How to structure financial incentives in our health care system

Next in a series.

In my previous post, I explained the basics of my Healthcare Incentives Framework, which enumerates the jobs we want a health care system to do for us and links them to the parties in the health care system that have the greatest incentive to fulfill those jobs. If you haven’t read that post, I recommend you read it first. For those who have, here’s a refresher:

There is utility in identifying which parties have incentives to perform which jobs, but a more important issue is how to structure those incentives in a way that encourages those parties to fulfill their jobs as effectively and efficiently as possible. Because we all know providers and insurers can do much better than they’re doing now!

To understand this discussion, two core definitions must be absolutely clear.

First, the definition of value: Value = Quality / Price

High value can be found at any price point. For example, it could be reasonable quality (as defined by the person buying the service—maybe they care most about bedside manner, distance from their home, convenient parking, or great customer service) for a super low price, or it could be the absolute best quality for a not-crazy-high price. It depends on how much money they’re willing to spend.

Second, the definition of a financial incentive: A financial incentive rewards a behavior with increased profit.

Profit is the key here. Leaders of companies don’t take huge risks and expend great effort on something that won’t result in more money for their company to keep. For example, a project that is projected to increase revenues but also increase costs just as much is a waste of effort from a company’s standpoint because profit won’t increase as a result of it. And, by the way, this also applies to non-profit organizations, only they call it “surplus” and then reinvest it to stay competitive.

With those two definitions clear, I will now make a statement about what is needed for parties in a health care system to have incentives to perform their jobs as effectively and efficiently as possible:

Providers and insurers need to make more profit when they provide higher value for patients. Or, put more succinctly, they need financial incentives to maximize value for patients.

This would motivate them to out-compete and out-innovate their competitors to actually provide higher value for patients.

Think about it. Instead of hospitals spending fortunes on beautiful lobbies, they would be competing on how to make care safer, cheaper, faster, and more convenient for patients. Because that’s how they would make more profit.

Or what about this? Instead of insurers climbing over each other to find ways to cream skim the healthiest patients and creatively design networks to get sick patients to avoid them, they would be competing on how to most efficiently provide cost-saving prevention and how to have the best customer experience for patients. Because that’s how they would make more profit.

As an aside, I want to address the misconception that “financial incentives have no place in health care.” People who believe this don’t understand that there will always be financial incentives in any industry where people get paid for their work. We can’t ignore the inescapable presence of financial incentives in health care. But we can shape them in a way that motivates providers and insurers to maximize the value delivered to patients.

To know how to shape incentives in a way that gives more profit when they deliver higher value for patients, we first need to understand the determinants of a company’s profit. Here is a simplified formula, which should be intuitive:

Profit = (Price x Quantity Sold) – Total Costs

So, which of those three variables would be effective at increasing profit as a reward for delivering higher value for patients?

Raising price. Medicare likes using this tactic (for example, the MIPS program for providers, and Medicare Advantage quality bonuses for insurers). The problem is, when you raise the price to reward a party for delivering higher value than others, it actually lowers their value (remember, Value = Quality / Price), which counteracts what we’re going for here. Our goal is not to get higher quality and pay more, but to get higher quality for the same price or similar quality for a lower price! Sure, other providers would be motivated to raise their quality to get the higher prices too, but all we’d end up with is a little better quality at a little higher price, with no clear path to much else. Therefore, raising prices to reward higher value with more profit is not a great solution.

Lowering total costs. Finding a way to lower the costs of higher-value providers is basically the same as raising their price–either way, more money is given to them as a reward for their higher quality. Shared savings programs may fit into this category.

Increasing quantity sold. We’re left with one last option, and I saved it for last on purpose. What would happen if patients started flocking to higher-value insurers and providers? They would certainly get more profit (assuming they have the capacity to take on the additional patients). And this would not lower their value like the other options do. Patients would sure be happy because more of them would be getting higher-value services. But think beyond the static world. Over time, higher-value parties would continue to make more money and expand, and lower-value parties would be forced to improve their value or just go out of business. Parties would have an incentive to take big risks on innovations to try to improve value for patients because they would know that, if the innovation ends up succeeding at improving their value delivered to patients (lower price, higher quality, or both), it will be rewarded handsomely with increased profits.

I started this post by promising to explain how to shape incentives so that parties in health care systems will perform their jobs as effectively and efficiently as possible, and I hope you didn’t get lost along the way. In summary, the only way to truly achieve our stated goal is to reward the higher-value parties with more profit by increasing their quantity sold (market share).

Why don’t patients choose higher-value providers and insurers already? It’s in their best interest, right? Well, not always. And even when it is, there are way too many barriers to them being able to identify which ones are higher value. But don’t worry, fixing health care is not a hopeless endeavor! In my next post, I will explain these barriers and show how enough of them can be removed to kick-start our health care system’s evolution toward higher and higher value from providers and insurers.

Taylor J. Christensen is an internal medicine physician and health policy researcher. He blogs at Clear Thinking on Healthcare.

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