Regulating Health Prices Is Not Costless

Political candidates often champion far-reaching reforms to control costs in U.S. health care, such as switching to a single-payer scheme, but the existing system is too vast and entrenched to change dramatically or abruptly. The realistic options are incremental steps toward more price regulation, or toward a functioning market.

Price regulation has the clearer path. It has appeal with some voters because it can seem painless, whereas market reforms, with less certain effects, are perceived as risky. Regulators can cap prices, and thus limit the financial exposure for consumers, with negative consequences that are less visible.

Official cost projections further tip the scales. The Congressional Budget Office (CBO) assigns savings to pricing rules based on comparisons with costs in a dysfunctional and unregulated market. It is more difficult to build projection models for better market incentives because competitive prices surface unpredictably from private actors. Thus, legislative schemes which rely on competition and choice often get set aside without serious consideration because CBO is either unable to estimate their effects, or is skeptical they will deliver real savings.

While price regulation faces less resistance, there are sound reasons to go against the grain and push market reforms anyway. The federal government, and the states, have been regulating prices in public insurance (Medicare and Medicaid) for decades, with decidedly mixed results. Pricing limits can reduce spending relative to a dysfunctional market, but the connection to sensible allocations of resources is tenuous, and regulated prices may still be high relative to what would occur in a properly structured market.

A major problem with regulated pricing is that the enterprises affected by the rules have the most to gain by trying to influence how they are written. They hire armies of lawyers and lobbyists to secure favorable concessions. Over time, the rules tend to cater to incumbents and restrict new entrants.

The list of Medicare payment rules is lengthy and essentially covers the full array of health services and products: inpatient hospital stays, physician procedures and office visits, outpatient surgeries and tests, psychiatric hospital admissions, hospice care, clinical lab facilities, physician-administered drugs, dialysis services, rehabilitation care, skilled nursing facility stays, graduate medical education subsidies, accountable care organizations bonuses, and fully capitated rates for privately-administered Medicare Advantage plans. Each is amended regularly, often annually, and made ever more complex.

While regulated payments can appear to be low because commercial rates in today’s dysfunctional market are higher, it is possible that prices that would emerge in a functioning market would be well below what regulators impose.

Medicare payments for durable medical equipment (DME) certainly followed this course. DME — wheelchairs, prosthetics, orthotics, glucose testing strips, and machines that aid patients with sleep apnea, and similar products — helps patients better manage their diagnoses and conditions. Historically, Medicare paid for these items based on cost reporting from the manufacturers even though many studies showed this method led to vast overpayments.

A major obstacle to sensible reform was, not surprisingly, the DME industry itself. It fought proposals to replace the outdated fee schedule with payments based on bids from competing manufacturers. Eventually, however, commonsense prevailed, and CMS began in 2011 to pay for large amounts of DME based on bids from regional suppliers.

The positive results were immediate and large. From 2011 to 2017, spending on DME and related items fell by 62 percent, from $7.5 billion to $2.8 billion. Over the same period, Medicare spending for bidding-exempt products rose by 44 percent. CMS estimates the government saved $25.7 billion from 2013 to 2022 from the switch in payment methods, while beneficiaries spent $17.1 billion less over the same period.

DME is more easily interchangeable than other medical services but that does not mean savings from competition is impossible in the rest of the Medicare program. Consumers could compare all-in prices for standardized and common interventions if providers of those services were forced to disclose what they would charge for them. With the right structure and the prospect of savings for consumers, much of medical care could be disciplined with competitive pricing too.

A structured market would not be exempt from the political meddling that afflicts regulation, as the delays in competitive bidding for DME demonstrate, but once a market is stood up and allowed to function, its demonstrated value would make it resilient to outside pressure. Calls for halting competitive bidding in DME are now mostly ignored by policymakers because of how costly it would be for taxpayers and beneficiaries.

The main political barrier to market reforms is consumer (and thus voter) skepticism: Today’s market dysfunction makes reliance on competition and choice seem fanciful.

Market advocates would help their case by making reform an upside only proposition for consumers. As an example, with standardized pricing of common physician services, Medicare patients should never pay more than what they would under current law, but they should get to keep much of the savings when they choose physicians charging lower fees in a competitive market.

It will be challenging politically to implement such a plan, but it would be worth the effort. The U.S.’s openness to private enterprises and medical innovation is an advantage, not a liability. Stronger market discipline is required to direct the energy of the private sector toward cost discipline and improved quality. That is possible with the right reforms and would insulate medical care from industry lobbying that mainly serves to protect the incomes of incumbent institutions and providers. 

James C. Capretta is a Contributor at RealClearPolicy and holds the Milton Friedman Chair at the American Enterprise Institute. This article is drawn from the monograph “The Political Economy of Health Reform: Price Regulation vs. Regulated Competition,” published in September by AEI.