This is the sixth post in a multi-part series, Insurance Foundations.
In my last post, I explored the origins of health coverage in the United States. By 1960, the expansion of health was, by almost any measure, a success. Millions of Americans who had previously gone without care now had access to it, whether through employer-sponsored plans or through new public programs like Medicare and Medicaid.
But that success came with an unintended consequence: costs began to rise — and then kept going.
Skyrocketing Health Costs
Much of the problem was structural. At this point, most health care in the United States was operated on the same fee-for-service basis that had existed for decades. Doctors, hospitals, and other providers received a payment for each service they performed: visits, tests, procedures. More services rendered meant more care, but it also meant more revenue.
It’s important to understand that health care providers don’t — and shouldn’t have to — work for free. This means that revenue is necessary even if the provider is operating on a non-profit basis. It’s needed to keep the lights on, to pay staff, and to purchase supplies, all so that the providers can continue offering services.
The fee-for-service model worked extremely well for expanding access. But it had a fatal flaw: it included no provisions for controlling costs.
Paying providers based on volume of services rendered, rather than outcomes, led to a rapid acceleration of health care spending. Preventive care was inconsistent (and, in some ways, disincentivized), coordination between providers was limited, and there was almost no mechanism anywhere in the system that asked whether a given service was necessary, appropriate, or efficient.
It barely took a decade before costs began to spin out of control. By the early 1970s, it was clear that expanding access to health care services by reducing cost barriers wasn’t sustainable. The fee-for-service system itself drove costs upward more quickly than inflation or the economy could keep up — and there was no mechanism to slow it down.
Health Maintenance Organizations
In response to this problem, policymakers began looking for ways to change not just who had access to health care, but how that care was delivered and paid for. The result was the Health Maintenance Organization (HMO) Act of 1973, which promoted and expanded a fundamentally different model for health care delivery.
Rather than paying providers for each individual service, HMOs were built around a prepaid structure. Providers received a fixed amount per patient who enrolled with their practice. In return, they were responsible for delivering a defined set of health care services. This approach, formally called capitation, shifted the financial incentive away from increasing the number of services. Instead, providers were rewarded for managing care efficiently and for avoiding unnecessary services.
In theory, this created a strong incentive for something the existing system struggled to support: preventive care. If patients could be kept healthier through regular monitoring, early interventions, and coordinated treatment, the need for more expensive services could later be reduced. Thus, fewer of those services would be rendered.
The Act supported this shift by providing federal funding to help establish HMOs, and by requiring certain employers to offer an HMO option to their employees if one was available in their area. This was, perhaps, the earliest large-scale attempt to actually manage health instead of treat illness, and it is why I use the 1970s as my “break point” between health insurance and health coverage.
Early establishments, such as Kaiser Permanente, demonstrated that the HMO concept could be effective under the right conditions. Kaiser Permanente centers continue to operate today.
But the HMO approach turned out to have its own set of limitations: it depended heavily on higher population densities, thus making it inefficient in rural communities. At the same time, providers strenuously resisted the model, objecting to both the financial constraints and to the loss of professional autonomy inherent in a more structured, team-based approach.
The backlash against managed care was considerable, and that backlash would be a major factor shaping the next evolution of health care delivery and coverage. Policymakers, providers, employers, and patients all needed more flexibility. However, a return to fee-for-service would simply shift the problem in a direction that was already known not to work.
Preferred Provider Organizations
A new approach, called Preferred Provider Organizations, began to emerge in the late 1970s and early 1980s. These plans sought to find a balance between cost control and flexibility. A PPO retains elements of the fee-for-service model while introducing cost control mechanisms. Patients were encouraged to receive care within a defined network, but that network was broader in scope than the HMO models: providers could join or leave networks as contracts permitted. In addition, PPO plans reimbursed patients for care received from non-network providers — but with a significantly higher cost share for that patient.
Providers were still paid on a fee-for-service basis, but those payments were made according to the rates negotiated in the network contract. Network rates were almost always lower than market-based rates — but providers could offset that loss with the increased number of patients who would be more likely to choose their practice in order to keep cost sharing as low as possible. Those financial incentives encouraged patients to remain within the network when possible, but allowed for the possibility of care from any provider.
As such, PPOs represented a middle ground. They didn’t attempt to fully manage care the way HMOs did, but they also didn’t leave costs unchecked. Instead, they relied on the provider contracts and network pricing to influence patient behavior. Patients and providers both had greater autonomy, but that autonomy was still shaped by financial incentives.
By the 1990s, HMO and PPO plans had become the standard designs for health coverage. The older plans, generally called indemnity plans, remained in place (and, in fact, still exist today). But their popularity declined over time. The first-dollar and copay-based coverage offered by HMOs and PPOs (which are collectively referred to as managed care) was much more popular with patients.
In the next post, I’ll explore the backlash against managed care that began to develop toward the end of the 20th century — and how regulators, carriers, providers, and patients have tried to address it. This was the world I entered when I took my first positions in employee benefits during the mid-1990s.