The Economics of Obamacare (Part 3): Understanding the Lessons of Medicare

This post explores Medicare, its role in the U.S. health insurance landscape and the lessons it holds for the future of health care and for investors in the wake of the U.S. Supreme Court’s historic decision to uphold the Patient Protection and Affordable Care Act (PPACA), more popularly known as ObamaCare.

What exactly is Medicare, and how does it work? Medicare is a government-run health insurance plan that provides coverage of medical-related costs for people over the age of 65. It is funded through income taxes on the tax-paying public. In contrast to the standard insurance model, Medicare is funded through taxes on persons A, B, and C, which are then used to pay the health care claims of other persons X and Y (i.e., the over-65 crowd). This is what makes Medicare a socialized model and not an insurance model per se. Moreover, an insurance model is able to estimate the cost of each policy reasonably well based on each person’s age, demographics, driving distance to work, and other factors — and hence prices its products accordingly. In the socialized model, the beneficiaries receive payments for claims, but do not pay for the policies themselves, so there is no practical way to link their contributions with their subsequent claims. As it stands now, persons A, B, and C pay into Medicare for many years through taxes and hope that the government will allow them to receive the unfettered coverage that their parents and grandparents received.

Medicare’s finances are further strained by the aging of the population. While the population has been aging steadily for some time, the population over age 65 is now exploding (see following exhibit of the increasing elderly population).

United States: Population Aged 65+ as a Percent of the Total Population

Sources: U.S. Administration on Aging, CFA Institute.

As illustrated in the estimate from U.S. Administration on Aging, people in the 65+ age cohort will grow from about 13% of the population in 2010 to about 20% of the population by 2030. This change is happening right now. Moreover, people in the age 65+ cohort spend about four times as much on health care as everyone else spends on average. As of 2004, those over age 65 spent $14,788 per year as compared to about $3,850 for everyone else. So, as the numbers of people in the 65+ age cohort swell, there will continue to be massive upward pressure on total costs.

Like any organization, Medicare tries to curtail its costs. And this is where it gets tricky: bureaucrats can only set limits on the prices they are willing to pay or limit the services they are willing to cover. While this does, in fact, help curtail costs to Medicare as a program, it doesn’t do much to curtail costs in the entire health care system. All of the underlying health care products and services must be produced by somebody — nurses, doctors, medical technology manufacturers, biologists, technicians, researchers, and so forth. Therefore, these things have their own costs for labor, materials, and research, to name just a few factors. So, doctors and hospitals treating Medicare patients are frequently left with partially unpaid bills. Consequently, doctors and hospitals raise their prices for everyone else (non-Medicare patients). Naturally, these more expensive price tags ultimately flow through to higher premiums on the private insurance policies covering these patients. In effect, the rest of the country picks up an increasing share of the tab for the Medicare crowd each year. So, persons A, B, and C pay for Medicare through taxes that pay claims for persons X and Y — and then these same persons A, B, and C simultaneously pay into a private insurance pool that pays claims for persons A, B, and C, as well as the disallowed portions of persons X and Y’s claims in Medicare. Got it?

Impact of the Insurance Mandate

As of today, the elderly comprise about 13% of the population in the United States (about 40 million people) and spend about 30% of all health care dollars. With 30 million additional people covered by PPACA, the role of government in health care will almost double overnight. The important lesson from Medicare is that this same exact framework of price mandates and cost shifting will also apply to the government-run plans that will become available on health care exchanges through PPACA. And by emulating the cost shifting of Medicare, the PPACA will see to it that more and more people migrate to government plans, only now it will apply to all age groups.

Private insurers like Aetna (AET), United Health Group (UNH), and WellPoint (WLP) receive the near-term trade-off of gaining millions of healthy, young, and currently uninsured customers to “join” their plans through the insurance mandate. The longer-term trade-off is that they must now compete with government-run insurance plans that can shift costs much like Medicare.

Looking at medical costs before and after the implementation of Medicare also helps to improve our perspective on the coming growth in bureaucracy from the PPACA. Medicare was passed in 1965 and implemented in 1966. The compound average growth rate in cost per patient day (adjusted for inflation) was 6% in the 10 years before Medicare and immediately and persistently escalated to 11% in the 10 years following implementation of Medicare — to the tune of a 5% premium to growth in real costs.

U.S. Hospitals: Real Cost per Patient Day (2005 Dollars)

Sources: American Hospital Association, CFA Institute.

In fact, the real cost per patient day in 2010 is $187, nearly 29 times as much as the cost per patient day of $6.50 in 1965. In combination, Medicare suffers from the triple whammy of no coinsurance (which encourages overconsumption), cost shifting to the private sector, and strong growth in the elderly population. However, over the ten years ending in 2010 (before PPACA was passed), the compound annual growth in real costs per patient day were only 4.7% per year (despite ongoing advances in medical technology, downward movements in out-of-pocket spending, and other trends already well underway). At the time Medicare was implemented, it covered a maximum of only 9.5% of the population. In contrast, the PPACA will immediately take on 30 million new people — about 10% of today’s population and, through the insurance exchanges, will take on many, many more with the potential to take on 100% of the population. Under PPACA, it is likely to create an even greater premium in cost growth due to the accommodation of larger percentages of the population. My estimate is that real cost growth accelerates from 4.7% to about 11.7% (about a 7% premium in cost growth) for the foreseeable future due solely to the passage of Obamacare.

In response to all these cost pressures over the years, hospitals and physicians have continually adapted the ways they do business. Shorter hospital stays and greater at-home recovery are just two outcomes. Perhaps critics might argue that the trend toward outpatient programs is a trend toward greater bureaucratic efficiency. Shorter stays mean higher throughput in hospitals and more patients being cared for by a single hospital. If there are in fact fewer patients staying in a hospital while more patients are processed through that hospital, isn’t that a sign of efficiency? Sounds plausible, until you consider cost on a per patient basis. If it were true that greater outpatient numbers meant greater efficiency, shouldn’t we expect the bureaucratic cost in hospitals to decline on a per patient basis? In fact, the opposite is true. Bureaucratic costs per patient increase materially. Note how the number of staff per occupied bed is moving like a runaway train. Note well the pivotal moment in the data: 1966, the year Medicare was enacted. In the ten years ending in 1965, hospital staff grew at a rate of 3.8% per year. In the ten years following implementation of Medicare, hospital staff grew at a rate of 6.8% per year.

Gammon’s Law: U.S. Hospital Staff vs. Occupied Beds

Sources: American Hospital Association, CFA Institute.

The number of staff per bed in 2010 exhibits a more than 11-fold increase over the corresponding figure in 1946. Note also that this increase in staff occured while the number of occupied beds declined. As Milton Friedman explained, technological innovations typically drive unit costs downward. It’s true in every other industry, but not health care. Why? Innovation and efficiency may explain the decline in occupied beds, but it does not explain the explosion in costs.

Likewise, as we look forward from today, we should expect hospital staff per occupied bed to accelerate and occupied beds to decline at an accelerated pace. Using Medicare implementation as a benchmark, growth in hospital staff should accelerate from 1.9% to approximately 4.9% per year, while occupied beds should decelerate from –0.4% to –2.8% per year as illustrated below.

Gammon’s Law: Estimates for U.S. Hospital Staff vs. Occupied Beds

Sources: American Hospital Association, CFA Institute.

Isn’t it also possible that a surge in innovation created new treatment regimens and new therapy classes including pharmaceutical products, medical devices, and diagnostic technologies? This can be a complex topic, to be sure. For example, even if a new therapy (A) is statistically proven to reduce costs when swapped out for a traditional therapy (B) in isolation, that savings can get lost across the entire system. For instance, many doctors may prescribe both therapy A and B, or they may prescribe therapy B to supplement therapies A, B, and C. In any event, in the aggregate, it is never clear just how much a new therapy is utilized as a substitute versus a supplement.

Another important driver of U.S. health spending is the fact that U.S. research effectively subsidizes the rest of the world. Because many other countries are already willing to limit access to care, they are also willing to demand lower prices from medical suppliers. So, if they don’t get the prices they want, they are willing to walk away from providing the product to their citizens at all. Moreover, because of the disincentives and difficulties of earning returns on R&D investments, many of these countries typically abstain from significant research, letting the U.S. market bear a disproportionate share of development. Consequently, health care manufacturers charge U.S. consumers higher prices than they charge in other markets for the very same products.

So, the U.S. health consumer has played a special role in the world by paying these higher prices. As other countries have increasingly socialized their health care systems, the United States has increasingly played the role of developer. Thus persons A, B, and C pay for the health claims of persons X and Y through Medicare AND pay for their own insurance (which person E buys for them), which pays claims for persons A, B, and C — as well as persons X and Y — and for persons H, I, J, and K, who live in foreign lands. And this, my friends, is how the cost of health insurance has become so expensive here in America. Unfortunately, the passage of PPACA will see to it that the government bureaucracy will be amplified many times over, greatly increasing the cost of US heath care and accelerating all current cost trends.  By design, the government can not match the program’s costs with corresponding revenues.  So, the great irony of Obamacare – whose advocates want free and equal access for all – is that the Government must eventually resort to its only real defense: limiting access to care in order to control costs.

But in the words of P.J. O’Rourke, “If you think it’s expensive now, just wait until it’s free!”

More articles from the Economics of Obamacare series:

• Part 1: The Implications for Health Care Investing
• Part 2: Analyzing the U.S. Health Insurance System

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.