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By 1970 the Senate was circulating memos examining ways to tamp down runaway Medicare spending growth. A set of 1972 amendments to Social Security included some unsophisticated attempts to cut Medicare payments, but hospital inflation continued to spiral upward, as did public concern about the issue. Hospital costs were growing at roughly twice the general inflation rate; between 1974 and 1977, total government spending on health care doubled.
Control Payments, Control Spending?
Medicare didn’t just drive spending upward; it also made health spending a government problem. With polls showing that the rapidly rising cost of health care was one of America’s top three policy concerns, elected officials took notice. And President Jimmy Carter came to believe that controlling payments was the best way to exert influence on the system.
In April 1977, Carter introduced a proposal to put strict limits on reimbursements to hospitals, which were believed to be a key driver of health care inflation. After years in which spending grew by an average of 15 percent, Carter wanted to impose a ceiling of 9 percent. Because he was responding to concerns about escalating costs across the medical sector, his plan imposed a federal cap on spending growth for both public and private payers. Rather than a single-payer system, it was a variation known as “all-payer.”
But Carter’s plan faced intense opposition from the American Hospital Association (AHA). The AHA successfully killed cost-control legislation twice under Carter by convincing a group of conservative Democrats that hospitals could control costs voluntarily. But the AHA’s members failed to hold up their end of the political bargain. As President Ronald Reagan took office, hospital inflation continued to balloon, growing 13 percent in 1980 and 18 percent in 1981. Voluntary restraint, it turned out, was no match for the temptation of nearly unlimited federal funds.
In 1982 Reagan responded with the Tax Equity and Fiscal Responsibility Act (TEFRA), which, among other things, would have imposed strict new limits on Medicare payments. The law ditched Carter’s “all-payer” idea and addressed public programs only.
The idea was to encourage cost-effective treatment by paying providers on a per-patient rather than fee-for-service basis. But TEFRA was intended more as a negotiating tactic than an actual reform. As David G. Smith, currently a professor emeritus of political science at Swarthmore College, points out in his 1992 book Paying for Medicare: The Politics of Reform, TEFRA was “designed to help the hospitals perceive the desirability” of reform. It wasn’t an overhaul; it was a threat.
Hospitals got the message and relented, dropping their opposition to a new payment system. In less than two months, Congress approved a system of standardized payments that paid a flat rate per case and allowed federal officials to determine hospital payment rates in advance. Reagan administration staffers convinced themselves the reform was market-based because standardized prices rewarded more efficient providers, but there was no mistaking the system’s fundamental element: bureaucratic price setting.
The only question was how the bureaucrats would decide what to charge. A robust system would need to create enough diagnostic groups to contain every possible patient and every possible diagnosis. That meant creating categories, and lots of them.
Think of a filing cabinet with hundreds of drawers, each labeled according to a particular category of medical diagnosis. These are Medicare’s diagnosis-related groups (DRGs), and every hospital patient is assigned to one. After that, prices are set based on the average cost of everything in the drawer. Anything from drawer number 707 —major male pelvic procedures—gets one price. Anything from drawer number 385—inflammatory bowel disorders—gets another price. What if a treatment ends up costing far more or less than the assigned price? The theory is that it doesn’t matter, since everything averages out in the end. Everything is covered; everything has a code and a category.
Or at least it’s supposed to. When the system was launched in 1983, there were 500 DRG codes. But like so many bureaucratic systems, this one grew larger and more complex over time. By 2010 there were almost 750 DRG codes. No matter how narrowly and meticulously Medicare’s bureaucrats organized their files, they were always forced into an implicit admission of defeat in their quest to create an all-encompassing system. Each revision of the DRGs left a junk drawer—labeled “ungroupable”—at the very end.
Leave the Hospital, Go to the Doctor
Did the Reagan administration’s price controls restrain Medicare spending? Within hospitals, yes. But the system had an unintended consequence: Hospitals, paid according to the diagnostic drawers their patients fit in rather than according to their own rates, were given an incentive to cycle through patients much faster. As a result, hospital stay lengths dropped dramatically, and so did inpatient hospital spending. A RAND Corporation study published in 1992 found that the new payment system reduced the length of hospital stays by an average of 24 percent.
Quicker discharges often meant sicker discharges. Where do sick patients who have been discharged from the hospital go? To doctor’s offices, outpatient hospital services, or, in the case of seniors, nursing homes, none of which was covered under the new payment scheme. That’s where the spending went too. Starting in 1983, outpatient hospital spending rose at three times the rate of inpatient spending. And according to a 2003 World Health Organization review of U.S. health policy, the savings generated by shorter hospital stays were offset by increased spending on nursing home and outpatient care. Throughout the 1980s, Medicare spending on physician payments grew an average of 13.7 percent—7 percent faster than all other services. By 1990 total Medicare payments to physicians had blown up to two and a half times what they were a decade earlier.
So by the mid-1980s, policy makers were hunting for yet another payment reform. This time physician payments would be the target. Whack one mole, another one pops up.