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Health care, particularly hospitalization, advanced technologies, and complicated treatments, is so expensive that most people cannot afford to pay for it by themselves. Total health care costs annually in the United States were about $1.9 trillion in 2004, and the cost of providing high-quality (not even the best quality) health care to everyone in the United States would be very much higher. Consequently, the cost of health care is usually shared by some combination of the person who is receiving care, employers, health insurance providers (including managed care organizations and private insurance companies), and the government.

Many people who are employed full-time (and often their family members) receive health insurance through their employer as an employee benefit. Many employers require employees to contribute some of the cost of the coverage through salary deductions. Such contributions may enable employers to offer plans with a range of benefits depending on how much the employee chooses to pay. Plans with more comprehensive coverage have higher employee costs, sometimes amounting to several thousand dollars per year. Other people purchase insurance privately. However, private insurance may be very expensive or unavailable, particularly for people who have preexisting disorders or risk factors for certain disorders. Also, it may not cover certain disorders. If people are eligible for government aid because they have limited financial means, are disabled, or are older than 65, health care costs may be covered by plans such as Medicare and Medicaid.

Whatever the source of health care coverage, most people have to pay some part of the costs themselves (called out-of-pocket costs). Typically, there are three sources of out-of-pocket costs:

• Deductibles: A certain amount of the initial cost is paid by the person before an insurance plan pays any benefits. A deductible may have to be paid only once during a given time (usually yearly) or each time certain services are provided.
• Copayments: Part of the cost of each service provided is usually paid by the person. A copayment may be a fixed amount or a percentage of the cost.
• Costs that exceed those covered by a plan: Plans may limit what they will pay for a given service (called the allowable amount). If a practitioner charges more than this limit, the person must pay it. Sometimes the limit is based on what the plan defines as usual, customary, and reasonable for a given service. Sometimes plans set a relatively low limit (which means people are likely to have to pay extra charges). However, people often pay extra charges only if the service is provided by a practitioner outside the plan's network because practitioners in the network have agreed not to charge more than the plan allows them to. Thus, people can usually avoid the extra charges by using practitioners in the network.

Care sometimes includes all three sources of out-of-pocket costs. For example, a person has an x-ray that costs $275. The person's plan has a $50 deductible, a 20% copayment, and a limit of $200 for this type of x-ray. Thus, the person pays the following charges:

• $50 for the deductible (the initial $50 of the cost) plus
• $30 as the copayment, which is 20% of the plan's allowable amount for the service minus the deductible ($200 minus $50, or $150) plus
• $75, the difference between the charge ($275) and the plan's allowable amount ($200)

The total charges are thus $155, which the person must pay out-of-pocket.

Traditionally, most people have had access to some type of plan. However, health care costs have been increasing much faster than the rate of inflation and are expected to continue to increase rapidly, partly because the population is aging and partly because advanced tests and treatments are increasingly available. As a result, many employers have eliminated or reduced health care insurance for their employees or retirees, and private insurance has become more expensive and difficult to qualify for. Thus, increasing numbers of people do not have insurance from their employer, cannot obtain or afford private insurance, and are not eligible for government coverage. In 2004, about 16% of the U.S. population was without health care insurance. Ironically, people without health care plans may be charged much more for services than people with plans because plans have bargaining power to negotiate low rates for their members.

Controlling Health Care Costs

Because health care is very expensive, all who are involved in health care—health insurance providers, health care practitioners, institutions, employers, and people who use health care—are looking for ways to reduce or at least control costs. One method for controlling cost is competition. For example, employers encourage competition between health insurance providers by comparing the costs of plans and choosing the cheapest that provides the desired services. People who have a choice between plans can similarly choose one that minimizes their costs. People also can help reduce costs by actively participating in their own care. They can learn to maintain good health, prevent disorders, and, if they have a disorder, manage it.

Health insurance providers, including managed care organizations and private insurance companies, can have a big effect on health care costs. Their strategies include reducing their costs and reducing the use of health care.

Reducing Their Costs: Health insurance providers try to reduce what they pay out in several ways:

• They can limit what they pay for specific services. Also, providers can require that practitioners agree to accept the lower payment to be able to receive any payment from the provider's plan.
• They can limit the services they pay for. For example, providers may pay for only a few days of hospitalization.
• They can pay a fixed amount for all people with certain diagnoses, such as pneumonia, regardless of what tests and treatments are used. This arrangement, called diagnosis-related groups, is usually made with hospitals.
• They can negotiate lower rates of reimbursement with groups of practitioners and hospitals.

These strategies give practitioners and hospitals a financial incentive to lower their costs and to treat people efficiently and rapidly.

Reducing Use of Health Care Services: Health insurance providers use several strategies:

• They can decrease the need for health care by encouraging good health. For example, they may set up wellness programs that encourage people to eat healthfully and exercise. They may provide educational materials to teach people to take preventive measures, such as visiting a primary care doctor regularly or getting an influenza (flu) vaccination. Providers may set up disease management programs, which can help people with a chronic disorder, such as diabetes, asthma, or hypertension, manage their disorder and thus prevent complications (and high costs).
• They can deny or limit coverage. For example, they can make eligibility requirements for the plan more restrictive. People with preexisting disorders can be denied coverage or given limited coverage. Coverage may be stopped if health care costs exceed a fixed amount during a year or a lifetime.
• They can limit access. For example, to be reimbursed, people may be required to get a referral before they see a specialist or get an approval before they have certain tests or procedures.
• They can increase how much the people who use health care pay. Health insurance providers or employers who provide health care plans for employees can increase deductibles and copayments. Payment for certain services (such as psychotherapy) may be limited or eliminated. This strategy may reduce the use of health care services because people have to pay for more costs out-of-pocket and thus may use services more selectively.

However, encouraging people to use health care services less and choose services more selectively has disadvantages:

• People may not get the services they need to maintain health or to prevent disorders. Then, health may eventually worsen, resulting in even higher costs to the health care system.
• Making good health care choices is difficult because people cannot easily compare the quality of health care. Also, people cannot easily access the costs of comparable services and thus cannot compare costs.
• Usually, people do not determine which health care services they need. Doctors do.

What Is a Flexible Spending Account? An employer may set up a flexible spending account to help their employees reduce what they pay for health care. These accounts enable people to set aside some of their salary before taxes to pay for health care costs that are not covered by their health insurance plan, such as copayments, deductibles, and over-the-counter drugs. The amount is deducted from their pay checks before federal income and Social Security taxes are withheld, so people pay less in taxes. Employers may limit the amount of money employees can contribute to the account. People must estimate how much they think they will need for health care in the coming year and designate this amount to be put in their flexible spending account. They must use the full amount put in the account by the end of each year, or the money is lost. The money cannot be carried over to cover costs in the next year. To be reimbursed for costs, people submit itemized receipts for services and drugs to the account's administrator.

How Health Care Practitioners are Paid

Generally, health care practitioners and institutions can be paid in two very different ways: as fee for service or by capitation. Many payment plans use aspects of both fee for service and capitation. Each system has advantages and disadvantages, and whether one is better than another is unclear.

Fee for Service: Each hospital stay, each visit to a health care practitioner, each test, and each treatment is paid for individually. Fee for service is the way people purchase most services, such as car repairs and consultations with lawyers or accountants. This system gives practitioners and institutions an incentive to work harder and to provide the type and quality of service that people want. However, there is no incentive to limit the type or amount of treatment provided. Thus, when there is a question of whether to do more tests or procedures in a borderline case, practitioners in this system tend to provide the additional care even when it is unclear that it will provide a real benefit. Because people with many types of health care insurance pay little or nothing for the additional care, they also tend to want the additional care. As a result, expenditures tend to be high and difficult to limit.

Many fee-for-service plans limit the amount that they pay for certain services. Sometimes the limit is based on what the plan deems to be a usual, customary, and reasonable charge for that service. The plan may require practitioners and institutions not to charge people any amounts above this limit. In such cases, the limit is called the contracted rate. If the plan allows practitioners to charge more, people must pay the difference.

Capitation: In capitated plans, practitioners and institutions are paid a fixed amount to provide health care for a specific group of people regardless of the number or cost of health care services provided. Unlike fee-for-service plans, plans that use capitation (capitated plans) give a financial incentive to minimize costs and tend not to provide services when the benefit is likely to be low or absent. Also, capitated plans often include a financial incentive to provide preventive care. Thus, these plans can minimize costs to those who receive care and potentially to society. However, the tendency to limit care can go too far. For example, if getting referrals to specialists or advanced medical centers is too hard, some people are discouraged and do not get the care that would benefit them. If practitioners are not rewarded for seeing or attracting more patients, the type and quality of service may suffer. For example, practitioners are not motivated to expand their office hours or provide on-call availability, and hospitals are not motivated to provide convenient times for diagnostic tests, good-tasting food, or liberal visitation policies.

Many people think managed care and capitated plans are the same. Managed care (see Making the Most of Health Care: Understanding Managed Care) often uses capitation, but it is not the same thing.

An arrangement for reimbursing hospitals called diagnosis-related groups is related to capitation. The hospital is paid a fixed amount for all patients with a particular diagnosis (such as pneumonia) regardless of services provided or the length of the hospital stay.

Incentives: In some plans, whether fee-for-service or capitated, the amount practitioners and institutions are paid depends partly on how well they provide care—a practice called pay for performance. Payment is increased or decreased based on the practitioner's or institution's performance. Health insurance providers use several measures to judge performance, such as the following:

• Measures of patient health, such as changes in blood sugar levels to evaluate control of diabetes, changes in blood pressure to evaluate control of hypertension, or the percentage of people who are need influenza vaccination and receive it
• The efficiency of the care provided, such as how quickly people with pneumonia are discharged from the hospital

Understanding Managed Care

Managed care has many variations. It is often thought of as capitation (paying a fixed amount to provide health care for a specific group of people regardless of the number or cost of health care services provided), but this definition is incorrect. Any plan that systematically directs the provision of care can be called managed care. Managed care is used to provide better, more consistent care and to control costs.

Managed care organizations improve care by providing practitioners and institutions with guidelines for care, which reflect what the current best practices are. Practitioners and institutions are monitored to determine how well they are complying with the guidelines.

Managed care organizations control costs in several ways (see Making the Most of Health Care: Controlling Health Care Costs):

• By encouraging and paying for recommended preventive measures
• By evaluating how well practitioners provide care and paying accordingly (pay for performance)
• By developing cost-saving arrangements (for example, by negotiating a lower rate of payment) with groups of practitioners
• By paying a fixed amount for all people with certain diagnoses, thus giving doctors and hospitals a financial incentive to lower their costs and to treat people efficiently and rapidly
• By using capitation

When people are choosing a managed care organization, they should choose one that best suits their needs and preferences.

Managed care organizations include health maintenance organizations (HMOs), preferred provider organizations (PPOs), and point-of-service (POS) plans. There are many more HMOs than PPOs or POS plans. Plans may combine various features. For example, an HMO may have POS and pay-for-performance features.

HMOs: HMOs can be less expensive than other managed care organizations but are restrictive. They have a list of practitioners, hospitals, and pharmacies (called a network) that have accepted their terms for payments. Typically, people must choose a primary care doctor or other practitioner and pharmacy and use a hospital from the list. People must see their primary care doctor before they see specialists or other practitioners. The primary care doctor must write a referral for care from other practitioners and sometimes writes orders for diagnostic or screening tests done at other facilities. Without a referral, the specialist or testing facility usually refuses to see the person unless the person pays the full cost of the service. Each person is responsible for having the correct referral form. The exception is emergencies. If people think their symptoms could represent a true emergency and go to the nearest emergency department and if the HMO agrees that the visit is appropriate (sometimes after the fact), the HMO usually partly or fully covers the costs. Sometimes whether symptoms represent a true emergency is unclear. In such cases, some plans do not reimburse people for an emergency department visit unless they first obtain authorization over the telephone from the primary care doctor. Thus, people should make sure they know in advance what their plan requires for reimbursement for an emergency department visit.

HMOs may have lower premiums. Copayments are typically very low or free. However, some HMOs (and some other plans, particularly Medicaid) keep costs low by paying practitioners a low rate for visits. Thus, practitioners may have an incentive to see more patients per hour.

PPOs: In PPOs, people are not restricted as in HMOs. They can choose their own practitioners. They do not have to choose a primary care doctor, and they do not need referrals. However, PPOs have a group of practitioners who have agreed to provide health care for members of the PPO at a discounted fee. People can see practitioners outside of the group, but care from these practitioners is more expensive than that from practitioners in the PPO group because people typically must pay the difference between the outside practitioner's fee and what the PPO allows.

POS: In POS plans, people can choose their own primary care doctor, as long as that doctor agrees to participate in the POS. When care from other practitioners is needed, the copayment is lowest if people go through their primary care doctor, who may direct them to practitioners in or outside the POS network. If people go directly to another network practitioner (without going through their primary care doctor), the copayment is higher. If people go directly to a practitioner who is not in the network, the copayment is the highest. Nonetheless, the plan still partly reimburses that practitioner.

Variations in Plans: Most managed care plans do not cover all types of health care, and what is covered varies from plan to plan. For example, coverage of certain kinds of care, such as mental health or physical therapy, may be limited. The total number of physical therapy treatments or mental health sessions may be limited during a year or over a lifetime, and copayments or deductibles may be higher than those for other types of care. Managed care does not usually cover assisted living or long-term nursing home care. Managed care organizations provide a list of tests, treatments, and other resources that are covered, and people can talk to their doctor about what types of care are covered. Most established diagnostic tests and treatments are covered. If people want a test or treatment that is not covered, they must pay for it.

Reimbursement procedures can vary greatly. For example, in some plans, people pay for their care when they receive it and are reimbursed for it later after the practitioner's office submits the required forms to the plan. In other plans, the practitioner's office is reimbursed directly by the managed care organization.

The variations in plans can be confusing and can lead to many problems (often in communication) for people and health care practitioners. Whether certain tests and treatments are covered is a common topic of discussion between people and their primary care doctor because no doctor can remember all the policies of the various plans. Thus, people who have a managed care plan should keep a summary of it handy for easy reference and should make sure they know what to do if a health emergency occurs.

Advantages: Managed care may have several advantages, in addition to lower costs:

• Prevention: Some managed care organizations emphasize prevention. For example, members may be notified when they need a particular screening test, such as mammography to check for breast cancer. Practitioners and members may be sent information about the benefit of annual influenza (flu) vaccination. The information often includes specific steps to follow so that members know how to get vaccinated. Practitioners may be sent current guidelines about tests and treatments.
• Individualized health care guidelines: Some managed care organizations try to identify members who have specific needs, who need complex health care, or who are likely to develop a disorder. To identify such people, these organizations may periodically send members health appraisals to fill out. Information is also collected from health care visits, insurance claims, and pharmacies. The information is used to develop and then distribute guidelines for managing the specific health care needs of certain members. For example, members who take many drugs may be sent a letter describing the risks of taking many drugs simultaneously. They may be advised to bring all their drugs (prescription and nonprescription) to their primary care doctor. The doctor can then check to make sure the drugs the person is taking are necessary and not likely to interact harmfully with one another. Sometimes the doctor can eliminate unnecessary or similar drugs, simplify the drug regimen, or recommend strategies for remembering to take drugs as prescribed.
• Coordinated health care: Records of a person's health care visits, insurance claims, and pharmacy visits may be kept in a central database that can be accessed from different places of care. If so, many health care practitioners can access complete medical information about the person, potentially avoiding duplicate, unnecessary, or harmful treatments, tests, and drugs.
• Care for older people: Some managed care plans are designed specifically for older people. Some of these plans coordinate the services of all involved health care practitioners at the appropriate sites of care (such as a hospital, rehabilitation facility, or long-term care facility). Also, managed care organizations tend to encourage access to health care services in the home. As a result, older people may be able to avoid a stay in a hospital or long-term care facility. Many plans include drug benefits under a special plan coordinated by the government called Medicare Part D. The reminders and guidelines for preventive care and coordination of care provided by some managed care organizations are particularly useful for older people. Organizations may also send practitioners guidelines about which tests and treatments are helpful for older people and which are unnecessary or may do more harm than good.

Paying for Drugs

The cost of prescribed drugs may be covered by health plans (government, employer-sponsored, or private) or by separate prescription plans. However, many plans do not cover drug costs. Plans that cover drug costs vary, but most have certain things in common:

• Over-the-counter drugs are usually not covered.
• Some plans cover only certain drugs. This list of drugs is called a formulary. Plans may exclude a drug that is more expensive than other similar drugs and that has no or only minor advantages. The drugs included in a formulary vary from plan to plan.
• Usually, people must pay a copayment each time they get a prescription filled.
• The copayment is often higher for a brand-name than a generic drug if an equivalent generic drug is available.
• Drugs prescribed for reasons other than a medical need (such as drugs used to treat baldness or minor cosmetic problems) are often not covered.

People eligible for Medicare are also eligible to participate in Medicare Part D. Part D is a government plan that supplements drug coverage provided by private prescription plans. Thus, to receive benefits from Medicare Part D, people must have a prescription plan supplied by a private insurer, such as their managed care organization.

Last full review/revision May 2007 by Marjorie A. Bowman, MD, MPA