How America’s Health Care Fell Ill


In the early days of hospital insurance, however, this fundamental defect was hardly noticeable. Twenty-one days was a very long hospital stay, even in 1929, and with the relatively primitive medical technology then available, the daily cost of hospital care per patient was roughly the same whether the patient had a baby, a bad back, or a brain tumor.

Today this “front-end” type of hospital insurance simply does not cover what most of us really need insurance against: the serious, long-term illness that can be diagnosed and treated only with very sophisticated and expensive technology. In the 1950s major medical insurance, which does protect against catastrophe rather than misfortune, began to provide that sort of coverage. Unfortunately it did not replace the old plans in most cases, but instead supplemented them.

The original hospital plans also contained the seeds of three other economic dislocations, unnoticed in the beginning, that have come to loom large. The first dislocation is that while people purchased hospital plans to be protected against unpredictable medical expenses, the plans paid off only if the medical expenses were incurred in a hospital. Cases that could be treated on either an inpatient or outpatient basis therefore became much more likely to be treated in the hospital, in order to take advantage of the insurance. This, of course, tended to maximize the use of hospitals, the most expensive form of medical care.

The second dislocation was that hospital plans did not provide indemnity coverage. Again, let’s look at auto insurance, which indemnifies the holder against loss. If a policyholder’s car is wrecked, the insurance company sends him a check for the value of the car, and the insured then shops for the best way to be made whole. He might have the car repaired, having looked around for the cheapest competent mechanic. He might use the money as the down payment for a new car, selling the wreck for what he can get. He might even put the money in the bank and walk to work thereafter.

But medical insurance provides service benefits, not indemnification. In other words, the insurance company pays the bill for services covered by the policy, whatever that bill may be. There is little incentive for the consumer of medical services to shop around. With someone else paying, patients quickly became relatively indifferent to the cost of medical care. This suited the hospitals perfectly because they naturally wanted to maximize the amount of services they provided and thus maximize their cash flow, smoothing out their financial problems. Doctors liked this arrangement for precisely the same reason that jewelry-store owners like vain women with rich and adoring husbands. If patients are indifferent to the costs of the medical services they buy, they are much more likely to buy more of them, even those that are of marginal utility or duplicative. Why not? After all, the nice thing about wearing both suspenders and a belt is that your pants hardly ever fall down.

None of this is to libel doctors or hospital administrators, but only to note their humanity. They pursue economic self-interest just like everyone else, and arrangements that maximize income are always going to be looked upon favorably by those whose incomes are maximized. One result was that the medical profession began to lobby in favor of this system. In the mid-1930s, for instance, as Blue Cross plans spread rapidly around the country, state insurance departments moved to regulate them and force them to adhere to the same standards as regular insurance plans. Specifically they wanted hospital plans to set aside reserve funds in order to handle unexpectedly large claims, a necessary but expensive part of the insurance business.

Had hospital plans come to be regulated like other insurance companies, it is likely that they would have begun acting more like insurance companies and the economic history of modern American medicine might have taken a very different turn. But they were not. Doctors and hospitals, by and for whom the plans had been devised in the first place, moved to prevent this from happening. The American Hospital Association and the American Medical Association worked hard to exempt Blue Cross plans from most insurance regulation, offering in exchange to enroll anyone who applied and to operate on a nonprofit basis. The Internal Revenue Service, meanwhile, ruled that these plans were charitable organizations and thus exempt from federal taxes.

Because they were freed from taxes and the need to maintain large reserve funds, Blue Cross and Blue Shield (a plan that paid physicians’ fees on the same basis as Blue Cross paid hospital costs) soon came to dominate the market in health-care insurance, with about half the policies outstanding by 1940. In order to compete at all, private insurance companies were forced to model their policies along Blue Cross and Blue Shield lines.


Thus hospitals came to be paid almost always on a cost-plus basis, receiving the cost of the services provided plus a percentage to cover the costs of invested capital. Any incentive for hospitals to be efficient and thereby reduce costs vanished. In recent years hospital use has been falling steadily as the population has gotten ever more healthy and surgical procedures have become far less traumatic. The result is a steady increase in empty beds.