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Vernellia R. Randall
17 U. Puget Sound L. Rev. 1 (Fall 1993)
Copyright (c) 1994 by Vernellia R. Randall


Those who cannot remember the past are condemned to repeat it. 
George Santayana(16)

Over the last one hundred years, America's health care system has undergone several major changes. It has moved from a home-based system to a hospital- based system. It has moved from a nursing care-based system to a technology- based system. It has moved from a patient-driven system to a provider-driven system. Each change introduced not only advances in health care, but also perverse negative aspects. Perhaps, the negative features that were introduced into the system might have been avoided if more attention had been paid to the down side of changes occurring in the health care system. The health care  system is again undergoing major changes as it moves from a provider- driven system to a third-party payer-driven system. As the new system is being designed and implemented, it is important to understand how the current systemic problems developed. Only then can actions be taken to avoid analogous pitfalls in this new third-party payer-driven system. Section A of this Part provides an overview of the historical development of third-party payers. Section B discusses the impact third-party payers have had on health care delivery. Finally, Section C considers the development of managed care products as a response to cost containment issues. Together these sections are designed to help us remember the past so that we will not be condemned to repeat it. 

A. Overview of Historical Development 

1. From Home to Hospital 

From the 1700s to the mid-1800s, those who became sick or injured and could pay stayed at home for treatment.(17) Only the lowest class person went to the hospital, which was often only a separate wing on the almshouse, jail, or pesthouse.(18) In the late 1700s, at the urging of European-trained physicians, a few communities established the first community-owned or voluntary hospitals.(19) Although these hospitals admitted both the poor and paying patients, (20) it was not until the late 1800s that hospital  stays became widely accepted. As late as 1873, there were only 178 hospitals with a total of 35,064 beds in the entire United States.(21) Only thirty-six years later, in 1909, the number had grown to 4,359 hospitals with 421,065 beds, and by 1929 to 6,665 hospitals with 907,133 beds.(22)

2. The Coming of the Blues 

The Great Depression caused a dramatic change in the economic state of hospitals as patients unable to pay for health care simply stayed away. As early as 1930, average hospital receipts fell from $236.12 per patient in the 1920s to $59.26, bed occupancy dropped from 71.28% to 64.12%, and hospital deficits rose dramatically.(23) Hard hit by the depression, the American Hospital Association (AHA) developed the Blue Cross concept to assure stable revenues.(24)

The Blue Cross plans simply guaranteed payment of hospital costs, albeit in an environment of limited technology and patient self-rationing. Given the general economic state, the popularity of the plans was predictable. The plans, however, covered only hospital costs. Physicians, through the American Medical Association (AMA), sought to keep coverage limited. The AMA took the position that medical ethics permitted only insurance that was paid directly to patients.(25) The AMA feared that if third-party payers became intermediaries, they would eventually play a significant role in determining medical treatment.(26) Specifically, the AMA feared that third-party payers who paid physicians directly would eventually require the physicians to make medical decisions based on the third-party payers' interest rather than on the patients' interest.(27) Nevertheless, under increasing political pressure, some state  medical societies approved medical service benefit plans called Blue Shield.(28)

Like Blue Cross, Blue Shield proved extremely popular. Over the last sixty years, the Blue Cross and Blue Shield plans have become the largest providers of private medical insurance. (29) The current interest in managed care plans, which emphasize controlling physicians' behavior, indicates that physicians' historical fears of third-party payer control of medical practice decision making were well founded.(30)

3. World War II and Beyond 

With the coming of commercial insurance after World War II, the health insurance industry experienced significant growth. As medical technology advanced, reliable access to medical services became increasingly important. This led employers to begin to use health care benefits as a part of employee compensation. This, in turn, led to an increasing demand for health insurance as a standard benefit of employment,(31) which brought commercial insurance companies into competition with the Blue Cross and Blue Shield plans.(32)

Unlike early Blue Cross and Blue Shield plans, commercial policies offered an indemnity benefit.(33) To compete, Blue Cross and Blue Shield adopted similar provisions and abandoned,  among other things, service benefit and community rating.(34) Because of the higher cost of insurance that is individually rated, the Blue Cross and Blue Shield abandonment of community rating and adoption of an individualized rating system left many people who could not afford the premiums unprotected.(35) Thus, an increasing health care access gap began to develop between those who had either health insurance or wealth, and consequently could afford the cost of health care services, and those who did not. 

4. Medicare and Medicaid 

In 1965, Congress responded to the medical insurance crisis by creating Medicare(36) and Medicaid(37) programs. To counteract initial opposition by the AMA and to assure physician participation, Congress gave Blue Shield the administrative responsibility for reimbursement of physicians. Medicare was to reimburse physicians on the basis of "customary, prevailing, and reasonable charges."(38) For Medicaid, state governments determined how physicians were to be paid.(39) Today, about one-half of the states pay physicians based on fee schedules.(40) The remainder provide some form of charge-based reimbursement.(41)

Since 1965, Medicare and Medicaid have grown significantly. Medicare currently accounts for approximately thirty-five percent of national health care expenditures and forty percent of hospital revenues.(42) Yet, Medicare's impact extends well beyond the program itself. For example, other institutional purchasers of health care, such as private insurers, typically follow Medicare's lead in medical technology and payment schedules.(43)


B. Impact of Third-Party Payers on Health Care 

By 1986, seventy percent of payments to providers were made by public or private insurance.(44) The insurers' reimbursement methods introduced into the health care system complex, often irrational economic incentives. The traditional reimbursement method of private insurers was the fee-for-service model,(45) while government insurance reimbursed on a cost  or charge basis.(46) Both of these forms of reimbursement created powerful incentives for all players in the health care system to intervene excessively with overpriced procedures.(47) No one had an incentive to economize. 

An individual who contracted with Blue Cross through an employer for eighty percent of the usual, customary, and reasonable cost (UCR) of medically necessary care lacked the incentive to economize because no matter what the cost of health care, the individual would be paying only twenty percent.(48) Because the insurance cost was shared with the employer, the individual was not likely to scrutinize medical expenditures to avoid future premium increases. Furthermore, because insurers did not base health care insurance premiums on "experience rating,"(49) a patient's health care use would not directly influence the cost of the insurance to the employer. Thus, the patient was not likely to realize the full financial impact of treatment decisions. 

Nor were hospitals and physicians motivated to economize. Because most insurers guaranteed providers eighty percent of their customary charges, fee- for-service or cost-based charges had an opposite and perverse influence on health service delivery.(50) Providers earned more under both reimbursement systems when they treated more. This phenomenon had two effects: First, physicians and hospitals tended to de-emphasize preventive care, which was not as lucrative as treatment services. Second, because insurers paid for discrete procedures, not  time spent with patients, providers tended to place excessive reliance on the use of medical technology. 

The insurers' methods of calculating fees to be paid further complicated the picture. The practice of covering the UCR allowed the provider to charge whatever the insurer would pay. 

When the maximum payments available under usual and customary became public knowledge, there was a natural tendency on the part of physicians ... to move to the maximum available.... Once that was done, the whole concept of usual and customary, based on physicians' pricing as an independent entity unaffected by their peers or others in the community, was gone. The whole program changed its nature both as to Medicare and as to private, usual and customary. Prices rose dramatically.... [The doctor] could find [the maximum UCR] out very readily by simply testing the system by raising his fees until he hit the upper limit, and they did. (51)

From the patient's point of view, insurance removed the need to ration health care dollars, thus creating the moral hazard problem.(52) From the insurer's point of view, a payment system that had worked well for auto and life insurance would seem to make sense. Thus, health care indemnity plans were designed and implemented on the basis of faulty assumptions and expectations by all parties: the insurers' failure to recognize the problem of moral hazard and the providers' and patients' failure to recognize the need to continue to ration health care.(53)

For over fifty years, the cost of health care was hidden from most of the participants in the system. However, as the cost of health care has spiraled upward, employers,(54) government, (55) and third-party payers have gained strong incentives to restrain costs.(56) Employers and third-party payers desire to protect their profits, and the government wants to reduce the deficit by decreasing health care expenditures. Because of their profit interest, third-party payers are rigorously looking for ways to control the untamed beast. During the early 1970s, major employers began to self-insure to reduce costs,(57) and the government switched to using diagnosis-related groups as its method of paying hospitals.(58)

These efforts have had limited effectiveness. While self-insurance helped employers avoid the problem of increased premiums, it did little to control the actual cost of health care.(59) Similarly, Medicare and Medicaid's use of diagnosis-related groups for prospective payment of hospital services has not proved effective in controlling costs.(60) In a second- stage effort to control health costs, third-party payers redesigned health benefit plans to pass on increased costs to the employee by eliminating "first- dollar" coverage and significantly increasing deductibles. (61) It is predicted that by 1995, ninety-eight percent of major employers will have eliminated first-dollar coverage.(62) Elimination of first-dollar coverage would appear to give the patient economic incentives to control the use of health care services. However, some individuals may respond to the incentives by significantly underutilizing services, thus adversely affecting their health.(63)

Current cost containment efforts shift the risk of financial loss for health care in whole or in part to the providers of that care.(64) Physicians are offered economic incentives to act as the third-party payer's agent-the gatekeeper to health care services.(65) As gatekeepers, physicians are concerned with limiting access to health care services so that third-party payers do not find excessive utilization. If a third-party payers determines that a physician has ordered too many services, the third-party payer financially penalizes the physician.(66) Consequently, physicians are motivated to order services for patients within third-party payer guidelines. Thus, gatekeeping shifts the focus of the health care system from the physician-patient relationship to the relationship between the physician and third-party payer. Ultimately, the physician and the third-party payer will determine the quality of care received by the patient and the patient's access to that care. (67)

As employers, government, and other third-party payers more aggressively seek market share and profits, the health care marketplace is driven by fierce competition for enrollees. (68) At the same time, third- party payers demand experience rating and utilization data on the services they are purchasing.(69) Third-party payers attempt to limit their costs by reducing the amount a physician or hospital receives for the average patient's care.(70) Third-party payers have developed plans that limit the amounts and types of services that can be used.(71) They have sought to restrict physicians' decision-making power. In short, third-party payers have entered the managed care business, with management in the hands of the third-party payer, not the physician or the patient.(72)


C. The Development of Managed Care Products 

The third-party payer-driven system can look deceptively like the provider- driven system. The traditional contractual relationships between patient and third-party payer, and between physician and patient, continue to exist. However, a new relationship between the third-party payer and the physician now exists. Thus, in the payer-driven system, there is a triangular relationship. The physician is legally and professionally obligated to act in the patient's best interest. The third-party payer is contractually obligated to pay for services rendered by the physician. The physician is contractually obligated to provide services under the guidelines set by the third-party payer if the physician wishes to be paid for the medical services. Thus, the physician manages the patient's health care for the third-party payer-leading to the term "managed care products." The two basic forms of managed care products are health maintenance organizations (HMOs) and preferred provider organizations (PPOs). 

1. Health Maintenance Organizations 

An HMO is an organized system of health care delivery for both hospital and physician services in which care delivery and financing functions are offered by one organization.(73) HMOs provide both services to an enrolled membership for a fixed and prepaid fee. The traditional HMO structure completely shifts the financial risk from the third-party payer to the provider. This shift means that HMOs can obtain cost savings only by controlling both utilization and expenses. They do so by encouraging fewer hospital admissions, more outpatient procedures, and fewer referrals to specialists.(74)

In Oklahoma in 1929, the Farmer's Union started the Cooperative Health Association using the familiar "farmer's co-op" pooled financing structure.(75) Around the same time, in Los Angeles, Drs. Ross and Loss started a prepaid group health delivery plan with comprehensive services.(76)

The AMA slowed the development of managed care by labeling the concept "socialized medicine" or "communism."(77) "The medical profession was unremittingly hostile [to managed  care], and by the end of the [1930s] succeeded in convincing most states to pass restrictive laws that effectively barred [managed care] plans from operating."(78) Because of this opposition, HMOs developed haphazardly in response to the needs of specific communities.(79) In the early 1970s, when skyrocketing health care costs were front page news, the AMA position weakened. Conservatives were certain that market competition in the health care system would reduce costs. 

In 1973, in response to increasing pressure, Congress passed legislation that required businesses with more than twenty-five employees to offer their employees at least one federally qualified HMO as an alternative to conventional insurance.(80) With federal grant and loan money in hand, the HMO industry experienced a steady growth between 1974 and 1983.(81)

Though the government discontinued federal loans, HMOs experienced another growth spurt between 1983 and 1988,(82) probably caused by the expansion of health maintenance coverage  to Medicaid and Medicare eligibles.(83) In 1982, former President Reagan signed a bill that expanded the definition of contracting entities to include entities other than federally qualified HMOs and authorized Medicare payment on either a prospective, per capita basis or on a reasonable cost basis.(84) Other roadblocks to the growth of HMOs were also removed during that period. For instance, many states had laws that forbade the corporate practice of medicine. Consequently, many states had to enact enabling statutes because HMOs required some kind of corporate practice.(85)

With Medicaid authorization and state legal clearance, the number of HMOs increased dramatically-about 900% in fifteen years.(86) While recent market consolidation has resulted in an actual decrease in the number of operating HMOs, the overall enrollment continues to climb. (87)

2. Preferred Provider Organizations 

As HMOs stabilized as a cost control mechanism, third-party payers pushed to find more efficient cost control methods. The push resulted in the proliferation of other managed care arrangements, most notably PPOs. PPOs contract directly with an employer through the employer's health benefits department or indirectly through an insurance carrier to provide health  care services from a preselected group of providers.(88) The limited list of providers means that the overall expense to the patient is lower than the expense of traditional insurance. Physicians entering into provider contracts with PPOs agree to accept both utilization review controls and financial risk shifting structures. Third-party payers give consumers economic incentives to use the PPO physicians through reduced fees for services.(89) Generally, local market conditions determine the organization of a PPO.(90) Most PPOs consist of a provider panel made up of preferred hospitals and physicians. The PPO employs fee schedules and utilization reviews that create a monetary incentive for consumers to choose the PPO provider, while leaving consumers free to choose their own providers.(91) A common feature among PPOs is the ability to efficiently process provider claims.(92) PPOs, however, can be organized in almost any form, and they are essentially unregulated.(93)

Despite the lack of definition, PPOs are classified according to sponsorship categories. (94) Another distinguishing feature is  the amount of risk that the PPO shifts to the provider. For example, in most full-risk PPOs, the PPO assumes the role of insurer and takes on all risk of loss. The PPO charges the employer a premium and covers all the services provided to the enrollee, including services offered at nonparticipating hospitals.(95) On the other hand, limited-risk PPOs assume only a portion of the financial burden and shift part of the risk of the enrollee's care to the provider.(96)


D. Summary 

Managed care products allocate financial risk in several ways, from the complete risk shifting of the health maintenance organization (HMO) to the varied risk shifting of the preferred provider organization (PPO). Nevertheless, both forms have the same goal: to reduce costs and increase profits by altering the practice behavior of providers.(97) Third-party payers reward or penalize providers based on the services they deliver, without regard to the quality of those services. Thus, there is a strong incentive for providers to control, for the financial benefit of the third-party payers, the care received by the covered patient. Whether that control will be detrimental to the overall quality of care remains to be seen. But, without a doubt, managed care products will be detrimental to some patients. 

In 1980, managed care products were begging for providers to enter into agreements with them. Today, it is not uncommon to see this situation completely reversed.(98) At least sixty percent of individuals with employer-sponsored health care plans  are enrolled in managed care products.(99) Furthermore, all types of individuals and entities are developing these products. (100)

Acute-care hospitals develop them as a device to maintain or increase their market share. (101) Physicians develop them to retain some control over health care delivery.(102) Insurers develop them to keep profits up and to protect market share.(103) Employers also develop managed care products to control costs.(104) Finally, entrepreneurs develop managed care products because "it appears to be a business in which one can make a profit."(105) Perhaps the only group not developing managed care products is the group most affected by the delivery of health services- patients. 

Efforts to control costs through limiting providers' expenditures will be magnified in the future because health care is an increasingly business- oriented activity. In the face of a third-party payer-driven delivery system, there is a need for either legal theories or a compensation system that particularly reflects institutionalized profit-seeking behavior. Otherwise, a third-party payer-driven system seems destined by its very structure to proceed at the expense of the patient's best interest.(106)

Go to: Third Party Cost Containment Meaurres





16. FN16. Paul R. Torrens, Historical Evolution and Overview of Health Services in the United States, in INTRODUCTION TO HEALTH SERVICES 3, 3 (Stephen J. Williams & Paul R. Torrens eds., 1980). 

17. FN17. See William L. Dowling & Patricia A. Armstrong. The Hospital, in INTRODUCTION TO HEALTH SERVICES 125, 127 (Stephen J. Williams & Paul R. Torrens eds., 1980). 

18. FN18. Moderate-sized cities had almshouses, which were also called poorhouses. These institutions primarily provided food and shelter for the homeless. Medical care was generally only a secondary function. Pesthouses operated as quarantine stations for persons with contagious illness. Usually, mentally ill persons received care at home, at the almshouse, or at the jail. See, e.g., id. at 126-28. 

19. FN19. Among the first voluntary hospitals were Pennsylvania Hospital, opened in Philadelphia in 1751; New York Hospital, New York City in 1773; Massachusetts General Hospital in 1816. Id. at 128. During the same time, governmental agencies established city, county, and state mental health hospitals, including ones at Williamsburg, Virginia in 1773; Lexington, Kentucky in 1817; and at Columbia, South Carolina in 1829. Id. 

20. FN20. Id. at 127-28. Voluntary hospitals were run as private charities. They were generally crowded and dirty. Most of the persons using them had contagious diseases, and nurses were usually former patients. Unpaid physicians worked out of a mixed sense of charity and the opportunity to practice their cures. Doctors charged medical students for medical training, and the students worked without pay, practicing and learning on the poor. Steven R. Owens, Pamperin v. Trinity Memorial Hospital and The Evolution of Hospital Liability: Wisconsin Adopts Apparent Agency, 1990 WIS. L. REV. 1129, 1131-32. 

21. FN21. Dowling & Armstrong, supra note 17, at 128. 

22. FN22. Id. 

23. FN23. See SYLVIA A. LAW, BLUE CROSS: WHAT WENT WRONG? 6 (1974); see also Dowling & Armstrong, supra note 17, at 131. 

24. FN24. The hospital industry developed the model state legislation necessary to create local nonprofit, tax-exempt corporations for prepayment of hospital services. See LAW, supra note 23, at 6-9; Dowling & Armstrong, supra note 17, at 131. 

25. FN25. See PAUL STARR, THE SOCIAL TRANSFORMATION OF AMERICAN MEDICINE, 215-16 (1982) (describing organized medicine's resistance to health insurance because of the potential for insurers to place themselves between patients and physicians). 

26. FN26. Id. 

27. FN27. Id. at 216-17. 

28. FN28. Id. at 306-09. 

29. FN29. In 1980, the Blue Cross and Blue Shield plans provided surgical coverage to 74 million individuals while all other companies insured about 101 million. In 1984, commercial insurers collected $43.6 billion in premiums and paid $33.3 billion in claims. During the same period, the Blue Cross and Blue Shield plans had $39.9 billion in subscription income and paid $35.7 billion in claims. Therefore, the commercial insurers paid 76.3 cents in claims of each dollar they collected in premiums. The Blue Cross and Blue Shield plans paid 90 cents of each dollar. Sylvia A. Law & Barry Ensminger, Negotiating Physicians' Fees: Individual Patients or Society? (A Case Study in Federalism), 61 N.Y.U. L. REV. 1, 7-8 n.31 (1986). 

30. FN30. See Minutes of the Eighty-Fifth Annual Session of the American Medical Association, 102 JAMA 2191, 2201 (1934) (recommending that there be "no restrictions on treatment or prescribing not formulated and enforced by the organized medical profession"). 

31. FN31. See J. LUNDY, HEALTH INSURANCE: THE PRO-COMPETITION PROPOSALS 4 (Congressional Research Service Report No. 81046, 1984). As part of employees' fringe benefits, most labor contracts now routinely include health care insurance. William B. Schwartz & Henry J. Aaron, Hospital Cost Control: A Bitter Pill to Swallow, HARV. BUS. REV., Mar-Apr. 1985, at 160-61 (describing development of health care "payment system expressly designed to shield patients and providers from the cost of hospital care"). 

32. FN32. STARR, supra note 25, at 313-15. 

33. FN33. An indemnity benefit pays patients directly. The insurance company sets premiums based on risk experience, allowing it to charge lower premiums to groups of reasonably healthy people. 

34. FN34. Blue Cross plans negotiated payment rates with participating hospitals. To the subscriber, the plans charged a single community-wide premium rating (community rating). The hospitals were guaranteed payments for the provision of selected services to the subscribers (service benefit). 

35. FN35. STARR, supra note 25, at 331-34. 

36. FN36. Congress established Medicare to provide medical care to the elderly. The patient's ability to pay was irrelevant. Social Security Amendments of 1965, Pub. L. No. 89-97, 79 Stat. 286 (codified as amended in scattered sections of 42 U.S.C.); see S. REP. NO. 404, 89th Cong., 1st. Sess. 4 (1965), reprinted in 1965 U.S.C.C.A.N. 1943, 1945-46. 

37. FN37. Medicaid, a cooperative state-federal program, provides health insurance to income-eligible individuals and families. 42 U.S.C. s 1396 (1988). 

38. FN38. Social Security Act, 42 U.S.C. s 13951(a) (1988). Reasonable charges are the lesser of the actual billed charge, the individual physician's customary charge, or the prevailing charge in the community. 42 C.F.R. s 405.502(a) (1993). 

39. FN39. 42 U.S.C. s 1302 (1988). The states' Medicaid payment levels to physicians may not exceed Medicare's reasonable charges. See Johnson's Professional Nursing Home v. Weinberger, 490 F.2d 841 (5th Cir. 1974) (upholding limitation of Medicaid payments to Medicare standard of reasonable costs). Regulations require physician reimbursement to be "sufficient to enlist enough providers so that services under the plan are available to recipients at least to the extent that those services are available to the general population." 42 C.F.R. s 447.204 (1993). 

40. FN40. Law & Ensminger, supra note 29, at 13. Under a fee schedule, Medicaid sets the fees that it will pay. Relevant to the range of physician fees, schedules can be set high, by using the higher physician fees, or low, by using the lower physician fees. States can adjust fees to account for the patient's diagnosis; the service provided; the physician's training, experience, and specialty; and whether the care was given in a hospital or an ambulatory setting. Id. at 12. 

41. FN41. Id. at 13. Charge-based reimbursement bases the payment to the provider on recent historical charges by the individual provider and her colleagues. Private insurance calls this "usual, customary, and reasonable reimbursement (UCR)," and Medicare calls it the "customary, prevailing, and reasonable charge method (CPR)." Id. at 12. When insurance pays charge-based reimbursement, it pays the least of the provider's actual billed charge, the median amount that she customarily charges for that procedure, or some percent of customary community charges for the medical specialty and geographic locality. Id. 

42. FN42. See generally Medical Technology Assessment: Hearings on H.R. 5496 Before the Subcomm. on Health and the Environment of the House Comm. on Energy and Commerce, 98th Cong., 2d Sess. 544 (1984) [hereinafter Hearings on H.R. 5496] (statement of Raymond Dross, M.D., on behalf of Health Insurance Association of America); OFFICE OF TECHNOLOGY ASSESSMENT, U.S. CONGRESS, MEDICAL TECHNOLOGY AND COSTS OF THE MEDICARE PROGRAM 45-61 (1984) [hereinafter COSTS OF THE MEDICARE PROGRAM]. 

43. FN43. COSTS OF THE MEDICARE PROGRAM, supra note 42, at 23. 


45. FN45. The fee-for-service system, euphemistically called the "free lunch" system, has delivered medical care without regard to cost containment and sometimes without regard to medical necessity. Under the fee-for-service system, third-party payers pay health care providers for each discrete item of service. In 1980, 50% of active physicians were compensated by fee for service, approximately 20% were salaried, and the remaining 30% received a mixed form of compensation. Sunny Yoder, Physician Payment Methods: Forms and Levels of Physicians Compensation, in REFORMING PHYSICIAN PAYMENT: REPORT OF A CONFERENCE 87, 88 (1984). 

46. FN46. Under cost-based or charge-based reimbursement, third-party payers reimburse providers for most of the costs or charges incurred in treating covered patients. 

47. FN47. Alexander M. Capron, Ethical Implications, Containing Health Care Costs: Ethical and Legal Implications of Changes in the Methods of Paying Physicians, 36 CASE W. RES. L. REV. 708, 715 (1986). 

48. FN48. When insurance induces a person to use more medical care than she would use if she were paying for the services directly, then the insurance is a "moral hazard" with respect to the person's indifference to cost. MARK A. HALL & IRA MARK ELLMAN, HEALTH CARE LAW AND ETHICS 8 (1990). 

49. FN49. "Experience rating" means that the annual recalibration of premiums will reflect each insured group's actual claims experience for the prior period. Mark A. Hall & Gerald F. Anderson, Models of Rationing: Health Insurers' Assessment of Medical Necessity, 140 U. PA. L. REV. 1637, 1671 n.131 (1992). With experience rating, the insurer has less incentive to refuse payment because all amounts it pays are recouped in next year's premium increases. 

50. FN50. See Capron, supra note 47, at 710-11 (stating that the payment system offers incentives for excessive intervention with overpriced procedures). 

51. FN51. Kartell v. Blue Shield, 582 F. Supp. 734 (D. Mass. 1984) (testimony of John Larkin Thompson, president of Massachusetts Blue Shield); Law & Ensminger, supra note 29, at 14. 

52. FN52. See supra notes 45-49 and accompanying text. 

53. FN53. See supra notes 48-52 and accompanying text. 

54. FN54. Corporate employers face increasing difficulty when competing in the international marketplace because of spiraling health care costs. Max W. Fine & Jonathan H. Sunshine, Malpractice Reform Through Consumer Choice and Consumer Education: Are New Concepts Marketable?, LAW & CONTEMP. PROBS., Spring 1986, at 213-14; Kenneth R. Wing, American Health Policy in the 1980's, 36 CASE W. RES. L. REV. 608, 672-75 (1986). 

55. FN55. The spiraling health care costs are pushing governmental programs to the brink of disaster. For example, it is predicted that by the mid-1990s Medicare will face bankruptcy. Board of Trustees Report, A Proposal for Financing Health Care of the Elderly, 256 JAMA 3379, 3379 (1986). State Medicaid programs consume excessive portions of limited state funds. Morreim, supra note 3, at 1720. 

56. FN56. See Jon Gabel et al., The Emergence and Future of PPOs, 11 J. HEALTH POL. POL'Y & L. 305 (1986). In 1989, private insurance and other private payers paid 37% of health care bills, government programs paid 42%, individuals paid 37% (premiums), and business paid 30% of the bills. HEALTH LAW. NEWS REP., supra note 3, at 3. During that year, 39% of the money went to hospitals, 19% to physicians, and 8% to nursing homes. Id. 

57. FN57. Harold L. Bischoff, Utilization Review and Health Maintenance Organizations (HMOs) (1989) (unpublished fellowship thesis, American College of Healthcare Executives, on file with the University of Puget Sound Law Review). 

58. FN58. See Alexander M. Capron & Bradford H. Gray, Between You and Your Doctor, WALL ST. J., Feb. 6, 1984, s 1, AT 24; see also infra note 60 and accompanying text. 

59. FN59. But see Tim Healy, High Stakes-For the Self-Insured- Health Costs Push Small Employers to Seek Alternatives, SEATTLE TIMES, Feb. 4, 1991, at B1. 

60. FN60. Medicare classifies each patient's hospital admission into one of 468 diagnostic groups. Medicare then multiplies the average price and "weight" of the procedure to predetermine the reimbursement the hospital will receive for the care given the patient. Michael Tichon, Current Issues in Reimbursement: Medicare and Medicaid, 6 WHITTIER L. REV. 851, (1984). From that payment, the hospital keeps, as profit, moneys not spent on patient care; alternatively, the hospital absorbs any loss. On the positive side, diagnosis-related groups limit hospitalization and the use of costly technologies. See Bruce C. Vladeck, Medicare Hospital Payment by Diagnosis-Related Groups, 100 ANNALS INTERNAL MED. 576 (1984). However, profit or loss potential creates an incentive for hospitals to discharge patients earlier and perform fewer interventions. Some providers have begun to stabilize the effect by "unbundling" care. See generally Arnold M. Epstein & David Blumenthal, Physician Payment Reform: Past and Future, 71 MILBANK Q. 193 (1993). 

61. FN61. Bischoff, supra note 57, at 3. 

62. FN62. Id. at 4. 

63. FN63. Eliminating first-dollar coverage has had limited effect on most patients. In general, unless the deductible is very high, the patient merely incorporates into her decision making only that portion of health costs that she is required to bear. Thus, if the patient must bear the first $300, only that amount affects her overall health care decision making. Such behavior is rational and predictable. Consider how our eating habits would differ if we had to pay only one fifth of our food costs. 

64. FN64. Despite the historical opposition by providers to risk shifting, the position of physicians and hospitals has been weakened by the current economic situation. One third of total hospital capacity is permanently idle, and patient days dropped from 280 million in 1980 to 240 million in 1984. By the mid-1990s, it is predicted that the number will drop to 120 million. There are now 2.2 physicians per 1,000 persons, 1.2 physicians more than needed. By the year 2000, it is predicted that we will have 1.5 more physicians than needed. Galen D. Powers, Allocation of Risk in Managed Care Programs, in MANAGED HEALTH CARE: LEGAL AND OPERATIONAL ISSUES FACING PROVIDERS, INSURERS, AND EMPLOYERS, at 279 (PLI Commercial Law and Practice Course Handbook Series No. 393, 1986), available in WESTLAW, TP-All File. 

65. FN65. Carolyn M. Clancy & Bruce E. Hillner, Physicians as Gatekeepers: The Impact of Financial Incentives, 149 ARCHIVES INTERNAL MED. 917, 917 (1989). 

66. FN66. See infra part III.B. 

67. FN67. The gatekeeping role is not new to physicians. They have used their position in several ways. For instance, physicians have used their authority as health care gatekeepers to resist hospitals' and insurers' efforts to influence medical treatment. Furthermore, they have generally used their role to obtain more services for the patient, not fewer. Now, however, they use their position to save money for third-party payers by ordering fewer services. See STARR, supra note 25 at 26-27; Capron, supra note 47, at 747. Thus, the fundamental change in the basic ethical concern of the system is revolutionary-from the "best interest of the patient" to "cost containment." 

68. FN68. Ossario, supra note 3, at 198; see Marc P. Freiman, Cost Sharing Lessons from the Private Sector, HEALTH AFF., Winter 1984, at 85, 86. 

69. FN69. For instance, insurance carriers increasingly attempt to identify inappropriate medical interventions. See, e.g., Capron, supra note 47, at 715. 

70. FN70. Essentially, third-party payers reduce provider pay by refining current payment methods, using explicit fee schedules, or bargaining for prices. Refining current payment methods, because it involves only modifying the calculation of the fee paid, provides the least radical change in third-party payer reimbursement. Explicit fee schedules have been used for basic medical expenses, and use of the schedules for provider pay would merely extend their current use. The third-party payer pays the lesser of the actual fee or the scheduled amount for the service. Under an explicit fee schedule, the provider is paid directly. Id. at 718. 

71. FN71. Third-party payers attempt to limit their payment for medical services by "bundling" services for reimbursement purposes. By using this payment method, third-party payers attempt to avoid the present excessive incentives to overtreat. Id. at 722. 

72. FN72. See Bischoff, supra note 57, at 4-5. 

73. FN73. DOUGLAS D. BRADHAM, HMO AND PPO OVERVIEW: HISTORY, DEVELOPMENT AND DEFINITIONS (Florida Bar 1989). There are five models of HMOs. The staff HMO model delivers services by a physician group that is employed by the HMO, with the hospital usually owned by the HMO plan. The group HMO model delivers services through an outside physician group under contract. Hospital services are usually contracted for as well. While the primary care network HMO model has multiple contracts with physicians, it is the primary care physician who controls all specialty referrals. The Individual Practice Association (IPA) HMO model delivers services through independent practices. These practices can be solo or group practices that have organized to pool the financial risk. The open-ended HMO allows enrollees to select services outside the HMO provider staff, network, or IPA, but coverage is at the traditional indemnity rate and is typically less comprehensive and more expensive than the HMO's standard package. Id. at 1.5-1.6. Methods of payment to a provider are based on the model used. Staff models use salary-based payment almost exclusively; IPA models use both capitation and fee for service; network models use capitation; group models are split among all three. See id. 

74. FN74. Id. at 1.2. 

75. FN75. Id. at 1.1. But see Sarah Glazer, The Failure to Contain Medical Costs, 2 EDITORIAL RES. REP. 510, 511 (1988) (giving Dr. Michael A. Shadid the credit for establishing the first prepaid group practice in 1927, also in Oklahoma). 

76. FN76. BRADHAM, supra note 73, at 1.1. The Ross-Loss Health Plan is the oldest HMO still in existence. Milton H. Lane, Legal Relationships and Responsibilities in HMOs, HEALTH CARE MGMT. REV., Fall 1983, at 53. 

77. FN77. BRADHAM, supra note 73, at 1.1. 

78. FN78. Glazer, supra note 75, at 511 (quoting STARR, supra note 25, at 302). 

79. FN79. For instance, in the 1930s, in response to a shortage of medical facilities for construction workers, Kaiser Health Foundation Plan originated an HMO in connection with the construction of an aqueduct near Los Angeles, California. The HMO started as a series of capitation agreements with area physician groups under which the group was paid $1.50 per month for each covered employee. As of March 1988, it was the largest prepaid plan in the United States with 4,904,768 members in five states. Jack F. Monahan & Michael Willis, Special Legal Status for HMOs: Cost Containment Catalyst or Marketplace Impediment?, 18 STETSON L. REV. 353, 359 n.21 (1989). 

80. FN80. Health Maintenance Organization Act of 1973, 42 U.S.C. ss 300e- 300aaa (1988). An HMO is defined under the legislation as an organization that provides health services to members in specific geographic areas in return for periodic, fixed prepayment. Id. s 300e. The prepayment is fixed without regard to frequency, kind, or duration of service. Id. s 300e(b)(1). An HMO must (1) assume full financial risk on a prospective basis for the services provided to its members; (2) maintain a "fiscally sound operation"; (3) protect its members from liabilities of the organization; and (4) provide commercial members a comprehensive package of health services, which was specifically prescribed in the legislation. Id. s 300e. Until the HMO Amendments of 1988, Pub. L. No. 100-S17, 102 Stat. 2578 (1988), HMOs were required to use community rate premiums for commercial members. Since 1988, however, HMOs are permitted to develop premiums on the basis of their revenue requirements for providing services to individuals and families of a group. 42 U.S.C. ss 300e-300q (1988); 42 C.F.R. s 417.104 (1992). Finally, the HMO Amendments of 1988 require employers to make an equal contribution to HMO and other health benefit options and forbid employers to financially discriminate against employees who enroll in an HMO. 42 U.S.C. s 300e-9 (1988). Nothing, however, prevents an employer from financially discriminating against an employee who does not enroll in a managed care product. 

81. FN81. Monahan & Willis, supra note 79, at 359. 

82. FN82. The number of HMOs rose from 290 to 648 between 1983 and 1988, and enrollment expanded from 13.7 million to 31 million members, averaging a 25% increase per annum. Id. at 360 n.27. 

83. FN83. Barry R. Furrow, The Changing Role of the Law in Promoting Quality in Health Care: From Sanctioning Outlaws to Managing Outcomes, 26 HOUS. L. REV. 147, 151 n.16 (1989). 

84. FN84. Health Maintenance Organization Act of 1973, Pub. L. No. 93-222, 87 Stat. 924 (codified as amended at 42 U.S.C. s 300e (1988)). This Act delineates the requirements an HMO must meet to become federally qualified according to organizational structure, health care benefits, and the manner of conducting business. Though federal qualification is not intended to represent that the HMO is financially viable, qualification is necessary to receive federal subsidies under the Act. Compliance also serves as a means to demonstrate publicly that the HMO has complied with a federally uniform standard. 

85. FN85. While the approach to legalizing HMO authority varied, some states required insurance providers to have a license to market their services. E.g., TEX. INS. CODE ANN. ss 20A.03-20A.06 (West 1993); WIS. STAT. ANN. s 609.01(2) (West Supp. 1993). Other states required licensing to solicit members and operate. E.g., Knox-Keene Health Care Service Plan Act, CAL. HEALTH & SAFETY CODE ss 437.02, .12 (West 1990). All states have generally exempted HMOs from state restrictions regarding the corporate practice of medicine. But see Williams v. Good Health Plans, Inc., 743 S.W.2d 373, 378 (Tex. Ct. App. 1987) (noting no liability for IPA because it could not practice medicine in Texas). 

86. FN86. Robert B. Friedland, Introduction and Background: Private Initiatives to Contain Health Care Expenditures, in THE CHANGING HEALTH CARE MARKET 15 (Frank B. McArdle ed., 1986). 

87. FN87. Monahan & Willis, supra note 79, at 361. 

88. FN88. See generally Cheralyn E. Schessler, Liability Implications of Utilization Review As a Cost Containment Mechanism, 8 J. CONTEMP. HEALTH L. & POL'Y 379 (1992). 

89. FN89. Greg de Lissovoy et al., Preferred Provider Organizations: Today's Models and Tomorrow's Prospects, 23 INQUIRY 7, 7-8 (1986). Monetary incentives to the patient effectively obviate freedom of choice. If a patient is unable to pay the difference, she will have no choice but to utilize the preferred provider. Approximately 20 states have attempted to resolve this issue by passing laws that limit the reimbursement differential between PPO and non-PPO utilization. It is unclear whether such limitations protect freedom of choice, as the protection limits the effectiveness of managed care products. Norman Payson, A Physician's Viewpoint on PPOs, 6 WHITTIER L. REV. 699, 699-705 (1984). 

90. FN90. Peter Boland, Myths and Misconceptions About Preferred Provider Arrangements, in THE NEW HEALTH CARE MARKET 500, 501 (Peter Boland ed., 1988). 

91. FN91. Nine states (California, Florida, Indiana, Louisiana, Michigan, Minnesota, Nebraska, Virginia, and Wisconsin) have laws that permit prepaid health plans that limit choice of provider. Fifteen states have pending legislation. Congress is also considering legislation that would override state laws inhibiting managed care health plans. Capron, supra note 47, at 721 n.39. 

92. FN92. De Lissovoy et al., supra note 89, at 7. 

93. FN93. Of the 51 jurisdictions, only 20 states have a regulatory scheme for PPOs. E.g., LA. REV. STAT. ANN. ss 40:2201-40:2205 (1992); NEB. REV. STAT. s 44-4106 (1988); N.C. GEN. STAT. s 58-65-1 (1991). Some states have indirectly regulated managed care products. For example, Indiana enacted a law that forbids an insurer from unreasonably discriminating against providers not willing to meet the terms of the agreement offered to them. IND. CODE s 27-8- 11-3 (1992). California forbids exclusion from membership based on the category of the license. CAL. INS. CODE s 10133.6 (West 1993). 

94. FN94. A 1986 national survey of PPOs classified them as (1) hospital sponsored (including corporate hospital chains and joint sponsorships by hospitals and physicians); (2) physician sponsored (including physician groups); (3) commercial insurance sponsored; (4) Blue Cross/Blue Shield sponsored; (5) investor (entrepreneurial) sponsored; and (6) sponsored by other entities, such as union trusts. Cathy L. Burgess, Comment, Preferred Provider Organizations: Balancing Quality Assurance and Utilization Review, 4 J. CONTEMP. HEALTH L. & POL'Y 275, 277 (1988). 

95. FN95. Powers, supra note 64, at 290-91. 

96. FN96. Id. at 290; see infra part III.B. 

97. FN97. Initially, managed care products were perceived as a combination of providers offering discounts from customary charges and retrospective utilization review programs for medical procedures and ancillary testing. Richard A. Hinden & Douglas L. Elden, Liability Issues for Managed Care Entities, 14 SETON HALL LEGIS. J. 1, 2 (1990). Although a significant portion of the marketplace still views managed care as discount medicine, today's managed care products have evolved into entirely different entities where the organization actively sets the parameters of medical practice. Id. at 2-3. 

98. FN98. Robert G. Stevens, Managed Care Plans and Participating Provider Agreements 3 (1991) (unpublished manuscript, on file with the University of Puget Sound Law Review). 

99. FN99. Id. 

100. FN100. One author has commented with dismay on the number of "inexperienced people" entering the "business" of managed care. Ossario, supra note 3, at 198 

101. FN101. Richard Blacker, Preferred Provider Organizations, 6 WHITTIER L. REV. 691, 692 (1984). 

102. FN102. Id. at 692-93. The fact that physicians control the managed care organization does not change the underlying analysis regarding liability. The underlying purpose to control cost remains and the physician's behavior will be essentially the same as other owners. 

103. FN103. Id. at 693. 

104. FN104. Id. 

105. FN105. Id. 

106. FN106. For example, on legal and operational issues facing providers, insurers, and employers, one commentator noted that changing physician practice patterns is more important than thwarting outliers. Joseph J. Martingale, Cost Containment Mechanisms: The Tools of the Managed Health Care Revolution, in MANAGED HEALTH CARE: LEGAL AND OPERATIONAL ISSUES FACING PROVIDERS, INSURERS, AND EMPLOYERS (PLI Commercial Law and Practice Course Handbook Series No. 393, 1986), available in WESTLAW, TP-All File. Outliers are services or patterns of practices that fall outside established norms. In general, outliers are statistical observations that are so far away from the rest of the sample that they should be disregarded in statistical calculations. See THOMAS H. WONNACOTT & RONALD J. WONNACOTT, INTRODUCTORY STATISTICS 417 (1972). 

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Professor Vernellia R. Randall
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The University of Dayton School of Law
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