Medicare Rx

The fundamental flaw with Medicare’s system of paying for healthcare services is that it attempts to find out what it costs to produce medical services. These costs are then used to set provider fees using complicated cost-plus-profit methodologies (RVU, DRG, RUG, etc.). Medicare collects these provider costs through various vehicles that include requiring providers to submit cost reports (See http://www.cms.hhs.gov/CostReports/ for a summary of these reporting regulations).

The basic assumption of Medicare's complex approach is this: that the price of a healthcare service is based on the costs of producing that service. But Medicare administrators and their supporters in academia have the cause and effect relationship between prices and costs exactly backwards! This is the same mistake that Karl Marx and his predecessor Classical economists David Ricardo and Adam Smith made in their unsuccessful attempt to explain how prices are supposed to be a reflection of labor costs and other factors of production costs like land, supplies, capital, etc. Costs do not cause price! The price of a product is set by the subjective judgments and valuations of individual suppliers and consumers exchanging goods in a free market. And it is this price that then determines costs of production! This takes place through a process of "value imputation" that flows from the consumer back to the factors of production. This "value imputation" happens when entrepreneurs and managers bid up the prices of factors of production in response to expected future profits.


Let us first illustrate the complexity of Medicare's attempt to collect cost information and then set prices. Medicare uses the following formula to determine the fees paid to physicians:

Work RVU x Budget Neutrality Work Adjustor x Work (GPCI)+Practice Expense (PE) RVU x PE GPCI+Malpractice (PLI) RVU x PLI GPCI= Total RVUxCY 2007 Conversion Factor of $37.8975= Medicare Payment

The three Relative Value Units or RVU's in the formula represent the value assigned by Medicare to the various resources needed to provide each physician service. The RVU's are supposed to reflect the work effort, skill, time, intensity and risk required of the physician depending on his specialty, his expenses in providing each service adjusted by a geographic practice cost index (GPCI), liability insurance costs (PLI), a "budget neutrality" cap on total Medicare payments to physicians mandated by Congress and the "conversion factor" which translates each RVU into a dollar amount.

RVU's were developed by the good folks at the Harvard School of Public Health in the mid 1980's when Medicare administrators awarded them a contract with the intent of establishing a rational, equitable and distortion-free approach to physician fees. Additional help was provided by KPMG Consulting who was charged with the development of the liability insurance cost factors. For a more detailed account of how those liability factors are determined go to http://www.ama-assn.org/ama/upload/mm/363/pliwhitepaper.pdf. And later still, more help was provided by experts in econometrics at the Urban Institute who developed the geographic practice cost index. Go to http://www.urban.org/publications/900540.html for fascinating account from one of its developers.

To coordinate the whole process, Medicare also enlists the help of the American Medical Association, the American Osteopathic Association and the major national medical specialty societies, all of whom participate in an advisory group ( RVS Update Committee http://www.ama-assn.org/ama/pub/category/16401.html) responsible for compiling data obtained from physician surveys to determine the time spent in performing the medical service and ranking the service relative to existing services.

There are over 10,000 values for each of the above three RVU categories, hundreds of GPCI's and PLI's adjusting each of those 30,000 RVU's resulting billions of potential combinations for physician fees. In the near future, Medicare will adjust this formula to reflect each physician's clinical outcomes or quality, which will result in another exponential increase in the number of potential combinations for fees. And this is only for the professional component of physician reimbursement. Physicians also receive Medicare payment for the facility components of certain procedures performed in their offices.

If one adds to this already mind-boggling array of physican fees calculations more layers of complexity represented by fees to hospitals, home health agencies, hospices, Medicare HMO's, ambulances, nursing homes and pharmacies, each with their own assigned methodologies for Medicare reimbursement, and one adds the mechanism by which the AMA and the government manipulate the supply of medical education (http://www.cogme.gov/) and hospitals and some state governments influence the supply of hospital beds through certificate of need regulations, one can only begin to appreciate the mammoth size and the power of the bureaucracies needed to attempt to centrally manage our healthcare system.

I wrote earlier that unlike what Medicare administrators assume, prices determine the cost of production. Let us illustrate the correct causal relationship between prices and costs with an example. Diamonds are expensive not because they cost a lot to produce, but because high demand and low supply forces prices to be high, which then allows producers to engage in the very expensive process of discovery, extraction and commercialization of diamonds. When diamond entrepreneurs are wrong in anticipating the price at which they will sell diamonds and their production costs are higher than the market price, their companies go out of business. When they are right and their costs are lower than the price at which they sell, they make a profit and prosper.

The higher their profits, the more other diamond entrepreneurs will enter the market, which bids up the prices paid to the factors of production or increases the quantity produced until, in the long run, the market for diamonds and the market for the factors of production of diamonds may approach equilibrium. It is only then that price of diamonds equal the costs of producing them. And it is then that casual observers are deceived into thinking that the price of diamonds is caused by their cost of production. This is because we tend to experience only the resulting price and costs of those companies that survive the competitive process. When we erroneously conclude that the value of a product is inherent in the costs of the inputs of the production process, we ignore the more vital and essential role played by the short run process of adjustments.

Theoretical work by the Austrian School of Economics since the 1870's has clearly refuted the incorrect theory of value that we inherited from the Classical school and Karl Marx and that economists and policy makers, including Medicare administrators, continue to use to this day. For an account of the Austrian approach and the theory of value imputation, see Ludwig von Mises' "Human Action" Chapter XVI, pp. 328-347 http://www.mises.org/humanaction/chap16sec2.asp:

"Attempts to establish cost accounts on an "impartial" basis are doomed to failure. Calculating costs is a mental tool of action, the purposive design to make the best of the available means for an improvement of future conditions. It is necessarily volitional, not factual. In the hands of an indifferent umpire it changes its character entirely. The umpire does not look forward to the future. He looks backward to the dead past and to rigid rules which are useless for real life and action. He does not anticipate changes... Profits do not fit into his scheme. He has a confused idea about a "fair" rate of profit or a "fair" return on capital invested. However, there are no such things... In a changing economy profits are not determined with reference to any set of rules by which they could be classified as fair or unfair. Profits are never normal..." pp. 346-347

The key insight of the Austrian approach is that not only are prices of consumer goods subjective, but that production costs are also subjective and determined through voluntary exchanges in a free market through a proces of value imputation that flows from consumers to producers to owners of factors of production. The collapse of the Soviet Union's economy has shown us that a centrally planned socialist approach based on an erroneous theory of value does not work in practice. This collapse has vindicated the work of many Austrian School economists who have shown since the 1920's that economic calculation under a centrally planned economy is theoretically impossible (for a devastating attack on central planning, see Ludwig von Mises' 1922 "Socialism" http://www.mises.org/books/socialism/contents.aspx).

Attempts by a central bureaucracy to use costs to set prices are not just difficult or "thorny" practical issues to resolve. Bluntly put, it is theoretically impossible for a PhD economist or a Medicare bureaucrat to figure out healthcare costs and therefore impossible for him to figure out the correct reimbursement rates for any healthcare service anywhere at any time. Only an unregulated free market where patients and physicians and other providers of healthcare services can voluntarily make exchanges can correctly solve the puzzle. The market for healthcare is not an exception to this inexorable and axiomatic economic law.

With the government sector accounting for more than 40% of healthcare spending (http://aspe.hhs.gov/health/costgrowth/) and with insurance and managed care companies and individual patients following Medicare's methodologies, the overwhelming majority of players in the healthcare market in the US are following a centrally planned socialist approach. The process and the results are disastrous and inevitable. First, Medicare compiles observed production cost data to calculate reimbursement rates or prices. Then healthcare providers take this price and it's implied expected future profit to bid up the price of the factors of production. The following year, these factors of production are then fed back to Medicare as costs to be used to determine the new reimbursement rates, and so on and so forth, into an ever ending negative feedback loop.

Is it any wonder that we have a collapsing healthcare system with ever increasing costs, misallocation of capital, meaningless prices, shortages, cues, rationing, cherry picking and fraud? Is it any wonder that a significant and ever increasing portion of patients are being priced out of the market and turning up in our emergency rooms as uninsured? Is it any wonder that patients, physicians, insurance companies and hospitals are pitted against one another with missaligned incentives in a battle to maximize Medicare dollars? Is it any wonder that Medicare taxes and deficit spending are causing an unprecedented inter-generational transfer of income from younger working poorer uninsured Americans to older, retired, insured and wealthier Americans?

CMS administrators should recognize that they are using a mistaken socialist economic theory to set their fees that will inevitably continue to bring the healthcare system to its knees. Physicians and hospitals should recognize that with this approach in which their own professional societies have actively participated, they have have lost complete control of their practices and hospitals and have simply become instruments of the state. And patients should recognize that their beloved Medicare has eroded the patient-physician relationship beyond recognition, one in which physicians can no longer respond to patient needs but to a bureaucracy in Washington.