Applying Health Economics to Managerial Decision Making

By Yunwei Gai

Cost Reduction and Incentive Creation

The main objective of health economics is to create incentives for individuals (and, thereby, for nations, as a whole) to achieve the highest level of health for each dollar of care purchased. Reaching this goal is trickier than you might expect because it requires adjustments of various inputs in our health care system, and one of the most important adjustments is the resource we allocate to prevention vs. treatment. In general, it is our unwillingness to address and accept compromises that has become a major source of our health care problems of the 21st century.

Look at the numbers. Each person in the United States spends about $7,500 per year in health care, which cumulatively amounts to more than 17 percent of our GDP (1). This spending is far more than that of any other country in the world, and it might be justified if the United States were the healthiest nation in the world, but it is not. In terms of life expectancy, we rank 50th among other nations (2). There are many explanations, and high on the list is U.S. inefficiency caused by its low emphasis on prevention and heavy reliance on treatment.

It is difficult to understand why basic principles of management, which are used readily in most other industries, have not been adopted by the health care industry. Most managers realize that goods can be produced using varying combinations of inputs, such as labor and capital. The mixture chosen depends on their relative prices and respective levels of output. Prevention and treatment are two inputs in the production of health, whose proportion in the health production process also should depend on their relative prices and levels of effectiveness, but it is not.

An example may help to clarify the problem. Based on data from Centers for Disease Control and Prevention (CDC), 24/7 Wall Street estimated that in the United States during 2010, the top 10 causes of death accounted for 75 percent of the nearly 2.5 million deaths and cost more than $1.1 trillion to treat them (3). There are many underlying causes of these deaths such as environment, genetics and lifestyle. Some of these underlying causes can be prevented, thereby reducing the expenditure for treatment. Among preventable causes, you will often find them to be poor diet, physical inactivity, misuse of alcohol, and smoking (4). The common denominator among them is that they are behavioral (not congenital)—and, therefore, preventable. Think of how much it costs each year to treat ailments such as coronary heart disease, Type 2 diabetes, and hypertension. Then, think of what else could be done with this $150 billion in annual spending if we can find a way to reduce these preventable diseases (5).

While you are thinking of costs (and I hope you are thinking big costs), consider the additional benefits that prevention offers by improving workers’ health, well-being, self-image, and productivity. Reputable studies suggest that health-related reductions in productivity can be two to three times larger than the direct costs of treatment. If this is true, then the yearly knock-on benefits of prevention amount to almost $450 billion (6). Anecdotal stories are plenty. In 1991, Bank of America initiated a health promotion program among its retirees at a cost of $30 per retiree per year. Over a 12-month period, retirees in the program lowered their insurance claims by $164 per person, while those not in the program had an increase of $15 per person in their claims (7). In 1994, Citibank started a comprehensive health management for its 11,194 employees. Evaluated over 38 months, the program generated savings between $4.56 and $4.73 for every dollar spent on the program (8). In 2002, Highmark launched a comprehensive health promotion program to its employees. In the course of a 4-year period from 2002 to 2005, the program cost $808,403 and led to total savings of $1,335,524 in health care expenses, yielding a return on investment of $1.65 for every dollar spent (9). A recent study summarizing past employer-provided wellness and prevention programs found that, for every dollar invested over a three-year period, the return on investment ranged from about $1.40 to $4.70 (10).

Without effective prevention and lifestyle changes, 42% of Americans seem destined to be obese, and 11% will be severely obese by 2030 (11). Despite the dire consequences, both in terms of financial burden and decreased quality of life, only 2 to 3 percent of health care spending is used for prevention, which is a miniscule amount compared to spending on treatments for condition that could have been prevented (12).

You might be asking yourself, if we know that the problem’s cause is an incorrect resource allocation on prevention and treatment, then why can’t we come up with incentives to correct the distortion? One of the main reasons is that health care is a complicated system, composed of many players such as insurance companies, federal and state agencies, health care providers, employers, individual employees and patients. To correct the distortion requires changes for each player as well as coordination among them.

For example, health insurance companies in the United States often face a high turnover rate. That is, their enrollees change insurance providers, mainly due to switching jobs or employers. Although preventive care brings savings to insurance companies eventually, the financial benefits accrue in the future over a period of time. When enrollees change health plans, some of the financial benefits to an insurer will be lost and the insurer may end up paying the costs of preventive care without fully enjoying the benefit (13). As a result, health insurance companies may hesitate to provide and reimburse preventive care services.

Another major player in the system, namely, health care providers including nurses, physicians, and hospitals may provide less than ideal amount of preventive care because they are generally reimbursed for their services on treatment while prevention related services are either compensated at low levels or not at all. Another bottleneck for increasing the utilization of preventive care is the shrinking supply of primary care physicians, whose time is already stretched thin. While other developed countries have at least 50 percent of their physicians specialized in primary care, the U.S. has less than 30 percent. During the past decade, less than one in five U.S. medical graduates chose primary care medicine (14). Even with the introduction of free preventive services under the 2010 Patient Protection and Affordable Care Act, we will not increase the use of prevention significantly without addressing the reimbursement system and the supply of primary care physicians.

Although workplace wellness and prevention programs have respectable returns on investment, adoption of such programs has not been universal. While 77 percent of large manufacturing companies offer formal health and wellness programs, less than 30 percent of small businesses offer some of them because they (and other similar preventive care services) often require substantial up-front costs, but their benefits may be uncertain and are likely to accumulate over time, rather than immediately (15).

Given the low survival rate of small businesses and their employees’ high turnover rate, return on investment from such programs is likely to be small or even negative for some small businesses. Herein lies another distorted incentive. Although workplace wellness and prevention programs improve workers’ health and create long-term social benefits, small business owners are unlikely to offer them. One solution to this impasse is for owners of small businesses to seek external funding, for example, from insurance companies, as well as local and federal governments. This funding could cover some of initial costs and allow the businesses to enjoy benefits without hurting their bottom lines. Insurance companies, such as Blue Cross Blue Shield, already offer wellness programs at no cost or very low cost to small businesses, offering lower insurance premiums or cash awards for participating businesses. Many states offer support for these programs by offering partial reimbursement or grants. To this end, the 2010 Patient Protection and Affordable Care Act authorized the appropriation of $200 million for small businesses to create comprehensive workplace wellness programs.

What types of wellness and prevention programs should be offered at the workplace is another key issue. Although studies have shown that diet counseling, increased physical activity, tobacco-use screening and intervention, cancer screening, and immunization are among the most cost-effective preventive services and wellness programs, there are no clear answers on the optimal design for different industries and firms. Labor-intensive manufacturing industries clearly face different health and behavioral risks than office-based workplaces. Until we accumulate more information, this heterogeneity remains, somewhat, a trial-and-error process.

Another important incentive question managers need to consider is how to properly motivate employees to participate in these programs, which often requires difficult behavioral changes such as healthy diets, more exercise, and less smoking. These lifestyle changes are, typically, harder to follow than taking a regular flu shot or measuring for high blood pressure. Many firms offer cash incentives, gift-card rewards, or reduced insurance premiums for employees who participate and achieve certain outcomes. Safeway, for example, differentiates employee contribution in insurance premiums based on their tobacco usage, weight, blood pressure, and cholesterol levels. Although Safeway’s approach and incentives adopted in other companies are not without controversies, their experiences do demonstrate that properly designed workplace wellness and prevention programs combined with right incentives improve employees’ health and productivity; reduce direct and indirect health related costs; and create social benefits by altering the combination of prevention and treatment in health care production.

Transitioning the United States from a treatment-based to a prevention-based health care system is a difficult task (some would say forbidding) but, at the same time, offers a golden opportunity for business and social entrepreneurs to exercise and demonstrate their limitless ingenuity. People respond rationally to well-designed incentives; so the key is finding the proper mixture of incentives to accomplish the broad-based goal of moving the United States from where it is now to where it could be. Clearly, the stakes are high because they have life-or-death consequences. In my opinion, the implications and resulting actions of this effort are among the most important we face and also among the most rewarding that we as a society should strive to accomplish.


The author is an Assistant Professor of Economics at Babson College. His current research focuses on insurance gaps and chronic condition management; impacts of health insurance on entrepreneurship activities; and the importance of preventative health care.

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