How Did “Big Med” Get So Big—and So Expensive?

In their new book, Big Med: Megaproviders and the High Cost of Health Care in America, David Dranove, a professor of strategy at the Kellogg School at Northwestern University, and his coauthor, Lawton R. Burns of the Wharton School at University of Pennsylvania, trace the evolution of the American healthcare system. They show how, again and again, misaligned or misunderstood incentives led to the massive consolidation of nearly every part of the industry—as well as an alarming disconnect between how physicians want to practice and how they are pushed to practice.

Kellogg Insight recently spoke with Dranove and Burns. We discussed how the U.S. ended up in an era of megaproviders, why it is costing all of us, and what might be done to change our system for the better.

This interview has been edited for length and clarity.

Kellogg Insight: In your book, you provide a fascinating history lesson about how the U.S. arrived at the healthcare industry we currently have: one full of sprawling, regional healthcare megasystems. Can you take us through some of the major turning points that showcase how we got to where we are today?

David Dranove: The introduction of Medicare and Medicaid in 1965 is probably a good place to start. Medicare and Medicaid dramatically complicated the lives of physicians and hospitals. Physicians used to be independent entrepreneurs. Occasionally, they were in small groups. You had lots of small hospitals and community hospitals and teaching hospitals, and they were all independent, and they were all just doing fine. Bankruptcy rates were low. Physicians loved their jobs, and everybody loved physicians. Then Medicare and Medicaid come along.

Lawton Burns: Medicare changes everything. Now care for the elderly and the poor, who never had insurance, is being paid for by the government. So that meant new public money is coming in to fund the private hospital and physician sectors. There’s also a lot of pent-up demand, because these patients didn’t have health insurance before and are typically in worse health than other patients. The hospitals responded by building up supply. And so the government provided incentives to fund the necessary capital expansion: cost-plus reimbursement on care, but also return-on-equity payments to the for-profit hospitals.

The for-profit hospitals are the first ones to develop hospital systems, because they’re entrepreneurial. They smelled the money. And so they built up these hospital systems and bought new equipment, bought up independent hospitals, and refurbished them (because they got reimbursed for all that refurbishment). And that motivated the nonprofit hospitals to follow suit.

Dranove: Medicare and Medicaid also introduced a lot of rules and regulations. Accounting suddenly became important. Finance suddenly became important. And this created the demand for a management class in the healthcare system. Suddenly, you added a layer of bureaucracy that is only going to grow bigger and bigger as the government involvement becomes bigger and bigger. All this sets the stage for the emergence of health systems.

The next big step I would say is in the 1970s and 80s, with the growth of health maintenance organizations (HMOs), which came in two flavors. One flavor was the provider-based HMO: Kaiser is the granddaddy of them all, but there are lots of others. These are integrated organizations that have taken full financial responsibility for their patients, to various degrees of success.

The other flavor was HMOs organized by insurers.

The Blue Cross Blue Shield association saw HMOs as a threat: independent healthcare providers were now selling health insurance! The Blue Cross plans started operating their own version of HMOs, which meant going out to providers and signing contracts. This then ramped up in the 90s through preferred provider organizations (PPOs), which amplified the notion that providers could gain the upper hand if they gained some kind of market clout.

Add to that a healthcare plan proposed by a new president.

Burns: Yes. The Clinton plan had elements that were very similar to what’s happened under the Affordable Care Act (ACA) with integrated delivery networks: hospitals linking up with doctors, in an array of strategic alliances and ownership agreements, to serve as the contracting partners with all of these burgeoning HMO and PPO plans.

The thinking is, if you organize the providers over here, you can have more leverage with the providers over there, or at least equal footing at the bargaining table.

So it didn’t even matter that the Clinton plan never passed—hospitals got on board and ran with it. The Clinton plan set off a wave of integrated delivery networks, and also set off another huge merger wave among hospitals and hospital systems.

Insight: But the Clinton administration’s plan didn’t come from nowhere. It came from economists promoting the merits of integration! Why were your fellow academic economists promoting integration as a great idea? And why have many since walked back that stance?

Burns: The number one rationale—at least for horizontal integration, or hospitals merging with hospitals—was economies of scale: “Bigger is more efficient, bigger is cheaper, and then we’ll pass on those savings to the customer.” But it never happened, because bigger did not turn out to be more efficient and cheaper. It actually turned out to be more bargaining power and higher rates from the commercial insurance companies.

A rationale for the vertically integrated delivery networks was their possible synergies: cooperation, alignment, we’ll get the two most expensive parties in healthcare working together for the first time. That never happened either.

Dranove: Much of healthcare delivery is capital intensive. When you hear capital intensive, you think scalability. For example, a neonatology unit requires a lot of capital. And if you have two hospitals, even now that they have a common owner, you still are stuck with two hospitals with two neonatology units. Your only hope of economizing is to consolidate the units into one. But that requires convincing patients that they should have their baby somewhere else and convincing doctors that they should move their practices somewhere else. And neither of those things happened.

Burns: And you have to convince the head of neonatology here to give up his or her position and be subsumed under somebody else.

Dranove: Now you get to the 2000s and 2010s. The pressure from the ACA, the creation of accountable care organizations, and the constant pressure to bring in the dollars to keep your doctors happy with the latest technology leads to the constant search for the right organizational structure. And there’s always been a bias towards growth.

Burns: And the belief that if you own it, you can control it and run it better.

Insight: During this period, the U.S. relied on antitrust regulators to put a check on consolidation and promote competition in healthcare. In your book, you make it very clear that, in your view, these regulators fell asleep at the wheel. Has their approach changed over the years? Are antitrust regulators more effective at cracking down on consolidation today?

Dranove: The original horizontal merger guidelines published by the FTC and DOJ were best applied to commodity products—not healthcare. When hospital mergers started to catch the eye of the antitrust enforcers, the agencies didn’t really have a tool kit for looking at those. They used a methodology that had been applied to a commodity product, coal, to help them identify the geographic scope of competition. They won that case, but the hospitals figured out how to use that method to their advantage. Throughout the 1990s, the courts sided with the hospitals, and agencies didn’t have any tools.

And this led a lot of economists to wonder how we can more realistically model what’s going on in healthcare markets? After all, healthcare is not a commodity like coal. Two people could be living right next to each other with the same health conditions and prefer different doctors, and as a result prefer to go to different hospitals. And these preferences can confer a lot of power to the doctors, to the hospitals.

In the late 1990s and early 2000s, two teams of researchers working simultaneously—one led by Bob Town, then at the Wharton school, and one led by me and Mark Satterthwaite at the Kellogg School—developed nearly identical methods and published them roughly at the same time. These methods were developed to capture the uniqueness of the preferences, and the overlapping of the preferences, to figure out which hospitals and which doctors are most likely to substitute for one another.

The method that Mark and I developed was a little more intuitive, a little easier to explain to a judge, and it became the method of choice. And the FTC started applying our methods in the 2000s and started winning every antitrust case.

Insight: So that put a stop to the most egregious mergers moving forward. But you argue that a lot of the damage is already done.

Dranove: That’s correct. The agencies can conduct retrospective reviews of consummated mergers and find that prices have gone up quite substantially. But it’s a lot harder to break up a large organization than it is to stop it from forming in the first place. The government has a lot of misgivings about taking a large system and decoupling it, so it tries to stay out of it.

Insight: So all this consolidation has certainly contributed to the rise in the cost of healthcare in the U.S. But another way of looking at this is through the lens of physician behavior. You point out that much of the increase in spending over the years actually comes down to what physicians do or don’t do. In your book, you reiterate the importance of getting physicians on board with any changes that we ultimately want to make to our healthcare system to improve the value of care.

Burns: Yes, the adage is that doctors control, directly or indirectly, 85 percent or more of all healthcare spending. And as David writes in the book, the single most expensive piece of technology in a doctor’s hand is the pen writing that prescription.

Insight: Have there been previous efforts to help doctors practice in a more cost-effective way? If these have traditionally fallen short, what can we do differently?

Burns: Prior efforts to change have been imposed top-down. The argument we make in the book is these large scale, one-size-fits-all, top-down-imposed changes rarely work.

Dranove: Physicians who control most of the spending have lost control over how the system is going to work. We will soon be speaking with a group of physician leaders. What we want to emphasize to them is that the ball is in their court. If they say to other physicians, “Trust me, if you’re more effective, you’ll be rewarded,” other physicians might believe them, whereas trust has been lost between the physicians and management.

We also need to get physicians to understand that, for the healthcare system to be more effective, some of them need to aspire to the upper ranks of management.

Insight: As you look ahead to the future, you don’t see catastrophe. We will still have a functioning hospital system. People will still get medical care. But how optimistic are you about the market improving in terms of its ability to offer high-quality, cost-effective care?

Dranove: Will any given healthcare organization figure it out or do we simply have the government dictate that work? Can we preserve competition amongst competing visions so that the market can do what markets always do, which is reward those that are most effective at delivering value to consumers?

Then again, the markets already have gotten to a point with consolidation where it’s very hard, in some places, to imagine change.

I’m a little more optimistic now in the wake of the Sutter settlement than I was a couple of years ago. The Sutter system is one of the poster children for megaproviders. And thanks to a very aggressive antitrust case brought by private plaintiffs as well as the state of California, Sutter has agreed to a settlement that might help increase competitiveness in Northern California. We will see.

Much of this will depend on consumers. We are so darn loyal to our doctor. If our doctor says, “Go to that hospital,” and that hospital is out of network, we raise hell: not with our doctor, not with the hospital, but with our employer and with our insurer. That makes it really hard to create competition.

Insight: I want to end with a final plug for your book: There are a lot of funny moments! In the antitrust chapters, healthcare economists are first the protagonists and then the villains and then the protagonists again. It’s like a movie.

Dranove: I tell my PhD students one of the reasons to do health economics is that you can point to real successes.

Insight: “One day you can be the James Bond of health economists.”

Burns: David’s been a real agent of change here on the antitrust side. I can’t think of very many health economists who had that kind of direct impact.

Dranove: You can say when I testified in antitrust cases, I was stirred, but never shaken.