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Journal of Policy History 16.2 (2004) 144-174

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Causal Chains and Cost Shifting:

How Medicare's Rescue Inadvertently Triggered the Managed-Care Revolution

University of Richmond

The conventional wisdom on how managed care came to replace traditional fee-for-service reimbursement as the nation's dominant mode of health insurance is that enlightened businesses and their employers led the way in responding to the emergence of market forces in health care in the 1990s.1 A common textbook treatment of managed care's ascendancy puts it this way: "Transformation of the health care delivery system through managed care has been driven principally by market forces, and reinforced by government."2 The irony is that the opposite sequence of events is a more accurate portrayal of what actually happened. As this article shows, the transformation of America's health-care system through managed care was initially triggered—albeit indirectly—by government actions and then driven by market forces. In other words, before business behavior was a cause of managed care's extraordinary growth, it was largely a response to and an unintended consequence of government policymaking: in this instance, Congress's reform of Medicare in 1983.

It is intuitively appealing to assume that the paradigm shift from fee-for-service insurance to managed care was solely the result of the business community seeking to reduce costs by increasing managerial control and market mechanisms. "Firms face a very clear incentive structure: they must strive to maximize profits," as Paul Pierson and Jacob Hacker note. "This conclusion does not rest on assumptions about individual greed, but on the recognition that market systems are powerful mechanisms for inducing decision-makers to adopt profit-maximizing behavior."3 But why, then, did the majority of businesses wait so long to begin switching their employees en masse into managed care? Lawrence Brown has explained why [End Page 144] managed care did not thrive in the 1970s, despite concerted government action on its behalf.4 Nevertheless, why did employers still not begin a big switch to cheaper managed care by the early 1980s or at least by the mid-1980s at the latest? Managed care had been a mandated alternative since 1974, a year after President Nixon signed the HMO Act, which required businesses with more than twenty-five employees that already offered health insurance to make HMOs available to their employees.5

Business' delayed transition to managed care suggests that existing market incentives were necessary but not sufficient for inducing such a major paradigm shift in health insurance. Providers (doctors and hospitals) and patients greatly dislike managed care, relative to fee-for-service health insurance, because it both restricts patients' access to more expensive medical care provided by specialists and limits physician autonomy. Employers, on the other hand, generally do not care about the specific form of health coverage they provide until its cost becomes a significant issue. Thus, there was no natural incentive or tendency for employers and employees to switch from fee-for-service insurance to managed care.

As the following analysis shows, the critical catalyst for making market incentives sufficiently appealing for this massive paradigm shift came as a result of change to another major actor in the American health-care system, the single largest purchaser of hospital care: Medicare. Since Medicare and employers in the private sector purchase their medical care from the same hospitals and doctors, a dramatic change to Medicare's payment policy was bound to greatly affect (directly and indirectly) the cost-benefit calculations and policy decisions of private employers. "Medicare is the 800 pound gorilla," observes David Abernethy, former senior Medicare specialist and staff director of the House Ways and Means Health Subcommittee. "So when it slows its rate of expenditure growth, hospitals' overall rate of revenue growth slows; and that, in the end, puts the final pressure on private payers."6

By examining the links in the causal chain between the reform of Medicare's payment policy and the rise of managed care, we find that government policymakers...