Distorting costs: third-party payments

By Adam Berkowitz

Caravus, LLC


The rising cost of health care including health insurance has played a dominant role in the nationwide discussion of reform. Rarely does the discussion consist of the effect of third-party payments, which is a major influence on the economics of health care.

In the United States, health insurance is, by and large, provided by the government (Medicaid, Medicare, Tricare) or by employers (a consequence of tax laws and wage controls during the second World War), with the end-recipient paying a fraction to none of the direct costs associated with medical care. To the extent that direct payment by consumers of medical care is lower than they would be if they had to cover the full costs, medical treatments tend to be sought after more often. This increase in demand alone raises the cost of care without even considering the added costs layered within bureaucracies to manage the third-party payments.

To take a more specific example, consider a flexible spending account (which, until recently, required any unused funds at the end of the year to be forfeited). All sorts of expenses can be funneled through these vehicles (massages, eye glasses, chiropractic adjustments). But now that the risk of losing that money has increased, so does demand for these types of services (many of which may not be medically essential). This inflation in demand is artificial — purely a function of tax laws and third-party payments. Were an individual required to spend their own money on these services, they might think twice — or maybe not at all, given that they don’t risk forfeiting their own money that's not spent by a certain date.

In countries that have a national health system (Canada, Britain, etc.), health care is paid for via tax transfers but not directly by consumers. This leads to a far-outpaced demand for medical services than would otherwise exist — and physicians on the other side of the equation have an incentive to over-prescribe and over-treat their patients since they receive payment from the government and don’t have to consider the ability of the consumer to pay. While some medical choices and trade-offs may be obvious, many others are more complicated. Third-party payments, while having perceived effect of lowering costs, does no such thing. Someone else along the way is paying for the offset cost either through a tax transfer or reduced salary (both occur in the employer-sponsored system).

To get at the cost issue, insurance plans and government programs adopt heightened aspects of managed care and pay-for-performance reimbursements schemes. Alas, these programs can’t cut through the heart of the issue that third-party payments place on the system — that the consumer of services and provider of services don’t deal directly in the transaction.

See also: What makes American health care so expensive?