AMERICA spends more on health care than any other country in the world. What is more, spending within America varies dramatically from one region to the next. This is well known. Less understood is how best to change it. The health system is enormously complex. Differing views on reform inspire rowdy protests and send pundits into frothy-mouthed rants. To lower health spending, it would help to know what drives it up. A huge new report from America’s Institute of Medicine (IOM) helps provide an answer. In the study, commissioned by Congress, the IOM looked at the geographic variation in spending within Medicare, the health programme for the old, and within the commercially insured population. It is the biggest ever analysis of why some regions spend more than others. Crucially, the factors driving the variation in Medicare spending are different from those affecting private coverage.

Researchers at Dartmouth University have studied regional variation in Medicare spending for over 30 years, finding little relationship between spending and health outcomes. This prompted some politicians to wonder if they should use Medicare payments to reward low-spending regions and penalise high-spending ones. This is a bad idea, the IOM concludes.

That’s because Medicare spending does not vary just by region, but within regions and even within hospitals and doctors’ groups. Adjusting payments by region would reward some inefficient hospitals in high-value regions, while penalising high-value hospitals in inefficient ones.

That still leaves the question of why spending varies so spectacularly. Age, sex and health status account for some of the difference—after controlling for these, factors such as race and income have little effect. The other big driver of variation in Medicare spending is the use of so-called post-acute care, such as services in skilled nursing facilities. Once the researchers controlled for post-acute care, the variation in spending dropped by 73%.

Interestingly, the drivers of variation are dramatically different for those younger than 65 with private insurance. The overuse of services explains some of the variation. For example, the researchers saw big gaps in the use of emergency rooms. But erratic pricing is by far the biggest culprit.

The Centres for Medicare and Medicare Services (CMS) sets a price for Medicare services, adjusted for various regional input costs. In contrast, private insurers negotiate payment rates with hospitals. In areas with a dominant hospital chain, prices are likely to be higher. The IOM reports that price mark-ups account for 70% of the variation in commercial spending.

These findings illuminate a long, boisterous debate. In 2009 the New Yorker’s Atul Gawande described how Medicare spending per person was much higher in McAllen, Texas than in nearby El Paso. But the following year a paper in Health Affairs showed the opposite phenomenon for commercial insurers: spending for privately insured patients was higher in El Paso than in McAllen. The IOM’s report helps explain this. For Medicare patients, most variation comes from differences in patients’ health status and the overuse of a particular service, post-acute care. For privately insured patients, price gaps are to blame. This bolsters the case long made by Uwe Reinhardt of Princeton, as well as Steven Brill’s great piece on hospital bills in Time and more recent data showing chasms between America’s prices and those of other rich countries.

The question now is what to do. The problems for both Medicare and private insurers stem from America’s reigning fee-for-service system, in which a doctor is paid more for each service he provides. This gives doctors a reason to provide more care and charge as much as possible.

Thanks to the Affordable Care Act or “Obamacare”, CMS is already exploring ways to reward better, more efficient hospitals. Accountable Care Organisations (ACOs), for example, reward networks of doctors for keeping costs below a benchmark. Bundled payments pay a set price for an entire episode of care, rather than a fee for each service. Similar experiments are underway in the private sector. UnitedHealthcare, a giant health insurer, has already linked some hospital payments to measures of quality and efficiency. This month United said it would more than double these contracts, from $20 billion today to $50 billion by 2017.

Still, it is too soon to know which experiments will work. The transition from fee-for-service will inevitably be slow. In the meantime, it would help if the millions of Americans with private insurance had any idea what hospitals charge. In May CMS published hospitals’ price lists, showing huge gaps from one hospital to the next. But few patients pay these charges—it would be more useful to know the rate negotiated with their insurers. This transparency does not require restructuring the health system. It just requires hospitals to lift the veil on prices. If they don’t, a regulator may do it for them.

(Photo credit: AFP)