Thursday 17 January 2019

WSJ exposes corrupt hospital practices that inflate healthcare bills

Last year, I discussed how corrupted incentives have acted to inflate drug prices well above what would have occurred in a properly functioning market. As noted at the time, this is just one small piece of the complex puzzle of why US healthcare costs remain so absurdly high (18-19% of GDP, more than twice the OECD average, which is itself far from optimised, and continues to rise).

In December, the WSJ ran an excellent article/expose on another feature of the system that is well worth discussing. I highly recommend the article be read in full (paywall). The article highlights how increasing market consolidation and 'vertical integration' amongst hospital networks into the provision of primary healthcare services, coupled with a third-party payer system and a lack of price transparency, have all contributed to the cost of labs tests and other tests & procedures all being grossly inflated.

I had a look at hospital group HCA in the US briefly in late 2017, when it was under US$80. I even bought a small amount. It looked cheap (about 10x PE - albeit with very high leverage). The basic thesis was that reforming healthcare was going to be too hard, so whatever fears people had about declining profitability was likely to be overblown, while its multiples seemed too low for a company with a strong market position, defensive earnings, and demographic tailwinds. However, as I looked a bit more closely, even I became uncomfortable with the fact that its EV/bed was more than twice Australia's Ramsay Healthcare - a best in class operator that at the time was trading at 30x PE (with significantly lower leverage).

Some serious funny business was going on, and I didn't feel I yet fully grasped the issues. It was only a very small position, and given the high level of leverage, I though there were better and lower risk opportunities elsewhere at 10x earnings. I sold at a small profit. I shouldn't have, however. The stock has since risen to US$130.

The WSJ article sheds some light on one aspect of the grossly unethical profiteering which is currently going on throughout the US healthcare industry. With respect to this aspect of the problem, here is how it works:

Hospital groups have been acquiring networks of 'primary care' providers, and thereby vertically integrating. Primary care GPs are a patient's first port of call when felling ill. They go to their local 'family doctor' when they are not feeling well, or are seeking a general check up. Primary care operations can therefore be a very attractive 'customer acquisition' channel for hospitals.

Naturally, patients defer to doctors' opinions. If the doctor thinks a blood test is required, or an MRI scan is needed, etc, seldom is the doctor's opinion going to be second-guessed (short of complex surgery being recommended), nor will the purchase of any recommended drugs be challenged. Furthermore, the friendly doctor will be happy to provide helpful referrals to pathology labs, pharmacies, and medical imaging equipment conveniently located at nearby (affiliate) hospitals, and the customer will in most cases have absolutely no inclination to question this referral or shop around. They trust their doctor; are not aware of superior alternatives; and in the vast majority of instances, will not be paying for the treatment in any case (the tab will typically be picked up by a private insurer or the government).

The article highlights that hospital groups have been pushing into primary care with the clear intention of increasing in-house doctor referrals to company owned pathology labs and other diagnostic equipment, etc. While explicitly demanding or financially incentivising in-house referrals is illegal - referrals officially need to be in the best interests of the patient - it is very clear that there are a number of 'soft' or unofficial ways hospitals can can 'encourage' doctors to refer patients in-house for tests and treatment, rather than to external provider groups.

Doctors are not stupid people, and they are also well paid, and like many well-paid people with a lot to lose, they are keenly aware of and alert to risks that might threaten to derail the gravy train. Consequently, when their managers send performance reports that clearly show their in-house referral percentage is being tracked, even though their remuneration is not explicitly tied to referrals, they will be all too aware of the game being played. Furthermore, while many doctors do care about the quality of care their patients receive, what they don't care about is the cost, as in most cases their patients are not paying for it themselves. Consequently, because most (but not all) of the time the quality of an in-house service is not going to be markedly inferior to those of external providers (particularly for standardised, commoditised services like an MRI scan or pathology blood test), it is not that difficult for a doctor to 'play ball' and still feel like they are giving their patients due care.

If the customer is going to get a roughly equal quality of care; the in-house price is much higher but somebody else pays; and it's good for the doctor's career and income prospects to refer in-house, it is pretty obvious what is going to happen most of the time. The bottom line is that by capturing the primary care entry-point, and then effectively incentivising network GPs to refer patients to in-house services, hospital groups have been able to not only boost volumes, but also hike prices on these referred services virtually without restraint.

One might initially think that private insurers and government agencies would push back against reimbursing prices for services that are clearly inflated. However, as I discussed at greater length in my article on drug prices, insurers don't mind paying more as long as every other insurer pays more as well, because that allows them to charge higher premiums, which in turn, ultimately allows them to earn more money. And this hospital vertical integration game has been played throughout the country by hospital groups everywhere, which has driven an across the board rise in prices. Furthermore, the government typically assesses the 'cost' of providing a service with reference to average prevailing prices across the industry (and confuses 'price' with 'cost'), and the level of price transparency is also woeful - and deliberately so (as it facilitates overcharging).

Furthermore, hospital groups have been consolidating at the hospital level as well (as well as vertically integrating into primary care), to the point where single hospital groups often control a large number of hospitals in a given geographic area. There is also a very clear commercial rational for this as well. It extends beyond the fact that people usually seek hospital services close to where they live (so relatives can come to visit, for e.g.), to the fact that if you control a large percentage of hospitals in a given area, and establish a well-known brand, it becomes extremely difficult for insurance companies to exclude your hospital group from their coverage. The exclusion of such a high profile hospital group would not only make the insurance coverage appear inferior, but also make the employer - who typically pays for the insurance on behalf of its employees (and then effectively deducts it from their paychecks) - look stingy. Who wants their employees to think they have an employer that is 'cheap' and who is only prepared to offer second-rate health insurance that excludes some of the most well-known provider networks from its coverage?

What this means in practice is that these hospitals have been freed from any pricing restraint on in-network referred services, and predictably, have done what any company with unconstrained pricing power does - raise prices. As the article notes, the price of many referred services is often double or more the cost available elsewhere. In some cases the cost of an MRI can be ten times as high in-network as is able to be procured independently (it can sometimes cost US$3k for an MRI scan - a totally absurd price). This acts to significantly inflate the overall cost of care.

Furthermore, not discussed in the article is that price is not the only potential issue. There is also a clear incentive to over-prescribe tests, drugs, and treatment, and because people trust their doctors and someone else is paying, these recommendations are seldom questioned. The excellent book Overdiagnosed: Making People Sick in the Pursuit of Health (Gilbert Welch) discusses the broadbased tendency towards over-treatment in recent decades, in everything from cancer scans, drugs, to full-blown operations.* Studies have been done showing that no matter what the level of healthcare infrastructure per capita in the US (e.g. hospital beds, MRI machines - sometimes varying very significantly from state to state), utilisation levels are always about the same. I don't buy the argument that that is because the industry is so efficient at matching demand with supply: it more likely reflects hospital groups being very effective at 'driving utilisation' through their (GP) 'sales channels'. Scary indeed - particularly if you live in a region with (what should be) excess capacity.

Many GPs are highly ethical people. However, their KPIs are going to look bad if they are under-prescribing treatment - they will be less profitable to the hospital groups they work for. This creates the incentive for hospital groups to pay them less, or even replace them, and the less ethical companies that are more willing to do that are likely to grow faster and be more profitable. This will provide them with superior financial resources to acquire more ethical (but less profitable) groups, and 'extract synergies' by 'improving management practices'. This is an example of how market forces can become terribly perverted, and where the incentives can act to ensure that the least ethical companies and individuals end up with the largest markets shares and market power. It all but ensures a bad outcome, as there will always be at least a few bad actors, and they will be able to grow and flourish.

So in short, we have a combination of both excess care and inflated prices, and that's how you end up with healthcare costs consuming an absurd share of GDP, at 18-19% (by way of comparison, Singapore achieves better health outcomes at 4% of GDP). And the vertical integration of primary care and hospital groups - as well as the consolidation in regional hospital groups that has been allowed to occur - is one key element of the problem. The incentives and practices in the US healthcare industry are so bad they make the financial industry look good.**

This sorry state of affairs requires much sterner regulatory action. Many healthcare reforms are needed, but making it 100% illegal for hospital groups to provide primary care services would be a good start. Pathology labs and pharmacies should also have to be 100% independent from both hospitals and GP networks. Making it illegal for explicit payments/kickback/financial incentives to be paid for referrals is not enough for in-house primary care practices, because there is too much scope for 'soft' pressure to yield the same de facto outcomes (as the WSJ expose clearly highlights).

In addition (1) greater price transparency is needed; and (2) there needs to be at least a small amount of 'skin in the game' for the paying consumer (so that greater transparency actually matters). When referred to a pathology lab for a blood test, for instance, the customer should have to pay, say, 10% of the cost (a 'deductible'), and should be given a full list of providers in the area (and beyond) and the price charged, so they are free to choose the cheapest one. And consolidation in the pathology space, in this example, should also be restricted, to ensure the existence of a competitive market.

Sadly, I have very little confidence this will happen, at least in the foreseeable future. It is possible that as healthcare costs continue to mushroom to completely unsustainable levels, action will eventually be forced. However, every time reforms have been attempted in the past, they have simply made the situation worse, as the issues and incentives are poorly understood by the people and politicans involved in attempting to institute change.

Usually, they are people motivated primarily by increasing access to care, who understand little about incentives and take for granted that healthcare is 'unaffordable' to the average person (whereas in a well functioning market, the average person would be able to afford most care, baring complex treatment/operations), and who view calls for reform as synonymous with calls to reduce access to care, which they naturally resist. I don't know what the solution is, but there is clearly a huge problem.


*For example, a lot of small tumours that are discovered via scans and surgically removed ought not to be - everyone has small cancers in their body at all times; most of the time they don't grow - even over many decades - to levels that threaten health. However, with more and more powerful diagnostic equipment, the industry has got better and better at finding tiny, non-threatening cancers, and then recommending dangerous and expensive operations (often with terrible side effects) to remove them. The industry is incentivised to do this because it gets paid on a per-procedure basis.

**In recent times, there has been regulatory scrutiny of financial planning groups referring customers to expensive in-house investment products, which is very analogous to what is happening with vertically integrated GP and hospital groups. There have recently been some calls to outlaw this type of vertical integration in financial services (e.g. in Australia, following the Royal Commission). However, the level of overcharging amongst financial planning groups is usually significantly less than the outright gouging seen in the healthcare industry; there is far greater levels of transparency on pricing; and the intangible costs are less severe (e.g. vs unnecessary surgery).