It would be nice to believe that the market forces of laissez-faire capitalism would bring down skyrocketing healthcare costs–but it won’t. The unique structure of American health systems actually aids free-market capitalism in raising hospitals’ prices. Let’s break down why that is. 

How Hospital Costs Work

Each of the nearly 1,000 private health insurance companies in the United States must negotiate prices for medical goods and services for each hospital it contracts with. Of these 1,000 insurance companies, they must negotiate particular prices for each good/service for each of the many plans it offers. In some markets, because there are so many insurers, each has relatively little bargaining power when negotiating these prices with the hospital, meaning hospitals can (and do) overcharge, and insurance companies are often forced to play along. The solution for the insurers? Pass the higher costs off onto consumers via higher premiums. In the 7-year period from 2007 to 2014, hospitals raised prices by 42%, which led to an associated 40% rise in premiums for families with employer-based healthcare. 

Why Market Forces Won’t Work

The answer to this dilemma seems simple: if insurers consolidate into fewer, but more powerful companies, they will be able to negotiate lower prices. Consolidating from 3 to 2 companies, after all, is associated with a 5% drop in prices paid to providers.*

*The catch: insurance companies aren’t incentivized to pass these savings on to the consumer, but rather squeeze both patients and providers alike. Consolidation may lead to lower negotiated prices, but also less competition, meaning the insurers have less and less reason to compete by offering lower premiums. Thus, fragmented insurers lead to more competition and lower costs in the short-term, but higher costs in the long term. Conversely, monopolized insurance leads to lower prices, but also reduced competition, and as such incentive to share savings. 

The 80/20 Dilemma

Even where insurance companies might be able to negotiate lower prices, they may, paradoxically, be encouraged to keep prices high. There is one main reason for this: the 80/20 rule. 

The ACA contained a provision that requires insurance companies to spend at least 80% of premiums they have collected on medical claims, aiming to put a cap on the acceptable level of profit and administrative overhead. Thus, if insurance companies can only keep 20% of the pie, why not make the pie massive?

If insurance companies fight too hard for lower prices, they’ll end up violating the 80/20 rule. If they pay higher prices for medical services, however, they can charge higher premiums, and then keep the same percentage of a larger pool of cash, earning them more money. This also helps fend off competitors by earning priority status with hospitals. Thus, the one main player in the health field meant to fight for lower prices is actually incentivized to keep prices high. Hospitals win, insurers win, and consumers lose. Big time.