Over the course of the decade preceding passage and implementation of the Medicare fee schedule, policy analysts came to a remarkable consensus over the goal of the program's physician payment policy.
Two independent analysts, Jack Hadley and James Baumgardner, explained why competition is the ideal goal for a physician payment system. Any third-party payer that wants to obtain services for its patients at the lowest cost will pursue this goal. In other words, patients will be indifferent at the margin between spending one more dollar on each service, and physicians will be indifferent at the margin between producing another unit of each service.
Why don't we rely on competition to get us to the efficient point in this market, as we do in many other markets in which the government does not set prices? The rationale behind the Medicare RBRVS is that the prices for physicians' services in the absence of controls are "distorted" - that is, if we form the ratio of two prices paid under Medicare, it will be different from the ratio found in a competitive market. The price ratio is also known as the "relative price," so we can also say that the relative price of Medicare Part B services will be distorted in the absence of controls.
Why should the prices of physicians' services under Medicare differ from the ideal competitive prices? There are problems on both the supply and the demand sides of the market for physicians' services. On the supply side, many analysts believe that physicians have market power - power to alter prices to their advantage - and that this power differs systematically across specialties, services, and geographic areas. Additional supply-side problems include constraints on the provision of medical care by non-physicians and restricted entry of new physicians. Given these problems, a large increase in demand for the services of a particular specialty may not cause the supply of that service to increase. Hence, the prices of services provided by that specialty will increase.
On the demand side, lack of information, insurance coverage, and "the special nature of medical care" mean that consumer demand is not fully informed, voluntary, or rational. If physicians are able to identify variations in patients' willingness to pay, they can "mark up" the prices of services for which demand is especially inelastic (for example, those with the deepest insurance coverage, or those about which consumers are least informed), often substantially higher than costs. The power to set high prices is especially pertinent for the prices of services provided by specialist physicians. Medicare spending increases for general surgeons from 1975 to 1982 were largely the result of price increases at 15 percent per year rather than volume increases.
Among the most notable market failures in the Medicare program is the widespread presence of supplementary insurance that insulates patients from Medicare's cost-sharing requirements. Sandra Christensen and Judy Shinogle estimated that about 70 percent of beneficiaries have private insurance that supplements Medicare, while George Chulis, Franklin Eppig, and John Poisal estimated the supplementary coverage rate at 78 percent. In addition, 15 percent of Medicare beneficiaries receive full or limited Medicaid benefits, bringing the total market share of all Medicare beneficiaries with either private or public supplementary insurance to 85–93 percent. Almost all researchers agree that supplementary insurance removes price from patients' calculations regarding the costs and benefits of using medical care, leading to consumption of more physicians' services than would be observed in its absence. This view is so widely held that it is almost an article of faith among health economists.
Even Robert Ball, one of the architects of Medicare and its first administrator, shared the opinion that "Medicare is paying a heavy price as private insurance rests on top of the basic Medicare coverage". The original framers of Medicare had no idea that this would happen. As Ball said, "We thought that the bills left uncovered were mostly too small to justify the administrative costs of supplementary insurance programs." But it did happen, and, to quote Ball again, "The result is that neither the patient nor the physician on behalf of the patient has an incentive to think twice about the cost of a procedure." I will pick up the topic of supplementary insurance again and again, with a simple proposal that such insurance be abolished.
Given that the market for Medicare physicians' services was failing in many ways, it is not surprising that the PPRC recommended, and Congress enacted, a new payment system that controls the price of every service supplied by physicians to Medicare. The seductive appeal of price controls arose because they appeared to be a way to correct the market failures in Medicare. Equally plausible was the idea that the Medicare fee schedule should be based on the resource costs of producing each service. The health policy debate that preceded the introduction of the Medicare RBRVS resembled the debate among early Christian theologians over what constituted a "just price."
Almost everyone - patients, providers, and Congress - was unhappy with the way that Medicare paid physicians. There was considerable support for junking the old system and replacing it with one based on resource costs "in the belief that resource costs are more fixed, less manipulable, and less subject to distortion than market fees". In other words, the RBRVS would provide the "just prices" that Baumgartner described. The market would clear, and no one would feel they could find a better set of services than the one they consumed or produced. However, if the market were not competitive, there would be no reason to believe that the ratio of measured average costs for any pair of services would be a more accurate assessment of their relative value than the distorted ratio of their prices. The very factors that distort relative prices (differential demand in the presence of insurance, limited entry, and imperfect information) also distort relative average costs.
When we think about Medicare's physician price controls, the following question inevitably arises: Many private health plans pay physicians with fee schedules modeled on Medicare's RBRVS. If Medicare's prices are flawed, why isn't the same true when private payers use these prices to pay physicians? In a careful analysis of the differences between government price controls and private-sector payment systems, H. E. Frech III answered this question. According to Frech, "There are many safety valves for consumers and competitive constraints" on what private insurers can do in contracting for low prices. Most private plans include provisions for consumers who don't like the quality or accessibility of contracting physicians to purchase medical care from noncontracting physicians at a higher price. Many consumers can also switch to a different insurer, offering a different network of contracting providers and/or different terms. The ability of consumers to exploit these safety valves distinguishes private insurers who use fee schedules from the superficially similar RBRVS. This observation does not mean that I support the use of private-sector fee schedules to pay physicians. Nevertheless, whether or not private physician payment systems are properly designed, they are not price-control systems.
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