the patient for the excess. Thus, the patient is happy,since they had little or no out-of-pocket expenditures, and next year, the physicianreceives a higher payment.To put an end to the spiraling cost of physician services, the Health Care

Financing Administration (HCFA) adopted a Medicare Economic Index (MEl),which tied increases in the prevailing charge to general inflation. It did this byredefining the prevailing charge to be equal to the lower of (3) above, or the relevantprevailing charge in 1973 times the MEl. The MEl itself, is a measure of inputprices and is comprised of a combination of general earnings and the costs ofmaintaining a physicians practice (Pauly et al. 1992). Thus, the MEl imposes aform of price-cap regulation on physician fees.In 1989, the federal government, unsatisfied with the current cost containment

efforts, adopted a radically new approach which involved three parts. First, underthe new restructuring of physician reimbursements, which was phased-in in 1992,all physicians would be paid on the basis of a predetermined Medicare FeeSchedule, based on the relative value ofeach service and adjusted for the geographiclocation. Second, overall controls were adopted on the volume ofservices providedtoMedicare recipients, which would prohibit expenditures from rising more rapidlythan desired by Congress. Third, strict limits were set on the ability of physiciansto balance bill Medicare beneficiaries (Pauly et al. 1992,3).The new fee schedule is based on a Resource-Based Relative Value Scale

(RBRVS), developed by Hsiao et al. (1988) and others. The basic idea behind thisscale is to establish measures of the relative value of the inputs used to provide aparticular service. Once established, these relative values remain constant overtime. To obtain the Medicare Fee Schedule, the relative values are multiplied bythe "conversion factor" to obtain dollar amounts. It is easy for Congress, or HCFA,to control increases in total expenditures, by adjusting the multiplier upwards ordownwards. If expenditures increase faster than desired, adjustments are made tofuture values of the conversion factor to bring expenditures down. Thus, the 1989reforms included a "Global Budget" approach to controlling Medicare physicianexpenditures. The idea is to make physicians, collectively, responsible for theallocation ofmedical resources. The more services physicians provided, the lowertheir fees. 13

13 It is unlikely that this "collective" approach will be successful. Physicians are so numerousthat each individual's behavior by itself will have no effect on the total. To the extent that


The final aspect of these reforms included restrictions placed on balancingbilling by physicians to Medicare beneficiaries. Concern over the rise in premiumsand potential financial liability for beneficiaries, Congress prohibited physiciansfrom charging more that 115 percent of the Medicare fee level, thereby placing arestriction on the amount which could be billed directly to the patient. Thisrequirement was scheduled to be phased-in in 1993 (Pauly et al. 1992).

Alternatives to Fee-Cor-ServiceAlthough fee schedules provide some promise for controlling overall expendi

tures, they maintain the incentives for over treatment imbedded within the fee-forservice structure. To counter these incentives, a number of alternative ways ofstructuring the market for physician services have arisen. These alternativesinclude the staffmodel HMO, the IPA model HMO, and the PPO or point-of-service plan. The ways in which each of these alternatives attempt to control physicianscosts are discussed in turn.The most radical departure from the fee-for-service approach is the staff model

HMO. Under this model of health care delivery, the physician is a salariedemployee of the HMO and works at the HMOs facilities. Enrollees of the HMOpay a fixed fee to the HMO which is responsible for providing all "medicallynecessary and appropriate" care, including both physician and hospital services. Inaddition, the patient may be required to make a "nominal" co-payment for eachoffice visit, ranging from $2 - $15. In some cases, the enrollee has his/her ownprimary-care physician, but in many cases, the enrollee sees which ever doctor ison duty. In addition to their base salary, many HMOs offer physicians bonusesbased on profitability. Thus, instead of incentives to over treat patients, HMOscreate incentives to under treat. SomeHMOs have even establish utilization reviewprocedures to make sure that individual physicians are not using too many resources.In an Independent Practice Association (IPA) model HMO, individual physi

cians maintain their own private offices, and often see patients outside of the HMOgroup. In many instances, an enrollee in an IPA-HMO will have a primary-carephysician, who also serves as a gate keeper for access to specialized services.Physicians in an IPA-HMO are typically paid on a capitated basis, so much perpatient month. In addition, physicians in an IPA-HMO may also have a budget forcovering additional services; if the physician manages to keep within his/herbudget, they receive a bonus-tying their income directly to their restraint in usingother services. In addition, members of an IPA agree to accept some form ofutilization review for access to other services. Patients typically pay a small

individually each physician thinks that he will earn more by providing more services, theincentives to over-treat imbedded in the fee-for-service remains. In fact, if a physicianindividually restrains hislher use of services, and others do not, he will find that his incomeactually falls.


co-payment each time they visit their primary-care physician.The Preferred Provider Organization (PPO) or point-of-service plan is essen

tially a cross between the IPA model and the traditional fee-for-service approach.Individual physicians are paid on a fee schedule basis, often at a discount from theUCR rates, and agree to accept utilization review. Individual patients generally donot have a primary-care physician, but have the option of choosing a physicianwithin the network, or going outside of the network each time they need a service.If they choose a physician within the network, they pay a fixed co-payment (as ifit were an IPA-HMO); if they go outside the network, there is usually cost sharing(as if it were traditional health insurance). Thus, although the PPO maintains theincentives of fee-for-service, it is able to impose more strict utilization review onits members as well as receiving a discount on the services provided.

4. Clinton Health Security Act

In this section, we provide a brief overview of the Clinton Health Security Act(HSA). The Clinton health care reform is guided by six underlying principles:Security, Simplicity, Savings, Quality, Choice, and Responsibility. The plan setsout to guarantee a comprehensive benefits package to all Americans, regardless ofemployment status or location. At the same time, it promises to reduce the paperwork and control health care costs; increase the quality of health care; and improveeach individual's choice in health care provider. Finally, it attempts to makeeveryone responsible for health care costs: providers, employers, and each individual (The White House Domestic Policy Council 1993, 17-20.) The proposedreforms use government regulation to restructure existing health care markets toharness market forces to achieve these objectives. This approach is broadly knownas Managed Competition.At the center of the HSA is a new institution called the Health Alliance. These

alliances are essentially purchasing cooperatives, individuals automatically become members of the alliance based on where they live, or where they are employed(employers with more than 5000 employees are permitted to establish their own"Corporate" Alliance). Alliances are created by individual states and "operate asnon-profit corporations, independent state agencies, or agencies of the executivebranch of the state" (Health Security Preliminary Plan Summary, page 22, hereafterHS). All individuals under the age of65 will be required to join an alliance, personsover the age of 65 will continue to be covered by Medicare.The role of the Health Alliance is central to the health care proposal. The Health

Alliance serves several functions which were formerly handled by the healthinsurance industry. First, it screens Health Plans and negotiates premiums withthem. Second, it provides information on Health Plans to the consumer. Third, itmanages the annual open enrollment period and collects premiums from individualmembers, their employers, and the federal and state governments. 14 Fourth, theHealth Alliance pays the Health Plans a fixed amount per capita, adjusted for grouprisk factors. At this point, it is not clear the relationship between the premiums,


which are community rated and paid by individuals and companies to the alliance,and the payments from the health alliance to the health plans, which are riskadjusted. In addition, it is not clear what the difference is between risk adjustment,used in the context of Clinton's plans, and experience rating, an often citedbogeyman of the current system of private health insurance.Health Plans are the second key ingredient to the Clinton Health Care proposal.

These are essentially quasi-insurancelquasi-provider groups. A Health Plan agreesto accept a capitated payment in exchange for providing all services which are"medically necessary or appropriate" and covered in the "comprehensive benefitspackage." The financial arrangements between the Health Plan and individualprovider are at the discretion of the Health Plan; that is, Health Plans can beorganized along the lines of a staff or group model HMO, an IPA HMO, a PPO, ortraditional fee-for-service indemnity plan. The financial arrangements with consumers, however, are limited to three forms ofcost sharing: 15 1) low cost sharingwhere consumers pay a $10 co-payment for outpatient and professional servicesbut no co-payment for inpatient services, preventive services, or home health carefollowing an acute illness; 2) higher cost-sharing-where members pay an annualdeductible ($200 individuals/$400 family) and 20 percent co-insurance, with anout-of-pocket cap ($1500 individuall$3000 family); or 3) combination-whereconsumers pay low cost-sharing ($10 co-payment) for "in-network" providers, andhigher cost-sharing for providers not in the network. The financial arrangementsbetween the Health Plan and the Health Alliance are a bit murky. "Health Plansbid each year to provide the guaranteed benefits, and alliances negotiate with themover premium levels. Premiums vary from plan to plan." (HS, p.16). But, thepayments to health plans are also risk adjusted (HS, p.23). In addition, Health Plansare required to accept all enrollees and are prohibited from terminating or restrictingcoverage to any individual. This latter requirement is intended to eliminate theproblem of favorable selection which dominate existing insurance arrangements. 16

14 Employer contributions are based on the average premium for the Alliance (80%) and not onthe basis of the premium for individual employees, whereas the individual's contribution isbased on their choice of Health Plan. This is intended to make individuals price sensitivewhen choosing a plan, but employers indifferent between which plan their employees choose.

15 Health Plans are also permitted to offer supplemental insurance plans, which could covercost-sharing or provide health benefits above and beyond the comprehensive benefits package.Such plans would seem to negate the beneficial effects of the cost sharing programs on themoral hazard problem.

16 However, Health Plans could achieve favorable selection in other ways, perhaps by thelocation of the plan's facilities or the choice of services offered. That is, plans which do notwant to attract the urban poor, for what ever reason, simply will not open an office in the innercity; only open a small, very crowded office staffed young inexperienced physicians; or notcontract with the local urban hospitals, but instead require patients to be admitted in hospitalswhich are more convenient to their target population. There seems to be a lot of room forHealth Plans to structure themselves to achieve favorable risk selection which cannot possiblybe addressed in legislation without making it overly bureaucratic. Moreover, mandating thatall Health Plans open facilities throughout each region could lead to drastic excess capacity,


Table 1. Health Security Preliminary Plan SummaryFederal Government: Set the basic framework for the system

Define guaranteed benefits packageDetermine caps on growth in insurance premiums"Reform" insurance systemEstablish aualitY standards

States: Implement health care reform within federal frameworkEstablish alliance(s)Certify health plansMonitor quality and availability of careImolement insurance reforms

Alliances: Serve as purchasina aaent for employers and consumersSolicit competitive bidsDistribute consumer information materialsCollect premiums and pay health plans

Thus, the basic idea behind the plan is to consolidate both consumers andproviders of health care into larger groups and standardize the benefits, financialarrangements, and claims forms. Proponents expect this standardization to encourage both price and quality competition among plans and expect open enrollmentand risk-adjusted payments to eliminate competition based on favorable selection. 17 A summary of the intended roles of the federal and state governments andthe alliances can be found in table 1, reprinted from HS 1993.

Price Regulation Under HSAIf these market forces are not sufficient to control costs, the plan has a "back

stop" based on capping the growth rate of premiums at the rate of inflation. Theaverage premium target for each alliance is based on current expenditures and isadjusted each year for general inflation and changing demographics. If the averagepremium exceeds the target, then "plans whose proposed premium increases exceedthe allowed rate of growth are required to accept lower premiums" (HS, p. 16).That is, the Clinton health care proposals explicitly include a form of PCR.However, the price cap extends not just across the products of a single firm, butacross the products (i.e., Health Plans) of many different firms. This would be aninnovation in the field of regulatory economics, and one should think carefully

while requiring them to contract with existing facilities could lead to a massive administrativeproblems and undermine the ability of the Health Plan to negotiate with providers-a keysource of the anticipated cost savings.

17 However, we have our doubts about whether risk adjustments will eliminate the incentives forhealth plans to try to reach favorable selection, since risk adjustment models tend to onlyexplain about 15-20 percent of the variation in costs across individuals.


through the incentives that it creates for firms.In addition, the HSA leaves in place or strengthens all of the price controls

currently applied to the Medicare system. This means that hospitals will continueto be paid by Medicare on the basis of the PPS, and physicians will be reimbursedunder the newly adopted RBRVS. Whether these payment methods will be adoptedby the new Health Plans remains to be seen.The HSA also includes a provision to expand the benefits provided under

Medicare to include Outpatient Prescription Drugs in 1996. Here one can clearlysee the willingness of the Clinton Administration to use market power as well asregulatory mechanisms to control costs. In order for a "non-generic drug" to beincluded on the Medicare formulary, a drug manufacturer must sign a rebateagreement with the Secretary of Health and Human Services. These rebates arediscussed in Abbott (1994).

5. Lessons from Public Utility Regulation for Health Care Reform

Rate-of-return or cost-of-service regulation has been subject to increasing pressuresin recent years. Attention has been directed more toward efficiency. The experience of PCR in Britain and in the United States has embodied a move away fromthe micro management and the desire for an industry-wide view of consumerprotection. PCR achieves these broad objectives by guaranteeing the consumersthat prices will fall in real terms over the period of the price cap and allowing thefirm to keep any gains it manages to achieve by increasing efficiencies and output.In health care, few of these lessons have been applied. Indeed, micro manage

ment continues to be a major aspect of the command-and-control regulation that ispresent, and the Clinton plan does not offer any relief. In fact, it creates newbureaucracies in the form of health care alliances. To make matters worse, medicalcare is also subject to sometimes conflicting regulation from the different agenciesthat are responsible for regulating the price and quality of care.We should not be too surprised that few of the lessons of utility regulation have

been incorporated into the regulation of medical care. Utility regulation has neverlabored under the major problems of health care regulation. In particular, the useof price as a rationing mechanism, although not unrestricted, is not subject to thesame kind of problems as in medical care. The delivery of medical care seems tobe set up with the intent of sparing consumers from the consequences of theiractions. Once you embark upon such a route the economist's primary rationingtool, prices, are no longer available. This means that the lessons of utility regulation, which rely increasingly on allowing efficient prices to operate, have by theirvery nature a limited message for the regulation of medical care. Before progresscan be made, the very reasonableness of the notion that medical care is differentfrom other goods in that it cannot be rationed by prices needs to come under criticalreview. The Clinton plan will probably make matters worse if implemented.However, in criticizing the present system and drawing attention to a majorproblem, the Clinton plan has already had an impact on our understanding of

LESSONS FROM PUBLIC UTILITY REGULATION

medical care markets.

References

37

Abbott, T.A. 1994. "Regulatorying Pharmaceutical Prices." This volume.Crew, M.A., and P.R. Kleindorfer. 1986. The Economics of Public Utility Regulation.Cambridge, MA: MIT Press.

Ermann, D. 1988. "Hospital Utilization Review: Past Experience, Future Directions."Journal ofHealth Politics, Policy and Law 683-704.

Feldstein, PJ. 1988. Health Care Economics, 3rd Edition. New York: John Wiley & Sons.Folland, S., et al. 1993. The Economics ofHealth and Health Care. New York: MacmillianPublishing.

Greenberg, W. 1991. Competition, Regulation, and Rationing in Health Care. Ann Arbor,MI: Health Administration Press.

Health Security Preliminary Plan Summary. 1993. 0 - 359-252: QL 3. Washington DC:U.S. Government Printing Office.

Health Security Act. 1993. U.S. Government Printing Office: Washington De.Hsiao, W.e., et al. 1988. "Resource-Based Relative Values: An Overview." Journal ofthe

American Medical Association 260(No. 16, October 28): 2347-2353.Joskow, P.L. 1981. Controlling Hospital Costs: The Role of Government Regulation.Cambridge, MA: The MIT Press.

Legislative Program Review and Investigations Committee. 1993. Health Care Cost Containment in Connecticut: Briefing Paper. Hartford, CT: Connecticut State Legislature(September 15).

McKie, J.W. 1970. "Regulation and the Free Market: the Problem of Boundaries." BellJournal ofEconomics and Management Science I (No.1, Spring): 6-26.

Newhouse, J.P., et al. 1981. "Some Interim Results from a Controlled Trial ofCost Sharingin Health Insurance." New England Journal ofMedicine 305: 1501-7.

Pauly, MY, et. al. 1992. Paying Physicians: Options for Controlling Cost. Volume, andIntensity ofService. Ann Arbor, MI: Health Administration Press.

Wennberg, I.E., and F.J. Fowler. 1977. "A Test of Consumer Contribution to Small AreaVariations in Health Care Delivery." Journal of the Maine Medical Association 68:27579.

The White House Domestic Policy Council. 1993. Health Security: The President's Reportto the American People. U.S. Government Printing Office (October).

Widman, M., and D.W. Light. 1988. Regulating Prospective Payment: An Analysis of theNew Jersey Hospital Rate-Setting Commission. Ann Arbor, MI: Health AdministrationPress.

Zajac, E.E. 1978. Fairness or Efficiency: An Introduction to Public Utility Pricing. Cambridge, MA: Ballinger.

COMMENTS

Warren Greenberg

What can we learn from public utility regulation that can be applicable to theregulation of health care markets? I believe that the answer to this question is "nota great deal" from the economic marketplace but a "good amount" from the politicalmarketplace. Indeed, I believe that the structure, conduct, and performance of thehealth care industry more closely resembles more industries in the economy thanthe typical public utilities of gas, electric power, and water.Most public utilities have decreasing long-run average costs and may be natural

monopolies through their realization ofeconomies ofscale. These economic criteriaseem to be missing in nearly all health care markets. Substantial economies, forexample, do not appear to exist in the physician, hospital, nursing home, andinsurance markets which would warrant natural monopoly or utility regulationstatus. Indeed, there are an enormous number of firms in the health care industry:more than 500,000 physicians; approximately 5,000 hospitals; approximately1,300 commercial insurers; and more than several hundred managed care plans.Regulation of health care has taken different forms than regulation of public

utilities. Regulation has included licensing of physicians, but more importantlyregulation has been used to control in-patient hospital costs (the diagnosis relatedgroup (DRG) approach) and set physician fees (through the resource base relativevalue system (RBRVS)). President Clinton's health care reform proposal wouldimpose limits on health care premiums charged by insuring organizations. Theseregulations will become increasingly more widespread because of the moral hazardproblem referred to by Abbott and Crew and the liability laws which createincentives for physicians to use the latest technology regardless of costs (GerardAnderson 1993). Here, regulation will replace the price system in limiting demand.In contrast, in the regulated industries which Abbott and Crew describe, regulationspecifically focuses on price or rate of return consistent with economies of scale.Now that we have the cost conscious, managed care buyer of health care serviceslimiting the supply of health care services (Dranove, Shanley, and White 1993), Isee little need for additional health care regulation which would limit supply.I would like to comment further on the Abbott-Crew paper. Their paper does an

excellent job ofdemonstrating the difficulties of regulating a natural monopoly andprovides an excellent review of the literature. Transactions costs, rent-seeking bymonopoly producers, and asymmetry of information between the regulated firm


and the state or federal regulator are some of the bigger hurdles. However, theymake a strong case for the countervailing power theory insofar as the countervailingtheory of moral hazard will offset monopoly power by physician and hospitalproviders. The large increases one observes in health care costs over the last threedecades might lead one to believe, however, that monopoly power will be morethan offset by moral hazard.I also believe that Abbott and Crew's assertion that the American people believe

that all individuals have a right to have services of public utilities and health careis not borne out by the facts. The current uninsured rate ofmore than twelve percentof the population would suggest that universal coverage is not an important priorityfor the American people.Abbott and Crew attempt to make the point that regulation often begets addi

tional regulation in many of the utilities. This does not appear to be true in healthcare. The failure of certificate-of-need regulation which limits the number ofhospital beds or new technology above certain dollar limits contributed, in fact, toa shift towards a more competitive market in health care. Under a more competitiveapproach, for example, antitrust laws began to playa greater role in health care.Physician boycotts and mergers which appeared to lessen competition were prosecuted by the Federal Trade Commission and the Department of Justice. Federallaws which prohibited the formation of preferred provider organizations (PPOs)were overturned. The provision of staff privileges at hospitals for osteopaths andchiropractors were also part of the competitive movement. Finally, laws such as"any willing provider laws" were removed from many state agendas. These lawsmade it difficult for PPOs to contract selectively with physicians and hospitals.President Clinton has introduced a managed competition health care proposal

which calls for competition among competing health insuring organizations. Withhealth care costs still increasing and with a large number of uninsured, it would notbe surprising that calls for increased regulation would follow this spurt of competition.

The Politics of Regulation

In the political marketplace, the "capture" theory of regulation applies to the healthcare sector as it does to utilities. Many of the licensing arrangements whichrestricted entry of physicians, for example, were at the behest of the AmericanMedical Association. Many state laws which mandate the use of any willingproviders were enacted at the behest of the providers which were least efficient inthe marketplace. Health care differs from utilities insofar as political power originates not only with providers but with buyers ofhealth care services as well. Buyerssuch as Blue Cross and Blue Shield, the commercial insurers, and the managed careplans, may have more or less political power than the providers of health careservices. Intermixed with this equation is the political power of employers whichsee health care benefits as an opportunity cost to increased profits or wages.

COMMENTS 40

Moreover, state governments may also be lobbied by education and highwayinterests, for example, to reduce payments for health care, especially Medicaid.The politics of health care regulation needs some more work on why regulation

has taken various forms. Why hospital regulation under DRGs before physician feeregulation under RBRVS?Why rate regulation for physicians before the enactmentofmeaningful volume regulation?Why government involvement in health care forsenior citizens, but not for young children?The Abbott and Crew paper provides an important perspective on health care

regulation because of its focus on utility regulation. By understanding both theeconomic and political reasons for the regulation of utilities, we can understandbetter what the appropriate doses of competition and regulation might be for thehealth care industry.

References

Anderson, Gerard, Mark A. Hall, and Earl P. Steinberg. 1993. "Medical TechnologyAssessment and Practice Guidelines: Their Day in Court." American Journal ofPublicHealth 83 (No. II, November): 9.

Dranove, David, Mark Shanley, and William D. White. 1993. "Price and Concentration inHospital Markets: The Switch from Patient-Driven to Payer-Driven Competition."Journal ofLaw and Economics 36 (April): 179-204.

COMMENTS

Geoffrey Liss

Abbott and Crew have written an interesting and insightful chronology of theeconomic and political constraints that faced health care regulators in New Jersey.I was asked to serve as a discussant in their three part Policy Workshop and toprovide my observations of the past regulatory efforts in New Jersey over the lastsixteen years. My qualifications for that task were based on my previous experienceas a financial analyst in the early years ofwhat is commonly referred to as the DRGsystem (P.L.1978, Ch. 83). Over the past five years, I served as the ExecutiveSecretary of the New Jersey Hospital Rate Setting Commission. The Commissionserved as a quasi-judicial body which would resolve hospital-specific rate appeals,sign offon Bond comfort letters, and give approval to an assortment of policy issuesthat effected the rates of 89 hospitals and over 6 billion dollars in revenue.The authors are on target in their descriptions of the roles of the regulators,

monopolists, and politicians respectively. There was a tension between the rentseeking monopolists and the regulator in search of the lowest cost. The regulatoryprocess created a large state bureaucracy and a cottage industry of specializedconsultants. The transaction costs of regulation were significant, and, although noone has attempted to quantify this number, my rough estimate is that it would rangebetween $10-15 million dollars per year when one considers the salaries of staff onboth sides of the table. Even at twice that amount, the cost savings in New Jerseyversus similar states without regulation made the expense worthwhile.Although New Jersey was among the lowest cost states for hospital care, its

regulatory process had become the target of employers and politicians in NewJersey, as the cost of health benefits continued to erode the financial solvency ofcompanies, large and small, private and public, in 1991. The rate setting systemwas designed to do several things. First, it provided a more equitable way of settingprices using DRG's and mean costs to establish standards. Second, it providedcontrolled mechanisms to permit differential payment among the major payers,especially Blue Cross, in order to subsidize their cost of insuring individuals whowould not otherwise be able to afford insurance. Third, hospitals would enjoyadequate reimbursement for what is the otherwise burdensome responsibility tocare for the uninsured by shifting the cost of care to the other payers, includingMedicare.


The problems of unconstrained access, inefficient access in urban areas, and thelack of insurance for large numbers of people were not being addressed. Ch.83 wasan easy political target for employers and politicians to blame for what was and isa systemic problem. Whether one is over or under insured, we are all poorly insured.Consumers are either lacking financial incentives (the moral hazard) or lack theappropriate information, education, or advocacy to drive the market in the rightdirection. Hospital regulation could only mask the greater political and economicissues, while it bore the blame for excessive waste, which was driven by factorsoutside the control of hospital administrators.Uncompensated care costs and increasing shifts of Medicare and Medicaid

shortfalls in payment burdened the financing of health care borne by employers.By 1993, Ch. 83 was discontinued in favor of de-regulation. While competitivepressures have changed the lives of hospital administrators, 1993 was a prosperousyear for most hospitals because few payers have successfully negotiated feeschedules. Those hospitals which provide care for a disproportionate number of theuninsured are struggling to survive, as much of the subsidies derived from Ch.83were removed without any reasonable substitute or alternative.Pure deregulation will adversely effect urban, especially teaching, hospitals,

while most suburban hospitals will benefit from the former's demise. As mergersunite and alliances form, new forms of rent seekers will be created. Deadweightloss, rent seekers, transaction costs, asymmetry of information, scale economies,and moral hazard issues still represent a real barrier for creating an efficient healthcare delivery system through a regulatory model. How well competition can workremains to be seen. The rent seekers and insurance companies, HMOs, andemployers retain the same motives. The only one not organized is the people. Willaccess or quality suffer in order to balance the competing needs of the providersand insurance purchasers or will measurable quality be the cornerstone of competition for market share in the years ahead? Will federal or state governments assumethe role of honest broker of the quality of care issues or abdicate that role to themanaged care companies and employer groups which have begun to assume amoreprominent role in the management of health care?As with any theoretical construct, Ch. 83 was a misguided plan to contain health

care costs by restraints on providers while consumer demand and physicianincentives, both economic and legal (e.g., malpractice insurance) were untouched.It was tantamount to rigging a governor on the car while the drivers were free todrive with reckless abandon-downhill all the way!The resistance to being regulated was apparent in the lack of data, its incompa

rability, and untimeliness. Once the regulators got the needed data, political forcesoften prevented them from making the hard, objective, but necessary decisions totrim what they had defined as "the fat" from hospitals budgets-notwithstandingthe less than perfect demand and access issues described above. Staff becamefrustrated. Morale was low. Succeeding political appointees which were to headthe agency blamed their predecessors and the remaining staff for the failings of thesystem.

COMMENTS 43

Most importantly, there was a lack of vision or sense of purpose and directionwhich would keep the regulator on course. There was no model of what wasdesirable or attainable let alone the blueprints to reach that goal. There was no modelhospital to copy or concrete goals and objectives to follow.As we now can step back, we can recognize that the failure to achieve the success

we hoped to achieve was destined to allude us because political and economicincentives were working against the regulator. Communities would not accept theloss of their local hospital where it was necessary. Physicians with limited privileges also enter the debate for obvious reasonsProvider inefficiency and scale economies, while important and attainable, are

secondary issues in the landscape of health care reform. Physicians pens are themost costly pieces of equipment. Malpractice reform, practice guidelines, andbetter consumer information will ultimately improve health care.Patients' expectations of what modern medicine can and should do must be

curbed through education and access to adequate information so that consumers,patients or their gatekeepers, can choose appropriate care at the lowest possiblecost. Those who served to regulate must turn their attention to monitoring how wellcompetition shapes and distributes quality health care. Ifpatients' best interests canbe preserved, let the market regulate!

3REGULATORY STRATEGIES UNDER

MANAGED COMPETITIONHEALTH CARE REFORMS1

Mark Schlesinger

1. Introduction

Over the past two decades, policymakers concerned about American medical carehave searched for a compatible combination of market forces and regulatorymechanisms (Morone 1993; Ginsburg and Thorpe 1992; Altman and Rodwin1988). Rapidly rising medical expenditures, substantial amounts of inappropriatetreatment, and persisting inequities in the use of health services represent thefrustrating result (Starr 1992; Aaron 1991). Recent efforts at federal health carereform represent a new attempt to effectively marry markets and regulation underthe rubric of "managed competition." This approach to reform emphasizes consumer choice among a set of competing health plans, each of which offers acombination of insurance coverage and a set of affiliated providers. This choice isto be made under the auspices of a national network of organizations whose task itis to "manage" the process of selecting plans and oversee their delivery of healthservices. Early versions ofmanaged competition proposals referred to these entitiesas "sponsors" or "health insurance purchasing cooperatives (HIPCs)." The ClintonAdministration's Health Security Act terms them "health alliances."Set within a competitive framework, these managers have a set of important

regulatory tasks. Indeed, this style of reform was originally referred to as "regulatedcompetition," an appellation that fell into disfavor because of its connotations ofactivist government (Enthoven 1993). Managed competition proposals typically

A number of the points developed in this paper grew out of my discussions with Nancy Wolff,who also provided valuable guidance in editing an earlier draft. The paper benefited fromwritten comments by Brad Gray, Harold Pollack, and Leland Neuberg, as well as suggestionsfrom Ted Marmor, Michael Graetz, Anne Marie Foltz, and other participants in the ISPSHealth Policy Seminar at Yale University. Tracey Thomas and Bonnie Kerker provided ableresearch assistance. Responsibility for any remaining flaws of logic or presentation I sharewith my computer.


emphasize two roles for the health alliances: disseminating information about planperformance to prospective enrollees and making it easier for enrollees who aredissatisfied with a plan to shift to an alternative plan. These are largely technicalroles and the alliances are portrayed more as repositories of information than asmechanisms for collective decisionmaking.My central thesis is that this misportrays the role that health alliances must

assume if managed competition is to produce a socially desirable allocation ofmedical services. The conventional story ignores three salient features aboutmedical care. First, as a result ofmoral hazard and benefit externalities, the choicesabout health care made by even well-informed consumers will significantly differfrom those one would favor from a societal perspective. Second, managed competition proposals implicitly assume that the health services that are delivered dependprimarily on the contractual arrangement between plans and enrollees. This ignorestwo other key interactions: the relationship between enrollee and their individualproviders (typically physicians), as well as the relationship between physicians andthe plans with which they are affiliated.2 Third, no matter how effective healthalliances are at collecting and disseminating information, significant asymmetriesof information will continue to exist among patients, plans, and providers. Thiscreates an important role for agency relationships in health care that must beaddressed in the context ofmanaged competition reforms. The first section of thepaper describes the importance of agency relationships in health care and detailsthe factors that undermine these relationships. The second section applies this logicto our understanding of the appropriate role for health alliances. I suggest that boththe formulation ofgoals and the regulatory instruments3 available to alliances undermost proposals are inadequate and should be replaced by a strategy of "countervailing agency." The paper concludes with a discussion of limitations of thisstrategy and the influence of the larger political context on the ways in whichalliances act as agents for societal interests.

2. Agency Relationships in Health Care

In the absence ofexternal interventions, market forces will fail to efficiently allocatemedical care resources (Sloan 1993). First, because most medical services are paidfor through insurance, moral hazard leads consumers to prefermore care than wouldotherwise be purchased. Second, many types of medical care benefit people other

2 In addition to physicians, there are a variety of other health care professionals who play animportant role in delivering medical services. Many of the same issues emerge in thinkingabout the role of these other providers under managed competition. To ease exposition, I willtypically refer simply to physicians, though readers can translate this to "physicians and otherhealth professionals" whenever they are so inclined.

3 In most managed competition proposals, regulatory tasks are distributed among the healthalliances, state, and federal governments. For simplicity. the paper treats all regulations asfalling under the mandate of the health alliance.

REGULATORY STRATEGIES UNDER MANAGED COMPETITION 47

than the patient (Evans 1984). For example, much ofthe costs of caring for chronicillness are borne by informal caregivers (family and friends), whose services arenever valued in the market. Third, information about treatment and the consequences of illness is often sufficiently complex or frightening that patients preferto delegate decisionmaking to providers and will actively avoid information (Hibbard and Weeks 1987; Strull et al. 1984).Under these circumstances, agency relationships playa critical role in the

delivery of medical care. Although the fidelity of agency relationships may affectmany aspects of medical care, we will focus primarily on the factors that influencethe intensity of medical treatment for patients who have been diagnosed with aparticular condition.4 For most conditions, there exist an array of possible treatments, each with associated costs and benefits. The choice among these alternativeswill be made by providers in consultation with their patients, shaped by theincentives and administrative arrangements established by the health plan.

2.1. Physician-Patient Agency RelationshipsSince Arrow's seminal article (1963), economists have recognized the impact

of information asymmetries on the relationship between patient and provider. Evenwith the best of intent, it is often difficult for physicians to act as effective agentsfor patients, whose interests may be difficult to ascertain and whose needs mayextend far beyond clinical criteria (Eisenberg 1986). In terms that gained currencylater, this relationship is characterized by both "hidden information" (adverseselection) and "hidden action" (moral hazard). As discussed below, the standardmechanisms for increasing compatibility between principal and agent are substantially circumscribed by characteristics of medical services.

2.1.1. Failures and Constraints on Physician AgencyPhysicians have been criticized for being imperfect agents for their patients.

Physicians' ability to act as a reliable agents for patients is circumscribed by theirown limited information (Rizzo 1993; Wolff 1989). Collective medical knowledgeis limited; it has been estimated that for less than a third of all medical proceduresis there strong evidence of clinical efficacy (Eisenberg 1986). Individual physicians apply this collective knowledge imperfectly (Sloan 1993). Patients havevaried, albeit often ill-defined, preferences about how to assess different aspects ofphysical and mental dysfunction, as well as how to respond to the risks associatedwith various types of treatment (Wolf 1989).Unless physicians have a sufficient base of experience with a patient (often

4 Analysis of the role of agency in other aspects of medical care, such as use of diagnostic testsor referrals from primary physicians to specialists, differs somewhat from the analysis oftreatment intensity. However, the same basic issues emerge as in our analysis in the text.Where applicable, I will describe in footnotes how the details of the analysis differ for theseother aspects of medical care.


termed "continuity of care"), it will be difficult to determine how the patient wouldwish to deal with uncertain benefits, risk of side-effects, and the like. Physiciansmay also fail to be effective patient agents because they falsely believe they canachieve more through treatment than is actually feasible or because they fail toascertain their patient's preferences about choices among forms of treatment (Evans1984; Rizzo 1993; Wolff 1989).Uncertainty about appropriate forms of treatment is compounded by uncertainty

associated with legal liability for malpractice (Budetti and Spernak 1992). Evidence suggests that physician behavior is sensitive to the perception of being sued,although their perceptions of risk may be quite inaccurate.5 Consequently, physicians' responses to uncertainty (e.g., risk aversion) may have a substantial influenceon the extent and nature of treatment (Gerrity et al. 1990).Agency failures are not exclusively the result of ill-informed decision makers.

Although professional codes ofethics require that patients' welfare beplaced beforethe physician's financial considerations, physicians do respond to monetary incentives by altering their treatment practices, although these changes do not clearlybenefit their patients (Pauly 1992; Eisenberg 1986). Were it possible to linkincentives to patient outcomes, this responsiveness could be used to improve thefidelity of the agency relationship (Arrow 1985). This has rarely proven feasible inhealth care, because (a) powerful incentives based on outcomes could lead riskaverse providers to avoid complex cases (Pauly, 1992; McGuire and Ellis 1986);(b) many outcomes of treatment are observable only long after treatment (Dranoveand White 1987); and (c) some outcomes are more readily measured than others,creating the risk that providers will overly divert resources to the measurabledimensions and downplay others that are equally salient for patients' well-being(Weisbrod and Schlesinger 1986).Because physicians retain some self-interested motives, financial incentives will

influence their treatment decisions, even if they are also motivated by ethicalconcerns or a desire to be an effective agent. Under fee-for-service paymentsystems, this leads physicillJ''i to provide more treatment than their patients prefer(Dranove 1988; Wilensky and Rossiter 1987; Woodward and Warren-Boulton1984). Under capitation, or fixed payments per patients, physicians will providetoo little treatment, compared to what their patients want (Woodward and WarrenBoulton 1984).The influence of malpractice liability exacerbates the bias toward excess treat

ment under fee-for-service reimbursement. The risk of malpractice claims issignificantly higher for errors of omission than those of commission and appearsto have less to do with the actual quality of care than with certain observablepractices (Budetti and Spernak 1992). This induces higher rates of treatment by

5 For example, physicians tend to believe that people from low-income households are morelikely to sue for malpractice than are other patients. Evidence indicates, however, that theopposite is the case (Burstin et aI. 1993).


self-interested physicians. Those who are most risk averse respond the strongestto the risk of being sued and thus generate higher levels of compensatory treatment.Increases in risk aversion among physicians may also increase the use ofdiagnostictests to reduce uncertainty about the need for treatment (Eeckhoudt et al. 1985).6The combination of fee-for-service reimbursement, the threat of malpractice, andrisk aversion among physicians suggests that the level of treatment prescribed bydoctors will be unambiguously higher that than preferred by a well-informedpatient/consumer. Because patients (who pay only a fraction of marginal costs oftreatment) prefer higher levels of treatment than are optimal from a social perspective, physicians under fee-for-service payment schema prescribe supraoptimallevels of treatment, compared to the level equating marginal social benefits andcosts.Comparative shopping for physicians by prospective patients reduces the extent

of imperfect agency. The more patients are able to accumulate information aboutthe practice styles of competing physicians and are willing to switch physicians,the less discretion physicians have to not internalize their patient's interests(Rochaix 1989; Dranove and White 1987). Thus, in more competitive markets,physicians should act as more reliable agents. Several aspects of medical care,however, limit a patient's ability to police physician-agents.First, patients learn about the practices of their physician over time, as they

experience various health problems (Pauly 1988). Similarly, physicians acquireknowledge about a patient's condition through extended interactions, learning tointerpret their reported symptoms, and monitoring their compliance with prescribedtreatment regimes. Both physician and patient thus have considerable humancapital invested in their relationship. This feature of the relationship, describedclinically as "continuity of care," inhibits the movement of patients among providers (Hibbard and Weeks 1987).Second, medical care is a "reputation good," in that individuals judge quality of

care based in part on the experience that others within their social networks havehad with a given provider (Pauly and Satterthwaite 1981). The extent of a patient'sinformation thus depends on the quality of the social networks through which theycollect data and the extent to which these networks have relevant information. Ina community with many physicians (i.e., more competitive markets), anyoneprovider may have little contact with a prospective patient's social network, so thatan individual will find it difficult to assemble sufficient information to judge thequality of care offered by that physician before seeking treatment.

6 The impact of risk aversion on treatment is unambiguous, but the implications for diagnostictesting are less certain (Eeckhoudt et al 1985). When physicians are initial risk neutral, a smallincrease in risk aversion increases the desire for testing to verify their diagnosis. However,diagnostic tests are useful for the clinician only if they affect the choice of treatment.Physicians who are highly risk averse will be strongly inclined to treat, so that they have littleneed to test.


Third, Evans (1984) suggests that the very effort by physicians to internalize thewell-being of patients into their clinical decisionmaking process may lead them todistort their own understanding of medical efficacy. By this logic, the moreconcerned physicians are for their patients, the more they will want to believe thattreatment can improve their patients' well-being. This leads them to overstate theeffectiveness of interventions both to themselves and to their patients. If thisaccurately portrays physician decisionmaking, then only the physicians who do notfeel any connection to their patients are unbiased in their assessment of medicalefficacy. But these are the physicians who will be most responsive to financialincentives encouraging overtreatment. Consequently, consumers who are "shopping" have choices only between two types of providers who each overtreat, albeitfrom quite different motives.For all these reasons, market forces fail to eliminate imperfect agency by

physicians. In the absence of other external constraints or incentives, this leavesphysicians providing more care than informed patients would prefer. This prediction is supported by evidence from recent demonstration projects designed to betterinform patients and empower their decisionmaking. Wt.en patients take a moreactive role with more complete information, they tend to prefer less aggressivetreatment than their physicians would otherwise have provided (Steinwachs, 1992).This agency failure is exacerbated by the fact that overtreatment imposes costs thatare more salient for society as a whole than for the individual patient with insurance.

2.1.2. Conflicts for Physicians Produced By Dual AgencyPatients who are insured pay only a fraction of the costs of their health care out

of pocket. The physician-agent, equating marginal costs with marginal benefits asviewed from the patient's perspective, will thus overprescribe treatment relative tothe societal optimum. When physicians are paid fee-for-service, their personalfinancial incentives reinforce this tendency to overtreat (Woodward and WarrenBoulton 1984; Pauly 1980).Over the past two decades, as health care costs grew faster than national income,

concern about these incentives for excess treatment grew more pronounced. Bythe early 1980s, observers began to suggest that physicians had an obligation tosociety to consider the true marginal social costs of medical care they prescribed(McGuire 1986; Goldsmith 1984). Those writing about medical ethics acknowledged this broadened definition of agency, which gained surprisingly broadacceptance among physicians, although some strongly resisted the role of agent forsociety (Wolf 1994; Brock and Daniels 1994; Mechanic 1987; Eisenberg 1986).By the early 1990s, the physician's role was being described by some observers asa form of "double agency," representing the interests of the patient as well as thirdparties (most generally, society as a whole) who pay for medical care (Blomquist1991; Morreim 1991). Anecdotes suggested that practicing physicians were givingsubstantial weight to both patient and societal agency (Smith 1993).It is doubtful that individual physicians can appropriately balance these two

agency roles. Physicians generally have only limited knowledge of the charges for


the care they prescribe (which may not reflect true costs of production), let alonean accurate assessment of the medical benefits of any given treatment for theirpatient (Eisenberg 1986). Assessing the marginal social costs and benefits wouldbe far more demanding. Medical care entails a variety of external benefits, aboutwhich clinicians have no particular expertise. Some of these involve contagiousdiseases, others result from an altruistic concern that the public has for those whoare ill (Evans 1984). Clinical expertise may help to assess the first type ofexternality, but offers little insight into the second.Several more externalities exist in health care markets, although they are

typicalIy overlooked in discussions of market failure (Sloan 1993; Pauly 1988;Evans 1984). The first involves the impact of medical care on productivity. Bydetecting disease at an early stage, prevention programs can reduce the subsequentcosts ofmedical care and increase productivity, albeit often at significant aggregatecost (RusseII1987). The productivity benefits are often far larger than the foregonemedical costs: for hypertension prevention, for example, they are three to five timesas large. But productivity benefits are difficult for clinicians to measure, and evenphysicians acting as informed agents for their patients are unlikely to fulIyinternalize these benefits.The second category of externalities involve the cost of informal caregivers.

For a variety ofchronic illnesses, these costs exceed those of formal services (Popeand Tarlov 1991). For example, it was recently estimated that for patients withAlzheimers disease who continue to live in the community, the social costs ofinformal care average three times as large as expenditures on medical care (D. Riceet al. 1993). The benefits from deterring the progression of chronic ilIness thusapply primarily to informal caregivers.A third category of externalities concern costs of illness shouldered by unrelated

persons. The clearest examples involve behavioral disorders. The Institute ofMedicine estimated that the social costs of ilIicit substances (not including alcohol)were between $50 and $100 billion annualIY' of which 15 percent stemmed fromlost productivity by coworkers, another 45 percent due to the consequences ofcrimeand spending on law enforcement (Gerstein and Harwood 1990).These various externalities are important features of contemporary medical

care.7 It is difficult to imagine how physicians could assess the presence or extentof these external costs and benefits since many involve the welI-being and prefer-

7 Exactly how significant depends on how one measures the prevalence of these variousconditions. The costs associated with treatment provide one measure. In the mid-1980s, it wasestimated that infectious diseases represented between five and ten percent of the costs of allmedical care, but this was before the advent of AIDS, which substantially increased thosecosts (Evans 1984). Preventive screening programs represent a more modest expense, perhaps2-3 percent of all medical spending (Russell 1987). Chronic illnesses is much more costly,representing at least a quarter of all health care spending (Pope and Tarlov 1991). Behavioraldisorders of various sorts involve slightly less than 10 percent of all health care spending(Frank et al. 1994).


ences of persons with whom the clinicians have no contact. Proposals to haveindividual doctors make treatment decisions based on benefit-cost studies(McGuire 1986) are unrealistic, given the limited assessment of medical treatmentin these terms, the difficulties in accurately measuring external costs and benefits,as well as the heterogeneity of health needs and treatment effectiveness forindividual patients.

2.2. Health Plans as Societal AgentsThe limited ability of physicians to internalize the costs and benefits of medical

care have led reformers to support the growth of prepaid health plans as a response.Prepaid health care plans were seen by their initial advocates as a means ofencouraging alternative styles of medical care (Luft 1981), since the plans sharedin the financial risks associated with the provision ofhealth care services. In contrastto traditional health insurance contracts, prepaid health plans agree to provide a setof health care services to enrollees for a pre-determined fixed fee. If the plan'shealth care costs exceed the capitated fees, the plan losses money; if, on the otherhand, fees exceed the costs, the plan earns a profit. Much of the appeal of prepaidplans to policymakers was based on the notion that prepayment led plans tointernalize the future costs of illness, encouraging them to treat illness at an early(and presumably cheaper) stage as well as to employ efficient forms of treatment(Brown 1983). This conception of organizational incentives and response led tothe label "health maintenance organization" (or HMO).Experience with HMOs during the 1970s and 1980s suggests that the incentives

associated with prepayment did lead to substantially lower health care costs,compared to other forms of insurance coverage (Arnould et al. 1993) However,there was considerable variation in performance among plans, associated with thestructure of the plan, its ownership form, the incentives it used to affect physicianbehavior, and the intensity ofmarket pressures (Hillman et al. 1992; Schlesinger etal. 1987; Luft 1981). Moreover, although prepaid plans had an incentive to reducethe provision of health services compared to other forms of insurance, it was lessclear that the level viewed as optimal for the standpoint of the plan wouldapproximate that viewed as optimal from the perspective of society as a whole.Prepaid plans combine functions of insurance and delivery of treatment within

a single organization. In so doing, they also introduce an information asymmetrybetween the patient/enrollee and the insurer (Pauly 1986). Because enrollees'health needs differ substantially in ways that are not readily measured, insuranceplans may suffer from adverse selection or benefit from favorable selection.Because the extent of health care costs reflects in part actions of enrollees thatinsurers cannot easily observe, insurance markets are also subject to moral hazard.As a result, those who are insured have less incentive to seek out the most efficientproviders or to obtain prevention services. We refer to differences in patients'health needs and propensity to exploit information asymmetries as the "heterogeneity" of the patient population. Insurers respond to this heterogeneity withselective enrollment strategies to avoid high risk patients as well as cost sharing


requirements and utilization management to dampen the effects of moral hazard(Pepper Commission 1990).

2.2.1.1mperject Agency by Health PlansProponents of HMOs have argued that prepayment creates an incentive for

efficient use of medical resources by making the plan face the true marginal costsassociated with treatment. In addition, the plan is expected to internalize thebenefits of prevention care, since it benefits from reducing the future costs ofmedical care (Luft 1981). For these reasons, it is argued that prepaid plans act asreliable agents for society and require no outside oversight to ensure that care undertheir auspices is optimal from a societal perspective (Boggs 1986). This claim isdemonstrably false. Although prepaid plans face the full marginal costs ofmedicalcare, they internalize the benefits of treatment much less completely. Consequently,plans will be imperfect agents for a society concerned about cost containment.Consider each type of benefit externality described above.Preventive care provides much of the rationale for the purported benefits of

HMOs. The incentives associated with prepayment, however, fail to reflect the fullmarginal social benefits of prevention and thus are inadequate to induce HMOs tobe social agents. Even if plans captured the full medical cost savings from keepin~

enrollees healthier, these typically represent less than halfthe total social benefits.However, the plan does not fully capture the medical cost savings from keepingenrollees healthy. Most preventive interventions reduce health costs that wouldhave occurred many years in the future. But enrollee turnover in HMOs is quitehigh, typically averaging about 15-20 percent annually.9 For enrollees who switchplans, the benefits of prevention are captured by whatever insurers they have in thefuture. 10 It is thus not surprising that the use of prevention services is not generallyhigher in HMOs than under fee-for-service insurance with comparable copayments(Freund et al. 1989; Office of Technology Assessment 1989; Luft 1981).Benefits that are externalities for patients or physicians may also be external to

prepaid plans. This is obvious for infectious diseases. The HMO has a financialincentive to deter infection among its members. But since anyone HMO enrolls

8 Most of the remaining benefits stem from increased productivity from a healthier workforce.This provides no benefits to the HMO. Of course, if the HMO competes to attract enrolleesand those enrollees are concerned about productivity, then it has an incentive to respond tothese concerns. However, as noted above, the costs of lost productivity for workers are alsosocialized in part through public and private disability insurance.

9 Calculated from unpublished data on HMOs operating between 1987 and 1991.10 There are some exceptions. Prenatal care has been shown to reduce the medical costs for

treating infants born at low birthweight (Office of Technology Assessment 1987). Since thesesavings occur within roughly nine months of conception, the HMO with pregnant enrolleescaptures much of the benefits of prevention. But even in this case, it fails to capture all of thebenefits. Much of the social costs of low birthweight result from developmental delays in thechild, which increase the subsequent costs of public education and likely reduce futureproductivity. These benefits remain external to the HMO.


at most a small portion of each community, these incentives are significantly lessthan the marginal social benefits.A comparable situation exists for other external benefits. To the extent that

treatment deters the progression of chronic diseases, the benefits accrue primarilyto informal caregivers. HMOs are thus likely to underprovide treatment for chronicillness, relative to the level that is optimal from a societal perspective (Schlesinger1986). Similarly, most of the costs ofbehavioral disorders are external to the healthcare system and many impinge on people who have no affiliation with the patient.Again, prepaid plans will provide too little treatment for these conditions.The incentives for health maintenance organizations to undertreat certain con

ditions are compounded by problems of adverse selection. Since HMOs aretypically paid a flat rate per enrollee, II it is in the plan's financial interest to avoidenrollees with above-average expenses and to encourage high-cost patients todisenroll (Luft and Miller 1987). For example, prepaid plans have an incentive toavoid prospective enrollees with chronic illness because they are predictablyhigh-cost cases. One way to do this is to provide minimal treatment for theirconditions, so that dissatisfied individuals disenroll (Schlesinger and Mechanic1993).For all these reasons, one would expect prepaid plans to offer suboptimal care

for a significant number of medical conditions. The extent of this departure fromthe social ideal depends on the magnitude of the uninternalized benefits. It mayalso depend on various characteristics of the plan, as discussed below.

2.3. The Interactions Between Plans and PhysiciansTo this point, we have been assuming that physicians and prepaid plans act

independently of one another. This is a sensible assumption for identifying thegoals of the two types of agents, but it is not an accurate description ofhow medicalcare is actually delivered. HMOs can only provide medical care under the auspicesof physicians. Whether physicians are employees of the HMO or are associatedwith the plan through some other contractual arrangement, the performance of theplan depends in large part on its ability to shape physicians' behavior to becompatible with the objectives of the HMO (Berenson 1991).HMOs make use of variety of financial incentives and administrative mecha

nisms to influence the treatment practices of affiliated physicians (Hillman 1991).The same information asymmetries that exist between physician and patient alsoexist between physician and plan. These make it difficult to "manage" physicians,a task that has been likened to "herding cats." The more successful the plan is atthis task, the more the health care delivered matches the plans's objectives and theless it reflects the preferences of affiliated physicians. In practice, not all plans are

II Those that enroll Medicare beneficiaries are paid a rate adjusted for age, sex, and geographiclocation, but these capture only a small portion of the individual variance in health care costs(Newhouse 1994).


equally successful at this (Staines 1993; Hillman et al. 1992; Moran and Wolfe1991.) As a result, there is a distribution of plan performance, with the goals of theHMO and the fee-for-service physician as endpoints.The ability of a plan to shape the practices of affiliated physicians depends on

the tools it has available, and its bargaining position. Physician behavior can beinfluenced by financial incentives, controlled by external review, or shaped by thedevelopment of norms ofpractice within the group. Evidence suggests that the latterapproach is the most powerful, but it can only be used in group practice plans(Staines 1993). Because these require substantial economies of scale (minimumsize for efficient operation appears to be between 100,00 and 150,000 enrollees),they are feasible only in areas with sufficiently dense population (Kronick et al.1993). Anecdotal reports suggest that financial incentives can be made sufficientlypowerful to induce significant changes in physician behavior, but these are infrequently employed because they create considerable financial risk for the providers(Hillman et al. 1993). Various forms of external review appear much less effectiveat changing provider behavior, although they may affect costs by prohibitingreimbursement for practices that violate practice standards. With any of theseinstruments, the plan will be more effective when it has more bargaining powere.g., when there are few alternative plans or there are a surplus of physicianscompeting for a limited number of affiliations.The arrangements between a plan and its affiliated providers can alter relation

ships between physicians and patients. More specifically, the influence exerted byplans over the delivery of medical care can both threaten the fidelity of physicianpatient agency and can alter the demands placed on effective agents. For example,if a large part of a physician's income is placed at risk by an HMO, the physician'sfinancial incentives may lead him or her to avoid agressively pursuing expensivetreatments, even ifthey are in the best interests of the patient (Wolf 1994). HMOsthat review physician decisionmaking through various forms of utilization management create a different a challenge for physician-agents. Utilization reviewgenerally requires that physicians obtain prior approval for selected procedures. Ifthe initial review discourages use of a treatment that the physician believes is in thebest interest of the patient, the physician acting as good agent must advocate for anappeal or otherwise try to convince the review organization that the initial decisionwas in error (Macklin 1993).

3. Regulation and the Role of Agency Relationships in Health Care

The preferred amount and type of medical care will be different for HMOs,physicians, patients, and society as a whole. The HMO equates expected marginalcosts to the plan with expected marginal revenues (e.g., the market response).Patients make their choice in terms of personal costs and benefits, physicians somecombination of personal interests and agency considerations, while society as awhole equate marginal social costs and benefits. Assume initially that providers,patients, and plans each have homogeneous needs and preferences. For many types


ofmedical care, these preferences can be unambiguously ranked on the basis ofourprevious analysis. One would expect HMOs to favor the least treatment, withsociety, patients, and physicians (paid on a fee-for-service basis) ranking inincreasing intensity of preferred treatment. (This ranking is illustrated in figure 1,with levels of treatment labelledTH, Ts, Tp, andTMrespectively, though the specificplacement along this continuum is arbitrary.)The primary exception to this pattern involves services where the external

benefits substantially exceed the personal benefits. For these services, the societaloptimum involves more treatment than individual patients would prefer, even ifthose services were available to them at no charge. Important examples includevarious forms of prevention, as well as treatment for substance abuse (and perhapsother behavioral disorders) (Steinberg 1993; Gerstein and Harwood 1990). Physicians are motivated to provide such services by financial incentives and professional norms, but since the medical benefits of prevention are generally smallrelative to the social benefits, providers will favor prevention to a lesser extent thanis socially optimal. Because the benefits of preventive services are largely externalto the plan, the optimal treatment from the plan's perspective will not differ greatlyfrom that for individual enrolleesP This leads to a ranking of preferences forprevention as portrayed in figure 1.The amount of treatment actually provided in the health care system depends on

the interaction of these four sets ofpreferences. The more competitive is the marketamong plans, the more responsive will the plans be to consumer preferences, sothat the care provided through plans will shift from TH toward Tp (and similarlyPH toward Pp). The greater the bargaining power of physicians relative to plans,the more treatment will reflect provider preferences. The more inclined or motivated are physicians to act as agents for patients, the more their actions will becongruent with patient preferences.

3.1. Proposed Goals and Strategies for Health AlliancesManaged competition proposals differ somewhat in terms of the role and scope

of powers assigned to the health alliances (Eckholm 1993; Starr and Zelman 1993;Wicks, Curtis, and Haugh 1993; Catholic Hospital Association 1990; Enthoven andKronick 1989). Nonetheless, they embody considerable agreement about the goalsof regulation under these reforms in general and the regulatory mission of healthalliances in particular. The primary objective for the health alliances in theseproposals is to make plan performance more compatible with the preferences ofpatients. To promote a more competitive market, alliances are expected to facilitateenrollees switching among plans by providing information about plan performance

12 Recall the evidence cited above that the frequency of preventive service use in HMOs wasabout the same as for individuals enrolled in fee-for-service insurance that did not charge themfor use of the preventive services.

REGULATORY STRATEGIES UNDER MANAGED COMPETITION

LOW

57

HIGH

THMO

TSOCIETAL

TPATIENT

TMD

LOW HIGH

p PHMO PATIENT

PMD

PSOCIETAL

Figure 1. Comparing Preferences About Medical Care

and regularly requiring "open enrollment," periods during which any individualcan join any plan. If inter-plan competition is to make plans responsive to individualpreferences, alliances must ensure that enrollment and disenrollment cannot bemanipulated by the plan in a manner that provides it with a healthier or less riskygroup of enrollees (Enthoven 1993).In an effort to introduce cost constraints to this market, many proponents of the

managed competition model favor a particular strategy for enhancing competition:encouraging plans to produce a relatively standardized set of services, so thatconsumers can more readily choose among plans on the basis of price. "Standardization should deter product differentiation, facilitate price comparisons, andcounter market segmentation. There are powerful reasons for as much standardization as possible ... to facilitate value-for-money comparisons and to focuscomparisons on price and quality" (Enthoven 1993,32).This strategy of regulation is coherent and in some ways plausible. However, it

is flawed as a basic mandate for regulating health services under managed competition. This is true for three distinct reasons: (I) it fails to reflect the impact ofexternalities on individual decisions about medical care, (2) it ignores agencyfailures by plans and providers, and (3) it overlooks the heterogeneity of patientand provider preferences and the implications of heterogeneity for enrollee choiceamong health plans.First and foremost, the conventional approach ignores the divergence of indi

vidual and societal preferences for medical care. Even if plan and physicianbehavior were made perfectly compatible with patient preferences (e.g.,TH =TM=Tp and PH=PM=Pp), there will be too much treatment and too littleprevention from a societal perspective. (Some, though not all, managed competition


proposals would reduce or eliminate tax subsidies for private health insurance tomake individuals more sensitive to the costs of using medical services. But thisdoes not eliminate the moral hazard produced by insurance that leads to excessivetreatment. Nor would it have any positive effect on the underutilization of preventive services.) Inevitably, alliances must assume the role of balancing individualand social preferences for the intensity of treatment or other attributes of medicalcare.A second problem with the conventional portrayal of goals for health alliances

emerges because the alliances, no matter how effective, will not be able to makeprovider and plan behavior fully consistent with patient preferences. Strategies thatenhance consumer choice ensure that plans will be fully responsive to enrolleepreferences. No strategy of information dissemination will be able to eliminate theinformation asymmetries between patients, plans, and providers: much of thisinformation is simply too technical for consumers to comprehend, and manystandards of performance are statistically unreliable for individual practitioners(Blumenthal 1994). As discussed above, even strong market forces do not necessarily induce plans or providers to act as perfect agents. And competition will oftenbe muted: most regions of the country lack sufficient population density to supportmore than two or three competing plans and many can sustain only a single plan(Kronick et al. 1993).Under these circumstances, it matters whether plan or provider preferences

prevail in shaping treatment for enrollees. In the circumstances illustrated in figure1, for example, plans that are affected more by physician preferences will behavein ways more compatible with patient preferences about treatment intensity, whiletreatment that is shaped more by the goals of the HMO will be more compatiblewith societal goals. Unless the health alliance has the mandate and the mechanismsfor influencing the balance of preferences within plans, it will have relatively littlecapacity to shape medical treatment in a manner that matches societal preferences.A third problem follows from the fact that the preferences of all providers and

patients are not in fact the same. Both physicians and patients will have variedpreferences for treatment, referrals, and the extent of preventive services, due tovariations in their aversion to risk as well as their valuation of the costs and benefitsof medical services (Pauly 1992). Because each health plan affiliates with a set ofproviders with varied preferences, the intensity of treatment or frequency ofreferrals will vary within the plan. The extent of this variation within each plan willdepend on the variance of preferences among providers practicing in the community, the number of plans operating in that community, and the ability of plans toinduce providers to practice in a manner that is compatible with the goals of theplan.With persisting information assymetries, consumer welfare will depend on the

behavior of plans and providers acting as agents. Given the limited prospects forusing incentives to achieve congruence, the fidelity of these agency relationshipswill depend to a significant extent on appropriate matching of preferences betweenprincipal and agent (Wolff 1989; Pratt and Zeckhauser 1985). For example, a


patient who is highly risk averse with respect to the side-effects of treatment willlikely be ill-served if enrolled in a plan that emphasizes aggressive treatment ortreated by a physician who is greatly concerned about the malpractice risks createdby a passive approach to a condition.Under managed competition schemes, matching occurs in two stages: the

enrollee chooses first the plan, then a physician within the plan. This approachassumes that patient/consumers can more easily assess the quality of a plan basedon its reputation (Enthoven and Kronick 1989). Assume initially that prospectiveenrollees are unable to make any reliable judgments about the quality of individualphysicians, or that the assessments that they do make reflect the interpersonal skillsof the providers, not their technical abilities or preferences about treatment (Mechanic 1989). The ability of patients to find an appropriately matched agent formaking decisions about the intensity of treatment thus depends entirely on theirassessment of the reputation of the plan. If there is considerable variance inphysician preferences within the plan, the odds of an appropriate match are lowerthan if provider preferences within each plan are relatively homogeneous. Ittherefore follows that health alliances should adopt policies that promote intra-planhomogeneity. Assuming that providers will affiliate with the most compatible plan,onemethod for doing this involves increasing the number ofplans in the communitythat operate in distinct market niches. More precisely, if patient and providerpreferences are uniformly distributed on an interval from low to high intensity oftreatment, principals and agents will be most effectively matched if the plans aredistributed over segments of length lI(N + 1) of this interval.Under some conditions, this even distribution is exactly the result that one would

expect from the behavior of profit-maximizing plans (Calem and Rizzo 1993).However, under other equally plausible circumstances, plans will bunch toward thecenter of the distribution-that is, inadequately specialize-unless the healthalliance intervenes. Indeed, the common proposal to have alliances encourageprice-competition among relatively similar plans calls explicitly for alliances toencourage this sort of "bunching." Although this would intensify competition overprice, it comes at the cost of increasing the mismatch between patients andproviders, because it produces greater heterogeneity of providers within each plan.Consider now a different, somewhat more realistic, assumption about patients'

learning. Assume that patients can discern from their experience reasonably accurate assessments of their doctor's practice style. What the patient cannot determinefrom observation is whether these practices are a result of the physician's ownpreferences or the constraints established by the HMO.13 Ifpatients are dissatisfied

13 Other aspects of the plan, including the price of its premium, may of course be signals of theplan's policies, so that the enrollee can estimate how much of their experience is specific to aparticular physician. For example, high premium plans may be plans that allow the mostreferrals and treatment, so that if one's own physician seems to be doing too little of either, thebest option is to look for another physician within the same plan. Price signals in this market


with their treatment, they will switch to either a new physician, a new plan, or both.The problem they face is in determining which of these changes is the correct move.Given the information asymmetries that exist in medical markets, this will be a

difficult call for most people to make. The decision is made more difficult whenplans use particular strategies for influencing provider behavior. When a plancontrols treatment practice through utilization review, a provider can be quite clearabout the treatment he or she considers appropriate and can inform the patient ifthat treatment plan is rejected by the utilization review process. However, ifphysician practices are influenced by financial incentives or group norms, they arelikely to internalize these influences. It becomes much more difficult for theenrollee to tell whether their treatment represents their provider's preferences orthose of the plan. Given the lack ofenrollee's knowledge aboutwhy they are treatedin a particular manner, they are likely to make the wrong switch. Switchingproviders when they ought to be switching plans repeatedly disrupts their continuityof care as they fruitlessly search for a particular physician who is a good match fortheir preferred style of treatment. Conversely, switching plans inappropriatelycreates its own set of costs and associated externalities.Disenrollment from one plan and enrollment into another is costly, requiring

additional administrative burdens and leading to higher use of health care whileenrollees accliminate to the plan's operating procedures. Studies indicate that anewly enrolled HMO member has costs that are five to 10 percent higher in the firstyear (Schlesinger et al. 1987). When these costs are created by mistaken switchingamong plans, they represent a form ofdeadweight loss to the system. A second costinvolves the incentives switching creates for plans. As discussed above, when thereis high enrollee turnover, plans have less incentive to invest in preventive care. Thiscompounds the problem ofbenefit externalities associated with preventive services.

3.2. Alternative Goals and Instruments for Health Alliances: The Strategy ofCountervailing AgencyThe analysis presented here suggests that the conventional regulatory strategy

favored for health alliances under managed competition proposals is both misleading and counterproductive. It is misleading because it portrays the health alliance'srole as purely technical, when in fact it involves value-laden choices about thepriorities given to individual versus societal well-being. It is misleading because itsuggests that consumers need only learn about the collective performance of healthplans in order to make sound choices about their health care. It is counterproductivebecause it ignores vital aspects of the physician-patient relationship that may suffer

are, however, quite unreliable. Plans may also have high premiums because they are inefficient(e.g., contract with high-cost hospitals) or are willing to enroll higher risk patients. If either ofthese is the case, an enrollee may mistakenly believe she has joined a "generous" plan andfruitlessly seeks physicians who will treat in this way, though in reality the plan is constrainingtreatment and referrals to low levels for all physicians.


under managed competition and it encourages strategies that make it more likelythat patients will be ill-matched to providers. There are alternative regulatorystrategies that health alliances might pursue that are just as compatible with theframework of managed competition. I describe one alternative here.

3.2.1. Goalslor the Health AllianceBecause the intensity of treatment (or preventive services) desired by individuals

and society differ, alliances can increase societal welfare by shifting medical careaway from the level preferred by individual patients. But this requires identifyingan appropriate alternative level. There are several complications.First, conventional economic criteria for societal optima (e.g., the point at which

marginal social benefits and costs from treatment are equalized) can be directlyapplied in medical care. More specifically, Americans weigh more heavily realizedsituations for individuals than expected outcomes for society as a whole (e.g.,"statistical lives") (Schelling 1968). To illustrate, policymakers often balk atpolicies that are life-saving but costly. However, in any defined instance (e.g.,children trapped in wells) people willingly expend far greater resources in life-saving efforts.Ethicists refer to this emphasis on realized individuals over statistical lives as

the "rule of rescue" (Hadorn 1991). It conflicts with the utilitarian analysis usedin defining social welfare functions. Indeed, from the utilitarian perspective, it mayappear irrational (Evans 1984). But it is quite clear that it reflects deeply held socialvalues and that these same values affect how physicians treat illnesses and societyallocates health care resources (Hadorn 1991; Eddy 1991; Menzel 1983). Ifpreferences about realized individuals are given additional weight beyond theexpected social optimum, then the optimal level of treatment that should be soughtby the health alliance lies somewhere on the interval [Ts, Tp], the exact pointdepending on the weight assigned to concerns for the rule ofrescue concern. Werefer to this new optimum as the "balanced optimum."Because people may differ in the relative value they assign to realized versus

statistical lives, disagreement should be expected regarding where on the interval[Ts,Tp] the health alliance should target. This is not a choice that can be made ontechnical grounds. It requires a means of identifying collective preferences on ahighly value-laden issue. The state of Oregon has made progress in this direction,though its chosen mechanisms have met with considerable criticism (Brown 1991).Remarkably little attention has been paid to the governance of the health alliancesor to the ways in which governance arrangements will affect the ability of theseorganizations to deal with contentious issues in a legitimate manner (Zelman 1993).Although the mechanisms for collective decisionmaking are left vague, there are

some clear parameters about the range of appropriate choices. The alliance shouldnever favor treatment rates above Tp or below Ts. These bounded thresholds arenot directly observable. But the levels of treatment preferred by HMOs andphysicians are observable, albeit with some imprecision. The gap between Tp andTM can be expressed as the magnitude of imperfect agency between physicians and


patients. A similar gap can be described for the relationship between Ts and TH.One way of ensuring that treatment rates under managed competition actually fallsomewhere within the desired interval is for the health alliance to minimize thesetwo gaps associated with imperfect agency. Consequently, under this strategy it isessential that the alliance be able to influence the behavior of both plans andproviders.Having minimized agency failures, the alliance can shift the allocation of

medical services between societal and individual optima by altering the "balanceof power" between physicians and plans which with they are affiliated. In areaswith a stronger preference for the individualized treatment optimum (i.e., the ruleof rescue prevailed), the alliance could strengthen the relative bargaining positionof physicians. In other areas, the position of the HMO could be enhanced.

3.2.2. Improving the Fidelity ofAgency Behavior by Plans and ProvidersIn the case of health plans, agency failures are fostered by two conditions:

extensive benefit externalities and incentives to selectively enroll or disenrollindividuals to create a favorable risk pool. Alliances could address the problem ofexternalities in three ways. First, they could adopt policies that internalize more ofthe benefits of the prepaid plan. For example, by reducing enrollee turnover, thehealth alliance ensures that the HMO internalizes a greater portion of the futurebenefits of prevention care. Similarly, plans that enroll a high proportion of thepopulation from a particular community would internalize more of the costs ofinfectious diseases or behavioral problems.The second alternative is to change the plan's perceived marginal benefits

through taxes and subsidies for those medical services with extensive negative orpositive externalities. This was the approach used in the British National HealthService to encourage capitated primary care physicians to deliver preventive care.By changing the way that primary care doctors were paid for preventive servicesto a fee-for-service system, utilization of preventive services was increased (Culyerand Meads 1992). Early versions of the Health Security Act incorporated provisionsof this sort for various types of patients, including the disabled, but these weresubsequently eliminated from the legislation.The third option involves encouraging the formation of plans that internalize

externalities as part of their objectives. Historically, firms operating under privatenonprofit ownership have provided significantly higher levels of public goods andresponded to a variety of market failures (Marmor et al. 1987). It remains unclearwhether ownership provides a comparable signal of organizational objectives forHMOs. Most prepaid plans began operation within the past decade when the healthcare system becamemore commercialized. Nonprofit organizations in this industrylack the history of philanthropic support and community involvement that is foundin many hospitals. Nonetheless, whatever their current track record, it is possiblefor health alliances to encourage thedevelopment ofnonprofit HMO plans, in returnfor some evidence that they are in fact providing some community benefits valuedby society.


Selective enrollment poses additional challenges to the health alliance. Theconventional mandate for health alliances focuses on enrollment practices, suggesting that the alliance should make it as easy as possible for people to switch fromone plan to another. As noted above, however, this ignores the externalities createdby switching plans and exacerbates other externalities (i.e., causes a greaterdivergence in the value the plan places on preventive care relative to their value forsociety as a whole). And this approach largely ignores the incentives facing plansto disenroll patients who they expect to have above-average costs in the future. Inthe absence of methods that can effectively adjust the payments that plans receiveto take into account health risks (Newhouse 1994), the externalities created byselective disenrollment must be addressed in another manner. One promisingmethod would require plans to pay a penalty for disenrollment. If it provedadministratively feasible, the size of this penalty could be made contingent on thesubsequent costs of care for the disenrolling patient. In other words, the plan fromwhich a person disenrolls would be required, at least for the short-term, to foot partof the bill for the plan that subsequently enrolls them. Because the newly selectedplan could be one that is high cost either because it is inefficient or favors intensivetreatment, this makes disenrollment a risky proposition for the original plan. Toreduce this risk, they have an incentive to devote more resources and attention tothe high-cost patients who might otherwise be underserved.The strategy of countervailing agency thus suggests that alliances should be

concerned about the behavior of plans, a focus that is similar to that of moreconventional mandates. However, the goal under this new strategy is to make thema more effective agentfor society, not for the individual enrollee. The interests ofindividual patients are to be protected by their physicians or other health careproviders.For these protections to be effective, alliances must ensure that the physician

patient agency relationship is not compromised in the evolution of the managedcompetition model. This is a role which has been almost completely neglected inpast discussions of health alliances (Wolf 1994; Blumenthal 1994). There are threeapproaches that alliances could employ to protect or reinforce the fidelity of thephysician's role as agent: (1) ensuring that physicians and patients are moreeffectively matched, (2) limiting the mechanisms that plans use to influencephysician behavior in ways that might compromise physician agency, and (3)monitoring the behavior of physicians to determine when they have failed in theirrole as agents.The match between physicians and patients could be enhanced in several ways.

As noted above, the information available to patients about treatment practicesunder managed competition will largely be at the level of the plan. Plan averagesare more meaningful reflections of the behavior of individual physicians only whenplans have a homogeneous panel of physicians. The more plans that are operatingin a community, the more they operate in distinct market niches with respect totreatment practices and the more completely physicians sort themselves to the planwith which their own treatment preferences are most congruent, the better plan


reputation can serve as a means of matching patients and physicians. As inconventional managed competition proposals, the strategy of countervailingagency thus calls for encouraging the entry of additional plans into each market. Incontrast with conventional approaches, plans would be expected to differentiatethemselves rather than compete on the basis of price for a common product. Thegoal of encouraging entry is not to induce greater competition among plans, but tocreate plans that have greater internal coherence of behavior, so that plan characteristics accurately signal provider preferences and enhance patient-physicianmatching, while minimizing the (switching) costs associated with matching.A second way ofpromoting better matching of patients and providers is to make

it easier for enrollees to determine when the treatment that they dislike is the resultof the preferences of their physician or the influence of the plan in which they areenrolled. As noted above, when plans use financial incentives or influence grouppractice norms, it may bequite difficult for enrollees to separate out these influenceson treatment practices. From this perspective, more overt forms of utilizationmanagement are preferable (Wolf 1994). It would therefore be in the collectiveinterest to limit the ways in which plans influence provider behavior, an authoritythat alliances are not given in existing proposals.The relationship between plan and physician may also have implications for

physician agency in a second sense. If the constraints or incentives that the planplaces on physicians are too powerful, they will compromise physician agency. Forexample, in a recent survey, administrators of HMOs reported that withholdingmore than a certain percentage of physicians' incomes created a strong incentiveto reduce treatment in a manner that compromised quality of care (relatively fewHMOs that were surveyed withheld this much income (Hillman et al. 1991».Similarly, utilization review programs that require that physicians spend a greatdeal of time explaining their diagnosis or treatment plan will discourage physiciansfrom providing some treatment that they believe is appropriate (Macklin 1993;Koska 1990). Here too, it may be appropriate for the health alliance to establishstandards about the terms under which physicians and plans affiliate and interact.A final means by which alliance could bolster physician agency involves directly

monitoring physician practices (Wolf 1994). The conventional scope of allianceresponsibilities requires that they collect information about the performanceofeachplan, including certain measures of treatment use and enrollee satisfaction. Butrarely do these proposals call for collecting data on individual physician: the HealthSecurity Act suggests this as an option, but undercuts this recommendation bynoting that many measures might not be statistically reliable for individual practitioners. A concern for reliability is perfectly appropriate. But discarding the onlymeasures that alliances collect on physicians leaves agency behavior at risk.Moreover, conventional measures of service use or satisfaction are likely to be poormeasures of agency in any case, since agency failures are most likely to occur foraspects of treatment that are not readily measurable or easily observable by patients.A more appropriate alternative would involve pro-active audits of physicianpractices, under which treatment decisions would be reviewed by a panel of peers.


Because these would be time consuming, the audits could be applied in a mannercomparable to tax audits by the IRS. Practice audits could be required for a smallpercentage of physicians chosen at random and a larger percentage for whomvarious measures (e.g., adverse outcomes for patients) signal potential agencyproblems. Audits would again require authority not currently allowed healthalliances under any existing proposals.

3.2.3. Altering the Balance ofInfluence Between Plans and ProvidersThe greater the fidelity of agency behavior by plans and providers, the more

likely the treatment that emerges from their negotiated arrangements will be in arange that balances the interests ofsociety and the individual. As amatter ofnationalor regional (e.g., individual alliance) policy, it may be decided that greater emphasisshould be placed on either individual or collective priorities. Ifagency relationshipswere strong, this objective could be implemented by shifting the balance of powerbetween plans and providers, the first serving as a societal agent, the second theagent of individual patients.There are a variety ofways in which a health alliance could affect the negotiated

outcome. The first involves the market in which plans and providers affiliate. Ingeneral, the strength of each party's negotiating position is positively related to thenumber of options that they have and is negatively related to the options availableto the party with which they are negotiating. For example, if providers can shift toan alternative plan, then they will have greater leverage in the negotiation process.Providers who are simultaneously affiliated with multiple plans (who can shift theirpractices at low cost) may therefore have greater "mobility" and thus a strongerbargaining position. Conversely, when plans can establish exclusive contracts withproviders, the plan's negotiating position is strengthened. By altering the rulesunder which affiliations are established or influencing the market conditions facingthe plans, health alliances could thus indirectly affect the balance of provider andplan interests as they influence the provision of medical care.An alternative approach involves regulating the contractual arrangements be

tween plans and providers. Unregulated plans will use a variety of monetaryincentives and administrative mechanisms to encourage physician practices that arecompatible with the plan's objectives. The more permissive alliances are aboutthese arrangements, the greater the power plans can exert over providers. Conversely, the more that these arrangements are circumscribed, the more that treatment will reflect the preferences of providers.To address these issues, health alliances ought to have the authority to oversee

both the process through which providers affiliate with plans and the contractualarrangements that they establish with one another. Most managed competitionproposals, however, explicitly prohibit such involvement by the alliances (Starr1993; Enthoven and Kronick 1989). This hamstrings the alliances. It prevents themfrom ensuring that either patient or societal interests are given appropriate consideration in treatment decisions.The Health Security Act contains one notable exception to these prohibitions. It


designates a class of health facilities and professionals as "essential communityproviders" (ESPs) if they primarily serve indigent clients in low-income communities. For at least the first five years of the program, all plans are required to affiliatewith these essential community providers and to pay them for services on relativelygenerous terms. These requirements establish a strong negotiating position for theESPs in their interactions with the plans. This makes itmore likely that the treatmentprovided under their auspices will reflect the objectives of the providers.

If one assumes that these providers will in fact be reliable agents for indigentpatients, this seems a sensible strategy, since these patients are the least likely tobe adequately served by the plans themselves (Pauly 1992). There is, however, noclear rationale for limiting these requirements to the first five years of the program.Nor are indigent clients the only group likely to be ill-served by plans undermanaged competition (T. Rice et al. 1993). It would therefore seem sensible toallow alliances the authority to create comparable requirements for different groupsof patients, providers, and health plans.The strategy of countervailing agency thus gives alliances a greater scope of

authority than under conventional managed competition proposals. It tempers thisauthority by establishing clearer and more appropriate objectives for regulation bythe alliance and by acknowledging that alliance policies will be value-laden ratherthan simply technical, placing greater emphasis on the need for representativegovernance mechanisms.

4. Discussion and Conclusion

The managed competition model has considerable intellectual and political appealprecisely because it blends regulatory and market reforms, appealing to a broadideological spectrum. However, because this approach to reform is relatively newand because it has been explicated by only a small number of advocates, there hasbeen too little attention paid to the conceptual framework supporting the model andthe strategies for regulation that are inherent in its structure. I have argued here thatthe conventional view of regulation within managed competition is too narrow,making it misleading and counterproductive.In my assessment, the alternative labeled here as the "strategy of countervailing

agency" is more realistic and more constructive. It acknowledges and balances thetwo fundamental agency roles, each of which is and will always be imperfect. Thisstrategy should provide clearer guideposts for the appropriate regulatory role forhealth alliances (a.k.a. sponsors, purchasing cooperatives) under managed competition. The analysis underlying these conclusions, though, relied on a number ofsimplifying assumptions. The models of agency that have been developed andapplied to health care are relatively crude, omitting a number of critical factors,including malpractice liability and the multi-dimensional aspect of health care. Ourunderstanding ofsome ofthese aspects ofhealth care, such as referral arrangements,are much less developed than in other aspects of care. In this context, we have onlybegun to explore the concept of countervailing agency. Although we identified a


number of regulatory instruments that might be useful for improving the performance of the health care system, we have made no attempt to assess their relativemerits nor consider the interactions.This discussion has only touched upon complicated questions of accountability

for the alliances under a scheme of managed competition. This topic, along withmany others raised in this paper, deserve more complete analyses. However, it isclear that the complex task of health reform creates the potential for substantiallyrestructuring the American health care system and altering the nature of the medicalcare that it delivers. Any such change, whether modest or sweeping, needs tocarefully balance the important but sometime contradictory goals nested within thepatient and social agency relationships. More generally, for any reform effort asambitious as that proposed under managed competition, it is essential that theinstitutional reforms be firmly grounded in a shared understanding of the rationalefor change, so that we have some guideposts to ensure that the strategies that arepursued are sufficiently comprehensive and avoid counterproductive side-effects.Much work remains to provide the principles to effectively guide practical reformefforts.

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COMMENTS

Countervailing Agency: A Perspective onRegulation Under the Health Security Act

John Ciccone

1. Introduction

The author correctly posed the central challenge of the plan, namely, balance ofcost versus quality of care. In general, the proposed health alliance structure is aregulatory one. Although physicians are indeed imperfect agents for their patientsand the existing health plans are also imperfect agents for society, historicallypatients have been imperfect agents for themselves. The concept of a "countervailing agency" is an interesting way of looking at these discrepancies but should beextended to include patient concerns.

2. Agency Relationships In Health Care

Although physicians are indeed bound by codes ofprofessional ethics, it is unlikelythat physicians are no longer sensitized to the cost ofmedical care. For many years,board certification examinations have included a critique of physicians' cost andindeed, sensitivity towards the cost and efficiency of medical care is standard farein most medical school curriculum. Physicians do adjust practice patterns inresponse to patients out of pocket medical costs throughout the country. Forexample, in 1992 the Medical Society of New Jersey estimated that $500,000,000of uncompensated care was delivered to patients unable to afford the cost of theirmedical care. It is naive to propose that a physician equates marginal cost withmarginal benefits and, therefore, will over-prescribe treatment relative to societaloptimums. Community standards of care are more likely to dictate diagnostic andtherapeutic decision making. Fee for service may not be a utopian form of reimbursement, but it has led to improvements in quality of health care. A reasonablefee for reasonable service provided places the onus of consumer satisfactionsquarely upon physicians shoulders. Since expectations of the patients remain high,to equate a fee for service relationship with a direct incentive for excess treatmentdescribes the physician/patient relationship more in terms of the predator/preyrelationship. The cited statement of McGuire creates a dangerous premise in that


the individual preferences of the physician will lead to his/her decision making.This might lead to the doctor/God complex where moral judgments are made basedon the practitioners particular ethics. In general, the concept of double agency ismore applicable to the physicians role in society. The statement that physiciansgenerally have only limited knowledge to charges for care they prescribe iserroneous. Further compounding this error is that physicians lack an accurateassessment of medical benefits for given treatments. The medical literature isreplete with examinations of outcomes of medical therapy. This is how medicaldecision making and standards of care are developed. Preventive programs aredifficult to sell to the public. Patients, much like physicians, desire an immediatereward for actions taken. In general, preventive programs, as well as outcomestudies, take many years to demonstrate efficacy. The fact that every procedure ordiagnostic test has not been definitively linked to therapeutic success is an artifactof the process of ongoing evaluation rather than failure to examine these processes.As regards chronic care being administered by informal care givers and loss ofproductivity, physicians are uniquely sensitized to these issues, particularly at theprimary care level. They are important features of contemporary medical care.Further development of cost effective strategies is highlighted by these considerations.

3. Emergence of Health Plans as Agents

The danger of HMOs as agents for administration of health care lies primarily indegradation of quality. Insurance markets are subject to moral hazard in that costrather than care has become a major consideration. Selective enrollment strategieshave been practiced by the industry for many years. Utilization review techniqueshave not been demonstrated to improve quality of care, I cite the example of thePeer Review Organization of N.J. no longer auditing Medicare charts.

4. Imperfect Agency by Physicians and Prepaid Plan

If the statements by Eisenberg and Geraty are indeed true, then no one should goto a physician. The statements that for less than a third of all medical procedures istheir strong evidence for clinical efficacy depends on the definition of clinicalefficacy. The fact that physicians apply collective knowledge imperfectly assumesthat, coupled with the statement that individual physicians have neither interest indeveloping successful strategies nor applying them efficaciously; it strongly implies that their primary motivation is avoidance of malpractice and maintenance ofhigh incomes. Causing physicians to bear full risk for patient treatment strategiesis very close to reality in that the chance ofmalpractice liabilities is extremely highin the United States when compared with other western medical systems. Thehuman body is not analogous to a car engine; if you change the right part,you willget the expected outcome every time in an engine. We are dealing with complicatedbiological systems and to expect that appropriate diagnostic or therapeutic proce-

COMMENTS: COUNTERVAILING AGENCY 75

dures will always lead to excellent outcomes is entirely unrealistic and is a reflectionof the author's inexperience with the delivery of health care.One must draw a strict distinction between a knowledgeable and mobile con

sumer and a hostile consumer. Knowledge and mobility of the consumer areimportant when placed in the right context. Unfortunately, the media has created,or attempted to create, a level of hostility between patients and physicians.A fee for service payment systemmay lead to more intensive treatment regimens,

but the patient always has the option ofdiscussing these regimens with the physicianand making a joint decision. Most physicians practicing medicine today seek theinput of the patient in the decision making process.Capitation payments do in fact present incentives to deliver too little treatment.

Frequently, capitation fees are so unrealistically low that it is financially disadvantageous for a physician to appropriately or aggressively treat a given illness.Malpractice leads to higher expenditures of health care, estimated to at least at $9billion per year and possibly as high as $25 billion per year in defensive proceduresalone. Faced with making a judgment call versus ordering a plethora of tests to"cover his posterior," most physicians will opt for the latter due to the threat ofmalpractice. More realistic guidelines need to be established for malpracticelitigation which would take into account the judgment factor needed in particulartherapeutic or diagnostic regimens. They would also improve protection for patients who indeed are injured by medical malpractice.To generalize that most physicians practicing fee for service over-prescribed for

financial benefit again formalizes the construct of predator/prey relationship.Although there are undoubtedly greedy physicians who fit this stereotype, mostpractitioners do not follow predator/prey.Frequent switch of physicians is neither in the physicians' nor the patients' nor

the systems' best interest. Patients do learn about a physician's behavior over timebut it is unrealistic to propose that an informed patient will stay with a sub-standardphysician over a long period of time.Patients have high expectations when they visit a physicians office. If those

expectations are not met, this is a clear signal that the patient should seek their careelsewhere. Limiting these options for the patient is not in the system's or thepatient's best interest.Physician reputation is indeed an important aspect of physician/patient relation

ships. Evans' statements that the more concerned physicians are for those patients,the more they want to believe the treatment can improve their patients well beingis utterly unscientific, inaccurate, and dishonest. Again, the physician is seen as apredator.True statement by Eisenberg that the cost of treatment by primary care physi

cians are lower and quality is lower are demonstrated in multiple medical studies.This brings the interesting question of increasing the care of patients to encompass50% generalist and 50% specialist. This is a naive expectation of the Clinton plan.More generalists will become an important portion of the health care ofAmericansover time but not in the short run. Medicine has become too technically demanding


and procedures too highly specialized to expect a general internist to be able tohandle complicated medical problems. Ifwe wish to maintain high quality of care,we must maintain high quality specialists. Patient preferences do range towardspecialists when generalists can frequently cover the problem in an expert fashion,and a balance must be struck between these. Arbitrarily seeking a 50% generalistto specialist ratio is an artificial construct not based upon a scientific analysis of thehealth care needs of the country.Referral is not based upon financial considerations but rather upon the complex

ity of illness relative to the experience of the generalist. Factoring in the need forspecialized diagnostic therapeutic procedures is another reason for referral. Thereare no financial incentives for the generalist to refer to a specialist and in fact, undercapitation plans, it is frequently a disincentive leading to lower quality of care.Boggs statement that HMOs require no oversight because they are reliable agentsassumes a not for profit relationship and an altruistic societal agent. In reality, allprivate insurance plans in the United States are profit-driven and not reliable agentsfor society. When an insurance plan is profit driven, the incentive will always befor lower levels of care. This clearly is not toward the benefit of society. It alsodiscourages high risk patients from becoming enrollees. Advertisement and promotion is frowned upon by most medical professionals. Likewise, the physiciandoes not "lure" patients to his/her office. Advertisement and promotion is, however,a major factor in capturing patients for HMOs.

5. The Interaction Between Plans and Physicians

HMOs do attempt to shape physicians behavior but not for medical good. They arefor profit organizations who seek to maximize profit by minimizing patient/physician interaction and utilization of services. The review process uniformly involvesnon-peer review by inexperienced non-medical personnel as the first line.

6. Health Alliances and the Regulation of Agency Relationships inHealth Care

The major flaw of the creation of health alliances is the legislated prohibition ofhealth care providers from the Board. This leads one to conclude that cost versuscare is not the true intent of the Clinton plan. The fact that no medical personnelare available to the health alliance directly for decision making leads one toconclude that reduction in cost with lack of consideration for quality of care is thetrue motivation of this plan.

7. Goals of the Health Care Alliance

The formula provided for collective optimums is interesting but should be extremely difficult to measure.

COMMENTS: COUNTERVAILING AGENCY

8. Heterogeneity, Infonnation Cost, and Deadweight Losses

77

A flaw in the argument of HMO physician matching is that most HMOs are moreor less alike, particularly under the Clinton plan where all must seek a benchmarkof care. It would be unrealistic to assume that there will be high-tech plans versuslow-tech plans. Likewise, physicians will not be able to choose their plan basedupon plan characteristics. Compounding this problem is the assumption of homogeneity which does not occur in the health care market. The fact of the matter isthat all physicians are not created equal. Although amongst board certified specialists there is a certain minimal level of expertise, there are clearly physicians whoare superior in their skills. Seeking homogeneity is equivalent to seeking mediocrity. I was impressed by the excellent analysis of the costs of plan switching anddisenrollment referred to as "churning" and the problems that result both in directcosts and in indirect costs to disruption of continuity of care.

9. Goals ofHealth Alliances Under the Health Security Act

All statements under this heading voice concerns expressed by the health carecommunity for defects in the plan. The fact that the plan starts out by excludinghealth care professionals from the health alliances coupled with the creation of aphysician hostile environment leads most health care professionals to be highlyskeptical of the plan. The patient consumer is the focus of the Clinton proposal butthe physician is nearly completely disenfranchised. The lack of review of qualityof care by the alliances is another major drawback. The criticisms of the planregarding utilization management, lack of specific provisions for oversight, and theassumption that physicians are a homogeneous population are important considerations.The lack of provision for establishing local norms of treatment and outcome

studies also make this plan more unworkable.The entire structure of the health alliances and national health board is an

administrative regulatory one. Little consideration is given for reasonable timelimits for the evaluation of health care strategies in a compassionate, cost effectivemanner. Once again, the fact that the Clinton act fosters switching is correctlyaddressed with the cited concerns often elaborated upon in the medical literature.

10. Strategies and Regulatory Instruments for the Health Alliance

The only criticism here is that in the structure of countervailing agencies, the patientshould be included as an agent because they do ultimately bear responsibility forchoosing plans and providers. They should become partners in decision making.The destruction of physician agency for patients will degrade the quality of thedoctor/patient relationship and the quality of health care in general. In light of thosedifficulties described, it was surprising that only passing mention was given tonon-profit plans. I might have expected at this juncture that the concept of


elimination of the health insurance industry with replacement by a single payorsystem would have been discussed in the context of the important flaws elaboratedin the previous sections. An excellent summary of the problems with the capitationsystem is provided.

11. Challenges to the Strategy of Countervailing Agency

Incentives might be more effective if placed at the patient level, in the form of lowerpremiums rather than with the plan or the physician. The problems delineated underthe multi-dimensional nature of health care could be addressed by the developmentof prevention and treatment guidelines developed with the input ofmedical professionals.

12. Heterogeneity, Selection, and Match of Patients

Once again, the major flaw here is the assumption of homogeneity amongstphysicians. Assuming that there will be different types of plans is somewhat naivein that insurers will likely opt for low treatmentJIow referral plans (because theyare profit driven). Patients dissatisfied with their care may misjudge the source oftheir satisfaction. Utilization review on a case-by-case basis has never been shownto be effective and should be examined. The concept of a whistle-blower fund isan extremely bad idea leading to a '~ackpot" mentality for consumers. This isanalogous to filing frivolous malpractice claims in hopes of gaining some rewardby settlement out of court to avoid high legal fees. It is frequently less expensivefor insurers to settle an unjustified claim for a small amount than to face prospectsof a lengthy legal battle even when there is no merit to the case.

13. Regulatory Strategies and Instruments Under the Health Security Act

Sanctions against plans and providers are intentionally vague under the Clintonplan and are another flaw. The fact that alliances are given the authority to fosterdevelopment of new health care plans with the above-mentioned lack of decisionmaking mechanism is a frightening prospect. The fact that the Clinton act iscase-oriented once again points out its naivete. Both supply and demand must beexamined in attempts to construct a national health care budget. Practice trends area more effective way of dealing with case review and are again neglected.

14. Balancing Costs Versus Duality

The Clinton plan is indeed reactive rather than proactive. A proactive plan entailsgreater planning but probably less cost in the long run. The rush to implement thissystem is clearly politically motivated and is not in the best interest of the healthcare of the country. Prospective planning with test markets would be a superior

COMMENTS: COUNTERVAILING AGENCY 79

strategy both from a medical and economic basis. Once again, physician heterogeneity will not be avoided because all physicians are not created equal and probablynever will be.There is no mechanism for addressing failures of physician agency but more

importantly, there is no mechanism ofjudging whether it is the plan rather than thephysician who has failed. According to the Clinton plan, it will almost always bethe fault of the physician, when in reality physicians will be greatly constrained intheir decision making. Loss of autonomy will result. The one goal of the plan whichis particularly helpful is the dissemination of information to consumers.The final flaw of the Clinton plan that when a failure is perceived by the

consumer, it may actually be a failure of the alliance rather than the provider of theplan. Consumers have the opportunity to switch providers or plans, but not thealliance. There will be little information and expertise available to consumers todistinguish the difference. Finally, accountability has historically always restedupon the shoulders of the physician. This is unlikely to change. In a society ofimperfect agents, physicians in general have acted more in the patients interest. TheClinton plan will specifically degrade the physicians ability to do so in the futureand will add an unreasonably high cost to society both in terms of dollars and indegradation of the availability and quality of health care.

4HEALTH CARE COST CONTAINMENT

IN CONNECTICUT

L. Spencer Cain

In 1993, the state legislature, through its chief oversight committee-the Legislative Program Review and Investigations Committee-undertook a study of Connecticut's health care delivery system. The goal of the Committee's study was tocreate a regulatory environment that encourages cooperative efforts for controllingcosts while setting boundaries for an emerging competitive health care market.This paper summarizes some of the findings and recommendations of the committee and is based on the executive summary of that report. The committee found ahealth care system that has been experiencing great change over the last two years.The market has begun to shift from a fee-for-service system to emerging networksof doctors linked to organized payment systems and programs of utilizationcontrols. The shift in the market has generally been in response to cost containmentefforts by the private sector.In the 1970s, cost control efforts centered upon employers moving to self-funded

arrangements designed to limit exposure to administrative costs and health risk byinsuring only their own workers. However, administrative costs effect only a smallpercentage of the costs, and health risks in small groups can be expensivedependingupon the population's demographics.The 1980s witnessed efforts to control the total medical costs by controlling the

price charged for services. The Commission on Hospitals and Health Care hasattempted to control costs through a number ofdifferent regulatory methodologies,including hospital rate control and budget approval. Fee-for-service indemnityplans also tried to limit the amount paid for a health care services. Controlling forprice increases, while somewhat significant, still only accounts for a small portionof the rise in total medical costs.In the 1990s, the market has sought to contain the most important factor driving

medical costs-the utilization of services. Committee research has found thatmanaging the utilization of services has become the primary focus of private healthcare companies and state governments seeking to contain costs.The keys to containing health care costs and maintaining high quality are: to

provide adequate information on health care outcomes; to control the utilization ofservices; and to reduce price increases for health care services. These goals must


be built into the design ofany new health care delivery system. The current deliverysystem has only begun to address these areas.Health services in Connecticut have historically been provided by a loosely

structured delivery system organized at the community level and financed by avariety of sources. The delivery of services has been largely provided by individualpractitioners or small medical groups and paid for on a fee-for-service basis.Institutional health care is offered by numerous facilities, many of them non-profitentities, located throughout Connecticut and in bordering states.However, there is no single statewide system of purchasing health insurance.

Rather, individuals and families receive coverage through an extensive variety ofemployer- and government-sponsored benefit plans. These private and publicplans differ in benefits covered, sources of funding, and payments to medical careproviders.

Competition. The health care market in Connecticut has the potential to becomevery competitive. The following five indicators have led to this conclusion. First,the state has excess hospital capacity, in terms of beds; second, a geographicallydispersed hospital network with a high number of community hospitals per squaremile; third, the population to physician ratio is one of the highest in the nation inall categories except generaVfamily practitioners; fourth, a large number of insurersoffering an array of health plans, including HMOs, with no single insurer, exceptMedicare, having more than 20percent of the market share; and finally, Connecticuthas the second highest insured population in the nation. In addition, barriers toentry to the health care market are not limited.Though themarket has gradually begun to shift from a fee-for-service reimburse

ment system to capitated managed health care plans, there has not been a corresponding shift in the regulatory structure. The current market direction towardsmore competitive health systems is at odds with an antiquated hospital costcontainment regulatory structure. To achieve health care reform, it is necessary todesign a government organization that can shape and guide a dynamic, competitive,health care finance and delivery system.Given these findings, Connecticut is well positioned to move to a competitive

health care system. The demand side of the market is moving into large purchasinggroups that can adequately share health risk. The state needs to restructure theregulatory environment by creating the necessary information base to supportcompetition in the health care sector and encouraging the development of standardized health plans than can be compared by consumers.

Regulatory Structure. The regulatory structure covering the marketplace is asvaried and fragmented as the delivery system. Four major state agencies havejurisdiction over health care services: 1) the Department of Insurance; 2) theDepartment of Public Health and Addiction Services; 3) the Commission onHospitals and Health Care; and 4) the Department of Social Services. Theseagencies have different responsibilities related to each area of the market. The

HEALTH CARE COST CONTAINMENT IN CONNECTICUT 83

insurance department is largely responsible for assuring the financial solvency ofcompanies offering health insurance products and approving health plans. Thehealth department licenses many health providers and institutions and provideshealth planning for the delivery system. The Commission on Hospitals and HealthCare has been responsible for containing costs by regulating the hospital sectorthrough budget and rate review and approval of capital expenditures. The fourthagency, the Department of Social Services, is responsible for providing access tohealth care for poor and disabled citizens.The Legislative Program Review and Investigations Committee's study presents

a comprehensive plan to contain costs and reform health care in Connecticut. Therecommendations are intended to encourage the development of a competitivehealth care market that is monitored by a well-designed state agency with clearlydefined functions. The report recommends eliminating hospital budget and rateregulation and the Commission on Hospitals and Health Care. In its place itproposes to:

• Create an Agencyfor Health Systems that is designed to establish the boundaries within which a competitive market shall operate. A single state agencywill take the state's fragmented approach to health care and focus on the fourmajor pieces of health care management: health systems planning; financingand developing health plans; cost containment; and access.

• Promote the creation of certified health plans that require the health providerside of the market to organize into cost-effective and efficient integrateddelivery systems available to consumers.

Certified health plans will be offered on a community rated basis to largepools of insured individuals and are the key ingredient to cost containment;an important function that must be part of any reform proposal.

• Establish the Connecticut Health Data Institute which will be responsible forcollecting information on how the health care system operates. The datainstitute is designed as a cooperative effort among the participants in thehealth care market.

For a competitive market to function properly, adequate information mustbe available. The purpose of the institute is to provide this information forcompetitive, not regulatory, purposes. It must foster collaborative efforts indata collection if it is to be successful.

• Encourage the growth of competitive health plan purchasing cooperatives.The purchase of health insurance by large groups is widely recognized as oneof the most effective cost containment measures that can be undertaken.Organizing the consumer side of the market is as important as organizing theprovider side, if a truly competitive market is to be attained. The proposedcompetitive purchasing cooperatives accomplish the goal of providing smallbusinesses access to the same market as very large companies.

84

Recommendations

HEALTH CARE POLICY AND REGULAnON

The Legislative Program Review and Investigation Committee recommends thatthe regulation of hospital budgets and rates be ended. It is further recommendedthat all payers be allowed to negotiate with hospitals on the delivery of services totheir members. It is further recommended that all hospital costs, both inpatient andoutpatient services, be monitored with respect to revenues, expenses, and utilization, and the information shall be submitted to the Connecticut Health Care DataInstitute. The certificate-of-need program shall be modified based upon recommendations found in this report.

The Agency for Health SystemsThe Legislative Program Review and Investigation Committee recommends

creation of the Agency for Health Systems. The agency shall be governed by ahealth policy council composed of the commissioner of insurance, the commissioner of Public Health and Addictive Services, or their designees, and the commissioner of the Agency for Health Systems. The commissioner of the agency shallbe appointed by the governor and is the administrative head. The health policycouncil shall be responsible for establishing health systems policy, adopting regulations, and certifying and licensing entities under the purview of the agency. Thehealth policy council may designate advisory councils as it deems necessary for theimplementation of health policy.The purpose of the new state entity, the Agency for Health Systems, is to provide

oversight in two areas that are currently separate and detached: the regulation ofhealth insurance plans and the provision of health care services. The principalresponsibility of this new agency will be to coordinate the interests of insurers,providers, and consumers of health care.Specifically the agency will be responsible for:

• regulating major capital expenditures and the acquisition of technologicallyadvanced equipment through certificate of need;

• certifying all health plans sold in Connecticut;

• licensing competitive health plan purchasing cooperatives;

• developing a state health plan, in conjunction with the Department of PublicHealth and Addictive Services;

• data collection and information;

• establishing incentives for the development ofmanaged care health networks;

• obtaining information on contractual arrangements between providers andcertified health plans;

• tracking health care costs, including hospital revenues and expenditures;

• administering the uncompensated care pool;

• expanding health care access through insurance for all residents ofthe state;and


• promoting cooperative agreements among hospitals.The agency will be composed of four bureaus: Health Planning and Certificate

of Need Regulation; Health Care Systems Regulation; Health Care Access andUncompensated Care; and Health Care Data Collection and Information. Thesefour bureaus shall be responsible for monitoring and regulating a competitive healthcare market in Connecticut. (This agency would replace the Commission onHospitals and Health Care, take over the planning functions from the Departmentof Public Health and Addiction Services, and provide for the regulation ofcertifiedhealth insurance policies.)

Bureau ofHealth Care Systems Regulation. This new bureau shall be responsible for regulating all aspects of health care insurance (with the exception offinancial solvency) and delivery systems. The agency shall be responsible forcarrying out the following statutory provisions:

• set standards for and certify health plans to be offered to purchasing cooperatives;

• license managed care and utilization review companies and third-party healthinsurance administrators;

• assist in the organization of and license competitive health plan purchasingcooperatives; and

• require all contracts between providers, insurers and consumers be filed withthe agency.

Certified Health Plans. The agency will be responsible for encouraging theformation of integrated health networks-systems of health care providers andfacilities responsible for managing the care of enrollees-as certified health plans.The agency shall be responsible for setting standards for certified health plans.Certified health plans shall be defined as those plans containing the following basicelements: a contracted network of providers; a managed care and utilization reviewprogram; capitated rates to purchasers; a quality assurance program; and thefinancial and administrative capability to provide reimbursement for services usedby enrollees as defined by the plan. Certified health plans shall also conform to thestatutory provisions of Part I (Health Care Centers) of Chapter 698a and Part III(Group Health Insurance) and IV (Comprehensive Health Care Plans) of Chapter700c of the Connecticut General Statutes. In addition to the current statutoryprovisions, certified health plans shall be standardized to prevent insurers fromengaging in risk selection by product differentiation.

Community Rating. Health plans in Connecticut shall be priced based upon thecost of providing health services unrelated to the risk of the insured population,except for two rating factors-age and geographic area. Geographic area shall beallowable only as it affects the cost differentials related to service provided indifferent regions of the state. The agency shall establish a risk adjustment methodology for the purpose of insuring that adverse risk selection does not underminethe functioning of purchasing cooperatives and certified health plans.Health plans also shall not require an eligible employee or dependent to be


subject to medical underwriting, evidence of insurability, or pre-existing conditionexclusions as a condition of membership.Health plans are required to submit data as deemed appropriate for certification

by the agency, as well as supply data on enrollment and costs as required by thenewly created Health Data Institute.The licensing of insurers and oversight of financial solvency ofcompanies shall

continue to be performed by the insurance department.Bureau ofHealth Care Access and Uncompensated Care. This bureau shall be

responsible for determining the current level of access to Connecticut's health caresystem. The goal shall be to achieve universal access to health care in the mostcost-effective manner. In addition, the bureau shall be responsible for administering the state's uncompensated care pool as defined by C. G. S. 19a-168b. Thebureau shall also be responsible for insuring that all employers comply with therecommendations regarding competitive health plan purchasing cooperatives. TheAgency for Health Systems shall study the issue ofemployer contributions to healthplans purchased by cooperatives and report its findings and recommendations tothe General Assembly by January I, 1996.

Bureau of Health Care Data Collection and Analysis. The bureau shall beresponsible for staffing the Health Care Data Institute. The bureau would alsocontinue to monitor health care costs and supply the necessary data and informationneeded for the state health plan.

Connecticut Health Data InstituteThe Legislative Program Review and Investigations Committee recommends

the creation of the Connecticut Health Data Institute which shall be responsible forthe collection of information on the financing and provision of health care. Theinstitute's mission is to create a state-wide data repository for a centralized cost andquality data system which can be used by both the public and private sectors. Thedata shall include information from health care providers, health care facilities,integrated health plans, and competitive health plan purchasing cooperatives,premiums, claims, enrollment, and outcomes. Certified health plans are requiredto report data deemed necessary by the institute.The institute shall be governed by a 17-member board that is representative of

the provider community, academic institutions involved in medical research,employers, consumers, and insurers. The board is required to establish the methodology for data collection and for providing direction on what data would be usefulto the plans, providers, consumers, purchasers, and researchers. The data instituteis required to adopt standards for collection of cost, spending, quality, outcome,and utilization data; and for the analysis and dissemination by private sector entitiesof information on costs, spending, quality, outcomes, and utilization provided tothe private sector entities by the data institute. The board is also required to establisha policy on the confidentiality ofdata. The board is granted the authority to contractwith private organizations to carry out the data collection initiatives.The health policy council, in consultation with the board of the Connecticut


Health Data Institute, is required to develop a Data Collection Plan. The plan mustidentify:

• data collection objectives, strategies, priorities, cost estimates, administrativeand operational guidelines, and timelines;

• encounter level data (data related to the utilization of health care services byand the provision of health care services to individual patients, enrollees, orinsureds, including claims data, abstracts of medical records, and data frompatient interviews and patient surveys).

The data institute shall have the authority to levy a charge for data provided.

Competitive Health Plan Purchasing CooperativesCompetitive Health Plan Purchasing Cooperatives. The Legislative Program

Review and Investigations Committee recommends the establishment of a corporate entity entitled "competitive health plan purchasing cooperative" which isallowed to organize as a non-stock, not-for-profit corporation or as a for profitcorporation and whose primary function would be to offer multiple certified healthplans to members. The Agency for Health Systems shall set standards for thelicensure ofcompetitive health plan purchasing cooperatives (CHPPCs). Competitive health plan purchasing cooperatives shall not be allowed to take insurance risk.If a non-stock, not-for-profit entity is created, the corporation's board of directorsshall have employer and employee representation. For profit corporations mustform an advisory board composed of employers and employees for purposes ofadvising the corporation's management.It is further recommended that only certified health plans be offered exclusively

to competitive health plan purchasing cooperatives.Cooperatives shall be required to reach a minimum size of 20,000 insured lives

within three years of their initial license application to the agency. The cooperativesshall offer at least three certified plans to their members. Cooperatives shallperform, at a minimum, the following functions: I) enrolling members; 2) collecting and distributing premiums; 3) establishing specifications for contracting ofhealth plans competitively; and 4) providing consumer information on cost andquality of competing plans.The Agency for Health Systems shall, by regulation, establish appropriate

business practices for CHPPCs. The agency shall have the authority to transferbusiness from a non-functioning entity, as determined by the agency, to a functioning one. The agency shall also insure that requirements established for joining apurchasing cooperative not result in the selection of members or employers byhealth risk.

Employers. All Connecticut employers are required to participate in a competitive health plan purchasing cooperative. Employers are free to choose, to join, orto form cooperatives as they deem appropriate and are guaranteed acceptance intoany cooperative if they meet the requirements established by the cooperative.

Access to Health Care. The Agency for Health Systems shall study the issue ofemployer contributions to health plans purchased by cooperatives and report its


findings and recommendations to the General Assembly on January 1, 1996. Anyemployer not joining or forming a cooperative shall be assigned to one by theAgency for Health Systems.

Connecticut's Health Care Reform Act: An Analysis of What theLegislature Enacted in 1994 Session

The Legislative Program Review Committee raised legislation based upon itsrecommendations and submitted the proposal to the 1994 session of theConnecticutGeneral Assembly. A number of other reform proposals joined the committee's,including one submitted by the governor. A single proposal emerged from thepublic health committee that embodied many of the ideas recommended by theprogram review committee. The legislature failed to pass a bill during the regularsession, but did enact a reform proposal during a special session held in May 1994.The following outlines the major features of Public Act 94-3 "An act concerninghealth care access".As noted by the Legislative Program Review and Investigations Committee,

Connecticut's current regulatory structure does not meet the needs of the state'semerging health care market. Efforts at containing costs have been directed at asmall segment of health care services and efforts to provide information on thesystems in operation have been minimal. The state lacks comprehensive healthplanning and has failed to provide direction towards comprehensive health carecost containment.The four major pieces of health care management-financing and developing

health plans; cost containment; health systems planning; and access-are under thejurisdiction of four separate state agencies producing a fragmented and uncoordinated regulatory structure. Each of these state agencies has specific responsibilitiesfor a portion of health care, but none has purview over the entire system. Exacerbating the problem is a lack of data on both the financing and delivering of healthcare.The keys to containing health care costs and maintaining high quality are: to

provide adequate information on health care outcomes; to control utilization ofservices; and to reduce price increases for health care services. These goals needto built into the design of any new health care delivery system.Earlier in the session the legislature deregulated hospitals and ended the prohi

bition on hospital discounting to health plans, thus allowing a competitive marketplace to contain health care costs. The proposals set forth in Public Act 94-3 fosterthe development a competitive market for health care in Connecticut while monitoring its emergence by a central state authority. The General Assembly's HealthCare Reform Legislation of 1994 specifically:

• Creates the Office ofHealth Care Access to administered by a three-memberpolicy board;

• Creates a seven-member reform review board composed of the policy boardand four legislative appointments to oversee and approve reports and recom-


mendations covering ten health policy areas including the meeting the goalof universal health coverage by 1997;

• Establishes the Connecticut Health Care Data Institute to run a state-widehealth care data system.

Legislative provisions also define purchasing cooperatives and certified healthplans and will lead to organized consumers purchasing services from integratednetworks of health providers in a competitive environment. Such an environmentwill create incentives for groups of providers, physicians, hospitals, health professionals, and insurers to provide higher value, lower cost health care and, byexpanding coverage, will result in a more efficient health care delivery system.

The Office of Health Care AccessPublic Act 94-3 establishes a single state agency to coordinate health policy in

Connecticut and will allow Connecticut to establish a regulatory framework for themanagement of competition in the market. The agency, the Office ofHealth CareAccess, will be governed by a board composed of the commissioner of insurance,the commissioner of Public Health and Addictive Services, or their designees, andthe commissioner of the office. The board is designed to facilitate policy development between the financing and the delivery of health care services. Appointmentsare coterminous with the governors. The board appoints an executive director tobe the administrative head. Also created is the 7-member Health Care PolicyReview Board, composed of 4 legislative appointments and the 3-member healthcare access board. A 25-member advisory board with representatives of theprovider community, employers, unions, consumers, and insurers is established.The bill requires the Office of Health Care Access to develop a plan for

consolidation of state health regulation and financing as well as making recommendations on health system reform. The Health Care Reform Review Board mustapprove all reform reports prior to their submission to the general assembly. Theoffice must report its recommendations to the insurance and public health committees. Additionally, a consumer education unit to assist the public in understandinghealth care reform is created within the office.Oversight performed by a single agency will streamline and consolidate into one

agency similar functions and provide more accountability in the health care system.The agency would be responsible for monitoring and assessing health care systemswithin a competitive environment while maintaining the quality of health carealready achieved in Connecticut. The new agency will be required to establish theboundaries for market competition and balance the needs ofprivate health care withthose of community health systems.

Future Studies. Connecticut's health care reform legislation by no means hasput an end to policy development in this area. In fact, if anything, the legislationhas only begun the reform process. The law calls for no less than ten studies to becompleted over the next two years. These studies will require an enormous amountof effort from the participants to complete, not to mention the efforts that will be


required to successfully create the Office ofHealth Care Access and the Connecticut Health Care Data Institute.Twomajor tasks faced by the office are the development ofa plans to consolidate

state health regulation and financing and enrolling all residents in a standardbenefits health plan by January I, 1997. A third task requires the agency makerecommendations to the legislature on the transfer of authority from the Commission on Hospitals and Health Care to the new Office of Health Care Access.Additional studies required encompass many areas of health policy including an

assessment for the need and structure ofpurchasing cooperatives, recommendationson a standard benefits package, community health centers and school-based clinics,health insurance subsidies for low-income individuals and small businesses, therole ofgovernment and business in achieving universal coverage, and the feasibilityof creating a single large purchasing cooperative composed of state-employees andMedicaid recipients.The office must also formulate standards for certified health plans that offer a

standard benefits package, guaranteed issue and renewability as an insurance plan,state-wide community rating, and no exclusions for preexisting conditions.Most of the reporting deadlines for plans, reports and recommendations occur

over the next two years giving the legislature and public-policy makers a tremendous amount of material to process as reform in Connecticut moves forward.

Connecticut Health Care Data InstituteThe Connecticut Health Care Data Institute will be operated by the University

of Connecticut Health Center. A 20-member advisory board composed of representatives of the provider community, unions, employers, consumers, and insurersis created.The Connecticut Health Data Institute is responsible for the collection of

comprehensive information on the financing and provision of health care and willserve as a repository for all health care data in the state. The Institute's mission isto create a state-wide data repository for a centralized cost and quality data systemwhich can be used by both the public and private sectors. The Institute is requiredto establish a methodology for data collection and for providing direction on whatdata would be useful to the plans, providers, consumers, purchasers, and researchers. The Institute is further required to adopt standards for collection anddissemination of costs, spending, quality, outcomes, utilization data, and dataconfidentiality. The 20-member advisory board, in consultation with the institute,shall identify those health care data elements to be collected.The program review committee considered the development of a data collection

system to be a critical component of any health care reform initiatives. Up-to-dateinformation needs to be available in order to monitor, evaluate, and regulate thehealth market. To accomplish this, the data must be easy to access, valid andreliable, and contain fundamental tracking information. In order for the state tooversee the health system, it is essential that the necessary data are accurate andcomplete so that public policy decisions can than be made based on objective and


factual information.Other state reform initiatives have considered health data to be crucial to

achieving success. Minnesota's reform efforts have led to the creation of Minnesota Institute for Health Care Information and the development of a detailed datacollection plan. The plan outlines a framework for data submission, potential users,linking to public health goals, and data privacy. The legislation requires theConnecticut's Health Care Data Institute to develop a similar plan to carry-out itsmission.The Commission on Hospitals and Health Care is terminated on July 1, 1995

and is replaced by the Office of Health Care Access. Another public act, 94-9,which restructured Connecticut's "uncompensated care pool" also deregulated thehospitals by eliminating budget and rate review. The bill also opened competitionby allowing all health plans to negotiate with hospitals on charges, utilizationreview, and other contract provisions.

Future Policy Initiatives

While the Connecticut General Assembly has made significant strides towardshealth care reform, much is left to be done. During the next two sessions, thelegislature must deal with numerous policy areas as required by the passage of theHealth Care Reform Act. Perhaps the most important result from this legislationis that the debate on reform will be focused on specific issues and will not disappearfrom the state's agenda at least in the near future.

5HEALTH CARE REFORM IN NEW JERSEY

Pamela S. Dickson

Historically, New Jersey has been in the forefront of health care reform. In 1980,the state became a laboratory funded by the Health Care Financing Administrationto test a prospective payment system. Under this system, popularly called "theDRG System," all acute care general hospitals were required to charge all payers aset of uniform rates set by the state. These rates were set for the stay rather thanthe day and were based on the diagnosis (DRG stands for diagnosis-related group).A significant element of this payment system was full reimbursement of uncom

pensated care (charity care plus bad debt) to hospitals. Although this featureallowed significant access to care for the uninsured, it eventually proved to advancethe DRG system's downfall. As the 1980s drew to a close, uncompensated carecosts became increasingly burdensome. These costs, paid as rate add-ons toparticipating payers, were aggravated by the departure ofMedicare, which initiatedits own Prospective Payment System (PPS) in New Jersey in 1989 after grantingtwo waivers to New Jersey which permitted its participation in the DRG systemthrough 1988.By 1991, the uncompensated care fund amounted to $840 million and repre

sented a 20% surcharge on every hospital bill. Soon after taking office, GovernorJim Florio convened a Commission on Health Care Costs to examine this crisis.The Commission closely studied the relationship between the surcharges on hospital bills and the rapid rise in insurance premiums. It concluded that these strainswere placing health insurance out of the reach of many of New Jersey's employersand citizens.The Commission also looked at costs arising from the unchecked proliferation

of expensive high technology medical equipment. New Jersey, for instance, hasseven times as many Magnetic Resonance Imaging machines as Canada, eachcosting more than a million dollars. It also focused on the need for early preventiveand primary care to keep people healthy and to decrease the need for later costly"sick" care. The Governor's Commission made 92 recommendations, many ofwhich were incorporated in the Health Care Cost Reduction Act, signed in July1991. One ofthe provisions of this act capped the uncompensated care surchargepaid by all hospital patients at 19.7%, which accounted in great measure for thedecrease in charity care and bad debt payments in 1992 to $754 million.


However, in 1992, an event precipitated a crisis which made it clear that theHealth Care Cost Reduction Act of 1991 was not sufficient to check health carecosts. In May of 1992, Judge Wolin upheld a United Wire court case whichexcluded self-funded benefit plans from paying the DRG system surcharges.Although this ruling was later overturned, it resulted in a bipartisan call forlegislation to replace the DRG system within 90 days. On November 30, 1992,Governor Florio signed the Health Care Reform Act of 1992 (HCRA '92), whichincorporated sweeping changes to the health and insurance regulatory environment.The forces behind this legislation were shaped by three issues: (1) the growing

number of uninsured people, particularly employed individuals whose employersdo not provide insurance; (2) dissatisfaction with heavy government regulation ofthe hospital industry; and (3) the search for an alternative financing mechanism forcharity care. The interactive laws which composed this legislation, New Jersey'sHealth Care Reform Act and the Individual and Small Group Health InsuranceReform Acts, represented a consensus position agreed to by Democratic GovernorJim Florio and the Republican majorities in the Senate and Assembly. These threelaws eliminated the twelve-year-old hospital rate-setting system and restructuredhealth insurance in New Jersey. In order to implement this law, three new boardswere created: the Individual Health Coverage Program Board, the Small EmployerHealth Benefits Program Board, and the Essential Health Services Commission.The termination of rate-setting freed hospitals to set their own charges and

compete for the growing number and scope of managed care networks. In order toeffect a smooth transition between the previous highly regulated system and thenew competitive marketplace, two hospital subsidy funds were established: Charity Care and Other Uncompensated Care. These two funds represent New Jersey'sprimary method of making Disproportionate Share Hospital (DSH) payments tohospitals. These subsidies are financed by surplus funds in the UnemploymentInsurance Trust Fund. The Charity Care subsidy began in 1993 with $500 millionin payments to hospitals, and it will gradually shift to subsidies for health insurancefor uninsured working people and those temporarily unemployed. The OtherUncompensated Care subsidy recognizes that hospitals will need a transitionalperiod to develop a pricing structure that incorporates Medicare's payment levelsinto a competitive environment. This subsidy begins at $100 million and decreasesthereafter, completely ending in 1996.HCRA '92 enacted a number of insurance reforms designed to make health

insurance more affordable and available to a larger number ofNew Jerseyans. Themajor reforms were as follows:

• Standard Benefit Packages. Health benefits packages will be universallystructured to cover necessary and appropriate health care services with anemphasis on prevention and primary care services. The advantage of standardization is that it permits true price competition among insurers.

• Guaranteed Issue. There will be open enrollment with portable coverage forpre-existing conditions with a one-time, twelve-month waiting period for firsttime buyers.

HEALTH CARE REFORM IN NEW JERSEY 95

• Community Rating. Instead of leaving small employers vulnerable to premium costs that reflect experience-rating, insurance premiums for any smallgroup or individual will be priced to reflect a large population base.

• Subsidized Insurance. Despite the broad scope of insurance reform, manyNew Jerseyans are still unable to afford insurance. HeRA '92 established asubsidized insurance program funded with $50 million in 1994 and $100million in 1995 to provide health benefits coverage to working people andthose who are temporarily unemployed. The regulations have been publishedand the program should be online this fall with the potential to cover up tothirty thousand individuals.

Implementation of the individual insurance reforms was effective August 1,1993. As of that date, insurance companies were required; (I) to provide insurancefor one of five standardized benefit packages to all comers regardless of healthstatus; or, (2) to pay into a fund used to subsidize any loses suffered by insurerswho cover everyone. The pricing for these new standard benefit packages must becommunity-rated.Implementation of the small employer (two to 49 employees) reforms was

originally to have been effective March I, 1994. Legislation was recently enactedthat allows for a more gradual phase-in of the reforms to facilitate greater consumerchoice of insurance plans:

1. Additional riders are permitted on the five standard plans. Any ridersthat reduce benefits must be preapproved by the Department of Insurance.

2. Multiple employer arrangements may have up to two additional yearsbefore switching over to the five standard plans.

Community-rating still applies to small employer plans. The highest premiumcost may be no higher than three times the cost of the lowest premium in 1994 and1995. This corridor decreases to two to one in 1996.Although implementation of insurance reform is less than a year old, it is already

showing results. Twenty-three new insurance companies are now selling individual policies at prices which are significantly less because of community rating.More than 50,000 new individual policies have been sold since August I, 1993.As New Jersey anticipates federal health care reform legislation, its goal will be tocombine the benefits of a national program with the significant state progress todate.

6HEALTH SECURITY ACT:SUMMARY AND IMPACT

Ronald RousePhilip Vernon

Linda StackmanKeith Servis

Revisions in New York State's health care delivery system will be required toimplement the goals and objectives of national health care. The impact of reformpolicies on New York-on its citizens, the health care infra-structure, and overallState expenditures and revenues-is significant. This paper provides an analysis ofsome of the issues that must be addressed as New York State prepares for federalhealth care reform policies.Issues relating to equity among States, such as maintenance of effort and cost

control measures, scope of coverage, and operational issues, are particularlyimportant. During the past decade, New York State has made incremental changesto its Medicaid program, delivery and provider systems, and financing programsthat have redirected the focus and growth of its health care system. Any federalproposal needs to be evaluated within this context. New York needs to maintainsome flexibility over its own system so that it can shape the system consistent withits own needs.

Significant Issues

The Health Security Act of 1993 (HSA) would vastly reform the current health caresystem. It presents some significant issues which must be addressed as New YorkState prepares for reform.

Equity Amoug States"Maintenance of effort" provisions would require states to contribute funding

at levels consistent with current Medicaid spending at a minimum. With a broadscope of optional benefits, expansive eligibility levels, relatively high cost providers, and the minimum federal matching rate (50 percent) for ourMedicaid program,New York will bear a disproportionate burden for financing reform in the state. At


the same time, the state will share in the federal cost (i.e., sin taxes, cost limits) ofsubsidizing coverage in other states with less expansive programs.The new National Health Board will be charged with several tasks related to

leveling states' contributions and health care costs in the future. Increasing theresponsibility of states with low contribution rates will help New York. On theother hand, as a state with higher than average health premiums, attempts to levelpremium rates will hurt.

Single Standard of CareThe fundamental goal of health reform is to provide universal access to uniform,

high quality health care. "Mainstreaming" access for Medicaid and currentlyuninsured populations would be a substantial benefit of reform.As currently proposed, however, publicly-subsidized populations will have a

choice of health plans where premiums are at or below average cost, plus the lowestcost indemnity (freedom ofchoice) plan. If this feature results in a clear separationof plans serving the poor versus higher income, employed beneficiaries, theprinciple of equal access will be lost.A similar concern can be expressed for the exclusion ofMedicare beneficiaries

and large employers (5,000 or more employees) from Health Alliances.

Scope of Benefits/Covered PopulationsThe proposed standard benefit package is expansive, roughly equivalent to the

benefits offered to many currently insured employed people. Coverage of preventive services, dental, and prescription drugs is more generous than most employment related insurance policies, but less than New York's Medicaid coverage.Significant programmatic and fiscal issues relate to those benefits limited or

excluded in the benefit package-particularly mental health, long term care (homecare and nursing home care), and public health related services.Mental Health. Mental health, mental retardation, and developmental disabil

ity, alcohol and substance abuse services would be limited annually to 60 inpatientdays (no more than 30 at a time) and 30 outpatient visits. Such limits impact servicedelivery design and coordination with other covered benefits and shift fiscalresponsibility to an unknown degree to the state.Long Term Care. The minimum benefit package will cover limited nursing

home and home health services (following hospitalization, similar to currentMedicare). A new home and community based long-term care program will coverthe severely disabled, regardless of income. The program will be capped, and statesmust develop a plan including limits on total beneficiary expenditures. A new,non-means-tested program could have serious implications for New York. Muchof this program's resources will be needed to support services to mental health,mental retardation and developmental disability, and substance abuse Medicaidrecipients whose coverage will be limited to the comprehensive benefit package.In addition, there are indications that Medicaid will be retained for long-term careof low income individuals.

HEALTH SECURITY ACT: SUMMARY AND IMPACT 99

Public Health. The public health service system plays a significant role in thedelivery of health services to vulnerable and disadvantaged populations, in additionto providing identification, outreach, and follow up services for a variety ofcommunicable diseases. It is critical that basic public health services be maintained, and the reform plan seems to recognize the importance of preserving andexpanding core public health functions. It is also critical that sufficient funds beprovided to assure stable funding streams if particular categorical programs areincorporated into the reformed system, and that allocation formulas are fair to NewYork, with adequate flexibility to direct services to priority areas.

Uncovered Populations. The plan would not provide equivalent benefits toundocumented aliens. With an estimated 490,000 undocumented aliens in the state,this feature would leave a substantial population in need of health services.

Will it Work?Federal reform relies on a new and untested mechanism-managed competi

tion-to achieve universal access, while controlling costs. A completely neworganizational structure has to be created, including a National Health Board,statewide or regional Health Alliances, and Health Plans (existing insurers andnewly formed provider groups).Control mechanisms rely on setting national premium targets, adjusted for each

state by the National Health Board, coupled with premium growth limits fixed infederal statute. A concern for New York is the fairness of premium levels allocatedto it, and the impact of living within fixed growth limits that will be about half ofcurrent growth rates.Health Alliances are responsible for developing a risk adjustment mechanism

(or using a National Board mechanism) to recognize legitimate differences inpopulations enrolled by Health Plans. New York has the only experience with suchadjustments (Chap. 501, Community Rating legislation).To avoid enforced premium limitations, competition among Health Plans is

expected to limit premium growth. This theory is untested. It is also less likely tobe effective in rural areas, where there are insufficient populations and providersto allow competing networks.

QualityHealth Plans would be required to collect and provide uniform performance

information to facilitate State and Alliance oversight and consumer choice. Asmany as 50 measures are contemplated.While the emphasis on quality measurement is appropriate and well-placed,

financial incentives may mitigate its effectiveness: consumer choice is designedto be influenced more by premium price than quality measures; and, health allianceshave to be more concerned with average premium growth to avoid penalties orpayment limitations.

If reform implementation timeframes are achieved, system reform will substantially precede the availability of uniform quality measures or adequate information


to support comparisons of Health Plans.This effort is not a substitute for the State's quality improvement effort (e.g.,

surveillance, performance measurement studies, such as cardiac surgery studies).Significant questions remain about the feasibility of utilizing multiple Health

Plans and Alliances to collect and analyze quality data.

Academic Health CenterslGME ReformThe reform plan recognizes the importance of developing more primary care

practitioners and fewer specialists. Fiscal support for training programs would becentralized-with approximately $6 billion in current funding pooled nationallyand distributed to support an emphasis on primary care practitioner trainingprograms. While New York has promoted the same objectives for many years, thespecific funding proposal, allocation decisions, and pace of change considered bythe HSA could have a substantial adverse impact on academic medical centers andother teaching programs in the state.

Choices for New York StateAssuming federal reform will be enacted, the State will have several choices in

designing its health care system:The HSA provides a range of organizational options for carrying out reform,

including a statewide single-payer approach, a statewide single-payer alliance withmultiple health plans, regional single-payer systems, or regional health allianceswith multiple health plans. Which approach/approaches are best suited for NewYork? If regional, how many, recognizing the difficulty of developing whole neworganizations to perform complex, new functions? Would we develop Alliancesas a state agency (applicable if we consider a statewide Alliance), quasi-publicentities, or not-for-profit corporations?What is the proper balance between regulation and competition, assuming we

create Health Alliances?

• Do we promote collaboration among competing health plans for sharing orconsolidating services? For sharing best practices? How can NYPHRM Vexpedite those activities?

• Do we maintain and even expand rate setting functions as a tool to controlcost/premium growth, or allow unlimited negotiations of payments betweenHealth Plans and participating providers?

• Do we continue to control the entrance of new providers, services, andtechnologies (CON process) to help control overall cost growth, or allowHealth Plans unlimited authority to develop their own networks?

• How do we ensure that the delivery infrastructure in underserved areas isdeveloped sufficiently to provide access?

• Does our responsibility change with respect to oversight of quality of careprovided? What is the relationship between the State's traditional oversightfunctions, HAs, regional quality centers, and the National Health Board?

HEALTH SECURITY ACT: SUMMARY AND IMPACT 101

How should we integrate the delivery of health care provided through HAs withthat provided to Medicare beneficiaries, employees in corporate alliances, militarypersonnel, and veterans?How do we expand and alter the medical educational system to address HSA's

new directions in primary care and mid-level providers?Do we choose to assume cost control responsibilities for total health care

expenditures in New York State or leave such responsibilities to the National HealthBoard?What public process is needed to decide these matters?Unless we wait for passage offederallegislation (which is likely to be substan

tially altered by the negotiation process), it will be necessary to advance Statelegislation in the upcoming session with answers to those basic questions andundoubtedly many more.

Acknowledgements

The authors would like to thank the following for their valuable contributions tothis paper: Gerald Bracken, Beth Dichter, Marjorie Geiger, Daniel Gordon, DavidPhilips, Edward Salsberg, Anthony Soccio, and Caleb Wistar.

PART IIPRICE REGULATION

7REGULATING PHARMACEUTICAL PRICES

Thomas A. Abbott, III

The Pharmaceutical Industry is highly regulated. Its products are subjected to yearsof testing before marketing, and many can only be sold under the direction of aphysician. In recent years, the industry has been criticized for increasing the priceof successful products and for introducing new products at high prices. Thiscriticism culminated in a report by the Senate Special Committee on Aging (1993),which purported that pharmaceutical prices had risen more than 128 percent overthe period from 1980 to 1992, despite agreements from the industry to hold priceincreases to inflation. Several bills have been introduced in Congress to controlthe price ofprescription drugs [HR 916, HR 1158, and HR 1434]. PresidentClintonalso proposed price regulation, in the form of rebates on single source pharmaceutical products sold to Medicare beneficiaries, as part of the Health Security Actlegislation. This paper examines the need for price regulation and the alternativesavailable for imposing price regulation.The paper is divided into five sections. Section 1 provides background on the

history of regulation and a description of the research and development process.Understanding the developmental process is critical for assessing the need for andeffects of price regulation. Section 2 examines the debate over whether prices aretoo high or have risen too fast. Part of this debate focuses on the way the Bureauof Labor Statistics constructs its pharmaceutical price index. These methods havebeen criticized for failing to adequately capture the affects of new product introductions and generic competition. After examining this debate, we shift focus andask whether profits are too high. The empirical evidence suggests that althoughthe returns in the pharmaceutical industry are slightly higher than expected, thereis no evidence of "price gouging" on the part of pharmaceutical firms.The third section focuses on whether pharmaceutical prices can be effectively

regulated in the long run. This draws heavily on Abbott (1993), which shows thatimposing price regulation could result in adverse consequences for both theindustry and consumers. The fourth section examines present attempts to regulatepharmaceutical prices, including the current Medicare Rebate program and proposed legislation. The final section provides concluding remarks and suggestionsfor future research.


1. Background on Pharmaceutical Regulation and Product Testing

The regulation of pharmaceutical products evolved in response to the increasedpotency, effectiveness, and toxicity of pharmaceutical products and in response tospecific tragic events. In the late 18oos, most "pharmaceutical preparations" hadthe immediate effect of making the patient feel better, although they did little tocure the underlying disease. This meant that patients could directly evaluate thebenefits of the drug and did not need extensive guidance in choosing products. Thefirst "modern" pharmaceutical product, the Diphtheria Antitoxin, was developedthe mid 1890s and dramatically reduced the incidence of diphtheria. 1 However,because these new drugs did not have an immediate effect on the patient, they weremuch more difficult for the patient to evaluate.2 Although the benefits were notreadily apparent, some of the side effects were. The first actual regulation, theBiologics Control Act of 1902, was in response to contaminated DiphtheriaAntitoxin which fatally infected thirteen children (Kondratas 1982). This incidentcontributed to concerns about the safety of the food and drug supply, which werefueled by books such as Upton Sinclair's The Jungle.These events were quickly followed by the passage of the Pure Food and Drug

Act of 1906. Although it focused primarily on the food supply, the bill requireddrug manufacturers to either: 1) follow standards established by the United StatesPharmacopoeia (USP) orNational Formulary (NF);3 or 2) provide a complete listof the contents on the label, if their product used the common name but differedfrom the standard; or 3) market the product under a unique brand name.4 Inaddition, the Act expanded the Agriculture Department's Bureau ofChemistry andgave it authority to oversee testing and compliance offood and drug manufacturers.In 1931, the regulatory aspects of the Bureau of Chemistry became known as theFood and Drug Administration (FDA).For the most part, during the first part of the twentieth century, the pharmaceu

tical industry worked with known technologies to produce bulk commodities forsale to packaging firms and pharmacies. Thus, pharmaceutical firms were notmanufacturing drugs in the sense of today's integrated firms. Moreover, despitethe existence of many drugs, there were few diseases which could be cured or

In Boston, for example, the incidence of diptheria fell from 30 per 10,000 before 1895 to only5 per 10,000 in 1899 (Temin 1988).

2 The mechanism behind the Diphtheria Antitoxin was to build up the patients immunity to thepoint that they were able to effectively fight off the disease and not become ill. Although onecan statistically demonstrate the effectiveness of the antitoxin, for an individual patient it isimpossible to say whether they would, or would not, have contracted the disease if they hadnot taken the antitoxin. Hence, individual patients are not in a position to directly determinethe benefits of the treatment.

3 Up until this time, the USP and NF had been private publications used to guide physicians,pharmacists, or anyone else needing guidance in preparing medications.

4 Temin (1980, 27-37).

REGULATING PHARMACEUTICAL PRICES 107

controlled by drugs.5 Against this backdrop, and in part because of the ElixirSulfanilamide incident,6 the Food, Drug, and Cosmetics Act was passed in 1938.This Act established several provisions. First, it required FDA approval of all newdrugs before they could be marketed? Second, it increased the amount of information on the label of any drug sold without a prescription, including statementsof recommended use and potential dangers. In doing so, the Act created the firstreal distinction between prescription and over-the-counter (OTC) drugs.8 Although previously any non-narcotic could be sold as either prescription or OTC,after 1938 nearly all new drugs were classified as prescription (Temin 1979). Thisunintended impact of the labeling requirement allowed manufacturers to restrictsales of its products to "prescription only," which they soon realized reduced theelasticity of demand, since the physician writing the prescription was not directlypaying for the drug and the patient and pharmacist could no longer substitutecompeting products once the prescription was written? The medical professionsupported these moves, in part, because they directly benefitted from forcingpatients to see a physician before receiving treatment.In the 1940s, three changes occurred which built on these regulatory changes

and altered the pharmaceutical industry. First, new techniques for discovering andisolating potentially beneficial substances were developed by Selman Waksman atRutgers University in the process of discovering streptomycin (Temin 1979).Second, the U.S. Patent Office ruled that the chemical modifications made whichenabled streptomycin to be isolated and purified created a new patentable product.Third, instead of licensing the use their patents, as had been the practice, pharmaceutical firms began to exercise their patent rights to control the production,distribution, and price of new products (Temin 1979). Taken together, thesechanges issued in the era of the modern pharmaceutical firm. These firms are R&Ddriven and use their patents to maintain prices above the competitive level, reapingthe rewards of the R&D process.The 1950s and early 1960s represented a heyday of new drug development as

one firm after another introduced new "wonder drugs." At the same time, manystates passed "anti-substitution" laws, which further reduced the elasticity ofdemand by requiring pharmacists to fill the prescriptions as written rather than

5 Temin (1979) observed that a poster from a 1931 symposium on fighting diseases indicatedonly seven diseases which could be controlled using drugs and another seven which could bepartially controlled.

6 During this incident. more than one hundred people died painfully because the solvent used tomake it in liquid form. diethylene glycol. had not been adequately tested for toxicity inhumans by its manufacturer (Temin 1980).

7 Firms were permitted to still distribute new dugs to trained specialists for "exprerimemtal"purposes.

8 Drugs sold on a "prescription only" basis did not have to comply with the strictest labelingprovisions of the law.

9 Temin (1980. 38-51).


substituting cheaper generic products. However, questions began to arise about theeffectiveness and high price of these new drugs. In 1959, Senator Kevhauver'sAntitrust and Monopoly Subcommittee held hearings on whether too many drugs,which were minor variations of existing drugs, were being introduced to extendthe patent life of a product line-questions which have a familiar ring today.Despite these questions, it was the Thalidomide incident which triggered passageof the 1962 Harris-Kevhauver Drug Amendments and brought this heyday to ascreeching halt.Thalidomide was a new drug used to treat nausea during pregnancy. Although

it had not received approval for marketing in the United States, it was widelydistributed to physicians for "experimental purposes" when it was discovered thatit caused major birth defects. This inflamed fears that drug companies, in their rushto market new drugs and earn large profits, were "egregiously exposing humans topotentially harmful drugs during clinical trials."10 As a result of this fear, Congresspassed legislation which greatly increased the burden on pharmaceutical firms tonot only show that their products were safe, but that they were also effective. 1I Thetesting procedures used to establish these results were overseen by the FDA. The1962 amendments also required pharmaceutical firms to follow "good manufacturing and laboratory practices," as defined by the FDA, and gave the FDA theauthority to inspect manufacturing plants. Finally, the 1962 amendments extendedtesting requirements to both generic (identical) and similar (me-too) drugs (Thomas1990). Previously, these drugs could avoid pre-market testing through certificationfrom the FDA that they were in effect the same as the original drug.This amendment had the dramatic effect of increasing the cost and time of new

drug development, thereby slowing the rate of new drug introductions. Baily(1972) reports that the average number of new drug introductions fell from 51 peryear between 1956 and 1961 to only 20 per year between 1962 and 1967. Althoughthese restrictions increased the cost of drug development to the pioneering firms,they reduced the effects of competition once the patent had expired by creating alarger barrier to entry for generic products. Over the years, considerable debateerupted over whether these restriction were excessive, whether they increased ordecreased consumer welfare, and whether they increased or decreased the profitability of pharmaceutical firms (Baily 1972; Peltzman 1973; McGuire et al. 1975;Temin 1979; Wiggins 1981; Thomas 1990). What is clear, however, is that afterthe passage of the 1962 amendments, the length of time between the discovery orsynthesis of a new drug and its market introduction increased dramatically.Thomas (1990) reports that in 1960 the average development time was 35 months;

10 Peltzman (1973, 1050-51).11 Physicians, however, were still permitted to prescribe the drug as they chose, regardless of the

indications. This practice of "off-label" prescribing continues today, although some thirdparty payers are beginning to refuse reimbursement to patients for the costs involved in thesenon-indicated uses of prescription products.


by 1980 this had increased to 145 months. This amendment also had a clear chillingeffect on the introduction of generic products, since generic manufacturers had toduplicate all of the safety and effectiveness research conducted by the pioneeringfirm before obtaining approval for their own New Drug Application (Grabowskiand Vernon 1983).In 1984, Congress passed the Drug Price Competition and Patent Term Resto

ration Act, which attempted to remedy some of the problems created by the 1962amendment. First, it established that Abbreviated New Drug Application (ANDA),which required that a generic manufacturer only show that their drug was "bioequivalent" to the pioneer's product rather than repeating all of the studies. Second,it established a formula for increasing the patent life of a new product to restoresome of the time (up to 5 years) lost due to the pre-market regulatory process(Grabowski and Vernon 1986). Thus, the 1984 law had two countervailing effects,first it extended the patent life on new products being introduced after 1984 (therebyincreasing returns to the innovative firm), and second it encouraged generic entr~(reducing price to consumers and decreasing returns to the innovative firm/Grabowski and Vernon (1986) argued that these effects would approximatelybalance out, leaving the incentives for R&D by the innovative pharmaceutical firmsroughly unchanged.In summary, pharmaceutical regulation has evolved in response to the perceived

needs for consumer protection and industry development. What began as a requirement for adequate labeling, protecting the public from adulterated or misrepresented products, grew into a system in which consumers relied on physicians (andsometimes even third party payers) to make choices for them. Along the way, theindustry was transformed from simply manufacturing existing products usingknown technologies to spending over $12.6 billion dollars annually searching fornew products (Pharmaceutical Manufacturers Association 1993).The time and money spent on research and development are crucial components

of the industry to have been greatly affected by changes in regulation. Prior to thePure Food and Drug Act of 1906, anyone could enter the pharmaceutical industry.After the Pure Food and Drug Act, it became only slightly more difficult to enterthe industry-firms had required to follow the labeling guidelines outlined in theAct. Although the FDA had the authority to ban harmful products, the burden ofproof rested with the FDA to show that the product was harmful. After the 1938Food, Drug, and Cosmetics Act the burden of proof shifted to the manufacturer todemonstrate that their product was safe for use as directed.There has been relatively little research on the cost of drug development during

the period between the 1938 and 1962 amendments. The OTA report, Pharmaceu-

12 Scherer (1993) observed that since the adoption of the ANDA, hundreds of new genericproducts have received approval under the accelerated procedures. One, of course, mustwonder how many of those products would have been introduced had there not been thechange in the law.

llD HEALTH CARE POLICY AND REGULATION

tical R&D: Costs, Risks and Rewards, (U.S. Congress, Office of TechnologyAssessment (hereafter OTA) 1993) referenced only two studies: Schnee (1972)and Baily (1972). Schnee examined the development of 75 successful projects atone large pharmaceutical firm over the 1950-1967 period. Ignoring the time valueof money, preclinical research costs, and any costs associated with unsuccessfulprojects, Schnee estimated the average cost of developing a New Chemical Entity(NCE) to be $534 thousand dollars (current dollars). Baily, using industry leveldata, estimated the cost ofdrug development before 1962 at $2.5 million, includingpreclinical testing and unsuccessful projects (in 1958 dollars). Given the substantial costs of preclinical testing and that many drugs which enter clinical trials arenot successful, these estimates are not inconsistent.In examining the effects of the 1962 amendments, Baily found that the costs of

research and development had risen three-fold, to approximately $6 million dollarsfor the period from 1962 to 1969, ignoring the time value of money. Part of thiseffect can be attributed to discontinued research on generics (which are presumablycheaper) and part to the higher standards imposed on the pharmaceutical firm as aresult of the amendment. As a result of the 1962 amendment, before any humantesting could be conducted by a pharmaceutical company or clinical researcher, anInvestigational New Drug (IND) application has to be filed with the FDA. Thisapplication summarizes all of the results from the animal testing and outlines futuretesting. Over time, the FDA has taken a more active role in shaping the IND andtesting protocols, further pushing up the R&D costs. Numerous studies have beenconducted on the costs of developing new drugs during the 1970s including:Schwartzman (1976), Hansen (1979), Wiggins (1987), Grabowski and Vernon(1989), and DiMasi et al. (1991). OTA concluded that the "... increase in theinflation-adjusted cost of developing a new drug from the early 1970s to the late1970s is dramatic. Real cash outlays per successful NCE increased by almost 100percent in the period.,,13 They go on that "for drugs first entering human testing in1970-82, the after-tax cost per successful drug, capitalized to the point of FDAapproval for market, was somewhere between $140 million and $194 million (in1990 dollars).,,14It is worth reviewing the R&D process to understand how and why costs have

increased. This process takes several steps, with the firm deciding whether tocontinue the project at each step. 15 The first step is either discovery or synthesisreflecting alternative approaches to new drug development. In the discovery stage,natural chemical compounds are isolated from biological samples. In the synthesis

13 OTA (1993, 72).14 ibid.15 In a recent interview published in the Harvard Business Review, Merck's CFO Judy Lewent

discusses the use of option pricing theory to help make the decisions of whether or not tocontinue on a particular research project. The use of option pricing theory is importantbecause even if a particular drug turns out to not be profitable, one may learn a great dealwhich can be used to help design newer drugs. See Nichols (1994).

REGULATING PHARMACEUTICAL PRICES III

stage, a new compound is synthesized from the results of previous research. Oncethe new compound is isolated, it is patented and screened for pharmacologicalactivity in vitro and in animals. This process takes up to three years and thousandsof compounds are examined for each one that moves onto the next stage of testing(Thomas 1990). Once a promising compound has been found, the firm files anIND, and, unless rejected, the firm begins human testing within 30 days.Clinical (i.e., human) testing is conducted in three phases. The first phase is

performed on a small number of generally healthy patients.16 The objective ofthese studies is to obtain preliminary information on the toxicity and dosage range.Generally, the drug is given sequentially to sets of three patients at each dosagelevel until a preset toxicity threshold is crossed.17 During the phase I trials, data isalso collected on the drug's absorption, metabolic effects, and the way the bodyeliminates the drug. These trials generally last slightly more than one year (DiMasiet al. 1991). Although signs ofefficacy are encouraging, they are not necessary formoving on to the phase II trials, because of the small size of the sample.In the second phase of testing, the drug is administered to a limited number of

patients whom the drug is intended to benefit (generally 30-300 patients). In thisphase, the first evidence of efficacy is obtained, although the focus of the trial isstill on safety. The trial also begins to examine the cumulative effects of the drug.On average these trials last about two years (DiMasi 1991). If the safety profilecontinues to look good, and there are signs of beneficial effects, the drug is movedinto the final stage of human testing.The final stage of clinical testing, the phase III trials, are intended to establish

the efficacy of the drug. Large samples, frequently thousands of patients, areexposed to the new drug. These trials are often double blind, where neither thepatient nor the treating physician know whether the individual patient is on theexperimental drug or the control drug (perhaps placebo). In addition to looking forevidence of efficacy, researchers continue to look at the safety profile of the drugas well as begin looking for potential adverse reactions to the drug. 18 To obtaininformation on the long term effects of the drug, these phase III clinical trials cango on for several years and on average take nearly three years (DiMasi 1991).At the same time as the clinical trials are under way, pharmaceutical firms

16 Cancer drugs are typically tested on terminal patients because a high level of toxicity isconsidered acceptable.

17 The acceptable toxicity level depends greatly on the nature of the disease which the drug isintended to treat and the availability of alternative therapies.

18 Despite the relatively large sample sizes, many important adverse reactions can be missedduring the phase III studies because they have a low probability of occurring. For example, aI: 10,000 adverse reaction causing death could easily go unnoticed in a phase III trial onseveral thousand patients, even though it could cause 30,000 deaths if the drug were releasedto all 300 million citizens. As a result, when a new drug is released, the FDA requires thepharmaceutical firm to conduct extensive post-marketing surveillance for any adversereactions and to immediately report all deaths of people taking the drug, regardless of whetherthere appear to be a direct link between the death and the drug usage.


conduct long-term animal testing, looking for adverse genetic or reproductiveeffects. Once the firm believes it has sufficient information to show that the productis both safe and effective, it files a New Drug Application (NDA) with the FDA.On average, only 1 if 5 drugs which enter the IND phase reach an NDA. Once theNDA had been filed, the FDA has 60 days to determine if there is sufficientinformation for the agency to conduct a substantive review. Although the FDA issupposed to render a decision within 6 months (OTA 1993) estimated that for drugsapproved during 1990, the average approval time took nearly 30 months. Part ofthis delay was the result of additional testing required by the FDA.As a result of the lengthy testing and approval process, from the time the firm

first began spending money on researching a new product, a total of over 10 yearshas generally elapsed before a successful product is marketed. It is thereforeimportant to take into account the opportunity cost of these expenditures whenassessing the cost ofdrug development. In the most comprehensive analysis to date(DiMasi et al. 1991) estimated the capitalized out-of-pocket costs at the point ofmarket approval averaged $231 million (1987 pre-tax dollars) including the costof abandoned projects. These investments are made in the anticipation ofobtainingfuture profits on the manufacture and sale of the drug. Grabowski and Vernon(1990) examine a sample of drugs introduced during the 1970s, and find that onlythe top 20% of the drugs had large enough returns to cover the average cost ofR&Dand that the higher drug prices in the 1980s were especially important for this result.They concluded that it is the hope ofan occasional "block-buster" drug which keepsresearch going.

2. The Current Debate: Are Prices too High and Rising too Fast?

We now examine whether prices in the pharmaceutical industry are too high,whether they have risen too rapidly during the 1980s, and whether governmentintervention is warranted. The Senate Special Committee on Aging (1993) presentsseveral arguments in suppc:-t of the contention that price increases have been"excessive" in this industry. Their report cites statistics provided by the Bureau ofLabor Statistics showing that over the period from 1980 to 1992, pharmaceuticalprices increased a total of 128 percent, while, over the same period, general inflationwas only 21.7 percent19-however, the report does not specify which measures ofpharmaceutical inflation and general inflation were used. Moreover, althoughthese numbers grabbed headlines and have shaped the current debate, they are notconsistent with the data presented in table 1 of their own report, which showed thatgeneral inflation over the period was 68.3 percent and Pharmaceutical Inflation was188.3 percent.20 Thus, one is left wondering what was the basis for the headlines?

19 Senate Special Committee on Aging (1993, I and Chart 2).20 In an attempt to resolve this inconsistency, I examined the Economic Report of the President,

1991, and found that the Consumer Price Index. all products, rose 58.6 percent over the


The issue ofwhich measures are used is not simply nit-picking; there are severalalternative measures of "general inflation.,,21 Moreover, there are alternative BLSprice indexes for the pharmaceutical industry-the Producer Price Index (PPI-Rx),and the Consumer Price Index (CPI-Rx). When looking at pharmaceutical priceincreases, one must decide whether to examine the prices received by pharmaceutical manufacturers or the prices paid by consumers. There could be importantdifferences between these measures because, as in other markets, there are severalsteps in the distribution chain between the manufacturer and the eventual consumer,including wholesale distributors and retail or hospital pharmacies. In many cases,a third-party payer is also between the consumer and the retail pharmacy or hospital.Hahn and Lefkowitz (1992) report that on average consumers paid only 57% of thecost of outpatient pharmaceuticals.22 If there are changes in the distribution chain,or if the operating margins of wholesalers or retailers change, then producer andconsumer measures of pharmaceutical inflation will be different.From the current prospective interest, it seems that the prices paid by consumers

(or their third party payers) is most relevant. If these prices increase rapidly andforce consumers to "make choices between buying food and paying for theirmedications" as is often claimed,23 then there is clearly an issue of public interest.However, these index numbers need to be examined closely before policy conclusions can be drawn.The Bureau ofLabor Statistics calculates theCPI-Rx using a fixed weight market

basket of selected pharmaceutical products. That is, they first choose a basket ofproducts (treating brand named drugs and their generics as separate products) andcalculate the revenue weights in a base year. Next, they sample prices of theseproducts (from a pre-determined set of retail outlets) and use the original revenueweights to construct the price index as a weighted average of the individual productprice relatives. Thus, the index implicitly assumes that consumers purchase thesame products at the same outlets when calculating how the "average" priceschanged. However, these assumptions simply are not the case.During the 1980 to 1992 period, there were significant changes in the distribution

channels of most pharmaceutical products. One change was the location wherepatients filled their prescriptions. Over this period, the number ofHMOs with their

1980-1990 period (which is consistent with the data in table I of the report), the GNP ImplicitPrice Deflator rose 53.4 percent, and the Producer Price Index, all finished goods, 35.4percent-none of which is consistent with the 21.7 percent figure given in the report.

21 The Consumer Price Index measures how a fixed basket of consumer products increases overtime, the GNP deflator is an implicit price index which measures how the prices of all goodsand services produced by the economy changed over time, and the Producer Price Indexmeasures how a fixed basket of goods produced in the United States changed over time.

22 For the time being, we will lump these third party payers in with the general class ofconsumers, even though the existence of insurance coverage for pharmaceuticals may directlyimpact the extent to which consumers (and physicians) are price sensitive because of the moralhazard problems discussed in Abbott and Crew (1994).

23 Senate Special Committee on Aging (1993, I).


own pharmacies increased and several large mail-order distributors (Medco beingthe best known) entered the market. These new outlets often discounts frompharmaceutical manufacturers (typically 15-20 percent) which are passed on to theconsumers and their third party payers. Second, during the 1980s, most statesrepealed their "anti-substitution" laws, and some states even passed laws requiringpharmacists to substitute a cheaper "generic" product unless the physician indicatedthat the prescription must be "filled as written." As a result, both the location ofpurchase and the products purchased changed in ways which are not captured bythe BLS index and would have lowered the price consumers paid.A simple example illustrates some of the problems in the BLS index. Suppose

that in the first year there was only the brand name product selling at a price of$100per standard unit (100 tablets of a given dosage). In the second year, the price ofthe brand product rose to $110 but a generic competitor entered the market at aprice of $70.24 For customers who remained with the brand named product, therewas a 10% price increase, but for customers who switched to the generic product,there was a 30% price decrease. The fixed weight BLS price index would report a10% price increase, assuming that all customers stayed with the brand nameproduct. However, assuming that 40 percent ofthe customers actually switched tothegeneric product, one would calculate the average price change as a 6% decline.25

To continue with this example, if in the third year, the price of the brand nameproduct rose to $120, the price ofthe generic dropped to $65, and the market shareof the generic increased to 50 percent, depending on whether the first or secondperiod quantity weights were used, the BLS price index would have increasedanother 9.09 percent or increased 2.6%, while the correct consumer price indexwould have fallen another 1.6%. A similar example can be used to illustrate theeffects of consumers switching from a "full price" retail pharmacy to a "discount"mail-order pharmacy.Griliches and Cockburn (1993) examine the issue ofgeneric substitution for two

24 Somewhat paradoxically, when faced with a generic competitor, pharmaceutical firms oftenincrease the price of their brand named product rather than decrease it to compete with the newcompetitor (Scherer 1993; Griliches and Cockburn 1993; Frank and Salkever 1992; Grabowskiand Vernon 1992; and Caves et aI. 1991). One explanation offered by Frank and Salkever isthat the pharmaceutical market actually consists of two distinct markets, one which is pricesensitive (hospitals, HMOs, and managed care plans) and the other which is not price sensitive(traditional insurance). When faced with a generic competitor, the originator finds it moreprofitable to abandon the price sensitive market and maintain a high price in the insensitivemarket. However, given the segmented market and the fact that the originator already givesthe price sensitive customers a substantial discount, it is not clear why the firm wouldn'tsimply increase the size of the discount and continue to compete in both markets.

25 To obtain the average price change, we calculate the weighted average price change for thegroup:

60%*.10 + 40%*(-.30) = -.06 = - 6%Notice that this assumes that consumers believe that the generic product is exactly the same asthe brand name product.


pharmaceutical products: Cephalexin and Cephradine. Their findings indicate thatthe "official" BLS methodology for Cephalexin would result in a measured priceincrease of 14 percent (over the period from October 1984 to September 1990),while their preferred index fell 48 percent because ofthe improved handling ofthegeneric substitution (they essentially treated about half of the initial price differential between the brand drug and the generic as reflecting difference in consumerperceived quality and the other half as real price reduction). Thus, at least in thiscase, the effects of ignoring generic products can have a dramatic effect ofoverstating the price index.Berndt et al. (1993) examine the effects of fixed products and weights on the

PPI-Rx, comparing it with indexes created from the complete price data of fourleading pharmaceutical firms. They found that the published index increased 50%faster than a similarly constructed index based on all products. They attribute thisdiscrepancy to an undersampling ofyounger products that had slower than averageprice growth and an oversampling of medium-aged products that had above-average price growth. These problems are the result of the fixed sample nature of theBLS procedures, which hold the products fixed for up to six years. Similarproblems can be anticipated with the CPI-Rx.In addition to the problems of purchase location, generic substitution, and new

product introductions, there are several other problems with the measurement ofprice changes in the pharmaceutical industry which are discussed in Keith andBerndt (1993). These problems include the use of list versus transactions prices,and questions about the units ofmeasurement (prescription filled, dosage strength,number of tablets or amount of liquid, etc). To the extent that consumer purchaseschange along these dimensions, the fixed weight price index leads to incorrectmeasures of the price change. In their analysis, the authors examine the effects ofusing alternative price indexes for measuring the price change for a random sampleof 100 cardiovascular drugs chosen in 1992. Table 4 of their study shows that theaverage annual growth rate from 1982 to 1992 ofthese products range from 5.84%to 12.29%, corresponding to a total price increase ranging from 76.4% to 219%,depending on which index was used. Thus, there is a wide range of alternativemeasures of inflation depending on the methods and assumptions used, and the BLSindex seems to be both methodologically deficient and at the upper extreme.One way to overcome these problems would be to more frequently update the

list of products covered in the index and recompute the weights used each period.The BLS currently updates the sample every four to five years, but they hope toupdate the pharmaceutical sample every two years, Keith and Berndt (1993).Clearly these changes will improve the quality of the data being used to examinewhether consumer prices have been rising rapidly, but the question will remain asto what extent the measured price increases over the 1980s reflect actual behavioror a statistical artifact created by the index construction.Most importantly, however, is that this debate over the price indexes misses the

real point of the question, which is whether consumers are paying too much fortheir pharmaceutical products! Unfortunately, this is a difficult question to answer,


and one that won't be answered by the right index number. Clearly, whatever thecurrent price, in the short run consumers gain from a price cut and producers lose.This sets up the classic regulatory economics problems of balancing the consumergains and producer losses, in an effort to maximize the net gains-as discussed inAbbott and Crew (1994). The relevant issues are whether prices exceed themarginal cost of production, and whether the demand curve is downward sloped.At this point, no one argues that the price of pharmaceutical products does notexceed the marginal cost of production-elearly, the primary reason why genericproducts rapidly enter the market after patent expiration is precisely that pricesexceed manufacturing costs. The issue over the slope of the demand curve is amore debateable. Some contend that because doctors (who are insensitive to drugprices) write prescriptions and patients comply, the demand curve facing individualsuppliers is likely to be vertical. If the demand curve is vertical, then lowering theprice will not stimulate consumption, and there will be no net social gains (merelya redistribution from producers to consumers and third party payers). However,most economists argue that price may influence physician's decisions as well aspatient compliance. In a recent study, Abbott and Rizzo (1994) estimated theelasticity ofdemand for products in the anti-hypertensive market and found that onaverage the market was elastic. Based on this, that in the short run, ignoring thecosts of regulation discussed in Abbott and Crew (1994), allocative efficiency couldbe increased by a regulatory imposed reduction in the price of pharmaceuticals.However, when evaluating a major policy change, such as regulating pharma

ceutical prices, one needs to look beyond the short-run analysis; one must considerthe long-run implications. As discussed above, the development time has risen toover ten years, and the average costs to over $230 million dollars (DiMasi et al.1991). Pharmaceutical firms are run for the profit of their shareholders; as such,investments in research and development are only undertaken if the expected gainsexceed the costs. Altering the way pharmaceutical products are priced wouldclearly affect the expected gains from R&D. The long-term consequences of sucha change, however, are not well understood; changing the pricing structure mightwell affect the projects selected, the number of competitors, and the internationalcompetitiveness of the industry. Moreover, how these changes alter the overall costand quality of medical care in this country is not well understood, even though itshould be the real objective of policy change. In a recent editorial in The Wall StreetJournal, J.D. Kleinke (1994) presents a persuasive case that new drugs lower theoverall cost of medical care, rather than increasing costs. However, the fundamental question is whether society could obtain the same benefits of these newer drugs,but at a lower cost.One way to address this question is to focus on the rate of return in this industry.

The rate of return, obtained from sales ofmarketed products, needs to be sufficientto attract the investments in R&D needed to develop those product. In this case,it is the expected profitability of the future products under development thatprovides the incentives to undertake investments today. This, in turn, implies thatinvestments today are sensitive to changes in the expectation of future profits ten


and twenty years into the future.26

The Senate Special Committee on Aging (1993) claims that the profitability ofthe industry is excessive since the return on equity "far outpaced the profit levelsof the median Fortune 500 company...,,27 Such an examination, however, ignoresthe lengthy time required for pharmaceutical investments to yield marketableproducts and the riskiness and uncertainty of those investments; both of whichwould indicate that a higher return on equity is needed to maintain investment inthis industry. To properly measure the rate of return in this industry, one needs tocompute the net present value of the cash flows for a representative sample ofR&Dprojects over time, adjusted for failures. Grabowski and Vernon (1990) performedsuch an analysis for drugs which were first introduced during the 1970s. Theirstudy concluded that "new drug product introductions in the 1970s realized returnsin line with the 9 percent industry cost of capital.,,28 Moreover, their sensitivityanalysis indicated that "if no real price increases had occurred .... the typical newdrug introduction would not have been able to cover average R&D costs.,,29 Afterreviewing the Grabowski and Vernon study, and commissioning two studies oftheir own, OTA (1993) concluded that "The net returns on NCEs introduced to theU.S. market between 1981 and 1983 are likely to exceed the cost of capital by anamount that would allow annual revenues to be reduced across the board by about4.3 percent,,,30 although they also conceded that these estimates "are highlysensitive to changes in market conditions for drugs throughout their product lifecycle.,,31 Finally, they concluded that the "evidence on the economic rate of returnto the pharmaceutical industry as a whole over a relatively long period (1976-87)shows returns that were higher than returns on nonpharmaceutical firms by about2 to 3 £ercentage points per year after adjustment for difference in risk amongfirms." 2Thus, although there is some evidence that pharmaceutical firms, as a whole,

26 Often one hears people in this debate speak as if current sales are "funding" current R&D,ignoring the investment aspects of the problem. This view arises, in part, because of the wayaccounting rules treat R&D as a current period expenditure. However, it is clear that apharmaceutical firm could terminate its entire R&D program today and continue to earnprofits for many years into the future. Thus, the relationship is better understood as aninvestment in intangible capital. That is, current sales are the rewards from past R&Dinvestments, and future sales will be the rewards from current R&D. When viewed this way,it is clear that a major determinate of current R&D investments is the anticipated returns fromthat investment well into the future. With the ten year development lag, a new projectundertaken today, if successful, would likely began showing sales in 2004, and continue on themarket well beyond 2025. Therefore, it is the anticipated market in those years (2004-2025)that will determine the investments begun today.

27 Senate Special Committee on Aging (1993,3 and Chart 10).28 Grabowski and Vernon (1990,820).29 ibid.30 OTA (1993,104).31 ibid.32 ibid.


were profitable during the 1980s, there does not appear to be overwhelmingevidence that these profits were of the order ofmagnitude which would necessitategovernment intervention. Moreover, with the current restructuring of the healthcare industries and the increased coordination and buying power of third partypayers, these fairly modest excess profits may quickly evaporate; mitigating theneed for price regulation. Finally, the above analysis ignores the cost of regulation,as discussed in Abbott and Crew (1994), which could easily overwhelm thesemodest gains.The proceeding analysis of the returns in the pharmaceutical industry took the

current pharmaceutical firm's expenditures on R&D and marketing as given. Oneexplanation for the appearance of "normal" profit levels, despite market power,would be that non-price competition eroded away much of the rents captured bythe pharmaceutical firms. Two obvious areas for non-price competition in thisindustry are R&D and marketing. To the extent that competition between firmsleads them to overinvest in either research and development or marketing, whencompared to a socially optimal level of investment, a restructuring of the pharmaceutical industry might result in substantial savings for consumers while maintaining adequate investment in new product development. The Senate SpecialCommittee on Aging (1993) report that whereas 16 percent of the manufacturerscomponent of the retail price of drugs "went to" current R&D activities, 22.5percent went to marketing and advertising.33 But, the issue is not whether pharmaceutical firms are spending a lot of money on advertising, the issue is whetherthey are spending too much.Hurwitz and Caves (1988) examined advertising expenditures ofpharmaceutical

firms. When looking at the competition between an innovator product and itsgeneric competitor, they found that the innovator's advertising expenditures werepositively related to their market share after generic entry. The authors interpretthis as evidence of rent-seeking behavior on the part of the innovator firm. Aperhaps more relevant area of examination would be the way in which advertisingexpenditures effect the market share across similar patented products. In a recentstudy, Abbott and Rizzo (1994) found that advertising (in the form of expenditureson detailing) not only increased the demand for individual products (which wouldbe consistent with both the informative and rent-seeking explanations of advertising) but that they also decreased the elasticity of demand for products in theanti-hypertensive market. The latter effect clearly provides an avenue for rentseeking behavior on the part of individual firms, as a lower elasticity of demandencourages the firm to raise its prices. Therefore, both studies find incentives whichwould lead pharmaceutical firms to overinvest in advertising, relative to thesocially-optimal level. Whether pharmaceutical firms are actually over investingin advertising, however, is a question which requires additional research.

33 Senate Special Committee on Aging (1993. 2).


To my knowledge, there has been surprisingly little work on the question ofwhether there is excessive research and development activities in the industry. Iknow of no studies which attempt to quantify the socially optimal level of competition between firms for the development of new products. On the one hand, it isclear that there could be some gains from the elimination of duplice R&D efforts.On the other hand, such competition encourages efficiency in the R&D and theexistence of "me-too" drugs injects competition into the pricing of existing products-particularly in the hospital and managed care portions of the market. Sincemore and more of the market is shifting in the direction of managed care, thebenefits of such competition should increase over time.The conclusions of this analysis of the returns in the pharmaceutical industry are

as follows: 1) it is probably true that the rates of return in the pharmaceuticalindustry are a little high, when compared to the levels needed to induce currentR&D investment; 2) pharmaceutical firms probably spend too much on advertising,when compared to the socially-optimal levels needed to keep physicians andconsumers informed about new and existing products; and 3) pharmaceutical firmsmay be spending too much on duplicative or similar research and development,when compared to socially optimal levels. However, on the latter two points, oneshould be skeptical about the ability of price regulation to move firms in thedirection of less advertising and more original R&D. Moreover, as we shall see inthe next section, price regulation creates its own set of problems.

3. Regulating Pharmaceutical Prices

In this section, we examine alternative methods of regulating pharmaceuticalprices. As discussed in Abbott and Crew (1994), imposing regulation on anindustry is not without cost. Regulation creates transactions and administrativecosts; it alters the incentives ofthe firm for production efficiency; it leads firms toincrease other rent seeking activities; and it may exacerbate some of the existingallocative inefficiencies through increasing cross-subsidies. Thus, one must carefully examine both the costs and the benefits of regulation, before undertaking amajor change in public policy. Moreover, one must be careful not to compare theoutcomes of an imperfect market with those of perfect regulation. If there is onelesson to be learned from the regulation of public utilities, it is that firms seek waysto maximize profits within the regulatory constraints and, as a result, their behaviormay differ significantly from the desired behavior anticipated by the regulator.As I have already extensively examined the application of rate-of-return regu

lation and price caps to this industry (Abbott 1993), I summarize the results here.Essentially, the problem which the regulator faces with respect to the pharmaceutical industry is similar to the classic public utility problem. In order for a firm todevelop a product, it must make a high initial sunk investment. Unless there issufficient assurance that these costs, and the associated risks, are covered, at leastin expectations, there will be no incentive for the firm to undertake the initialinvestment. What makes the regulatory problem even more difficult here is that,


as shown by Grabowski and Vernon (1990), only 2 out of 10 drugs which make itto the market, even under the current monopoly pricing, are able to cover theseaverage research and development costs. Thus, unless the firm is able to earn"excess" profits on those rare products which are very successful, it may be forcedto cut back or alter its research and development activities.34

Rate-or-Return RegulationA natural approach for regulating pharmaceutical firms would be to use rate-of

return (ROR) regulation, since the overall objective is to prevent the pharmaceuticalfirm from making an excessive profit given its monopoly position in the market.Under ROR regulation, the firm's R&D expenditures would be capitalized into therate base of the firm. One method of implementation would be to allow the firmto freely price its products as long as the total return was less than a pre-specifiedlevel, such as given in equation (1):

n

L Pit qit - C(qit) - dt::S; sRt

i=1

Rt=Rt_1+RDt-dt, (1)

where Pit is the price of product i in period t, qit is the quantity of product i sold inperiod t, Ct( ) are the manufacturing and distribution costs in period t, dt is thedepreciation in period t, s is the allowed rate of return, Rt is the rate base in periodt, and RDt is the new research and development expenditures incurred in period t.This approach would insure that the firms could not make excessive profits fromthe development of a new drug, but would be able to cover the costs of their researchprojects using revenues from all products. A number of issues remain including:which products would be subject to the return constraint, what the allowed rate ofreturn would be, the rules for determining depreciation of the rate base, and whathappens if the firm's revenues fall short of the constraint in a given period (are themissed profits lost forever?). The key question we want to focus on is how thisregulation would alter the behavior of the firm. First, lets examine the incentivesfor R&D, since they are a primary concern to both the industry and society. Clearly,

34 At this point, it is not clear to what extent the firm is able to a priori estimate the likelydevelopmental costs, likelihood of success, and the marketing potential for each of its projects;Schnee (1972) provides some evidence from research projects in the 1950s and 60s, whichsuggests that firms are able to predict fust year sales reasonably well-55% of the forecastswere within 50% of the projection, whereas only 26 percent of the cost estimates were withinthose bounds. If firms are able to project these costs and potentials sufficiently to rank orderits projects, then imposing a cap on the "profits" of individual drugs would result in the firmre-allocating its R&D resources towards less costly and lower risk projects, which Schneefound to be the "alternative dosage forms" and "compounded products," rather than the workon "new chemical entities" which provide the breakthrough advances in medical care.


if the allowed return (s) were high enough so that no firm ever hit the revenueconstraint, nothing would happen-thus the usual corporate line that you woulddestroy all incentives for R&D can't apply in all situations.35 On the other hand,if the value of s were set too low, i.e., below the cost of capital for the industry, thiswould undoubtedly be true. Thus, the regulator would have to set s above the costof capital. In theory, in choosing s one also chooses the R&D projects. If thepharmaceutical firm ranks its projects, based on the expected internal rate of return,one would expect the firm to invest in all projects which have an internal rate ofreturn above s and not invest in those projects which have a rate of return below.However, in practice, a firm which would normally hit the revenue constraint

would have an additional incentive to invest in R&D projects, since the R&Dexpenditures are built into the rate base. That is, for every dollar ofadditional R&D,regardless of what it was used for, the firm would be able to collect s in additionalprofits because of the revenue constraint in equation (1). This could lead to overinvestment in R&D by the successful firms. In fact, if firms were permitted toflexibly price under the ROR constraint, it would be optimal for them to adjust theirinvestments in R&D to the point that their prices are identical to the unregulatedprices. This is an extreme version of the well-known Averch-Johnson (1962)effect. In public utility regulation, this effect is counteracted by the "used anduseful" criterion, which requires the regulated utility to demonstrate that an investment was prudent before it can be incorporated into the rate base. In the pharmaceutical industry, it would be very difficult to implement a similar requirementgiven the uncertainties of the R&D process described in section 1 and the asymmetry of information on the value of the research project.36A second problem with the ROR model is that there are little or no incentives

for productive efficiency. If the firm has products which can generate revenues inexcess of the cap, each additional dollar of manufacturing costs increases therevenue constraint one dollar. Under these circumstances, the firm might as wellprovide its employees with large salaries and excellent benefits, its executives with

35 I am always amazed how many people in the pharmaceutical industry think that priceregulation and the incentives for research and development are totally incompatible. Onemerely has to recall the experiences of AT&T to realize that the protection which goes alongwith regulation can provide opportunities as well as challenges. AT&T-Bell Labs was amodel of corporate research during most of this century. In fact, AT&T employees even wonthe Nobel Prize for their work on the development of the transistor in 1956.

36 Evaluating whether an electrical generator or telecommunications switch is being used tocapacity is relatively easy for a regulator to do compared to determining at what point the firmshould give up on a new drug. R.I. Kogan, President and COO of Schering-PloughCorporation, wrote in The Wall Street Journal a letter discussing the development of alphainterferon, claiming that early efforts to develop a genetically engineered version of the drugwere conducted at a time when the known market was relatively small; but after itsdevelopment, a much larger market evolved as new information led to using it to treat manyother diseases. He suggests that an outside government reviewer might not have seen thevalue of this project and therefore would have rejected it early on.

122 HEALTH CARE POLlCY AND REGULAnON

perks, and spend even more money on advertising and promotions-things whichthe pharmaceutical industry is currently accused of doing. Finally, if the firm isintegrated across regulated and unregulated operations, there would be an incentiveto shift as much of the unregulated costs over to the regulated division. 37 If thepre-clinical research is applicable to both OTC and prescription markets, this mightnot be that difficult to do.Overall, ROR regulation does not hold much hope for constraining pharmaceu

tical prices, even though, in the best of all possible worlds, it is the cleanest formof regulation. The incentive problems created by ROR regulation would appear toswamp the consumer benefits. Fortunately, none of the proposals in Congress callfor applying ROR regulation to this industry.

Price-Cap RegulationUnder price-cap regulation (PCR), the prices in one period would be constrained

by the prices charged in the proceeding period, adjusted for inflation. In general,this can be written as

n n

LPiflit-l:5: LPit-Iqit-1 x (1 + CPlt+X),

i=1 i=1

(2)

where Pit is the price for product i in period t, qit-I is the quantity of product i inperiod t-l, CPlt is the increase in the consumer price index during period t, and Xis an adjustment factor used to allow prices to rise more rapidly than inflation, orto insure that consumers get real price declines.38 The price-cap approach constrains the average price increases for pharmaceutical products to the increaseinflation plus the offset.39 In an idealized world, PCR would prevent some of thecurrent objections.However, as with ROR regulation, PeR is not implemented in a perfect world.

In order to permit price flexibility, price-cap constraints are applied to a basket ofgoods rather than to each good individually. This creates problems, particularlywhen the demand for the individual products in the basket grow at different rates,as discussed by Neu (1993) and Abbott and Crew (1993).40 In the pharmaceutical

37 This is currently a major problem with deregulation of the local telephone companies-howdo they keep their regulated and unregulated divisions separated from the stand point of therevenue constraint?

38 In the telecommunications industry, X is generally a negative number (because of anticipatedproductivity gains) so that consumers are guaranteed real price decreases over time.

39 Notice that although last periods quantities are used to weight the new prices, unlike the BLSfixed weight index, these weights are updated each period.

40 The basic idea behind can be illustrated with a simple example. Assume there are twoproducts, and the demand for product I is growing, while the demand for product 2 isshrinking. Even if there is no inflation. the firm can increase its revenues by increasing theprice of product I and decreasing the price of product 2, because the constraint is based on last


industry, where there is a strong product life cycle, a regulated firm might be ableto manipulate the price-cap constraint to increase the prices on the products withrapidly growing demand and decrease prices on products which are losing revenues.More importantly, price-cap regulation does not provide any constraint on

pricing new products. As a result, a firm could playa dynamic game by introducinga new product at a high price and lowering it to offset a price increase on anotherproduct in the same basket. Much of the debate between the pharmaceuticalindustry and the Senate Special Committee on Aging has to do with how the"average" price increase is calculated--exactly this issue. The Committee focuseson one measure of "average" price increase, while the industry focused on another.One solution to the problem of dynamic distortions would be to apply the price

cap to each product individually-provided the products are well defined. In thiscase, however, there would be considerable debate over how define the product. Isa bottle of 100 tablets, 250 mg. of one drug, the same product as a bottle of 50tablets, 500 mg. of the same drug? If they are placed under the same price cap, thenthere is the opportunity for dynamic distortions as discussed above. If they are notplaced under the same price cap, then by introducing the latter and phasing out theformer, a firm would have an unrestricted change in the price. While this simpleexample sounds pedantic, one can imagine a situation in which the product changewas in the delivery mechanism, formulation, or presentation and the actual objective of the firm, increasing its price, would be more difficult to detect.Finally, if the firm anticipates the price-cap constraint, the introductory price

will be chosen not to maximize profits in the first period (as is presently the case),but to maximize profits over the life of the constraint. In a situation where it isoptimal for the firm to raise its price over the life of the product, this means theunrestricted introductory price will be unambiguously higher under the price capthan under no regulation. In an industry, where new products are continuouslybeing introduced, the effects could be quite dramatic.Abbott (1993) used data from the OTA report to estimate the optimal introduc

tory price under a price-cap constraint. It found that the optimal, multi-period,regulated price was 50% higher than the average unregulated introductory price.Moreover, it wasn't until the sixth year that the unregulated price exceeded theregulated price. Thus, in the short run, because price-cap regulation fails to controlthe introductory price, consumers are forced to pay more for their prescriptions ofnew products under the price-cap regulation than they would have if there was noregulation at all. After the first six years, consumers benefitted from having lowerprices under the regulation. However, depending on the social discount rate, thenet present value ofthe benefits to the consumer could be either positive or negative.Moreover, after firms adapt to the price-cap environment, the impact on total profitsare relatively small-on a brand which peaks at $100 million in sales, the effects

period quantities while revenues are based on this period's quantities.


on profits would only be $2 million in present value compared to consumer lossesof $29 million in the first year.The key assumption underlying this indictment of price-cap regulation is that

the firm is able to optimally choose its introductory price. If the regulator couldcontrol the introductory price of a new product, then a price-cap mechanism couldbe used to control the prices thereafter. But, in this case, we are back to the originalquestion: How do you determine what is a "fair" price for a new product? Forexample, what is a reasonable price for TPA, a synthetic blood thinning agentwhich, when used immediately after a heart attack, reduces the probability of deathfrom 7 percent to 6 percent compared to the alternative. Gentech, its developer,introduced TPA at a price of $2000 per dose. Is that unreasonable? How are yougoing to decide? Price-cap regulation doesn't provide the answer. and, as discussedabove, looking at the rate of return on the R&D investment won't help eitherbecause a lot of the costs ofdevelopment cannot be traced to an individual product.What do you do about the R&D costs associated with products which never madeit to the market? Unless this fundamental issue of pricing new drugs can beresolved, price-cap regulation will simply be a temporary stop-gap solution whichwill cut into short term pharmaceutical profits on existing products, but notdramatically affect the way pharmaceutical firms operate since, within ten years,most of the existing products would have been phased out and replaced with newproducts which were initially priced for the PCR environment.41

Cost-Effectiveness PricingOne way to establish a "fair" introductory price might be to use Cost Effective

ness Analysis. Under this, a new therapy which was more cost effective than theexisting treatment, would be considered appropriate and the product would beapproved for marketing. Cost Effectiveness Analysis (CEA), discussed in Drummond et at. (1993), assumes a single dimension on which the effectiveness ofalternative treatments can be assessed (such as cost per year of life saved, or costper quality adjusted life year saved) and uses the cost effectiveness ratio to choosebetween alternative therapies. It is easier to apply CEA than Cost Benefit Analysis(CBA) because rather than measuring the dollar value of all of the benefits, oneonly needs to measure the effectiveness of the therapy along the chosen dimension.However, in practice, it is sometimes difficult to measure the cost effectivenessagainst such broad-based measures, and often an intermediate measure, such aspercentage of patients within a target blood pressure range in the case of ananti-hypertensive product, are used.To use cost-effectiveness to evaluate the introductory price of a new pharma-

41 The short term gains from price-cap regulation may not even be there. Pharmaceutical firmswould undoubtedly challenge the constitutionality of imposing, ex post, price controls onexisting products as being a confiscatory practice in violation of the fifth amendment. Such achallenge could involve years of litigation and cost millions of dollars.


ceutical product, the regulator needs to determine the appropriate dimension foreach product. In the above TPA example, lives saved per 1000 doses might be theappropriate dimension. Next, the regulator needs to determine the appropriatetherapy to use as a standard ofcomparison-this could be done in conjunction withthe FDA which already selects a therapy ofcomparison to evaluate the effectivenessof the new product. Finally, an empirical analysis would be conducted to determinethe cost-effectiveness of the new therapy. The cost effectiveness ratio (CIE) isdefined as the ratio of the additional costs using the new therapy to the additionaleffectiveness. This ratio is illustrated in figure 1, which shows the existing standardtreatment (A) and the new product (N) plotted on a cost-effectiveness graph. Anyproduct with effectiveness less than EA is automatically rejected by the FDAeffectiveness standard. In addition, any product which costs less that CA (but ismore effective) would be automatically approved. The cost-effectiveness ratio ofthe new product can be illustrated as the slope of the line between the new productand the standard therapy. This CIE ratio can be compared to either an absolutestandard (such as $50,000 per life saved) or against the averageCIE standard of theexisting therapy, as illustrated by the line through A and the origin. If the newproduct satisfies the regulatory standard, the product would receive marketingapproval. Since the pharmaceutical firm would probably conduct these studies, asis the case with the FDA approval, they would be in a position to adjust theirintroductory price as needed to satisfy the cost-effectiveness standard. Australia isexperimenting with using cost-effectiveness as a pricing criteria in allowing newpharmaceutical products in its market (OTA 1993).On the surface, this approach has much appeal. Any new treatment that meets

approval would be a social improvement, since it would be both at least as effectiveas the current treatment and meet the cost effectiveness standard. Many industryexperts have argued that new drugs actually save the health care system money, forexample Boston Consulting Group (1993) and Kleinke (1994), so one would thinkthat such a requirement would not be viewed as insurmountable by the industry.The only additional analysis needed to satisfy the cost-effectiveness standard wouldbe a cost study, which in some cases might reduce to simply comparing the cost ofthe pharmaceuticals.42

Unfortunately, there are a number of problems with this approach which needto be considered before any major policy change is made. First, treatment effectiveness is rarely uni-dimensional. Treatments can differ in many respects including: the probability of full recovery, the prospects for partial recovery,contra-indications, adverse drug interactions, and serious adverse drug reactions.Ideally, each of these should be used as a separate dimension of analysis, since anew therapy may be more effective in some directions but not others, thereby

42 Recently, some managed-care organizations have begun to require cost effectiveness studiesbefore they include a new product or therapy on their formulary. Thus, many pharmaceuticalcompanies are beginning to include cost-effectiveness studies in their new drug studies.

126

CostperFOfient

HEALTH CARE POLlCY AND REGULAnON

EffectivenessFigure 1

making it the preferred treatment for some of the patients. Thus, the nice cleanranking of therapies which conceptually underlies CEA does not exist in manycases.Second, under the cost effectiveness criteria, companies would be shooting at

a moving target. To illustrate the point, suppose an average C/E standard were usedand that it is currently $65,000 per life saved today, when a pharmaceuticalcompany begin to develop a new product.43 Over time, one would expect theaverage C/E ratio to decline as new treatments are introduced which satisfy thecost-effectiveness criteria. By the time the new product is ready for introduction,the C/E ratio of the standard could be dramatically lower-low enough that theproduct cannot be introduced (even though it might be the preferred method oftreatment for some patients). As a result, companies that invest today would facegreater uncertainty about future market conditions, leading them to perhaps notinvest in the development of some important new drugs, or to at least require ahigher expected rate of return on the investments they do undertake. Without thecost-effectiveness requirement, the company would have been permitted to intro-

43 The same issue arises in the case of the absolute CIE standard, but it is a little more difficult tovisualize on figure I, thus we will assume the average CIE standard for illustrative purposes.


duce the new drug anyway and perhaps re-coup part of the initial investment.A third problem is that the overall cost of treatment depends on more than just

the cost of the pharmaceutical products. As a result, although the firm may be ableto control part of the cost of treatment, they are not in a position to control all ofthe costs. Therefore, it is unreasonable to hold them responsible for making surethat the treatment method is cost effective. Moreover, something which may becost effective at one point in time could easily become not cost effective, if theprices of the related services change, and vice versa.Finally, because the cost-effectiveness method treats the existing standard as

given, a new therapy which is not quite as cost-effective but is significantly moreeffective could be rejected even though, on average, people might be willing to payfor the better therapy. Although, one might be tempted to suggest that regulatorscould be provided some flexibility in cases where a new therapy is significantlymore effective, thereby avoiding the such obvious errors, it is also important to keepin mind that medical innovations don't just happen. The effectiveness of a newtreatment program generally improves as physicians gain experience with it. Thus,a treatment which may eventually become significantly more effective may bediscarded early on, because its expected cost-effectiveness ratio exceeds the standard, before it has the opportunity to evolve into the superior treatment.Thus, although cost-effectiveness is conceptually attractive, it is difficult to see

how it could be implemented in a way that would provide the kind of protectionneeded to control introductory prices of new innovative products. In the case ofsimilar drugs, either "me-too" or generics, cost-effectiveness may be a usefulcriterion.44 In these cases, because the drugs are so similar, the way in whichpatients are treated using these drugs are nearly identical. Thus, treatment costcomparisons would generally reduce to a direct comparison of drug costs. However, in the case of similar products, it is not clear to what extent the introductoryprices are a major concern. To date, I know of no analysis which shows that the"me-too" drugs are being introduced at prices in excess of the originator drugs. Infact, a casual examination of anti-hypertensive prices suggests just the op~osite,

"me-too"s appear to be priced substantially below the innovative products 5 Theevidence is much stronger for the case of generics, which are often introduced atdiscounts ranging from 40 to 70 percent (Scherer 1993). Thus, in the instanceswhere cost-effectiveness could most easily be applied, it is not clear that societywould gain much, since it appears that the market is already imposing a similarrequirement on producers.

44 "Me-too" drugs are drugs which are designed to be similar in action to existing products, whilegenerics are chemically identical.

45 One explanation for this may be the brand loyalty built up by the innovator during the time inwhich they were the only product on the market. In order to counteract this brand loyalty andattract customers away from the originator product, producers of similar products must chargea lower price.

128 HEALTH CARE POLlCY AND REGULAnON

4. Current and Proposed Regulations

Medicaid Price Rebate ProgramAs part of the Omnibus Budget Reconciliation Act of 1990, Congress adopted

a Medicaid Rebate Program which required manufacturers selling prescriptiondrugs to Medicaid patients to give each state a rebate. In exchange, the lawprohibited the states from establishing exclusive formularies which restrict Medicaid recipients access to FDA approved medications (OTA 1993). The MedicaidRebate consisted of two parts, a basic rebate and an additional rebate. The basicrebate is the maximum of either 10 percent of the Average Manufacturer Price, oran amount equal to the largest discount given to any single buyer by that company.The additional rebate was the difference, if any, between the current price and theOctober 1990 price adjusted for inflation. That is, the Medicaid Price RebateProgram essentially imposed a price-cap mechanism and is therefore subject to theproblems discussed above. However, given the relatively small size of the Medicaid market, its not clear that such a price cap would have a major impact on thebehavior of pharmaceutical firms.46

Current Legislative ProposalsAs noted above, there are several bills pending in Congress which attempt to

control pharmaceutical prices. We will briefly review each of these proposals.

Prescription Drug Prices Review Board Act of1993 - HR 916This Act would establish, within the FDA, a board known as the Patented

Medicine Prices Review Board. The board would have the authority to removepatent protection and recapture tax benefits on any drug it deemed as being sold atan "excessive price." Within the legislation, an excessive price is any price whichhad an annual increase which exceeded the rate of inflation, or any price higherthan other products in the same therapeutic category, or any higher than what theproduct is sold at in other countries. Thus, in addition to imposing a price cap onall products, the board is permitted to make cross product and international pricecomparisons. Many of the problems discussed above under price-cap regulationwould apply to this legislation.

Prescription Drug Affordability Act of1993 - HR 1158This Act would amend the IRS tax code to reduce the "excess" Section 936 tax

credit (related to employment in Puerto Rico) by a percentage which would be equalto twenty times a sales-weighted average of the excess price increases over the

46 Scherer (1993) indicates that in 1989 Medicaid covered approximately 14 percent of all UnitedStates prescriptions (by dollar volume), while the Congressional Budget Office estimated thatMedicaid, Veterans Administration, and Public Health Service rebates totaled $1.24 billiondollars (Keith and Berndt 1993).


inflation rate (if any) on each single source or innovator multiple source drugs.That is, if the pharmaceutical firm were to increase the prices of half of their drugs(by sales volume) covered by this Act 1percent more than the rate of inflation, theirSection 936 excess tax credit would be decreased 10 percent, regardless of howmuch they might have lowered the prices on their other drugs. Thus, rather thanplacing a restriction directly on drug prices and tying the penalties to revenuescollected by "excessive" price increases, this bill uses reductions in the tax creditto punish firms which increase their prices faster than inflation. Pharmaceuticalfirms would need to evaluate whether the increased revenues from such priceincreases were greater or less than the tax credit losses.

Prescription Drug Consumer Protection Act of 1993 - HR 1434This Act creates the Prescription Drug Price Review Board which would

establish its own guidelines for determining whether an existing price was excessive, whether a price increase was excessive, or whether a new product's price wasexcessive. If after establishing these guidelines, the board finds that a product hasan excessive price, it will: publish its findings, hold public hearings, and thenrevoke the patent on the product if it still believes the price is excessive. Theremoval of patent protection would permit immediate generic entry and dramatically reduce the innovative firms revenues. Whether firms would continue to putR&D money at risk when faced with a board with such broadly defined powers isa question for additional analysis.

Health Security Act of 1993The proposed Clinton Health Security Act creates an outpatient drug benefit for

all Medicare beneficiaries starting in 1996. This benefit would cover the cost ofmost prescription drugs used on an outpatient basis subject to a $250 deductible,20 percent coinsurance, and a $1000 out-of-pocket limit per individual. Such aprogram could greatly increase the ability of older Americans to purchase outpatient pharmaceutical products and, as a result, could dramatically increase theassociated moral hazard problem. In addition, it would further reduce the elasticityofdemand, leading pharmaceutical firms to have the incentive to increase the pricethey are charging for their products. To counter this effect, Section 2003 of theproposed Act outlines aMedicare Rebate Program, which by any other name wouldbe price-cap regulation.The Medicare Rebate Program begins by establishing a list of products covered

by the benefit, i.e., a restrictive formulary. To be included on this formulary, themanufacturer has have to enter into a "rebate agreement" with the Secretary ofHealth and Human Services. This agreement would include provisions to pay HHSa quarterly rebate comprised of two parts, patterned after the Medicaid Rebates, abasic rebate and an additional rebate.The basic rebate is computed for each drug/dosage as the total number of units

purchased by Medicare beneficiaries times the maximum of: 1) the differencebetween theAverageRetail Price for that manufacturer and theAverageNon-Retail


Price for that manufacturer or 2) 17 percent.47 Thus, HHS is using its buying powerthrough a restricted formulary to extract discounts from the pharmaceutical firmsfor a large segment of the market.48The additional rebate is a price cap. For existing products, there would be an

additional rebate, in an amount equal to the units purchased times "the amount, ifany, by which the average manufacturer retail price of covered drugs ... exceedsthe average manufacturer retail price for the base quarter, increased by the percentage increase in the Consumer Price Index.,,49 That is, the rebate would imposeequation (2) on each and every drug/dosage by forcing the manufacturer to eitherrepay HHS the difference, or have their drug removed from the formulary. Thisapproach is, open to the problem of artificially creating new products to get aroundthe constraint, as discussed above. Moreover, when you are dealing with roughlyone third of the retail market, and a significantly higher share for certain types ofdrugs, the incentives to try to manipulate the price cap could be quite strong.For any new drug (or drug/dosage?), the Secretary of HHS, would have the

power to negotiate a rebate if: 1) the product was not marketed elsewhere and "theSecretary believes the average retail price may be excessive,',50 or if the drug ismarketed in other countries at "significantly" lower prices. Thus, although it isclear the Clinton Administration realizes the problem ofnew product introductions,they do not have any mechanism to determine a "reasonable" price. One can onlyimagine the kinds of legal and political problems that might arise if the Secretaryof HHS failed to reach an agreement with a pharmaceutical manufacturer on theprice of a new alzheimer product, thereby keeping it off the formulary and out ofthe hands of senior citizens. Thus, I am not very hopeful that such a vague approachto the new products problem will overcome the financial incentives to raise theintroductory price as discussed above.

5. Conclusions

After examining the issues involved in regulating pharmaceutical prices, one is leftwith the realization that there are many unanswered questions which affect the needfor and the effects of government price regulation on this industry. At the same

47 The Average Retail Price is defined in the legislation as ..... the average price (inclusive ofdiscounts ...) paid to the manufacturer for the drug in the United States for drugs distributed tothe retail pharmacy class of trade" and the Average Non-Retail Price is defined as "the averageweighted average price (inclusive of discounts ...) paid to the manufacturer for the drug in theUnited States by hospitals and other institutional purchasers that purchase drugs for institutionuse and not for resale." Health Security Act (1993, 368-9).

48 Using 1988 data from IMS's National Prescription Audit, Thomas and Schondelrneyer (1992)estimated that elderly Americans spent $9.1 billion dollars on retail prescription drugs,accounting for nearly 35 percent of the retail market in that year.

49 Health Security Act (1993, 364).50 Health Security Act (1993, 364-5).

REGULATING PHARMACEUTICAL PRICES I3I

time, one is not very optimistic about the ability of government regulators toeffectively control pharmaceutical prices using the traditional tools of eitherrate-of-return or price-cap regulation. The fatal flaw in ROR is that the regulatorwill not be able to adequately monitor the R&D expenditures which are built intothe rate base, thereby allowing firms to inflate the rate base and raise pricesaccordingly. The fatal flaw for PCR is that the regulator cannot determine a"reasonable" price for the introduction of new products and, without being able tocontrol introductory prices, the benefits ofPCR are greatly diminished in a dynamicenvironment.A second conclusion drawn from this analysis is that too much emphasis is being

placed on the wrong thing. Everyone seems caught up in the debate over how fastprices rose during the 1980s. But, the issue is not whether prices have risen fasterthan inflation, or even how can we best contain the cost of pharmaceuticals, theoverall question is how to contain the cost of medical care. Granted, in the shortrun, the high cost ofpharmaceuticals increases the overall cost ofmedical care whencompared to have those same pharmaceuticals at a lower cost; but in the longer run,high prices encourage research and development which may eventually reduce theoverall cost of medical care by substituting pharmacological treatments for morecostly forms of treatment, such as surgical. On the other hand, it would be nice tobe able to identify those areas where research could have the largest impact onoverall health care expenditures and create incentives for firms to target researchin those areas.51 To do this, one would need to develop a much better understandingof how R&D is related to new product development in specific areas, and how thosenew products might effect overall health care expenditures.A third conclusion is that the pharmaceutical industry is a very dynamic industry.

The industry has evolved greatly over the last century, going from sellers of "snakeoil" to developers of the latest genetically engineered products like TPA; and goingfrom relatively small manufacturing facilities to the operators of some of the largestresearch laboratories in the world. Along the way, the companies themselves weretransformed from single establishment manufacturing facilities to large, verticallyintegrated, multi-national corporations. In many ways, the evolution of the industrycontinues today, with the recent rise in merger activity like the Merck-Medcoconsolidation. These changes in the industry structure are in response to both theactions of the federal government and other players in the health care market. Inparticular, the rise of managed-care organizations, with their focus on pre-paidhealth plans, budgeting, and risk sharing, have led to a restructuring of the

51 The Orphan Drug Act of 1983 provides one attempt at using regulation to provide incentivesfor firms to undertake targeted research and development projects. As of September 1992, 79biological and drug applications had been approved for marketing by the FDA with orphanstatus (OTA 1993). Perhaps a similar approach could be used to encourage research in thoseareas where there is the potential for high savings. Such a program might include pricingcommitments in exchange for tax benefits, direct R&D subsidies, or accelerated FDA approval.


pharmaceutical industry.As the demand side of the market evolves towards larger and larger buyers, much

of the aggregate variation in their pharmaceutical usage decreases, making the useof alternatives to per unit pricing possible. Fundamentally, the problem in pharmaceutical pricing is to develop prices which: 1) maximize allocative efficiency bygetting the per unit charge as close to the marginal cost of production, and 2) insurethat the pharmaceutical firm receives an adequate return to cover the initialinvestment in R&D. The use of per unit pricing is a very restrictive way ofaccomplishing these objectives. Coase (1946) and Oi (1971) examine this problemusing ofa two-part tariffconsisting ofa fixed "access" charge and a per unit "usage"charge. Per unit pricing is a special case ofa two-part tariffwhere the access chargeis zero and capitation is another special case at the opposite extreme where the usagecharge is zero. In some cases, two part tariffs can be shown to provide a bettersolution than either per unit pricing or capitation, e.g., Ellis and McGuire (1993).As the market for pharmaceuticals continues to evolve, two-part pricing may

become a viable alternative to the present per unit pricing system. Such two-partpricing schemes have been used extensively in public utilities and may hold a keyto obtaining both the objective of allocative efficiency and covering the fixed costs.Additional analysis is needed to determine if two-part pricing can be effectivelyused to price pharmaceutical products and optimall~ share the cost risk betweenthe manufacturer and the patient's third-party payer. 2 Additional analysis is alsoneeded to determine whether two-part pricing should be instituted by regulation,or whether competition between newly integrated, broader spectrum companieswould be more efficient.

References

Abbott, TA. "Price Regulation in the Pharmaceutical Industry: Prescription or Placebo?"Rutgers University Working Paper. November 1993.

Abbott, TA. and M.A. Crew. "Incentives for Efficiency Under 'Incentive' Regulation."presented at the Sixth Annual West Coast Conference of the Advanced Workshop inRegulation and Public Utility Economics, Monterey, CA, July 1993.

Abbott, TA. and M.A. Crew. "Lessons from Public Utility Regulation for the EconomicRegulation of Health Care Markets: An Overview." presented at the Health Care Policyand Regulation Workshop, Rutgers University, January 1994.

Abbott, T.A. and lA. Rizzo. "Advertising and Competition in the Pharmaceutical Industry:Evidence from the Anti-hypertensive Market" mimeo.

Averch, H. and L.L. Johnson, "Behavior of the Firm under Regulatory Constraint", American Economic Review, December 1962. p. 1052-69.

Baily, M.N. "Research and Development Costs and Returns: The U.S. PharmaceuticalIndustry." Journal ofPolitical Economy. 80(1):70-85. 1972.

52 Currently, it is rumored that Merck-Medco is working on developing a capitated plan for largemanaged care organizations.


Berndt, E., Z. Griliches, and J. Rosett. "Auditing the Producer Price Index - Microevidencefrom Prescription Pharmaceutical Preparations." Journal of Business and EconomicStatistics. II (3):251-264. 1993.

BostonConsultingGroup. The Contribution ofPharmaceutical Companies: What's at Stakefor America. September 1993.

Caves, RE., M.D. Whinston, and M.A. Hurwitz "Patent Expiration, Entry, and Competitionin the U.S. Pharmaceutical Industry," Brookings Papers on Economic Activity, Microeconomics. 1991. p. 1-48.

Coase, RH. ''The Marginal Cost Controversy" Economica. 1946. p. 169-189.DiMasi, J.A., R.W. Hansen, H.G. Grabowski, and L. Lasagna. "Cost of innovation in thepharmaceutical industry." Journal ofHealth Economics. 10 (1991) 107-142.

Drummond, M.F., G.L. Stoddart, and G.W. Torrance.Methodsfor the Economic EvaluationofHealth Care Programmes. New York, NY: Oxford University Press. 1993.

Ellis, RP. and T.G. McGuire. "Supply-Side and Demand-Side Cost Sharing in Health Care"Journal ofEconomic Perspectives. Fall 1993. p. 135-151.

Economic Report of the President. Washington, DC: U.S. Government Printing Office.February 1991.

Frank, RG. and D.S. Salkever. "Pricing, Patent Loss and the Market for Pharmaceuticals."Southern Economic Journal. October 1992. p. 165-79.

Grabowski, H.G. and J.M. Vernon. The Regulation of Pharmaceuticals: Balancing theBenefits and Risks. Washington, DC: American Enterprise Institute for Public PolicyResearch, 1983.

Grabowski, H.G. and J.M. Vernon. "Longer Patents for Lower Imitation Barriers: The 1984Drug Act", American Economic Review: Papers and Proceedings. May 1986. p. 195198.

Grabowski, H.G. and J.M. Vernon. "A New Look at the Returns and Risks in PharmaceuticalR&D." Management Science. 36(7):804-821. July 1990.

Grabowski, H.G. and J.M. Vernon. "Brand Loyalty, Entry and Price Competition inPharmaceuticals After the 1984 Drug Act" Journal oflAw and Economics. 35(2):331350. October 1992.

Griliches, Z. and I. Cockburn. "Generics and New Goods in Pharmaceutical Price Indexes."presented at the American Enterprise Institute conference on Competitive Strategies inthe Pharmaceutical Industry. October 1993.

Hansen, R "The Pharmaceutical Development Process: Estimates of Developmental Costsand Times and the Effect of Proposed Regulatory Changes" in Issues in PharmaceuticalEconomics RA. Chien editor. Lexington, MA: D.C. Heath and Co. 1979.

Hahn, V. and D. Lefkowitz. Annual Expenses and Sources of Payment for Health CareServices (AHCPR Pub. No. 93-0007). National Medical Expenditure Survey ResearchFindings 14, Agency for Health Care Policy and Research. Rockville, MD: Public HealthService. 1992.

Health Security Act. Washington, DC: U.S. Government Printing Office. 1993.Hurwitz, M.A. and RE. Caves. "Persuasion or Information? Promotion and the Shares ofBrand Name and Generic Pharmaceuticals." Journal of lAw and Economics. October1988. p. 299-320.

Keith, A. and E.R. Berndt. "A Primer on Issues in the Measurement of Price Change andPrice Impact: An Application to Pharmaceuticals." presented at the Southern EconomicsAssociation Annual Meetings. New Orleans. November 21-23,1994.

Kleinke, J.D. "Expensive Drugs Lower Health Care Costs" editorial in The Wall StreetJournal, February 16, 1994.


Kogan, R.J. "Clinton Rations Future Cures" editorial in The Wall Street Journal, February16,1994.

Kondratas, R.A. 'The Biologics Control Act of 1902", in The Early Years ofFederal Foodand Drug Control. Madison, WI: American Institute of the History of Pharmacy. 1982.

McGuire, T., R. Nelson, and T. Spanvins. "An Evaluation ofConsumer Protection legislation: The 1962 Drug Amendments: A Comment" Journal of Political Economy. 1975.p.655-667.

Neu, W. "Allocative Inefficiency Properties of Price-Cap Regulation." Journal ofRegulatory Economics. June 1993. p. 159-182.

Nichols, N.A. "Scientific Management at Merck: An Interview with CFO Judy Lewent."Harvard Business Review. January-February 1994. p. 88-99.

Oi, W.Y. "A Disneyland Dilemma: Two Part Tariffs for a Mickey Mouse Monopoly"Quarterly Journal ofEconomics. 1971. p. 77-90.

Peltzman, S. "An Evaluation of Consumer Protection Legislation: The 1962 Drug Amendments" Journal ofPolitical Economy, September 1973. p. 1049-1091.

Pharmaceutical Manufacturers Association. PMA Annual Survey Report: Trends in U.s.Pharmaceutical Sales and R&D. Washington, DC. 1993.

Scherer, F.M. "Pricing, Profits, and Technological Progress in the Pharmaceutical Industry". Journal ofEconomic Perspectives. Summer 1993. p. 97-115.Schnee, I.E. "Development Cost: Determinants and Overruns." Journal of Business45(3):347-374. 1972.

Schwartzman, D. The Expected Return form Pharmaceutical Research. Washington, DC:American Enterprise Institute. 1975.

Temin, P. "Technology, regulation, and market structure in the modem pharmaceuticalindustry." Bell Journal ofEconomics. Autumn 1979. p. 429-446.

Temin, P. Taking Your Medicine: Drug Regulation in the United States. Cambridge, MA:Harvard University Press. 1980.

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Thomas, I. III, and S. Schondelmeyer. "Price indexes for pharmaceuticals used by theelderly" Health Care Financing Review. Fall 1992. p. 91-105.

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United States Senate, Special Committee on Aging. Earning A Failing Grade: A ReportCard on 1992 Drug Manufacturer Price Inflation. Serial No. 103-B. Washington, DC:U.S. Government Printing Office. February 1993.

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Wiggins, S.N. The Cost of Developing a New Drug. Washington, DC: PharmaceuticalManufacturers Association. 1987.

COMMENTS

Alison Keith

1. Introduction

Abbott's paper on pharmaceutical price regulation is an important contribution tothe current debate on this contentious subject. Abbott raises many of the key issueswith regard to the putative rationales for regulation and explains the theory and thelimitations of two leading regulatory approaches, price caps (limitations on priceincreases) and rate-of-return regulation.Abbott rightly divides his analysis into two components. The basic question is

whether drug price regulation is warranted. In other words, are drug prices toohigh? Only if the answer is "yes" is it logical to proceed to the second stage:choosing the form of price regulation that would be most effective in containingdrug prices. It is this first "necessary but not sufficient" element in the analysis ofpharmaceutical price controls that I will focus on. In particular, I will review theevidence on what I believe is the heart of the matter: whether pharmaceuticalcompanies have been earning excess profits.The second component is the examination of various regulatory approaches to

price control. Ifcontrol of price increases is the objective, price controls may takethe form of price caps, limiting the average price across a collection of products,or on a product-specific basis. Abbott concludes that imposition of price capswould lead to increases in new-product prices. Thus, either as a separate objectiveor as a concomitant to limitations on price increases, restraints may be applied tolaunch prices. Abbott also examines the usefulness of a public-utility-type rate-ofreturn regulatory system. He observes that here the question of inflated base priceswould arise. Criteria for judging the appropriateness of launch prices might range(short-sightedly) from short-run marginal cost considerations to cost-effectivenessanalysis. While cost-effectiveness as a criterion is much more sensible than purecost considerations (or, rather, much less non-sensible), using cost-effectivenessanalysis for this purpose has severe limitations. In view of such limitations, itcannot be argued that cost-effectiveness analysis furnishes a sufficiently soundtouchstone, from a public policy perspective, for judging price controls to befeasible. Because Abbott has done an admirable job in explicating and evaluatingprice caps and rate-of-return regulation, the latter part of this paper will focusmainly on expanding his discussion of the use of cost-effectiveness as a criterion.

136

2. Are Drug Prices Too High?

HEALTH CARE POLICY AND REGULATION

The most frequent arguments about drug prices being too high derive from theallegations that i) they are rising too fast, ii) drug manufacturers' profits are toohigh, iii) pharmaceutical manufacturers spend too much on marketing, iv) on R&D,and finally v) they are higher in the United States than in other countries. I take upeach of these allegations in turn.

2.1. "Prices are rising too fast."Prices cannot be considered to be too high simply because they have risen. A

large increase in a low price may result in a still-low price. Conversely, a smallincrease in a high price would still leave the price high. Popular reports often failto acknowledge that price changes and price levels are not logically linked.Moreover, publicly cited numbers as to pharmaceutical price increases are ofteninaccurate, and even well-intentioned measures are often misinterpreted. As Abbott notes, the official data, the BLS' Producer Price Index for pharmaceutical(PPI-Rx), has significantly overstated actual price increases. Three separate factorscontribute to the overstatement. First, the PPI-Rx sample has overrepresented olderproducts with faster rising prices. (Berndt, Griliches and Rosett 1993, 251-264).Recent research shows that the use of an out-dated sample of products led to a 41%overstatement of the PPI over the 1987-91 period (Berndt and Greenberg 1993).Second, the PPI-Rx (and the Consumer Price Index for pharmaceutical) does nottreat switches to generics as a price decrease, and increases in generic market sharesare not incorporated as promptly as appropriate. For one antibiotic studied (cephalexin), while the "BLS approach" would have shown a price increase of 14%, theauthors find a price decline of 48% (Griliches and Cockburn 1994). Third, failureto make adjustments for quality improvements and undersampling of new discountoutlets also lead to overstatement (Reinsdorf 1994).

2.2. "Profits have been excessive."Economic theory points to the existence of persistent excess profits as a more

reliable way of judging whether prices are too high. Here again popular discussionrevolves around numbers that do not properly measure what the theory specifies.The typical estimates of pharmaceutical industry profits are for accounting profits,not economic profits, and they therefore do not provide the data for determiningwhether profits are excessive, which could be done only by comparing actualeconomic profits to "normal" profits. For example, the accounting profits published in Fortune (and drawn from companies' annual reports) suggest at first glancethat the pharmaceutical industry earns "four times the profit level as other industries" (12.8% v. 3.2% in 1991) (Fortune 500 Special Report 1993). Moreover, evenaccounting profits are stated in various forms. Another number, profits as a percentof equity instead of sales, cuts that ratio in half: pharmaceutical companies onaverage, in the Fortune sample, had profit-on-equity rates twice, not four times,those in other industries (26.1% v. 10.2% in 1991).

COMMENTS 137

Neither of these accounting measures is an accurate yardstick of economicprofits for the pharmaceutical industry, which are markedly lower. Examinationof the alleged "excess economic profits" was a central focus of a recent the OTAreport (U.S. Congress, OTA 1993). OTA estimated the average economic rate ofreturn for pharmaceutical companies to be 14% (for 1976-1987)-much lower thanthe 26% shown in the Fortune compilation. The OTA's 14% is higher than theOTA's estimate for other industries, 11-12%. Yet comparing these two numbersis still not enough to support a conclusion that the pharmaceutical industry wasearning excess profits. The reason is simple: riskiness in the compared industrieswas not necessarily the same, and it is a commonplace in financial markets thathigher risks demand higher returns.Relative risk must be considered in assessing whether the 14% rate of return is

excessive. To do this, the 14% must be compared with the cost of capital tocompanies in the pharmaceutical industry. The OTA's own report contains anestimate of the cost of capital for the pharmaceutical industry of 14%. The simpletest of whether the rate of return (here, 14%) exceeded the cost of capital (here,14%) seems clearly not met (although OTA also asserts that its 14% cost of capitalestimate is itself an overstatement).The OTA conducted a second analysis which purportedly also showed that the

pharmaceutical industry had been earning excess profits. In this analysis, the OTAbuilt up an estimate of the average excess return over the cost of R&D for newdrugs introduced between 1981 and 1983. Their estimate was $36 million per drug.However, if a few of the assumptions in the model are varied in accord with someindustry and academic views, the $36 million changes considerably and may evenbe reduced to zero. For example, if only one alteration is made-if the too-lowestimate of the initial investment in a manufacturing plant of$25 million is replacedwith $45 million, a replication of the OTA's model shows an excess return of only$2.2 million. In addition, several academic economists believe that the OTA usedinappropriate tax rates; this correction also reduces the estimate of excess profits.In two recent companion studies, Grabowski and Vernon underscore the ab

sence of excess profits in the pharmaceutical industry. The first study was ofNewChemical Entities (NCEs) launched in the 1970s, and an update for NCEs launchedfrom 1980 to 1984 has recently been completed (Grabowski and Vernon 1990,804-821; Grabowski and Vernon 1993). The study of the 1970s' NCEs found thatthe average rate of return on R&D costs per NCE was approximately equal to thecost of capital. Similarly, the study of drug introductions in the first half of the1980s was 11.1%, to be compared with the estimated cost of capital of 10.5%.Grabowski and Vernon conclude,

Our findings do not provide general support for the assertion frequentlymade by policymakers on the basis of accounting data, that returns onpharmaceutical R&D are large and persistent compared to the financial risksinvolved.

Moreover, any estimate of past "excess profits" has little relevance for currentpolicy analysis, since the pharmaceutical market is so changed. The stock market


has not been predicting "excess profits:" the value of the stocks of the majorresearch-based pharmaceutical companies fell by at least $90 billion over the18-month period ending in June 1993 (Price Waterhouse 1993). The extent ofadversity is further evidenced by widespread layoffs and consolidations, along withthe apparent difficulty biotech firms are having in raising capital for increasinglycostly R&D. In addition, the growth of cost-conscious managed care, with toughbargaining and restrictive formularies, has sharply circumscribed the latitudeavailable to drug manufacturers with respect to both pricing and marketing. Furtherevidence of intensified price competition may be seen in slower price increases andthe fact that the launch prices of certain important new products are appreciablybelow that of their competitors. A striking example of this phenomenon is theintroduction of a new cholesterol reducing drug by Sandoz called Lescol at a price50% lower than that of the leading existing product in that area, namely Merck'sMevacor (New York Times, March 23,1994). The move to generics has acceleratedcutting brand name reveneues. Most analysts expect revenue from Tagamet (aleading anti-ulcer drug whose patent expired on May 17) to plunge as lower-pricedgenerics grab market share, and apply strong pressure on zantac, another anti-ulcerdrug, as well (New York Times, May 17, 1994).

2.3. "R&D is excessive."The concerns surrounding allegedly excessive R&D seem to reflect several

misperceptions. In fact, new academic studies (e.g., Henderson and Cockburn1993) confirm the commonsensical notion that R&D not only creates new andimproved technologies but also adds directly to social value. This occurs viaspillovers between R&D projects which, for the most part, reinforce innovationrather than duplicate it. Some minimal duplication and creation of somewhatsimilar products is inevitable. But these "additional" products, when marketed,create competitive pressures on prices of existing products serving approximatelythe same therapeutic need. Also, since many medical needs are idiosyncratic insome dimensions, multiple products within the same therapeutic class may beneeded to satisfy such needs. In sum, the apparent duplication of effort may wellbe more illusory than real, and the assertion that R&D expenditures are excessiveis shown to rest on a very fragile base.

2.4. "Marketing expenditures are excessive."Similarly, the assumption implicit in the criticism that marketing is largely

wasteful or unnecessary is inaccurate. Marketing or commercialization is appropriately viewed as an extension or even a component of the R&D process (Moweryand Rosenberg 1989). Furthermore, the notion that marketing necessarily raisesprices appears to be far from well-founded. Several economic studies have shownexamples of the price-lowering effects of marketing. Finally, other studies demonstrate how the myth of misleading promotion is just that: a rare exception ratherthan rule (e.g., Macleod and Beales, forthcoming).

COMMENTS 139

2.5. "Prices are too high because they are higher in the United States thanelsewhere."

The inference, from international comparisons ofdrug prices, that United Statesprices are too high, does not stand up to careful scrutiny. Rigorous and ongoingacademic research has demonstrated that most such comparisons are seriouslyflawed, both with respect to index number methodology and in welfare-theoreticterms. Technical difficulties aside, a lower price index does not imply that thecountry's consumers are better off. As is well known, preferences, tastes, andrelative prices, inter alia, are critical factors in such an assessment. Uniform pricesacross nations would by no means be ideal. Besides, efficiency considerationsdictate that different countries' contributions to the extraordinarily high fixed costof R&D would and should vary. Last, but not least, the United States marketsupports global R&D. For example, the four largest British-based pharmaceuticalcompanies depend on the United States market for at least halftheir sales; withoutthe United States market-or with a United States market with heavily controlledprices, it would be unlikely that foreign firms could sustain their research effortseither.

It seems clear, then, that there is no convincing evidence that either prices orprofits in the drug industry are excessive and, therefore, there are no reasonablegrounds for advocating price controls.

3. Deleterious Effects of Price Control

Moreover, policies built upon the erroneous assumption that drug prices are toohigh would not be innocuous. Indeed, it is apparent that the consequences of pricecontrols can only be deleterious. Grabowski and Vernon (1993) have attempted tomodel the effects of stylized price control proposals. They focus on the effects ofprice controls placed on "breakthrough drugs," defined for the purpose of theiranalysis to be those NCEs whose lifetime net revenues were highest. If (only) thetop 10 percent ofNCEs were constrained to break even (i.e., earn returns just equalto the average drug's cost of R&D), the net present value (NPV) of the averageNCE would fall by $80 million, to an average loss of $60 million.

4. Forms of Price Control Regulation

Despite the absence ofconvincing evidence that price controls are needed, it seemsprudent to analyze the feasibility and implications of alternative approaches tocontrolling prices. Abbott has done an excellent job of explaining and evaluatingprice caps (limits on price increases) and indirect price regulation through rate-ofreturn profits regulation. I will therefore confine myself to cost-effectiveness as acriterion for determining whether a price is reasonable. In addition, it is worthbearing in mind that any particular form of price restraints will shape the allocationof research across potential projects. For example, mandatory special rebates forMedicare would discourage development of drugs for the elderly.


5. Limitations of Cost-Effectiveness Analysis as Criterion for"Reasonableness" of Prices

The advantages of the cost-effectiveness approach derive from the breadth of thecontext of its analysis. The analysis can be made with reference to alternatives tothe specific drug, including non-drug therapeutic modalities, and it can take intoaccount not only all health care costs but also other direct costs of a disease, suchas custodial expenses, and indirect costs, such as any lost workplace productivity,associated with the disease or condition causing that loss.However, while the advantages of the cost-effectiveness approach make it an

attractive criterion, there are countervailing limitations. First, too often, the problem is defined in an inappropriately narrow way. Focusing only on drug-drugcomparisons, for example, rigidifies the tendency of many decisionmakers tocompartmentalize various segments of healthcare, e.g., pharmaceutical as separatefrom physician services or hospitalization. The compartmentalization is driven byseparate budgets (e.g., "Minimize drug expenditures") but hinders efficient decisionmaking by ignoring possible cost-saving tradeoffs between, for example,pharmaceutical and other health care costs. Similarly, costs and benefits are toooften defined narrowly; limiting the purview to healthcare costs alone meansignoring the potential for reducing other true social costs even at some increase inhealthcare costs.Yet other aspects of the seemingly "standard" approach to cost-effectiveness

also fail to challenge likely inefficiencies. Cost-effectiveness analysis is oftenenvisioned to focus on decisions about new drugs only. Old drugs and technologiesescape evaluation, although it is widely accepted that old technologies may be overor inappropriately utilized. In addition, making a decision about a new product justas it enters the market means that the information about its costs and benefits is bynecessity extremely constrained, since much of the relevant information about aproduct's new uses and side-effects, as well as its effectiveness and associated costsin typical use, becomes available only after it is well into its life-cycle. Finally,costs and prices typically fall over time, as new methods of production aredetermined, or lower doses confirmed as sufficient, or new competitors (eventuallygeneric competitors) intensify price competition. A decision made on only theinformation available when a product is launched might turn out, in the longer term,to be a wrong decision.

6. Conclusion

It seems clear that neither the need nor the feasibility and appropriateness of anyform of price regulation has been established with any measure of definiteness.This is not to deny that there may be imperfections in the way the market performs.Rather, these imperfections are of a smaller order of magnitude than those entailedby cumbersome regulation.

COMMENTS

References

141

Berndt, E., Z. Griliches, and J. Rosett. 1993. "Auditing the Producer Price IndexMicroevidence from Prescription Pharmaceutical Preparations." Journal ofBusiness andEconomic Statistics I I (3): 251-264.

Berndt, E., and P. Greenberg. 1993 (October). "PriceGrowth ofPrescription PharmaceuticalPreparations: An Update and Extension." American Enterprise Institute Conference onCompetitive Strategies in the Pharmaceutical Industry, Washington, D.C.

Fortune Magazine. 1993 (April). "Fortune 500 Special Report"Griliches, Z., and I. Cockburn. 1993. "Generics and New Goods in Pharmaceutical PriceIndexes." NBER Working Paper; No. 4272.

Grabowski, H.G., and J. Vernon. 1990. "A New Look at the Returns and Risks to Pharmaceutical R&D." Management Science 36 (7): 804-821.

Grabowski, H.G., andJ. Vernon. 1993. "Returns to R&D on New Drug Introductions in the1980s". American Enterprise Institute Conference on Competitive Strategies in thePharmaceutical Industry, Washington, DC (October).

Henderson, R., and I. Cockburn. 1993. "Racing or Spilling? The Determinants of ResearchProductivity in Ethical Drug Discovery." American Enerprise Institute Conference onCompetitive Strategies in the Pharmaceutical Industry, Washington, DC (October).

Price Waterhouse. 1993. "Financial Trends in the Pharmaceutical Industry and ProjectedEffects ofRecent Federal Legislation." Preparedfor the Pharmaceutical ManufacturersAssociation ( October.)

MacLeod, W., and Howard Beales. 1994. "Experts' Assessments of Pharmaceutical Advertisements: A Critical Analysis." (forthcoming).

Mowery, David, and Nathan Rosenberg. 1989. Technology and Pursuit of EconomicGrowth. New York: Cambridge University Press.

The New York Times. 1994. May 17 and May 23.Reinsdorf, Marshall. 1994. "Price Dispersion, Seller Substitution and the U.S. CPI". BLS

Working Papers. No. 252.

8HOSPITAL PRICE REGULATION:

Evidence and Implicationsfor Health Care Reform

Jack Hadley

1. Introduction

Hospital price regulation has been an important part of the health care landscapeever since Medicare and Medicaid were enacted nearly thirty years ago. Mosthealth care reform proposals leave Medicare largely intact, ensuring that hospitalprice regulation will continue as an important element of the market for inpatienthospital care. Outside of Medicare, the debate seems to be between two camps:extending Medicare-style hospital price regulation to all payers versus fosteringcompetition among hospitals and between hospitals and health insurance plans.This paper addresses three questions relevant to this debate. What forms of

hospital price regulation are available? What does the evidence suggest about theeffectiveness and consequences of hospital price regulation and of increasedcompetitiveness? Should hospital price regulation be an essential component of areformed health care system?

1.1. Market Failure in the Provision of Hospital ServicesAs is generally well known, the market for hospital services is characterized by

several distinctive features that cause it to deviate from the economist's ideal of theperfectly competitive market. First, uncertainty about the incidence of illness andinjury causes people to seek insurance against the costs ofmedical care. Insurance,in turn, lowers individuals' private marginal cost ofconsuming medical care, whichis thought to lead to overconsumption of services from a social perspective.Second, patients lack the information to diagnose and treat their illnesses, especiallyif they should require the use of hospital services. Thus, they must rely on theirphysician to act as their agent in terms of recommending what is best for them.Third, the production technology is often uncertain. Diagnosis can be difficult orelusive altogether. Even if the diagnosis is known, the best treatment may not beknown. And even if a standard treatment is known, it doesn't always work, perhapsbecause of random variations in unobservable patient characteristics. Fourth, theepisodic and irregular nature of the demand for hospital services, patients' imper-

144 HEALTH CARE POLICY AND REGLATION

fect information, their inability to comparison shop very effectively, and the roleof provider reputation all suggest that individual hospitals face downward slopingdemand functions and, therefore, have the potential to engage in monopolisticpricing. Fifth, hospitals compete for patients on the basis of perceived qualitybecause the market demand for hospital services is very price inelastic. Qualitycompetition takes two forms: providing amenities that are not clinically essentialbut exceed what a patient would demand if faced with their true marginal cost, andseeking to attract doctors (and their patients) with the latest equipment, extensivesupport staff, or subsidized office space.Finally, there may be an altruistic or public goods rationale for hospital price

regulation. In general, a competitive equilibrium will not allow any cross-subsidies, either from one class of patients to another or from patient care services toother kinds of services. If hospital products such as care to the uninsured, healthprofessions education, and medical research are valued by society but cannot befunded explicitly, then hospital price regulation may be one way of ensuring theirprovision by hospitals.

1.2. Social Responses to Market FailureExcepting the altruistic rationale for hospital price regulation, all of the other

factors boil down to some variation on the theme "We spend too much on hospitalcare," in the sense that the marginal social cost exceeds the marginal social benefit.Demand-side features of health care reform proposals advocate two approaches tocorrect this inefficiency. One is increasing consumers' cost consciousness byincreasing cost sharing and reducing or eliminating the tax subsidy for healthinsurance purchases. The other is encouraging consumers to join managed careplans by providing various financial incentives, such as lower cost sharing andlower premiums. The managed care plan then acts as the collective agent for itsmembers in bargaining with providers over price, evaluating their quantity recommendations, and monitoring the quality of care.In principle, supply-side J'lpproaches take as given patients' inability to make

price sensitive decisions about their use of medical care. Instead, they seek to callforth the socially desired level of quantity and quality by calling out the "right"price and, in effect, leaving the micro allocation decision ofwhich patients actuallyget which services to mechanisms such as time prices and providers' triagedecisions. In practice, however, price regulation is also often accompanied byvarious utilization review activities to monitor quantity (and sometimes quality).

2. Alternative Approaches to Hospital Price Regulation

2.1. Reasonable Cost ReimbursementUntil the early 1980s, reasonable cost reimbursement, which was employed by

Medicare, most Medicaid programs, and many Blue Cross plans, was the dominantform of hospital price regulation. Cost reimbursement originated with the development of hospital insurance by hospital associations, which established nonprofit

HOSPITAL PRICE REGULAnON 145

organizations, Blue Cross plans, to administer hospital insurance sold to the public.The rationale for cost reimbursement was that nonprofit hospitals were communityresources meeting community needs for hospital care. Blue Cross, also a nonprofitorganization, was committed to paying the reasonable costs of making thoseresources available to its subscribers, plus an allowance or mark-up needed to fundfuture investments and capital replacement. Since Blue Cross plans are localcommunity institutions, they presumably are in a position to influence hospitals'decisions regarding reasonable resource use. In practice, Blue Cross plans' abilityto negotiate with hospitals depends very much on their share of the local market.Where Blue Cross plans have relatively small market shares, they typically pay onthe basis of discounted hospitals' charges with very little or no influence overhospitals' resource use decisions.When implemented in the mid-1960s, Medicare and Medicaid adopted Blue

Cross-style reasonable cost reimbursement, primarily as a concession to an industrythat was very nervous about government involvement and interference in theprovision ofhealth care. Initially, Medicare paid cost plus 2 percent, on the groundsthat Medicare patients consumed more nursing care than other patients. Becauseof its size and centralization, however, Medicare was not in a position and did notattempt any direct negotiations with providers over the reasonableness of theirresource use.As Medicare's payments for hospital care grew faster than both projected costs

and costs in other sectors of the health care system, Medicare began to imposevarious limits and ceilings on its cost reimbursement formula. First to go was the2% add-on. This was followed by limitations on allowed costs established bysection 223 of the 1972 Social Security Amendments, and, later more restrictiverules for reimbursing capital costs. Eventually, Medicare scrapped reasonable costreimbursement altogether.The economic consequences of retrospective cost reimbursement are generally

well known and clearcut, although rigorous analytic demonstration may requireimposing some fairly restrictive assumptions. In essence, cost reimbursementalters the hospital's revenue function by including as revenue some proportion ofcosts incurred in caring for patients covered by cost reimbursement. The consequence is that the marginal cost of inputs is reduced for the hospital, leading it toemploy more inputs than it would in the absence of cost reimbursement. Moreover,if the cost reimbursement rules favor or restrict some inputs differentially, such ascapital, nurses, or medical residents, the hospital will be led to employ a sociallyinefficient mix of inputs, as well as too many inputs and, correspondingly, too muchoutput (quantity and quality) from a social perspective.Another important aspect of cost reimbursement is that it leads hospitals to

compete for patients primarily on the basis of perceived quality, since patientscovered by cost reimbursement typically face a zero marginal cost of hospital care.For example, Medicare patients pay a fixed deductible that does not vary with thechoice of hospital and Medicaid patients do not pay anything. In effect, then, costreimbursement underwrites quality competition by encouraging hospitals to adopt

146 HEALTH CARE POLICY AND REGLAnON

new technologies they might not otherwise purchase in a more price-competitiveenvironment.

2.2. Prospective ReimbursementIn its original form, prospective reimbursement was primarily a modification of

retrospective cost reimbursement. The primary difference between the two wasthat the cost settlement was done in advance rather than after the fact. Whilepotentially more cost constraining than retrospective cost reimbursement, prospective reimbursement still shares some of the inefficiency incentives of cost reimbursement. To the extent that payments are still based on hospitals' costs, inputuse may still be subsidized and distorted. In fact, ifthe prospective amount is basedon individual hospitals' prior resource use and if the inflation or update factor isboth frequent and generous, there may be very little practical difference betweencost reimbursement and prospective reimbursement. Conversely, to the extent thatthe price regulators adopt restrictive rules for setting prospective amounts and relyon the cost experience of classes or groups of hospitals, the less the similaritybetween cost and prospective reimbursement systems.

2.3. Medicare's Prospective Payment SystemBeginning in October 1982, Medicare began a transition from the cost reim

bursement system it had been using to pay' hospitals to a new method, which it callsthe Prospective Payment System (PPS).1 Like prospective cost reimbursement,PPS sets payment rates in advance. However, it differs in three key characteristics.First, the implicit unit of output was changed from hospitals' inputs to the patientcase, categorized into approximately 470 groups based on diagnosis. Second,although PPS rates are based on historical costs, when fully implemented by thelate 1980s, PPS effectively uncoupled hospitals' payments from their own actualcosts, excepting for adjustments based on variations in hospitals' outputs. Third,PPS puts all hospitals fully at risk for costs incurred in excess of PPS paymentamounts and allows them to benefit fully from any resource conservation.Although there are exceptions that I shall note below, PPS is essentially a

combination of yardstick and price-cap regulation in which the price regulator setsthe price exogenously and hospitals choose their inputs to maximize profits. In itsearly years, the PPS rates were based on the average costs of large groups ofhospitals, adjusting for differences associated with case-mix and input prices. Inthis regard, it is a form of yardstick regulation (Shleifer 1985, 319-327).Over time, however, its rates have borne less and less direct relationship to

hospitals' actual costs, even as a group. Annual updates in the PPS rates are basedon judgements aboutjustifiable increases in costs balanced by political assessmentsof what types of hospitals are either benefitting or hurting unfairly from PPS.

PPS began in October 1983. It was preceded by TEFRA reimbursement regulations whichpaid hospitals a fixed cost per case with very limited opportunities for profit or loss.


Hospitals' actual costs have become less important over time, unless hospitals caneffectively argue that their cost increases are beyond their control or that the PPSformula unfairly disadvantages them. Currently, then, PPS is closer to price-capor fixed-price regulation then to yardstick regulation, which in principle sets ratesbased on the experience of the hospital group.In either case, PPS should eliminate the incentives to either overuse inputs or to

choose the wrong mix of inputs. In fact, PPS did not fully eliminate theseincentives. Initially, both capital and medical education were excluded from thePPS rates and treated as cost-reimbursable expenses. However, starting in 1991,capital costs are being phased into the exogenous PPS rate over a ten year period.Medical education costs continue to be exempted.In addition, PPS includes three hospital-specific elements. Hospitals receive

higher payments as a function of their ratio ofmedical interns and residents per bed(the indirect medical education adjustment), the proportion of their Medicarepatients who qualify for either Medicaid or the Supplemental Security Incomeprogram (the disproportionate share adjustment), and the proportion of theirMedicare cases that are either extremely costly or extremely long stays relative tothe means for their particular diagnostic group (the outlier adjustment). Theindirect medical education adjustment, which was acknowledged to be an adjustment for the presumably sicker and more complex cases within diagnostic groupstreated by teaching hospitals, creates an additional incentive to prefer the employment of medical residents over other inputs. The outlier adjustment, on the otherhand, is revenue neutral in the sense that those payments represent reallocations ofpayments among hospitals classified by type of community (rural, small metro,large metro), rather than additional payments made by Medicare.PPS rates are updated annually, essentially by political decisions. The Prospec

tive Payment Assessment Commission (ProPAC) makes annual recommendationsto the Congress, which makes the final decisions regarding the amount of the rateincrease and any other structural changes in the program. As a result of thesedecisions, different groups of hospitals may experience different rate increases.The recommendations and final decisions are based on a range of factors asevaluated by the ProPAC commissioners, the Health Care Financing Administration, which comments on ProPAC's recommendations, and the Congress. Thesefactors include the rate of increase in hospital input prices, changes in technology,hospitals' financial status, possible spillovers to other purchasers of hospitalservices, and Medicare beneficiaries' access to high quality hospital care.An important, but implicit and difficult to define criterion in these deliberations

is the reasonableness or justifiability of hospitals' cost increases. In effect, ProPACtries to distinguish between cost increases that are beyond the control of individualhospital administrators and those that can be influenced by hospitals' decisions.Furthermore, to its credit, it also looks beyond hospitals' financial status to thequantity and quality of care received by Medicare patients.


One of the concerns typically raised about any regulatory process is potentialcapture by the industry. Although there is little explicit evidence on this issue,ProPAC appears to have avoided capture. This may be due in part to its highlycentralized structure, which makes it relatively inaccessible to most hospitals in thecountry. It may also be due to the fact that the hospital industry itself has becomemore fragmented over time, partially as a result of PPS's structure, which oftenmakes the politics of hospital payment into a zero-sum game with hospitalscompeting against each other for shares of a fixed pie, rather than joining togetherto increase the size of the total pie.Theoretical analyses of the effects of a PPS-type price regulation have focused

on the clear incentive to underprovide services to patients (Ellis and McGuire 1986,129-151) and the consequences of fixed price regulation under different marketstructures (Pope 1989, 147-172). Both analyses conclude that a system thatcombines a fixed prospective payment with a hospital-specific component, muchlike PPS during its transition period, would be more desirable than a purely fixedprice system that paid the same total amount per case to the hospital. A mixedreimbursement system, by explicitly tying a portion of revenues to resource use, asin traditional cost reimbursement, reduces the tendency to underprovide care.Pope (1989, 147-172) suggests that as markets become more competitive,

hospitals will both produce efficiently and provide the maximum level of qualityfeasible with the given reimbursement rate. Conversely, in a noncompetitivemarket, hospitals may be both inefficient in production and use their implicit profitsfrom patient care either to produce inefficiently, underwrite other hospital objectives or, in the case of for-profit hospitals, distribute them to owners as above-market returns. His analysis also suggests that a mixed reimbursement system reducesthe undesirable effects of a noncompetitive market, since the cost-reimbursedportion of the rate encourages greater input use and, presumably, higher quality.

3. Empirical Evidence on the Effects of Hospital Price Regulationand "Competition" on Hospital Costs

3.1. The Impact of PPSStudies of the effects of PPS on hospitals' costs generally agree that PPS

succeeded in reducing the rate of growth in spending for inpatient hospital services.As shown in table 1, the rate of increase in Medicare's spending for inpatienthospital services has fallen dramatically, from almost 6 percent per year in the fiveyears before the transition to PPS (1977-1982), to only 1 percent per year from1985 through 1991. National spending for hospital care (including Medicare) alsogrew more slowly during the PPS phase-in period, partially because of the effectsof the recession that began in 1982. Since 1985, however, total national spendingfor hospital care has been growing at just over 4 percent per year, only slightly lessthan its annual growth rate prior to PPS' s implementation. Since national per capitaspending includes Medicare, non-Medicare spending per capita for hospital carehas grown even faster since PPS's implementation.


Table 1. Average Annual Rates of Growth in Hospital Expenditures, 1977-1991(constant 1991 dollars)

Time Period National per Capita Medicare oer EnrolleePre-PPS (1977-82) 4.4% 5.9%

PPS Phase-In (1982-85) 2.3 3.6Post-PPS (1985-91) 4.1 1.0Source: Congressional Budget Office (1993).

Medicare spending for hospital care, of course, is not the same as hospital costs,their spending for the inputs used to produce hospital services. Here, too, however,the evidence generally shows reduced rates of growth in the cost of care forMedicare inpatients and for all hospital services. Moreover, these cost-reducingresults appear to be a combination of the change in incentive associated with PPS,i.e., the opportunity to earn a profit, and the extent of fiscal pressure imposed byPPS on hospitals. Feder, Hadley, and Zuckerman (1987, 867-873) found that bothMedicare cost per case and total hospital expenses grew more slowly between 1982and 1984 in hospitals covered by PPS, compared to hospitals still under the priorreimbursement system. Within PPS hospitals, Medicare cost per case grew threetimes faster, 10.2 percent, among hospitals facing the least fiscal pressure, compared to 3.2 percent for hospitals under the most fiscal pressure. Studies ofhospitals' total expenses between 1980 and 1986 also show significantly lowercosts under PPS relative to cost reimbursement (Hadley and Swartz 1989,35-47;Hadley and Zuckerman 1991).

Percent20r-------------------------,

10

5

=""'-~~.::.:.:::.::.= 1--··_·.~. ..

--II

01-------------------'--"=-""""",--------1

PPS8PPS7PPS6PPS5PPS4PPS3PPS2-5 '--__-'- -'----__-''--__--L -'----__-'L-__--..I

PPS1

-..- PPS Operoting Margin 1%1 -8-. Challgo in PPS O"oratingCosl per Case 1'Yol

Figure 1. PPS Profits Decreasing Over Time; Cost Growth Now Decelerating

Source: ProPAC (1993)


Most of the incentive effect associated with PPS seems to have occurred in itsfirst two years (Hadley, Zuckerman, and Feder 1989,354-365). Figure 1 showsthat the annual change in the cost of a Medicare case jumped back up to about 10percent per year from 1985 through 1989. (In part, this was probably due to asubstantial jump in the average complexity of aMedicare inpatient case, since mostof the reduction in admissions occurred among less complex cases, i.e., lower-valued DRGs, that could be treated on an ambulatory basis.) Since PPS rates wereincreased less slowly than costs over this period, PPS profit margins fell dramatically, from over 14 percent in the first two years of PPS to negative values onaverage for 1990 and 1991. In the two years since the PPS margin turned negative,the annual increase in the cost per Medicare case has slowed each year, from justunder 10 percent in 1989 to about 7.5 percent in 1991.One apparent consequence of Medicare's adopting PPS for hospital inpatient

services has been very rapid rates ofgrowth in the use of unregulated services, suchas hospital outpatient care, home health care, skilled nursing care, and physicians'services generally. Nevertheless, these offsets have not fully counteracted PPS'simpact on hospital spending. The data in table 2 show that inflation-adjustedMedicare spending per enrollee, both in total and for supplementary medicalinsurance, grew more slowly during the post-PPS period than before it. Whilemany factors affect aggregate trends such as these, the prima facie case for anoffsetting increase in non-hospital spending is not self-evident.

Table 2. Average Annual Rates of Growth in Medicare Spending per Enrollee,1975-1993 (constant 1991 dollars)

Hospital SupplementaryTime Period Total Insurance Medical Insurance

1975-80 6.7% 6.0% 8.5%

1980-85 7.0 6.7 7.7

1985-93a 3.0 2.2 6.4a 1993 based on projected outlays.Source: Conaressional Budaet Office (1993).

As implied by the data in table 1, total non-Medicare spending for hospital carehas been growing faster in recent years than before PPS. Also, hospitals' total profitmargins have rebounded from a post-PPS low of 3.3 percent in 1988 and appear tohave stabilized at about 4.5 percent, even though PPS profit margins have beenfalling steadily since 1985 and became negative in 1990. (See figure 2.)The casual explanation for these trends is cost-shifting. Hospitals have been

increasing their charges to privately insured patients in order to make up for lossesincurred on care toMedicare and Medicaid patients. While an intuitively appealingexplanation supported by the clear existence ofdifferences in the ratio of paymentsto costs for different payers (table 3), analytic studies of cost shifting in a dynamiccontext are much more ambiguous (Zuckerman 1987b, 165-187; Foster 1985,

HOSPITAL PRICE REGULATION

Percent

6

4.2 4.2

151

4.3

1976 1978 1980 1982 1984Yeor

1986 1988 1990

Figure 2. Total Profits Are IncreasingHospitals' Aggregate % Total Margin, 1976-1991

Source: American Hospital Association Annual Hospital Survey

Table 3. Hospital Payments as a Percent of Costs, by Source of Payment,Need to Cost Shift and Abilitv to Cost Shift 1989 and 1990A. Payments as a Percent of Costs, Payments as a

bv Source of Pavment (1990) Percent of CostPrivate Insurance 127.6%Medicare 89.6Medicaid 80.1Uninsured 21.0All Pavers 103.6B. Private Payers' Payments as a Percent of Costs,

bv Need and Abilitv to Cost Shift 1989High Cost-Shifting Potential (1989)aHigh Need to Cost Shiftb 150.0%Low Need to Cost Shift 148.0Low Cost-Shifting Potential (1989)High Need to Cost Shift 86.0Low Need to Cost Shift 77.0a Hospitals with a high proportion of privately insured patients.b Hospitals with a high proportion of uninsured patients and/or low Medicare/Medicaid

payments relative to costs.Source: ProPAC (1992).


261-271; Dranove 1988,47-57).2 For one thing, data presented in table 3 indicatethat hospitals with the greatest need to cost shift, as approximated by their volumesof Medicare, Medicaid, and charity care patients, don't appear to mark-up theirpayments any more than other hospitals. Rather, payment-to-cost ratios appear tobe much more closely related to the availability of privately insured patients. Anearlier study (Hadley and Feder 1985,67-80) found that hospitals with a high needto cost shift increased their percentage mark-up by only 0.93 percent between 1980and 1982, compared to 2.27 percent for hospitals with a low need to cost shift. Onerecent study, which examines the effects on hospitals of fiscal pressure generally,found that both low and high profit hospitals experienced similar changes in totalrevenues and percentage increases in mark-ups between 1987 and 1989 (Hadley,Zuckerman, and Iezzoni 1994). This evidence suggests that hospitals do in factface a demand constraint and cannot simply charge whatever is needed to maintainsome minimum profit level.How, then, have hospitals been able to maintain their total profits in the face of

declining PPS profit margins? One possible answer is product diversification.Hospitals earned 25 percent of their revenues from outpatient services in 1992,compared to half that in 1980 (ProPAC 1993,67). At the same time, as figure 3illustrates, more and more hospitals are adopting complex, high cost inpatientPercent Providing Service

30,---------------------------,

25.425

20

15.2

11Jl··15.2

CardiacCath.

Open-HeartSurgery

Lithotripsy MAl OrganlTissue Trans .

• 1980 .1986 D 1991

Figure 3. More Hospitals Are Providing High-Tech(High Profit?) Services, 1980-1991

Source: ProPAC (1993)

2 Dranove found positive evidence of cost shifting in ll1inois, but noted that increasingcompetitive pressures will eliminate the ability to cost shift.


services, such as open-heart surgery, magnetic resonance imaging, and organtransplant services. While these services all add to hospital costs, they maynevertheless be relatively more profitable than less costly services. In fact, thereis some evidence that PPS's DRG weights may overcompensate for high complexity diagnoses-a high Medicare case-mix index value has been found to have apositive effect on total margin in a couple of studies (Hoerger 1991, 259-289;Williams, Hadley, and Pettengill 1991, 174-187).

3.2. State Hospital Rate SettingSince the 1970s, a small number of states have employed some form of

regulation at various times to control hospital cost growth. These programs haveranged from covering all payers, including Medicare, to regulating rates only forMedicaid. They have also ranged from reviews of individual hospitals' budgets,to cost-based limits and ceilings on classes of expenditures, to PPS-like DRGsystems. In spite of their diversity, several studies have concluded that the mature,all-payer rate setting systems were successful in limiting cost growth, as were someof the partial-payer systems. Estimates of the cost saving vary, but range from 2to 5 percent lower annual growth in cost per case depending on the state and year(Biles, Schramm, and Atkinson 1980,664-668; Schramm, Renn, and Biles 1986,22-33; Thorpe 1987, 391-408; Zuckerman 1987a, 307-326; Hadley and Swartz1989,35-47; Hadley and Zuckerman 1991). Thorpe and Phelps (1990,143-166)found that the tightness or degree of fiscal stringency imposed by the rate settingsystem appears to be an important element of its effect on costs. Inpatient cost peradmission grew only 1.94 percent in New York hospitals that received paymentsbelow cost and were rebased every three years, compared to 7.50 percent inhospitals with annual rebasing and payments equal to cost. Studies of rateregulation in the nursing home industry have reached similar conclusions (Thorpe,Gertler, and Goldman 1991,357-365; Holahan and Cohen, 1987, 112-147).

3.3. Competition and Hospital CostsStudies of the effects on hospital costs of managed care organizations, such as

HMOs and PPOs, have focused primarily on the experience in California. Changesin state law in 1982 spurred the growth of PPOs and permitted the negotiation ofselective contracts between third-parties, Medicaid and PPOs, and hospitals. Between 1980 and 1987, the proportion of the population insured by some type ofregulated (PPS) or contracted fixed price for hospital care increased from under 20percent to over 70 percent. Analyses have looked at both hospital costs and pricesin assessing the effects of interhospital competition on hospital behavior.One set of studies analyzed the effects of both competition and PPS's imple

mentation by examining the growth in total hospital costs between 1980 and 1987(Melnick, Zwanziger, and Bradley 1989, 129-136). Prior to PPS and selectivecontracting in 1982/1983, hospitals' expenses were increasing at just over 6 percentper year. During the phase-in period, 1983-1985, hospitals in competitive marketsactually had cost decreases of about 3 percent per year, followed by positive growth


Table 4. Growth in Inflation-Adjusted Hospital Expenses, California,1980-1987 bv Market Comoetition and PPS Fiscal Pressure

Hiah Market Comoetition Low Market CompetitionTime High PPS Low PPS High PPS Low PPSPeriod Pressure Pressure Pressure Pressure1980-82 5.9% 6.4% 6.5% 6.2%1983-85 -4.3 -2.1 2.5 2.71986-87 4.4 4.2 5.2 6.7Source: Melnick, Zwanziaer, and Bradlev (1989).

rates of about 4 percent, which were about 2 percent lower than for hospitals in lesscompetitive markets (table 4).Other studies have found a substantial degree of price sensitivity to competitive

pressures (Melnick et al. 1992, 217-233; Gruber, 1992). For insurers that paycharges, lower charges generally translate into lower spending. However, Gruber'sanalysis, which covered 1984-1988, did not find lower hospital costs, suggestingthat mark-ups of charges above costs declined. His analysis also found thatcompetition and reduced mark-ups were associated with reductions in hospitals'care to uninsured people.Finally, Robinson and Luft (1988, 2,676-2,681) compared the change in hospital

costs in California between 1982-1986 to changes in hospital costs in the four statesthat had all-payer rate setting and in all other states combined. Overall, they foundthat California and three of the rate-setting states (Maryland, Massachusetts, andNew York) had significantly lower cost growth than in the unregulated states, withthe lowest growth in Maryland and Massachusetts. (New Jersey's experience wasnot significantly different from the unregulated states.) When they also controlledfor the degree of hospital competition (table 5), they found that hospital cost growthin less competitive California markets was the same as in unregulated states, andthat cost growth was lower in more competitive markets regardless of the presenceof rate setting or market orientation.

Table 5. Percentage Change in Cost per Adjusted Admission, 1982-1986,bv Level of Market Comoetition

Market and State Percentage Change1982-1986

Highly Competitive Markets

California 41.0%

Four All-Payer Statesa 44.0

All Other States 52.0

Less Competitive Markets

California 62.0

Four All-Payer States 55.0

All Other States 61.0a Unweighted average of growth rates in Massachusetts, New York, New Jersey, andMaryland.Source: Robinson and Lu1111988l.

HOSPITAL PRICE REGULAnON

4. Discussion

155

What conclusions and implications can be drawn from this evidence? First, it seemsfairly clear that hospital price regulation, whether at the state level or at the federallevel in the form ofPPS, has succeeded in constraining the rate ofgrowth ofhospitalcosts relative to unregulated environments. Moreover, there is little evidence thatcost restraint has come at the cost of reduced quality of care (Kahn et al. 1992) and,in the case of the all-payer rate setting systems, rate setting may have actuallyencouraged at least the maintenance of effort in providing charity care by buildingcross subsidies into regulated prices (Rosko 1990, 815-832). One possible adverseconsequence of Medicare price regulation is so-called cost shifting, in the form ofhigher charges to privately insured patients, although the evidence on the magnitudeof this response to price setting is quite ambiguous. Lastly, the cost of regulation,at least at the federal level, appears to be quite modest.The evidence also suggests that competition works. Not surprisingly, it works

best in markets for hospital care that are very competitive. There is also someevidence that competitive pressures, as suggested by theory, reduce hospitals'ability to cross subsidize activities such as care to the poor.The Clinton Administration's Health Security Act and other health care reform

proposals, except the single-payer approach, adopt a competitive strategy as theirfirst line of attack on restraining hospital costs. Competing health plans, whichpotentially will cover large populations in relatively concentrated geographic areas,will have the market muscle to negotiate good deals with hospitals, in terms of bothprice and, increasingly, supervision of quantity. One recent study of HMOs' priceelasticity ofdemand for hospital services estimated a highly price-sensitive demandfunction (Feldman et al. 1990,207-222).In theory, these health plans will counteract the two classic sources of market

failure in health care, information asymmetry and uncertainty. By acting on behalfof a relatively large population, they will be able to predict fairly well the incidenceofparticular diseases and the amount ofmedical care that they will need to purchase.Since health plans will include clinicians and medical directors on their staffs, theywill be able to assess the quantity, quality, and medical necessity and appropriateness of treatments prescribed for their patients on an equal footing with theproviders of those treatments. Moreover, by being highly price sensitive in theircontracting arrangements with hospitals, they can make markets with only a fewhospitals more competitive than one might infer based on the traditionalHirschman-Herfindahl index.The potential flaws of the competitive approach are twofold. First, the health

plan may put its financial interests ahead of patients' health interests. Ellis andMcGuire (1986, 129-151) have shown that a physician-agent in a price-regulatedsystem like PPS will equate the marginal benefit to the patient with the marginalsocial cost of treatment only if the physician is a perfect agent, i.e., someone whovalues equally a dollar of profit to the hospital and a dollar's worth of benefit to thepatient. If the hospital's financial position is valued more highly, then there will


be a tendency to underprovide services, in the sense that the marginal benefit to thepatient will exceed marginal social cost at the equilibrium quantity of services. Inother words, a perfectly informed patient facing the full social marginal costs ofcare would choose to purchase more care than the imperfect physician agent.The Ellis-McGuire model assumes that the physician's compensation is inde

pendent ofthe amount of hospital care consumed. Under the competing health planmodel advocated by proponents of managed competition, the health plan aspatient-agent faces a potentially much more compromising tradeoff, a dollar'sworth of benefit to the patient versus a dollar of profit to the health plan. Presumably, health plans will be competing for subscribers on the basis of both premiumsand quality. This will place some constraint on flagrant restrictions on the use ofhospital care, as will the threat of law suits in cases where necessary and appropriatetreatments are denied. However, as many have noted, our ability to define,measure, and interpret data on the quality of care is rudimentary at best. Moreover,as Pauly (1988, 227-237) illustrated some time ago, poor information can be moremisleading than no information. Pauly (1987, 73-82) has also warned against thepossible danger of monopsony power in the hands of insurers.A second possible problem with the competitive approach is that providers may

consolidate by either merging or forming networks for the purpose of negotiatingwith health plans. It would appear that the Federal Trade Commission will haveto play an active role in evaluating the competitive effects ofmarket power on bothsides of the market. If providers are successful in consolidating, then, it is muchless certain that the outcomes (prices, quantities, and qualities of care) of negotiations between bilateral oligopolies will approximate the competitive ideal (Pauly1987,73-82).A third consideration in assessing the competitive approach is that managed care

plans may not be viable in ormay not choose to enter rural geographic areas. Peoplein rural locales may often have only the fee-for-service, unmanaged care option astheir primary health plan. While this is not necessarily a dominant reason forrejecting a competitive approach outside of rural areas, the issue of how toincorporate rural communities into health care reform still needs to be considered.The Health Security Act does not explicitly call for hospital rate regulation as a

general requirement, although it does seem to suggest that fee-for-service plansadopt Medicare's PPS as their mechanism for paying hospitals. It also certainlygives individual states the option of adopting PPS-style all-payer hospital ratesetting as part of their state plans. States that have experienced little growth ofmanaged care plans or that have histories of regulating hospital rates may very wellchoose to follow this approach instead of, or in addition to fostering competitionamong managed care plans.In spite of hospital price regulation's apparent success in constraining cost

growth, it too, obviously, would face several potential problems as the method ofhospital payment under health care reform. First, its relatively narrow focus oninpatient hospital care has probably contributed to spillovers of care to other,unregulated providers, such as outpatient departments, home health agencies, and

HOSPITAL PRICE REGULATION 157

until recently, physicians' services generally. A managed care provider in acompetitive health plan has the incentive to evaluate the costs and benefits of theentire range of medical care production technology. Hospital price regulation,unless closely coordinated with price regulation of other medical providers, runsthe risk of distorting production decisions in favor of unregulated services, manyof which may in fact be owned by hospitals as they change their corporateconfigurations to become more vertically integrated providers.Second, Medicare's PPS and Medicare beneficiaries have probably benefitted

from the fact that the private market for hospital services has been shrinking andbecoming increasingly more competitive ever since PPS was adopted. Thus, eventhough PPS's rates have been increasingly tightened relative to the accounting costsof caring for Medicare patients, there has been little evidence of problems withaccess to care or quality of care for Medicare beneficiaries. A fully regulatedsystem, however, would not have this luxury and would be much more likely toface direct tradeoffs over time between access, quality, and stringent rates.This is not necessarily bad, of course, since these are the types of decisions that

fully informed consumers are expected to make all the time. What is worrisome tosome is how well a distant regulator will be able to observe deteriorating accessand quality, and how responsive the regulator will be. In this case, the highlydispersed and disaggregated patient population may have a very difficult timemaking its case to regulators. To some extent, decentralizing regulation to the statelevel will alleviate the communication problem. However, it may also exacerbatethe capture problem, with hospitals being the strongest pitchmen for the harm beingcaused to patients by stringent rates.A third generic problem with PPS-type price regulation is its potential for

rigidity over time as technologies change, as well as the potential for calling outthe wrong prices for specific services. For example, there are some indications thatcurrent PPS rates may be too generous for high-valued DRGs and too low forlow-valued DRGs. Whether this is intentional or unintended is unclear. But if thereare distortions in relative prices, they provide clear incentives for hospitals to altertheir product mix in response. Moreover, ifregulated prices must be accepted byboth providers and purchasers, purchasers' incentives to shop around and negotiatefor the best deal are clearly eliminated.Lastly, the problems noted by Ellis and McGuire (1986, 129-151) and Pope

(1989, 147-172) would certainly apply to an all-payer PPS, i.e., the danger thatphysicians would not act as perfect agents or that hospitals in noncompetitivemarkets would systematically underprovide quality or produce inefficiently. Theiranalyses suggest that maintaining a mixed system that has some elements of costreimbursement is preferable to a purely prospective and fixed, regulated pricesystem.


5. Implications for Health Care Reform

As noted at the outset of this discussion, the challenge of health care reform is todevelop a system that compensates for market failure. Judging how well healthcare reform in general and the Health Security Act in particular propose tocompensate for market failure involves addressing the following questions. Whohas the information about the quality and quantity of hospital care, and who has theability to evaluate that information? Which approach will be most sensitive topatients' interests and to balancing them against society's interests for efficientproduction and equitable distribution? Who bears the risk of incorrect decisions?Which system is best able to consider the full range of available productiontechnologies in making treatment decisions?My judgement is that the Health Security Act is about right in terms of structure,

but perhaps much too ambitious in terms of its timing. The promise of managedcompetition is quite appealing, especially to economists. Managed care plans willhave the people on the ground and close to the action who are essential to evaluatingthe quality and quantity of hospital care and negotiating its worth. Since managedcare plans will be competing with each other to attract subscribers on the basis ofprice (premiums) and quality, they have strong incentives to make decisions thatare in patients' best interest, i.e., reflect the tradeoffs that patients would makethemselves if they had perfect information and faced the full marginal social costsof their decisions. If they are also legally liable for withholding or failing to provideappropriate treatment, then they will have strong incentives, in the form of bothfinancial penalties and potential loss of reputation in the market, to keep thepatients' interests ahead of their short-term profit concerns. Moreover, managedcare plans offer the flexibility of tailoring themselves to fit not only variations insubscribers' health needs, but also in their demands for quality, including amenitiesand convenience. Finally, the institutional infrastructure of managed care plansand companies is already largely in place.The new institutional structures described by the Health Security Act will take

time to develop. It will take time to hire and organize staffs. More importantly, itwill take even longer to develop the information systems needed to carry out thefunctions envisioned for the health alliances and the National Health Board. Theirmost problematic aspects are, in fact, those that are essential to their serving asenlightened price regulators. Therefore, for practical as well as philosophicalreasons, I believe that it is more appropriate to focus first on their roles as enhancersof market competition, i.e., umpires. Only if managed competition proves unableto deliver on its promise of slower cost growth and value for money, should thefull-blown regulatory aspects of the Health Security Act be invoked.The Health Security Act calls for health alliances to evaluate health plans'

premiums and disallow those it deems too expensive. It also requires fee-for-service plans to adopt PPS-type price regulation (and the Medicare fee schedule forphysicians) without any flexibility regarding payment rates. These features of theplan should be postponed until managed competition has been implemented and


evaluated, and until the data necessary to exercise regulatory control are developed.My judgement is that it will take at least five years to make this assessment, fromthe point of enactment of a health care reform plan that guarantees universalcoverage and builds on managed competition to compensate for market failure.In the meanwhile, Medicare will continue to use PPS to pay hospitals and will

continue to benefit and learn from actions taken in a dynamic and presumablycompetitive private market. PPS will also be available for adoption by fee-for-service or managed care plans that wish to use it to pay hospitals, possibly with differentconversion factors or multipliers than those implicitly used by Medicare. Duringthis time period, high priority should be given to developing the information thatwill be needed both to assess the quality and appropriateness of hospital care forall people, not just Medicare beneficiaries, and to evaluate appropriate premiumlevels across the country should the need for premium regulation arise.

If managed competition fails to deliver, should hospital price regulation, presumably in conjunction with price regulation of physicians and other providers, bethe first line of response? The answer depends in part on how managed competitionfails. It may fail to control costs, perhaps because plans find that price competitionis ineffective relative to quality competition in attracting subscribers, or perhapsbecause reconfigured hospital systems tum out to have the upper hand in pricenegotiations. If the former, then some type of premium regulation, perhaps basedon yardstick comparisons among health plans, would probably be preferable toimposing hospital price regulations per se. Premium regulation would preserve thepresumed flexibility and responsiveness of managed competition, but would limitquality competition to an externally imposed cap, i.e., the regulated premium. Ofcourse, this scenario assumes that there is some type ofdisconnect or schizophreniabetween consumers' preferences expressed through their purchase of "too expensive" health plans, as opposed to their complaints about the cost of health careexpressed through the political process. Which one is right or should dominate isa question better left for a political scientist.

Ifplans can't control costs because they are unable to negotiate good deals fromhospitals, then the case for extending PPS to all payers would be considerablystronger. Even then, however, it may be best to think of PPS rates as price caps,rather than rigid prices. Giving individual plans the opportunity to negotiate betterrates, if they are able, both provides information to the rate setter about theappropriateness of the regulated rates as well as allows plans to tailor hospitalarrangements more closely to their subscribers' preferences. For example, a planthat is trying to carve out a niche at the lower end of the quality spectrum may beable to negotiate for fewer amenities if it does not have to accept the regulated rate.

If managed competition is deemed to fail because it scrimps unacceptably onquality, then premium regulation may resolve this dilemma if there is activecompetition among health plans for subscribers. In theory, a competitive marketfor subscribers should push plans toward providing the maximum level of qualityconsistent with earning a competitive profit. In a sluggish market, either becauseit is too small to support competing plans or because the number ofcompeting plans

160 HEALTH CARE POLlCY AND REGLAnON

is small and oligopolistic, then it is less clear that a regulated premium willnecessarily improve quality. In this situation, Pope (1989, 147-172) has arguedthat a mixed reimbursement system, part prospective and part cost subsidy, shouldlead to greater input use and, therefore, greater quality in the production of hospitalservices. Whether there is an analogy than can be drawn to premium regulation isnot at all clear. Regardless of the extent of competition among health plans, therewould need to be some mechanism for assessing whether the level of qualityprovided is optimal, i.e., that the premium level is right.One of my father's favorite expressions was "Hope for the best and prepare for

the worst." In the case of hospital price regulation under health care reform, hopingfor the best is equivalent to hoping that managed competition will be able to deliveron its promise of value for money. Preparing for the worst means investing in theinformation systems that will be necessary to regulate health plan premiums and,probably, prices for hospital and other health care services. Competition amonghealth plans in a price-regulated environment may still offer the best hope of goodquality care and responsiveness to patients. However, the technology and expertisefor measuring and evaluating the quality ofcare will have to be pushed well beyondthe current frontier before most people will be comfortable with a highly priceregulated health care system.Ultimately, the solution to health care market failure may be political debate and

voting over how much to spend on health care and how fast to let health carespending increase. In this regard, the experience ofMedicare's PPS, ProPAC, andannual congressional review and resolution may be somewhat encouraging. If ithas the needed information, a National Health Board making recommendations tothe Congress about rates of increase in allowed premiums may work just fine, ifthe premium caps can be flexible and if quality can be monitored on a systematicbasis. Flexible premium caps might mean that competing health plans are free toset lower premiums if they can in fact get better deals from providers or if they canorganize their own provider networks more efficiently. Flexibility should probablyalso allow people to purchase more expensive health plans, as long as moreexpensive premiums are not subsidized by the tax system.Hope for the best and prepare for the worst.

References

Biles, Brian, Carl Schramm, and Graham Atkinson. 1980. "Hospital Cost Inflation UnderState Rate Setting." New England Journal ofMedicine 303(12): 664-668.

Congressional Budget Office. 1993. "Trends in Health Spending: An Update." (June): 1-77.Dranove, David. 1988. "Pricing by Non-Profit Institutions." Journal ofHealth Economics7(1): 47-57.

Ellis, Randall, and Thomas McGuire. 1986. "Provider Behavior Under Prospective Reimbursement." Journal ofHealth Economics 5(2): 129-151.

Feder, Judith, Jack Hadley, and Stephen Zuckerman. 1987. "How Did Medicare's Prospective Payment System Affect Hospitals?" New England Journal ofMedicine 317 (No.14, October I): 867-873.


Feldman, Roger et al. 1990. "Effects of HMOs on the Creation of Competitive Markets forHospital Services." Journal ofHealth Economics 9(2): 207-222.

Foster, Richard. 1985. "Cost-Shifting Under Cost Reimbursement and Prospective Payment." Journal ofHealth Economics 4(3): 261-271.

Gruber, Jonathan. 1992. ''The Effect of Price Shopping in Medical Markets: HospitalResponses to PPOs in California." Harvard University, unpublished paper, (June).

Hadley, Jack, and Judith Feder. 1985. "Hospital Cost Shifting." Health Affairs 4 (No.3,Fall): 67-80.

Hadley, Jack, and Katherine Swartz. 1989. ''The Impacts on Hospital Costs Between 1980and 1984 of Hospital Rate Regulation, Competition, and Changes in Health InsuranceCoverage." Inquiry 26 (No.3, Spring): 35-47.

Hadley, Jack, and Stephen Zuckerman. 1991. "Determinants of Hospital Costs: Outputs,Inputs, and Regulation in the 1980s." Urban Institute Report No. 91-10.

Hadley, Jack, Stephen Zuckerman, and Judith Feder. 1989. "Profits and Fiscal Pressure inthe Prospective Payment System." Inquiry 26 (No.3, Fall): 354-365.

Hadley, Jack, Stephen Zuckerman, and Lisa Iezzoni. 1993. "Hospitals' Responses toFinancial Pressure." Georgetown University, Center for Health Policy Studies, unpublished paper (December).

Hoerger, Thomas. 1991. "'Profit' Variability in For-Profit and Not-for-Profit Hospitals."Journal ofHealth Economics 10(3): 259-289.

Holahan, John, and Joel Cohen. 1987. "Nursing Home Reimbursement: Implications forCost Containment, Access, and Quality." Milbank Quarterly 65(1): 112-147.

Kahn, Katherine, et al. 1992. ''The Effects ofthe DRG-Based Prospective Payment Systemon Quality of Care for Hospitalized Medicare Patients." The RAND Corporation, FinalReport R-3931-HCFA.

Melnick, Glenn et al. 1992. ''The Effects of Market Structure and Bargaining Position onHospital Prices." Journal ofHealth Economics 11(3): 217-233.

Melnick, Glenn, 1. Zwanziger, and T. Bradley. 1989. "Competition and Cost Containmentin California." Health Affairs 8 (No.2, Summer): 129-136.

Pauly, Mark. 1988. "Is Medical Care Different? Old Questions, New Answers." Journal ofHealth Politics, Policy and Law 13(No. 2, Summer): 227-237.

Pauly, Mark. 1987. "Monopsony Power in Health Insurance." Journal ofHealth Economics6(1): 73-82.

Pope, Gregory. 1989. "Hospital Nonprice Competition and Medicare ReimbursementPolicy." Journal ofHealth Economics 8(No. 2, June): 147-172.

Prospective Payment Assessment Commission. 1992. "Medicare and the American HealthCare System: Report to Congress." (June).

Prospective Payment Assessment Commission. 1993. "Medicare and the American HealthCare System: Report to Congress." (June).

Robinson, James, and Hal Luft. 1988. "Competition, Regulation, and Hospital Costs,1982-1986." Journal ofthe American Medical Association 260 (No. 18, November 11):2676-2681.

Robinson, James, and Ciaran Phibbs. 1989. "An Evaluation ofMedicaid Selective Contracting in California." Journal ofHealth Economics 8(4): 437-455.

Rosko, Michael. 1990. "All-Payer Rate Setting and the Provision of Hospital Care to theUninsured: The New Jersey Experience." Journal ofHealth Politics. Policy and Law15(4): 815-832.

Schramm, C.J., S.c. Renn, and B. Biles. 1986. "New Perspective on State Rate Setting."Health Affairs 5 (No.3, Fall): 22-33.


Shleifer, Andrei. 1985. "A Theory of Yardstick Competition." Rand Journal ofEconomics16(3): 319-327.

Thorpe, Kenneth, Paul Gertler, and PaulaGoodman. 1991. "The Resource UtilizationGroupSystem: Its Effect on Nursing Home Case Mix and Costs." Inquiry 28 (No.4, Winter):357-365.

Thorpe, Kenneth, and Charles Phelps. 1990. "Regulatory Intensity and Hospital CostGrowth." Journal ofHealth Economics 9(20): 143-166.

Thorpe, Kenneth. 1987. "Does All-Payer Rate Setting Work? The Case of the New YorkProspective Hospital Reimbursement Methodology." Journal ofHealth Politics, Policyand Law. 12(3): 391-408.

Williams, Deborah, Jack Hadley, and Julian Pettengill. 1992. "Profits, Community Role,and Hospital Closure: An Urban and Rural Analysis." Medical Care 30(2): 174-187.

Zuckerman, Stephen. 1987a. "Rate Setting and Hospital CostContainment." Health ServicesResearch 22 (No.3, August): 307-326.

Zuckerman, Stephen. 1987b. "Commercial Insurers and All-Payer Regulation." Journal ofHealth Economics 6(3): 165-187.

Zwanziger, Jack, and Glenn Melnick. 1988. "The Effects of Hospital Competition and TheMedicare PPS Program on Hospital Cost Behavior in California." Journal of HealthEconomics 7(4): 301-320.

9PAYING PHYSICIANS AS AGENTS:

Fee-For-Service, Caption, Or Hybrids?

Mark V. Pauly

1. Introduction

How physicians should be paid is a key question for privately managed HMOs andinsurance plans, administrators ofpublic insurances, and public policy makers. Thepopular concern usually is with the level ofphysician net income-do doctors maketoo much?-but the analytical problem is frequently more concerned with how agiven income is earned, and what consequences it has for substitute or complimentinputs and services physicians can control. After all, physician net income is only12% of total health spending; cutting it by 10% would do little good, but increasingit by 40% might be a bargain if the increase could be coupled with financialincentives to reduce the use of other inputs.There are (at least) three distinct settings in which physician payment issues

might arise, only one ofwhich is related to the economics of price regulation. First,payment policies are one of the set of management strategies that might be chosenby a set of competing managed care plans. It appears to be the case that plans cancoexist quite happily when different plans pay physicians in different ways: somefee-for-service, some capitation, some salary, and various combinations of theabove (Hillman 1987; Welch et al. 1992). Second, Medicare, as the country'slargest health insurer, needs to decide how it will pay physicians who provideservices to its insureds. Medicare has recently implemented a new payment methodfor physicians taking fee for service payment, basing relative payments for differentservices on an estimate of "Resource Based Relative Values" (RBRVS) andcalculating actual payments (under full implementation) by multiplying theRBRVS weight for any service by a politically determined conversion factor, withlimits on balance billing. (Physicians providing services to Medicare beneficiariesenrolled in managed care plans, in contrast, can be paid in any mutually acceptableway.) While RBRVS is sometimes alleged to represent government price regulation, in fact it does not. Rather, it simply represents government procurement policyin a market in which government is a major but not the only buyer: it representsthe payment policy of an oligopolistic (and oligopsonistic) insurer. Finally, it ispossible to imagine a single method of payment and payment level set by law by a


public regulatory body. This actually did happen temporarily during the NixonEconomic Stabilization Program, and it is envisioned as applying (for fee-for-service physicians only) as part of the Clinton health reform bill (1993).What objectives would be pursued, and what criteria would be used to judge

outcomes under each ofthese alternative models? In the "competitive equilibrium"model, the objective of health plans can be postulated to be profit maximization,that of consumers utility maximization, and that of physicians real income maximization. The normative judgment should be based on economic efficiency.In contrast, if there were a single (tax financed) payment system, the social

objective might be economic efficiency-which would imply taking account of lostproducers' surplus as well as gains in consumers' surplus. The real-world governmentmight, however, be interested only in consumerwelfare, choosing to disregardeffects of lower payments on the well-being of doctors and their employees.Finally, if Medicare were an oligopsonistic purchaser of physician services, wemight model its objectives as minimization of budgetary outlays subject to aconstraint on the level of patient health.

2. Two Undesirable Polar Cases

The two alternative "base-case" conceptual ways of paying for physician servicesare fee for (specific) service and capitation. Somewhat surprisingly, economicincentives under capitation are easiest to describe: do as little as possible of anyactivity with positive physician cost-in terms of either physician time or otherinputs. The need to retain patients in a physician's panel may mitigate this effectsomewhat, but the fundamental incentive under capitation is toward the lowesttolerable level of care, and very possibly toward underuse relative to some socialoptimum.On the other hand, fee-for-service is usually (and erroneously) believed to offer

incentives to produce more than the ideal. As we shall see, this proposition is notnecessarily true, but incentives for over supply surely can happen. For some levels(but not all) of fee-for-service in some circumstances, the financial incentive is toproduce as much output as possible, to supply an infinite amount of output. Aplausible inference would be that the socially optimal volume would fall somewhere between the minimum possible and infinity. Thus the ideal payment methodmust, in some sense, fall between the two extremes of complete capitation andcomplete fee-for-service.

3. What Is The Optimum Quantity and How Can We Get There?

The ideal "in between" solution is not easy to obtain, however, if physicians onlyrespond to money income, and costs per unit of their services (including the implicitcost of physician time) are constant. Let the general formulation for physicianpayment be: ax +b. Here, x is the volume of identified services and b is a capitation(or prospective) payment. If the payment system is fee for service, then a is the fee

PAYING PHYSICIANS AS AGENTS 165

per service and b is zero. Under capitation, a would be zero and b some positivenumber. Ellis and McGuire (1986) have analyzed such "two-part" payment systems in a set ofcomplex models, models largely directed to hospital payment. Theyrequire providers to value patient health as important in the assumed provider utilityfunction. In what follows, I will show that some simpler models can be used togenerate insights about physician behavior.

If physicians are only concerned about net (real) income and average costs areconstant, this payment scheme has bizarre knife-edge properties. Let C be theaverage (or marginal) cost. Then there is knife-edge supply behavior-if C> a,the practice will wish to supply no services. If C < a, the practice will wish tosupply (and persuade patients to accept) an infinite amount. Only if C = a (exactly)can there be an ideal outcome. Even that would require physicians to determinepatient needs.

4. An Alternative Model

One way to avoid such knife-edge behavior is to change the assumption about cost,and to add some small amount of physician concern for patient well-being. I beginby discussing a method of paying physicians who have already chosen to work fora managed care plan. Their only alternative to work is leisure; they cannot providecare for patients of other plans or switch to other plans.There is a single service physician provider. Provision of the service can be

observed, and requires a certain level of physician time and other practice inputs.The cost function for this service is assumed to be subject to increasing marginalcost beyond some point; this can be rationalized by appealing to the increasingmarginal disutility of physician work time.Identical physicians get utility from money income and leisure. They value

patient well-being slightly, only in the sense that, faced with two alternative actionsthat yield them same utility in money income and leisure (real income), they willchoose the one that makes patients better off.The managed care plan assigns a "large" set of patients randomly to each

physician. The plan knows the number of services that is optimal per patient insuch a population, but does not know which specific patients will have greaterbenefit from (greater need for) those services.

5. The Proposition

There exists a fee for service payment that approaches a first-best outcome asthe number of patients per doctor goes to infinity.

6. The Intuition

The intuition behind this proposition is straightforward. With a large number ofpatients, one can assume that the aggregate desired volume of services appropriate

166

Price. Cost

HEALTH CARE POLICY AND REGULATION

MC

•p

Figure 1

x • Volume ofServices

for a physician's population can be determined with near certainty, despite therandom incidence of illness. Let that number be x· in figure 1. Let the marginalcost curve of services be the curveMe. Then the appropriate price p* (= a) is theprice at which x* services will be supplied.Suppose the HMO buyer can accurately estimate the total volume of services it

wishes to be delivered to a given population. It wishes larger volumes of servicesto be delivered to patients in poorer states of health, but the HMO does not knoweach insured person's state of health. The primary care physician, however, doeshave information on health states, assumed to be generated costlessly as part of the

provision of diagnostic services. Let x7 be the target volume of services to bedelivered to patient i, and let C= qr.x7) be the physician's cost function, withincreasing marginal costs (C' > 0). Since physician time is a major component ofthe inputs into care for the patient, and since the marginal disutility of physicianwork time is plausibly assumed to be increasing beyond some point, the assumptionof increasing subjective costs appears plausible. (Research suggests minimal


income effects on physician supply of work effect (Sloan 1975)).The optimal fee-for-service price is then easy to identify. It is that price p* which

satisfies C'(r-xi') =Pi*' That is, it is the price which equals the marginal cost thatwould be incurred when the optimal volume is supplied to each patient.Such a price will generate the optimal total volume, but should the physician be

expected to supply the optimal level of services to each patient? Ifphysicians cared

only about (real) net income, there would be no reason to expectXi to equal xi, sincethe physician would be indifferent about any distribution of volume over patients.To get the physician to use the information already collected on patient health status,we need to assume that physicians have some concern, however slight, for patientwell-being. All we require is that, given some aggregate volume, the physician gets

highest utility from setting Xi = xi compared to some other distribution. If thephysician is going to supply his or her total services to the single HMO, theconclusion then is straightforward.I now consider modifications to this simple basic model that may change this

formidable conclusion about the optimality offee-for-service payment. I consider:a) existence of alternative plans,b) variation in total desired volumes,c) multiple insurance plan contractors,d) referral to other physicians, ande) patient-specific costs.

7. Existence of Alternative Plans

The McGuire-Ellis two-part solution can arise in this model if physicians havealternatives to working in the particular managed care plan which has a givendesired volume of services per enrollee and a given number of enrollees perphysician. Physicians who work for any managed care plan need to achieve thesame level of utility (real income) as they can obtain in their next best alternativeopportunity-whether that be another managed care plan with a particular compensation schedule or a fee for service indemnity practice with a particular fee level.A lump sum amount will need to be added to or subtracted from the compensationprovided by the fee level p* if the real income U* the physician obtains from theper-service fee alone does not yield the reservation utility level (U) availableelsewhere.

If u* < U, then a lump sum amount will be added to compensation (b > 0). IfU* > U, then a lump sum amount will be subtracted from total compensation (b <0). We do see examples of the former case, but rarely see the latter one, althougha lump sum investment by a physician is sometimes required in order to obtain anHMO contract for a physician group. However, it appears that the size of suchlump sum elements in the compensation structure may imply that the distributionof physicians across the populations in different plans is not optimal. That is, itwill generally be more efficient for a plan to adjust the incomes its physicians


receive by varying the number of enrollees per physician (by adding or subtractingphysicians) than by adding lump sum amounts to compensation. At least this willbe so if marginal cost is continuously increasing and there are no (or negligible)fixed costs per physician.A simple example illustrates. Suppose there is a population of N identical

persons divided into equal sized managed care plans, and a population of Midentical physicians. Then the optimal arrangement must be for each plan to choosethe number of physicians so that the number of enrollees per physician is N/M, andthen set the price p* that yields the optimal volume of services, given the per-physician real cost function and the per-enrollee marginal benefit from services. If, bymistake, some plan sets its value of N/M above the market-wide average, itsphysicians will have to work harder, it will have to set a higher price, and, althoughit may also have a negative lump sum amount, its total cost for physician serviceswill be higher than necessary. The overall question of whether the social optimumwill be a profit-maximizing equilibrium can be complex, especially if supplyelasticity and the degree of complementarity of physician and other services vary.

7.1. Uncertainty About Average Illness LevelsThe compensation structure just described requires that the realized average

illness severity of each physician's panel of patients be uniform. If patient populations per physician are sufficiently large and patients are randomly assigned tophysicians, the law of large numbers will assure that the average severity of eachphysician's panel will be virtually certain. Given the sizes of the patient populations seen by gatekeeper physicians, it appears that this type of averaging will workeffectively (Langwell and Pauly 1986). On the other hand, for some specialtiesthere may be a greater danger that one very sick patient will cause a nontrivialincrease in the total number of services desired in any time period. More importantly, patients may not randomly distribute themselves by expected severity acrossphysicians. Then, at any price, those physicians who attract unusually sick patientswill undersupply services, relative to the optimum for that population, and thosewho attract less sick patients will oversupply services, relative to the optimum forthat population.

If enrollees know which physicians supply which volumes of services (i.e., ifpatient health levels at different practices can be measured and made known), asituation of non-random distribution of severity with price p* will be self-correcting, at least to some extent. Those higher risk enrollees who disproportionatelychose a particular physician will note that the health level there will be lower thanthat they could achieve by using physicians who treat less sick enrollees. Migrationof patients will ensue, until the average level of severity is equalized across allphysicians.Obviously if physicians differ in their skill levels or in their cost curves, a single

price will not be guaranteed to produce the ideal outcome. As long as the variationin ability or cost is not substantial, however, an efficient outcome can be approximated.


There is a potential general solution to the problem ofvariation in patient severityacross each physician's panel ofpatients, but it will not achieve a first-best optimumand will require somewhat more physician concern for patient well-being. Insteadof establishing a single price per unit of service p* for all physicians, the HMOcould announce a schedule of so-called "volume-based" prices, in which the pricewould increase with the total volume of services supplied. (See Pauly et al., (1993)for a discussion of volume based pricing in a different context.) In this case, theideal payment scheme would exactly equal marginal cost at average severity; theaverage price would increase as volume increased in such a way that the marginalprice fell short ofmarginal cost, but not by too much, for severity levels both aboveand below the average.

7.2. Differences in Consumer Demand for Intensity of TreatmentTo this point, we have assumed that an ideal outcome requires the same volume

of services to be rendered to an enrollee of a given illness level. It seem plausibleto suppose, however, that consumers may vary in their demand for intensity oftreatment. Some may be willing to accept lower levels of services per person inorder to obtain lower HMO premiums. Different managed care plans might beexpected to differentiate themselves in terms of the intensity oftreatment they offer.Every HMO will deliver the care the patient needs, but different HMOs makedifferent determinations about how much is needed. Knowledgeable consumerscan then be expected to sort themselves across plans, depending on their willingnessto pay for additional intensity.The obvious implication of this is that different plans may choose different

compensation schedules, depending on which intensity niche they expect to occupy. This endogenous choice of compensation structure when the demand forquality varies has recently been treated in detail by Kwon (1993); here I provide abrief and simple illustration of market equilibrium.Suppose consumers are of two types: some demand high quality and others

demand low quality. The number of physicians per enrollee and/or the fee forservice price level would be set higher in those HMOs that catered to the demandersof high quality. Physician real incomes would be equalized across plans.

7.3. Multiple ContractingA key assumption for the payment mechanism just described to work is that each

physician cares only for the enrollees of one HMO. This assumption was made toguarantee that the total volume of services they physician supplies are all deliveredto HMO members. What happens if physicians contract with multiple HMOs orinsurers? If all consumers demand the same level of intensity, the optimumoutcome can still be achieved if each HMO sets its price at p* and monitors thetotal number of enrollees (its own and those of other HMOs) per physician withwhich it contracts.I further conjecture that if the number of enrollees per physician is set at N/M

and the price is set at P*, then the resulting outcome will be optimal and an


equilibrium in terms of total numbers of enrollees per physician. That is, nophysician will want to accept a panel of any different size than what he or shecurrently has, given the real income earned.

8. Comparison of Results

It may be useful to contrast this result with those obtained by McGuire and Ellis(1986; 1990) and Selden (1991). In all of these models, the optimal compensationmechanism turns out to be a mixed system, in which providers are partially paid alump sum amount, and partially paid an amount that depends on "cost." In my idealmethod, however, there need be no lump sum payment. There are, however, someimportant differences between these models and mine which lead to these differences in conclusions.First, the McGuire-Ellis models were actually developed to discuss reimburse

ment of hospitals, not physicians---even though the discussion is sometimesimplicitly generalized to all providers. Indeed, the specific application they examine is the DRG payment system for hospitals, in which the hospital is paid a fixedprice per discharge in a given Diagnosis Related Group (DRG). In effect, the DRGsystem is like a fee for service payment per discharge; the only issue is whether alldischarges in a given DRG are homogeneous. More importantly, all of thesemodels explicitly or implicitly assume that average costs are constant. Such anassumption is plausible for hospitals, for which empirical studies do indicateconstant costs (Granemann et al. 1986). However, it is not as plausible forphysician services. The alternative approach is to define "units" of care in termsof dollars of cost (Selden 1991), but then effects of volume on unit cost becomecontaminated with the functional form of patient and doctor utility functions.The key issue for FFS reimbursement to be optimal is that the "unit" on the basis

of which payment is made is homogeneous; its quality cannot be varied in anundetectable fashion by the provider and must be independent of patient illnessseverity. Such perfect homogeneity does not characterize actual physician services,of course, but the question is whether it comes close. One way to explore thisquestion would be to see whether, at a given price per unit, the number of unitsdifferent patients receive is highly correlated with illness severity. The level oftheFFS price will affect the absolute amount of services rendered, but the relativeamounts may not be much affected by the price level. In such a case, the volumeof measured services may be a good proxy for illness severity.Finally, in the case of physician services, it is not clear how to apply the "cost"

concept. The cost of physician input is not measured directly and surely is notconstant. Physician time or "work," as in theMedicare RBRVS approach, is almostsurely not an unequivocal or accurate indicator of opportunity cost.In summary, the approach to FFS that I take in this paper appears to be

compatible with the McGuire-Ellis approach. In effect, they construct a proxyupward sloping supply curve by putting patient health in the provider utilityfunction. Supply only gradually declines as price falls below marginal cost because


providers accept lower profits in order to keep patient health from falling too far.In the model in this paper, the positive slope need only be based on the physician'sconcern for his own work time.

8.1. Will the Optimal Price Control the Growth in Spending?The models discussed thus far are static; they do not allow for changes in

technology or increases in the demand for physician services. We surely do notwant to propose a zero rate of growth in real spending on physician services(adjusted for demographic changes) as a desirable social objective. Rather, theobjective ought to be that rate of growth in spending consistent with introducingnew products and increasing quality or amenity at appropriate rates-rates whichbalance benefits and costs.

If a single managed care plan or a set of competing plans knew the appropriaterate of growth in quality or intensity and the rate of growth in its (minimum)marginal cost, the task of setting optimal prices is simple: Let p* grow at the rateof growth in cost for appropriate care. But would a set of competing managed careplans find it profit maximizing to choose the appropriate rate of growth? Theliterature on this point is somewhat ambiguous, with Goddeeris (1984) andBaumgardner (1992) offering models in which the equilibrium rate might be higherthan the optimal rate, and Pauly (1980) offering reasons why the optimum may beapproached.At this point all one can say is that the primary virtue of capitation is its ability

to control the rate of growth in spending-but that may also be its primary vice,since too Iowa rate of increase in the capitation payment may simply reinforce thestatic incentive under capitation to underprovide services. More research is neededon this subject.

8.2. Incentives for Appropriate ReferralsThe optimal price p* pays the gatekeeper physician to tailor his own services

ideally to patient need. If the alternative to treating the patient is to refuse treatmentwhich is appropriate, the optimal payment schedule avoids this kind of "dumping."But what if an alternative to treatment by the primary care physician is referral tosome other physician or treatment site? Might sicker patients not be "dumped" toother providers? Conversely, might patients who should be referred be inappropriately retained for treatment by a less well qualified primary care physician?Solving the principal-agent problem of optimal referrals is one of the most

difficult issues in reimbursement policy. Kerstein (1992) solves for a solution in aspecial case, but it is very difficult to find a general solution if patients are insured.(If patients are not insured, the "general contractor" model (Pauly 1980) indicatesthat there will be an optimal competitive equilibrium.)However, the problem of inappropriate under- or over-referring should not be

very serious if the price is set at P*, assuming that p* is chosen based in part onthe managed care plan's knowledge of the appropriate volumes of own-treatmentand referrals. Suppose that the optimal solution is for the gatekeeper physician to


provide XI office visits himself and refer for X2 visits to specialists. Then settingp* so it equals marginal cost at volume XI will induce the physician to want toprovideXI visits in total, and even a slight concern for patient well-being will causehim to choose to provide those visits to those patients who get the most benefit fromthem if he provides them himself, and to refer all other patients who would be betteroff if treated by a specialist. Excessive referrals are a sign that the primary caredoctor's price was set too low, while failure to make approptiatc referrals meansthat it was set too high. Of course, the primary care physician has no particularincentive to choose cheaper specialists, if he is not at risk for the cost of theirservices, so we cannot be sure of "first-best" referral patterns.

8.3. Optimal Pricing and RBRVSWould p* be the price that would be chosen under the resource-based relative

value approach? At first thought, one might think the answer should be affirmative(and in reality anything can happen). After all, RBRVS attempts to base relativeprices on relative resource costs. If there are two different services that the primarycare physician provides, and one has twice the marginal cost of the other, its valueof p* should be twice as great. In practice, however, the process for settingMedicare prices based on RBRVS may not well approximate these relative weights.There are two problems. First, as noted, the appropriate relative weight should

be based on the ratio ofmarginal costs, that is, the ratio of resources used when thephysician is working the optimal number of hours doing the optimal set of things.But the RBRVS weights, to the extent that they are based on real data rather thanpolitical negotiations or subjective judgment, were based on the assumption thatthere is a unique resource cost currently being incurred by physicians which oughtto be the basis of relative prices. The approach in my model says that there is nounique resource cost for physician services, since the marginal cost depends onvolume, and one need not assume that marginal costs are proportional to averagecosts. So the RBRVS weights, though they may not be too far off in general, maystill not be accurate.For instance, consider two services, one which is physician time intensive (e.g.,

office visits) and the other uses little physician time but more of others' time (e.g.,lab tests). Then the relative price of the first services must increase more rapidlywith volume than that of the other service.More seriously, the application of the RBRVS approach requires that a conver

sion factor be chosen to convert relative prices into absolute prices. There is noparticular reason to believe that the conversion factor that Medicare will choose isone that would yield the price P*. Instead, the conversion factors seem to be solelybased on political or budgetary needs, without a conscious or explicit selection ofany target volume to be achieved (except that Congress does choose the volumeconsistent with (politically) desired spending growth as a volume performancestandard). While RBRVS has the same goal of "incentive neutrality" at the marginas is achieved by the optimal payment scheme (Hsiao 1988), there is no particularreason to think that, in practice, it offers the incentive for the right total volume.

PAYING PHYSICIANS AS AGENTS

At best, it gets relative volume about right (Pauly 1991).

9. Conclusion

173

Fee for service is a wonderful incentive mechanism, if the level of fees is setproperly. It is also a powerful mechanism, able to cause lots of disruption if thefee is set incorrectly. There is strong reason to believe that current market wide feelevels are too high for most specialties in most parts of the country, and the needto compete with the currently inefficiently organized but lucrative indemnityinsurance options makes it difficult for managed care plans to move directly to theideal outcome. Although I tend to be highly skeptical of government's ability todo so, in principle establishment of the p* fee schedule by government would beone way to move to a more efficient outcome than at present. Alternatively anevolutionary process of competition may move, more slowly but perhaps moresurely, in the same direction.This analysis has very little good to say about capitation, and that may appear

odd given the widespread use of that method. The truest statement to make is that,although capitation may lead to a better outcome than would be achieved under feefor service price if such prices are set too high, there is always some fee for serviceschedule that will do better than capitation. However, the information requirementsfor setting the optimal fee for service level are severe: the managed care plan hasto admit that it wishes to ration care, and to select the level to which it wishes toration. In contrast, setting capitation payment puts the onus for rationing on theprimary care doctor, without requiring plan management to bear explicit responsibility. At present, consumers do not have good information about the quality ofdifferent managed care plans, and those plans very much want to encourage thebelief that they only ration out useless or harmful care. As buyers become moreknowledgeable and more sophisticated, it may become more acceptable to talkabout management choosing the levels of service and taking responsibility for theincentive structures that lead to those volumes.

References

Baumgardner, J. 1992. "Medicare Physician-Payment Reform and the Resource-BasedRelative Value Scale: A Recreation of Efficient Market Prices?" American EconomicReview 82 (No.4, September): 1027-1030.

Clinton, W.J. 1993. President Clinton's Health Care Reform Proposal and Health SecurityAct as Presented to Congress on October 27, 1993. Chicago: Commerce Clearing House,Inc.

Ellis, R., and T. McGuire. 1986. "Provider Behavior Under Prospective ReimbursementCost Sharing and Supply." Journal ofHealth Economics 5 (No.2, June): 129-151.

Ellis, R., and T. McGuire. 1990. "Optimal Payment Systems for Health Services." JournalofHealth Economics 9 (4): 375-396.

Goddeeris, J. 1984. "Insurance and Incentives For Innovation in Medical Care." SouthernEconomic Journal 51 (No.2, October): 503-39.


Granneman, T, et al. 1986. "Estimating Hospital Costs: A Multiple-Output Analysis."Journal ofHealth Economics 5 (No.2, June): 107-127.

Hillman, A. 1987. "Financial Incentives for Physicians in HMOs: Is There a Conflict ofInterest?" The New England Journal ofMedicine 315: 511-3.

Hsiao, W. 1988. "Resource-based Relative Values: An Overview." JAMA 260 (No. 16, Oct.28): 2347-53.

Kerstein, J. 1990. "A Theoretical and Empirical Study of Physician Compensation Arrangements." Dissertation for Ph.D. in Health Care Systems at the Wharton School, Universityof Pennsylvania.

Kwon, S. 1993. "Payment Systems, Provider Incentives, and Consumer Information inHealth Care Markets: Physician Compensation Arrangements." Dissertation for Ph.D.in Health Care Systems at the Wharton School, University of Pennsylvania, 1993.

Langwell, K., and M. Pauly. 1986. "Physician Payment Reform: Who Shall Be Paid?"Medical Care Review 43 (No. I, Spring): 101-132.

Pauly, M., et al. 1989. "Methods for Pricing the Technical Components ofDiagnosticTests."DHHS HCFA, Contract No. 99-C-99/69/5-01 (April).

Pauly, M. 1980. Doctors and Their Workshops. Chicago: University of Chicago Press.Pauly, M. 1991. "Fee Schedules and Utilization." In Regulating Doctor's Fees: Competition

Benefits, and Controls Under Medicare, edited by H.E. Frech, 288-305.Sloan, F. 1975. "Physician Supply Behavior in the Short Run." Industrial and Labor

Relations Review (July): 594-613.Welch, W.P., et al. 1990. "Contractual Relationships between HMOs and Primary CarePhysicians: Three-tiered HMOs and Risk Pools."Medical Care 30 (February): 136-148.

COMMENTS

Beatrice E. Manning

Pauly proposes: "There exists a fee-for-service payment that approaches a firstbest outcome as the number of patients goes to infinity." It is this proposition thatforms the underlying basis of his paper. There follows an intricate discussion ofthe setting of this payment rate. Optimally, it would equal the marginal cost ofservices and could be adjusted to be incentive neutral in terms of determining theamount of services rendered.While developing this proposition and pursuing the implications, Pauly success

fully debunks several myths which are presently dominating the health care debate.These are:

(1) Compared to fee-for-service, capitated managed care will lower medical expenses.

(2) A payment approach which moves health care dollars from specialiststo primary care providers, e.g., RBRVS, will lower health care costs.

(3) Health plans or other purchasers of medical services need to choosethe same payment method for all physicians.

The debunking of these myths and considerations regarding how to develop theappropriate price are the most important contributions of the paper.The paper is most limited by an assumption that this price can best be developed

in the market place. For the market place to work effectively, those buying andselling services must have good knowledge of the market and its incentives.Beyond primary care services, the medical market has not been predictable. Anyhealth reform initiatives which cover additional persons traditionally withoutinsurance will only result in decreased predictability. Pauly acknowledges thisweakness but falls back on the argument that the market will continue slowly butsurely to correct for this lack of knowledge.Beyond the lack of knowledge about market considerations, there is also

considerable debate about the clinically appropriate amount of care. Pauly, discusses the use of statistics to predict the number and type of services used by apopulation. From the work of Wennberg, Codman, and others we know thatpractice patterns vary considerably even after controlling for health and insurancestatus and severity of illness. Unfortunately, there is essentially no outcome datato suggest what is the optimal amount of care or type of treatment nor by whom itcan most appropriately be given. While Pauly attributes considerable power to the


market, there is no reason to believe that it can determine the optimal treatment.Ironically, it is costly, clinically questionable, late-stage-disease treatment thatmarket forces have been the most unsuccessful in controlling.As long as reliable outcome data are missing, I suggest the following proposition

to guide treatment decisions.Proposition: The economics of treatment being more or less equal, treatment

should be in the least restrictive setting and require the least number of return visitsappropriate.This is not a medical but a social proposition. It is reflective of the underlying

societal value placed on maximizing personal independence.Starting from this proposition and using Pauly's work, it is possible to begin to

think about the appropriate method of determining physician reimbursement undervarying circumstances. Decisions concerning the payment ofphysicians then hingenot so much on how much they earn and whether or not this is too much, but ratheron how does the amount and the method of payment affect patient access and theoverall cost of health care.Pauly points out that physician net income is only 12% of total health care

spending; stringent cost control measures which might produce a 10% decreasewould have little impact on overall costs. I would add, the administrative costswhether public, e.g., development of rating setting accompanied by the appropriateenforcement mechanism, or private, e.g., careful utilization review and gatekeeping, could equal or exceed savings. Pauly also points out that increasing physicianincome by as much as 40% might be a bargain if it could be coupled with reductionsin use of other inputs. The unspoken proposition is that cost controls on a sectorof health care result in increases in other sectors.I offer the following contracting examples as possible uses ofPauly's work. The

arrangements could be used by any purchaser (government, a health plan, anemployer). Contracting on a fee-for-service basis with psychiatrists at a rate even50% to 100% above current levels to have emergency night availability could wellresult in considerable savingr through decreases in mental hospitalization. Anotherimportant example might be paying primary care physicians fee-for-service particularly for patients with illnesses such as asthma. It would take many expensiveoffice visits to exceed the average cost of even one hospitalization.In summarizing my comments on Pauly's work, I suggest (1) this paper should

constantly be referred to when considering health care reform as protection againstdrifting toward solutions which are part of the myths debunked by Pauly; (2) Allpurchasers and those active in health care reform efforts need to draw on Pauly'swork and creatively design payment methods which will help foster patient independence and contain costs.

COMMENTS

David W. Lee

The central message of Professor Pauly's paper is that physicians' fees can, intheory, be efficiently regulated using Fee-For-Service (FFS) reimbursement. Thekey insight of the paper is that fee regulation using FFS reimbursement is preferableto regulating capitated fees because the incentive to over-utilize under FFS can beincorporated into the regulatory mechanism to ensure that the desired volume ofservices is delivered. This is an application ofwhat one might call 'judo regulatoryeconomics"-physicians' incentives to over-supply services under FFS are, in asense, used against them to assure that the desired level of care is provided asefficiently as possible. In contrast, regulated payments under a capitated reimbursement system do not reverse the incentive to under-supply services. IThe paper does not, however, argue that physicians' fees can be regulated simply

because such regulation is theoretically possible. Knowing that FFS fee regulationcan achieve a first-best outcome is a necessary, but not sufficient, condition forsuccessful regulation of physicians' fees in practice. The remainder of this comment briefly addresses the feasibility ofphysician fee regulation by discussing someof the obstacles that must be overcome in setting prices for physician services.

1. Is Physician Fee Regulation Feasible?

Evidence from the regulation of public utilities, airlines, oil, natural gas, and so onsuggests that price regulation is, at best, successful only part of the time (Stiglerand Friedland 1962; Joskow and Rose 1989). Given the historical difficulty inachieving an efficient regulatory outcome in these industries, it is useful to elaborateon the political and informational obstacles to efficient regulation of physicians'fees.

Moreover, physicians have a strong incentive to avoid treating high-risk patients under acapitated reimbursement system because treatment expense, by definition, exceeds thecapitated payment amount. In contrast, physicians paid on a FFS basis would either beindifferent toward, or may even prefer, treating high-risk patients because revenue increaseswith volume.

178 HEALTH CARE POLlCY AND REGULATlON

1.1. Political ObstaclesFor physicians' fees to be set efficiently, regulators must have efficiency as their

objective. However, it is likely that regulators will be motivated by the desire tomaximize political support rather than by some notion of social welfare. Moreover,standard regulatory theory predicts that regulations tend to favor small groups withintense interests at the expense of larger, more diverse groups whose preferencesare more diffuse. The implication of this theory for setting physicians' fees isstraightforward: regulators who are more concerned with their own politicalwelfare rather than social welfare would be likely to set fees at levels that benefitthe relatively small and vocal group of providers at the expense of patients.Health system reform initiatives based on the managed competition model, such

as the Clinton plan, make this outcome particularly likely because they concentratepolitical power with providers and diffuse it among regulators. Managed competition utilizes a network of bureaucratic agencies, each of which is assigned aspecific area of responsibility. Thus, the issues that each bureaucracy faces becomerelatively narrow and the ability of the regulator to "trade-off' special interestgroups across issues becomes limited. At the same time, managed competition isdesigned to increase concentration at the provider/insurer level, which has the effectof creating interest groups where they otherwise might not exist (i.e., it reduces thecosts of organization). The likely result is that the relatively small group ofproviders will be able to influence the relatively diffuse set of regulators topromulgate pro-provider regulations.

1.2. Informational ObstaclesEven if the regulator acts to maximize welfare, is there any reason to believe that

it is possible to calculate the optimal reimbursement rate? For example, Medicarephysician payment reform legislation established the Medicare Volume Performance Standard (MVPS), which was intended to provide a targeted rate of expenditure growth that would accommodate fee inflation, enrollment growth, changes intechnology, and other factors exclusive of unnecessary or inappropriate care.Unfortunately, reliable estimates of the impact of technology or unnecessary careon health care spending do not exist, and, as a result, the MVPS has been setarbitrarily since its inception (PPRC 1993). The following outlines some of theinformational problems that would be encountered when setting physicians' fees:

Diversity of the Industry. There are thousands of physicians, each offering aslightly different bundle of services consisting of several hundred distinct procedures. This is in sharp contrast other regulated industries, such as public utilities,where there is typically one output and one firm.

Marginal Cost. Marginal cost is an economic concept that cannot be calculateddirectly from accounting data. Consequently, estimates of marginal cost must bemade using econometric techniques, and these estimates necessarily contain error.Lessons about the prospects for estimating marginal costs for physician servicescan be learned from the hospital cost function literature. After nearly two decades

COMMENTS 179

of effort, there is absolutely no agreement about the shape of the hospital costfunction or even the definition of output.2

Variations in Scope and Scale Economies. The cost of providing a service variesnot only with the size of the practice, but also with the mix of services provided.Efficient reimbursement must recognize this and adjust payments accordingly.This is an important aspect of reimbursement that is overlooked in the ResourceBased Relative Value Scale (Hadley 1991).

Geographic Variation. The vast majority of health care services are providedlocally, and the demand for and cost of care also vary geographically, especiallybetween urban and rural areas (Zuckerman et al. 1990). The more national theregulated fee, the less efficient will be the outcome.

Determining Quantity. Determining the "correct" amount of physician servicesto purchase seems an almost insurmountable task. Consider first that outputincludes not only the volume, but also the quality of services provided. However,measures of quality, if they can be developed at all, are likely to be imprecise.Determining the appropriate volume and mix of services, irrespective ofthe qualitywith which they are delivered, is also difficult. Practice parameters and practiceguidelines provide some information about appropriate medical treatment for thetypical patient. However, the existing set ofguidelines cover only a limited numberof services, and there is no mechanism in place to assure that they are promptlyrevised to reflect changes in medical technology.

Physician Responses to Reimbursement. If reimbursement rates are to beestablished on the basis of some notion of desired output, it is imperative that anestimate of the physician's supply response to these rates be made. While there hasbeen considerable and important theoretical work in this area, actually designingand implementing a regulated price system will ultimately require some empiricalestimate of the degree to which physicians adjust output in response to changes infees. To date, research comparing utilization under capitated and FFS reimbursement has been contradictory (Stearns et al. 1992), and empirical estimates examining the incentive effects are incomplete because they do not fully adjust for demandeffects or the existence of non-fee controls on utilization.

Adjusting Regulated Fees Over Time. One of the most important and oftenoverlooked aspects of fee regulation is that fees must be continuously adjusted toaccommodate changes in the marketplace. The longer the lag in adjustment, themore likely that current fees will be inefficient even if they were set efficiently tobegin with. In addition, fees serve as signals for the movement of resources intoand out ofthe health care sector and must be established accordingly.3 For example,current regulated fees would have to be large enough to attract the number of new

2 The number of articles estimating hospital cost functions are too numerous to mention. SeeBreyer (1987) and Vita (1990) for recent examples.

3 Baumgardner (1992) makes this same point regarding fees in the Medicare Part B program.


physicians needed to treat the baby boom generation as they enter their high healthcare demand years.

2. Summary

The main theme communicated by Professor Pauly's paper is that incentives are animportant aspect of physician fee regulation and that these incentives can be usedin a FFS reimbursement scheme to arrive at a first-best outcome. The commentspresented here have questioned whether physician fee regulation is feasible. Basedon the political and informational obstacles to regulation discussed above, it is astraightforward conclusion that efficient fee regulation is simply not feasible. Amore difficult question to assess, and one that remains unanswered, is whetherinefficiently regulated fees would result in a more efficient outcome than wecurrently have.

References

Baumgardner, J.R. 1992. "Medicare Physician-Payment Reform and the Resource-BasedRelative Value Scale: A Re-creation of Efficient Market Prices?" American EconomicReview 82 (September): 1027-1030.

Breyer, F. 1987. "The Specification of a Hospital Cost Function: A Comment on the RecentLiterature." Journal ofHealth Economics 6 (June): 147-157.

Hadley, 1. 1991. 'Theoretical and Empirical Foundations of the Resource-based RelativeValue Scale." In Regulating Doctors' Fees: Competition. Benefits, and Controls UnderMedicare, edited by H.E. Frech, III, 97-125. Washington, DC: American EnterpriseInstitute Press.

Joskow, P.J., and N.L. Rose. 1989. "The Effects of Economic Regulation." In Handbookof Industrial Organization. Volume II, edited by R. Schmalensee and R.D. Willig,1449-1506. Amsterdam: Elsevier Science Publishers B.V.

PPRC. 1993. "Fee Update and Medicare Volume Performance Standards for 1994." Physician Payment Review Commission, publication No. 93-1 (May 15).

Stearns, S.c., B.L. Wolfe, and D.A. Kindig. 1992. "Physician Responses to Fee-for Serviceand Capitated Payment." Inquiry 29 (Winter): 416-425.

Stigler, G.J., and C. Friedland. 1962. "What Can Regulators Regulate: The Case ofElectricity." Journal ofLaw and Economics 5 (October): 1-16.

Vita, M.G. 1990. "Exploring Hospital Production Relationships with Flexible FunctionalForms." Journal ofHealth Economics 9 (June): 1-21.

Zuckerman, S., W.P. Welch, and G.C. Pope. 1990. "A Geographic Index of PhysicianPractice Costs." Journal ofHealth Economics 9 (June): 39-69.

PART IIIQUALITY REGULATION

10MEDICAL PRACTICE GUIDELINES AND THE

EFFICIENT ALLOCATION OF RESOURCES

John A. RizzoJody L. Sindelar

1. Introduction

Medical practice guidelines have grown increasingly popular as policy instrumentsto control escalating health care costs and improve the appropriateness and qualityof care. In this paper, we describe medical practice guidelines and discuss theirpossible effects on a variety of outcomes, including the cost and quality of care,and the pace of innovation in the physician services industry. While great attentionhas focused on guideline development, we argue that guideline selection andimplementation are equally important considerations which have received too littleattention in the burgeoning literature on medical practice guidelines. Whetherguidelines succeed or fail in improving physician care and controlling costs hasmuch to do with how they are presented to physicians. Further, great care shouldbe used in deciding which guidelines to develop. Priority should be given to thosewhich are likely to produce the greatest gains to society in terms of better resourceallocation.

2. The Nature and Objectives of Practice Guidelines

Before proceeding, it is necessary to define what we mean by practice guidelines.While the term may mean different things to different people, a consistent, explicitdefinition is necessary for further discussion. A definition adopted by the InstituteofMedicine Committee to Advise the Public Health Service on Practice Guidelinesdefines the term "practice guideline" to mean:

systematically developed statements to assist practitioner and patient decisions about appropriate health care for specific clinical circumstances.)

This definition is quoted in Audet, Greenfield, and Field (1990, 709). For the Institute ofMedicine Committee report, see Field and Lohr (1990).


Other explicit definitions exist and there are many more implicit definitions.Examining the goals ofguidelines is another way to understand the differences andsimilarities in what is meant by practice guidelines. Most conceptions share thecommon objective of improving quality, but tend to be vague on how this goal willbe achieved.The goals of physician practice guidelines have been stated to be increased

quality of care, greater effectiveness of care, more efficiency of care, improvedclinical outcomes, greater cost-effectiveness of care, reductions in wasteful care,and/or lower overall costs? Clarity in stated goals is necessary in order to evaluatea guideline or a set of guideline policies. Further, the goals themselves should beevaluated. Care should be used in selecting goals to ensure that public and privatepolicies will be directed toward improvements in society's well-being.Audet, Greenfield, and Field (1990) surveyed eight prominent organizations,

each ofwhich was involved in guideline development, to ascertain their objectives.Every respondent stated that they sought to improve "clinical effectiveness" and"quality of care." Six organizations stated that cost control was a secondaryobjective, while two organizations did not believe cost control to be an importantfactor in guideline development. In general, however, the researchers found thatobjectives tended to be defined only in vague terms. The reasons for the imprecisestatements of goals are not entirely clear. Audet, Greenfield, and Field (1990)speculate that this may have resulted from a desire to avoid controversy anddisputes, which might hinder the process of guideline development.

2.1. Types of GuidelinesThere are a variety of typographies that could be developed in reference to

guidelines. One could delineate, for example, guidelines that prescribe versusproscribe (see Werner (1993) advocating proscriptive guidelines); or guidelinesthat are standards or suggestions as compared to those that are more like rules orregulations that must be followed if penalties are to be avoided.One typography offered bv the Physician Payment Review Commission (1992)

delineates guidelines by diagnosis (diagnostic guidelines), evaluation of individualservices (service guidelines), or appropriate treatment regimens for specific conditions (management guidelines).3 The first two types of guidelines identify illness

2 Cost control might be questioned as a goal. However, Brennan (1991) notes that:"Although some people say that cost is not the important issue, and that a procedure isappropriate if the benefits to the patient's health exceed the risks (Brook 1989, 70),cost-effectiveness is usually the driving force behind development of appropriatenessguidelines. These are intended to reduce care that is unnecessary or inefficient in cost."However, Brennan also notes that a second type of guideline focuses on outcomes and is notmotivated by cost considerations. These he defines as standards ofcare.

3 The three main types of guidelines, diagnosis, management, and service, have been describedin a recent Physician Payment Review Commission Report to Congress (1992) as follows:"Diagnostic guidelines are targeted at evaluating patients with particular symptoms (such as

MEDICAL PRACTICE GUIDELINES 185

and evaluate specific medical technologies or services, respectively. Managementguidelines, however, prescribe appropriate treatments for an entire episode of carefor a patient with a given medical condition. At present, AHCPR is devoting thevast majority of its efforts to the development of diagnostic and management'd l' 4gUl e meso

2.2. Who Sets Guidelines?With the establishment in 1989 of the Agency for Health Care Policy and

Research (AHCPR), the federal government made the development of practiceguidelines an important component of health care regulation. AHCPR has initiatedwork on 16 practice guidelines. In addition, over 50 health care organizations areactively involved in the development of practice guidelines. These organizationsinclude professional groups, third-party payers, hospitals, academic medical centers, health maintenance organizations, independent researchers, and malpracticeinsurers (Physician Payment Review Commission 1992,222). Depending upon thetype of organization establishing the guidelines, the guidelines will have differentgoals (e.g. third party payers may be more cost-conscious than medical professionalgroups) and also different implementation options (again, insurers have moreoptions for penalties than do professional groups). Predictions as to the effects ofguidelines will depend, therefore, on the developing and issuing organization aswell as the specific characteristics of the guidelines and how they are implemented.For example, an academic medical center may have less of a cost-control emphasisthan an insurer and the academic center may rely more on the informationalcomponent of guidelines as opposed to financial incentives.

2.3. How Are Guidelines Developed?Guidelines may be developed in a variety of ways. Included in the possibilities

are: 1) informal consensus, 2) formal literature reviews by experts; 3) internaljudgments with little input from external experts; and 4) expert literature reviewcombined with a formalized group judgment processes such as the Delphi method(Audet, Greenfield, and Field 1990). Evidence based on expert opinion andpublished research results are probably preferable on scientific grounds. However,

chest pain) for the presence of diseases that would benefit from intervention (such as angina oresophagitis). They are also used to guide the screening of asymptomatic populations for earlystages of disease (to detect, for example, hypertension or diabetes).Management guidelines cover the evaluation and treatment of patients who are known to havecertain conditions. Examples are guidelines dealing with low back pain or benign prostatichypertrophy.Service guidelines are organized around particular diagnostic and therapeutic procedures (suchas chest X-ray, colonoscopy, appendectomy, or administration of hepatitis vaccine, presentingappropriate and inappropriate indications for their use" (Physician Payment ReviewCommission 1992, 214).

4 See Physician Payment Review Commission (1992, 223).

186 HEALTH CARE POLlCY AND REOULATION

they are costly in terms of time and money. The requirement of completed clinicaltrials and published data combined with the time it takes to specify a scientificguideline could render the guideline obsolete by the time that it is issued. On theother hand, informal consensus by local groups may be more timely and moreappropriate to each setting. Research results are often not generalizable to specificsettings. In general, a guideline based on "hard," scientific evidence would bepreferable, but in some circumstances it may need to be balanced against timelinessand flexibilitl.

3. Will Guidelines Affect Physician Behavior?

As noted above, guidelines are developed to increase quality of care, improveclinical outcomes, and enhance efficiency (i.e., reduce wasteful care and costs).Several points deserve mention here. The first is obvious, that guidelines will notachieve their goals unless they are in fact followed by the physicians. Whether ornot they are followed depends upon a host of factors, including how they areimplemented, whether there are penalties for ignoring the guidelines, whether theguidelines provide positive feedback in terms of the outcomes of their patients, andso on.Another point worth mentioning is that the guidelines may have unintended

effects. The attractiveness ofmedicine as a profession and, ultimately, the availablesupply of physicians is an example. Moreover, physician guidelines can haveimpacts beyond those on physicians alone. Hospitals, for example, may be affectedif physicians' decisions as to how to allocate hospital resources are changed.Hospitals may suffer financially if length of stay is dramatically reduced, forexample.6 Medical malpractice premiums and litigation may be affected (Brennan1991). Further, insurance premiums and even insurance coverage ofnon-physicianservices may be affected. The necessary personnel and other resources used inadministration of the guidelines may affect state and federal budgets. Thus, athorough evaluation of a guideline would involve a broad analysis, including theintended as well as the indirect effects.

3.1. Will Guidelines Be Adhered To?Whether guidelines are adhered to depends on a variety of factors, including the

degree of uncertainty associated with the guidelines; monetary, psychic, and othertypes of penalties from non-adherence; clinical reinforcement from one's own

5 Aexibility may be a "double-edged sword" in the case of guidelines. On the one hand,flexibility allows for heterogeneity across patients in their medical needs and personalpreferences and also allows for differences in the physicians' skills and comfort levels. On theother hand, too wide a range could negate the benefits of the directive; that is, if there is toowide of a band, then there will be little impact on behavior.

6 Precise financial impacts on the hospital will also depend on how the hospital is paid, e.g.,DRO type versus fee-for-service.


practice; and method of dissemination and implementation. All predictions ofoutcomes depend, obviously, upon whether or not the guidelines are followed.

3.1.1. Clinical Certainty ofGuidelinesOne may expect that physicians will adhere to practice guidelines in inverse

proportion to the degree of clinical and scientific uncertainty associated with them,holding everything else constant. Ifguidelines are based on inconclusive evidence,one might expect many physicians to deviate from them, particularly if theguidelines are substantially different from the standard practice. Physicians mayhave difficulty gauging the degree of scientific evidence and clarity associated withan individual guideline, however. Classifying guidelines by the certainty of thebacking scientific evidence could prove helpful in this regard. Some medicalpractice parameters have been implemented in this fashion. In particular, clinicalpractices for which there is broad consensus are termed standards of care, whilethose subject to the greatest uncertainty are called options. Practice parametersfalling between these two extremes are called guidelines.A related issue concerns how rigidly guidelines are defined. A guideline that

offers little flexibility might be easier to explain and easier to monitor. In addition,it might at first blush have an aura of greater certainty. However, such a strictguideline would not necessarily be suitable to the variety of circumstances facingphysicians and their patients. The narrower guideline could result in less adherence,depending again on how close the guideline is to standard practice.

3.1.2. Deviation ofGuidelinesfrom Standard PracticeIf the guideline differs radically from the standard practice pattern, then it may

be more difficult to encourage physicians to adopt the new practice pattern.Physicians would not, for example, have accumulated any experience using thenewer suggested pattern ofcare and thus could be more uncertain about the benefits.On the other hand, it may be easier to monitor a guideline that differs substantiallyfrom the standard; deviations would be more apparent.

3.1.3. Penalties from Non-AdherenceEven if guidelines remain subject to considerable uncertainty, physicians will

adhere to them in direct proportion to the perceived penalties associated withnon-adherence. Ifguidelines are used in evaluating the merits ofmedical malpractice claims, for example, physicians who deviate from them may risk considerablemalpractice exposure. In such an event, a guideline may serve as a signpost to thephysician for the type of defensive medicine he or she should engage in to limitmalpractice exposure. At present, the state ofMaine has passed legislation whichincorporates practice guidelines into malpractice litigation (Smith 1993).7 Such

7 Specifically, Maine implemented the Maine Medical Liability Demonstration project. Enactedin 1990, the project gives physicians some degree of malpractice liability protection if they


efforts may be expected to increase physician adherence to guidelines.In addition to any possible pecuniary effects, there will likely be psychic costs

of deviating from the guideline. The magnitude of such effects will vary acrossphysicians, but could also vary by the guidelines as well. For instance, ignoring aguideline that offers greater scientific backing would likely impose greater psychiccosts than ignoring one without such support.

3.1.4. The Importance ofProcessHow guidelines are implemented will play a critical role in whether they are

adhered to. Mittman, Tonesk, and Jacobsen (1992) have argued that guidelinedevelopment and dissemination alone will have little effect, since there remain avariety of barriers to guideline acceptance:

Lack of acceptance of guidelines may be due to factors such as physicianresistance or incomplete information concerning the need for guidelines.Guidelines are seen by some as a threat to physician autonomy and patientchoice or as an unnecessary and/or inappropriate substitute for clinicaljudgment. Other possible barriers to guideline use include custom and habit,malpractice concerns, constraints and barriers related to organizationalstructures and systems, and payment. (p. 413)

These researchers and others (i.e., Greer (1988); Lomas and (Haynes) 1988; Foxet al. (1989) ) argue that group norms and social influences among physicians playan important role in their willingness to follow practice guidelines. In this view,providing individual physicians with information and financial incentives alonewill be insufficient for effecting change: the group norms must be changed as well.Advocates of the so-called social influence approach advocate a variety of

strategies for achieving guideline adherence. These strategies vary according tothe size of the population being targeted. For example, academic detailing has beensuggested as a means for effecting change at the interpersonal level. This approachborrows from the drug detailing model, and involves one-on-one contact betweena detailer and a medical practitioner whose behavior has been targeted for change.The use of opinion leaders is recommended when larger audiences are involved.This approach relies on established, influential individuals or professional groupswho have the standing to change practice norms. A number of alternative approaches are available, including continuous quality improvement, study groups,and participatory guideline review. Although these approaches differ in detail (seeMittman, Tonesk, and Jacobsen (1992) for further discussion), they share thecommon feature of achieving group consensus about the appropriateness anddesirability of changing practice patterns to adhere to the guideline. These approaches help to avoid the difficult "first mover" problem which would occur when

adhere to clinical practice guidelines. Rather than granting complete immunity, the programessentially permits physicians who adhere to guidelines to apply a statue of limitations tonegligence cases. See Smith (1993) for further details.


individual physicians are confronted with a guideline which deviates from thesocial norm. Evidence suggests that use of opinion leaders in guideline implementation is more effective than other approaches such as mailing guideline informationto physicians in achieving adherence (Lomas et al. 1991).Thus, the degree to which physicians will change their behavior based on

guideline dissemination is highly dependent on the implementation tactics andpenalties for non-compliance. The voluntary guideline without penalty for nonadherence serves as education only. While some evidence suggests that suchinformational interventions can be successful in changing behavior if supported byopinion leaders, the likelihood of adherence is apt to increase with more explicitpenalties for non-adherence. Of course, the ultimate effect of non-adherence willdepend on the quality of the guidelines themselves. If the guidelines are "good"guidelines, better adherence would result in greater increases in quality. In contrast,ifguidelines are clinically "problematic," lack ofadherence would serve as a bufferagainst untoward events.

3.1.5. Conflicting Guidelines and IncentivesThere are at least two sources of potential conflict with a stipulated guideline.

First, given the multitude of groups developing guidelines, there is the possibilitythat two groups would have overlapping but inconsistent guidelines. As the studyby Audet, Greenfield, and Field (1990) indicates, some guideline-setting agenciestake cost control into account while others do not. Thus, while AHCPR (1993)indicates that cost conditions are important in the guideline process, a specialtysociety may develop a guideline which pays relatively less attention to cost controlissues, and relatively more to quality and revenue enhancement issues. Suchconflicts may prove confusing to the practitioner and undermine the impact ofguidelines.A conflict that seems even more likely to emerge is with respect to the reim

bursement system. The Resource Based Relative Value Scale (RBRVS) paymentsystem that is used to pay physicians for their Medicare patients, for example, mayhave greater incentives for cost-control than would the guidelines in general. (SeeRizzo and Sindelar (1993).) Thus there may be situations in which the incentivesfrom the RBRVS conflict with the objectives of the guideline.

4. Expected Effects

A primary motivation for the development and implementation of physicianpractice guidelines is to reduce inappropriate care and improve patient outcomes.While this goal of improved quality of care is explicit, some proponents ofguidelines cite a secondary goal of rationalizing the use of health care resources,i.e., controlling patient care costs through the elimination of "non-productive"medical treatments and services. Practice guidelines may also have implicationsfor the pace of technological innovation in medical treatment and for medicalmalpractice costs as well.


As noted earlier, how guidelines are implemented has important implicationsfor adherence. Not surprisingly, this also has important implications for their likelyeffects. We consider three types of implementation. Type 1 (the disseminationapproach) is the current situation: the vast majority of resources are spent inguideline development, with relatively little attention focused on implementation.Type 2 (the persuasion approach) is the case in which some resources are allocatedaway from guideline development towards guideline implementation using community opinion leaders. Finally, type 3 implementation (the regulatory approach)essentially regulates adherence. This could be achieved through implied penaltiesfrom non-adherence which could result in an environment where practice guidelines are widely used as standards of care in medical malpractice cases. Table 1summarizes the predicted effects of guidelines under the three implementationscenarios.

Table 1. Alternative Implementation Types and Outcomes of Concern forPractice Guidelines

A. Imolementation Tvoe Examole1. Dissemination distribution of information through professional groups2. Persuasion use of an opinion leader3. Regulation financial penalties to deviating from the prescribed

standardsB. Kev Outcomes Affected bv Guideline1. Quality2. Patient care cost3. Innovation4. Medical malnractice costsC. Other Outcomes Possiblv Affected bv GuidelinePhysician supplyUse of hospital and other medical careGovernment budaets used in auideline develooment

4.1. QualityWhile some degree of inappropriate care has been documented in the literature,

the magnitude of inappropriate care and the degree to which it is driven by physicianinformation deficiencies remain uncertain. Moreover, while some areas of medicine may be characterized by a fair degree of certainty, other areas challenge eventhe most expert practitioners and researchers to define the "right" way to care forthe clinical condition. In such cases, defining inappropriate and/or unnecessarycare is problematic.Given the wide medical practice variations that have been documented by

Wennberg and colleagues for many years (i.e., Wennberg (1987); Wennberg,Barnes, and Zubkoff (1982», it is clear that there is substantial uncertainty regarding the appropriate course of treatment in many clinical situations. This hasremained true despite the fact that guidelines have existed for many years.


Nevertheless, practice guidelines which reflect the best available professionalopinion and evidence should on average improve quality, provided they areimplemented effectively. The problem seems to be that guidelines have typicallynot been communicated to physicians in a manner that persuades significantnumbers of them to change their behaviors. It is typically the case that guidelinesare simply disseminated, and the onus left to the individual physician to review thisinformation. This approach has largely failed: survey evidence indicates thatpractice guidelines have had relatively little effect on clinical decision-making todate (Emmons and Chawla 1990).As noted earlier, however, proper attention to guideline implementation may

change medical practice substantially. The most successful approach appears tobe enlisting the aid of a community opinion leader- a physician or group ofphysicians who are well-respected by their peers-to discuss guidelines and makerecommendations regarding their usefulness.Under the present system of implementation (the dissemination approach), we

expect that guidelines will have fairly little effect on quality, since many physicianswill simply ignore them. If existing guidelines are marketed through opinionleaders (type 2 implementation), we would argue that quality of care will improve.To be sure, some opinion leaders will unwittingly urge their peers to adopt flawedguidelines. Others may be overbearing and even coercive. But it is difficult tobelieve that a concerted effort to persuade and educate community physicians aboutthe best available evidence on clinical care will on average not help, especially ifthe evidence in support of the guideline is good.The regulatory approach offers the possibility of stronger enforcement and thus

adherence. Thus, if the care suggested according to guidelines is on averagesuperior to existing treatment patterns, then the strong adherence afforded by theregulatory approach to guideline implementation would seem to induce betterquality. Below we discuss implications ofsuch stronger enforcement for adherence.

4.2. Patient Care CostsPatient costs may well decline with the implementation ofguidelines. Ofcourse,

some guidelines will produce greater cost savings than others. If there is muchwasteful or inappropriate care being provided, then a guideline that reduces thiswaste can retain quality while reducing costs.As noted above, defining wasteful inappropriate care is a daunting task. That

much effort is currently directed at further guideline development attests to thedifficulties inherent in that process. Nevertheless, there is good reason to believethat, properly developed and implemented, guidelines will reduce medical carecosts. First, the non-price competition in medical markets encourages excessivetreatment intensity. In the physician markets, having and using the latest diagnostic and therapeutic equipment helps attract and retain patients, price tends not to beas important. Second, given that the strong majority of United States citizens havehealth insurance, they are responsible for only a fraction of the cost of their care.This moral hazard phenomenon facilitates a pattern of overly intensive treatment.


Third, the threat of malpractice litigation has induced physicians to engage in avariety of behaviors designed to mitigate the incidence and severity ofmalpracticesuits, including prescribing more tests and treatments (Reynolds, Rizzo, andGonzalez 1987). Last but hardly least, available evidence on specific treatmentssuggests that overuse is a more common phenomenon than underuse (Brook andMcGlynn 1991).8Again, how the guidelines are implemented will affect costs. The regulatory

approach has perhaps the greatest potential to reduce costs, followed by thepersuasion method, and lastly followed by the pure information only method.

4.3. InnovationThe effect ofguidelines on innovation appear to be ambiguous. Innovations that

are demonstrably more effective and possibly more cost effective could have morerapid and widespread adoption because guideline research would provide firmevidence of this. On the other hand, guidelines may inhibit innovation by discouraging experimentation with innovative treatments. Moreover, new methods andmedicines may be choked off if guidelines are not updated or if there are delays inpublishing the scientific support evidence.Once again, how guidelines are implemented will play a crucial role in these

outcomes. With little attention to implementation and minimal penalties fordeviations from the guidelines, we again predict minimal effects. In contrast, boththe persuasive and the regulatory approach to implementation have the potential tosignificantly increase or importantly reduce innovations. The ideal would be toachieve the increases in quality and the reductions in cost potentially associatedwith the stronger forms of regulation and persuasion without losing the flexibilityrequired for experimentation and innovation to occur. However, given that manyhave decried excessive innovation in this industry, one might argue that measureswhich limit innovation are desirable. The problem with the stronger approaches,however, are that all changes-marginal variations as well as pathbreaking innovations-may be discouraged.

4.4. Medical Malpractice CostsBoth the persuasive and regulatory implementation approaches should lower

8 For example, Brook and McGlynn cite results form a variety of studies which indicate overuseranging from 7% to 75%, depending on service. Based on such evidence, Brook hasconcluded that:"our best guess is that one-quarter of the things we do to people- not only surgery but allmedical procedures- we could get rid ofwithout any impact on health" (as quoted in Henig1992).Others have questioned the extent of overuse. Stano (1994) argues, for example, that questionsabout the appropriateness of care have only been addressed for a relatively small number ofdiscretionary procedures. He concludes that levels of unnecessary care "are probably muchlower than commonly perceived" (p. 52).


medical malpractice costs. The regulatory approach will lower malpractice costsboth because suits will tend to be brought only in those instances where guidelineshave been ignored and because guidelines will expedite judicial inquiry into theappropriateness of care in tried cases. To the extent that the persuasive and theregulatory implementation increase the quality of care, they would also lower theincidence and severity of malpractice suits.Should guidelines be used in medical malpractice cases? Brennan (1991) makes

a strong argument in the affirmative:

One should not underestimate the importance of this function of practiceguidelines. Many judges and lawyers today are discouraged by the qualityof expert testimony on scientific issues (Weinstein 1989; Wessel 1988).They witness case after case in which the adversarial process producesdiametrically opposed opinions regarding medical or scientific issues. Neither side in litigation perceives any strategic value in moderating its testimony. The introduction of practice guidelines could lead to suchmoderation, as experts would have to reveal the relationship of their ownopinion to that of the prestigious guideline issuer. ... (p. 73)

Brennan's point is well taken. However, the difficult challenge remains to weighthe social benefits from rationalizing medical malpractice litigation against thepossibly larger social costs from regulating a particular pattern of care.

4.5. Satisfaction with the Medical ProfessionPhysician dissatisfaction with the medical profession is already a common

phenomenon. A nationally representative sample of young (under age 40) physicians revealed that fully 40 percent of them would not have become physicians hadthey to do it over again (Cohen, Cantor, Barker, and Hughes 1990). Interferencewith their clinical decision-making practices was a commonly cited reason fordissatisfaction. Uncertainty about appropriate treatment was another importantsource of anxiety for many physicians.Depending on the degree of intrusion on physician autonomy, the expectation

that medicine is practiced from a standard set of guidelines smacks of "cookbookmedicine" and may result in job dissatisfaction among certain subgroups ofphysicians. Within these subgroups, physicians might reduce the hours they devoteto medicine, retire early, or change professions. These considerations suggest thatthe regulatory approach to guideline implementation will make medicine lessattractive as a career, lowering physician supply. In contrast, there is little reasonto expect that the persuasive approach will have this effect.

5. Guidelines and the Optimal Allocation of Resources

The technical quality of the guidelines and the method of implementation are ofgreater importance as we are stressing in this paper. In addition, however, wesuggest that guideline selection and implementation be prioritized to maximizeexpected gains to society. Setting appropriate priorities requires foresight with

194 HEALTH CARE POLlCY AND REGULATION

respect to 1) guideline selection and 2) the allocation of resources between guideline development and implementation. We consider each in turn.

5.1. Guideline SelectionMuch discussion and effort has been directed at guideline development. Far less

attention has been paid to identifying appropriate guidelines for development.Ideally, one would want to first develop guidelines for which: 1) there is substantialuncertainty among practitioners regarding efficacy; 2) there is good reason tobelieve that careful development of guidelines can substantially reduce this uncertainty; 3) there is the expectation that guidelines can be developed in a reasonableperiod of time; 4) the information in the guidelines will not likely soon be out ofdate; 5) physicians can be persuaded by such guidelines; 6) there is a fairly largepotential gain, e.g., a common or important procedure; and 7) the expected benefitsoutweigh the expected costs of guideline development.In the real world, it will be impossible to achieve precise rankings for all or even

most potential guidelines according to these criteria. We do not recommend suchan extreme and onerous effort. What we are suggesting is that there are substantialbenefits to be had from thinking systematically and openly about procedures forselecting guidelines for development. For instance, great gains in quality and costsavings may be achieved if the guideline provides new information about the besttreatment pattern; that is, if the guideline differs in some important way from thecurrent standard of care. Benefits could also occur in cases where there is considerable variation in treatment patterns, perhaps indicating that some physicians werenot following the best clinical strategy.How do guideline-setting institutions select guidelines for development?

AHCPR selects candidate topics based on the:• Potential for reducing clinically significant variations in preventing, diagnosing, treating, and managing the clinical conditions or in related patientoutcomes.

• Number of individuals affected by the clinical condition.• Adequacy of the scientific evidence on which to develop a guideline.• Amenability of a particular condition to prevention.• Specific needs of the Medicare and Medicaid populations.• Cost of the condition to all payers, including patients (Agency for HealthCare Policy and Research 1993).

Candidate topics for guideline development are then placed in the Federal Registery on an annual basis, and comments are invited.Insurance companies also can have their own methods for developing priorities

(Bailit et aI., 1994). However even though some developers of guidelines have setup methods to prioritize, we suggest that there are substantial to be gained in thisarea.9,l0

5.2. Guideline DevelopmentGuideline development has received much more attention than guideline imple-

MEDICAL PRACfICE GUIDELINES 195

mentation. TheAgency for Health Care Policy and Research, the flagship guidelineinstitution in the United States, directs the vast majority of its funds for practiceguidelines to development instead of implementation. Nonetheless, we feel thatthe development process itself could be improved.Roughly one-third of the Agency's budget is spent on outcomes research, which

is intended to improve guidelines. Some observers are beginning to question thewisdom ofthis approach:

After spending nearly $200 million on outcomes research...AHCPR cannotpoint to a single case in which its database studies have changed clinicalpractice. Just this month, its most definitive result- that "watchful waiting"is often a better option than surgery for benign prostate disease- was issuedas a guideline to physicians. Even then, the researchers recommend aclinical trial to confirm their findings. (Anderson 1994, 1080).

One of the problems is that guideline development can take a very long time andmay in fact be out of date soon after release. Also, given the time and expenseinvolved, guidelines can address only a small portion of all clinical decisions to bemade. Further, the guidelines do not typically give direction for the vast amountof heterogeneity involved with patient/physician pairs. Given these limitations toguidelines, we suggest that there should be some innovations in guideline development. For example, there could be a constant flow of information that summarizes, on a timely basis, what is currently known about a large variety of clinicaldecisions (in this case it would not be possible to have regulation as the method ofimplementation). This might be similar to the methods that physicians currentlyuse such as attending conferences, participating in continuing education, andreading professional journals, but would be more formalized and attempt to reacha larger audience. Alternatively, the government might create a competitivebidding arrangement for the development of new standards or offer financialrewards contingent upon the savings due to new standards that improved care at alower costs. II Other innovations in the proccess itself could be productive.

5.3. Guideline ImplementationWhether or not guidelines will succeed in their aims also depends on how they

are implemented. As Audet, Greenfield, and Field (1990) note, implementationapproaches vary:

9 As Chassin (1988) notes, guideline setting institutions typically select guidelines fordevelopment "without specifying any principle or process of selection" (p. 441).

10 Of course, certain organizations may have a natural interest and comparative advantage indeveloping particular guidelines. The American College of Cardiology, for example, will quitenaturally focus on cardiac management. But even within this more narrowly defined realm,there are important gains to prioritizing guideline selection.

II We thank Mark Schlesinger for some of these ideas on innovations in the process ofdeveloping guidelines.


organizations such as Value Health Sciences, Harvard Community HealthPlan, and MetroHealth have specific methods (computer software, specialtraining programs, and monitoring systems) for promoting and implementing the use of guidelines to fit specific organizational settings. In contrast,the efforts of the American College of Cardiology, The American Collegeof Physicians, and the American Medical Association are largely limited todissemination and these organizations have not had specific implementationstrategies for their guidelines. (p. 712)

In order to change physician's behavior for the better, physicians must find theguidelines understandable. This, in turn, requires that considerable effort andresources be directed at implementation issues.In a classic article on the management of essential hypertension, Stason and

Weinstein (1977) investigated the relative merits of screening more patients forhypertension versus achieving greater patient compliance with antihypertensivedrug therapy. The results of that study suggested that greater attention to compliance issues, and less attention to screening more people, would increase lives savedwithout affecting aggregate costs. In other words, reallocating resources towardcompliance and away from screening could improve the cost effectiveness of themanagement of hypertension.The StasonIWeinstein analysis highlights an important lesson for proponents of

practice guidelines. Given that funds available for guideline development andimplementation are scarce, careful attention needs to be paid to how those fundsare allocated toward developing new guidelines, which may take years to developjust a handful, and implementing existing guidelines, which could be implementedquickly and cover a wide number of clinical situations.The present allocation of resources seems far too heavily skewed toward

guideline development. We need to rethink this distribution of scarce resources.A recent study by Bailit, Federico, and McGivney (1994) echoes this notion. Indescribing guideline development and implementation issues from the perspectiveof a large managed care organization (MeO), the authors note that:

...at this point in time the major challenge facing more mature MCOs is notthe development of medical policies based on outcomes research. Rather,it is the operational difficulty of obtaining compliance with these policiesby plan medical staff and network physicians (p. 16).

Among existing guidelines, how many reliable guidelines could have beenimplemented, using opinion leaders or other approaches, to improve the quality ofcare and lower costs? What is the optimal allocation of resources between newguideline development and guideline implementation? While there are no easyanswers to these questions, it is important that we start asking them. Failure to doso may lead us, as a society, to spend many millions ofdollars to develop guidelineswhich have little effect on clinical behavior.Given that funds available for guideline initiatives are scarce, careful attention

needs to be paid to how those funds are allocated toward guideline selection,development, and implementation. It can take years to develop a guideline; thus,


careful attention to the choice of which guidelines to initiate is important. Similarly, choices have to be made whether to implement existing guidelines, whichcould occur quickly, or to develop new guidelines.

5.4. Lost OpportunitiesFinally, it is important to stress that practice guidelines, as currently conceived,

address only physician behaviors. Thus, there may be lost opportunities in thefailure to redirect non-physician inputs into the production of medical care andhealth. For example, guidelines typically do not address the potential for substitution of nurses or physician assistants (PAs) for doctors when it may increase bothclinical effectiveness and cost-effectiveness. Similarly, unlike the payment incentive ofRBRVS, the guidelines do not try to influence the use of less costly internalmedicine physicians when clinically appropriate instead of using specialists.Guidelines for the substitution of less costly types of health care providers for

appropriate tasks is thus another means for improving allocation of scarce healthcare resources without compromising quality. Indeed, this may free physicianservices for reallocation to areas where they will yield greater benefit to society.

Acknowledgements

Prepared for presentation at the Health Care Policy and Regulation Workshop atRutgers University on April 22, 1994. We would like to thank Elizabeth Bradley,Mark Schlesinger, W. Robert Simons, and Kathy Weiss for helpful comments andsuggestions.

References

Agency for Health Care Policy and Research. 1993. AHCPR-Supported Clinical PracticeGuidelines. Rockville, MD: US Pubic Health Service.

Anderson, C. 1994. "Measuring What Works in Health Care." Science 263: 1080-1082.Audet, A.M., S. Greenfield, and M. Field. 1990. "Medical Practice Guidelines: CurrentActivities and Future Directions." Annals ofInternal Mediciney 113: 709-714.

Bailit, H., 1. Federico, and W. McGivney. 1994. "Use of Outcomes Studies by a ManagedCare Organization: Valuing Measured Treatment Effects." Paper presented at the conference titled: Measuring the Effect of Medical Treatment," sponsored by the Agencyfor Health Care Policy and Research, April 21-22, 1994, Minneapolis, MN.

Brennan, T.A. 1991. "Practice Guidelines and Malpractice Litigation: Collision or Cohesion? Journal ofHealth Politics, Policy and ww 16:67-66.

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MEDICAL PRACfICE GUIDELINES 199

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COMMENTS

Kathleen A. Weis

The paper, "Medical Practice Guidelines and the Efficient Allocation of Resources," by Rizzo and Sindelar is thoughtful and relatively complete. I would liketo suggest some "changes in perspective," and mention a few issues that wereperhaps overlooked. The introduction to the paper states that the priority for thedevelopment of guidelines should be focused on topics that provide the "greatestgains to society in terms of better resource allocation." I do not disagree with theend result-better resource allocation that should be derived from cost-effectiveness, cost-benefit, or cost-utility analyses and other important factors (e.g., trade-offbetween cost of providing health care and the main purpose of health care whichis to improve the health of people) required to make well considered and informedallocation decisions. I suggest a different statement of the means to that end.Ofequal importance to choosing guideline topics that provide the greatest gains

to society in terms ofresource allocation is the issue of providing better quality carewith the resources used. Clinical practice guidelines that are developed throughsupport from the Agency for Health Care Policy and Research (AHCPR) aretargeted at conditions in which some uncertainty exists as to the optimal clinicaltreatments, and this uncertainty leads to considerable variability in the type andnumber of services/treatments provided with and without any concomitant differences in patient outcomes. Identifying and recommending care that is consideredeffective (i.e., produces some positive clinical benefit given the clinical risks andharms) increases the quality of care, may decrease the cost of care, and leads tobetter use of resources.An effect of improving the quality of care may be to lower the overall costs of

care. However, the care recommended by a single guideline may not decrease thedirect costs of care for the clinical condition if newer, more expensive technologyis recommended. Additionally, if more preventive care is recommended in theguideline, direct health care costs are increased and shifted to the out-of-pocketexpenses of those whose insurance does not cover preventive care. However, inthe aggregate, the cost ofguideline-based care is expected to be lower because carethat has not been proven to be beneficial is not recommended. In most of theguidelines published to date, the care recommended in the guideline is less thanthat currently being provided, because certain services are not recommended or theprovision of some services is recommended on a less frequent basis.


With respect to "Who sets guidelines," AHCPR is not a regulator~ agency.AHCPR supports the development of clinical practice guidelines. It can not anddoes not require their use by clinicians.In response to the section on how guidelines are developed, their effect on

physician behavior, physician adherence to them, and the clinical certainty ofguidelines, it is suggested the authors consider the following with respect tophysician behavior. Guideline recommended care that is based on science is moreacceptable to physicians, and a number of physicians reviewing clinical guidelineshave indicated they want scientific proof that a treatment is safe and that it providessome positive clinical benefit before they would consider its use. The informationon treatment benefit generally has been derived from the results of clinical trials.However, if one makes the distinction between efficacy and effectiveness, whereinefficacy is defined as that which does more good than harm among those whoreceive it, and effectiveness is that which does more good than harm in those towhom it is offered, the "gold standard" of the clinical trial result may not beappropriate for everyday practice decisions. The distinction between the two terms(efficacy and effectiveness) is related to the selection of the individuals to whomthe treatment is provided and the conditions under which it is provided.There are not enough clinical trials to cover all the treatments currently used, the

cost of clinical trials is very high, and the time to conduct a trial is long. Theseaspects of clinical trials, along with others mentioned in the literature on theproblems of generalizing the results of the clinical trials, do not support requiringclinical trials for all treatments prior to their widespread use in general practice.There are certain treatments that have an obvious clinical benefit and have beenwidely accepted without a clinical trial (e.g., immunizations).Physicians tend to require a more stringent process by which guideline panels

arrive at their decisions on recommended treatments than the process by which theyreview the literature and base their individual practice decisions. By this I meanthat physicians expect the guideline panel to evaluate all the available literature ona topic, grade or weight the information in some objective, scientific fashion, andbase the recommendations for care on this explicit process. In actual practicesituations, physicians do not have the time to review and weight the complete,published literature in an area prior to their deciding which treatment(s) to provide.Regardless of whether they agree with the guideline recommendations, panel

work can benefit all clinicians through the review and organization of all availableinformation and identification of inefficacious and ineffective treatments, andtreatments that have no indication of any proven benefit. These non beneficialtreatments can be discouraged, and those that have some proven clinical benefitcan be identified.Given the use ofa stated process ofguideline development, physician opposition

to guidelines may not be related to the care recommended. The opposition reallyis to who developed the guideline, what the physician interprets as the "under lying"purpose of the guideline (i.e., whether the guideline is developed to improve qualityof care or to contain costs), and physician input into the process. A very important

COMMENTS 202

issue related to guideline acceptance and use is whether the recommended treatments are used as guidelines or imposed by regulation as practice parameters.The issue raised by the authors of individuals not wanting to go into medicine

because of the use of practice guidelines is puzzling to me. Physicians havepracticed by some form ofclinical guidelines since the beginning of the practice ofmedicine. AHCPR-supported guidelines are developed for conditions in whichthere is considerable uncertainty of care. Physicians have stopped practice becauseof the uncertainty of clinical practice and the outcome of care. As an example, anumber of family practice physicians do not provide obstetric care because of thepotential for unexpected poor outcomes and the malpractice suits that result. Ifguidelines help to indicate appropriate care and practice corresponds to this, therewould be less risk of a malpractice suit. The result would be a net benefit from asocietal perspective as coverage for obstetrical care would be increased, andmalpractice insurance should be decreased, thus decreasing the cost of care to thepatient.Dr. Rizzo et. al. indicate that hospitals may suffer financially if length of stay is

decreased as a result of guideline-based practice. The hospital should provideneeded services. If fewer days are required to provide the proper care, this shouldbe acceptable practice for hospital administrators. The potential loss of hospitalincome because of shortened length of stay should be managed by decreasing bedcapacity and by other strategies, rather than by pressing physicians to keep patientsin the hospital longer. Additionally, the financial cost to the hospital may be offset by the increased benefit to the patient from early discharge and return to work.A societal perspective would be a more appropriate perspective to determine thecost effectiveness or cost-benefit of guideline-based care, not the perspective of theprovider (e.g., hospital) as suggested by the authors.With respect to evaluation and dissemination of the guidelines, AHCPR is

presently investigating the most effective means to disseminate the information sothat it will have a positive effect on clinician behavior. The guidelines are publishedin two versions: a clinician version and a consumer version. Technical appendicesare available for researchers, educators, and others interested in the detail. Not onlyshould physician behavior be the target of change, but also the patients' behavior.Additional studies are needed to determine how to reduce the effect of the moralhazard created by extensive insurance coverage and whether or not more-informedconsumers can change the behavior of their personal physicians by requesting carebe provided that is similar to that recommended in the guideline.The issue raised by the authors about the guidelines' deviating from standard

practice is interesting. As previously indicated, guidelines generally are developedfor conditions that have a wide range of "standard care." It has been my experiencein working with guideline panels that when they are presented with the array ofservices and treatments that are presently being provided to patients, the cliniciansare overwhelmed at the number and types of treatments being used. This raises thequestion of what is really considered "standard practice."


In conclusion, I agree with most of the issues and the discussion in the paper. Iwould add that evaluating the impact and effect of the guideline from a societalperspective is the most appropriate to determine the net benefit or cost of guideline-based care. This perspective encompasses all costs and benefits and providesthe information necessary for informed resource appropriation and allocationdecisions.However, having said this, I must also state that an economic evaluation from

the societal perspective is very difficult and involves the use of scarce resources.The expense in time and money to collect data on indirect costs of care, directnon-medical costs, and intangible costs is considerable. Consideration must begiven to the trade-off of the cost to collect the data that provides the most usefulinformation and the cost of not having better information on which to base adecision.

Acknowledgements

This article was produced in the federal domain under the auspices of the Agencyfor Health Care Policy and Research, Department of Health and Human Services.The views expressed are the author's. This is a U.S. Government work. There areno restrictions on its use.

11CONTENDING VIEWS OF QUALITYMANAGEMENT IN HEALTH CARE:

Implications for Competition and Regulation

David BlumenthalRichard Bohmer

"I have a few bad apples [among the physicians in our organization]. AndI know who they are. But for quality improvement to work, you have toconstruct a 'safe' environment where doctors trust you. Any time you starttaking names, you're going to start a cycle of fear, and quality improvementwill not work."

Dr. Brent James, Direct ofQuality Improvement,Intermountain Health Care, Salt Lake City, Utah,

speaking before a congressional committee(New York Times, March 31, 1994).

"As those words come out of [Dr. James' mouth] ... that's a terribleindictment of them and of the practice of medicine that they are willing tosacrifice patients to unnecessary mortality, morbidity, injury and pain bythese doctors. It's unconscionable!"

David E. Robinson, Chairman of the Utah State Medical Board,commenting on Dr. James' remarks(New York Times, March 31,1994).

Encapsulated in this exchange is a conflict of perspectives that has profoundimplications for the future of American medicine. This conflict has received verylittle attention in the media (indeed, the article quoted above may be the first andonly treatment of the topic in a major newspaper) or in health care reformlegislation, but observers should not be deceived. Underlying the views of Dr.James on the one hand and Mr. Robinson on the other are fundamentally differenttheories concerning human motivation, organizational behavior, and the role ofregulation in society generally, and the medical sector in particular. Adherents tothese theories are currently contending for the hearts and minds of public policymakers and private sector managers. The outcome of this debate could signifi-


cantly influence howquality ofcare is promoted in the future and the role ofmarketsin the health care system.

1. Contending Views ofQuality Management in Health Care

1.1. Total Quality Management: History and PrinciplesDr. Brent James is a pioneering advocate and practitioner of applying the

concepts and methods of Total Quality Management (TQM) to health care. TQMhas apparently produced remarkable benefits for Japanese and American industryoutside of the health care sector (Ishikawa 1985; Juran 1989;Walton 1986; Deming1986; Feigenbaum 1991; Wadsworth, Stephens, and Godfrey 1986).In Japan, companies that excel in applying the techniques of Total Quality

Management are eligible to receive one of that country's most prestigious awards,the Deming Prize, named for Dr. W. Edwards Deming, an American physicist andstatistician who taught TQM to many Japanese managers after the Second WorldWar (Ishikawa 1985). In the United States, the Malcolm Baldridge award isconferred by the U.S. Department of Commerce for comparable achievement inTotal Quality Management. Some United States companies that have achievedmajor gains in market share and profitability by utilizing the concepts of TQMinclude Motorola, Xerox, the Ford Motor Company, Alcoa Aluminum, and 3M.American industries became interested in these new approaches to quality

management in the early 19808 after the broadcast of an NBC documentary thatattributed much of the success of Japanese industry in international competition toits use ofTQM (Walton 1986). However, it was not until the late 1980s that a verysmall number of health care managers became interested in and began experimenting with the techniques of Total Quality Management (Berwick 1989; Laffel andBlumenthal 1989; Berwick 1991). The use ofTQM in health care received a majorboost when the Joint Commission for the Accreditation of Healthcare Organizations (JCAHO), which is the principal accreditor of hospitals and health plans inthe United States, embraced this approach to quality management and made its usea requirement for passing the triennial reviews conducted by JCAHO (O'Leary1992). Since JCAHO accreditation is a necessary condition for Medicare reimbursement in most states, this change in JCAHO policy got the instant attention ofhealth care managers around the United States. Not surprisingly, by 1992,3100non-federal hospitals around the country were responding in surveys that they hadTQM programs (Grayson 1992).

What is Total Quality Management? A full elaboration of the theory andpractice of TQM is far beyond the scope of this paper, and the reader is referred tothe many texts devoted to this topic. However, a few salient points are essential toreview if the controversy over health care quality is to be fully understood,particularly as it relates to the role of regulation and markets in the health caresystem.

CONTENDING VIEWS OF QUALITY MANAGEMENT IN HEALTH CARE 207

At the core ofTQM is an unwavering commitment to the scientific method as away of improving processes ofproduction and service in large organizations. Froman evolutionary standpoint, it is notable that many of the techniques ofTotal QualityManagement were developed by statistici~ns working either in the laboratories ofWestern Electric and American Telephone and Telegraph prior to World War II,or in the proving grounds and laboratories of the United States military during theWar (Wadsworth, Stephens, and Godfrey 1986). The founders of TQM mademajor advances simultaneously in statistical theory and in the application of thattheory to everyday work. The understanding ofvariation in processes ofproductionand service receives particularly heavy treatment in treatises on TQM. The methods developed to capture and analyze variation-sampling techniques, Shewhart'scontrol chart, boxplots and other tools ofexploratory data analysis, simple methodsfor conducting experiments in everyday work-{;ontinue to be used daily to controland improve quality in industrial plants around the world. Perhaps the mostbrilliant contribution of the intellectual fathers of TQM was not their advances instatistical methods, but their development of user-friendly technologies for applying quantitative methods to daily work. These technologies were accessible andunderstandable to workers with minimal education and provided the tools theyneeded to take intelligent control of the processes of production in which they werepersonally involved. Thus, it can be argued that the applied technologies ofTQMwere the foundation upon which modern approaches to worker empowerment arebased. TQM made possible a revolution in the organization and management ofproductive units in modem society-a revolution whose depths are just now beingexplored, and which, we might add, have just begun to make its way into healthcare.However, a funny thing happened on the way to this revolution. As Shewhart,

Juran, Deming, and others sought to spread their newly developed statistical toolsin post-war America, they couldn't find any American producers who wereinterested in these new methods (Wadsworth, Stephens, and Godfrey 1986;Walton1986). Indeed, they couldn't find anyone interested in improving the quality oftheir products. American industry completely dominated world commerce in theWar's aftermath and was selling as much as it could produce without attending toquality or price.

In contrast, chance encounters by Deming and Juran with Japanese industrialleaders in post-war Japan revealed these businessmen to be hungry for knowledgeabout how to improve quality in their plants. The result was an historic alliancebetween American theorists of quality and Japanese industrialists that completelytransformed international markets and, in the process, markedly affected theoriesof quality management as well.

In particular, practical experiences with introducing quality management toJapan and the United States convinced quality theorists of the critical importanceof the "soft" sciences in putting the hard sciences to work for quality improvement.These soft sciences included theories of leadership, organizational behavior, learning, human motivation, interpersonal relationships, and group dynamics. Deming,


Juran, Crosby, and others found, for example, that unless organizational leadersembraced quality as a goal and committed their personal time and resources to itsachievement, attempts to apply scientific tools of quality improvement rarelysucceeded. Thus, Deming's continuing emphasis on "constancy of purpose"among organizational leadership. As Feigenbaum (1991) says: "Quality is, in itsessence, a way of managing."Furthermore, TQM advocates discovered that organizational culture and incen

tive systems could make or break efforts to use scientific methods effectively. Ifworkers were fearful that they would be blamed for bad performance, then theywould invariably conceal defects and problems and distort the data that wasanalyzed by their superiors. No matter how valid the scientific methods, organizations were powerless to improve quality without good data. This observation ledto Deming's fanatic emphasis on "driving out fear" among employees (Deming1986). It is this sentiment that is reflected in Dr. James' quote. Furthermore, theJapanese experience and their observations of American firms also lead qualitytheorists to conclude that teamwork was central to improving quality in complicatedmodern industrial organizations, and that traditional incentive systems withinAmerican companies-bonuses and raises linked to individual performanceoften encouraged workers to promote themselves to the disadvantage ofcoworkersand teams. TQM theorists came additionally to believe-and this view is centralthat processes of work, not individual performance, explained most of the variancein quality and productivity between and within organizations. Thus, systems ofquality improvement that depended on purging poor performers-the "bad apples"-were ineffective. Worse, such approaches were counterproductive becausealmost all workers viewed themselves as potential bad apples ("there but for thegrace of God go f'), and the result of public organizational executions was that allworkers retreated into a kind of sullen, defensive passivity that undermined effortsto drive out fear and to promote openness, honesty, and collaboration in problemsolving.A final facet ofmodern quality theory is its emphasis on planning and managing

for the long-term, and its deemphasis on short-term economic calculations inguiding organizational decision-making. Observers of Japanese quality management came to the conclusion, for example, that the ingrained American practice ofbuying supplies from the lowest price bidder was destructive to quality improvement, and ultimately raised the costs of manufacture by promoting variation ininputs, thus leading to rework and waste. TQM theorists instead advocatedlong-term relationships between suppliers and producers in which both partiesworked together to promote compatibility in their processes of work, thus optimizing the fit between different stages of process of production. In effect, TQMadvocates the creation of interorganizational and even industry-wide systems ofrelationships that seem on the surface rather different from the prescriptions ofmarket theorists.The theory and practice ofTQM, therefore, has followed a fascinating develop

mental path that has tended to obscure its origins in scientific, data-based ap-


proaches to improving quality and productivity in modern organizations. At thecenter of TQM lies an enormously powerful applied technology for bringingscientific methods to bear on enhancing daily work. Over time, that core set oftechnologies has come to be bolstered and encrusted with a variety of theories andinsights that may be fundamental to the success of TQM, but sound hopelesslynaive, impractical, and even self-righteous to some observers. These theories havean ideological and even quasi-religious tone. They emphasize the need for wise,selfless leadership; for non-economic incentive systems that rely on organizationalpride and the fundamental goodness of workers; for trust and openness withinorganizations; for putting the welfare of the group ahead of the individual; forpassing up short-term profits for long-term success; and so on. It should come asno surprise that many hardened, hard-nosed, individualistic American managersand policy-makers have reacted with skepticism to these tenets.

TQM and Markets. Though we claim no basis as neo-classical economists,we cannot resist, given the focus of this volume, spending a moment on theimplications of TQM for theories of market functioning. The statisticians andengineers who developed TQM started out by thinking about how to improve theability of economic entities to compete in market economies and ended up bychallenging-at least superficially-some of the assumptions that underlie neoclassical economics.TQM assumes and embraces the existence of market economies, and the

resulting need to compete in order to survive. Indeed, TQM consultants sometimestalk of the need for a "brush with death" to motivate organizational leaders to makethe enormous changes required for TQM to work within their companies. Thus,Deming (1986) comments in his classic work, Out o/the Crisis: "Who will survive?Companies that adopt constancy of purpose for quality, productivity and service .. . have a chance to survive... Charles Darwin's law of survival of the fittest, andthus the unfit do not survive, holds in free enterprise ... It is a cruel law, unrelenting"(p. 155). However, some of the assumptions about human nature and the prescriptions for behavior that are embodied in modern quality theory do not seem whollyconsistent with market economics, at least in its more radical forms.For example, TQM theorists do not see workers as primarily motivated by a

desire to maximize their personal economic welfare. Nor do they think firms areor should be driven primarily by the motive to maximize profits. Long-termsurvival-protecting the jobs of workers-is often advocated as the preferredobjective. ''The result [of adopting new quality methods]," says Deming (1986, 2),"is a chain reaction-lower costs, better competitive position, happier people onthe job, jobs and more jobs."Indeed, when they do focus on economics, leading scholars ofTQM often sound

more like economic nationalists than free marketeers: advocating the reformationof industrial management practices so that the United States (or Japan, as the casemay be) can compete against its international rivals. In pursuitof this goal, Demingand others advocate alliances between customers and suppliers, greater cooperation


within and between industries, a relaxing of antitrust regulation (Deming 1986), anend to the leveraged buyouts of the late 1980s, and the moderation of otherfree-market practices and policies. TQM may be seen, therefore, as a response tothe demands of markets, as assuming the continued existence of the competitivepressures that markets create, but as advocating the transformation of competitiveeconomies to make them softer, gentler, more protective ofworkers (and in a senseless "competitive"), and better harnessed to national interests.

1.2. Traditional Approaches to Quality in Health CareCurrent interest in applying TQM to health care has arisen in part because of

frustration with our existing health care system, including traditional approachesto managing quality of care (Palmer and Adams 1993). However, it would be amistake to underestimate the influence or persistence of these traditional methods,which are grounded in theories that are just as powerful, if not as functional, asthose underlying TQM.Palmer and Adams (1993) have described two traditional approaches to manag

ing quality in health care: the professional and bureaucratic. Each is grounded inan elaborate conceptual model of how the health care system functions, bothdescriptively and normatively.The professional model, which is perhaps most relevant to our discussion here

today, has been well-described by sociologists, including Freidson (1970) and Starr(1982). According to this model, the primary guarantee of quality in health care isthe "personal responsibility and integrity of each physician," reinforced by acollegial commitment to the regulation of professional peers (Palmer and Adams1993). The central role assigned physicians in quality management is a recognitionof their privileged place in society. Physicians' unique knowledge of the scienceand art of medicine makes it extremely difficult for non-professionals to regulatephysicians' work or to judge its quality. They are, therefore, granted considerableautonomy, both legal and practical. In economic terms, they enjoy monopolycontrol over the means of health care production, a monopoly protected by licensingstatutes that are, in turn, largely administered by the profession itself. In return forthis autonomy, and the economic benefits it confers, they are expected to supervisetheir own work and that of their peers, to maintain their professional competence,and to observe certain ethical standards (Starr 1982).An interesting aspect of the professional model is its personalization of the

responsibility for assuring quality in health care. Professional autonomy meansthat each individual physician must ultimately be responsible for the outputs oftheelements of the system over which he or she has control. Each physician, in a sense,lives and works under the conditions of a social contract, in which he or she enjoyspower and privilege so long as he/she acts with integrity and responsibility.Consistent with this model of quality assurance, traditional approaches to qualitymanagement have relied on setting standards for physician licensure and credentialing and on detection of substandard physician performance, through monitoringand investigation of adverse events.


The professional model of quality assurance reflects what one might call the"black bag" model of medical practice. It arose at a time when medicine wasinfinitely simpler (and less effective) than it is today: a time when that creature ofmyth and reverence, the family physician, did, indeed, have command over mostof the critical processes in health care delivery and could contain all the crucialinputs in his or her head and a little black satchel. The power of this model ofpractice in the public mind and discourse is remarkable, perhaps because itresonates with a deep human desire for a benign, trusted caretaker during times ofgreat personal need (Blumenthal 1994). In the contemporary debate on health carereform, with all its economic and technical complexity, the public's desire for a"family physician" seems undiminished. That notion has reappeared in modernparlance under the economically correct term of "primary care gatekeeper:" thephysician who is supposed to stand at the portals of the medical care system, todecide who shall enter and who shall be barred, to direct the traffic inside the system,and thereby simultaneously to improve the quality and reduce the cost of medicalservices (Franks, Nutting, and Clancy 1992).Of course, there is another side to the professional model of medical practice,

and its corresponding approach to quality assurance. Americans have never beenfully comfortable with power and privilege, and especially with power and privilegethat is protected by the state. Along with the reverence for the old-style familypractitioner, the public seems to have harbored an abiding suspicion and distrust ofphysicians. Americans seem to fear that, human nature being what it is, physiciansas individuals are bound to fall prey to laziness, indifference, incompetence, andgreed, and that as a group, physicians' professionalism will always tend towardcronyism.Historically, the profession has certainly contributed in certain respects to these

suspicions. It has acted collusively at the local level to suppress economic competition from alternative health care organizations (Harris 1969), often citing theprotection of professionalism as the rationale. The profession has, for example,used state-level prohibitions against the corporate practice of medicine to fightestablishment of health maintenance organizations and has been successfullyprosecuted for restraint of trade in such cases (Starr 1982). In 1943, the AmericanMedical Association (AMA) was convicted of violating the Sherman Antitrust Actfor its efforts to squelch the creation of the Group Health Association ofWashington, D.C., one of the earliest HMOs. The AMA's 75-year history of opposition touniversal health insurance, and its vicious fight against Medicare legislation, isoften portrayed as a form of anti-social behavior that has had the purpose ofprotecting the profession's economic autonomy at the expense of the health andwell-being of the general public (Harris 1969). More recently, the increasingcommercialization ofmedicine and the participation of physicians in the ownershipof health care organizations has added to the perception that the medical professionis motivated as much by greed as altruism and must be held accountable in new andmore effective ways for its actions (Gray 1991).


However, perhaps the most unsettling evidence of the fallibility of medicalprofessionals, and the potential problems inherent in leaving quality assurance tothe professionals, has been the revelation by Wennberg and others of wide variations in practice patterns among physicians (Wennberg and Gittelsohn 1982).Lacking any apparent scientific justification, such variations have created wholesale doubts about the scientific basis ofmedical practice and the claims to superiorcompetence upon which the professional model of quality assurance is based.These contradictory elements underlying the professional model ofmedicine

the deep, abiding wish for a trusted, wise personal caretaker, and the equally deepdistrust of and disappointment with the medical professional-exert a powerful, iflittle discussed, effect on current approaches to quality management in medicineand health care reform generally. On the one hand, they make the public veryreceptive to appeals by medical professionals to be left alone to practice medicineas they see fit, and they reinforce Americans' desire to retain free choice ofphysician as a guarantee of quality. This right to choose a doctor is at the center ofcurrent debates about the structure of health care reform proposals. After all, ifquality is a function of individual competence and integrity, what better way toassure quality than having the right to choose the best? The intuitive appeal of thisapproach to quality management has lead the Clinton administration to promisethat the right to choose a physician will be protected under the Administration'sreform proposal, though debate continues over how meaningful that guaranteeactually is under provisions of the Health Security Act.On the other hand, the persistent influence of the professional model also makes

the public-and its appointed and self-appointed representatives in government andthe press-very receptive to what TQM theorists would call the "bad apple"approach to quality management. See, for example, an article appearing in theNewYork Times less than two weeks ago, which carried an across-the-page headlineproclaiming: "Medical Incompetence: A Whispered Factor in Rising Costs" (Verhovek 1994). The idea here is that the quality of care-and perhaps the success ofhealth care reform~ependson identifying and protecting the consumer from theincompetent or unethical physician, who should then be held accountable for hisor her mistakes, subjected to intensive reeducation, or driven out of practicealtogether. The concept that holding physicians personally responsible and accountable for their actions is a good way to manage quality has justified a series ofregulatory and quasi-regulatory approaches to quality improvement. One of theseis malpractice litigation. Another is Medicare's programs of quality supervision:the Professional Standard Review Organization (PSRO), now called the Professional Review Organization (PRO). The disciplinary authority of boards of licensure has a similar justification. And finally, both the private and the public sectorincreasingly rely on the direct monitoring of physicians' decisions to regulate thequality of care. An entire industry has arisen whose chief purpose is to holdprofessionals accountable through the application of practice guidelines for thequality of the medical decisions they make. Interestingly, this industry itself islargely unaccountable and unregulated (Gray 1991).

CONTENDING VIEWS OFQUALITY MANAGEMENT IN HEALTH CARE 213

It should be noted that a similar approach to quality management is oftenembraced by the profession itself, which finds certain aspects of the professionalmodel-notably, its suggestion that physicians should left alone to improve themselves-very congenial. The classic approach to traditional quality assurance usedby medical professionals-the retrospective review of bad outcomes and problematic cases through "morbidity and mortality" conferences or "tissue committees"focuses almost exclusively on the decision-making of the individual physician, thusperpetuating the black bag theory of quality improvement. Traditional qualityassurance failed to take into account the fact that physicians practice within a widerhealth care system and failed to encourage physicians to take the initiative inimproving systems of care.In the health care reform debate, the distrust ofprofessionals has had a very clear

effect on the Clinton Administration's Health Security Act. Title V of the HealthSecurity Act contains its quality-related provisions and is revealingly entitled"Quality and Consumer Protection" (italics added). Partly at the behest of consumer groups, the legislation advocates the collection and publication of outcomesdata in the form of a "report card" that can be used by lay purchasers (bothindividuals and groups) to choose among providers of service. Such providerswould include both health care organizations and individual physicians. Whilethere are other, very convincing justifications for collecting and disseminatingoutcomes data, one reason is clearly to allow the identification of individualprofessionals whose performance "needs improvement." The very term reportcard-which transports many of us back to grade school ("Everyone line up andhold hands!")-is pregnant with meaning about some ofthe assumptions underlying the approaches to quality improvement contained in theClinton Health SecurityAct.

The Professional Model and The Market. Neither the assumptions underlyingthe professional model nor its implications for how to improve quality of care tendto reinforce market solutions to current health care problems. The professionalmodel emphasizes the fundamental asymmetries in information that exist betweendoctors and patients (Arrow 1963), a condition that violates a basic condition foreffective functioning of markets. Furthermore, this assumption of asymmetricinformation leads to methods for quality monitoring and improvement that arebased either on professionalism and self-regulation or on enforcement of standardsthrough external regulation. Neither of these approaches puts the consumer incharge of his or her own destiny. Increasing discontent with results of relyingexclusively or largely on professionalism has promoted use of external regulationof quality. The logical conclusion of this trend would be to treat the medicalprofession as a variety of public utility: recognizing that the profession's monopolyon the means of production is unavoidable for technical reasons, but imposing apublicly managed regulatory framework on the profession to protect the consumerfrom abuse.


1.3. The Application of TQM to Health CareThough the professional model remains alive and well as an organizing concept

for quality management in health care, it has been increasingly challenged in recentyears by alternative models of how health care is produced, and alternativeapproaches to managing its quality. Among the most popular of these alternativesare the models and methods underlying TQM (Palmer and Adams 1993; Berwick1989).The rationale for using TQM instead of the professional model starts with the

argument that TQM posits and builds upon a more realistic model of the processof producing health care in modern societies. Comforting as it may be to imaginethat the physician's professionalism is still the main safeguard of quality, this issimply not true any more. At an accelerating pace, the health care system has cometo be dominated by large organizations (hospitals, health maintenance organizations, nursing homes, multi-specialty physician groups, and combinations of theabove known integrated health care delivery systems). These organizations represent, in effect, the industrialization of medicine.The Massachusetts General Hospital, where the authors work, is now the largest

single employer in Boston, with 14,000 employees. It produces more than 37,000hospital stays yearly and more than 500,000 ambulatory visits. The numbers oflaboratory tests and procedures produced by its support facilities number in the tensof millions annually. Recently, the Massachusetts General Hospital merged withits sister institution, Brigham and Women's Hospital, which has volumes of servicecomparable to the MGH.Within such mammoth (by historical standards) health care organizations, the

individual patient's care and well-being depends on the successful execution ofthousands of processes that must be choreographed with extraordinary precision tocreate the optimal result. These processes begin with the dozens of separateactivities that constitute an "admission" to the hospital (registration, assessment ofinsurance status, pre-admission or admission testing, examination by admittingphysician, writing of admission orders, transcription of admission orders, preparation of a vacated room, admission to the floor by the unit secretary and the nurse,and more). Next come diagnostic and treatment processes. These include visits byprimary physicians and consultants, assessment of their recommendations, writingand transcription of more orders, the notification of radiology or other diagnosticfacilities, the transport of patients to and fro, the processing and communication ofresulting information, the assessment of that information, the prescription ofmedications or procedures, and so on, almost endlessly. The mere process ofdischarge at the end of this mind-numbing set of activities seems almost a miracleof coordination when its many facets are broken down into subprocesses.In the midst of all this, the physician plays an extremely important role, but the

physician is nearly paralyzed without the proper execution of myriad other actionsthat are largely invisible to him or her, to the patient, and indeed, to any singleindividual. The system just described, however, would be very familiar to practitioners of TQM, who have spent the last 80 years trying to discipline and improve


the quality of such beehives of human activity in non-health care sectors. The toolsand techniques they have developed emphasize, as noted, the process as the keyunit of analysis in complex systems of production. TQM advocates the identification of critical processes and the application of scientific methods to the diagnosisand treatment of problems in those processes. TQM further insists that thepersonalization of the process ofproduction by attributing problems to the behavioror misbehavior of any individual (physician included) is both inaccurate as adescription of reality and counterproductive as a way to improve quality. TQMalso notes that processes are susceptible to continuous improvement, and thatorganizations that pursue continuous improvement (transcending existing standards) will enjoy a competitive advantage in the marketplace.Another interesting facet ofTQM that has increasing relevance to modern health

care is its focus on the consumer or customer (Berwick 1991). The professionalmodel of health care production emphasizes the superior wisdom and judgementofthe physician and casts the patient as the passive beneficiary of the professional'sservices. In contrast, a number of factors have emphasized recently the importanceof involving patients in medical decision-making and of paying greater attentionto their needs and expectations (Laffel and Blumenthal 1989). This partly reflectsthe demands of purchasers of care, who have become newly assertive as the costof care has increased. But the emphasis on the consumer also reflects new ways ofthinking about and measuring outcomes of health care services (Mulley, Blumenthal, and Slavin 1992). Research on outcomes of care has documented thatsubjective experiences of patients constitute a critical result of treatment and havedeveloped valid and reliable techniques for measuring these outcomes. Further,they note that different patients value these and other outcomes of care differently,and that optimal therapy for the same condition may vary from patient to patient.Quality in health care, therefore, is to some degree in the eye of the beholder (orpatient). New technologies for incorporating patients' wishes and expectations intotreatment decisions are under rapid development. These include patient surveysand interactive videodisc devices that enable patients to learn about and choosealternative outcomes that may result from a given therapeutic choice (Mulley,Blumenthal, and Slavin 1992). The "re-structuring" of inpatient care is in part aresponse to the increased understanding of the patient's experience gained fromsatisfaction surveys and other sources.The current interest in TQM also reflects disappointment with the failure of

traditional quality management techniques (usually characterized as "quality assurance" or QA) to achieve desired levels of quality in health care. There is evidencethat much of medical practice lacks an adequate scientific basis. Other evidencedemonstrates that, in spite of a long history of quality assurance, there are manyinstances ofwhat is regarded as poor quality, either poor health care delivery (Leapeet al. 1991), poor medical decision making (the RAND appropriateness studies, forexample Chassin et al. (1987» or poor access to services (Wenneker and Epstein1989; Wenneker, Weissman, and Epstein 1990). Further, comparatively few doc-


tors are investigated by State Medical Boards, and this disciplinary process is slowand closed (Brinkley 1994).Traditional quality assurance has been hampered by a tendency to focus

retrospectively on individual "adverse" events. Once the cause of an adverse eventis identified and rectified attention shifts away until the next event. There is littleopportunity to identify and learn from accumulating data about poor quality, littleapplication of statistical thinking, and an almost complete failure to understand thatimproving processes of care may be the best way to improve quality. Based in theprofessional model, traditional QA has also tended to assume that adverse eventsare primarily the result of failures by physicians (to admit otherwise would be toaccept that physicians are not fully in control of health care processes, which isdifficult for doctors to accept). The result is that physicians approach the exercisewith fear and defensiveness and participate grudgingly, if at all.Another reason for the rapid growth of interest in TQM is that large purchasers

of care have become much more concerned with quality of care and service andhave begun to transfer lessons learned from their own work to their health carepurchasing decisions. The concern with quality reflects, in part, an anxiety thatquality will suffer as purchasers use their market power to push down prices. Someof these purchasers consist of organizations-Xerox, Hewlett-Packard, DigitalEquipment Corporation, to name a few-that have been able simultaneously toreduce costs and increase quality in the production of copying machines, computers, and other equipment using Total Quality Management. Recently, an allianceof providers in Minneapolis won a contract to provide services to a large purchasingcoalition by convincing those buyers that the provider group was serious aboutusing TQM techniques in their operations (Blumenthal and Edwards, forthcoming).As noted, the JCAHO requires hospitals to incorporate at least the methods if notthe philosophy of quality management in order to pass their accreditation review,and JCAHO accreditation is essential for providers to remain competitive.Once they become familiar with it, aspects of TQM can also be very appealing

to forward-thinking professionals. The style of TQM is similar to the scientificmethod that is at the core of medical research and decision making. It stresses thepivotal role of data collection and analysis to guide care. It provides a frameworkfor future outcomes research needed to expand the knowledge base ofmedicine. Instressing improved quality as a central objective of health care delivery, TQM alsoresonates what many well-intended professionals see as their primary mission. Inan era when physicians feel badgered and diverted by cost containment, financialincentives, regulatory control, and market competition, TQM can appear as a returnto traditional values of medicine.

2. Implications for Public Policy

The tensions between traditional approaches to quality monitoring and improvement and the new approaches embraced by advocates of TQM are quite obvious.In its emphasis on the physician as the process of health care delivery, the


professional model frustrates efforts by TQM advocates to portray health caredelivery in its full, modern complexity: as the result ofan intricate array ofprocessesthat attempt to unite activities of teams of workers for the purpose of servingpatients. Modern quality theorists would argue that until health care managers andproviders grasp the complexity of the process of health care production, they willnot understand the necessity of applying modern quality management tools toimproving that process of production. In emphasizing so strongly the professionalresponsibility and culpability of individual physicians (and also other health careworkers), traditional QA places a premium on finding and eliminating the badapples in health care. This in turn promotes precisely the climate of fear that TQMadvocates feel makes true quality improvement almost impossible. Brent James'concern with gaining the trust of physicians (as expressed in the quote introducingthis piece) does not reflect a naive or cynical wish to coddle bad performers. Ratherit grows out of the conviction-based on the empirical experience ofTQM theoristsin other industries since World War II-that if physicians (and other health careworkers) feel safe to share their failures without retribution, then more effectiveways can be found to prevent those errors in the future-for example, by buildingfail-safe systems that compensate for inevitable human failings. A famous teachingof Japanese quality managers is that "every defect is a treasure," because defectsindicate opportunities for improvement that should not be neglected.By relying on external regulation of quality when professionalism fails, the

professional model also contradicts a fundamental assumption of modern qualitymanagement: that in many ways, all quality is local, and depends on mobilizing thepower of workers to use their intimate knowledge of processes of production toimprove those processes. Even when there is consensus on what constitutes bestcare, different institutions will develop different mechanisms for delivering thatcare. Externally imposed standards assume that the knowledge of outside expertsis superior to the knowledge of those involved in producing the product inquestion-or at least, that the perfidy or ignorance of producers means that theycannot be trusted to use their knowledge to serve consumers. The potentialproblems in using exogenous standards to guide or judge the process of health careproduction are perhaps best illustrated in the case of guidelines for care.Guidelines-algorithms prescribing the ideal management of particular clinical

problems-have many potential uses (Institute of Medicine 1990). They capturean enormous amount of medical knowledge in easily digestible form, and thus arepotentially very valuable as heuristic devices. They can be incorporated intoautomated medical record systems and thereby provide the information necessaryto give feedback to health care workers in real-time concerning whether theirdecisions are following usual patterns of care. Indeed, one of the central technologies for quality improvement used in Total Quality Management is the flowchart(Scherkenback 1986)-the careful charting of existing or ideal processes of production for the purpose of understanding those processes and assisting compliancewith improved ones.


However, no single set ofquidelines can be expected to apply universally, eitherin the production of steel or in the production of hernia operations. Especially inhealth care, there is too much variation in critical local inputs: the preferences ofparticular patients for alternative outcomes of care; the availability of technology;the skills of local personnel; the co-morbidities of patients. As educational devices,guidelines have great promise; as regulatory devices, they are at best unproven, andat worst potentially harmful.In the eyes of advocates of markets, these disadvantages of the professional

model are likely to be compounded by the barriers it sets in place to the expansionof market-based mechanisms for allocating health care resources. It should comeas no surprise, therefore, that advocates of so-called managed competition in healthcare-whose leading exponent, Alain Enthoven, is an economist-have embracedTotal Quality Management (Ellwood, Enthoven, and Etheridge 1992). Indeed,proponents of managed competition seem to see its compatibility with principlesof TQM as one of the major attractions of this approach to health care reform.However, to implement successfully the principles and practices of TQM in

health care, health care reform will have to reform a number of existing publicpolicies that are rooted in the professional model. Advocates of managed competition will also have to look closely at some policies they are advocating that mayundermine the implementation ofTQM. For reasons noted above, TQM has movedbeyond neoclassical economics in its approach to organizing processes of production, and pro-market policy-makers need to consider carefully whether markettheories will have to be tempered to take advantage of the potential of modernquality management.

Changing Public and Private Policies Originating in the ProfessionalModel. Perhaps the most obvious and important change in existing policies that isrequired to make TQM work concerns malpractice law. Imagine trying to convincea jury that every physician error is a treasure! Physicians' fear of being sued is apowerful deterrent to sharing objective information on their mistakes. Some ofthose mistakes may be due to true incompetence, but the great majority are almostcertainly the result some combination of factors that involve both systemic flawsin the processes ofhealth care production and the inevitability ofhuman error. Eventhe existence of incompetent physicians raises questions about whether bettersystems could be designed to detect such individuals and rehabilitate them, ifmalpractice law did not deter them or their colleagues from coming forward withevidence that problems existed.Malpractice lawyers are not the only group that tends to oppose reforms in

malpractice laws designed to reduce or eradicate the enormous fear these lawsgenerate among physicians. Informed in part by the professional model of qualityimprovement, consumer groups and policy-makers who represent them also tendto oppose wholesale changes in malpractice that would seem either to depriveconsumers of compensation or let physicians off the hook.


A second area in which existing policies must be changed if TQM is to bepromoted is the use of external monitors to review the daily practice of medicine.Though the purpose of this monitoring is usually to reduce cost, physicianscorrectly perceive that the effect of third-party reviews of medical decisions is toalter the process of medical decision-making in ways that affect both quality andcost. This has inherent inefficiencies, but one of its most important effects is toinvolve physicians in and accustom them to a game of cat and mouse with payersand purchasers of care that is fundamentally destructive to the concept of supplierpurchaser partnerships and to cooperation for the purpose of improving quality. Adesire to dispense with such utilization monitoring may prove to be one motive forenlightened purchasers, such as employer coalitions in Minnesota, to requireproviders to adopt TQM as their approach to improving quality. Such contractscan emphasize long-term partnerships and a joint commitment to quality improvement that may reassure purchasers that they do not need to look over providers'shoulders.

Necessary Modifications in Approaches to Competition in Health Care.The logic of TQM tends to make its advocates supporters of market approaches tohealth care delivery. The reason lies in the enormous difficulty of forcing organizations to adopt the changes necessary to make TQM work. Without competitivepressures, and a true fear of extinction at the hand of market pressures,few healthcare organizations can be expected to adopt the required measures (Blumenthal andEdwards, forthcoming).At the same time, supporters ofTQM~specially in health care-are suspicious

of markets in their unbridled American form. The reasons are several. First, someaspects of competitive markets as we have known them in this country do not seemconducive to the implementation ofTQM principles. These characteristics includean overwhelming interest in maximization of short-term profits, an insufficientinvestment in education and training of workers, and a strong ideological opposition to a constructive role for the state in ordering and improving markets.Second, there are important ways in which health care markets are different.

The most important of these is the true asymmetry of information between consumers and providers ofservices, and the resulting public attachment to the professionalmodel of health care services. The fact is that the public persists in hoping thatphysicians will be somehow better than typical humans-above the market. Theywant deeply to trust their physicians (Blumenthal 1994), because they recognizetheir irremediable vulnerability at times of need. To the extent that participationof physicians in the commercial enterprises undermines this trust, as it already has,then the public reaction may be to support regulatory approaches to qualitymonitoring. The implication is that to be successful, markets in health care mustbe structured and managed to assure consumers that providers will not be motivatedprimarily or exclusively by the desire to maximize profits.How this is to be accomplished remains to be defined. One thing is clear. It will

not be achieved by the wholesale release of data on physician or organizational


performance in health care. Such information is difficult to understand andinterpret (Winslow 1994) and may tend to force physicians and other providers intoa defensive posture that is inimical to promoting true quality in the long term. Thechallenge facing advocates of TQM and market solutions to health care is how tostructure such markets so that they make it possible to promote real quality.

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COMMENTS

Malcolm G. Coblentz

In their paper entitled, "Contending Views ofQuality Management in Health Care:Implications for Competition and Regulation," Drs. Blumenthal and Bohmerdiscuss Total Quality Management (TQM) from its inception to its application inindustry. This portion is well presented and clear to the reader. However, Blumenthal and Bohmer have no concept of the real issues facing practicing physicianstoday. For this reason, they have chosen to put patients and physicians intopremeasured "production units" which are all supposed to be standardized.Patients and their problems are not standard, and it is impractical to try to

compartmentalize them as such. Patients require both the science as well as the artof medicine, but that cannot be figured mathematically into production units.The system of health care is patient driven. Patients want and expect the very

latest that technology has to offer. They want cures for cancer, AIDS research, thelatest neonatal advances, open heart surgery, life-prolonging medical care for theelderly, transplants, etc. These technologies are not free and add dramatically tothe overall cost of health care, and, again, they are demanded and expected bypatients. In order for physicians to provide these technologies, the system mustmake allowances.Many companies want a "gatekeeper" or primary care physician who will decide

who shall receive care and for what length of time, keeping in mind that costs mustbe kept to a minimum. These same companies provide financial rewards at the endof the year for saving the system money, but, conversely, also inflict financialpenalties for costing the system money. This places the primary care physician ina dilemma for which there is no answer.Total Quality Management is excellent for the purchasing of materials, mainte

nance ofequipment and the physical plant, and standardizing certain processes, buta significant portion of the TQM process is the patient. TQM dehumanizes the"process" of caring for individuals who are sick or dying. It also makes noallowances for the time spent talking to a patient recently diagnosed with cancer,or for the time spent to answer the questions and attempt to allay the fears of apatient's upcoming operation.TQM has no common standard in the health care field today. Each insurance

company has their own set of standards. Even hospitals are relatively free to settheir own level of standards within broad guidelines, while still adhering to the


JCAHO guidelines. Which set of guidelines should a physician follow? Thegovernment is over budget, the taxpayers are angry, and legislators' electedpositions are on the line. Insurance companies want corporate profits, whilehospitals must reduce costs to stay viable. The person in the middle of this dilemmais the physician who cannot keep both sides content while pursuing their primarypurpose, which is to care for the patient in the best way possible.Costs can be reduced effectively through the use of practice parameters, which

are established by physicians as a guide for the management of clinical situations.The elimination of "middle management" in health care consumes, according toMrs. Clinton, as much as two hundred billion dollars annually.The true concept of Quality Assurance is to identify problems and reeducate

physicians, on a peer basis and in depth. Blumenthal and Bohmer view medicineas a production industry and try to apply TQM to the care of patients, but a goodworking model was not presented. TQM works in industry. In the reality ofmedicine with real patients, it cannot work because it cannot predict or regulatehuman illnesses or needs. Human illnesses or needs still require a physician, onewho is free to practice in the best interests of the patient and fulfill the HippocraticOath.

COMMENTS:Economic Issues Regarding the Applicationof Total Quality Management in Health Care

Martin Gaynor

1. Introduction

David Blumenthal and Richard Bohmer have written a very interesting papercharacterizing Total Quality Management (TQM) as applied to health care anddiscussing some issues associated with its use. Quality is a very large issue in healthcare currently. The question is how to achieve it. Many different approaches tomanaging or controlling quality are being proposed, one of which is TQM. I willpreface my comments with two caveats. First, I am an economist, so my commentswill concentrate on economic issues. Second, I am a complete TQM neophyte.Consequently, I will raise questions that I see regarding the application ofTQM inhealth care, with the caution that I may be ignorant of existing research on theseissues.The goal ofTQM is the production of the product quality desired by the customer

in the most efficient manner possible. The emphasis is on the micro-managementof production processes at the product line level. The tools of modern industrialengineering, management science, and operations research are used to provideinformation and feedback to workers and managers. The tools of industrialpsychology and organizational behavior are used to structure an environment andrelationships that induce cooperation. The TQM goal of improving quality islaudable, and the insights and methods seem useful. Improving cooperation andcoordination is crucial for organizations to reach their goals. Economists haveincreasingly realized that non-financial methods (e.g.,"corporate culture") to induce cooperation are crucial to organization success (Kreps 1990). Further, theapplication of TQM has led to some notable successes. Boeing reduced thetolerance for airplane parts fit from aquarter inch to the thickness of a sheet of paperafter adopting TQM. Federal Express Corporation has successfully applied TQMto reduce errors and costs. West Paces Ferry Medical Center, Intermountain HealthCare System, and the University of Michigan Health System are all examples ofhealth care institutions which have successfully used the techniques of TQM.Nonetheless, the usefulness of TQM to health care organizations has not been


firmly established. A number of hospitals have tried and abandoned TQM afterfailing to detect an effect on the bottom line.In what follows, I will raise some questions that I see with the application of

TQM in health care. They are divided between issues regarding applications withinthe firm and implications for markets.

2. Issues with Applying TQM within Health Care Firms

It seems to me that there are a number of issues concerning the applicability ofTQM within health care organizations. These issues revolve around costs, themeasurement of quality, the organization of production and management, the roleof the physician, reward structures, and the functioning of the market. I will discussthem in turn.There are two issues related to cost and TQM. The first is how costs respond to

TQM. If the application ofTQM is successful, inefficiencies, redundancies, waste,and mistakes should be signicantly reduced; consequently, costs should be lower.A key question here concerns the dimensions of quality. If quality is the absenceof mistakes, e.g., as in the case of Federal Express, then clearly successful application of TQM will reduce costs. This is often referred to as "Quality of Conformance" in the TQM literature. It refers to the extent to which the product meetsspecifications or standards for a given design.However, if quality also has other dimensions, then the effect ofTQM on costs

is not so clearcut. Suppose one of the dimensions of quality is improved healthoutcomes. This kind of quality is referred to in the TQM literature as "Quality ofDesign," i.e., the standards at which practice is set. Assuming mistakes and otherforms of waste are minimized, there are many cases in which health outcomes canbe improved only through the more intensive use of resources. Thus, on the onehand the application ofTQM may both increase certain kinds ofquality and reducecosts simultaneously, but tend to increase costs if other kinds of quality areincreased. I The net effect is an empirical matter.2

The second issue concerning TQM and cost is the cost of TQM itself. TQMseems to be a very intensive process which requires large investments in organizational human capital. Whether the savings from the application ofTQM outweighits costs is a key question. There is a great deal of anecdotal information on thistopic, but clearly general studies are called for if they do not already exist.The successful use of TQM requires precise measures of quality. This is one

area in which its application to health care may be difficult. There is currently a

This is not to contend that TQM should serve to contain costs, or even that costs should becontained. This has to do with societal decisions about how much and what kind of healthcare we wish to purchase.

2 There may very well be empirical studies attempting to assess this question of which I amunaware.

COMMENTS 226

great deal of work engaged in attempting to measure quality in health care, muchof which is very careful and innovative. Nonetheless, measuring the quality ofhealth care is an extremely difficult task. Health care is a very complicated expertservice. Experts' services are not only heterogeneous by their very nature, they areheterogeneous due to the heterogeneous characteristics (and preferences) of consumers. It may be feasible to contract for certain agreed upon quality characteristicswith payers (i.e., private or public insurers), but this does not necessarily solve theproblem. First, it will not necessarily be true that payers will contract over thedimensions ofquality which are important to patients (more on this later). Second,to the extent that important dimensions of quality are measured incompletely, therewill be an incentive for providers (or workers and managers in health care organizations) to shirk on the unmeasured (and hence uncontracted upon) dimensions ofquality. This does not mean that attempting to measure quality and employ thosemeasures using TQM is bad, just that there may be some potentially undesirableconsequences if it is not recognized that information is incomplete. An interestingquestion is the extent to which improvements in the information about one dimension of quality can improve welfare if there is no corresi'onding improvement inthe information about other dimensions of quality. My guess is that a necessarycondition for welfare to improve is for information to improve about all aspects ofquality which both: mattermost to customers and are costly ordifficult for providersto produce. I am sure there are some reports from individual organizations'experiences with TQM which are very illuminating on this point.TQM requires that a firm must be organized around teams at the (lowest) product

line level, which fit together at higher levels of aggregation. This can requiresubstantial reorganization of management and production in a health care organization. There are two aspects to this question of organization. One is simply thecost of reorganization as part of the cost of implementing TQM. The second ismore subtle. Reorganization may alter agency relationships within the firm bychanging the individuals who interact, how they interact, and the informationstructures between these individuals. Indeed, it is likely it will. Some of these maybe planned changes which lead to improvements in agency relations and some maybe unintended. Whether efficiency will be increased or decreased is not clear.The role of physicians may be greatly altered under TQM. Traditionally, the

physician operates quite independently of the hospital or any other health careinstitution. In the TQM model, all members of a product line team work togetherto achieve efficient production of a high quality product. Implementing this modelwould seem to require a substantial alteration of existing relationships betweenphysicians and other health care providers or insurers. Further, some have arguedthat the weakness of the ties between physicians and hospitals and insurers servesto strengthen the physician's role as the patient's agent (Arrow 1963). Strengthening the ties between physicians and hospitals or insurers may weaken the potentialfor physicians to take on the role of patient advocate.When reward structures are discussed in the context ofTQM, it is recommended

that rewards be structured at the group, or team, level. Not only may there be


institutional rigidities which pose a barrier to such structures, as discussed in theprior two points, but it may not be optimal to do so. The economic theory of agencyindicates that individuals' rewards should be tied together only to the extent thatoutcomes are correlated (Holmstrom 1982). In the case of uncorrelated outcomes,the less an individual's reward is tied to his actions, the more he will shirk, barringsome strong group institutions to induce cooperation.3 Further, there is evidencefrom medicine consistent with this hypothesis (Gaynor and Pauly 1990). All ofthis suggests that the optimal reward structure may not necessarily be based purelyon group or on individual incentives, but on some combination of the two.One of the key assumptions underlying TQM is that market competition will

function to furnish providers with an incentive to produce the quality ofcare desiredby buyers. This presumes that buyers are informed enough about quality to chooseproviders on that basis. This may not be a bad assumption where the buyers arepayers. Payers have become increasingly sophisticated in shopping for health care,and the evidence is that the market has become more competitive (Dranove 1993).It is not clear, however, that payers are concerned about the same factors as patients.Most of the payer-driven competition has been over price. Payers will be motivatedto compete over quality only to the extent that patients choose payers on that basis.While this doesn't require perfect information about quality on the part of patients,it does require "enough" information to affect the market (Dranove and Satterthwaite 1992). There is a significant movement to disseminate information toconsumers gained through the measurement of quality. I don't know of enoughexperience with such policies to judge their success at present, but this certainlyseems important.The last issue concerning the application of TQM within health care firms is

whether TQM is the best, or the only, way to achieve the desired goal of controllingquality. There are a number of methods for managing quality, of which TQM isone. Table 1 characterizes methods by whether control is internal or external andwhether responsibility is individual or team. The "traditional" model of qualitycontrol is professional self-regulation, where a professional regulates his own

Table 1. Methods of Qualitv ManaQement

CONTROLRESPONSIBILITY Internal External

Individual "Traditiona'" Professional Market: (UR, PROs,... ),Model: Regulation: ("..."),Individual, QA QR Leaal SvstemfTorts

Team/System "New" Professional Market,Model:TQM ReQulation

3 It does seem as if one of the purposes of TQM is to build just such institutions/patterns ofbehavior.

COMMENTS 228

behavior, or is regulated by a professional association. This constitutes internalcontrol with individual responsibility. Current models of quality control involveexternal review of individuals, either by market organizations, public regulation,or last, via the legal system. This involves some degree ofconflict and punishmentfor individuals identified as deviating from acceptable quality levels. TQM involves professional self regulation, but at the team, rather than the individual level.Thus, this is internal control with team responsibility. Another key dimension isthat in TQM the emphasis is upon improving the process or the system in responseto problems, as opposed to retribution. Last, external review or controls could beapplied to teams, as opposed to individuals, either by the market or via regulation.Optimal control/management of quality may involve any combination of theseoptions. I have seen no analysis of this, but it is certainly possible that the optimalsystem may combine internal quality control via TQM with external controls viamarket or regulatory review.

3. TQM and the Market: Mercantilism in New Clothes?

A number of TQM advocates have called for relief from antitrust laws. TQM hasemphasized the building of close relationships between organizations and theirsuppliers and customers. Some have also called for coalition building among firmswithin industries. Such coalitions have traditionally been viewed with somesuspicion by antitrust authorities. Some TQM advocates have claimed that whatis good for firms is what is good for society.4 This simply sounds like a mercantilistmanifesto for the '90s. There is ample evidence that the interests of industry andsociety do not always coincide, thus any relaxations of antitrust law or exemptionsfrom enforcement must be considered very carefully.At present, there is a great deal of pressure being brought to bear to grant

exemptions from the antitrust laws to health care organizations. Hillary RodhamClinton has stated that antitrust policy would no longer stand in the way ofhospitalsthat try to share technology or form networks (New York Times, August 10, 1993).At the same time, health care trade associations are lobbying for exemptions fromantitrust enforcement. The AMA sponsored a bill (H.R. 5309) in the 102ndCongress proposing antitrust exemption for "medical self-regulatory entities," i.e.,medical associations engaged in quality review and promotion activities. The AHAsponsored bills exempting mergers in low population areas from antitrust laws(RR. 2406) and exempting joint ventures for the sharing of high technologyequipment and services (S.2277).The emphasis in recent antitrust policy has been on horizontal relations: hospital

mergers (e.g, FTC v. University Health, Inc., 1991), provider boycotts (e.g.,Medical Staff of Holy Cross Hospital, 1991), price fixing conspiracies (e.g.,

4 By society I mean all members of society, including stockholders and employees of firms, notsimply everyone other than stakeholders and members of firms.


Southbank IPA, Inc., 1992), and tying arrangements (e.g., Sandoz PharmaceuticalsCo., 1992). Federal attention has turned only recently to vertical matters (e.g., FTCv. Home Oxygen, 1993), although there has been considerable private litigation(e.g., U.S. HealthCare v. HealthSource, 1990). In September of 1993, the FederalTrade Commission and the Department of Justice issued Statements ofAntitrustEnforcement in the Health Care Area in which specific conditions are indicatedunder which the federal agencies will not challenge joint activities among healthcare providers per se, but will employ the rule of reason (i.e., effects on socialwelfare).Vertical and horizontal associations among firms can be efficiency enhancing

for a number of reasons. They may reduce transactions costs, increase reliability,increase the ability to monitor cost or quality, etc. At the same time, such relationshave the potential to reduce competition. The role of antitrust policy is to weighthese factors against each other. As I mentioned previously, the antitrust enforcement authorities have made it plain that they will employ the rule of reason inapplying the antitrust laws. Consequently, in principle, efficiency enhancingarrangements should have nothing to fear. In practice, it can be difficult for firmsto know what sorts of arrangements will pass a rule of reason test. Antitrustauthorities do provide guidelines, but there is some residual uncertainty, plus thepossibility of private suits. Last, TQM itself is predicated on the notion of vigorouscompetition. TQM proponents advocate the "brush with death" as a necessarymotivation for the promotion of quality and efficiency. Allowing anticompetitivepractices by firms will undermine the competition on which the success of TQMis based.

Acknowledgements

I would like to thank Laura Morlock and Annemarie Wouters for very helpfulcomments. The usual caveat applies.

References

Arrow, Kenneth. 1963. "Uncertainty and the Welfare Economics ofMedical Care." American Economic Review 53: 941-973.

Dranove, David. 1993. ''The Case for Competitive Reform in Health Care." In CompetitiveApproaches to Health Care Reform, edited by Richard 1. Amould, Robert F. Rich, andWilliam D. White. Washington, DC: The Urban Institute Press.

Dranove, David, and Mark A. Satterthwaite. 1992. "Monopolistic Competition When Priceand Quality are Imperfectly Observable." Rand Journal ofEconomics 23(4): 518-534.

Gaynor, Martin, and Mark V. Pauly. 1990. "Compensation and Productive Efficiency inPartnerships: Evidence FromMedical Group Practice." Journal ofPolitical Economy 98:544-573.

Holmstrom, Bengt. 1982. "Moral Hazard inTeams." Bell Journal ofEconomics 13: 324-340.Kreps, David. 1990. "Corporate Culture and Economic Theory." In Perspectives on Positive

Political Economy, edited by James E. Alt and Kenneth A. Shepsle. Cambridge, UK:Cambridge University Press.

12MEASURING AND IMPROVING QUALITY

IN HEALTH CARE

Mark R. Chassin

In the swirl ofdebate around health care reform, too little serious attention has beenpaid to measuring and improving quality of care. Yet, I believe our success inpursuing these activities will likely dictate our ability to achieve universal accessto health care at a price we can afford.There are three different categories ofquality problems: overuse, underuse, and

misuse. A recent Institute of Medicine study concluded that, while considerableevidence documented the presence of all three in the American health care system,it was not possible to estimate their relative adverse impacts on health. Manystudies have documented overuse of medications, hospital admissions, diagnosticservices, and surgery. Others have demonstrated underuse of immunizations andother preventive services and the treatment of hypertension. The Harvard MedicalPractice Study was probably the single best examination ofthe many manifestationsof misuse in hospitals.This categorization is useful for a number of reasons. Current quality assurance

efforts focus predominantly on problems ofmisuse, with some attention to underuse(but only after a patient presents for evaluation and treatment), and little or nonedevoted to overuse. Each of these different problems requires significantly different measurement techniques to assess, different interventions to ameliorate, anddifferent monitoring approaches to assure continued improvement.From the perspective of measurement, we have enough knowledge today to

construct measures assessing all three kinds of problems. Underuse presents themost difficulty in this regard, but the problems are by no means insurmountable.What we have lacked to date is sufficient investment to develop the broad range ofspecific applications needed to build reliable and valid measures across a wide arrayof specific quality problem areas. It is this lack of investment that is, in my view,the single most important obstacle to the production of comprehensive informationabout quality.There is also some confusion about the attributes of a "good" measure ofquality.

Some observers argue that health care outcomes are the only true measures ofquality. Others argue in favor of structural measures, such as board certificationof physicians. The worth of a quality measure can be judged by four criteria.


The measure should have reasonably high sensitivity; a high proportion of truequality problems should be identified by poor performance as judged by themeasure. It should also exhibit reasonable specificity; the measure should notproduce enormous numbers offalse positive results. In most cases a trade-offexistsbetween sensitivity and specificity. One can increase the sensitivity of a test ormeasure at the expense of decreasing specificity. Because many, if not most,quality measures are used to identify potential problems that must be investigatedfurther, a certain frequency of false positive results is expected. In developing andcalibrating measures ofquality, one should aim for as high a sensitivity as practicalwithout overwhelming the system that must use the measure with false positives.Previous research has revealed little evidence that structural measures ofquality

(e.g., board certification for physicians, nurse staffing ratios for hospitals) identifysignificant quality problems. These measures have very low sensitivity and verylow specificity. In recent years, researchers have turned more and more to measuresof health care outcomes in the quest for reliable and valid measures of quality. Iftaken to extremes, this movement risks overlooking many important candidatequality measures that assess processes of care. Process measures have fallen fromfavor in part because research has shown few of them to relate to outcomes. Whileit is true that some process measures make poor quality measures, the same is truefor some measures of outcome.The third and fourth criteria defining good measures ofquality permit us to avoid

these pitfalls. The third is that if the quality measure assesses a process of care, thatprocess must be related to an outcome we care about. The fourth is that, if thequality measure assesses an outcome, that outcome must be related to a process ofcare that we can manipulate to affect the outcome. Some examples may serve toillustrate these principles. Assessing the quality of ambulatory care by measuringthe effectiveness of the treatment of hypertension requires measuring processes ofcare. But we know that the process of adequately treating hypertension is relatedto outcomes we care about (decreased stroke and mortality). Other process measures are not such good quality measures. For example, is the admission history andphysical recorded in the medical record within 24 hours of admission? Conversely,not all outcome measures are good quality measures. The proportion of patientswith lung cancer who develop liver metastases within six months is a fine outcomemeasure. It is a poor quality measure, because no processes of care have beenshown to affect the outcome.How does quality measurement relate to quality improvement? At least three

different strategies can be articulated: regulation, competition, and professionalism.Each has advantages and disadvantages. The regulatory strategy envisions settingstandards of care by means of quality measures, inspecting providers for compliance with these standards, and enforcing compliance with penalties. Its advantagesinclude its capacity to reach and assess all components of a community's healthcare system with uniform measures and rules. Another advantage is that regulatoryapproaches are the only way in which to remove from the delivery system thoseindividuals and institutions who practice so poorly as to present a danger to the

MEASURING AND IMPROVING QUALITY IN HEALTH CARE 233

public's health. Among its disadvantages are inflexibility and the relative inabilityto motivate average and above average providers to improve the quality of the carethey deliver.The competitive strategy envisions collecting data on quality and making them

widely available to consumers and payers. Providers will then compete to improvetheir quality to attract more business from consumers and from payers who channelconsumers to (or away from) certain providers. This may be an intriguing theory,there is little evidence to date that supports it. While competing on quality mayprove a powerful motivator toward quality improvement, it is far from clear howone could structure the health care marketplace to achieve such competition.In addition, it is clear that competition in health care can have adverse effects.

Competition among hospitals has led to what some observers have dubbed the"medical arms race," in which each institution strives to acquire the latest, highesttechnology equipment and services to attract (or retain) physicians and, morerecently, to compete for business from HMOs and employers. The outcome of thisbidding war is unneeded multiplication of services and overbuilding of acuteinpatient beds. Needed collaboration and consolidation of services is blocked.Competition also provides disincentives to hospitals and health plans to share

best practices. It may be true that few consumers care how two different computermanufacturers produce low cost computers, assuming the specifications for howthey perform are the same. Consumers should care a lot about how two hospitalsachieve the same reduction in length of hospital stay. One may accomplish thisobjective by improving preadmission testing and reducing needless waiting timefor diagnostic studies. Another may get to the same length of stay by dischargingpatients too soon, before they or their families can care for them. Ifhospitals mustcompete with each other for HMO business, why would the first hospital want togive up a competitive advantage and share information on how it achieved a safelength of stay reduction?To date, there is little evidence that managed care companies compete on quality.

A recent Foster Higgins survey showed that 69% of such companies surveyedattributed their success in the market to successfully competing on price. Only 9%said competing on outcomes or quality data was important.The third strategy recognizes that continuous quality improvement (CQI) or total

quality management is becoming popular in health care. The Joint Commission onAccreditation of Healthcare Organizations has embraced it. More and morehospitals claim to be using it. The strategy of professionalism envisions a collaborative effort among health care providers, fueled by data on comparative performance used internally in the search for opportunities to improve.While CQI may be the best strategy for an individual institution to employ in

the search for quality improvement, too few providers are so committed today topermit reliance on this strategy alone. Further, as currently practiced, CQI hastended to focus on a narrow segment of quality problems, preferring to concentrateon misuse problems while largely ignoring serious problems of overuse.I believe that it is not necessary to choose a single strategy from among these


three; they are not mutually exclusive. A successful strategy will require a blendof all three approaches. We have used such a blend in New York State to achievea high degree of quality improvement in the delivery of invasive cardiac services,especially coronary artery bypass surgery. Regulation allows us to strictly limit thenumber of hospitals permitted to offer this service. Only 31 hospitals in New Yorkperform cardiac surgery. This figure compares to about 120 hospitals in California,a state without any regulatory program to limit capacity. California has about 60%more people than New York, but 300% more hospitals doing cardiac surgery.In addition to this regulatory program, for the last six years we have operated a

collaborative effort to improve mortality following coronary bypass surgery. Withthe aid of a statewide advisory committee, we collect data prospectively on riskfactors from all 31 hospitals on every patient undergoing cardiac surgery. Weproduce a multivariate risk adjustment analysis and feed back risk-adjusted operative mortality data to hospitals and cardiac surgery programs across the state. Thesedata have led to very specific quality improvement activities at hospitals where thedata suggest problems exist.The competitive part of this program arises from the annual public release of

data by hospital and surgeon on volumes of procedures and risk-adjusted operativemortality rates. The competition occurs not because patients move from onehospital or surgeon to another based on the data; very little such movement actuallyoccurs. Rather, the competition occurs because of the peer pressure generated bypublic knowledge of poor performance. Over the first four years of this program(1989-1992), we have witnessed a decline of 41% statewide in risk-adjustedoperative mortality. In addition, the number of hospitals with statistically elevatedmortality has declined from five in 1989, to three in 1990 and 1991, to one in 1992.Devising an effective quality improvement strategy is particularly crucial in the

current environment of health reform. I believe that assured quality must be a goalof health reform, equal to the goals of universal access to care and affordable cost.Indeed, I believe we can attain the other two goals only by employing effectivequality improvement strategies.

It is politically impossible to imagine achieving universal access by increasingthe amount we spend on health care. All major reform proposals plan to realizethis goal by creating savings from current health care expenditures. If such savingsare to be obtained safely, without jeopardizing access to necessary and effectivecare, we must employ quality measurement and quality improvement.Using these techniques to attack the serious problems of overuse that exist in

American medicine can achieve the savings we need to fund universal access whileimproving quality at the same time. I believe that a conservative reading of theliterature documenting overuse leads to the conclusion that we could safely eliminate about 20% of what we do in health care and quality would actually improve.This improvement would occur because patients would be spared the unnecessaryrisk that attends to inappropriate health services. Solving problems of overusewould contribute to the reform goal of affordable cost not only by reducing whatwe spend today (by eliminating overuse of common services) but also the rate at

MEASURING AND IMPROVING QUALITY IN HEALTH CARE 235

which that spending is increasing (by limiting the indiscriminate diffusion ofpoorlyevaluated new tests and treatments).Thus, I believe we can define and measure quality, and we can use those

measures to improve it. We need a serious investment to develop a new armamentarium of sophisticated quality measures and link them to specific programs ofquality improvement. To implement an effective quality improvement strategy, ablend of regulatory, collaborative, and competitive programs will be required. Theimportance of embarking on this effort is magnified to the extent real health reformis desired. Achieving the goals of universal access to care and affordable cost willrequire a major quality improvement effort devoted to solving the problems ofoveruse that currently plague American health care.

COMMENTS

James F. Burgess, Jr.

Mark Chassin's remarks on the subject of measuring and improving quality inhealth care were wide-ranging and insightful. In my comments, I will be addressingsome extensions of his point on the relationship between quality improvement andhealth care reform. In particular, I want to make two assertions. First, the microfocus of health services research on outcomes from particular procedures orconditions will not yield the broad measures of quality evaluation that health carereforms would be likely to require for consumers comparing health plans. Second,developing comparable measures ofquality evaluation for providers or health plansby industry groups is unlikely unless databases are collected from which uniformmeasures could be developed by regulatory or purchasing cooperative agencies ingovernment. In making these assertions, I will draw on the experience of theDepartment of Veterans Affairs (VA) as contrasted with the experience of themanaged care industry in the United States.The VA health care system consists of over 170 hospitals and a network of

outpatient clinics delivering services to veterans on an annual federal budget inexcess of$16 billion. Efforts to allocate this budget between facilities on a capitatedbasis (Lehner, Burgess, et al. 1993) and prospects of closer integration with the restof the health care system under health care reform have intensified a focus oncomparing quality of care between facilities in the last year. More generally,veterans and their service organizations have advocated for improvements in thequality of care to address perceived problems over the last decade. By expressingthese concerns through the Congress, a political will has developed to investigatequality evaluation in the VA in systematic ways. Four general approaches havebeen pursued. First, hospital internal records on patient incident reports andoccurrence screens have been aggregated to the facility level and collected withstandardized reports. Second, a specific quality evaluation questionnaire has beendesigned and implemented. Third, general standards have been established througha focus on accreditation of VA facilities by the Joint Commission on the Accreditation of Healthcare Organizations (JCAHO). Fourth, a set of uniform qualitymeasures is being assembled from national VA databases.From the national point of view, the usefulness of these attempts at quality

evaluation can be assessed using economic incentives or internal consistency ascriteria. Economic incentives always are present in some form, so in this context


adding quality evaluation to the existing health care system should not promotelower quality facilities or hinder higher quality facilities. Internal consistency as acriterion should prevent quality evaluation from measuring differences that do notexist. Since VA investigation of quality evaluation has been a political decision,some attention also needs to be paid to political difficulties that may not be wellarticulated in the process of evaluation. By these criteria, the first two approacheshave not been successful, the third has been politically successful, and the fourthshows the most promise for being more generally successful and applicable tonational problems faced under health care reform.Since the first two approaches depend on facility self-reporting of quality

problems, they are subject to the "bad apple" problems discussed by DavidBlumenthal in his paper. The VA has tried to implement a national Total QualityManagement (TQM) program, so internal recognition of failures or defects isessential for continuous improvement; however, national database reporting to rankfacilities on the basis of their quality problems gives perverse incentives tominimize problems. VA facilities have dramatically improved their JCAHO scoresin the last decade as the VA Office of Quality Management has coordinated thedistribution among VA facilities of common deficient grid elements and otherinformation on their experience with the JCAHO process. These results serveimportant political purposes in addition to any improvements they represent inveteran patient care.Nevertheless, the most dramatic progress has come in the last area ofdeveloping

uniform quality measures from national databases. For the purposes of this discussion, some general lessons that VA has learned may be most instructive. First, thedenominators of ratio measures have been the most important focus as VA has triedto develop measures using capitated patient denominators. Exclusions of patientsnot at risk, consistency of the patient database, and accuracy of the measure are afew of the factors that have been considered. Mortality for VA patients is measuredfrom the Beneficiary Identification and Record Locator System (BIRLS) VAmaintains that tracks death benefits paid to survivors of veterans and terminationof veteran benefits. The accuracy of the BIRLS has been tested against Medicare'sHealth Information Skeletonized Eligibility Writeoff (HISKEW) file by Fleming,Fisher, et al. (1992, 384) who found concordant mortality in more than 98% ofcases. Moreover, risk adjustment is done with national database records instead offrom facility reports targeted as quality measures. In using integrated data reportingsystems to derive quality measures, as opposed to having facilities derive and reportquality measures, the internal consistency of the results improved dramatically.As health care reform has centered its focus on the health plan as opposed to the

health provider, the relevant measurement ofquality for consumer choice is shiftingto the insurer or payer. In complementary fashion to the development of JCAHOas an organization ofhealth providers studying themselves, the National Committeefor Quality Assurance (NCQA) is developing performance comparisons for healthplans. NCQA is an alliance of insurers, managed care corporations, and largeemployers providing accreditation standards for use in employer-provided health

COMMENTS 238

care. At this point, the primary customer for the Healthplan Employer Data andInformation Set (HEDIS) is the employer benefits manager; however, a frameworkis being established that could be used to distribute information directly to consumers. A self-study approach creates a number of problems that are not easilyaddressed by a member accreditation organization. First, integrated data systemsare not possible for antitrust and confidentiality reasons, so HEDIS is a reportinginformation system instead ofan data information system. Second, partially for thatreason and partially because quality measures are a recent development, theperformance standards only are proxy medical practice guidelines of the typediscussed by John Rizzo and Jody Sindelar in their paper. Only two proxies are inVersion 2.0 of HEDIS in the acute/chronic general clinical area: measures ofasthmatic hospital admissions and retinal exams for diabetics. Using proxies thatapply only to small subsets ofpatients or enrollees can cause problems ofspecificityand generalizability in resource allocation.When a small number ofspecific proxiesare used, excessive resources will be devoted to those specific areas so all healthplans will score well, and they may be so specific that they are not related to thegeneral quality ofother services provided. These concerns are generally understoodby the accrediting organizations (Clarke and O'leary 1994,28).In many ways, the problem for VA is much simpler because facilities are much

more similar than they are different, and the federal system ownership facilitatesthe development of national integrated data reporting systems. Nevertheless, theexperience of VA in developing facility level performance standards from thesenational data systems has shown that it is possible to make aggregate comparisonsconsistently and accurately. Under health care reform, such measures are not aslikely to come out of member accreditation organizations that have to balancecompeting interests of their members, but from government agencies that canassemble unified information systems. This is the challenge to leaders in government in alliance with the expertise in academia that this workshop has broughttogether. As Dennis O'leary, President ofJCAHO (Clarke and O'Leary 1994,30),and others have said, quality report cards called for by the Clinton administration'splan for health care reform will not happen without Federal standards and guidancethat will take additional research at a more aggregated level than what is currentlybeing supported by the Department of Health and Human Services.

Acknowledgements

Conclusions and opinions expressed are those of the author and do not necessarilyreflect official positions of the U. S. Department of Veterans Affairs.

References

Clarke, Richard L., and Dennis S. O'leary. 1994. "News Profile on JCAHO's O'leary:'We are an interpreter of public expectations,.n Healthcare Financial Management 48(No.4, April):22-30.


Fleming, Craig, Elliott S. Fisher, Chiang-Hua Chang, Thomas A. Bubolz, and David 1.Malenka. 1992. "Studying Outcomes and Hospital Utilization in the Elderly: TheAdvantages of a Merged Data Base for Medicare and Veterans Affairs Hospitals."Medical Care 30 (No.5, May): 377-391.

Lehner, Laura A., James F. Burgess, Jr., David Hults, and Theodore Stefos. 1993. "Data andInformation Requirements for VA Resource Allocation Systems." Working Paper forVA Conference on Databases: A Resource for Research and Decisionmaking (November).

COMMENTS

Paul M. Schyve

Dr. Chassin presented evidence for overuse and misuse of certain medicalprocedures. He described the activities of the New York State Department ofHealth to measure clinical outcomes for selected procedures, risk adjust thoseoutcomes, and publicly release the risk-adjusted outcomes data in a format that canbe used to compare the performance of hospitals in the state. He also presentedfindings suggesting that these comparative data have been used by hospitals toimprove their outcomes with respect to the selected procedures. Finally, hereported on the public release of physician-specific, risk-adjusted outcomes datafor these same procedures.Dr. Chassin' s presentation of this elegant work to measure patient outcomes for

the purpose of improving medical care raises three issues for further comment: therole of regulatory agencies in improving health care; the interpretation of publiclyreleased physician-specific outcomes data; and risk-adjustment of outcomes datarelated to health care delivery networks serving defined populations, such as ageographic community.Improvement in the performance of a health care organization-and, thereby,

improvement in the outcomes it achieves-is dependent upon the actions of thehealth care organization itself. It must be motivated to improve: to measure andassess its own performance and to plan, test, and implement those changes thatcould result in improved outcomes. While this motivation must be primarilyinternal, deriving from a professional commitment to provide good care to patients,a regulatory agency can provide incentives or disincentives for the organization toimprove its performance. A regulatory agency can foster improvement by settinga priority on improvement among the many competing demands on health careorganizations. The agency can also require the use of uniform performancemeasures and risk-adjustment data that facilitate comparisons among organizationsfor the purpose ofbenchmarking. And the regulatory agency can respect the normalvariation in outcomes, intervening with sanctions only in egregious situations toprotect the public.Accrediting bodies, such as the Joint Commission on Accreditation of Health

care Organizations, are not regulatory agencies with sanctioning power. Rather,they work in a public-private sector partnership with health care organizations andregulatory agencies. Accrediting bodies set standards that foster improvement


activities in health care organizations, survey the organizations for conformance tothose standards, provide consultation and education to the organizations about howto improve their performance, and provide to the pubic, and to federal and stateregulatory agencies, information about the organizations' performance. And theJoint Commission has begun to collect, risk-adjust, and analyze outcomes data thatare nationally uniform, permitting useful comparisons and benchmarking not onlywithin local communities and states, but regionally and nationally as well.With regard to the public release of physician-specific data about outcomes from

hospital care - a release forced in New York State by the courts - there are seriouscautions. The outcomes of hospital c:rre are influenced by three sets of factors:patient-specific variables, such as the severity of the patient's illness, other illnessesthe patient has (comorbidities), the patient's participation in the care, and normalbiological variation such as age and sex; the systems and processes of the hospitalitself, including the performance of nurses and other clinicians who work with theprimary physician; and the competence-knowledge, skills, and judgement-ofthe physician whose performance is being measured. The kind of care that isprovided in a modern hospital is so complex that the hospital's systems andprocesses are major contributors to patient outcomes. Since these systems andprocesses are relatively the same for physicians within one hospital, comparisonsamong physicians from the same hospital may be informative-and can effectivelybe evaluated and interpreted through peer review.But the systems and processes may differ so much among hospitals, that

comparing the performance of a physician in one hospital to that of a physician inanother hospital, based on health outcomes that are risk-adjusted only for patientvariables, is likely to be misleading. Such comparisons would, in general, bemeaningful only if "adjustments" could be made for the differences among thesystems and processes in the different hospitals-a currently impossible task-justas adjustments are made for patient factors. This suggests that while comparisonsof performance among physicians within a hospital can be helpful for improvementpurposes (and to identify real "outliers"), using the same data to compare theperformance of individual physicians in different hospitals is problematic.Finally, the measurement system Dr. Chassin described facilitates useful com

parisons among hospitals, and as suggested above, among physicians within thesame hospital. However, the future health care system is likely to be characterizedby integrated health care delivery networks, each providing care to a definedpopulation, such as enrollees from a specific community. In this scenario, theperformance of a health care network will be assessed in part by measuring thehealth status of the defined population, not just by the health outcomes of patientswho received treatment in the hospital, nursing home, or physician's office. Inorder to make meaningful comparisons of performance among health care networkswith respect to population health status, it will be necessary to "adjust" for thosecommunity factors that may affect population health status, but are not under anetwork's control. These include factors such as the population's socioeconomicand educational levels, community lines of communication, environmental pollu-

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tion and toxins in the community, and local funding priorities. While theseadjustments will be less relevant when comparing the performance (with regard topopulation health status) of networks serving the same population, they will berelevant if attempts are made to compare this aspect of performance amongnetworks serving different populations. Developing and testing such adjustmentswill be a new challenge, especially for government agencies (such as state departments of health) that will have a responsibility for regulating networks and foraccrediting bodies (such as the Joint Commission) that will evaluate and accreditnetworks and provide the public with information about their performance.

HEALTH, ECONOMICS, ANDREGULATION GLOSSARY

Accountable Health Plans (AHP) Under managed competition, an AHP is aprovider organization which agrees to provide all medically necessary andappropriate services for its enrollees in exchange for a capitated payment.AHPs may be internally organized on an HMO, PPO, or fee-for-service basis,and must be approved by the Health Alliance.

Adjusted Average Per Capita Cost (AAPCC) An estimate of the average percapita cost incurred by Medicare per beneficiary in the fee-for-service system,adjusted by county for differences in age, sex, disability, Medicaid eligibility,and institutional status. These costs were used to determine the payment ratefor Medicaid enrollees in capitated health care systems.

Adverse Selection Problem A problem which results from asymmetric information between the buyer of insurance and the insurer, in which the buyer hasbetter information about health risks, and only purchases insurance if theirexpected medical costs exceed the premiums. That is, at any given price, themedical coverage is more attractive to sicker people, and less attractive to wellpeople. The net result of the adverse selection problem is that on average, thoseindividuals that choose to buy insurance are sicker than the population as awhole, and sicker (on average) than those who do not buy insurance. This is alarger problem in the case of individuals than in the case of larger groups whichwere formed for reasons independent of the purchase of health insurance.

Agency for Health Care Policy and Research (AHCPR) A Federal Agencycreated to help assess the effectiveness of medical interventions and outcomes,and disseminate the results of effectiveness studies. Created as part of thePublic Health Service in 1989.

Agency Problem See Principal-Agent Problem.

Allocated Costs One method of assigning costs to individual products, service orpatient in order to compute the average or standard cost. Under the allocatedcost method, the total costs for a department or activity (eg. pharmacy) aresummed and then "allocated" to the individual products, services, or patientsbased on an "allocation rule" such as setting costs proportional to operatingtime, revenue, or length of stay. See Traced Costs.


Allocative Efficiency A market is said to be allocative efficient if all thoseindividuals who value the good or service more than the marginal cost ofproduction are able to purchase the good or service, and those who value thegood or service less than the marginal cost ofproduction do not purchase it. Asa result, the deadweight loss in the market is zero. See figure 1, if the price wereset at pe, the quantity would be qe, and the deadweight loss (area DW) wouldbe zero. A competitive market is allocative efficient because the price is equalto the marginal cost of production. A monopoly market is generally allocativeinefficient because the price is greater than the marginal cost. Many economistbelieve that the health care markets are allocative inefficient because theinsurance lowers the price ofmedical care, to the consumer, below the marginalcost of production, resulting in people purchasing too much medical care, asituation referred to as the moral hazard problem.

American Hospital Association (AHA) An industry association of Americanhospitals which has a very active in lobby in Washington.

American Medical Association (AMA) An industry association of Americanphysicians. The AMA has a great deal ofpower over health care in this country.The AMA played a major role in getting states to pass licensure laws, and inputting control of the examinations into the hands of the local medical societies.It also plays a major role in the accreditation of medical schools and residencyprograms, and in getting hospitals to restrict admitting privileges. The AMAis also a powerful lobby in Washington.

Assignment An agreement by a clinician to accept the reimbursement of aninsurance company or government program (MedicarelMedicaid) as paymentin full for services rendered, cf Balance Billing.

Asymmetric information A situation in which the two parties involved in atransaction have different sets of information relevant to the transaction. Forexample, a clinician is in a much better position to evaluate the necessity of aparticular treatment than the patient. Information asymmetries often lead toPrincipal-Agent problems.

Average Cost The total cost for providing a good or service divided by the numberof goods/services provided.

Average Length of Stay (ALOS) A frequently used measure of hospital efficiency. The average length of stay is usually adjusted for "case-mix" using theDRG system. That is, the average length of stay for a particular hospital ismeasured as a deviation from the average across all hospitals.

Averch-Johnson Effect From their paper entitled "Behavior of the Firm underRegulatory Constraint", American Economic Review, December 1962. In thispaper, the authors noted the propensity ofa firm under Rate ofReturn regulationto over invest in capital (which was used to determine the rate base) in order toincrease the level of total profits allowed by the regulator.

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Balance Billing The practice billing patients directly for the difference betweenwhat an insurance company or government (in particular Medicare) is willingto pay for a specific service and what the clinician charges, cf assignment.

Benchmark Pricing A cost containment strategy in which the reimbursement fora specific service is set by the lowest priced "qualified" provider of that service,and any amount above the benchmark is the financial responsibility of theindividual consumer or patient.

Board Certification A process of examination of physicians in specialties orsub-specialties. Certification is managed by the relevant specialty or sub-specialty association and is voluntary, although Board Certification may be acondition for the granting of practice privileges by hospitals, employment byHMOs or affiliation by PPOs.

Bundling (of Physician and Hospital Services) Setting a fixed payment for boththe inpatient (hospital) services and physician services associated with a singleepisode of illness. The division between the physician and hospital would benegotiated between those two parties.

Casemix Adjustment Using DRGs to "adjust" for differences in length of stay orcost by calculating averages by DRGs. Also, in PPS, each DRG has a costweight and the average of such weights multiplied by volume in each DRG isthe hospital's "casemix index".

Capitated Payment The practice of paying a provider a fixed fee for providinghealth care services to a specific individual or group of individuals regardlessof the amount of services provided. Also, the practice of a pre-paid grouppractice of charging individuals or employers a fixed fee for providing allnecessary medical services for an individual or group of individuals, andthereby absorbing the risk associated with providing these services. In the U.K.,primary clinicians are paid on a capitated basis.

Certificate of Need (CON) A regulatory program introduced by the federalgovernment to control the expansion of health care facilities. Hospitals, andother health care institutions, are required to obtain approval before constructingnew hospital beds, purchasing new equipment or setting up new programs.

Coding A process of turning diagnostic or procedural labels into computerreadable form for reporting purposes. See ICD and CPT codes.

Coinsurance The practice by an insurance carrier or other provider group of fixingreimbursement at a level below charges, resulting in either 1) the patient eitherobtaining additional insurance to cover the gap or paying the difference, or 2)the clinician accepting reimbursement as payment in full (i.e. accepting assignment). The basic idea behind coinsurance is to sensitze the patient to the costsof treatment and reduce the moral hazard problem.

Community Health Accreditation Program (CHAP) An agency that accredits


community health programs on a voluntary basis, although accreditation maybecome required for reimbursement.

Concurrent Review The process of reviewing patient services while the patientis hospitalized. See also Utilization Review.

Community Rating The practice of charging a common health coverage premiumfor all individuals within a given community. Although the premium may beage/sex adjusted, the important characteristic is that the rate does not dependon the past experience of the individual. c.f., Experience Rating.

CompetitiveMarket A competitive market is said to exist when: 1) there are manybuyers and sellers of a good or service, 2) there is complete information aboutall buyers and sellers, and 3) there are no entry barriers. In a competitive market,individual sellers are unable to affect the price for their goods or services. Ifthey try to set a price above the market price, no one will buy from them. Themarket price is determined by the intersection of supply and demand, and isequal to the marginal cost of production. In the long run, because of entry ofnew sellers, economic profits are zero.

Competitive Price The price that would exist if the market were competitive. Thisprice corresponds to the minimum long run average cost and results in zeroeconomic profits. It also results in allocative efficiency. Regulators try determine the competitive price, and force the regulated firm to sell at that price.

Consumer Surplus A dollar denominated measure of the gains received byconsumers from engaging in transactions with suppliers. It is measured as thearea under the demand curve but above the price line. The height of the demandcurve measures the consumers willingness to pay, thus consumer surplus isdefined as the summation over each unit purchased, of the difference betweenthe willingness to pay and the actual price paid. See figure 1- the area denotedas CS is the consumer surplus if the price were pC.

Consumer Welfare An aggregate measure of consumer surplus across all consumers.

Continuous Quality Improvement (CQI) A program of continual re-examination to determine if a company can better meet the needs of its customers. Itbegins with the recognition that the product being provided by the firm is nota single dimensional physical item, but a multi-dimensional service which ismeeting some need of the customer, and then continually reassess what theneeds of the customer are and how the firm can better meet those needs.

Conversion Factor The multiplicative factor applied to the relative value scale toproduce a schedule of dollar amounts of payments to clinicians.

Copayment The practice by an insurance carrier or other provider group ofrequiring a patient to pay a fixed charge for each service used.

Cost-Benefit Analysis (CBA) A method of comparing the monetary value of all

GLOSSARY 247

of the benefits of some action with all of the monetarized costs. CBA is oftenused to compare alternative social projects to determine how to allocate monies,for example, should we fund public health program A or public health programB (assuming that we can only fund one program).

Cost-Effectiveness Analysis (CEA) A method of comparing one treatment regime against a standard using a single dimension of effectiveness, e.g., livessaved or quality-adjusted life years saved. The cost effectiveness ratio iscalculated as the change in costs divided by the change in effectiveness. Thisratio is then compared to a "standard" to determine if the new treatment is costeffective.

Cost-of-Service Regulation See Rate-of-Return regulation.

Cost Sharing The practice of an insurance company or health care system ofrequiring a patient to pay some of the costs of each service the receive.Deductibles, Copayments and Coinsurance are popular forms of cost sharing.

Cost Shifting A situation in which a health care provider compensates for theeffects of decreased revenue from one payer by increasing charges to anotherpayer.

Cross-Price Elasticity A measure of how the demand for one good changes inresponse to a change in the price of another good - where the changes aremeasured in percentage terms. If the cross-price elasticity is positive, the goodsare defined as "substitutes"; if the cross-price elasticity is negative, the goodsare defined as "compliments".

Current Procedural Terminology (CPT Codes) A system of codes (about13,000) developed by the American Medical Association for use in identifyingand billing of clinician services and diagnostic testing.

Customary, Prevailing, and Reasonable Charges (CPR) The method of payingclinicians under Medicare from 1965 until implementation of the Medicare FeeSchedule in January 1992. Payment for a service was limited to the lowest of(1) the clinician's billed charge for the service, (2) the clinicians customarycharge for the service, or (3) the prevailing charge for that service in thecommunity. See Usual, Customary, and Reasonable charges.

Deadweight Loss The loss in social welfare resulting from a price in excess of themarginal cost of production. That is, because the price is higher than marginalcost, and consumers only purchase a good if the price is less than theirwillingness to pay, there will be some consumers who would be willing to paymore than what it would cost to produce a good or service, who do not purchasethe good at the existing price. See figure 1 - the area denoted as DW is thedeadweight loss. One of the objectives of regulation is to minimize thedeadweight loss.

Deductible A cost sharing requirement of many insurance plans which requires


the enrollee to pay, out-of-pocket, the first X dollars for services obtained duringa specific period (generally enrollment year) before the coverage begins.Generally these amounts are on the order of$SOO per individual, or $1,000 perfamily although there is a large variation across plans.

Demand Function (also Demand Curve) The relationship between the price ofa good and how much an individual, or group of individuals would like topurchase at that price. Generally, demand functions slope downward (whenplotted with the price on the vertical axis and quantity on the horizontal axis)indicating that as the price of the good increases, consumers purchase less ofthe good. See figure 1 - the curve D represents the demand function.

Department of Health and Human Services (DHHS)

Diagnosis Related Group (DRG) A framework for grouping patients by diagnosis and/or procedures and other variables into a relatively small number ofrelatively homogeneous groups to permit the analysis of production acrosshospitals and health care delivery systems. DRGs are based on groupings ofICD9 codes. These codes are first grouped into 23 mutually exclusive andexhaustive Major Diagnostic Categories. Then, each category is broken intotwo groups depending on whether or not a surgical procedure was performed.Finally, these classifications are further broken down into separate categorieson the basis of age, co-morbidity, and the average length of stay/cost oftreatment. After their original development, DRGs evolved into a method usedby the federal government to pay hospitals prospectively for patient treatmentbased on the average length of stay and cost of each DRG. See ProspectivePayment System for additional details.

Discount Rate A measure used to value a dollar at some point in the future in termsof today. Usually expressed in terms of an annual percentage. It could bethought of as the inverse of the interest rate.

Economic Cost A measure of the resources consumed in producing a good orservice, when those resources are valued at their opportunity cost.

Economic Profit A measure of a firm's profit above the economic cost ofproviding the good or service.

Economies of Scale A situation in which the average cost of producing a good orservice decrease as the scale of production (i.e. quantity) increases.

Economies ofScope A situation in which the cost of producing two or more goodsor services jointly is less than the cost of producing them individually.

Efficacy A measure of how a drug performs under normal use, c.f., effectiveness.

Effectiveness Under FDA guidelines, and effective drug is defined as one that hasbeen demonstrated to achieve its intended objective in a clinically controlledsetting.

Elasticity A measure of responsiveness where things are measured in terms of

GLOSSARY 249

percentage changes rather than absolute changes. For example, a price elasticity, would be the percentage change in quantity divided by the percentagechange in price.

Employee Retirement Income Security Act of 1974 (ERISA) A law passed in1974 principally to protect employees' pension benefits, but which also insulated self-insured employers from state premium taxes and insurance regulations. Recent interpretations have been broadly extended these protections toinclude prohibitions on charging self-insured companies surcharges to compensate hospitals and other health care providers for uncompensated care; i.e.restricting cost shifting to self-insured companies.

End Stage Renal Disease (ESRD) Program An entitlement program underMedicare which provides payment for dialysis treatments to persons with endstage renal disease. and also provides Social Security payments to familymembers. Payments to treatment facilities are a fixed dollar amount. Sometimes called the "first DRG".

Externality A case in which the production (consumption) of a good by one firm(person) affects the profits or utility of another. For example, your getting a flushot provides a positive externality to your co-workers, because it reduces theprobability that they will be exposed to the flu virus. Alternatively, yoursmoking at work provides a negative externality because of the second handsmoke.

Experience Rating The practice of setting an insurance premium based, in part,on the past usage of the individual or group. See Community Rating.

Fee for Service A payment arrangement in which the provider is paid for eachservice given to a patient.

Fixed Cost Any cost which does not vary with the quantity of goods or servicesproduced.

Food, Drug and Cosmetics Act (1938) Legislation that established the FDA. Itrequired that all drug manufacturers preregister new drugs with the FDA andprovide proof of safety before they could be sold, giving the FDA the opportunity to prevent unsafe drugs from being marketed. In addition, it also established regulations creating the first real distinction between over-the-counterdrugs and prescription drugs, formerly any non-narcotic drug could be purchased either way.

Food, Drug and Cosmetics Act Amendments (1962) (Harris-Kehauffer Amendments) Amendments to the original FD&C Act which stipulated that pharmaceutical firms must demonstrate that their product is both safe and effective, forthe intended indication, before the product can be marketed in the United States.It also gave the FDA the responsibility of overseeing both the testing, manufacturing and marketing of pharmaceuticals.


Food and Drug Administration (FDA) An agency of the federal governmentcreated in 1938 and responsible for insuring that all pharmaceutical productssold in the United States are safe and effective.

Formulary A restricted list, generally of pharmaceuticals, from which a cliniciancan prescribe treatment for patients without obtaining special permission froma plan administrator. Also, a cost saving strategy under which a plan administrator negotiates prices with suppliers that wish to have products included onthe formulary. Finally, a list of "approved" pharmaceuticals a hospital pharmacy will supply to inpatients.

Free Rider Problem A free rider is an individual or firm that allows someone elseto pay for a public good, yet is able to enjoy all or some of the benefits fromthat good.

Fully Distributed Average Costs A regulatory pricing mechanism in which theall non-traced costs are allocated to individual products and prices are set tocover these fully distributed average costs.

Gate-Keeping The practice of controlling referrals or hospitalization, usually byassigning enrolled persons to a primary care provider who must authorizeadditional services.

Global Budget The idea of putting a limit on the amount of resources spent onmedical care for a specific group of individuals. Global budgets are generallyapplied in a top down fashion, such that one begins with a budget for the entirecountry, then budgets for each state, etc., down to (perhaps) the level of theindividual hospital or physician. Generally, budgets are enforced through theuse of withholds, in which a portion of the payment for services rendered iswithheld by the payor until the end of the year, at which time the money is paidout on a pro-rated basis if overall spending was less than the global budget.

Health Care Financing Administration (HCFA) An Agency of the Federalgovernment within the Department of Health and Human Services responsiblefor administering the financing and quality assurance programs for Medicareand the Federal participation in Medicaid.

Health Insurance Purchasing Cooperatives (HIPC) A local board created undermanaged competition to enroll individuals, collect and distribute premiums, andenforce the rules that manage the competition.

Health Maintenance Organization (HMO) A prepaid, organized health careplan. Individuals are enrolled in the plan, and services are provided through asystem ofaffiliated providers. Comprehensive benefits are financed by prepaidpremiums with limited co-payments. An HMO may be either a Staff Model,Group Model (which contracts with a physician group) or Independent PracticeAssociation.

Health Systems Agencies (HSA) A system of regional public organizations

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created by PL 93-641 to plan for the development ofhealth services and approvenew institutional services (CON). HSAs were to produce annual plans for theirregion with implementation objectives; regional plans were aggregated to thestate level. HSAs were advisory to other state agencies and were widespreadin the 1970s but have become less common because federal funding wasdiscontinued in 1986 by the Reagan Administration.

Hill-Burton Act (1946) A government program designed to expand rural healthcare facilities by providing matching grants to non-profit hospitals and healthcenters, in exchange for a promise that those facilities would provide care tothe needy.

HMOAct (1973) Under this act HMOs are required to have open enrollment oncea year, community rate all premiums, and offer a specific minimum benefitspackage if the want to be federally qualified. It also provided for feasibilitygrants, planning grants, and development funds; and required employers with25 or more employees, located in an area with a federally qualified HMO, tooffer their employees the HMO option in addition to any traditional healthbenefit plans.

ICD Codes A system of translating narrative diagnosis descriptions into a numbering system to make them computer readable. Under the direction of theWorld Health Organization (WHO), the codes are to be updated every 10 years.In the U.s. a Clinicial Modification (CM) of codes provides additional clinicalspecificity through a fifth digit (for diagnoses) or a fourth digit (for procedures).The current version is ICD-9; ICD-IO is intended to be implemented in 1994.

Income Elasticity The elasticity of demand for a particular good or service withrespect to an individuals income. That is, the percentage change in quantitydemanded divided by the percentage change in income.

Incomplete Markets A situation in which private markets fail to meet the demandfor a good or service. For example, individuals with cancer, AIDS, or someother known condition may not be able to buy private insurance at any price.Incomplete markets is often given as a rationale for government regulations ordirect involvement.

Indication The approved reason for prescribing a drug as listed on the packageinsert and in the Physician's Desk Reference. Although a drug may be onlyapproved for one indication, clinicians have a great deal of freedom to prescribethe drug for other medical conditions. Some health plans have started to cutdown on this freedom by only reimbursing patients for drugs which have anapproved indication for their diagnosis.

Independent Practice Association (IPA) An HMO that contracts with individualphysicians to provide services to HMO members at a negotiated per capita orfee-for-service rate. Physicians maintain their own offices and can contractwith other HMOs or fee-for-service patients.


Investigational New Drug Application (IND) An application, filed by a pharmaceutical firm, to begin testing a new chemical entity in humans. The INDapplication is a compilation of all known information about the compound anda description of the clinical research plan for the product and the specificprotocol for phase I study. The FDA has 30 days to reject the application orthe firm can begin phase I clinical trials.

Joint Commission on Accreditation of Health Care Organizations (JCAHO)A national organization of health care provider representatives that offersvoluntary inspections and accreditation on the quality ofoperations to hospitalsand other health care organizations. JCAHO accreditation is needed in orderfor a hospital to receive reimbursement under Medicare part A.

Length of Stay (LOS) See Average Length of Stay.

Managed Care Any system of delivering health services where the plan receivesa capitated payment for providing all "medically necessary" services to itsenrolled members. It often involves a defined delivery system ofproviders withsome form of contractual arrangement with the plan.

Managed Competition An approach to health care system reform where Accountable Health Plans compete to serve the medical needs of enrollees. Under atypical proposal, enrollees would sign up with an Health Insurance PurchasingCooperative and be provided a choice of plans during an open season. All HIPCmembers would pay community rated premium for coverage by the benchmarkplan, and pay any additional charges associated with more expensive plans.

Marginal Benefit The additional benefit of using one more unit of a good orservice.

Marginal Cost The additional cost of producing one more unit of output orproviding one more service.

Medicaid A joint federal and state program to pay for medical care for those whomeet the "need" criterion, generally in terms of family income. The benefits,above the federally mandated benefits, and need criteria vary state by state.

Medical Evaluation Study In depth evaluations of medical treatments designedto measure the effectiveness of treatment alternatives and support the development of practice guidelines. See also Outcomes Research.

Medicare - Part A The hospital insurance program that covers the cost of hospitaland certain related post-hospital services for most Americans over the age of65, persons who are disabled, and persons with end stage renal disease.Eligibility is normally based on prior payment of payroll taxes. Beneficiariesare normally responsible for an initial deductible per episode of illness andcopayments for some services.

Medicare - Part B The Supplementary Medical Insurance (SMI) program thatcovers the costs of physician's services. outpatient laboratory and X-ray tests,

GLOSSARY 253

durable medical equipment, outpatient care, and certain other services. Part Brequires payment of a monthly premium, which covers roughly 25 percent ofprogram costs. Beneficiaries are responsible for a deductible and coinsurancepayment for most covered services.

Medicare Economic Index (MEl) An index which measures the changes inpractice expenses and general earnings, which was used to limit the increasesin prevailing charges under Medicare between 1976 and 1992 (when RBRVSwas instituted).

Medicare Fee Schedule The resource based relative value fee schedule used byMedicare to pay physicians for services rendered.

Medicare Participating Physician and Supplier Program A program established as part of the Deficit Reduction Act of 1986 which rewarded physicianswho agreed to participate by accepting assignment from Medicare for allservices provided (i.e. would not balance bill patients) by 1) publishing adirectory of all such physicians for Medicare recipients, and 2) releasingparticipating physicians from the federally imposed price freeze (from 19841986) 6 months early.

Medigap Insurance Private health insurance for Medicare enrollees. The benefitsare designed to supplement Medicare coverage and may include paying Medicare deductibles, coinsurance, balance bills, and services not covered by Medicare.

Monopoly A situation in which there is one supplier ofa particular good or service,in a particular region, at a particular point in time. Ifanyone wishes to buy thatgood or service, they must purchase it from the monopolist. For example,Gentech is a monopolist with respect to the drug TPA.

Monopoly Power The ability of a firm to raise the market price for its servicesabove the competitive price and earn positive economic profits.

Monopsony A situation in which there is only one buyer of a particular good orservice in a particular region, at a particular point in time. If anyone wishes tosell that good or service, they must sell it to the monopsonist. For example, ina small town with only one hospital, that hospital is a monopsonist with respectto surgical nursing services.

Moral Hazard Problem An insurance term which represents the disincentivescreated by insurance for individuals to take measures which would reduce theamount of care needed because of the existence of the insurance. In the healthservices literature, it is more commonly used to express the additional quantityof health care demanded because of the net price of care to the consumer is lessthan the posted price because of insurance. See figure 2 - D represents thedemand for medical services by the individual. Without insurance, the consumer would have to pay the price of p for each unit of service, and wouldchoose to purchase q units of medical care. However, with insurance, and a


coinsurance rate of c, the consumer only pays the price of cp, and chooses ahigher level of services equal to qC. For example, if you have to pay $100 tovisit your doctor, you will only go when its urgent, but if you only have to pay$10, you will go more often.

National Health Planning and Resources Development Act (1974) Federal lawmandating that states establish Certificate-of-Need (CON) programs whichwould review and approve any changes in hospital bed capacity or majorequipment purchases above a specified threshold.

National Institutes of Health (NIH) In general, the health care research arm ofthe federal government. NIH contains various institutes, generally for relatedresearch (eg. Heart, Lung, and Blood; Cancer; Arthritis; etc). Institutes administer funds allocated to them for support of research conducted either intramurally by the Institute, or in the form of peer-reviewed competitive grants andcontracts to external researchers. In addition, NIH contains the Clinical Center,a very specialized hospital where patients are admitted under investigationalprotocols.

New Chemical Entity A chemical which has not previously been tested inhumans. A NCE is defined at the point when the firm files and InvestigationNew Drug Application (IND) and begins testing in humans. See Phase IClinical Trials.

Opportunity Cost The cost of committing a resource to a particular use andthereby eliminating it from potentially being used elsewhere. Thus, the opportunity cost is the marginal value of that resource in its next best use.

Oregon "Rationing" Plan Recently adopted changes to the Oregon Medicaidprogram which sought to expand coverage to all residents under the federalpoverty limit, but controlled expenditures by limiting coverage. The coveragelimitations were determined by first rank ordering a list of condition-treatmentpairs on the basis of cost-effectiveness, then fully funding each pair workingdown the list until the proposed budget was expended. Those items below thatpoint would not be paid for by Medicaid.

Outcomes Research In depth evaluations of medical treatments designed tomeasure the effectiveness of treatment alternatives and support the developmentof practice guidelines or support the promotion of specific products.

Pareto Efficiency A situation in which it is impossible to improve the welfare ofone party without hurting the welfare ofanother party. Situations in which thereare dead weight losses are said to be Pareto inefficient, because some consumerscould have their welfare increased if they were able to purchase the good at aprice which would more than cover the cost of providing that good.

Peer Review Organization (PRO) A corporation (either for-profit or non-profit)which replaced the PSROs for monitoring the appropriateness and quality ofcare provided under the Medicare and Medicaid programs. PROs use pre-ad-

GLOSSARY 255

mission reviews as their primary cost containment strategy.

Pharmaceutical Manufacturing Association (PMA) An industry association forthe major pharmaceutical firms in the United States.

Phase I Clinical Trial The first studies of a New Chemical Entity (NCE) inhumans. Generally, phase I studies are focused on determining the maximumtolerable dosage (MID) for humans, as well as studying the absorption,distribution, metabolism, and excretion patterns of the drug in humans. Toestablish the MID, researchers start out at relatively low doses (compared tothe MID in animals) and test the NCE in a small number of patients (generally3). As the study proceeds, the dose is escalated (generally on a pre-determinedschedule) and tested in new patients. This process continues until a pre-definedthreshold for toxicity is reached.

Phase II Clinical Trial The second stage of testing involving humans. Althoughthis stage begins to look for efficacy of the New Chemical Entity (NCE) in theintended indication, the primary purpose is to develop a safety profile for thedrug under normal conditions. The study will generally involve between 20and 50 patients, and attempt to discover some of the common side effects of thedrug.

Phase III Clinical Trial The final stage of testing a drug before it is marketed. Inthis stage, large scale (l00 - 30,000 patients) clinical trials are used to measurethe effectiveness of the drug versus standard treatments or placebo. Althoughdevelopment of the safety profile continues, the primary emphasis is showingthat the NCE is either 1) better than existing treatments, or 2) at least as goodas the existing treatments and has fewer side effects.

Phase IV Clinical Trial Additional testing of currently marketed drugs forpurposes of establishing new indications or developing promotional claims.

Physician Payment Review Commission (PPRC) Appointed by Congress in1986 to study the rising cost of physician services under Medicare Part B.Recommended development of the Medicare Fee Schedule.

Point-of-Service Plan A hybrid model of health care financing that combinesfeatures of both prepaid and indemnity insurance. Enrollees decide whether touse network or non-network providers at the time care is needed, but are usuallycharged sizable copayments for selecting the latter. See HMO and PreferredProvider Organization.

Post Marketing Surveillance The practice of monitoring the usage of a new orexisting drug in large populations using the techniques of pharmacoepidemiology to determine if there are any low probability but severe adverse reactions.

Practice Guideline An explicit statement of what is known and believed aboutthe benefits, risks, and costs of particular courses of medical action intended toachieve a meaningful difference in patient outcomes.


Pre-admission Review The practice of requiring a clinician to obtain pre-approvalfrom the insurance carrier or third party payer before admitting a patient to ahospital in a non-emergency situation. Generally used as part of a UtilizationReview program.

Pre-certification The practice of requiring a clinician to obtain pre-approval ofthe insurance carrier or third party payor before treating a patient in a non-emergency situation. Generally, pre-certification is limited to high cost diagnosticand treatment services such as CAT scans, Ultrasound, or MRI imaging.

Pre-Existing Condition Clause A provision commonly found in health insuranceplans which stipulates that treatment for a medical condition which existed priorto enrolling in the plan is not covered by the plan (as an attempt to avoid adverseselection problems.) For example, a person diagnosed with cancer who changesinsurance, will generally not be covered for cancer treatments for a period ofup to 2 years after enrolling in the new plan.

Prepaid Group Practice (PGP) A prepayment arrangement under which participating providers agree to provided necessary medical services to a member inexchange for an essentially capitated payment (some PGPs have co-paymentsassociated with some services). These organizations are frequently referred toas HMOs. Generally, all non-emergency services obtained outside the groupare not covered.

Preferred Provider Organization (PPO) An insurance arrangement in which thecost sharing is significantly reduced if the member obtains services from adesignated list of providers; but some coverage is provided for servicesrendered by providers outside of the network. Thus, a PPO can be viewed as ahybrid between the Prepaid Group Practice and Indemnity Coverage. SeePoint-of-Service Plan.

Preventive Care Generally, childhood immunizations and certain kinds of regularexaminations or testing (~.g. cholesterol screening, Pap tests, etc.). May alsoinclude risk reduction programs such as smoking cessation, weight loss, etc.

Price-Cap Regulation (PCR) A regulatory mechanism in which an index of thefirms prices is permitted to increase at an adjusted rate of inflation. In the caseof telecommunications, where PeR is popular in the US, the adjusted rate ofinflation is the Consumer Price Index (CPI) less a productivity offset X (forlong distance communications about 3 percent per year.)

Price Controls Generally short term measure used by governments to control therate of increase in prices, for example a price freeze which holds all prices fixedfor a specific period of time.

Price Elasticity Also, Own Price Elasticity. A measure of the responsiveness ofdemand to changes in price. Measured as the percentage change in quantitydivided by the percentage change in price. Because the demand curve is slopeddownward, the price elasticity is always negative.

GLOSSARY 257

Primary Care First contact, comprehensive and continuing care for any episodeof illness, as distinct from "secondary" or "tertiary" care.

Principal-Agent Problem An agency relationship is said to exist when there aretwo parties (a principle and an agent), where the principal must rely on the agentto do some thing on their behalf. The problem arises when the incentives of theagent are different from those of the principal. Typical examples of theprincipal-agent problem include: the conflict between stockholders and managers; stockholders must rely on management to run their firm and wantmanagers to work hard to maximize the value of the firm, while managers wantto maximize their total benefits (salary and perks); or the conflict betweendoctor and patient, where the patient must rely on the doctor to make her well,and the doctor, who, along with wanting to make the patient well, earns anincome from selling treatments to the patient.

Production Function A function which relates the maximum level of outputsobtainable from any given set on inputs.

Productive Efficiency An operation is said to be productive efficient if it isobtaining the maximum amount of output from a given set of physical inputs,that is, the firm is operating on the production possibilities frontier. Same asTechnical Efficiency.

Professional Standards Review Organization (PSRO) Organizations, mandatedunder the amendments to the Social Security Act of 1972, that assure the qualityand appropriateness of health care services delivered to federal beneficiariesthrough Concurrent Reviews, Medical Care Evaluation Studies, and ProfileAnalysis.

Profile Analysis The practice of using information collected in concurrent reviews, claims data, or discharge abstracts to identify areas of significantvariation in practice patterns or outcomes across individual institutions orclinicians. These areas then become subjects for future Medical EvaluationStudies and Outcomes Research.

Prospective Payment Assessment Commission (ProPAC) A review committeewhich reports to Congress on its activities in monitoring the ProspectivePayment System (PPS). ProPAC recommends changes in the payment systemand in DRG reformulation annually.

Prospective Payment System (PPS) The method of hospital reimbursementphased in by Medicare beginning in 1983 under which hospitals receive a fixedpayment determined by the patient's DRG. These rates are pinned to nationalstatistics on average length of stay (ALOS) and cost by DRG with certainadjustments for labor markets and hospital type.

Public Good A good that no one can prevent another from using (a.k.a. non-excludability), and for which the marginal cost of another person using the goodis very low (a.k.a. non-exclusivity) but for which the total cost of providing the


good is very high. Example, national defense - it protects everyone regardlessof whether they specifically paid for it; and my being protected does notdiminish the value of the protection to you. To some extent, hospitals andparticularly the provision ofemergency room services, can be viewed as publicgoods.

Quasi-Fixed Cost Any cost which does not vary over a range of output levels.For example, the costs of ultrasound machines (with a capacity of 15 patientsper day) would be a quasi-fixed cost up to 15 patients per day, but beyond thatone would need to have a second machine, and thus the cost of the machineswould be increased.

Ramsey Prices The set of prices which maximize consumer surplus subject to aprofit constraint for the firm. These prices are also referred to as efficient prices,because they minimize the dead weight losses to society.

Rand Health Insurance Experiment (HIE) A set of experiments conductedduring the 1970s to determine the impact of alternative forms of health insurance (levels of deductibles and co-insurance rates) on the demand for healthservices.

Randomized Clinical Trial (RCT) A clinical trial intended to measure theeffectiveness of a specific treatment in which patients are randomized into thetreatment and control group. The control group generally receives the "normal"treatment or a placebo. Often these studies are conducted as double-blindexperiments in which neither the patient nor the attending physician is awareof which treatment the patient is receive, although in some situations this isclearly not practical or ethical.

Rate base A measure ofthe invested capital ofa firm used to determine the revenuerequirement under Rate-of-Return regulation. Regulators often scrutinize theregulated firms investments in order to keep the firm from artificially inflatingthe rate base through net"dless expenditures on capital. See Averch-Johnsoneffect.

Rate-of-Return Regulation (ROR) A regulatory mechanism whereby prices areset so that the net operating profits of the firm are constrained to be less than orequal to an allowable rate-of-return times the rate base.

Referral The practice of one clinician referring a patient to another for specifictreatments. As partofa gate-keeping system, patients are only covered for visitsto specialists upon receiving a referral from their primary clinician.

Relative Value Scale (RVS) An index that assigns weights to each medical servicerepresenting the relative amount to be paid for each service. The RVS used inthe development of the Medicare Fee Schedule consists of three components:physician work, practice expense, and malpractice expense.

Renal Dialysis Treatment of end stage renal disease by artificially cleansing the

GLOSSARY 259

patient's system of built-up metabolites which the kidneys (the renal system)can no longer excrete. Dialysis may be done in a treatment setting by machine(hemodialysis), or by the patient (peritoneal dialysis) infusing a solution (dialysate) into the abdomen to draw out the toxins, then withdrawing the solutionfor disposal. See also End Stage Renal Dialysis Program.

Resource Based Relative Value Scale (RBRVS) A relative value scale that isbased on the resources involved in providing a service. See Relative ValueScale.

Retrospective Review The process of reviewing a patients services after thepatient has been discharged from the hospital.

Revenue Requirement Under Rate-of-Return regulation, the amount of revenueneeded to be raised through sales to cover the operating costs and the allowedreturn on the rate base.

Risk Adjuster The use of risk measures to adjust the premium paid on behalf ofa group of enrollees in order to compensate for expenses that are expected tobe lower or higher than average, based on the risk status of the enrollees.

Safe and Effective The criterion applied by the FDA to determine if a New DrugApplication is to be accepted.

Second Opinion A cost saving, quality improving strategy designed to eliminateunnecessary services by requiring patients to obtain a second opinion fromanother physician before undergoing expensive treatment.

Self Referral The practice of physicians referring patients to groups or organizations in which they have a financial interest.

Single Payor System An insurance mechanism in which the financial risk ofproviding treatment to the entire population (i.e. state or nation) is born by asingle entity, generally the government. Although a single payor system couldbe consistent with fee-for-service, it has generally become synonymous with"nationalized" or "socialized" medicine, in which the providers are employeesof the single payor.

Social Security Administration The federal agency charges with administeringthe Social Security system for retirees, the disabled, and patients with end stagerenal disease and their families.

Social Welfare A measure of the total net benefits to society because of theexistence of a market for a good or services. This is generally taken as the sumof the consumer surplus and the producers economic profits, although in thecase of health markets one would also want to include any extranalities.

Staff Privileges Rights granted annually to clinicians and affiliated staffmemberswhich allow the clinician to provide specific kinds of care in a hospital. Theextent of the privileges is determined by professional peers, based on educationand past performance of the clinician.


Sunk Cost A cost which cannot be recovered even if a firm was to go out ofbusiness. Examples might include: expenditures for printed business cards, orhighly specialized equipment (in excess of the salvage value).

Tax Equity and Fiscal Responsibility Act (1985)

Technical Efficiency. An operation is said to be technically efficient if it isobtaining the maximum amount of output for a given set of physical inputs.That is, the firm is operating on the production possibilities frontier. Same asProductive Efficiency.

Third Party Payer A financial arrangement in which neither the consumer (buyer)or provider of a good or service is financially responsible for paying for thatgood or service, but a third party (generally not present at the time of thetransaction) is responsible. The classic example of this is a standard indemnityinsurance plan.

Third Party Administrator (TPA) (Also Fiscal Intermediary) An organizationthat is responsible for processing the insurance claims for a health plan,generally providing utilization review, coverage checks, and checking thatdeductibles and cost sharing requirements have been met.

Total Quality Management (TQM) Generally attributed to W. Edward Deming,TQM advocates a set of principles of continuous quality improvement throughdata based analysis of the production process for goods or services, in thecontext of a clearly stated mission of the company and responsibility-centeredmanagement practices.

Traced Costs The practice of keeping track of all activities related to a particularproduct, service or patient for purposes of computing the average or standardcost. That is, one would trace the number of pills, nursing minutes, etc. to eachpatient in order to determine what that patient's care cost the hospital.

Universal Access (Also Universal Coverage) All members of the population(defined by citizenship) are afforded access to health care beyond emergenciesby mandates insurance coverage for basic health care services.

Usual, Customary, and Reasonable Charges (UCR) A method of establishingpayment used by private insurers that is comparable to Medicare's customary,prevailing, and reasonable charges. See Customary, Prevailing and ReasonableCharges.

Utilization Review (UR) A program that attempts to determine whether specificservices provided to individual patients were medically necessary and deliveredat the appropriate time, in a cost effective manner. Utilization review can beperformed either concurrently or retrospectively, and is used as a basis for denialof payments.

Veterans Administration (VA) An agency of the federal government responsiblefor providingmedical services to all veterans whom have injuries resulting from

GLOSSARY 261

their service, and which can provide medical services to any veteran on a spaceavailable basis.

VolumeOffset The change in the quantity and intensity ofservices that is projectedto occur in response to a change in fees. A 50 percent volume offset means thathalf of the savings from fee reductions will be offset by increased vplume ofservices. See elasticity of demand.

Volume Performance Standards (VPS) A mechanism included in OBRA89 toadjust fee updates based on how annual increases in actual expenditurescompare to previously determined performance standard rates of increase.

Welfare Triangle See deadweight loss.

Yardstick Competition A regulatory pricing policy in which the average cost ofall competing firms is used to determine the price level in order to induce thefirms to engage in cost-cutting innovations. The Prospective Payment Systemis an application of yardstick competition.

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Health Care Policy and Regulation