This section outlines the history of supply restrictions for hospitals and physicians as well as the current policies that give providers incentives to consolidate their services, particularly in higher-cost hospital settings, and that subsidize high prices.
The United States spends the most and has the worst outcomes
Health experts generally agree that we can measure the performance of a country’s healthcare system by balancing patient access and outcomes with the cost that the system assesses for that care. Because the purpose of the healthcare system is to save lives and prevent unnecessary suffering from treatable conditions, comparing countries by combining measures of cost and outcomes can illuminate where the U.S. stands in comparison with similarly wealthy nations.
But how expenditures relate to outcomes is not straightforward. Each country has populations with unique health needs, and spending on care represents different types of interventions, care delivery models, and uses of technology.13 In particular, a country whose population has a higher underlying prevalence of disease cannot readily be compared with a country where the population is healthier if our goal is to focus on the performance of the healthcare system once people are sick. To mitigate this problem, Figure 1 focuses on what the OECD calls “treatable deaths” — that is, deaths from conditions that would not be fatal if properly detected and treated. This measure, unlike life expectancy, does not include suicide deaths or traffic fatalities, which occur at higher rates in the U.S. than in other wealthy countries.14 Nor does it include conditions such as, for example, lung cancer. The intuition is that if a fatal disease is generally preventable, a health system with higher incidence of that disease should not be “penalized” in this performance measure. Treatable causes of mortality do include some cancers, diabetes and other endocrine diseases, circulatory system diseases, and other conditions.
Figure 1. The U.S. spends the most on healthcare and has the highest rate of treatable deaths among highest spending countries15
Figure 1 clearly shows that among high-spending countries, the U.S. is a remarkable outlier in terms of outcomes and spending. Among the top 12 highest-spending countries, healthcare makes up the largest portion of GDP in the United States, while the U.S. lags behind those same countries in deaths from treatable conditions.
The U.S. may spend a reasonable amount on healthcare considering its above-average population needs. However, the outcomes indicate that funding is not going towards the types of interventions or delivery models that work for patients. Patients report experiences with the health system that confirm the concerning statistics. A recent poll found that only 6 percent of Americans felt the health system offered them high value.16 Addressing the issues plaguing health supply will require a focus on both improving value and incentivizing quality care delivery. This starts with identifying the causes of our high and ineffective health spending.
Negotiated service prices are driving ineffective health spending
To identify the key drivers of ineffective health spending, we must look no further than the prices providers charge for their services. To see why provider charges are so important, consider the breakdown of health spending in Figure 2.
Figure 2. Hospital care and physician services make up the majority of healthcare spending17
Prescription drugs consume an enormous amount of political energy because patients often pay for them out of pocket, making the expense visible to those who can afford it and putting medication out of reach for those who cannot. But they account for only 10 percent of the total $4.5 trillion in health spending in the United States. Spending on hospitals and physician offices accounts for over half, and this has been the case since at least 1960.18
Which payers are covering healthcare costs and what is driving the growth? Spending on health services is done primarily in three ways: out-of-pocket costs (11% of total spending), private health insurance (29%), and government programs like Medicare, Medicaid, CHIP, Veterans Affairs, etc. (43%). The remainder of government spending goes toward other third party programs, state and local programs, and public health and investment (17%). As with prescription drugs, patients are ultimately the only payer, though: They cover health insurance premiums in the private market and pay taxes to cover government insurance programs and any other health spending.
Figure 3 illustrates that in the crucial arena of hospitals and physicians’ services it is rising prices, not utilization, that are responsible for driving up health spending in recent years. Accounting for inflation, prices (stated in 2019 dollars) have increased at much higher rates than utilization in recent years, aligning closer to the cumulative rise in total spending on healthcare services. About two-thirds of the spending growth between 2015 and 2019 came from higher prices, which rose by 18 percent. Increased service utilization, which include visits and prescriptions per person, grew by only 3.6 percent. The gap was even more pronounced for inpatient care, which had a 30 percent cumulative rise in prices and a -12.5 percent decrease in utilization. Prices for care are rising faster than demand for care, an inefficiency that underlines an urgent need to specifically address prices as a driver of spending.
Figure 3. Average prices increase at higher rates than utilization, alongside total spending19
International evidence also suggests negotiated service prices are driving spending. The U.S. offers relatively fewer healthcare resources to patients while maintaining relatively higher prices. The United States sits below the OECD average in several metrics related to healthcare supply: As of 2015, the U.S. had 19 percent fewer practicing physicians than the OECD median, 20 percent fewer practicing nurses, 26 percent fewer inpatient hospital beds, and the lowest percentage of generalist physicians in the OECD.20 Meanwhile, as of 2017, price levels for health goods and services in the United States were 27 percent higher than the OECD average and 36 percent higher for hospital care.21
Due to relatively higher prices, the U.S. spends three times the OECD average but only consumes care at two times the OECD average.22 This is why simply reducing overutilization of healthcare services is not an effective strategy to improve the American system’s performance — instead, we must reduce prices to improve value. Scaling up higher-value care requires incentivizing and expanding care models with reduced prices (like independent physician offices and ambulatory surgery centers) and improving overall market dynamics to lower prices on hospital and physician care.
Although all transactions ultimately lead back to patients’ wallets, it is primarily commercial insurers and the government that negotiate and pay physician and hospital bills. Patients are largely disconnected from the actual cost of care at physician offices and hospitals. Patient out-of-pocket spending only accounted for 2.6 percent of payments to hospitals in 2022 and around 7.6 percent of payments to physicians and clinics.23 Medicare covers around 26 percent of hospital and physician services, while commercial insurance takes on between 35 and 39 percent.24 Patients rely on their insurance company and their government to negotiate fair rates for services. Medicare payments to physicians and hospitals are determined via federal rules and regulations, and the programs tend to pay less than commercial insurers do for the same services.25 In the private market, those prices are decided via negotiation between the insurance company and provider.
Over the past few years, providers have been integrating both horizontally and vertically, consolidating ownership by buying up hospitals, physician offices, and even merging with insurance companies. Although some hospital consolidation provides benefits in the way of better coordination for care, which can reduce operating costs, research consistently shows that hospital mergers result in higher prices with no corresponding benefits in the way of quality.26 A study of 1,164 hospital mergers from 2000 to 2020 found that prices increased by an average of 1.6 percent over two years, with a 5.2 percent increase in cases where mergers significantly boosted market power.27 As providers consolidate, they gain bargaining leverage over insurance companies in price negotiations. Higher negotiated prices for insurers mean higher premiums for patients and higher costs for employers.
But higher premiums also create more revenue for insurance companies. Because of this, insurance carriers do not always have sufficient incentive to negotiate lower rates for the services they cover. This can be observed in the difference between cash pay rates and negotiated rates. For example, the cash price for a colonoscopy can be as much as 128 percent lower than the prices insurance companies negotiated for the same procedure.28 Insurance companies can negotiate uncompetitive prices for routine services because paying higher prices does not necessarily mean they collect less revenue.29 They only need to set premiums in such a way that covers their costs.
Policies to decrease health costs must focus on leveling the playing field in price negotiations and aligning incentives for payers. Preventing consolidation via antitrust enforcement requires a reactive whack-a-mole approach, and while addressing anticompetitive conduct in this way can help on a case-by-case basis, antitrust enforcement does not change the underlying incentive structure for providers.30 Preventing future consolidation must start with reforming the foundational market incentives that encourage hospitals to consolidate.
Before we explore policies to correct the many perverse incentives that encourage hospitals to consolidate, an important question remains: Why does the U.S. offer fewer healthcare resources to patients?
History of hospital supply restrictions
In 1960, the United States had 9.2 hospital beds per 1,000 people. In 2017, that number was around 2.9 – 43 percent fewer beds than the OECD average.31 Figure 4 illustrates the drastic drop in hospital bed availability over the years. The United States population has increased over 85 percent since 1960 and total hospital bed supply has decreased 68 percent in that same time period.32
Figure 4. Availability of hospital beds has decreased every decade since 196033
There are numerous reasons for the drop in hospital bed availability, including a shift away from inpatient to more outpatient care due to technological advances and Medicare payment incentives for shorter hospital stays.34 The drop in bed availability is also due to policy decisions spurred by concerns over excess hospital capacity and the effect it had on spending. At a time of rising demand for health services precipitated by the creation of Medicare and Medicaid in 1965, the U.S. passed the National Health Planning and Resources Development Act of 1974. The bill established a federal and state regulatory system to restrict the supply of hospitals. At the time, Congress believed that the increase in hospitals being built due to legislation like the Hill-Burton Act of 1946, which provided grant funding for hospital construction, was causing an unnecessary increase in spending on hospital care.35 The intellectual foundation of the restrictive 1974 bill was “Roemer’s Law,” a theory from UCLA researcher Milton Roemer, who argued that in an insured population, “a bed built is a bed filled:” Providers would induce demand by offering beds to insured patients where payment was guaranteed.36 By decreasing available hospital beds, the U.S. could theoretically decrease utilization, and the costs associated with it – essentially, a rationing of hospital care.
But we now know that while federal and state health spending did balloon following Medicare and Medicaid creation, increasing by 12 percent each year between 1966 and 1973, it was driven by increased demand for services rather than an oversupply of facilities for care.37 While an increase in available services can prompt more utilization, the ratio is not 1:1. Later research found that a 10 percent increase in bed availability led to a 4 percent increase in utilization, a ratio of 5:2.38
Even when applying Roemer’s Law to other types of services such as imaging, there is limited correlation between acquiring equipment and increased utilization.39 Rather than restrict expansions and limit providers, we should give them the flexibility to expand services and capacity in response to an increase in demand for healthcare services.
Hospitals began reporting strained capacity in the early 2000s.40 With per-enrollee spending continuing to rise year-over-year during this time, industry groups and the media began reporting increased interest in expanding hospital capacity to meet the demand for care. Yet, the regulatory barriers to increasing capacity and supply of healthcare centers remain.
Among the entry barriers are state laws known as Certificates of Need (CON). The National Health Planning and Resources Development Act required states to establish CON programs to ensure that additional hospital construction and equipment were needed or risk the loss of federal funding. CON programs are administered by state health authorities and require providers to request approval to build hospital facilities or acquire new equipment.41 In 1964, New York became the first state to enact a CON law; 48 other states followed suit by 1982. Although the federal mandate and corresponding incentives were repealed in 1987, 38 states still have a CON or similar program.42
CON laws may establish a helpful incentive for hospitals to consider expanding capacity by becoming more efficient (rather than adding equipment/facilities), but the laws also allow existing providers to ward off competition. In most states, the approval process allows for competing hospital systems to challenge new market entrants and even sue to prevent the building of new facilities. As a result, current providers are able to exercise what amounts to a “competitor’s veto” of new hospital construction.
To be sure, the relationship providers have with expanding capacity is complicated. Some research shows that strained capacity can improve a provider’s bargaining leverage in negotiations with insurance companies.43 This opens the possibility that providers might deliberately restrict their own supply, a problem that repealing CON laws would not solve. But it also underscores their incentive to restrict new entrants into the market — a problem that CON law repeal would address. Research in the early 2000s found that hospital services did not adjust well to increases in demand, moving slowly and often lagging behind the need.44 This was before further increases in demand for services spurred by the Affordable Care Act, which expanded Medicaid coverage to the previously uninsured in some states. Later research found the supply response to Medicaid expansion to be similarly inelastic, due to a combination of entry barriers, oligopolistic providers charging higher prices rather than increasing supply, and the lead time required to set up new care centers.45
It is difficult to estimate how many hospital construction plans were delayed, spiked, or never conceived due to CON programs, but research consistently finds that patients in CON states have access to fewer hospitals.46 Following CON repeal in five states, researchers found a substantial increase in hospitals in both urban and rural settings.47 CON repeal also has effects on health outcomes. Research shows that states with CON laws have higher mortality rates for pneumonia, heart failure, and post-surgery complications.48 Ultimately, CON rationing methods were a tragically blunt attempt to mitigate the perverse provider incentives of the fee-for-service payment model, capping supply to limit “provider-induced demand” without regard to the value of the care subject to the cap.
The efforts to limit hospital supply and bed availability in the 1960s and 70s have resulted in a provider market that is slow to respond to increases in demand for care. Providing patients more options for care and allowing existing hospitals the flexibility needed to meet demand will improve care delivery. But it is not just hospitals that experienced restrictive policies due to concerns about oversupply. Physicians now face a similar challenge.
History of physician supply restrictions and the primary care shortage
It is widely understood that the United States is approaching a physician supply crisis. The Association of American Medical Colleges (AAMC) estimates that by 2036 the U.S. will be short 20,000 to 40,000 primary care doctors and as many as 124,000 total doctors.49 Figure 5 shows how the U.S. compares to the top 12 highest spending OECD countries when it comes to both generalists and specialists per capita. Generalist physicians under the OECD definition are similar to what the U.S. would refer to as primary care doctors. Specialists represent anyone who focuses on a patient group or medical field, including surgeons, psychiatrists, pediatricians, etc. While the U.S. is roughly in the middle of the pack with the number of specialists per capita compared to other high-spending countries, it has the smallest number of primary care physicians.
Figure 5. The U.S. lags behind high-spending countries in primary care physicians, but not specialists50
The dearth of primary care physicians and solid supply of specialists can be explained by bottlenecks and faulty incentives in the U.S. residency system’s pipeline.51 Becoming a doctor in the U.S. requires anywhere from 11 to 19 years of post-secondary education and training. U.S. doctors then graduate with over $200,000 in student debt on average with no guarantee of matching with a residency.52 In contrast, medical students in Europe only go through a dedicated six-year medical program, which allows them to get placed into medical practices quickly.53 Medical students in the U.S. have a larger incentive than those in Europe to go into more lucrative specialities as a result of the more expensive and arduous process.
The process became fatefully more arduous in the early 1970s, when previously separate accreditation organizations consolidated and created the Accreditation Council on Graduate Medical Education (ACGME). Until this point, a physician seeking to work as a general practitioner would only need to finish a one-year rotating internship following medical school. The ACGME eliminated that pathway and replaced it with specialist residency training. From that point forward, the primary care workforce would have to go through three-year residency requirements via specialties like family and general internal medicine.54 Enrollment in subspecialities exploded because medical students could make more money as a specialist than a primary care doctor without necessarily having to go through more years of training. The income gap between primary care doctors and specialists persists to this day.55
Around the same time that policymakers began fretting about overbuilding of hospitals, a report from the Graduate Medical Education National Advisory Committee (GMENAC) in 1981 sounded the alarm bells about a physician surplus.56 Primed by the Reagan revolution’s retrenchment orientation, policymakers became concerned that without any supply controls, too many physicians would needlessly increase utilization and spending. As we saw, federal support for the construction of hospitals (where medical residencies occur) was completely cut off. Meanwhile, medical schools voluntarily froze both new residency slots and the construction of additional medical schools between 1980 and 2005 upon the GMENAC’s recommendation.57 The number of annual MD-entrants into residency programs fell as a result, not reaching its 1980 high until after 2005.58
Another important restriction came through the Balanced Budget Act of 1997, which capped Medicare-funded residency slots at 1996 levels – a cap that was increased by 1,000 in 2021.59 Medical schools are able to increase slots above the cap, but cannot receive Medicare funding to cover the costs. This serves as a limiting factor to licensing physicians. In 2022, over 3,300 medical school graduates failed to match with a residency due to a lack of available slots.60 Because medical residents often remain in the same area where they complete their training, the cap effectively froze the geographic distribution of slots as well, fueling the mismatch between local demand for medical services and physician supply.61
The purposeful downsizing of the 1980s and 90s was based on the idea that having too many physicians would lead to unnecessary increases in spending on health care. But as seen in the section above on hospital care and supply, the relationship between supply and spending is not straightforward. Health care spending has accelerated while the relative level of health care resources, both physicians and hospitals, has declined. Increasing the supply of primary care physicians would change how the US spends money on health care, directing spending towards the type of care Americans need most.
There is good news: In response to the projected shortage of primary care doctors and regional distribution challenges, physician supply has increased since the early 2000s. Since 2002, the number of MD graduates has increased by 58 percent – from 18,212 to 28,811 in 2022-23.62 The number of doctors of osteopathic medicine (DOs), who undergo similar training to MDs and represent a quarter of U.S. medical students, has increased at a much faster rate in that time, nearly tripling between 2002 and 2021.63 Because DO training emphasizes more holistic approaches and symptom treatment, more than half of them become primary care doctors, compared to only 28 percent of active MDs. DOs are in an advantageous position to respond to the primary care shortage.64 Although DOs used to have a separate residency matching program, the consolidation of residency pathways continued in 2020 and now both MDs and DOs have to go through the same matching process under a single accreditor, the ACGME.65 Even without Medicare expanding its residency funding to match the larger cohort of aspiring doctors, hospitals created new slots for many of them. But as noted, in 2022 more than 3,300 physicians still failed to match, and the proportion of graduates going into specialties rather than primary care remains imbalanced.66
A lack of primary care doctors has implications for health outcomes and access. Patients have to wait longer for primary care services and then have to choose between higher-cost hospital settings or urgent care centers for conditions that require consistent attention. It is worth considering the connection between access to primary care and treatable mortality. As noted earlier, the U.S. leads highest-spending countries in deaths due to treatable conditions even as we have the smallest number of primary care physicians — and these trends are probably not unrelated. Research shows that counties in the U.S. with better access to primary care experienced lower mortality rates from treatable conditions.67 The U.S. will not be able to address its primary care physician shortage without meaningful reform to physician training and residency, including reducing the financial incentive students have to enter non-primary care specialties.
Perverse incentives in federal policy lead to market consolidation and ineffective spending
The undersupply of hospitals and physicians was an intentional policy choice. Some of the remaining problems with healthcare supply are the result of government policies with good intentions and unintended side effects that created perverse incentives for providers to consolidate or payers to artificially increase spending, maximizing profits at the expense of patients and taxpayers. Among individual payers, Medicare and Medicaid together cover 39 percent of all health expenditures, a larger proportion than what commercial insurance covers (29 percent).68 The negotiated rates that commercial insurers pay for services are set by the market (although distorted by various federal mandates), but policymakers determine the reimbursement for services by Medicare and Medicaid.
How much the government pays for care and what services it covers create incentives for companies who seek to maximize their revenue. For private payers, the federal government extensively regulates both private insurance and providers through federal programs and patient protections. This section deals with the incentives baked into those policies and the implications for patients and taxpayer spending.
Fee-for-service: Quantity is not our biggest problem
Historically and through the present day, much of the health policy conversation revolves around the idea that overutilization of care is our biggest problem. In recent decades much opprobrium has been heaped on the fee-for-service model, in which providers get paid primarily on a service by service basis, both when billing Medicare and private insurance. Each service, from the least to most complicated, receives a specific code with a designated price. Naturally, this means that providers can charge more when they provide a higher volume of services, regardless of patient outcomes. The number of billable services has tripled since the 1960s, and with each new billable service, providers see more revenue.69 This often comes at the expense of patients, who receive bills with line items such as an “IV push” which can result in a $700 charge each time a nurse provides an intravenous medication.70
To address the disconnect between hospital incentives and patient needs inherent to fee-for-service, providers and insurers have tried different models that either bundle services for one price or set fixed monthly fees for each beneficiary and provide rewards for better health outcomes. These models are broadly referred to as value-based care. Insurance groups like Health Maintenance Organizations (HMOs), Accountable Care Organizations (ACOs), and Managed Care Organizations (MCOs) use capitation payment models where payers pay a fixed, monthly rate for each patient regardless of the volume of care they receive and rewards like performance bonuses tied to service quality. The ACA incentivized the creation of value-based payment structures like ACOs in Medicare.71
But while there is room for value-based payment structures in a cost-reduction strategy, their track record is mixed.72 More importantly, they do not attack the primary cost problem, which is less the rising quantity of services and more the rising price. Recall, for example, Figure 3, which showed that increases in the price of services have far outstripped increases in their utilization. Attacking prices, meanwhile, requires that we tackle consolidation, and on this front, value-based care could even be contributing to the problem. Studies have found that the rise in ACOs has contributed to physician group consolidation, because larger, more integrated providers are better able to coordinate service delivery in an ACO model.73 Efforts to move away from fee-for-service must ensure that incentives are aligned to prevent further market concentration and reward providers that offer lower-cost, higher-quality services.
Medicare
Reimbursement rates for providers who participate in the Medicare program are primarily determined by the Physician Fee Schedule (PFS), which covers reimbursement rates for services performed by physicians, and the Outpatient and Inpatient Prospective Payment Systems (OPPS & IPPS), which cover reimbursement to clinics and hospitals. Medicare has several other payment systems that calculate unique rates for certain types of facilities, such as skilled nursing, psychiatric, hospice, long-term care, and home health agencies.
Site-based billing
A contributing factor in the relative growth in Medicare outpatient spending is the increase in consolidation of hospital systems and site-based differential in payments.74 Medicare has different reimbursement rates for different types of facilities. The original intention of such “site-based billing” was to compensate hospitals for higher overhead costs brought on by regulatory requirements to provide services at all hours, among other requirements. For some services, the higher rates of payment may be needed to keep up with expenses. But site-based billing also applies to routine services that are usually provided by physician offices as well in most cases.75 Medicare pays hospital outpatient departments nearly double what it would pay a freestanding physician’s office for the same service, and can rise to four times higher for routine services like x-rays.76
Policies like site-based payments created an incentive for hospital systems to acquire freestanding physician offices where they could immediately begin receiving higher reimbursements by simply labeling an off-campus facility as a hospital outpatient department (HOPD) without changing the care patients receive.
Site-based payments for new off-campus HOPDs were repealed in 2015, but existing off-campus HOPDs were grandfathered in. Meanwhile, site-based payments remain for all on-campus HOPDs, emergency departments, and ambulatory surgery centers, regardless of the service they are providing. Medicare could save $126.8 billion over 10 years if site-neutral payments were extended to all HOPDs just for routine services.77 Correcting perverse payment incentives like site-based billing is a necessary step to stem the tide of rising hospital consolidation — and save taxpayers a great deal of money.
Impacts of the ACA’s Medical Loss Ratio
Site-based billing is not the only perverse incentive baked into Medicare’s payment policies. A little-known provision in the ACA also has implications for spending in Medicare Advantage (MA), the program in which Medicare services are provided through private insurers. The medical loss ratio (MLR) is a regulation enacted as part of the ACA that requires insurers, including those in MA, to spend no less than 80 percent (individual and small-group markets) or 85 percent (large-group) on medical costs, or else pay back the difference to customers (usually employers providing retiree health benefits) in the form of a rebate. The remaining 15 or 20 percent can be spent on administration, setting a proportional, but not absolute, cap on administrative costs and profit. Because it is proportional, insurers have an incentive to spend more in total to increase the profit potential of their MLR.
The MLR was intended to prevent runaway administrative costs and provide relief for employers who bear the brunt of rising premiums, but insurers have found a loophole. Because payments to subsidiaries and sister companies are counted as a medical “cost”, insurers are able to shift profits to their subsidiaries without having to rebate employers due to a lopsided MLR.
This process has been well-documented with pharmacy benefit managers (PBMs), where UnitedHealth has managed to transfer 25 percent of its medical claim revenue to its own PBM and subsidiary Optum, which was formed a year after the MLR took effect.78 Because UnitedHealth also owns or has influence over a tenth of physicians in the U.S., it is also able to shift profits to their own physician groups – a practice economists call “transfer pricing.”79 The MLR, which took effect in 2011, offered a perverse incentive for Medicare Advantage insurers to vertically integrate and side-step MLR rules to increase their bottom line.80 This regulatory arbitrage ultimately hurts employers and patients who have to deal with higher premiums while large health conglomerates benefit from double margins. These reimbursement policies benefit large health care companies while providing no additional benefit for Medicare patients. Providing more scrutiny over MLR practices or even updating MLR requirements could reduce such gaming of the system.
Medicaid
Medicaid’s payment policy is a partnership between the federal and state governments. The federal government provides states with guidance on how to deliver and pay for care, but state governments ultimately determine how much providers are reimbursed when serving Medicaid beneficiaries. Federal support for Medicaid is uncapped and provided via a matching grant reimbursement known as the Federal Medical Assistance Percentage (FMAP). The grant currently covers anywhere from 50 to 83 percent of costs depending on the per capita income of the state’s residents. ACA expansion states receive a 90 percent matching rate for the expansion population (those with incomes up to 138 percent of the poverty level). As a result, there is significant variation in both Medicaid costs and coverage by state. As a whole, the federal government financed 73 percent of the total $805.7 billion spent on Medicaid in 2022. The FMAP program offers two key perverse incentives that both limit the capacity of poorer states and inflate already-rising healthcare spending.
Flawed FMAP formula
First, while there is no binding cap on the portion of funds covered by the federal government, there is an FMAP minimum of 50 percent – regardless of the fiscal capacity of each state. Because the FMAP is inversely correlated with per capita incomes, the statutory minimum percentage disproportionately benefits wealthier states, whose percentage of federal funding would otherwise be lower.81 Per-capita income does not account for other fiscal capacities like corporate income or capital gains and thus underestimates the fiscal capacity of states like Wyoming, which would receive a 44 percent match without the floor.82 It also does not reflect the health needs of the populations in each state. While Florida and Wisconsin receive the same FMAP due to similar per capita income levels, Florida has 22 percent higher poverty levels and a similarly higher proportion of adults reporting poor health status.83 Rather than bring about a progressive distribution of federal funding, the 50 percent FMAP floor serves as a benefit to wealthier states and strains the fiscal capacity of poorer states.
Secondly, states take advantage of the FMAP through creative financing schemes. Because the federal government reimburses states based on their reported spend on Medicaid beneficiaries, when states increase their total payments to providers, they receive a higher effective matching rate. The primary way states do this is through levying provider taxes. In theory, provider taxes are a commonsense way for states to fund their portion of Medicaid spending. But in practice, states often tax and boost payments to the same provider simultaneously, allowing them to inflate their Medicaid spending without increasing their net spending.84 This artificially increased the reported prices for Medicaid services and federal reimbursement. All states but one use provider taxes to fund Medicaid, an increase from 21 states in 2003. Between 2008 and 2018, states used revenue from provider taxes to fund more and more of their Medicaid spending — increasing by 270 percent to the tune of $37 billion, 17 percent of total Medicaid costs.85
Under current policy, Medicaid offers perverse incentives to states to inflate their spending, while not providing adequate reimbursement to poorer states that need additional fiscal capacity. As a result, it is no surprise that states are seeking to increase their effective matching rate, particularly for poorer states that receive the short end of the stick due to the flawed FMAP formula. Federal Medicaid policy should ensure that states are receiving fair payment to administer their Medicaid programs while also establishing guardrails to prevent financing schemes that artificially increase federal spending.
Private insurance and other provider payments
A number of federal policies create incentive structures that distort the private market and allow hospitals to receive higher payments than is commensurate with the level of care provided.
Federal tax policy plays a large role by offering advantages to hospitals and employer-sponsored insurance plans. Among those advantages are hospitals’ status as tax-exempt nonprofit entities. 58 percent of America’s community hospitals are nonprofit, nongovernmental entities and exempted from paying most taxes. Together, they drew around $28.1 billion in tax exemptions in 2020 – around half from federal tax exemptions and the other half from state and local.86 This benefit was originally offered to hospitals at a time when they were largely run by religious organizations and provided extensive charity care to low-income patients. Today, hospitals must meet a vague standard of providing “community benefits” to earn this status.87 If charity care is the benchmark, they are clearly not meeting it: Independent analysis has found that nonprofit hospitals spend 2.3 percent of their operating costs on charity care — well below the estimated 4.3 percent value of their tax exemption.88 It is ultimately patients and taxpayers that have to pay higher taxes to accommodate the resulting drop in tax revenue, while experiencing little benefit in return.
Both these extensive tax benefits and site-based billing through Medicare are ostensibly designed to compensate hospitals for their complex patient mix and higher overhead costs. But hospitals also charge patients facility fees — to cover operational expenses.89 These fees can be levied against patients who receive care in hospital outpatient settings with more routine care and less overhead costs than the hospital itself. Facility fees unnecessarily increase patient out-of-pocket costs and inflate the price of care in a hospital setting relative to an independent physician’s office. For patients receiving chemotherapy treatment, a one-hour infusion can cost nearly three times more in a “hospital” setting compared to an independent physician’s office.90
In recent years, policymakers have made major strides in protecting patients from other billing practices that unnecessarily cost patients, including surprise billing. In December 2020, Congress enacted the No Surprises Act (NSA) to shield patients from surprise bills that were often the result of a patient receiving a service from an out-of-network provider without their prior knowledge. Patients have mostly been protected from those bills since its implementation — but much of the costs seem to be funneling into premiums. That is because the legislation sent such bills into arbitration between providers and insurers, and the process is so biased toward providers that it allows them to receive even higher payments than they were receiving before.91 Providers are winning 75 percent of disputes in the new arbitration process for payment disagreements and receive payments three times the median in-network rates.92 Essentially, the bill has passed on the costs to insurance premiums, which will result in higher costs for patients. The No Surprises Act is one example of how patient-centered policy changes need to take into account provider market dynamics to prevent negative externalities.
Another well-intentioned effort was the 1992 340B Drug Pricing Program, which was enacted to subsidize safety-net hospitals for prescription drugs. Qualifying hospitals that treat low-income patients can buy prescription drugs at a discount of 25 to 50 percent.93 The program started out with around 500 qualifying providers but has increased substantially, to 50,000 by 2020. It is now the second largest drug pricing program in the U.S. — second only to Medicare part D.94 Because providers in the 340B program are able to buy drugs at a discount and then charge insurers a much higher price, there is an incentive to purchase more expensive, brand-name drugs to increase their revenue through the program.95 But qualifying hospitals are not required to use profits from the discounted drugs to provide care to underserved populations or to disclose their profit margins from the program. There is also evidence that qualifying providers are incentivized to consolidate hospital systems and clinics to expand the number of clinics that qualify for the program. Reporting shows that hospitals were purchasing clinics in wealthier neighborhoods but remaining in the program because they list newly acquired clinics as an extension of the qualifying “poorer” facility.96
Well-intentioned programs meant to protect patients from hospital closures or overly high bills for services often include loopholes and distort market dynamics to the advantage of providers. It is critical that policymakers identify these incentive structures and reshape them to avoid further consolidation and even higher prices.
