Uwe E. Reinhardt is an economics professor at Princeton. He has some financial interests in the health care field.

About half a century ago, organized medicine and the hospital industry in this country struck a deal with Congress that in retrospect seems as audacious as it seems incredible: Congress was asked to surrender to these industries the keys to the United States Treasury.

Today's Economist Perspectives from expert contributors.

In return, the industries would allow Congress to pass a 1965 amendment to the Social Security Act, described as “an act to provide a hospital insurance program for the aged under the Social Security Act with a supplementary health benefits program and an expanded program of medical assistance, to increase benefits under the Old-Age, Survivors, and Disability Insurance System, to improve the Federal-State public assistance programs, and for other purposes.” We have come to know it as Medicare.

As Wilbur Cohen, a chief architect of the law and subsequently secretary of health, education and welfare, later described the deal (Page 25):

The sponsors of Medicare, myself included, had to concede in 1965 that there would be no real controls over hospitals and physicians. I was required to promise before the final vote in the executive session of the House Ways and Means Committee that the federal agency [to be in charge of administering Medicare] would exercise no control.

Medicare was not to interfere in any way in the physicians’ treatment of Medicare patients – through what we now know in private health insurance as “managed care.” Nor was Medicare allowed to influence the way hospitals were constructed and operated. Finally, the deal called for a completely one-sided payment system.

Hospitals: Under this payment system, Medicare was required to reimburse each individual hospital (and other inpatient facilities) retrospectively for all the money that individual facility reported having spent on treating Medicare patients. These pro rata costs included operating costs, annual depreciation of the capital investments in the facility, interest of debt incurred to finance that capacity and, for investor-owned hospitals, a guaranteed rate of return to equity capital invested in the hospital.

The guaranteed rate of return to profits, incidentally, helped the large investor-owned hospital chains get off the ground, because whatever capital outlays on acquiring hospitals the chains made could be so easily recovered through “reimbursement.” Doing well for shareholders in those days was like shooting fish in the barrel.

One need not have a Ph.D. in economics, of course, to appreciate that the deal was inherently inflationary.

Physicians: For their part, organized medicine struck a deal under which each physician (and certain other professionals) was to be paid his or her “customary, prevailing and reasonable (C.P.R.)” fee for each service. The “reasonable” fee to be paid the individual physician for a particular service was determined as the lowest of three fees:

the physician’s actual charge for the service, the median of the frequency distribution of the fee he or she had charged in the previous year (the “customary” fee) and the 75th percentile of all “customary” charges for all physicians performing that service in the relevant market area.

The C.P.R. system for physicians was inherently inflationary as well, because it gave all physicians the incentive to inflate in year t their actual charges in order to push their own and the market area’s frequency distribution of fees in year t+1 to the right, toward ever higher median fees and 75th percentiles. (A similar phenomenon, I believe, has been at work in corporate executive compensation.)

As Rick Mayes reports in his wonderful essay “The Origins, Development, and Passage of Medicare’s Revolutionary Prospective Payment System,” a prominent leader of a hospital association later acknowledged that the retrospective full-cost reimbursement feature established under this deal was “just stupid.” It is hard to disagree with that assessment.

So how could the policy analysis and politicians pushing for Medicare’s passage be so “stupid” as to agree to such a deal?

In the early 1960, more than a third of America’s elderly lived in poverty. Hospitals in many states were strictly segregated by race, with predictable differences in the quality of care. At the same time, modern medicine was progressing in terms of effectiveness, but also in cost. In the absence of Medicare, the blessings of modern medicine would have been out of reach for millions of older Americans.

Medicare’s sponsors dreamed of a health system in which these blessings would be shared on roughly equal terms by all elderly Americans, regardless of their own ability to pay for needed health care or their race.

To help implement that vision, these proponents reluctantly paid the price the providers of health care extracted in return for accepting the legislation: Congress surrendered to the providers the keys to the United States Treasury, full well knowing that this social contract could have only a short shelf life. One would assume that physicians and hospital leaders knew that as well.

In other words, the proponents of Medicare who signed on to the deal were anything but stupid. When confronted by the health care sector with a harsh trade-off between their cherished vision for health care, on the one hand, and a sensible payment policy, on the other, they let their vision override economically sound payment policy. Millions upon millions of America’s senior citizens are indebted to them for a program that remains highly popular to this day.

Younger leaders of medicine and the hospital industry would do well to recall this dubious social contract struck by their predecessors to appreciate that the countless amendments to Medicare and the ever-new regulations emanating from the program are just the byproduct of many skirmishes in a protracted and tenacious war over possession of the keys to the Treasury.

It is no small irony that the fiercest generals in this war on the government’s side have been Republican stalwarts who would normally deplore the tactics they employed – Presidents Reagan and George H.W. Bush. Desperate over the ever-escalating costs of Medicare during the 1970s and ’80s, both presidents resorted to what has been described as a Soviet-style payment policy for Medicare: administered prices set by the central government for the whole country.

For hospitals it was the prospectively set diagnosis-related case payments, implemented by the Reagan administration during 1983-86. For physicians it was the Medicare fee schedule, enacted under the first Bush administration in 1989 — along with a prospective global budget for Medicare spending on physician services called Volume Performance Standard and implemented under the Clinton administration.

But the war over the keys to the Treasury will probably never be fully concluded. Every so often in the past, the government thought it had retrieved the keys, only to discover that some providers of health care – be it skilled nursing facilities in the 1990s or physical therapists or home health care agencies or providers of durable medical equipment – still have possession of some of those keys, calling forth yet more government-initiated skirmishes in the form of added legislative amendments or regulations.

Struggles over the payment of health care providers go on year in, year out, in all modern health systems. But the struggles in other countries do not seem nearly as messy and as fierce as those in the United States. The root of that struggle goes back to the deal forced on Medicare during that program’s breech birth – a deal that had to be cut just to get the law enacted.

In retrospect, it would have been better all around to cut a more rational deal from the outset.