Is fee-for-service the problem?

August 24, 2010
John Goodman, PhD

Almost everyone says that it is. Conservatives. Liberals. Republicans. Democrats. A vast swath of the health policy community. With near unanimous agreement among everybody who knows anything about health economics, how could we even ask the question?


Trouble is, all these people are wrong.

We pay for most things fee-for-service. Or, more precisely, the payment mechanisms that are predominant in health care are widespread in almost every other market.

By fee-for-service, we mean that units of service are individually priced. The more you consume the more you pay. This is usually contrasted with capitation - under which the fee is independent of the quantity consumed. Under fee-for-service, doctors are said to have an economic self interest in overprovision, since the more the patient consumes, the higher the doctor’s income. Under capitation, by contrast, the doctor gets the same income, regardless of the amount the patient consumes. Under capitation, doctors are said to have a self interest in under-provision.

How do these payment mechanisms work in other markets?

Take the restaurant industry. Most things on a common menu are priced fee-for-service, but not everything. There is typically one price for tea, but unlimited refills at no charge.  Think of this as explicit capitation. Other items (condiments, butter, rolls, water, etc.) are available in unlimited quantities with no charge. Think of this as implicit capitation, since the average per-customer cost is embedded in each customer’s overall bill. Another thing that is implicitly capitated in a restaurant is time. Not your time, but the time of the restaurant staff. You can usually stay at a table indefinitely - with no extra charge.

At a lawyer’s office, these same payment mechanisms are employed, but in different ways. The lawyer’s time is typically sold fee-for-service, while such items as paper, ink, materials, secretarial time, etc. are usually implicitly capitated. Paralegal time might be priced either way.

At the doctor’s office, things are reversed. The doctor’s time is implicitly capitated, while something called a “visit” is sold fee-for-service. But in many ways this is a misnomer. “Doctor visits” are usually discrete capitated events. That is, each visit requires a fixed fee that is fairly independent of the amount of time the doctor actually spends with the patient (although the fixed fee usually varies by what is judged to be the complexity and intensity of the service). Additional services, such as X-rays, vaccinations, etc., are usually priced fee-for-service, while such items as bandages, etc. are explicitly capitated. If we extend from one-visit-one-fee to X-number-of-visits-for-an-annual-fee, you have the typical (capitated) arrangement offered by a concierge doctor.

Which brings us back to square one. If there is nothing particularly special about the payment mechanisms, what is it that makes health care different? There are three things: (1) third-party payment of the bill, (2) rationing by time and not money, and (3) an inability on the part of providers to repackage and reprice their services.

A restaurant can change its payment mechanisms at the drop of a hat. The restaurant can price side dishes ala carte or package them with the entre. It can have an all-you-can-eat (capitated) salad bar or it can sell salads (fee-for-service) plate by plate. It can even employ both pricing schemes in the same restaurant at the same time. 

But whatever combination of payment mechanisms it employs, the restaurant is still competing for customers on price and quality. The restaurateur has a self interest in meeting customer needs in the most economical way.

In general this is not true in health care. On the average, we pay only 10 cents out of pocket every time we spend a dollar at a doctor’s office, and 90% of Medicare patients, almost all Medicaid patients and many privately insured do not even pay the 10 cents. That means we predominantly pay for care with our time, not with our money. As a result, doctors don’t compete for patients on the basis of price. And because they don’t compete on price, they don’t compete on quality either.

Even if they tried to do so, health care providers are trapped in a system in which they cannot repackage and reprice their services in patient-pleasing ways. For example, third-party payer bureaucracies prevent doctors from pricing their services the way lawyers do - charging their time out on a fee-for-service basis, but explicitly capitating other services.

In such a world, providers will naturally tend to try to maximize against third-party reimbursement formulas. There is no other way, after all, for them to increase their income. In response, the third parties try to minimize their payout.  Both sides will use their intelligence, creativity and innovative ability in institutionalized warfare that has only tangential relationship to low-cost, high-quality care.

Bottom line: The fundamental problem in health care is not that we are using too much of one payment mechanism and too little of another. The problem is that the person who benefits from the service is not the same as the person who pays the bill.