Not long ago, the News Director at 1110 KBND radio in Bend, Oregon asked us a simple question: “Why does the cost of healthcare keep going up?”  Initially it seemed that the answer should be perfectly obvious.  After all, hasn’t everyone been keeping up with what’s been going on in the Obama Administration and in Congress and in the states and with the healthcare reform law?  Doesn’t anyone read this blog?  And then it occurred to us: “Of course not!  Are you nuts?”  The vast majority of us have no idea why their health insurance premiums are going up by 9% each year.  In fact, the great majority of our political and economic leaders don’t seem to have the slightest clue as to what’s going on or why.  If they did, how could they possibly create laws, rules and regulations that run so counter to common sense and the best interests of their constituents?  So we thought we’d try to put things in terms that anybody with a head on their shoulders and experience with what doctors call “activities of daily living” ought to be able to relate to.  Did we succeed?  You be the judge, for this is what we wrote in reply:

“The short answer is that prices are responding to: (1) artificially high demand; (2) the absence of a free market for healthcare goods and services that would tend to automatically balance supply and demand; and (3) the relentlessly increasing cost of administrative overhead caused by government regulation and insurance company practices.  But to really help us understand how all of this is happening and why, let’s perform a thought experiment using a slightly different industry where each person likes to be treated as an individual: the hair cutting and styling business.

Right now when you go to Supercuts, a barber or a hair salon, you have a list of things that you want done that is tailored to fit your needs.  In addition, you also have detailed information about how much each of those goods or services cost, and whether each of those things is worth the price that you’re willing to pay given your budget and how much your hair is bothering you.  Because hair care is a free market, how much we spend is a balancing act between supply and demand.  Price is the signal that is used to automatically regulate the two.  Other things equal, the higher the price, the less people can afford to buy and the more providers are willing to supply.  Both behaviors will tend to bring the price back down.  The system works pretty well and is very efficient; no one has to do anything that they wouldn’t have done automatically.  There’s no special administration cost to the system, so overhead is low.  Now let’s introduce some changes that parallel what’s happened in healthcare and see what happens.

The first change we’ll make is to create hair insurance that covers you not just for the catastrophic loss or destruction of your hair, but also for routine maintenance such as cutting and shampooing.  To make it even easier for many union members, executives, the poor, prison inmates, most seniors and those with disabilities, we’re going to waive any co-pays or cost sharing for hair care or hair products.  They can go for hair care as often as they need to, and their insurance companies and state and federal governments will pick up the tab.  That’s a lot of people: over one hundred million of them, or about one-third of the entire population.

Since these folks pay little or nothing for their hairdos, it’s pretty easy to imagine that few, if any, of them are going to take cost into account when they head to their local hair care provider.  No matter how much the price of hair care products and services increases, they themselves won’t pay a penny more.  So price is gone as a useful means of telling just how much a haircut, perm or highlighting is worth to them.

To complicate things further, the second thing we’re going to do is take down that list of prices off the wall where it’s readily seen by everyone.  Instead, we’ll replace it with hundreds of different hidden prices for each individual good or service available.  The price of everything will now depend upon who is paying, what specific hair insurance plan is involved, where you are in the country and literally dozens of other factors.  Even if you wanted to know how much something costs, it’s nearly impossible to find out.  What’s even more amazing is that these prices are fixed by the government and private hair insurers without any consideration for how much these goods and services actually cost to produce.  Perversely, the people who pay the most are those who have to pay cash out of their own pocket.

What effect does this have?  For one thing, since price was the signal that we had previously used to balance supply and demand, the supply side of that equation is thrown out of kilter.  Even your barber can’t tell you how much revenue your haircut is going generate – he has no idea what your insurer is going to pay or what they’ll agree to cover.  For another, insurers who don’t pay providers enough will increase costs for everyone else.

In the real world, Medicare and Medicaid often don’t pay anywhere near the actual cost of the care provided to their beneficiaries, so the only way many doctors and hospitals can stay in business is to make up the difference by charging private insurers more.  Of course insurers simply pass on that cost in the form of premium increases to businesses and individuals.  Every time you hear about Medicare and Medicaid cutting payments to providers, you can count on seeing an increase in your own health insurance premiums.  As a side note, the recent healthcare reform bill requires Medicare to cut payments to providers by $500 billion over the next ten years, while in his most recent proposal President Obama has asked the Congressional “super committee” to cut $248 billion more.  If doctors and hospitals keep seeing Medicare patients, all of this will ultimately be passed on to businesses and individuals.  It’s no exaggeration to say that federal cost-shifting from Medicare and Medicaid is steadily destroying our ability to afford regular insurance and pay out-of-pocket for care.

Finally, someone has to keep track of all of these prices.  That brings us to another very important piece of the cost puzzle – an explosion of rules regulations and administrative overhead.  Let’s go back to our “hair care” thought experiment.

The presence of all of these insurers and all of these plans means that the process of billing has gotten very complicated for hair stylists everywhere.  Where you used to hand them some cash or a credit card, now they have to hire dedicated staff or entire companies to do the billing for them.  Meanwhile as costs rise, insurers try to reduce payments by requiring more and more paperwork to document the need for every haircut, highlighting and bottle of Brazilian Blowout.  As one means of limiting expenditures, government insurers officially announce that they will only pay for “high quality” hair care.  To enforce this, they begin to require increasing levels of documentation from barbers and stylists each year.  All hair care providers have to add ever more expensive levels of “certification” their credentials.  To help track what barbers and stylists do, the federal government mandates that all hair providers and salons must spend billions of dollars on expensive and hard-to-use electronic record keeping systems that record each cut, tint and perm.  To support all of this paperwork and recordkeeping, barbers and stylists end up employing scads of administrators; currently more than five for each person who actually wields a pair of scissors.

All of this might sound far-fetched, but all of this is exactly what’s happened in the healthcare industry, and it’s an important reason why the cost of everything from insurance premiums to well-baby checks keeps rising every year.  Right now, about one-third of every dollar spent on healthcare goes for administrative overhead.  That’s over half a trillion dollars each year.  Every time clinicians turn around, there are more requirements, more standards, more paperwork and more guidelines that they have to follow in order to stay within the law.  It costs a phenomenal amount of money.

Where does the new healthcare reform law fit into the picture?  Is it adding to the increase in costs that we’re seeing now?  To a certain extent, it is.  For example, the law requires health insurers to pay for a routine health screening visit for every insured person each year.  Since the vast majority of people are well, this increases everyone’s costs now, while any savings (if there are any) won’t be seen for years.  The law also allows children up to age 26 to be placed on their parent’s healthcare policies.  This will naturally increase the cost of insurance to parents and the businesses that insure them.

However these sort of immediate costs are dwarfed by new expenses that the law will incur in future years.  Remember when we talked about how the losses generated by Medicare and Medicaid patients have to be subsidized by higher costs for private insurance and those paying out-of-pocket for care?  By 2014, the Affordable Care Act will add sixteen million additional people to the Medicaid program.  If you have private insurance, your premiums will inevitably jump yet again to cover this new expense, as well as the huge cuts in Medicare payments that the law requires.  The law also adds huge amounts of additional complexity to the existing healthcare system.

If you’re worried about the rising cost of healthcare, I’m sorry to say that with our current healthcare policies, there’s just no good news on the horizon.  If you’re not, then you should be.”

It would be fascinating to see a Presidential debate focused solely on the topic of healthcare, with the very first question being: “Please explain to us why you believe that the cost of healthcare keeps going up.”  Sad to say, we seriously doubt that any of the participants – including President Obama – really understand it on even the most basic level.