The Three Different Ways We Could Set Prices in Healthcare

Image credit: AP Photo/Damian Dovarganes

Image credit: AP Photo/Damian Dovarganes

Out of the three general ways we could set prices in our healthcare system, one is best. Too bad we’re using the other two.

First, I’ll describe each method:

  1. Administrative pricing: This one is very straightforward. The government says, “For procedure A, healthcare providers will be paid X dollars.” Usually the methods for coming up with that dollar amount are sophisticated and rely on the best available data, but not always because they are subject to various political influences and government budgets.
  2. Bargaining power-based pricing: This one is easiest to explain using an example. Think of a small town with only two family medicine docs. One, Dr. Awesome, treats 90% of the town’s residents; the other, Dr. Mediocre, treats the other 10%. All patients are insured by one of four different private insurers, each of which has approximately equal market share. Now think of Dr. Awesome sitting down at the bargaining table with one of the insurers to decide on prices. He says, “If you don’t pay me at least Medicare rates times 1.4, I won’t accept your insurance. I’m serious, I won’t accept anything less.” And the insurer says, “Hey, that’s a horrible deal, but if we stop covering care you provide then most of our policy holders in your town will just switch to one of our three competitors and we’d lose out on even more profit!” Now think of the conversation between Dr. Mediocre and that same insurer. Dr. Mediocre says, “Pay me Medicare rates times 1.4.” And the insurer responds, “No. We’ll pay you Medicare times 0.8. If you say no and we don’t have you listed as a provider in our network anymore, that’s okay because only a tiny percentage of our policy holders are your patients. And we know that you don’t have many patients, so you can’t afford to risk losing 1/4 of them by saying no to the price we offer.” Relative market share between the two parties is the primary determinant of bargaining power, so a bigger market share means you can get a better price.*
  3. Competitive pricing: This is the method used to determine prices in almost every other industry. Here’s basically how it plays out: Competitor A says, “Everyone knows that our product has similar quality to our competitor’s product, so we can’t price it higher than theirs without sacrificing quite a bit of market share. We could sell it for less than theirs to win more market share, but then the price is perilously close to our costs, so we’ll have to do some math to see what the profit-maximizing price/market share combination is likely to be.” Note the one huge condition that is required for this to work: Potential customers must be able to compare the price and quality of all their options, which is starting to happen more and more as better quality information is starting to become available and as prices are becoming more transparent.

Our healthcare system currently relies primarily on number 1 (think: Medicare and Medicaid) and number 2 (think: private insurers and providers setting prices with each other). But which method is best?

If you want to have the lowest possible prices, administrative pricing is the obvious best choice. But that’s only for the short term (as you’ll see), and it does nothing to encourage quality improvement unless you start getting into the treacherous area of performance incentives.

The only thing I’ll say about bargaining power-based pricing is that I don’t like it. I’d rather not have prices that are totally unrelated to costs or quality and instead are determined by relative market share.

Now let me tell you why I like competitive pricing so much. I want our healthcare system to deliver better value right now (Value = Quality / Price), and even more than that I want that value to go up over time as providers and insurers innovate in ways that allow them to decrease prices, increase quality, or both. Competitive pricing is the only method that provides an incentive for competitors to innovate because it rewards the highest-value offerings with increased market share and profit. The other two options don’t do that, which seems like a pretty big downside, don’t you think? I’d be willing to forgo short-term super-low administratively set prices in favor of stimulating innovation that will improve value way more over the long term.

In my next post, I’ll explain how we can shift from bargaining power-based pricing to competitive pricing.

* Do you ever hear those arguments that if public insurers lower their prices any more, providers will just raise their prices for private insurers? Well, now you know why those arguments are mostly hogwash. Providers are already leveraging their relative market share to get as high prices as possible from private insurers, and getting paid less by public insurers doesn’t change that relative market share.

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2 thoughts on “The Three Different Ways We Could Set Prices in Healthcare

  1. Another well thought out and presented post. A couple questions and comments.

    1. For bargaining power pricing, if the public payer reduces their reimbursement rate, it is true that providers will use their market share to drive their compensation as they do now. However, won’t they use that leverage to drive their private rates up?

    2. I would like competetive pricing also if there is a way to do it. The system today is so opaque that the average consumer has little to no way of determining cost. I think this is especially true in a a fee-for-service world. Your caveat is absolutely essential. Also, there are some quality and cost measures in use by various insurers that reward providers for things like lower hosital readmissions and penalize them for tets that are consistently out of line with community standards. Getting less from public insurers does not change their market share but sure gives tham an incentive to charge someone more!

    • I always appreciate your thoughtful questions, thank you!

      1. The point I was trying to make in my post was that providers are always maximally leveraging their market share trying to push prices as high as they possibly can. Thus, a drop in public payer rates wouldn’t affect the prices providers are setting with private insurers because the providers are already getting the highest possible prices their bargaining power enables them to get. I suppose it’s possible that a drop in public payer reimbursements could allow providers to claim they’ll go out of business if private payers don’t agree to slightly higher reimbursements, but the empirical data seems to say that effect, if it exists, is minimal.Please let me know if I’ve misunderstood your question.

      2. Yes, lower payments from insurers is one thing that has pushed providers to increase the volume of services they charge for. That’s why the average appointment time is so much shorter than it used to be–it’s providers trying to maintain historical income levels.

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