How inflation will affect our health system

All eyes are on interest rates as investors look for more signs of trouble ahead.

If their concerns over higher-than-expected inflation prove accurate, many players in the U.S. economy will suffer the burden of higher costs. But perhaps no sector would feel the strain more than health care. Higher costs would be just the start of many problems to come for providers, insurers and, eventually, patients.

Surging inflation would create a vicious cycle

After years stagnant wages and low-interest rates, fears of rising inflation have packed a wallop in recent weeks, shaking investors and igniting market volatility.

Economists point to a pair of budget bills on Capitol Hill as the root of the recent turmoil: GOP tax reform, signed in December, along with the more recent bipartisan compromise to avert a government shutdown, will add an estimated $1.8 trillion or more to the federal deficit over the next decade, according to budget experts. That number could climb significantly if Republican lawmakers fail to deliver on $338 billion in projected savings from their repeal of health-coverage mandates.

Business leaders worry that a tightening labor market, along with rising interest rates and higher capital costs, could wreak havoc on their bottom lines.

In “normal” inflationary cycles, industries counter higher costs by raising prices. Consumers, in turn, pay more for just about everything, from fuel and food to transportation and health care. Employees complete the vicious cycle by demanding higher salaries and better benefits to offset living expenses.

But if inflation surges as some predict, the impact on health care coverage costs will be especially severe. With American medicine’s unique reimbursement model, major inflation could yield devastating consequences.

Why health care isn’t a “normal” industry

Federal and state governments control slightly more than 50% of all U.S. health care funding. These entities offer public coverage through Medicare, Medicaid and the Children’s Health Insurance Program (CHIP), and they provide subsidies through the Affordable Care Act and other legislation.

But unlike private insurers, public payers have the power and the unilateral authority to determine how much they’ll reimburse doctors and hospitals.

Ask these providers, and they’ll tell you it’s nearly not enough. Following the Balanced Budget Act of 1997, the government has kept Medicare rate increases relatively low (at about 1-2% annually, in line with the overall rate of inflation). As a result, doctors and hospitals now receive only 90% of the fully allocated costs for their Medicare patients. In states like California, Medicaid reimbursements have dropped to as low as 60% of the total cost of care.

So, what do providers do when half their revenue stream comes from the public sector, which reimburses them at less than cost? They have no choice but to demand more from the other half: the private sector.

Each year, providers negotiate reimbursement rates with commercial insurers. In some cases, doctors and hospitals can negotiate commercial rates as high as 200% of what Medicare pays for the same procedures and hospital days, depending on (a) the provider’s clout and (b) how much of their income comes from the public sector. But, on the whole, health plans like United, Aetna, and Anthem pay hospitals and physicians approximately 120% to 130% of the actual cost of providing coverage, which still leaves businesses and privately insured patients to foot higher bills.

Importantly, the gap between public and private reimbursement rates is widening. A major inflationary cycle will exacerbate this trend, and not by a little. Here’s why.

Businesses, employees would feel the pain

Since the global economic crisis a decade ago, total health care costs have increased approximately 3-4% each year on average. Because Medicare and Medicaid reimbursements increase a scant 1-2% per year, commercial insurers have been forced to make up the difference, paying annual rate increases of 5-6%. Although that’s more than they desire, this rate of inflation has been tolerable amid a growing and vibrant economy.

However, the math would change dramatically in the context of rapid inflation.

Let’s assume the federal deficit drives up interest rates, and that added government spending aggravates the current labor shortage, thus fueling wage increases over the next few years. Suddenly, health care costs that previously rose only 3-4% annually would climb up to the 6-7% range.

Naturally, the government would continue to limit costs by keeping Medicare and Medicaid reimbursements on the same flat trajectory as today, with 1-2% increases each year. This would leave the commercial sector having to fund not only the 6-7% increase incurred by enrollees, but also the difference between what the government pays and the cost of caring for its beneficiaries. The outcome would mean double-digit increases in commercial premiums year over year.

Few payers would be able to tolerate such a hike, especially those that would already be experiencing the higher costs of supplies, labor, and capital borrowing.

The impact of rapid inflation on health care

The consequences of double-digit health care inflation for businesses could be dire, with more drastic responses than we’ve seen before. Some businesses, particularly smaller ones that are not subject to ACA requirements, could either shift the costs to beneficiaries or drop commercial health coverage altogether. And without a government mandate to purchase coverage, millions of Americans would likely rejoin the ranks of the uninsured.

Over time, insurance companies will try to use their growing market power to limit provider reimbursements, leading to even narrower networks, and further reducing patient access to medical care. Doctors and hospitals, meanwhile, will get pinched from both sides as they face higher office/employee costs on one hand and tightening revenue on the other.

No one in health care does well in an inflationary world. That’s especially true for patients.

If there’s a ray of sunshine in this high-inflation scenario, it’s that the barriers to disruptive innovation fall in times of financial crisis, paving the way for new solutions. However, disruption is always painful, particularly for those who have done well in the past. A major inflationary period would usher in powerful economic woes. Hospitals would close as investments in new technology languish.

The best solution for today’s health care system is to embrace change before it’s too late. That will require some hospitals to shut down clinical services in communities where there’s provider redundancy. Doing so would help maximize volumes and efficiency among those that remain. It also will mean capping the number of physicians performing complex procedures in order to boost specialization and clinical competence for others. And it will require providers to focus on reducing medical errors, maximizing prevention and eliminating treatments that have minimal or no clinical efficacy. This will prove much more effective than their current strategy of market consolidation for the sole purpose of raising prices.

Change is never easy. Leaving the past behind is always painful. But if the U.S. health care industry can reduce the cost of high-quality care, it might stand a chance of surviving a major inflationary cycle. Perhaps today’s inflationary fears will serve as the change catalyst we need. Let’s hope so, for all our sake.

Robert Pearl is a physician and CEO, Permanente Medical Groups. He is the author of Mistreated: Why We Think We’re Getting Good Health Care–And Why We’re Usually Wrong and can be reached on Twitter @RobertPearlMD. This article originally appeared in Forbes.

Image credit: Shutterstock.com

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