A new study in Health Affairs is attracting attention for its depiction of how powerful hospitals are extracting “steep payment increases” from insurers. But what the study really tells us is how much the exceptional cost of American health insurance is caused by our system’s original sin: the fact that, due to a quirk in the

federal tax code, most of us don’t buy insurance for ourselves, but instead have it bought on our behalf by our employe

“In the constant attention paid to what drives health costs,” the authors begin, “only recently has scrutiny been applied to the power that some health care providers, particularly dominant hospital systems, wield to negotiate higher payment rates from insurers.” If you’re a regular reader of The Apothecary, you know from where some of that scrutiny has come. And hence, you won’t be surprised to learn that the Health Affairs study does indeed find that powerful hospital systems have the power to dictate prices to insurers.

“Must-have” Hospitals Possess Pricing Power
There are some predictable nuances to the authors’ findings, which are based on the Community Tracking Study from the Center for Studying Health System Change. (The study’s lead authors, Robert Berenson and Paul Ginsburg, hail from that institution.) The authors found that top-tier, “must-have” hospitals had the strongest leverage over insurers. These are the brand-name hospitals, like Harvard-affiliated Partners HealthCare in Boston, that insurers have a tough time leaving out of their provider networks. Second-tier hospitals that provide unique services, like organ transplantation, have some leverage over insurers, but not as much as the “must-haves.”

Third-tier hospitals—typically community hospitals and Medicaid-oriented safety-net institutions—had the least amount of leverage. The Community Tracking Study conducted 539 interviews with local health care leaders in 12 metropolitan areas, from March-October 2010: Boston; Cleveland; Indianapolis; Little Rock; Miami; Phoenix; Seattle; Greenvile, S.C.; Lansing, Mich.; northern New Jersey; Orange County, Calif.; and Syracuse, N.Y.

Insurers have been responding to hospital consolidation with their own. In many areas, a single carrier—often Blue Cross Blue Shield—has dominant market share, which, in theory, allows the insurer to compensate for hospitals’ market power. But a secondary finding of the Health Affairs study—and, arguably, its most important one—was that these dominant insurers were not using their market power to get tough with hospitals.

“Even in markets with dominant Blue Cross Blue Shield plans—in our sample, these markets included Boston, Greenville, Indianapolis, Little Rock, Lansing, and Syracuse—respondents thought that hospital negotiating strength was growing. Perhaps more important, dominant Blue Cross Blue Shield plans were perceived as not using all of their potential bargaining power.”

Why is it that these dominant insurers are rolling over when powerful hospitals demand higher prices? It’s quite easy to explain.

Fourth-party Insurance is Worse Than Third-party Insurance
The fundamental cause of this problem is the fact that only 10 percent of Americans with health insurance buy it for themselves. Due to an artifact of World War II-era wage controls, if employers take money out of your paycheck and use it to buy health insurance for you, you don’t pay income or payroll taxes on those funds. However, if you decide to buy insurance for yourself, you have to do so with after-tax dollars. As I described in a 2010 article for National Affairs, this quirk gives employers a “major incentive to provide generous benefit packages.”

For example, a worker who pays federal and state income taxes at a combined rate of 30 percent will receive $7,000 for every $10,000 his employer provides in gross salary. But the same employee will receive $10,000 in benefits for every $10,000 his employer spends on health insurance—a 43 percent improvement.

No such price signal exists in the employer-sponsored insurance market. If you bought insurance for yourself, you might be quite willing to accept health care from the “second-tier,” but reputable, hospital if it meant that you could save 30 percent on your premiums. But while you know how much you make each month in salary, you likely have no idea how much your employer pays each month for your health insurance.

Partners HealthCare System and Tufts Health Plan announced a parting of the ways in October 2000. Although they eventually came to terms, more than three months of contentious contract negotiations took a toll. Tufts and Partners—which includes the renowned Massachusetts General and Brigham and Women’s hospitals and more than 4,000 affiliated physicians—were unable to agree on payment rates. A contract termination could have caused an estimated 100,000 people to lose access to Partners’ hospitals unless they selected another plan that included the hospital system in its network.

Claiming they had lost $42 million in treating Tufts’ enrollees in the previous two years, Partners argued it could no longer accept payments that did not cover the system’s costs. According to local news reports, in initial negotiations with Tufts, the system demanded a 29.7 percent increase over three years, or 9.9 percent per year. Partners’ previous success in gaining a double-digit payment increase from Blue Cross and Blue Shield of Massachusetts, the largest Boston health plan, also emboldened the hospital system.

Tufts counteroffered with a much smaller increase. To meet Partners’ demands, Tufts contended it would need immediate premium increases of 20-25 percent, threatening a loss of business the plan could not afford. In addition to rising medical costs, the plan was recovering from significant financial and membership losses, largely because of an ill-fated regional expansion strategy in the late 1990s.

However, Tufts faced pressure to return to the negotiating table. The timing of Partners’ contract termination during Tufts’ largest annual open enrollment period left the plan at a disadvantage, because it opened up the possibility of large-scale enrollment shifts if people wanted to maintain access to the Partners system. Moreover, as the impasse played out in the media, consumers and physicians flooded Partners and Tufts with phone calls expressing concern about losing access to Partners’ providers, while local employers pressured the two sides to come to some resolution. The state attorney general, though limited in authority to intervene, sent a letter urging the two sides to resume negotiations and avoid disrupting consumers.

Shortly after Partners broke off negotiations with Tufts, the plan attempted to contract directly with some of the large physician groups affiliated with the system. Physicians decided it was in their best interest, however, to remain aligned with the hospital system. With few remaining options, Tufts resumed talks with Partners one week after Partners broke off negotiations, and the two sides settled on a contract several days later. While neither side would disclose specifics, Tufts confirmed the deal contained significant payment increases.