Where do the Extra US Health Care expenditures Go? Paul Krugman said awhile ago that the report ‘Accounting for the Cost of Health Care in the United States’ is the best analysis currently available. This post is a summary of that report’s conclusions.

To begin, I will give my opinion of what McKinsey report is and is not. It is a comprehensive synthesis of studies of the size of excess US health care expenditures and their causes. It uses a simple model to estimate excess health care expenditures in the US, and identifies where those excess expenditures go, and why.

It is not a formal analysis of the economic costs of US health care because it does not distinguish between expenditures that are true economic costs of real resources used in production vs. those that are transfer payments due to regulation and imperfect competition. It does not offer a unified theory of why the US health care industry is so expensive, and does little formal economic theorizing or statistical analysis (which is either a good or bad thing, depending on your viewpoint). It offers neither a comprehensive structural model of the industry, nor specific proposals for reform. It certainly offers no magic formula to reduce costs.

The report first estimates the magnitude of the excess US expenditure compared to other developed economies. This is not completely straightforward because developed economies differ in many ways. However, there is a strong relationship between per capita health expenditure and per capita national income. The report estimates the relationship between national per capita income and per capita health expenditure in high income countries and then estimates what the US would spend, given its per capita income, if it were an average high income economy with an ‘average cost’ health care system.

In 2003 the US would have spent $3990 per person if its health care industry were ‘average’, but actually spent $5635, leaving an excess of $1645. Health care in the US seems to be about 40% more expensive compared to other developed economies. Looking at it another way, almost 30% of every dollar spent in the US goes to these estimated excess expenditures.

We will use a hypothetical example to simplify the analysis of where these estimated excess expenditures go. Assume that you spent $3667 on health care in 2003. If you lived in an average high income country, but with the per capita income of the US, the expenditure would have been $2667, leaving $1000 of excess spending.

About $490 (49% of the total $1000 excess) are due to higher prices for health professional services and medical supplies. About half of that $490 is due to higher compensation for healthcare professionals: physicians, pharmacists, nurse practitioners, etc. Slightly over a quarter is due to higher drug prices and the remainder is due to higher prices for other medical supplies. Note that these excess costs are due to higher relative prices for these goods and services. That is, the price of a unit of service from a physician (per visit, hour, operation, etc.) or price of a pill is higher in the US than in other developed economies.

About $200 (20% of the total $1000 excess) is due to easily identifiable excess administrative costs. About 80% of this $200 is due to the costs of administering insurance and health provider contracts. The remainder is due to costs of data management and administration of public health programs, which the report finds are mostly due to program administration and record keeping (though the function of these costs is unknown -for example, how much is required for basic administration vs. work required to monitor socially wasteful eligibility and means testing). A small proportion is due to higher per capita expenditures on medical and pubic health research (though, some of this research is on why the US health system, and population health, is so messed up, and this part of research spending could also be considered unnecessary, if we had a better system).

Around $50 to $100 (5% to 10% of the total $1000 excess) is due to poorer health status of the US population compared to other high income countries.

About $260 (26% of the total $1000 excess) is attributed to what the report calls ‘organizational and structural inefficiencies’, which are explained below.

About 40% of this $260 is due to problems in managing hospital capital and patient care. There has been a very aggressive reduction in hospital care, to the point that there may be excess hospital capital stock. This could be because hospital care is inefficient, but the adjustment of hospital capital has been slow, leaving much over capacity. However, it could also be that reductions in hospital care have been driven by inefficient reimbursement policies, and hospital capital is under utilized, poorly maintained, and run with obsolete administrative practices.

The report finds that substantial excess costs also arise from poor coordination of hospital and subsequent outpatient care. These costs would include unnecessary re-admissions due to poor coordination of care, and inefficient coordination of drug care and rehabilitation and outpatient care following. These last bits can be quite costly. For example, choices of medication during hospitalization due to provider contract provisions may severely restrict choice of outpatient drug therapy after discharge.

In the health care consulting and health services research industry in the US, there has been a lot of talk about how hospitals are inherently ‘bad’ places to deliver care. Hospitals being a major source of antibiotic resistance is an example of the reasons given for this conclusion. I don’t think these are established facts, however. Other sources of antibiotic resistance exist, and international survey results show that some high income countries with more hospital utilization have much lower rates of hospital infection. I think the real reasons for the decline in hospital utilization, whether hospitals have been efficiently utilized, or whether capacity should continue to shrink, are unclear. Some of it is due to higher costs of capital in the health care sector in the U.S.: for quite awhile it was considered better business strategy for providers to rent or contract out hospital services rather than own hospitals, whenever possible.

About 30% of this $260 is due to what looks like an inefficient use of ambulatory care in private outpatient ambulatory care and surgery centers. This inefficient use is a result of reimbursement policies that compensate outpatient surgery centers at rates above their average costs. Some of this excess may be due to overcapacity and underutilization of these outpatient facilities: they are reimbursed at rates greater than their average cost, therefore too many have been built by providers in order to capture the resulting excess profit.

The remaining 30% of this $260 is due to higher employment of nonclinical labor. Some of the functions of these nonclinical employees seem to be involved in negotiation of provider and vendor contracts, risk management related to malpractice and other risk management, and monitoring contract compliance (which is nightmarish in the US healthcare industry, even for large organizations that have the same problems with incomprehensible bills and receipts as individuals). Therefore, a portion of this category may really be hidden administrative costs.

The report does not do a full analysis of the costs of malpractice. It does calculate the contribution of malpractice premiums in the price of health professionals, which is about 7%. So $35 if the approximately $245 dollars going for higher price of a physician is due to malpractice costs. However, the analysis does not deal with unnecessary tests and treatment to avoid lawsuits, so should be considered a lower bound of the true costs. (But I am not endorsing the view that all, or even most, excess testing and treatment are due to defensive medicine).

The overall conclusion is that relatively high health care expenditures in the US are due to several reasons and that reduction in costs to those of the developed country average requires extensive reforms to the pricing, reimbursement policies, capital stock, and administration of the industry.

The report also reminds us that there are real costs and trade-offs for the current structure of the US health care system. For example, the report finds that the high cost of drugs in the US discourages drug therapy: utilization in the US is about 20% less than comparable high income countries.

Other researchers have concluded that the higher price of health care inputs are a significant source of excess costs (Anderson 2003). The correct way to estimate excess administrative costs in the US is contentious. See (Wollhandler 2003) and the debate it sparked. There is little doubt that administrative costs in the US health care system are high, but these estimates cast doubt on the idea that savings from reduced administrative expenditures can pay for most of healthcare reform, as economists like Krugman have suggested in the past. The report finds that 20% of the excess spending is due to clear excess administrative costs, and about another 10% due to possible excess administrative costs.

The pricing structure of the US healthcare is extremely complex, partly because of cross subsidization needed to compensate many Medicare services that are reimbursed at below cost, and uncompensated care in emergency rooms. It is also very difficult to estimate what real economic costs are, because the lack of transparent pricing in the industry. Due to price discrimination and cross-subsidization, the publicly observable list prices (the ‘charges’) of many services are far higher than the vast majority of reimbursements. In some states, listed prices for services exceed the crude estimates of their real average economic costs by 50% or more -California is an especially bad example.

Some details:
This analysis is of gross excess costs. The net excess in the US may be about 15% lower than the gross costs (that is the net excess might be $850, rather than $1000, in the simple example above). The difference in net and gross costs is because there is lower use of nursing and home care and durable medical equipment (eyeglasses, etc.) in the US than in other developed countries. If the report’s estimate of the potential reduced spending in the US is correct, then the net per capita excess cost in the US in 2003 would be about $1400 rather than $1645 gross excess. I did the analysis on gross costs for simplicity, but the adjustment for net costs is easy for anyone who wants to make a spreadsheet.

The report gives ranges for some estimates, so I took the average of the high and low range for these calculations.

The report was published in 2007, so could not fully estimate the effect of the Medicare drug benefit. Provisions probably unnecessarily increased the price of drugs to Medicare. The policy of reimbursement of certain private providers in excess of estimated costs was expanded, so the corresponding components of excess costs have probably increased since the report was published.

Sources

Paul Krugman. Health Care Costs (2007) The Consicence of a Liberal, February 7
http://krugman.blogs.nytimes.com/2007/11/09/health-care-costs

Accounting for the Cost of Health Care in the United States.(2007) McKinsey Global Institute URL: http://www.mckinsey.com/mgi/reports/pdfs/healthcare/MGI_US_HC_fullreport.pdf
(may need to register)

(Anderson 2003) Gerard F. Anderson, Uwe E. Reinhardt, Peter S. Hussey, and Varduhi Petrosyan (2003) It’s The Prices, Stupid:Why The United States Is So Different From Other Countries/ Health Affairs 2003: 22 (3): 89-105.

(Woolhandler 2003) Steffie Woolhandler, Terry Campbell and David U. Himmelstein ()Costs of Health Care Administration in the United States and Canada. New England Journal of Medicine | www.nejm.org 2003349(8): 768-75. Editorial, comments and authors’ replies:
N Engl J Med. 2003 Aug 21;349(8):801-3.
N Engl J Med. 2003 Dec 18;349(25):2461-4; author reply 2461-4.