Medical Service Risk and the Evolution of Provider Compensation Arrangements

Kenneth Arrow (1963: 962) discussed two forms of provider compensation that were in existence during the 1960s: fee-for-service and prepayment. Like many others before him, he recognized a problem with the former that has been the subject of much subsequent discussion in health economics. Under traditional indemnity insurance, consumers face incentives to expand their health services utilization because the effective price for their health services is less than the actual price. Fee-for-service compensation provides no financial incentives for health providers to mitigate consumer moral hazard, but prepayment does. However, Arrow noted that physicians were resistant to prepayment for two reasons: (1) their inherent aversion to accepting financial risk, and (2) the potential impediments to physician autonomy through the use of closed panels for referral (957).

Since Arrow's time, the U.S. health system has experienced rapid growth in HMOs, risk contracting, and a plethora of provider intermediary organizations (e.g., medical groups, Independent Practice Associations [IPAs], Physician Hospital Organizations [PHOs], Management Services Organizations [MSOs], physician practice management companies, organized delivery systems). Taken together, these developments provided a platform for transferring greater amounts and types of medical service risk to health providers through prepayment, or what is now more commonly called capitation. Provider intermediary organizations in particular provided the means to address some of the concerns about prepayment raised by Arrow. First, they offered a convenient method to pool and manage financial risks across many affiliated health providers and thus reduce the risks that providers would otherwise individually confront under capitation. Second, the large volume and geographic dispersion of capitated lives encompassed by the contracts of a provider intermediary organization should accommodate a large panel of affiliated providers to whom individual physicians can refer and thus reduce concern about overly restrictive and narrow closed panels.

Despite the development of organizational structures and strategies that should allow expanded transfer and better management of risk, evidence is mounting that retrenchment in broad-based prepayment, especially global capitation, is occurring in several markets across the United States. This essay examines the evolution of provider compensation mechanisms, especially as it relates to the transfer of medical service risk to health providers. Then, it offers explanations for the retrenchment in capitation that is being observed, drawing on themes and arguments raised by Arrow in his seminal article. This essay also examines why there is an incomplete market for insuring health providers against the risks they assume through capitation and how this too adds to the current problems with capitation.

Evolution of Provider Payment Methods

Through the 1960s, physicians, hospitals, and other health providers in the United States were largely paid on a fee-for-service basis for the services they delivered. This approach predated the development of health insurance and was likely an artifact of a market-based U.S. economy in which buyers and sellers traded distinct goods and services for mutually accepted prices. Arrow observed that fee-for-service payment could promote inefficient use of services among poorly informed consumers. However, economists subsequently noted certain advantages and other disadvantages with fee-for-service that Arrow did not consider. Joseph P. Newhouse (1996) noted that an advantage of fee-for-service payment was that it minimized provider behavior to select against bad risks because physicians and hospitals are paid more for sicker patients who require more services. James C. Robinson (1999) noted that agency theory supports the use of piece-rate, fee-for-service payment when desirable behaviors can be standardized and easily measurable, but fee-for-service performs poorly when multiple tasks need to be performed and coordinated. Clearly, technological advances in medicine have vastly increased the complexity of care, producing an almost incomprehensible array of potential diagnostic and treatment combinations and blurring the settings of care. In this context, fee-for-service promotes inefficiency because it lacks incentives...