Start with a cautionary tale. Health care in Vermont is a success story. Of sorts, anyway: while the state has one of the highest rates of insurance coverage in the country, its residents pay higher premiums and suffer from longer wait times for care than in peer states.

In part, that’s because there are simply not enough doctors and related resources to address rising demand. Adding to the problem, a lack of competition allows Vermont hospitals to charge higher prices than the national median.

As goes Vermont, so goes the nation. Other states with aggressive “demand-side” health coverage strategies suffer similar frustrations to one degree or another. Thus, while universal insurance coverage is an admirable goal in health care and is often the path of least political resistance in reform initiatives, the seemingly inexorable rise of costs and a growing doctor shortage require that policymakers shift their attention to the supply side.

Changing Perspective

There are myriad ways to capture the failings of a health care system in simple statistics. One of the most telling: among OECD countries, the U.S. spends the most per capita on health care but has the highest rate of treatable mortality  – that is, deaths from conditions patients could survive if they were identified and treated in time.

This kind of detection and intervention is the special province of primary care physicians, who can flag and treat chronic and life-threatening conditions in patients they see routinely. Unsurprisingly, the U.S. is significantly below the OECD average on both the number of primary care physicians per capita and the number of primary care visits, and these numbers continue to decline as policy prioritizes access to insurance over access to care. To chart a sustainable way forward, we must embrace a vision of health care abundance in which providers are plentiful and resources are more accurately funneled toward patients’ needs.

The Trump administration’s initial stab at the issue focuses on improving market allocation, such as requiring price transparency for negotiated rates and encouraging price comparisons by consumers. Both are laudable goals. But the emphasis on transparency overlooks the reality that health care is unlikely to ever operate like most private markets, in large part because the primary buyers of health services (government and private insurers) are not the consumers. And in any event, better price intermediation will not have the intended effect if public policy constrains entry or encourages consolidation.

Traditional health care reformers have always been driven toward paths of least resistance, typically pairing subsidies to expand coverage with regulation to contain costs. But the first is easier than the second, thereby boosting demand for care without increasing the supply of care – a condition my colleagues at the Niskanen Center have labeled “cost disease socialism.” There is an alternative agenda, though, that explicitly identifies and removes roadblocks to increased supply and better directs resources toward the type of care with the highest societal payoff: primary and preventive care. Serendipitously, this type of care is also lower cost compared to more specialized services.

Shattering the Iron Triangle

Designing win-win-win health care policies requires breaking through what health economists call the “iron triangle” of access, cost and quality. Often, a decision that improves one or potentially two of these will come at the expense of the third. For example, increasing insurance coverage may increase access and quality but raise costs in the process, while containing costs typically chips away at access or quality.

But these tradeoffs are only set in stone – well, iron – for a system that is already operating near peak efficiency. If the system is underperforming on a variety of fronts, it is possible to make improvements on one front without harm to others. And the relative success of peer OECD nations plainly suggests that the U.S. is, indeed, lagging pretty much everywhere you look.

Substandard performance provides numerous opportunities to break through. For example, the limited supply of primary care doctors and the dwindling of independent primary care clinics often force patients to choose between expensive hospital emergency room visits and impromptu urgent care stops to treat conditions that would be better attended to by physicians who already know their history. Increasing the supply of primary care doctors  – and, more broadly, expanding the selection of adequately skilled providers outside of the hospital system  – would not only improve access and lower costs but also improve quality by encouraging the right intervention at the right time. Treatment for high blood pressure from your primary care provider soon after test results beats the value (and health risk) of seeing a cardiologist a year later due to more severe symptoms.

Tangled Webs We Weave

To find the primary drivers of wasteful health care spending, we need to look no further than the prices providers charge for their services. With most consumer products, the interaction of supply and demand in relatively competitive markets determines prices. Health care is a different sort of beast. In most circumstances the buyer of health care services is not the consumer but third parties – private insurers and government programs. As a result, patients are largely shielded from the real cost of their health care, feeling the pain only mediated through higher insurance premiums and lower take-home pay or higher taxes.

Out-of-pocket spending, the amount the patient “sees,” makes up only 11 percent of total health care spending. When it comes to hospital and physician services, patients are even further disconnected from cost. Out-of-pocket spending only accounted for 2.6 percent of payments to hospitals in 2022 and 7.6 percent of payments to physicians and clinics.

Data from the 2010s show that, for hospitals and physician services, rising prices rather than increased utilization are largely responsible for driving up spending. Adjusting for general inflation, around two-thirds of health care spending growth between 2015 and 2019 came from higher prices, which rose by 18 percent. Increased service utilization, which includes visits and prescriptions per person, grew by only 3.6 percent.

This is why focusing on reducing overutilization should not be the priority in a strategy to increase the productivity of the system. Scaling up higher-value care requires incentivizing and expanding care models with lower prices (like better utilizing ambulatory surgery centers instead of full-service hospitals) and improving overall competition to lower prices on hospital and physician care.

Identifying the Culprit

In fact, we’re headed in the opposite direction. In the absence of competitive markets, patients rely on their insurance companies and their government to negotiate rates. But out of sight of patients, service providers have rapidly consolidated ownership, buying up other hospitals, physician’s offices and even merging with insurance companies, allowing them to increase their pricing power.

Although some degree of consolidation provides efficiency benefits in the way of economies of scale and better coordination for care, there is strong evidence that hospital integration has led to higher prices with little benefit in the way of quality. As providers consolidate, they gain bargaining leverage over insurance companies in price negotiations, allowing them to receive higher rates for services. A study of 1,164 hospital mergers from 2000 to 2020 found that prices increased by an average of 1.6 percent over two years.

Some argue that addressing consolidation must start with stricter antitrust enforcement. But preventing mergers in this way requires a whack-a-mole approach. And while stricter merger guidelines and enforcement would make a difference, it does not change the underlying incentive structure for providers. Deterring consolidation requires changes in the financial incentives that encourage hospitals to consolidate in the first place.

Blame Washington (In Part)

Medicare and Medicaid together cover 39 percent of all health expenditures, compared to just 29 percent covered by commercial insurance. The negotiated rates that commercial insurers pay are set by bargaining with providers. But policymakers determine the reimbursement for services by Medicare and Medicaid, which in turn heavily influence private negotiations.

How much the government pays for care and what services it covers thus drive the behavior of providers who seek to maximize income. And Medicare is the source of a doozy of a perverse incentive blandly labeled site-based billing. Specifically, Medicare offers different reimbursement rates for different types of facilities providing the same service. In some cases, Medicare pays hospitals nearly double what they would pay a freestanding physician’s office. Even for routine services like X-rays, rates are up to four times higher for Medicare in hospital outpatient departments.

Site-based payment discrimination has led hospital systems to acquire independent physician offices where they can collect more simply by labeling an off-campus facility as a hospital outpatient department. Indeed, all told, Medicare could save an estimated $127 billion over 10 years if site-neutral payments for routine services were extended to all hospital outpatient departments. Note the potential bonus here: correcting payment distortions for hospital-based services would dampen the incentive for facility integration that increases hospital market power.

The Medicaid program also distorts incentives in ways that discriminate against poorer states, even as it supercharges health care inflation. All states are eligible for a minimum 50 percent match to cover the costs of the means-tested Medicaid program. And Washington recognizes the reality that poorer states with less fiscal capacity need a higher match.

But the formula for Medicaid’s compensatory federal medical assistance percentage (FMAP) is based on per capita income rather than a realistic estimate of taxing capacity. That leaves Wisconsin with the same FMAP as Florida, which has a 22 percent higher rate of poverty. Rather than creating a more progressive distribution of federal funding based on individual needs, the 50 percent FMAP floor benefits wealthier states and strains the fiscal capacity of poorer ones.

There’s an element of straight-out gaming here, too. Because the federal government reimburses states based on their reported outlays for Medicaid beneficiaries, when states increase their total payments to providers – whether or not patients are the beneficiaries – they receive a higher effective matching rate.

The primary way states manage this is by levying taxes on providers, often boosting taxes and payments to the same provider simultaneously. This allows states to claim more from the feds without increasing their net spending.

All states but one use provider taxes to fund Medicaid – an increase from 21 states in 2003. The lesson is obvious: while Washington should offer more generous Medicaid reimbursement to needier states, it should also establish guardrails to prevent financing schemes that artificially increase federal spending.

Note that, in addition to perverse incentives that waste or misallocate health care dollars, there is a more fundamental issue dogging American health care: we are not producing enough care capacity in key areas to keep up with changes in demand. And without an increase in health care resources, more spending will lead to higher costs without better outcomes.

Too Few Beds

In 1960, the United States had 9.2 hospital beds per 1,000 people. In 2020, that number has dwindled to around 2.7 per thousand – 38 percent fewer than the OECD average. To put it another way, while the U.S. population has increased over 85 percent since 1960 (as well as growing older), total supply of hospital beds has decreased 68 percent.

To be sure, the drop in bed availability in part reflects policy decisions spurred by concerns over excess hospital capacity in the last century. The U.S. responded with the National Health Planning and Resources Development Act of 1974, which established a federal/state regulatory system to restrict the supply of hospital capacity.

The intellectual foundation was “Roemer’s law,” named after UCLA researcher Milton Roemer, who argued that, in an insured population, “a bed built is a bed filled”: providers induce demand by offering beds to insured patients where payment was guaranteed since the decision-makers (physicians) don’t foot much of the bill. Thus by decreasing available hospital beds, the U.S. could decrease wasteful utilization.

But the timing, a few years after the creation of Medicare and Medicaid, was hardly propitious. In what should have been a surprise to no one, federal and state health spending ballooned, increasing by 12 percent annually between 1966 and 1973. Rather than restrict expansion, we should have left providers with greater flexibility to expand services and capacity in response to an increase in demand. 

Hospitals began reporting strained capacity in the early 2000s. As the industry started to expand in response, it faced a wall of regulation set up in an era with very different expectations. Among the entry barriers are state laws known as certificates of need. CON programs, administered by state health authorities, require providers to gain approval to build hospital facilities or to acquire new equipment. And in most states, the process allows for incumbent hospitals to challenge market entry using the CON process.

As a result, current providers have been able to exercise what amounts to a “competitor’s veto” over new hospital construction. Although the federal mandate and corresponding incentives were repealed in 1987, 38 states still have a CON or similar program.

The idea of using rationing to reduce distortions created by third-party payments for health care is not inherently wrongheaded. But capping supply to limit “provider-induced demand” without regard to the value to the consumer was both badly timed and tragically blunt as a means of offsetting perverse provider incentives.

Research in the early 2000s found that hospital services did not adjust well to increases in demand, moving slowly and often lagging behind need. And this was before further increases in demand for services were spurred by the Affordable Care Act, which expanded Medicaid coverage to the previously uninsured in some states and cross-subsidized privately insured patients to encourage coverage. Research later found that the supply response to Medicaid expansion was inelastic due to a combination of entry barriers, monopolistic providers charging higher prices rather than increasing supply and the lead time required to set up new care centers.

Giving patients more options for care and allowing existing hospitals the flexibility to meet demand would improve care delivery. But it is not just hospitals that have been restricted in response to past concerns about oversupply. Physician training faces a similar challenge.

Calling Dr. McDreamy

The United States is in a slow-motion physician supply crisis. The Association of American Medical Colleges estimates that by 2036 the U.S. will be short 20,000 to 40,000 primary care doctors, a figure confirmed by international comparisons. Compared to the top-12 highest-spending OECD countries, the U.S. has a similar number of specialists per capita but the smallest number of primary care physicians.

The dearth of primary care physicians (as well as specialists in some fields) can be explained by bottlenecks and perverse incentives built into the U.S. residency system’s pipeline. Becoming a doctor in the U.S. requires anywhere from 11 to 19 years of postsecondary education and training. U.S. doctors subsequently graduate with an average of over $200,000 in debt with no guarantee of a residency that’s well matched to their skills, locational preferences or interests. In contrast, medical students in Europe go through a dedicated six-year training program.

Why the shortage? Around the same time policymakers began fretting about overbuilding of hospitals, a report from the Graduate Medical Education National Advisory Committee in 1981 sounded the alarm about a physician surplus. Policymakers became concerned that too many docs would needlessly increase utilization and spending. Graduating one more surgeon, the hoary joke went, guaranteed $2 million a year in billing for surgery.

On the GMENAC’s recommendation, medical schools voluntarily froze both new residency slots and the construction of additional medical schools between 1980 and 2005. Annual MD-entrants into residency programs fell accordingly.

Another important restriction came through the Balanced Budget Act of 1997, which capped Medicare-funded residency slots at 1996 levels. Medical schools were able to increase slots above the cap, but could not receive Medicare funding to cover the costs. By no coincidence, last year 8,863 freshly minted MDs failed to find a residency match due to a lack of program slots. Because medical residents often remain in the same area where they complete their training, the cap effectively froze the geographic distribution of slots as well, fueling the mismatch between local demand for medical services and physician supply.

The purposeful downsizing of the 1980s and 90s was based on the idea that having too many physicians would lead to unnecessary increases in spending on health care. But plainly, the relationship between supply and spending is not straightforward. What we can be pretty sure about, though, is that increasing the supply of primary care physicians could change how the U.S. spends money on health care, directing spending toward the type of care Americans need most.

Health Care Abundance

Three overarching ideas provide a foundation for moving forward. First, to put downward pressure on prices, lawmakers must correct policies that incentivize hospital consolidation and thereby use a combination of market power and ill-considered reimbursement policies to more easily raise prices. Second, lawmakers should expand system capacity by (a) removing restrictions on the growth of existing care centers and construction of new ones, and (b) encouraging innovation in treatment and care models. Third, lawmakers should expand access to primary care physicians by using payment policies to correct specialty payment disparities and perhaps rethinking physician training requirements.

Realigning Incentives

Medicare’s site-discrimination in billing policy is one of the key drivers of Medicare spending and provider market consolidation. One can only hope that, faced with the specter of ballooning budget deficits and Medicare insolvency, Congress will bull its way past hospital lobbyists to approve proposals for reining in this practice.

Medicare’s newest program, Medicare Advantage, which was introduced in 1997 with the goal of using market incentives to contain Medicare costs, ironically inflates health care spending without delivering proportional benefits to patients. The independent Medicare Payment Advisory Commission estimated that private-insurer-run Medicare Advantage cost 22 percent more than traditional fee-for-service Medicare would have for the same beneficiaries in 2024.

This amounts to over $80 billion annually in overpayments, most of which are due to “upcoding” for unnecessary services. Medicare Advantage companies have financial incentives to make their enrollees appear sicker, as graver recorded diagnoses result in increased payments. Lawmakers have noted that Medicare Advantage plans exploit professional chart reviews and in-home health assessments – tools unavailable to traditional Medicare  – to inflate payments. Strengthening safeguards against upcoding would significantly reduce waste and improve the program’s integrity.

Medicaid’s spending also creates perverse incentives for states to increase their spending without adequately compensating states with less fiscal capacity. Lawmakers could remedy this by reducing the 50 percent FMAP floor for wealthy states. Policymakers should also confront state strategies discussed earlier that artificially increase effective matching rates.

Boost Lower-Cost Care

As consolidated hospital systems seek greater market power and perverse elements of payment policy squeeze out independent providers, it’s imperative that policymakers find ways to support practitioners delivering quality care at lower costs. Start with the reform of the states’ CON laws that serve as primary barriers to building and expanding care centers.

Physician-owned hospitals offer an alternative care model that promises a more attractive trade-off between quality and cost than large hospital systems. Yet, while grandfathering in existing physician-owned hospitals, the Affordable Care Act bars physicians from owning or operating new ones. There seems to be no compelling societal reason for Congress to let the prohibition stand. Another promising innovative model is direct primary care, which offers patients virtually unlimited access to a primary care doctor for an affordable, fixed monthly fee. Because DPC practices do not accept traditional insurance, DPC doctors spend less time and resources on paperwork and more time with patients. Recent efforts to encourage Medicaid partnerships with DPC clinics constitute a ripe opportunity for improving access.

More Physicians Where They're Needed

If we are to increase physician supply, policymakers must reform the primary bottleneck in physician training: the residency pathway. Medicare’s formula for subsidizing residency programs has contributed to both regional physician shortages and a broader lack of primary care doctors. For one thing, Medicare capped funding for residency slots. Arguably as important, Medicare reimburses programs in part based on services rendered, which rewards training programs in wealthier, urban areas along with those that complete more expensive procedures.

As a result, both training programs and prospective residents have a strong incentive to aim for more lucrative specialties outside of primary care, and less rural, less affluent parts of the country receive fewer residency slots. To address the imbalances, Congress should lift the per-hospital residency cap, consolidate funding streams into a geographically uniform per-resident payment and address payment disparities between primary care and other specialties.

State policymakers also have an opportunity to expand doctor supply by removing blatantly protectionist licensing requirements placed on foreign-trained doctors. Most states require foreign physicians who have already completed residency training elsewhere to complete a U.S.- or Canada-based program to get licensed. This redundant requirement is keeping thousands of qualified doctors on the sidelines. The states have already made some progress in the right direction, beginning to create alternative licensing pathways to accommodate these doctors. But 41 states still maintain business-as-usual residency requirements.

The fragmented nature of medical regulation is also a culprit in making physician supply less responsive. Because licensing occurs at the state level, physicians face barriers both in providing care to out-of-state patients and in moving their practices to new states. Policymakers should streamline licensing and enter into interstate compacts on common criteria for certification. For their part, federal policymakers should consider allowing exceptions to state licensure requirements so that doctors with established relationships with out-of-state patients can continue providing care when patients move to other states.

* * *

The American health care system is a mighty engine for delivering services – but one pieced together messily over decades by interests with conflicting objectives. In the past half century, politicians and policymakers have responded to popular discontent by expanding access without coming to terms with constraints on efficiency. And it shows, both in terms of rising costs and the patchwork of regulation that generates huge gaps in quality and availability.

The good news here is that strengthening the supply side could transform health care by introducing more provider competition and giving patients more affordable options for care. The bad news is that failure to redirect our efforts toward supply-side reform will mean ever-greater pressure from demand that will raise prices and invite the sorts of distortions that are inevitable in formal or informal rationing of services. From this perspective, the choice looks easy.