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

“Medicare, Where Soviet Economic Thinking Lives On,” was the headline on a recent blog offering commentary on an article about Medicare pricing in The Wall Street Journal, accompanied by a videotaped, highly critical interview on The Journal’s “Online Opinion.”

The article and the video are focused on Medicare pricing of physician services. But the Soviet label can also be affixed to Medicare’s pricing for hospital care.

Joseph Antos, the widely respected Wilson H. Taylor Scholar in Health Care and Retirement Policy at the American Enterprise Institute, agrees with the Soviet label. “Medicare ignores the market, setting prices for physician services based on an academic theory with its roots in the Soviet Union,” he wrote in his “Confessions of a Price Controller.”

Dr. Antos writes with authority on this issue. As he acknowledges in the piece, he oversaw both the academic study leading to this pricing system for physicians and its subsequent implementation.

I find it hard to disagree with Dr. Antos. Medicare fees are administered prices, set by a central government for the entire country. And that is Soviet economics.

So naturally one is led to ask: Who imported this fiendish Soviet pricing theory to the United States and imposed it on Medicare?

It was the administration of President Ronald Reagan, with the concurrence of a Congress controlled by the Democrats.



The Reagan administration acted after it became alarmed at the inflationary force inherent in a payment mechanism adopted by Medicare at its inception, at the behest of the hospital industry: retrospective, full-cost reimbursement of each hospital for its reported costs.

After exploring a number of alternatives, most of them probably not politically feasible, the Reagan administration and Congress decided to switch, during 1983-86, to set, centrally administered prices. It’s hardly likely that the Reagan administration or Congress thought themselves inspired by Soviet theory, a notion that has been advanced more recently. These policy makers just thought the new system made more economic sense.

Most health economists — including me — saluted the switch, believing it would lead to more efficient hospital management. Hospital executives took a less kindly view, because it signaled the end of the Golden Era of hospital management.

The new payment system for hospitals used case-based bundled payments for “diagnostically related groupings” of inpatient cases, each with roughly similar reported costs and with a small and tolerable variance of actual costs per case around average costs for that case. The system is now known simply as the D.R.G.’s. It started with about 535 distinct D.R.G. cases and now has 745.

The D.R.G. system had its origin in pioneering research by Profs. John D. Thompson and Robert Fetter of Yale. They intended the D.R.G. classification to be mainly a management tool, a basis for managerial cost accounting and cost control commonly used in other industries.

It soon dawned on policy makers, however, that the D.R.G. classification could also be used as a basis for paying hospitals. That idea was successfully tested in the early 1980s in New Jersey and was put into effect nationwide in 1983.

In the words of Prof. Rick Mayes of the University of Richmond, who has chronicled the genesis of the D.R.G.’s in a fine paper: “The change was nothing short of revolutionary. For the first time, the federal government gained the upper hand in its financial relationship with the hospital industry.” Indeed, that revolutionary innovation has by now been widely copied around the world, first in Australia and France, and subsequently in Germany and several other countries.

The Medicare fee schedule for physicians — the actual focus of the article in The Wall Street Journal — was introduced in 1992, by the administration of George H.W. Bush.

Dr. Antos confesses to having been part of its genesis. I confess that I, too, played a bit part, in my capacity as an appointed commissioner on the Physician Payment Review Commission, established by Congress. The commission unanimously recommended the adoption of the new payment system to Congress at the beginning of the 1990s.

The new Medicare fee schedule was based on research financed by the Reagan administration during the 1980s and conducted jointly by Prof. William Hsiao of Harvard and the American Medical Association. It was implemented in 1992 by the Bush administration, along with what was, in effect, a national budget for Medicare’s total payments to physicians, then known as the “volume performance standard,” and modified in 1997 to what is called the S.G.R. system, for “sustainable growth rate.”

This new payment system for physicians replaced a highly dubious mechanism under which Medicare paid each doctor his or her “customary, prevailing and reasonable” fees, a clone of the “usual, customary and reasonable” system then widely used by private health insurers. It was a bewildering, computer-intensive system, with several filters based on each physician’s own charge profile for each service during the previous year, along with frequency distributions of fees for each service by all physicians in the physician’s market area.

The “usual, customary and prevailing” system, used since the inception of Medicare at the insistence of organized medicine, had proven to be highly inflationary, as could have been predicted at the outset. It also was unfair, because it could result in quite different Medicare payments for the same service to two physicians working in the same building — simply because one was more aggressive in billing than the other.

Soviet label notwithstanding, the relative fee structure underlying the Medicare fee schedules imposed in 1992 — the so-called “resource-based relative value scale” — has by now been widely adopted by many private health insurers in the United States as the basis for negotiating fees with physicians. The scale values procedures relative to a base unit that is given a monetary value by Congress and adjusted every year.

Among private insurers, this approach has replaced “usual, customary and reasonable.”

In coming weeks I will examine more closely how Medicare’s pricing for hospital services and physician services actually works, and contrast that with how fees are determined in the private insurance sector.