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

A common phrase in the current debate over the so-called fiscal cliff is “Medicare needs to be restructured.” The term serves as code for policies unlikely to be appealing to voters, a term that can mean everything and, thus, nothing.

Today's Economist Perspectives from expert contributors.

The question is what problem restructuring is to solve in traditional Medicare, which remains one of the most popular health insurance programs in this country . People who use this vague term should always be challenged to explain exactly why and how Medicare should be changed.

Critics of traditional Medicare – even those who should know better – often accuse it of being “fee for service.” It is a strange accusation. After all, fee-for-service remains the dominant method of paying the providers of health care under private insurance, including Medicare Advantage, the option of private coverage open to all Medicare beneficiaries.



Describing Medicare as fee-for-service insurance is about as thoughtful as describing a horse as “an animal that has four legs,” a characteristic shared by many other animals. The practice is particularly odd, given that traditional Medicare as early as the 1970s was the first program to develop so-called “bundled payments” for hospital inpatient care – the diagnostically related groupings, known as D.R.G. – in place of fee-for-service payment of hospitals, an innovation that has since been copied around the globe.

A more descriptive term for traditional Medicare would be “free choice of providers” or “unmanaged care” insurance. These features, of course, would hardly be viewed as shortcomings among people covered by traditional Medicare or their families. Neither term would be a good marketing tool among voters for proposals to abandon traditional Medicare.

In this regard, it may be helpful to list the various contractual relationships that can exist between the insured and insurers, on the one hand, and the various methods of paying the providers of care, on the other:

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Indemnity Insurance: This is the oldest form of health insurance. It offers the insured free choice of health care provider and of treatment, which is why such policies tend to be expensive.

Under indemnity insurance, providers of care are typically paid on a fee-for-service basis. Insurers usually pay a stipulated fraction (say 80 percent) of the providers’ bills for covered services. Patients absorb the rest in the form of deductibles and coinsurance (e.g., 20 percent of the providers’ bill). Under some policies, insurers ask patients to pay providers first and then seek reimbursement from the insurer.

Managed-Care Contracts: The other three insurance contracts shown in the display – H.M.O., P.P.O. and P.O.S. contracts – are generally lumped together under the generic term “managed care.” It is another ill-defined term that can mean a host of specific limitations on the insured’s freedom of choice.

Doctors may assert that it is they who manage the medical treatments. But in health-policy circles, the term managed care means that the doctor’s medical treatments are subject to external constraints imposed by a private regulator — the patient’s health insurer — although, in principle, public insurers could “manage” care as well, if legislators permitted it.

These externally imposed constraints may take the form of formularies for prescription drugs or prior authorization by the insurer for specific procedures – e.g., expensive imaging or elective surgery – before the insurer agrees to pay for the procedures. They may mean exclusion from coverage of procedures deemed by the insurer to have a low expected benefit-cost ratio. While Congress forbids Medicare to let cost-benefit analysis guide its coverage decisions, private insurers are not subject to that constraint.

Finally, managed care techniques might include the external coordination of medical treatments that involved multiple providers of health care, especially the treatment of chronic disease, often by subcontracted companies specializing in care coordination.

These are the major forms of managed care insurance contracts.

Health Maintenance Organizations (H.M.O.): These contracts represent the most restrictive form of managed care. The insurer provides covered health care benefits through a network of health care providers under contract to the insurer, with zero or very modest cost-sharing at point of service on the part of the insured.

In a staff model H.M.O., the insurer actually owns the health care facilities and health professionals are the insurer’s salaried employees. More commonly, the H.M.O. merely contracts with a set of otherwise independent providers that are paid negotiated fees or, for primary care, sometimes annual capitation payments per patient on the doctor’s list.

Usually, in an H.M.O., the insured is asked to select one from a roster of primary-care doctors who regulates referrals to specialists. In principle, under an H.M.O. contract the insured is confined to the H.M.O.’s network of providers for covered services and pays in full out-of-pocket for health care procured outside that network.

Preferred Provider Organizations (P.P.O.): A popular alternative to the strictly limited choice under H.M.O.’s is a Preferred Provider Organization. Under that contract, the insurer negotiates prices with a network of “preferred” providers of care and the insured can contact specialists without a required referral by a primary-care doctor.

For the most part these providers in the network are paid on a fee-for-service basis as well, often X times the Medicare fee schedule, where X could be smaller than 1 but usually exceeds 1, where X is negotiated between the insurer and providers. The insured usually faces an annual deductible and relatively modest copays (dollar amounts, not fractions of the fees) if they obtain care from a provider in the network.

If the insured obtains care from a provider outside the P.P.O.’s network, the insurer will reimburse the insured only at what the insurer considers a reasonable fee, leaving the insured to pay any billed fee above that reimbursement. According to a report by the American Health Insurance Plans, these out-of-network fees can be exorbitantly high, which serves as a natural constraint on the free choice of provider under P.P.O.’s.

Point of Service (P.O.S.) Contracts: These contracts are combinations of H.M.O. and P.P.O. contracts. The insured still must select a primary-care doctor who coordinates the insured’s overall medical care, but patients can procure covered care from providers outside the H.M.O.’s network, albeit at high rates of cost-sharing. In that regard the arrangement resembles a P.P.O.

High-Deductible Health Plans (H.D.H.P.): These contracts couple indemnity- or preferred-provider (P.P.O.) insurance with very high annual deductibles, sometimes exceeding $10,000 for a family. The theory is that by putting the insured’s skin in the game, these plans will give patients an incentive to shop around for cost-effective health care. Some call them “Consumer-Directed Health Plans” (C.D.H.P.’s), because in theory they elevate “consumers” (formerly “patients”) to act as the chief managers of their own health care. However, the requisite information for shopping around has not generally been available to patients, forcing them to function in health care as would blindfolded shoppers in a department store.

What the critics of traditional, government-run Medicare actually find wanting in traditional Medicare is that it basically is classic indemnity insurance. It offers its enrollees free choice of doctor, hospital and other providers, and doctors relatively free choice of treatments, while most private insurers typically no longer do.

In other words, the complaint is that health care rendered under traditional Medicare is unmanaged care. These features, of course, are precisely the reason why in the eyes of the public traditional Medicare is still one of the most popular insurance products.

A case can be made, on theoretical and sometimes empirical grounds, that properly managed or coordinated care can on average yield superior medical treatments, at lower cost, than completely unmanaged care under classical indemnity insurance.

The problem has been and continues to be that this is not the folklore among patients or doctors. The latter, as noted, generally believe they can manage their patients’ care properly without outside interference into their clinical decisions. Among patients and doctors, the term managed care is still not quite respectable.

This can explain why critics of traditional Medicare delicately but nonsensically prefer to decry it as being fee for service rather than as free-choice-of-providers insurance or unmanaged-care insurance.