The theoretical argument for cost equivalency of private plans and Medicaid

I had a long chat with David Ramsey of the Arkansas Times last night. We helped each other more fully understand how, in theory, the cost to the federal government of covering a Medicaid beneficiary with a private, qualified health plan (QHP) in an exchange could equal that of traditional Medicaid (hereafter, just “Medicaid”). I’m going to spell it all out in this long, wonky post. (David’s post on this subject is here.) The theory rests on several assumptions, which I will point out. At the end I will make some comparisons to other programs that have tried to harness competition to reduce costs.

The case begins with the observation that the cost of the care is mostly driven by the prices the payer (whether Medicaid or a QHP) pays to providers. Of course this is not the whole story as cost also depends on utilization, which is related to the nature of the risk pool. Let’s assume, for simplicity, the risk pool is fixed. We’re only considering how the cost of that fixed pool differs in Medicaid vs. a QHP. Right off the bat we also have to ignore drug costs. Medicaid gets cheaper drug prices than a QHP ever will. I’ll return to this at the end, but let’s ignore drugs for now.

If the cost of care is driven by provider prices then it can be driven to zero by shrinking the density of the network of participating providers to zero. That is, pay nothing, get nothing. No providers are going to take a $0 pay rate. As the pay rate increases, more providers will be willing to participate. This is true for Medicaid or a QHP. In both cases there is or will be some rule about network adequacy. Medicaid and QHPs must pay high enough rates to attract enough providers to achieve some minimum level of access. I don’t know what those rules are, and I’m not going to chase them down. (Readers, feel free to help out here.) The key to the argument is that the network adequacy rules have to imply the same minimum level of access for Medicaid and QHPs. Neither can be skimpier than the other in terms of the density of participating providers. This is a big assumption, but let’s go with it.

Let’s focus on the QHPs in the exchange. They have to meet this network adequacy requirement, which sets a floor on payment rates. If they pay below a certain rate, they will not attract enough providers. The next step is to argue that competition in the exchanges will force payment rates down to this floor. Here’s how that works, again, in theory: The federal government is on the hook to pay income-related premium subsidies driven by the cost of the second cheapest silver rated plan. (In addition, it pays income-related cost sharing subsidies.) If a consumer in the exchange wants a more generous plan, she has to pay the marginal cost. Therefore, price sensitive consumers, and in particular income constrained ones in the Medicaid expansion population, are going to gravitate toward the second cheapest silver rated plan.

If more customers means more revenue and profit for plans, they have an incentive to be the second cheapest silver rated plan. They will bid down their premiums to be so. This is the competitive bidding design at work. And how do they bid down their premiums? In the theory we’re working with here, the only way to do so is to pay providers less. (I’m sure you can think of other ways plans could reduce costs, so this highlights the assumption that provider rates are the sole, relevant cost to plans.) Therefore, competition will drive provider rates paid by the second cheapest silver rated plan down to their minimum, just sufficient to meet the network adequacy requirement, whatever it is. Notice that plans are more motivated to compete in the way described the larger the pool of consumers they are likely to attract by being the second cheapest silver rated plan. This is a means by which moving the large, Medicaid expansion population onto the exchange enhances competition.

A big assumption here, among others, is that there are enough plans in the exchange for competition to operate as efficiently as just described. Broadly, competition is doing a lot of work in this argument. If it doesn’t operate as well in practice as in theory, the argument unravels.

We have just argued that, under healthy competition, the federal government will pay subsidies that are as low as possible given the network adequacy requirements. They cannot be lower. Now let’s focus on Medicaid. As assumed, its network adequacy requirement is the same as that of the QHPs. If the QHPs are paying the minimum necessary to meet it, then that’s the same rates Medicaid must pay. It is possible Medicaid rates will have to go up to achieve this. But either way, if the network requirements are the same and if competition works as described, Medicaid costs and QHP costs are equivalent. (This presumes a legislature isn’t interested in spending more on Medicaid than it has to. If so, its state Medicaid program’s network will be no more expansive than necessary.)

What could possibly go wrong? A lot. First of all, I pointed out several assumptions above, none of which need hold in reality. 

  • In reality, the risk pool of QHPs may not be equivalent to that of Medicaid. This actually doesn’t matter much if one is assuming provider payments are the only lever a plan has to control costs. If they’re at a minimum, they’re at a minimum and the cost of a specific individual will be the same no matter the plan type. But, of course cost will vary across individuals according to need and utilization. So, if one also considers disease management and utilization control functions a plan might employ, there may be important differences across plan types for different risk consumers. After all, a service’s cost is not just price. It’s the product of price and volume. With the federal government fully subsidizing cost sharing, or nearly so, for the Medicaid expansion population, volume control is a big issue. Who will do it better, QHPs or Medicaid? Before answering, remember that QHPs serve more than just the Medicaid population and most consumers don’t like to be told “no.”
  • In reality, provider costs are not total costs. Drugs cost something and Medicaid gets preferred drug rates that private plans don’t. This is one reason why private, Medicare Part D plans cannot offer a drug benefit as cheaply as Medicaid or the VA, despite its competitive bidding design that bears some relation to that of the exchanges. Another reason is that Part D plans have different rules about formulary generosity than Medicaid or the VA. That’s the analog to provider network adequacy in the argument above. If the nature of the benefit (formulary generosity, network adequacy) is not equivalent across sectors (public and private) the costs will not be equivalent. 
  • In reality, the network adequacy rules may not be equivalent for Medicaid and QHPs, but, as I wrote above, I don’t know.
  • In reality, competition may not be sufficiently vigorous to drive QHP costs to their theoretical minimum. In addition to Medicare Part D, there is also competition in Medicare Part C, Medicare Advantage (MA). Despite the competition, the cost of (not the government prices paid to) MA plans is not at or below that of traditional Medicare everywhere. In some areas, MA plans are more costly because they are unable to counter the market power of providers and drive rates below that paid by traditional Medicare. Now, the program does not have a competitive bidding design. But it is also not without competitive incentives to reduce costs. My point is that plan competition can’t always drive prices down to those of a public program.
  • In reality, size matters. Just as MA plans are too small in some areas to counter the market power of providers and achieve traditional Medicare-like prices, QHPs in an exchange may be too small. On the one hand, we need enough QHPs to create vigorous competition. On the other, more plans further segments the market, making each less necessary for a provider to serve. Public programs are not subject to market power dynamics in the same way. No matter their size, they have the force of law behind them. If a legislature is so motivated, I bet it is creative enough to find a way to coerce providers to participate at rates below those of private plans. I’m not saying that’s good or bad. It just is.

All in all, I find the theory interesting and clarifying, but ultimately not convincing. I do believe the difference between Medicaid and QHP costs could narrow. I seriously doubt it will converge to zero.


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