Health Care Cost Equation

In the 1980s and 1990s, most plan sponsors were asking: "Should we move our plan into managed care?" and "Does managed care save money?" Today, with about 95 percent private industry health plan membership in some type of managed care plan, the questions more likley are: "What type of managed care is best for our health care benefit plan?", and "How does managed care save us money?" Few questions in the vast industry of employee benefits are getting more attention today, and this text would not be complete without trying to answer them. However, it is important to note that these two latter questions are distinctly different questions.

The question, "What type of managed care is best for our health benefit plan?" requires a response more complex than just how much savings are produced by the various forms of managed care. While cost control has been the primary driver behind the establishment of managed care products, there are many other fundamental considerations for the plan sponsor, such as the impact on employee satisfaction, the degree of plan design flexibility, and whether managed care networks are available to plan participants.

The plan sponsor must also consider the types of managed care in the broader context of its employee benefit philosophy. If senior management does not understand, nor fully support, the offering of managed care, the plan sponsor may not devote adequate internal resources to ensure proper employee education and acceptance of the plan. Managed care plans rely heavily on proper understanding of, and acceptance by, the member population, for the plan sponsor to fully realize expected savings. So, the first step to achieving expected savings from any managed care plan requires the plan sponsor to establish clear expectations and to make the necessary commitment to its success.

The second question is the primary subject "How does managed care save money?" To answer that question, it is first important to understand the elements that drive health care costs. Savings will reflect the initial cost reductions from transitioning membership from a traditional indemnity plan to some form of managed care, as well as the level of provider discounts, the change in benefits, and the degree of utilization control included in the new managed care plan.

To understand the potential impact of managed care alternatives on the costs of medical care, it is important to understand the basic health care cost equation: Cost = Price × Use, where Price is the average cost per unit of health services delivered, and Use (or utilization) represents the average number of units of health services.

Effective managed care strategies must address both portions of the cost equation: price management, which is a function of network development and provider reimbursement strategy; and utilization management, which is a function of medical management capabilities and quality controls employed by the managed care company.

Elements of Price Management

Provider reimbursement methodology is the cornerstone of price management. It must cover broad provider service categories, and it must be actively managed, with regular review and renegotiation. Those health plans that fail to take advantage of negotiated pricing will bear greater and greater cost shifting from governmental and other managed care plans.

Hospital reimbursement strategies are most important, since facility expenses account for, on average, more than a third of total health care expenditures. Common strategies include the following:

1. Straight discount (percentage off) is simply a negotiated percentage (e.g., 15 percent) off billed charges with no risk sharing by the provider. Managed care companies disfavor straight discounts because they do not protect expenses against general medical inflation; hospitals can still increase their prices, while the managed care company can only take the same discount off higher and higher costs. Furthermore, this method does little to control increased utilization of hospital services.
2. Diagnostic (diagnosis) related group (DRG) pays a prenegotiated amount to the hospital for the total cost of treatment, for each of about 520 specific "diagnoses." DRGs became increasingly common after they were universally adopted for Medicare reimbursements in 1984. With DRGs, the hospital has an incentive to manage utilization of services, by being put at some financial risk to effectively manage length of stay and intensity of services per admission. However, since the number of admissions is not limited, hospitals could discharge patients early and readmit them. Stop-loss arrangements are often set up to protect the hospital from catastrophic cases. Additional problems with DRGs include negotiating an appropriate pricing level for the various DRG categories, which requires significant claims data; artificially high charges can occur if the base is determined before utilization has been aggressively managed. The additional administrative burden of assigning a DRG number requires advanced billing and claims adjudication software to avoid "DRG creep" whereby a hospital raises the classification of an illness in order to receive a higher amount. Periodic claim audits are critical to assure actual treatment matches the assigned DRG for the hospital confinement.
3. Case rates are flat negotiated reimbursements for a specific type of service (e.g., outpatient surgery rates or obstetrical (OB) case rates), rather than for all services related to a specific diagnosis. With this arrangement, the hospital is at risk for managing cost as well as increases in cost for services but not for managing the actual number of services provided.
4. Per diem entails a prenegotiated fixed daily rate, usually set up in broad categories, such as medical/surgical, delivery, intensive care, and so on. Per diem allows the managed care company to share some risk with the hospitals and gives the hospital an incentive to effectively manage cost per day. However, in contrast to DRG reimbursement, the hospital is paid for each day of care and thus has no incentive to control admission rates or the average length of stay (ALOS) per admission.
5. Global rates pay a specific fee for a major episode of care. They are broader than DRG reimbursement because the negotiated fee includes all professional, ancillary, anesthesia, and facility fees associated with the episode of care, so one payment is made for all services rendered (usually to the facility). Under global rates, the hospital is at risk for effectively managing all health costs related to the negotiated episodes as well as increases in the cost of these services. These arrangements are typically restricted to high cost, catastrophic types of care, such as organ transplants, or where larger integrated health systems already have wholly owned facility and professional services.

It is not uncommon for HMOs to engage in multiple reimbursement arrangements with various hospitals and other inpatient facilities. Based upon the HMO Industry Report 9.1, in July 1998, 72 percent of hospital contracts used discounted charges, 86 percent used per diems, 50 percent used DRGs, and 33 percent used a combination of case or global rates.

Physician reimbursement strategies depend largely on the type of managed care plan, discussed in detail below. Physicians costs are influenced two ways in a managed care environment:

1. Non-risk-sharing arrangements, which focus only on negotiating unit prices and then employ specific utilization management procedures, such as detailed medical treatment protocols coupled with advanced information measurement systems, which intend to intervene, monitor, and influence physician practice.
2. Risk-sharing arrangements that give providers financial incentives to control patient utilization.

Most managed care programs rely on both of these strategies, depending on the readiness and sophistication of the local provider community. But it is the physician reimbursement strategy that provides the basic structure in controlling costs.