Journal of Financial Service Professionals

Consumer-Driven Health Care: Taming the Health Care Cost Monster
March 2004

By Regina Herzlinger

Corporate financial executives all over the United States are tearing their hair out, or whatever hair they have left after coping with the doubledigit inflation in health care costs they have encountered since the 21st century began.

How did this happen? Was not managed care supposed to knock out the health care cost monster? And what can be done about it now that managed care has failed to contain costs?

Why Managed Care Failed

Managed care was the magic bullet that corporate financial executives eagerly embraced in the early 1990s. This magic bullet would both kill health care inflation and improve health care quality. The bullet was much needed; by 1989, health care costs equaled corporate profits in magnitude.[1]

Cost control via managed care was what the experts promised. According to them, managed care organizations, modeled after California’s fabled Kaiser Permanente, were winwin solutions.[2]  They would recreate the inefficient, ineffective U.S. health care delivery system to provide better quality and lowercost health care.

However, the magic bullet turned out to be a problem, not a solution.  Americans substantially rejected the Kaiser model; they rebelled against its limitations in the choice of physicians and hospitals to only those affiliated with Kaiser.  This socalled “group” or “staff” vertically integrated version of managed care lost substantial market share over the 1990s.[3] Then too, most of the new managed care organizations were no Kaisers.  Few could afford the multibilliondollar investments in owned hospitals and uniquely affiliated doctors that the vertically integrated Kaiser model required.  Instead, they cobbled together narrow networks of independent doctors and hospitals who were willing to discount their fees in exchange for the insurer’s patient volume, and/or they instituted gatekeepers—insurance officials whose purpose was to “just say no” to requests for what they judged as unnecessary referrals to expensive specialists and hospitals.

American consumers rebelled against the gatekeepers. They induced socalled “patient protection” legislation to require access to health care benefits.[4]  Meanwhile, formerly fragmented independent providers merged so they could better resist managed care’s pricecutting practices.  For example, two world famous Boston hospitals became “partners” so that managed care could no longer pit one against the other in pricing discussions.[5]

So much for managed care’s costreducing magic. As the power of gatekeepers waned and newly oligopolistic providers no longer had to offer “discounts,” managed care’s cost control went up in smoke.[6]  Advocates argued that the public was at fault for rejecting managed care’s structures.  Were nationalized health care or even more stringent managed care the only alternatives?[7]

ConsumerDriven Health Care—The New Solution

A few enlightened executives and academics saw this glass as being half full rather than half empty. They reasoned that managed care had failed because it tried to supplant the judgment of consumers and providers with that of health insurance executives.  Elsewhere, the highly productive U.S. economy flourishes because consumers and suppliers are empowered.  There, insurers are not authorized to supplant their judgment. For example, although the automobile insurer GEICO is highly respected, nobody expects it to revive the U.S. automobile industry. The sector’s revival relies on the ability of entrepreneurial executives to respond to the needs of the assertive, picky, informed U.S. automobile buyer.

As an example of the power of this dynamic, a McKinsey study demonstrated that six sectors accounted for the bulk of the increased productivity in the U.S. economy in the 1990s. Surprisingly, the top two were not high tech.  To the contrary, they were oldfashioned service sectors—retailing and finance—that most observers would not have selected as bastions of productivity. But because they were consumerdriven and highly competitive, they were forced to redesign their products to offer better quality for the money.  For example, in retailing, new outlets focused on lifestyles—Staples, Home Depot, Ann Taylor—supplanted everythingforeverybody department stores while WalMart’s mass discounting gave them a run for their money too.[8]  As these new types of retail outlets flourished, consumers benefited, as did their successful entrepreneurial providers.

Revolutionary health care thought leaders reasoned that the key to creating better, cheaper health care was to empower consumers and providers. In a 1999 Harvard Business School conference, I dubbed this nascent movement “ConsumerDriven Health Care.”

Unlike managed care, with its onesizefitsall plans, consumerdriven health care empowers consumers by offering them a wide variety of health insurance plans so they can select the one that most closely meets their needs. (Most employees currently offer a “choice” of one health plan.)  In 2003, for example, enrollees in “highdeductible” plans—with deductibles ranging from $1,000 to $7,000—could trade insurance coverage for lowcost items for a $2,000 to $4,000 employersponsored “health reimbursement account” (HRA) to cover uninsured items, such as weight loss support classes and longterm care insurance policies.  A 2003 U.S. Department of Treasury ruling that protected the taxexempt and rollover status of these HRAs increased their popularity.[9] Simultaneously, new plans emerged, such as the Minneapolisbased Buyers Health Care Action Group (BHCAG), that enabled providers organized as care teams to freely develop innovative care programs and to quote their prices.  In the BHCAG plan, enrollees are given enough money by their employers to purchase the most costeffective plan from among the providers (for example, the Mayo Clinic). If enrollees prefer a highercost care team, they pay for the difference in price themselves.

Not surprisingly, both types of consumerdriven health care models—those that empower consumers and those that empower providers—demonstrate cost-controlling properties.  In some cases, the highdeductible plans not only control increases but actually reduce costs. For example, Aetna and a large firm that implemented highdeductible plans for all its employees found cost reductions.  Significantly, they were achieved through changes in consumption behavior to seek out lowercost resources.[10] These highdeductible plans are typically accompanied by complete coverage of preventive care, so enrollees can readily maintain these services.[11] A massive study conducted in the 1980s of the impact of high deductibles on expenditures and health status supported these early-adopter findings: its enrollees demonstrated considerable price elasticity while they maintained their health status.[12]

The providerempowering consumerdriven health care plans also appear to work. For example, BHCAG controlled cost increases to rates lower than managed care’s.  BHCAG not only induced consumers to move from highcost provider systems to lowercost ones, but also, and more importantly, induced providers to change their cost structure. For example, one academic health care system that was categorized as high cost reorganized itself to become low cost a few years later.[13]

Switzerland, which has long had a consumerdriven health care system in which all citizens must purchase health insurance, provides the best longrun evidence of its workings. The government’s role is to subsidize those who cannot afford it and to riskadjust insurers’ premiums.  (The risk adjustment corrects for insurer profits and losses incurred solely because of the health status of the enrollees.)  The combination of a consumerdriven system and risk adjustment provides a carrot and a stick to insurers. Consumer control is a stick for product differentiation. And, indeed, the Swiss market features many different insurance products, including a fiveyear policy in which enrollees can get up to 45% of their premium payments back for maintaining their health. The risk adjustment is a carrot that induces the innovation of products that focus on the sick.

The results? The Swiss enjoy excellent health status, ample capacity, and highquality resources at costs 30% lower than those of the United States.[14]

The ConsumerDriven Health Care Naysayers

Consumerdriven health care plans have encountered considerable resistance from health policy experts and others who believe that they, and neither consumers nor providers, are best suited to manage health care.

Some of the stories they spin to deter adoption of consumerdriven health care are fables, such as the luridly named “death spiral.”  This story avers that consumer-driven health care will induce the highcost sick enrollees to enter new health plans tailored for their needs, whose high prices will deter healthier enrollees. A financial death spiral follows as the plans for the sick price themselves out of existence.

But the story is irrelevant for selfinsured employers who already pay for the cost of the sick enrollees. Would the employer not prefer to see the sick enrolled in plans that can best manage their needs rather than an everythingforeverybody plan?  Since health care expenses follow Pareto’s Law—20% of the users account for 80% of the costs—clearly health care costs can best be controlled with plans that are specifically designed for these 20%.

Focused factories are a major innovation that consumerdriven health care will induce.  These are programs focused on costly, unmet health care needs, such as integrated care for chronic diseases, disabilities, and underserved populations with special needs.  For example, a congestive heart failurefocused factory reduced the costs of the disease by more than $8,000 per enrollee in only one year.  With newly integrated treatment from the diverse providers of care for the disease, patients’ health status improved substantially and their costly hospital use plummeted.[15]  Because five chronic diseases account for roughly 75% of health care costs[16] and are generally regarded as mismanaged, focused factories offer special promise. Enrollees with chronic diseases who are offered focusedfactory options are likely to choose them in lieu of everythingforeverybody health care services.

Yet another story asserts that Joe Six Pack is incapable of choosing wisely among complex consumer-driven health care plans. So how does Joe manage to choose cars, computers, and financial products?  After all, these are highly complex consumerdriven products whose costs have steadily dropped while their quality has steadily increased.

The answer to the Joe Six Pack story comes from Economics 101: markets are shaped by marginal consumers, not average ones. The marginal consumers are members of the picky, assertive, hardtoplease crowd who are the last to buy a product. They are the ones who force producers of complex auto, finance, and computer products to create the better and cheaper offerings from which the rest of us benefit. In health care too, the marginal consumers will reshape the sector and the rest of us will benefit.

Role of Government in a ConsumerDriven Health Care System

Yet, other concerns about consumerdriven health care are valid.  Some worry whether enrollees will be able to judge alternative plans, given the current absence of information about them. However, nascent entrepreneurial providers of information about providers have already emerged. The purveyors of highdeductible plans offer their products, such as the riskadjusted death and morbidity rates for openheart surgery in all local hospitals.  In my view, audited versions of such outcome data will ultimately be required by the government, just as financial executives were ultimately required to provide financial statements by the SEC Acts.  The data requirements will likely be formulated by a privatesector organization, resembling the FASB’s structure, and audited by independent thirdparty professionals.[17]

Some also worry about the quality of the risk adjusters. Excellent risk adjustment requires specific personal data that threatens enrollee privacy, while risk adjusters that rely on more neutral data—age and sex—lack explanatory power.[18] But again, entrepreneurial firms are working on this problem.  One, for example, offers itself as a “Chinese wall” thirdparty risk adjuster that can use powerful, personal data to risk adjust individuals while protecting their privacy.

How to Make ConsumerDriven Health Care Happen

Employerbased consumerdriven health care requires the following steps:

1. Offering a number of highly differentiated health insurance policies that vary in benefits, outof-pocket payments, and term (i.e. length of the policy). These options should include ones in which providers can freely create and price their offerings.
2. Subsidizing each plan by the same dollar amount so that enrollees’ costs follow those of the company. Currently, many employers subsidize different plans by different amounts so that the enrollee does not understand the company’s underlying costs.
3. Offering excellent information about the clinical and patient satisfaction of the providers in each plan. Consumers are much more interested in data about the quality of providers than the quality of health plans,[19] and providers can play a much larger role in reshaping health care costs than insurers.
4. Offering excellent education and support.
5. Getting out of the way.

These five rules will enable financial executives to tame the health care cost monster, not by “just saying no” to consumers and providers, but with an oldfashioned American marketbased system that enables demand and supply to create better, cheaper health care.

(1) Helen Darling, “Market Reform: Large Corporations Lead The Way,” Health Affairs 14(l) (1995): 122124; Mike McNamee, Joseph Weber, and Russell Mitchell, “HealthCare Reform: It’s Already Here,” Business Week, No. 3323 (June 14, 1993): 114.

(2) Alain C. Enthoven and Sara J. Singer, “MarketBased Reform: What to Regulate and by Whom,” Health Affairs 14(l) (1995):105119; Alain C. Enthoven, “The History and Principles of Managed Competition,” Health Affairs 12 Supplement (1993): 2448.

(3) Karen Davis, Karen Scott Collins, Cathy Schoen, and Cynthia Morris, “Choice Matters: Enrollees’ Views of Their Health Plans,” Health Affairs 14(2) (1995): 99113.

(4) Amy Goldstein and Juliet Eilperin, “House Votes to Increase Rights of HMO Patients,” The Washington Post, 8 October, 1999, p. Al; Robin Toner, “House Is Set to Take Up Debate on Patients’ Rights,” The New York Times, 4 October, 1999, p. A24; Amy Goldstein and Juliet Eilperin, “Patients’ Rights Accord Reached,” The Washington Post, 2 August, 2001, p. Al.

(5) Daniel Golden and Charles Stein, “MGH, Brigham Plan to Merge,” The Boston Globe, 8 December, 1993, p. 1.

(6) Jon B. Christianson, Cara S. Lesser, Laurie E. Felland, Suzanne Felt-Lisk, Paul B. Ginsburg, Alison K. Vratil, and Elizabeth Eagan, “Increased Consolidation Raises Concerns,” Community Report No. 02 (Washington, D.C.: Center for Studying Health System, 2000).

(7) Robert Pear, “Health Spending Rises to 15% of Economy, a Record Level,” The New York Times, 9 January, 2004, p. A16.

(8) Bradford C. Johnson, “Retail: The WalMart Effect,” The McKinsey Quarterly, No. 1 (2002): 4042.

(9) Charles H. Klippel, Section 2, Chapter 1 of ConsumerDriven Health Care, by Regina E. Herzlinger (San Francisco, CA: JosseyBass, 2004): 133.

(10) Synhrgy HR Technologies, “Whitepaper: Consumer Driven Health (CDH) Plan Shows Positive Results for Employer,” January 2003 (Houston, TX: Synhrgy HR Technologies).

(11) Regina E. Herzlinger, “ConsumerDriven Health Care: Medtronic’s Health Insurance Options,” HBS Case No. 302006 (Boston, MA: Harvard Business School Publishing, 2001).

(12) Joseph P. Newhouse, RAND Health Insurance Experiment, 1974-1982 (Santa Monica, CA: The RAND Corporation, 1986).

(13) Ann Robinow, Section 2, Chapter 1 of ConsumerDriven Health Care, p. 179.

(14) Regina E. Herzlinger and Ramin ParsaParsi, “ConsumerDriven Health Care: Lessons From Switzerland,” working paper, Harvard Business School, 2004.

(15) David J. Whellan, Laura Gaulden, Wendy A. Gattis, Bradi Granger, Stuart D. Russell, Michael A. Blazing, Michael S. Cuffe, and Christopher M. O’Connor, “The Benefit of Implementing a Heart Failure Disease Management Program,” Archives of Internal Medicine 161(18) (2001): 22232228.

(16) Centers for Disease Control and Prevention, “The Burden of Chronic Diseases and Their Risk Factors: National and State Perspectives” (Atlanta, GA: Dept. of Health and Human Services, Centers for Disease Control and Prevention, 2002): 3 (www.cdc.gov/nccdphp/burdenbook2002/index.htm).

(17) Herzlinger, ConsumerDriven Health Care, p. 940.

(18) Lisa I. Iezzoni, Section 2, Chapter 1 of ConsumerDriven Health Care, p. 75.

(19) Karen W. Endresen and Jeanne C. Wintz, “Inside the Mind of Today’s Consumer,” Marketing Health Services (Winter 2002): 1923.

©2004 Journal of Financial Service Professionals