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Where should healthcare look to save costs?

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Jun 30, 2016

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People often refer to the U.S. healthcare system as an 800-lb gorilla. Although this reference might be born out of healthcare’s size and the clout of its players, its sheer unwieldiness actually reminds us more of a wild hippo. Healthcare is big and overweight with its appetite for spending reaching new heights every year, and it’s also resistant to change.

According to Medicare, U.S. healthcare expenditures grew 3.7% per year between 2008 and 2013, but accelerated to 5.3% in 2014. Unfortunately, the government estimates an average of 5.8% annual growth for the next ten years. It seems that the hippo will soon be even more difficult to get under control.

The press has been quick to lay the blame on the Affordable Care Act (ACA) and rising drug prices, but spending data suggests that the problem is elsewhere. Although the ACA and the new Hepatitis C drug (Sovaldi) could be easy answers in explaining the jump in expenditures in 2014—when both were introduced to the system—they cannot explain the long-term growth. In fact, Medicare forecasts that the share of prescription drugs in total healthcare expenditures is estimated to remain around 10% per year until 2024, implying that prescription drugs will not be the main drivers of growth. Additionally, given that the ACA is designed to deliver long-term cost savings rather than short-term, it is too early to label the ACA a failure.

When we look at how the U.S. national health expenses are categorized (Figure 1), we see that 55% of annual costs are tied to two main categories: paying for hospital care (32%) and paying for clinical professionals (23%), both of which are expected to maintain their respective shares over the next decade. It makes sense that these two categories are responsible for the majority of spending—after all, hospitals and clinicians are the core of healthcare. But, the inconvenient truth is that if we are going to bring healthcare costs under control, spending on both will need to be meaningfully reduced.

Figure 1: 2014 U.S. Health Expenditures by Spending Categories

Figure 1

Source: The Center for Medicare and Medicaid Services

The theory of disruptive innovation provides a unique perspective as to why we keep spending more for hospital care and clinical professionals. Over the years our hospital systems have developed into world-class health systems, and they have done this primarily through sustaining innovations, which are based on incremental improvements of existing technologies. Hospitals today can treat many more diseases using a variety of novel technologies and methods. Imaging technology is better, surgeries are now done by robotic instruments, minimally invasive methods are used, and fully-implantable mechanical devices extend lives. Unfortunately, with each additional step of sustaining improvement in care modalities, the cost of care has also risen. Just as better products often cost more, so does better care. This is a major downside of sustaining innovations. A similar trend can also be observed among clinical professionals. As physicians specialize by gaining additional training and expertise, their services in turn become more expensive.

At the same time, since most health systems rely on third-party insurance to pay on behalf of patients, costs continue to rise. Individual hospitals (and the clinicians who work there) dictate prices, and patients consent to them. Because their insurance will oftentimes pick up the majority of their bill, and their co-pay will remain the same regardless of the overall cost, patients don’t care how much it costs. They’re essentially going “shopping with other people’s money,” as insurance companies respond by raising their premium on their members to cover the rising cost of care. Insurance companies have little incentive to push back, thus perpetuating a system that is proving to be less and less sustainable.

Given the current outlook on cost trends and cost structure of our healthcare system, the only way to shed the increasing weight is by bringing more disruptive innovations to providers and clinical professionals. Unlike sustaining innovations, disruptive innovations not only make products and services simpler and more accessible, but also less expensive. These solutions will be effective at bringing down the system cost with as little friction as possible, because disruption initially does not compete against the establishment.

So, what will disruption in healthcare look like?

Disruptive innovations will put less of an emphasis on hospital-based care and introduce new low-cost care models that focus on disease prevention and behavioral changes.

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First, disruptive innovations will reduce the need for patients to access the traditional hospital system by introducing alternative clinical models. These models will be able to handle many routine healthcare services for minor illnesses such as the flu or acute cases such as broken bones. Over time, they will become better at addressing the same health problems that hospitals used to handle exclusively, but at much lower costs. Patients will no longer find the established hospital model to be the best option to deal with the majority of their health problems. Payers will be supportive of these new models, as they can curb rising premiums tied to high cost care models. They will always pay for effective care services that reduce financial burden on their members without undermining their margin.

Second, disruptive innovations will focus on curing diseases rather than treating their symptoms.  Unfortunately, the established drug and device industries are more interested in extending solutions they already have in the market, even if those solutions only address the symptoms of diseases, but not their root causes. Innovators must find ways around this entrenched fad of just treating the symptoms by investing more in diagnostics that can precisely determine the causes of diseases. When diseases can be more precisely diagnosed, finding the most effective treatments becomes easier, and the total cost of care can be reduced.

Finally, we need an insurance model that will provide affordable and effective care to its members by developing a whole new reimbursement system. This will be possible only if the existing third-party insurance model is replaced with either a direct-pay or integrated provider model. A direct-pay model can bring discipline to spending by putting more responsibility on consumers and employers to decide what services to choose. Because the consumers of care are also the ones paying for it, they are more likely to make financially responsible choices. On the other hand, an integrated provider like Kaiser Permanente can control how care services are provided in the most cost-effective way, because care services are also providing insurance coverage to its patients, making them more financially responsible.  Only when the third-party payer model is replaced with models that make one of the interacting parties pay, will we see a meaningful impact on the cost of care.

When we review the data, we see that the $3 trillion hippo we call healthcare is currently a very inefficient and wasteful system that is too narrowly focused on sustaining innovations. While sustaining innovations are vital for dealing with complex problems and diseases, they can be poisonous to systems with cost problems since they make costs go up. To reduce the cost of burden we must focus on developing disruptive innovations that target hospital care and physician services.

Spencer Nam

Spencer researches disruptive innovation in the healthcare industry. He has over 15 years of professional experience working with U.S. and international healthcare enterprises, most recently as an equity research analyst covering medical technology companies.

  • Evan Shore

    Spencer, great article! I am not sure I agree that integrated models are catalyzing disruptive innovation.

    First, what are your thoughts on population health and its ability to reduce inappropriate utilization, as well as provide better care for the most at risk patients? To me that sounds like a sustaining innovation that helps large health systems operate more efficiently.

    Also, the motivation behind many provider sponsored health plans is market share, to drive higher in-system utilization of major health systems, even if the care is more expensive there. The plan sits adjacent to the (still) fee for service volume business of the health system. The system offers the plan rate cuts and supports population health to reduce overall utilization, but the system benefits in the end by driving volume to the system (by controlling benefits/network design to channel patients back into its own facilities). Disruption, on the other hand, would enable unbiased consumer choice of site of care and facilitate volume downstream rather than in-system. Because of these conflicting motivations, I am not convinced that health systems (even integrated ones) will fully embrace disruption.

    What alternative financial / organizational structures do you think would best support disruption?

    • Spencer Nam

      Hi Evan, thank you for your comments. You make some important observations, and I generally share your views. With respect to “population health,” I think the term is appropriate for describing macro issues, but we need to be careful how we categorize things. At the Christensen Institute, we hypothesize that using traditional categories such as age, gender, and diseases will most likely perpetuate the status quo. However, if we redefined population health based on individuals’ circumstances, it could turn out to be an extremely useful way to segment a single disease into subgroups with similar environmental contexts. For example, type 2 diabetes is a population health problem, but most of the established categorization schemes shed little insight to how patients deal with the disease. We need contextual data based on new categories.

      In terms of integrated models, I agree that an integrated model that tries to support the established business models will not be useful in reducing costs of care. But, given that 55% of total costs are hospital and physician related, making the “payer” an insider might change the dynamics enough that it could have a meaningful impact on lowering certain costs. To that end, I wonder if a payer-led integration might be more effective than a provider-led one, but we have plenty of examples of providers trying to transform care delivery, so the success will come down to execution.

      Finally, to answer your questions about alternative models and whether integrated models can truly be disruptive, I believe the waves of disruption first need to arise among the healthy population. They are the ones who are currently not consuming healthcare products and services, but data on chronic diseases show that they should be. This current non-consumers, I believe, should be the primary target population for healthcare models that aspire to disrupt the establishment. The obvious choices are the self-insured employers who are highly motivated to adopt value-based capitated programs. I also think there is significant unmet needs in helping people to stay out of hospitals. A primary care model that encourages non-consumers to pay for basic services that will keep them out of hospitals long-term is a potentially successful model. Clearly, new stand-alone models that emerge without the burden of existing cost structure are likely to succeed.

  • Rene Lau

    Great Article! But it fails to address many issues. It is, indeed, telling that you did not put the percentages on the pie chart. Did you get paid for that quirk? The research percentage appears minuscule and is like that courtesy of the AMA. There is little money in it!

    The greatest percentage, of course, goes to hospitals and/or clinicians. What percentage goes to over charges and fraud. Since the patient(s) pays(employee insurance) modest sums, they do not care or examin their billing. I bet a trillion is wasted and nobody knows.

    Hospitalization implies lack of preventive care (a non-money maker). Annual checkups (real ones) should be compulsory but…politics gets in the way!

    You see the AMA subsidizes political campaigns and golf outings and entertainment for the politicians, so nothings gets done! They can overcharge, commit fraud and create ghost patients with total impunity. There is cancer growing in our political system perpetrated by something called Citizen United verdict.

    We are worried about the Zika virus (we should be) but do not worry about the individual insurance payer that are overweight or obesee w/o demanding redress for their lack of responsibility. Hearth disease, diabetes anda multitiude of medical care are DIRECTLY related to this issue. Obesity is a major cancer in our society. We should tax the fast food companies for selling products beyond a reasonable calorific value; a 2000 calorie latte is a crime against society. A triple burger with bacon and a ton of cheese should be outlawed. Any obese person should pay at least five times the premiums that healthy payer’s pay. These ideas are in a sense extremely disruptive yet common sense! The pursuit of happiness in our Declaration of Independence does not cover gluttony!

    People pay for having their oil changed and do not complain. Yet, they never go to a Dr. till they go to the emergency room where they drop at last $5,000 for learn that diverticulitis may be an issue because they eat six bags of seeds while watching “reality shows”. It is disruptive to compel society to be responsible since, in the end, we pay for the stupidity of those who are not! Encourage is a word w/o foundation. Models based on false assumptions (the foundation), I am sure you are aware, will fail.

  • Vinod Seth

    US would save healthcare costs by focusing on improving the health of Americans. We are the last to ban transfats. Sugars are doled out in drinks and with our crazy focus on low-fat also sugars make up large amounts of our grocery purchases. Our roads are not as safe our alcohol levels permitted are too high. In all respects our healthcare costs reflect our societal ignorance of prevention. Prevention in America is early diagnosis of disease with multiple diagnostic studies creating a lot of false positives and extra health care consumption. Mammography is a case in point and so the focus of the article about reducing healthcare health care costs by various modalities dealing with the payment mechanisms etc. could more aptly be called barking up the wrong tree.