2: Paying for Health Care

Health care is not free. Someone must pay. But how? Does each person pay when receiving care? Do people contri­bute regular amounts in advance so that their care will be paid for when they need it? When a person contributes in advance, might the contribution be used for care given to someone else? If so, who should pay how much?

Health care financing in the United States evolved to its current state through a series of social interventions. Each intervention solved a problem but in turn created its own problems requiring further intervention. This chapter will discuss the historical process of the evolution of health care financing. The enactment in 2010 of the Patient Protection and Affordable Care Act, commonly referred to as the Affordable Care Act, ACA, or “Obamacare,” created major changes in the financing of health care in the United States.

The four basic modes of paying for health care are out-of-pocket payment, individual private insurance, employment-based group private insurance, and government financing (Table 2-1). These four modes can be viewed both as a historical progression and as a categorization of current health care financing.

Out-of-Pocket Payments

One hundred years ago, people like Fred Farmer paid physicians and other health care practitioners in cash or through barter. In the first half of the twentieth century, out-of-pocket cash payment was the most common method of payment. This is the simplest mode of financing—direct purchase by the consumer of goods and services (Fig. 2-1).

People in the United States purchase most consumer items and services, from gourmet restaurant dinners to haircuts, through direct out-of-pocket payments. This is not the case with health care (Arrow, 1963; Evans, 1984), and one may ask why health care is not considered a typical consumer item.

Need Versus Luxury

Whereas a gourmet dinner is a luxury, health care is regarded as a basic human need by most people.

If health care is a basic human right, then people who are unable to afford health care must have a payment mechanism available that is not reliant on out-of-pocket payments.

Unpredictability of Need and Cost

Whereas the purchase of a gourmet meal is a matter of choice and the price is shown to the buyer, the need for and cost of health care services are unpredictable. Most people do not know if or when they may become severely ill or injured or what the cost of care will be.

The unpredictability of many health care needs makes it difficult to plan for these expenses. The medical costs associated with serious illness or injury usually exceed a middle-class family’s savings.

Patients Need to Rely on Physician Recommendations

Unlike the purchaser of a gourmet meal, a person in need of health care may have little knowledge of what he or she is buying at the time when care is needed.

Health care is the foremost example of asymmetry of information between providers and consumers (Evans, 1984). A patient with abdominal pain is in a poor position to question a physician who is ordering laboratory tests, x-rays, or surgery. When health care is elective, patients can weigh the pros and cons of different treatment options, but even so, recommendations may be filtered through the biases of the physician providing the information. Compared with the voluntary demand for gourmet meals, the demand for health services is partially involuntary and is often physician rather than consumer-driven.

For these reasons among others, out-of-pocket payments are flawed as a dominant method of paying for health care services. Because the direct purchase of health services became increasingly difficult for consumers and was not meeting the needs of hospitals and physicians to be reliably paid, health insurance came into being.

Individual Private Insurance

With private health insurance, a third party, the insurer is added to the patient and the health care provider, who are the two basic parties of the health care transaction. While the out-of-pocket mode of payment is limited to a single financial transaction, private insurance requires two transactions—a premium payment from the individual to an insurance plan (also called a health plan), and a payment from the insurance plan to the provider (Fig. 2-2). In nineteenth-century Europe, voluntary benefit funds were set up by guilds, industries, and mutual societies. In return for paying a monthly sum, people received assistance in case of illness. This early form of private health insurance was slow to develop in the United States. In the early twentieth century, European immigrants set up some small benevolent societies in US cities to provide sickness benefits for their members. During the same period, two commercial insurance companies, Metropolitan Life and Prudential, collected 10 to 25 cents per week from workers for life insurance policies that also paid for funerals and the expenses of a final illness. The policies were paid for by individuals on a weekly basis, so large numbers of insurance agents had to visit their clients to collect the premiums as soon after payday as possible. Because of the huge administrative costs, individual health insurance never became a dominant method of paying for health care (Starr, 1982). In 2013, prior to the implementation of the individual insurance mandate of the ACA, individual policies provided health insurance for 7% of the US population (Table 2–1).

The ACA has many provisions, described in detail in the Kaiser Family Foundation (2013a) Summary of the Affordable Care Act and discussed more in Chapter 15. One of the main provisions is a requirement (called the “individual mandate”) that most US citizens and legal residents who do not have governmental or private health insurance purchase a private health insurance policy through a federal or state health insurance exchange, with federal subsidies for individual and families with incomes between 100% and 400% of the federal poverty level ($24,250 to $97,000 for a family of four). Details of the individual mandate are provided in Table 2-2.

Employment-Based Private Insurance

The development of private health insurance in the United States was impelled by the increasing effectiveness and rising costs of hospital care. Hospitals became places not only in which to die, but also in which to get well. However, many patients were unable to pay for hospital care, and this meant that hospitals were unable to attract “customers.”

In 1929, Baylor University Hospital agreed to provide up to 21 days of hospital care to 1,500 Dallas schoolteachers such as Betty Lerner if they paid the hospital $6 per person per year. As the Great Depression deepened and private hospital occupancy in 1931 fell to 62%, similar hospital-centered private insurance plans spread. These plans (anticipating health maintenance organizations [HMOs]) restricted care to a particular hospital. The American Hospital Association built on this prepayment movement and established statewide Blue Cross hospital insurance plans allowing free choice of hospital. By 1940, 39 Blue Cross plans controlled by the private hospital industry had enrolled over 6 million people. The Great Depression reduced the amount patients could pay physicians out of pocket, and in 1939, the California Medical Association set up the first Blue Shield plan to cover physician services. These plans, controlled by state medical societies, followed Blue Cross in spreading across the nation (Starr, 1982; Fein, 1986).

In contrast to the consumer-driven development of health insurance in European nations, coverage in the United States was initiated by health care providers seeking a steady source of income. Hospital and physician control over the “Blues,” a major sector of the health insurance industry, guaranteed that payment would be generous and that cost control would remain on the back burner (Law, 1974; Starr, 1982).

The rapid growth of employment-based private insurance was spurred by an accident of history. During World War II, wage and price controls prevented companies from granting wage increases, but allowed the growth of fringe benefits. With a labor shortage, companies competing for workers began to offer health insurance to employees such as Rose Riveter as a fringe benefit. After the war, unions picked up on this trend and negotiated for health benefits. The results were dramatic: Enrollment in group hospital insurance plans grew from 12 million in 1940 to 142 million in 1988.

With employment-based health insurance, employers usually pay much of the premium that purchases health insurance for their employees (Fig. 2-3). However, this flow of money is not as simple as it looks. The federal government views employer premium payments as a tax-deductible business expense. The government does not treat the health insurance fringe benefit as taxable income to the employee, even though the payment of premiums could be interpreted as a form of employee income. Because each premium dollar of employer-sponsored health insurance results in a reduction in taxes collected, the government is in essence subsidizing employer-sponsored health insurance. This subsidy is enormous, estimated at $250 billion per year (Ray et al., 2014).

The ACA made a change in employer-based health insurance, requiring employers with 50 or more full-time employees to offer coverage or pay a fee to the government; the fee is meant to discourage employers from dropping employee health insurance, which they might be tempted to do since their employees could buy individual insurance through the health insurance exchanges (Kaiser Family Foundation, 2013b).

The growth of employment-based health insurance attracted commercial insurance companies to the health care field to compete with the Blues for customers. The commercial insurers changed the entire dynamic of health insurance. The new dynamic was called experience rating. (The following discussion of experience rating can be applied to individual as well as employment-based private insurance.)

Health insurance provides a mechanism to distribute health care more in accordance with human need rather than exclusively on the basis of ability to pay. To achieve this goal, funds are redistributed from the healthy to the sick, a subsidy that helps pay the costs of those unable to purchase services on their own.

Community rating achieves this redistribution in two ways:

1. Within each group (bank managers, truck drivers, and mine workers), people who become ill receive benefits in excess of the premiums they pay, while people who remain healthy pay premiums while receiving few or no health benefits.

2. Among the three groups, the bank managers, who use less health care than their premiums are worth, help pay for the miners, who use more health care than their premiums could buy.

Experience rating is less redistributive than community rating. Within each group, those who become ill are subsidized by those who remain well, but among the different groups, healthier groups (bank managers) do not subsidize high-risk groups (mine workers). Thus the principle of health insurance, which is to distribute health care more in accordance with human need rather than exclusively on the ability to pay, is weakened by experience rating (Light, 1992).

In the early years, Blue Cross plans set insurance premiums by the principle of community rating, whereas commercial insurers used experience rating as a “weapon” to compete with the Blues (Fein, 1986). Commercial insurers such as Healthy Insurance Company could offer cheaper premiums to low-risk groups such as bank managers, who would naturally choose a Healthy commercial plan at $300 over a Blue Cross plan at $500. Experience rating helped commercial insurers overtake the Blues in the private health insurance market. While in 1945 commercial insurers had only 10 million enrollees, compared with 19 million for the Blues, by 1955 the score was commercials 54 million and the Blues 51 million.

Many commercial insurers would not market policies to such high-risk groups as mine workers, leaving Blue Cross with high-risk patients who were paying relatively low premiums. To survive the competition from the commercial insurers, Blue Cross had no choice but to seek younger, healthier groups by abandoning community rating and reducing the premiums for those groups. In this way, many Blue Cross and Blue Shield plans switched to experience rating. Without community rating, older and sicker groups became less and less able to afford health insurance.

From the perspective of the elderly and those with chronic illness, experience rating is discriminatory. Healthy persons, however, might have another viewpoint and might ask why they should voluntarily transfer their wealth to sicker people through the insurance subsidy. The answer lies in the unpredictability of health care needs. When purchasing health insurance, an individual does not know if he or she will suddenly change from a state of good health to one of illness. Thus, within a group, people are willing to risk paying for health insurance, even though they may not use it. Among different groups, however, healthy people have no economic incentive to voluntarily pay for community rating and subsidize another group of sicker people. This is why community rating cannot survive in a market-driven competitive private insurance system (Aaron, 1991).

In a major reform contained within the ACA, insurers are severely limited in using experience rating to set premiums; they can only vary premiums based on family size, geographic location, age, and smoking status. The ACA also limits how much premiums can differ between older and younger individuals (Kaiser Family Foundation, 2013b).

The most positive aspect of health insurance—that it assists people with serious illness to pay for their care—has also become one of its main drawbacks—the difficulty in controlling costs in an insurance environment. With direct purchase, the “invisible hand” of each individual’s ability to pay holds down the price and quantity of health care. However, if a patient is well insured and the cost of care causes no immediate fiscal pain, the patient will use more services than someone who must pay for care out of pocket. In addition, particularly before the advent of fee schedules, health care providers could increase fees more easily if a third party was available to foot the bill.

Thus health insurance was originally an attempt by society to solve the problem of unaffordable health care under an out-of-pocket payment system, but its very capacity to make health care more affordable created a new problem. If people no longer had to pay out of their own pockets for health care, they would use more health care; and if health care providers could charge insurers rather than patients, they could more easily raise prices, especially during the era when the major insurers (the Blues) were controlled by hospitals and physicians. The solution of insurance fueled the problem of rising costs. As private insurance became largely experience rated and employment based, persons who had low incomes, who were chronically ill, or who were elderly found it increasingly difficult to afford private insurance.

Government Financing

Employment-based private health insurance grew rapidly in the 1950s, helping working people and their families to afford health care. But two groups in the population received little or no benefit: the poor and the elderly. The poor were usually unemployed or employed in jobs without the fringe benefit of health insurance; they could not afford insurance premiums. The elderly, who needed health care the most and whose premiums had been partially subsidized by community rating, were hard hit by the trend toward experience rating. In the late 1950s, less than 15% of the elderly had any health insurance (Harris, 1966). Only one program could provide affordable care for the poor and the elderly: tax-financed government health insurance.

Government entered the health care financing arena long before the 1960s through such public programs as municipal hospitals and dispensaries to care for the poor and through state-operated mental hospitals. But only with the 1965 enactment of Medicare (for the elderly) and Medicaid (for the poor) did public insurance payments for privately operated health services become a major feature of health care in the United States. Medicare Part A (Table 2-3) is a hospital insurance plan for the elderly financed largely through social security taxes from employers and employees. Medicare Part B (Table 2-4) insures the elderly for physician services and is paid for by federal taxes and monthly premiums from the beneficiaries. Medicare Part D, enacted in 2003, offers prescription drug coverage and is paid for by federal taxes and monthly premiums from beneficiaries. Medicaid (Table 2-5) is a program run by the states that is funded by federal and state taxes, which pays for the care of millions of low-income people. In 2013, Medicare and Medicaid expenditures totaled $586 and $450 billion, respectively (Hartman et al., 2015).

With its large deductibles, copayments, and gaps in coverage, Medicare paid for only 58% of the average beneficiary’s health care expenses in 2012. Ninety percent of the 50 million Medicare beneficiaries in 2012 had supplemental coverage: Thirty-three percent of beneficiaries had additional coverage from their previous employment, 19% purchased supplemental private insurance (called “Medigap” plans), 24% were enrolled in the Medicare Advantage program, and 14% were enrolled in both Medicare and Medicaid (Kaiser Family Foundation, 2015a).

The Medicare Modernization Act (MMA) of 2003 made two major changes in the Medicare program: the expansion of the role of private health plans (the Medicare Advantage program, Part C) and the establishment of a prescription drug benefit (Part D). Under the Medicare Advantage program, a beneficiary can elect to enroll in a private health plan contracting with Medicare, with Medicare subsidizing the premium for that private health plan rather than paying hospitals, physicians, and other providers directly as under Medicare Parts A and B. Beneficiaries joining a Medicare Advantage plan sacrifice some freedom of choice of physician and hospital in return for lower out-of-pocket payments and are only allowed to receive care from health care providers who are connected with that plan. Two-thirds of beneficiaries with Medicare Advantage plans are in health maintenance organizations (HMOs) (see Chapter 6); the remainder are in private fee-for-service plans. In order to channel more patients into Medicare Advantage plans, the MMA provided generous payments to those plans, with the result that they initially cost the federal government 14% more than the government paid for health care services for similar Medicare beneficiaries in the traditional Part A and Part B programs. The ACA reduced payments to Medicare Advantage plans with the goal of saving the Medicare program $136 billion over the following 10 years. In 2012, HMO Medicare Advantage plans on average cost the federal government 7% less than traditional Medicare while fee-for-service plans cost 12% to 18% more than traditional Medicare (Biles et al., 2015).

Medicare Part D provides partial coverage for prescription drugs. In 2013, 73% of Part D was financed through tax revenues, and 75% of Medicare beneficiaries had enrolled in the voluntary Medicare Part D program. Part D has been criticized because (1) there are major gaps in coverage, (2) coverage has been farmed out to private insurance companies rather than administered by the federal Medicare program, and (3) the government is not allowed to negotiate with pharmaceutical companies for lower drug prices. These three features of the program have caused confusion for beneficiaries, physicians, and pharmacists and a high cost for the program. Two-thirds of beneficiaries on Medicare Part D are enrolled in one of the 1,001 stand-alone private prescription drug plans and one-third receives their Part D coverage through a Medicare Advantage plan. Sixty-three percent are enrolled in one of five large companies. Different plans cover different medications and require different premiums, deductibles, and coinsurance payments. The standard benefit in 2015 has a $320 deductible and 25% coinsurance up to $2,960 in total drug costs, followed by a coverage gap. During the gap, enrollees are responsible for a larger share of their total drug costs until their total out-of-pocket spending reaches $4,700. Thereafter, enrollees pay only a small percentage of drug costs. The coverage gap, called the “donut hole,” is a major problem for patients with chronic illness needing several medications. The ACA gradually reduces the amounts beneficiaries must pay in the donut hole (Kaiser Family Foundation, 2015b).

In 2009, the trustees of the Medicare program estimated that the Part A trust fund would be depleted by 2017. The ACA, by raising social security payments and reducing expenditures, extended Medicare’s solvency through 2030.

The Medicaid program is jointly administered by the federal and state governments, with the federal government contributing at least 50% of the funding to match state expenses for operating Medicaid programs. Although designed for low-income Americans, not all poor people have traditionally been eligible for Medicaid. In addition to being poor, until enactment of the ACA Medicaid required that people also meet “categorical” eligibility criteria such as being a young child, pregnant, elderly, or disabled.

The ACA (Table 2-5) eliminated the categorical eligibility criteria and required that beginning in 2014, states offer the program to all citizens and legal residents with family income at or below 138% of the Federal Poverty Line—about $16,000 in 2015. The ACA did not change Medicaid policies that continue to exclude undocumented immigrants from eligibility for federal funding. The ACA intended that it be mandatory for states to expand Medicaid eligibility, and provided states an incentive for expansion by having the federal government pay almost all the cost of the increased Medicaid enrollment (100% of the cost of expanded enrollment in 2014 to 2016, phased down to 90% in 2020 and thereafter). However, in June 2012, the Supreme Court ruled that the ACA’s Medicaid expansion was optional for states. In February 2015, only 28 states plus the District of Columbia had expanded Medicaid (Obamacare Facts, 2015; Kaiser Commission on Medicaid and the Uninsured, 2015). Medicaid now covers one in six people in the United States, making it the single largest health program in the nation. Enrollment grew dramatically in recent years even before implementation of the ACA in 2014, with enrollment increasing from 32 million to 60 million people between 2000 and 2013 (9 million of whom were “dual eligibles” receiving both Medicare and Medicaid). By the end of 2014, an additional 6 million people had enrolled in states participating in ACA Medicaid expansion—falling short of the goal of 16 million new enrollees, if all states had participated in the expansion (Rosenbaum, 2014).

From 2000 to 2013, Medicaid expenditures rose from $200 billion to $450 billion. To slow down this expenditure growth, the federal government ceded to states enhanced control over Medicaid programs through Medicaid waivers, which allow states to make alterations in the scope of covered services, require Medicaid recipients to pay part of their costs, and obligate Medicaid recipients to enroll in managed care plans (see Chapter 4). In 2014, more than half of Medicaid recipients were enrolled in managed care plans. Because Medicaid pays primary care physicians an average of 58% of Medicare fees, the majority of adult primary care physicians limit the number of Medicaid patients they will see.

In 1997, the federal government created the State Children’s Health Insurance Program (SCHIP), a companion program to Medicaid. SCHIP covers children in families with incomes at or below 200% of the federal poverty level, but above the Medicaid income eligibility level. States legislating a SCHIP program receive generous federal matching funds. In 2012, 8 million children were enrolled in the program, some of whom are transitioning to Medicaid under the expanded eligibility criteria enacted in the ACA.

Government health insurance for the poor and the elderly added a new factor to the health care financing equation: the taxpayer (Fig. 2-4). With government-financed health plans, the taxpayer can interact with the health care consumer in two distinct ways:

1. The social insurance model, exemplified by Medicare, allows only those who have paid a certain amount of social security taxes to be eligible for Part A and only those who pay a monthly premium to receive benefits from Part B. As with private insurance, social insurance requires people to make a contribution in order to receive benefits.

2. The contrasting model is the Medicaid public assistance model, in which those who contribute (taxpayers) may not be eligible for benefits (Bodenheimer & Grumbach, 1992).

It must be remembered that private insurance contains a subsidy: redistribution of funds from the healthy to the sick. Tax-funded insurance has the same subsidy and usually adds another: redistribution of funds from upper- to lower-income groups. Under this double subsidy, exemplified by Medicare and Medicaid, healthy middle-income employees generally pay more in social security payments and other taxes than they receive in health services, whereas unemployed, disabled, and lower-income elderly persons tend to receive more in health services than they contribute in taxes.

The advent of government financing improved financial access to care for some people, but, in turn, aggravated the problem of rising costs. The federal government and state governments have responded by attempting to limit Medicare and Medicaid payments to physicians, hospitals, and managed care plans.

Different methods of financing health care place different burdens on the various income levels of society. Payments are classified as progressive if they take a rising percentage of income as income increases, regressive if they take a falling percentage of income as income increases, and proportional if the ratio of payment to income is the same for all income classes (Pechman, 1985).

What principle should underlie the choice of revenue source for health care? A central purpose of the health care system is to maintain and improve the health of the nation’s population. As discussed in Chapter 3, rates of mortality and disability are far higher for low-income people than for the wealthy. Burdening low-income families with high levels of payments for health care (i.e., regressive payments) reduces their disposable income, amplifies the ill effects of poverty, and thereby worsens their health. It makes little sense to finance a health care system—whose purpose is to improve health—with payments that worsen health. Thus, regressive payments could be considered “unhealthy.”

Out-of-pocket payments are a regressive mode of financing. According to the 1987 National Medical Care Expenditure Survey, out-of-pocket payments took 12% of the income of families in the nation’s lowest-income quintile, compared with 1.2% for families in the wealthiest 5% of the population (Bodenheimer & Sullivan, 1997). This pattern is confirmed by the 2000 Medical Expenditure Panel Survey (MEPS, 2003). Many economists and health policy experts would consider this regressive burden of payment as unfair. Aggravating the regressivity of out-of-pocket payments is the fact that lower-income people tend to be sicker and thus have more out-of-pocket payments than the wealthier and healthier.

Experience-rated private health insurance is a regressive method of financing health care because increased risk of illness tends to correlate with reduced income. If Jim Hale and Jack Hurt were enrolled in a community-rated plan, each with a premium of $300, they would respectively pay 5% and 17% of their incomes for health insurance. With community rating, the burden of payment is regressive, but less so than with experience rating. Most private insurance is not individually purchased but rather obtained through employment. How is the burden of employment-linked health insurance premiums distributed?

Do Jill and Bill pay nothing for their health insurance? Not exactly. Employers generally agree on a total package of wages and fringe benefits; if Jill and Bill did not receive health insurance, their pay would probably go up by nearly $300 per month. That is why employer-paid health insurance premiums are generally considered deductions from wages or salary, and thus paid by the employee (Blumberg et al., 2007). For Jill, health insurance amounts to only 5% of her income, but for Bill it is 12%. The MEPS corroborates the regressivity of employment-based health insurance; in 2001 to 2003, premiums took an average of 10.9% of the income of families in between 100% and 200% of the Federal Poverty Line compared with 2.3% for those above 500% of poverty (Blumberg et al., 2007). In 2012, employer-sponsored health insurance premiums represented 58% of family income for the bottom 40% of American families compared with 4% for the top 5% (Blumenthal & Squires, 2014).

The progressive income tax is the largest tax providing money for government-financed health care. Most other taxes are regressive (e.g., sales and property taxes), and the combined burden of all taxes that finance health care is roughly proportional (Pechman, 1985).

In 2009, 46% of health care expenditures were financed through out-of-pocket payments and premiums, which are regressive, while 47% was funded through government revenues (Martin et al., 2011), which are proportional. The sum total of health care financing is regressive. In 1999, the poorest quintile of households spent 18% of income on health care, while the highest-income quintile spent only 3% (Cowan et al., 2002). Overall, the US health care system is financed in a manner that is unhealthy.

Neither Fred Farmer nor his great-grandson Ted had health insurance, but the modern-day Mr. Farmer’s predicament differs drastically from that of his ancestor. Third-party financing of health care has fueled an expansive health care system that offers treatments unimaginable a century ago, but at tremendous expense.

Each of the four modes of financing health care developed historically as a solution to the inadequacy of the previous modes. Private insurance provided protection to patients against the unpredictable costs of medical care, as well as protection to providers of care against the unpredictable ability of patients to pay. But the private insurance solution created three new, interrelated problems:

1. The opportunity for health care providers to increase fees to insurers caused health services to become increasingly unaffordable for those with inadequate insurance or no insurance.

2. The employment-based nature of group insurance placed people who were unemployed, retired, or working part-time at a disadvantage for the purchase of insurance, and partially masked the true costs of insurance for employees who did receive health benefits at the workplace.

3. Competition inherent in a deregulated private insurance market gave rise to the practice of experience rating, which made insurance premiums unaffordable for many elderly people and other medically needy groups.

To solve these problems, government financing was required, but government financing fueled an even greater inflation in health care costs.

As each “solution” was introduced, health care financing improved for a time. But rising costs have jeopardized private and public coverage for many people and made services unaffordable for those without a source of third-party payment. The problems of each financing mode, and the problems created by each successive solution, have accumulated into a complex crisis characterized by inadequate access for some and high costs for everyone.