Those who cannot remember the past are condemned to repeat it.

George Santayana [FN16]

Over the last one hundred years, America's health care system has undergone several major changes. It has moved from a home-based system to a hospital-based system. It has moved from a nursing care-based system to a technology-based system. It has moved from a patient-driven system to a provider-driven system. Each change introduced not only advances in health care, but also perverse negative aspects. Perhaps, the negative features that were introduced into the system might have been avoided if more attention had been paid to the down side of changes occurring in the health care system. The health care *10 system is again undergoing major changes as it moves from a provider-driven system to a third-party payer-driven system. As the new system is being designed and implemented, it is important to understand how the current systemic problems developed. Only then can actions be taken to avoid analogous pitfalls in this new third-party payer-driven system. Section A of this Part provides an overview of the historical development of third-party payers. Section B discusses the impact third-party payers have had on health care delivery. Finally, Section C considers the development of managed care products as a response to cost containment issues. Together these sections are designed to help us remember the past so that we will not be condemned to repeat it.

A. Overview of Historical Development

1. From Home to Hospital

From the 1700s to the mid-1800s, those who became sick or injured and could pay stayed at home for treatment. [FN17] Only the lowest class person went to the hospital, which was often only a separate wing on the almshouse, jail, or pesthouse. [FN18] In the late 1700s, at the urging of European-trained physicians, a few communities established the first community-owned or voluntary hospitals. [FN19] Although these hospitals admitted both the poor and paying patients, [FN20] it was not until the late 1800s that hospital*11 stays became widely accepted. As late as 1873, there were only 178 hospitals with a total of 35,064 beds in the entire United States. [FN21] Only thirty-six years later, in 1909, the number had grown to 4,359 hospitals with 421,065 beds, and by 1929 to 6,665 hospitals with 907,133 beds. [FN22]

2. The Coming of the Blues

The Great Depression caused a dramatic change in the economic state of hospitals as patients unable to pay for health care simply stayed away. As early as 1930, average hospital receipts fell from $236.12 per patient in the 1920s to $59.26, bed occupancy dropped from 71.28% to 64.12%, and hospital deficits rose dramatically. [FN23] Hard hit by the depression, the American Hospital Association (AHA) developed the Blue Cross concept to assure stable revenues. [FN24]

The Blue Cross plans simply guaranteed payment of hospital costs, albeit in an environment of limited technology and patient self-rationing. Given the general economic state, the popularity of the plans was predictable. The plans, however, covered only hospital costs. Physicians, through the American Medical Association (AMA), sought to keep coverage limited. The AMA took the position that medical ethics permitted only insurance that was paid directly to patients. [FN25] The AMA feared that if third-party payers became intermediaries, they would eventually play a significant role in determining medical treatment. [FN26] Specifically, the AMA feared that third-party payers who paid physicians directly would eventually require the physicians to make medical decisions based on the third-party payers' interest rather than on the patients' interest. [FN27] Nevertheless, under increasing political pressure, some state *12 medical societies approved medical service benefit plans called Blue Shield. [FN28]

Like Blue Cross, Blue Shield proved extremely popular. Over the last sixty years, the Blue Cross and Blue Shield plans have become the largest providers of private medical insurance. [FN29] The current interest in managed care plans, which emphasize controlling physicians' behavior, indicates that physicians' historical fears of third-party payer control of medical practice decision making were well founded. [FN30]

3. World War II and Beyond

With the coming of commercial insurance after World War II, the health insurance industry experienced significant growth. As medical technology advanced, reliable access to medical services became increasingly important. This led employers to begin to use health care benefits as a part of employee compensation. This, in turn, led to an increasing demand for health insurance as a standard benefit of employment, [FN31] which brought commercial insurance companies into competition with the Blue Cross and Blue Shield plans. [FN32]

Unlike early Blue Cross and Blue Shield plans, commercial policies offered an indemnity benefit. [FN33] To compete, Blue Cross and Blue Shield adopted similar provisions and abandoned, *13 among other things, service benefit and community rating. [FN34] Because of the higher cost of insurance that is individually rated, the Blue Cross and Blue Shield abandonment of community rating and adoption of an individualized rating system left many people who could not afford the premiums unprotected. [FN35] Thus, an increasing health care access gap began to develop between those who had either health insurance or wealth, and consequently could afford the cost of health care services, and those who did not.

4. Medicare and Medicaid

In 1965, Congress responded to the medical insurance crisis by creating Medicare [FN36] and Medicaid [FN37] programs. To counteract initial opposition by the AMA and to assure physician participation, Congress gave Blue Shield the administrative responsibility for reimbursement of physicians. Medicare was to reimburse physicians on the basis of “customary, prevailing, and reasonable charges.” [FN38] For Medicaid, state governments determined how physicians were to be paid. [FN39] Today, about one-half of the states pay physicians based on fee schedules.*14 [FN40] The remainder provide some form of charge-based reimbursement. [FN41]

Since 1965, Medicare and Medicaid have grown significantly. Medicare currently accounts for approximately thirty-five percent of national health care expenditures and forty percent of hospital revenues. [FN42] Yet, Medicare's impact extends well beyond the program itself. For example, other institutional purchasers of health care, such as private insurers, typically follow Medicare's lead in medical technology and payment schedules. [FN43]

B. Impact of Third-Party Payers on Health Care

By 1986, seventy percent of payments to providers were made by public or private insurance. [FN44] The insurers' reimbursement methods introduced into the health care system complex, often irrational economic incentives. The traditional reimbursement method of private insurers was the fee-for-service model, [FN45] while government insurance reimbursed on a cost *15 or charge basis. [FN46] Both of these forms of reimbursement created powerful incentives for all players in the health care system to intervene excessively with overpriced procedures. [FN47] No one had an incentive to economize.

An individual who contracted with Blue Cross through an employer for eighty percent of the usual, customary, and reasonable cost (UCR) of medically necessary care lacked the incentive to economize because no matter what the cost of health care, the individual would be paying only twenty percent. [FN48] Because the insurance cost was shared with the employer, the individual was not likely to scrutinize medical expenditures to avoid future premium increases. Furthermore, because insurers did not base health care insurance premiums on “experience rating,” [FN49] a patient's health care use would not directly influence the cost of the insurance to the employer. Thus, the patient was not likely to realize the full financial impact of treatment decisions.

Nor were hospitals and physicians motivated to economize. Because most insurers guaranteed providers eighty percent of their customary charges, fee-for-service or cost-based charges had an opposite and perverse influence on health service delivery. [FN50] Providers earned more under both reimbursement systems when they treated more. This phenomenon had two effects: First, physicians and hospitals tended to de-emphasize preventive care, which was not as lucrative as treatment services. Second, because insurers paid for discrete procedures, not *16 time spent with patients, providers tended to place excessive reliance on the use of medical technology.

The insurers' methods of calculating fees to be paid further complicated the picture. The practice of covering the UCR allowed the provider to charge whatever the insurer would pay.

When the maximum payments available under usual and customary became public knowledge, there was a natural tendency on the part of physicians ... to move to the maximum available.... Once that was done, the whole concept of usual and customary, based on physicians' pricing as an independent entity unaffected by their peers or others in the community, was gone. The whole program changed its nature both as to Medicare and as to private, usual and customary. Prices rose dramatically.... [The doctor] could find [the maximum UCR] out very readily by simply testing the system by raising his fees until he hit the upper limit, and they did. [FN51]

From the patient's point of view, insurance removed the need to ration health care dollars, thus creating the moral hazard problem. [FN52] From the insurer's point of view, a payment system that had worked well for auto and life insurance would seem to make sense. Thus, health care indemnity plans were designed and implemented on the basis of faulty assumptions and expectations by all parties: the insurers' failure to recognize the problem of moral hazard and the providers' and patients' failure to recognize the need to continue to ration health care. [FN53]

For over fifty years, the cost of health care was hidden from most of the participants in the system. However, as the cost of health care has spiraled upward, employers, [FN54] government, [FN55] *17 and third-party payers have gained strong incentives to restrain costs. [FN56] Employers and third-party payers desire to protect their profits, and the government wants to reduce the deficit by decreasing health care expenditures. Because of their profit interest, third-party payers are rigorously looking for ways to control the untamed beast. During the early 1970s, major employers began to self-insure to reduce costs, [FN57] and the government switched to using diagnosis-related groups as its method of paying hospitals. [FN58]

These efforts have had limited effectiveness. While self-insurance helped employers avoid the problem of increased premiums, it did little to control the actual cost of health care. [FN59] Similarly, Medicare and Medicaid's use of diagnosis-related groups for prospective payment of hospital services has not proved effective in controlling costs. [FN60] In a second-stage effort to control health costs, third-party payers redesigned health benefit plans to pass on increased costs to the employee by eliminating “first-dollar” coverage and significantly increasing deductibles. [FN61] It is predicted that by 1995, ninety-eight percent of major employers will have eliminated first-dollar coverage. [FN62] *18 Elimination of first-dollar coverage would appear to give the patient economic incentives to control the use of health care services. However, some individuals may respond to the incentives by significantly underutilizing services, thus adversely affecting their health. [FN63]

Current cost containment efforts shift the risk of financial loss for health care in whole or in part to the providers of that care. [FN64] Physicians are offered economic incentives to act as the third-party payer's agent-the gatekeeper to health care services. [FN65] As gatekeepers, physicians are concerned with limiting access to health care services so that third-party payers do not find excessive utilization. If a third-party payers determines that a physician has ordered too many services, the third-party payer financially penalizes the physician. [FN66] Consequently, physicians are motivated to order services for patients within third-party payer guidelines. Thus, gatekeeping shifts the focus of the health care system from the physician-patient relationship to the relationship between the physician and third-party payer. Ultimately, the physician and the third-party payer will determine the quality of care received by the patient and the patient's access to that care. [FN67]

*19 As employers, government, and other third-party payers more aggressively seek market share and profits, the health care marketplace is driven by fierce competition for enrollees. [FN68] At the same time, third-party payers demand experience rating and utilization data on the services they are purchasing. [FN69] Third-party payers attempt to limit their costs by reducing the amount a physician or hospital receives for the average patient's care. [FN70] Third-party payers have developed plans that limit the amounts and types of services that can be used. [FN71] They have sought to restrict physicians' decision-making power. In short, third-party payers have entered the managed care business, with management in the hands of the third-party payer, not the physician or the patient. [FN72]

C. The Development of Managed Care Products

The third-party payer-driven system can look deceptively like the provider-driven system. The traditional contractual relationships between patient and third-party payer, and between physician and patient, continue to exist. However, a new relationship between the third-party payer and the physician now exists. Thus, in the payer-driven system, there is a triangular relationship. The physician is legally and professionally obligated to act in the patient's best interest. The third-party payer is contractually obligated to pay for services rendered by the physician. The physician is contractually obligated to provide services under the guidelines set by the third-party payer if the physician wishes to be paid for the medical services. Thus, the physician manages the patient's health care for the third-party payer-leading to the term “managed care *20 products.” The two basic forms of managed care products are health maintenance organizations (HMOs) and preferred provider organizations (PPOs).

1. Health Maintenance Organizations

An HMO is an organized system of health care delivery for both hospital and physician services in which care delivery and financing functions are offered by one organization. [FN73] HMOs provide both services to an enrolled membership for a fixed and prepaid fee. The traditional HMO structure completely shifts the financial risk from the third-party payer to the provider. This shift means that HMOs can obtain cost savings only by controlling both utilization and expenses. They do so by encouraging fewer hospital admissions, more outpatient procedures, and fewer referrals to specialists. [FN74]

In Oklahoma in 1929, the Farmer's Union started the Cooperative Health Association using the familiar “farmer's co-op” pooled financing structure. [FN75] Around the same time, in Los Angeles, Drs. Ross and Loss started a prepaid group health delivery plan with comprehensive services. [FN76]

The AMA slowed the development of managed care by labeling the concept “socialized medicine” or “communism.” [FN77] “The medical profession was unremittingly hostile to managed *21 care , and by the end of the 1930s succeeded in convincing most states to pass restrictive laws that effectively barred managed care plans from operating.” [FN78] Because of this opposition, HMOs developed haphazardly in response to the needs of specific communities. [FN79] In the early 1970s, when skyrocketing health care costs were front page news, the AMA position weakened. Conservatives were certain that market competition in the health care system would reduce costs.

In 1973, in response to increasing pressure, Congress passed legislation that required businesses with more than twenty-five employees to offer their employees at least one federally qualified HMO as an alternative to conventional insurance. [FN80] With federal grant and loan money in hand, the HMO industry experienced a steady growth between 1974 and 1983. [FN81]

Though the government discontinued federal loans, HMOs experienced another growth spurt between 1983 and 1988, [FN82] probably caused by the expansion of health maintenance coverage*22 to Medicaid and Medicare eligibles. [FN83] In 1982, former President Reagan signed a bill that expanded the definition of contracting entities to include entities other than federally qualified HMOs and authorized Medicare payment on either a prospective, per capita basis or on a reasonable cost basis. [FN84] Other roadblocks to the growth of HMOs were also removed during that period. For instance, many states had laws that forbade the corporate practice of medicine. Consequently, many states had to enact enabling statutes because HMOs required some kind of corporate practice. [FN85]

With Medicaid authorization and state legal clearance, the number of HMOs increased dramatically-about 900% in fifteen years. [FN86] While recent market consolidation has resulted in an actual decrease in the number of operating HMOs, the overall enrollment continues to climb. [FN87]

2. Preferred Provider Organizations

As HMOs stabilized as a cost control mechanism, third-party payers pushed to find more efficient cost control methods. The push resulted in the proliferation of other managed care arrangements, most notably PPOs. PPOs contract directly with an employer through the employer's health benefits department or indirectly through an insurance carrier to provide health *23 care services from a preselected group of providers. [FN88] The limited list of providers means that the overall expense to the patient is lower than the expense of traditional insurance. Physicians entering into provider contracts with PPOs agree to accept both utilization review controls and financial risk shifting structures. Third-party payers give consumers economic incentives to use the PPO physicians through reduced fees for services. [FN89] Generally, local market conditions determine the organization of a PPO. [FN90] Most PPOs consist of a provider panel made up of preferred hospitals and physicians. The PPO employs fee schedules and utilization reviews that create a monetary incentive for consumers to choose the PPO provider, while leaving consumers free to choose their own providers. [FN91] A common feature among PPOs is the ability to efficiently process provider claims. [FN92] PPOs, however, can be organized in almost any form, and they are essentially unregulated. [FN93]

Despite the lack of definition, PPOs are classified according to sponsorship categories. [FN94] Another distinguishing feature is *24 the amount of risk that the PPO shifts to the provider. For example, in most full-risk PPOs, the PPO assumes the role of insurer and takes on all risk of loss. The PPO charges the employer a premium and covers all the services provided to the enrollee, including services offered at nonparticipating hospitals. [FN95] On the other hand, limited-risk PPOs assume only a portion of the financial burden and shift part of the risk of the enrollee's care to the provider. [FN96]

D. Summary

Managed care products allocate financial risk in several ways, from the complete risk shifting of the health maintenance organization (HMO) to the varied risk shifting of the preferred provider organization (PPO). Nevertheless, both forms have the same goal: to reduce costs and increase profits by altering the practice behavior of providers. [FN97] Third-party payers reward or penalize providers based on the services they deliver, without regard to the quality of those services. Thus, there is a strong incentive for providers to control, for the financial benefit of the third-party payers, the care received by the covered patient. Whether that control will be detrimental to the overall quality of care remains to be seen. But, without a doubt, managed care products will be detrimental to some patients.

In 1980, managed care products were begging for providers to enter into agreements with them. Today, it is not uncommon to see this situation completely reversed. [FN98] At least sixty percent of individuals with employer-sponsored health care plans *25 are enrolled in managed care products. [FN99] Furthermore, all types of individuals and entities are developing these products. [FN100] Acute-care hospitals develop them as a device to maintain or increase their market share. [FN101] Physicians develop them to retain some control over health care delivery. [FN102] Insurers develop them to keep profits up and to protect market share. [FN103] Employers also develop managed care products to control costs. [FN104] Finally, entrepreneurs develop managed care products because “it appears to be a business in which one can make a profit.” [FN105] Perhaps the only group not developing managed care products is the group most affected by the delivery of health services-patients.

Efforts to control costs through limiting providers' expenditures will be magnified in the future because health care is an increasingly business-oriented activity. In the face of a third-party payer-driven delivery system, there is a need for either legal theories or a compensation system that particularly reflects institutionalized profit-seeking behavior. Otherwise, a third-party payer-driven system seems destined by its very structure to proceed at the expense of the patient's best interest. [FN106]