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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

SEPTEMBER 2008
NUMBER 254a

Chicago Fed Letter
Creating value-based competition in health care
by Sam Kahan, senior economist

On April 14–15, 2008, the Federal Reserve Bank of Chicago and the Detroit Regional
Chamber co-sponsored the second annual forum on health care. This year’s program focused
on how the health care system could be improved in terms of cost, quality, and accessibility.

The problems of the U.S. health care

Materials presented at this
year’s conference, titled
The Value Chain Approach—
Maximizing Value, are available
at www.chicagofed.org/
news_and_conferences/
conferences_and_events/
2008_detroit_health_care_
forum.cfm.

system in terms of rising costs, uneven
quality of service, and limited accessibility are well known. Medical costs are
high, and they continue to rise rapidly.
Since 1989, medical care costs, as measured by the Consumer Price Index (CPI),
have risen at a 4.9% compound annualized rate, compared with the 2.9% pace
for the overall CPI. While this differential
has narrowed to about 1.5 percentage
points over the past six years, the pace
of medical cost increases still exceeds
that of aggregate price increases.1
In addition to high and rising costs for
health care overall in this country, there
is a wide variation in quality and costs of
medical services across geographical areas.
For example, per capita health-related
spending in 2004 ranged from about
$4,000 in Utah to $6,700 in Massachusetts.
According to the Congressional Budget
Office (CBO), much of the quality and
cost differentials cannot be explained
by variations in income, health conditions of the patients, or demographics.
Furthermore, it appears that higher
spending is not necessarily associated
with better care or with better results.2
In addition, the rate of medical errors in
procedures and prescriptions is high in
the U.S. The Institute of Medicine estimated that between 44,000 and 98,000
patients died annually because of errors
in medical treatment.3 Access to health
care is limited as nearly 47 million

Americans go without formal health
care coverage.4 As a result, it is not surprising that the U.S. ranks low in international comparisons of health care;
for instance, the U.S. has the third highest infant mortality rate among OECD
(Organization for Economic Cooperation
and Development) countries.5
Our recent health care leader forum focused on how to improve the U.S. health
care system from a “value chain” perspective. The value chain, a term popularized
by Michael E. Porter,6 examines the
process of production—from the input
of raw materials to the creation of a final
product—as well as the value created
(added) at each stage of the process.
Competition among participants and the
free flow of information about price and
quality along the production process
(both upstream and downstream) provide the impetus for creating optimum
value at the lowest cost. The value chain
approach has proved to be a useful model
for explaining behavior in many industries, especially the auto sector. Health
care has not been able to generate these
beneficial effects; some observers argue
this is largely due to a lack of coordination among the various participants and
a paucity of relevant information for
sound decision-making.
Restructuring for success

In her keynote address to the conference,
Elizabeth Olmsted Teisberg, University
of Virginia, observed that different actors

in the current health care system are
competing to shift costs and increase
their bargaining power; many of them
are also reducing their costs by restricting
services rather than by competing to deliver value to patients. Teisberg argued
that the current system requires a change

information on the prices and quality of
products and services, and of making informational content more readily available to the ultimate consumer of health
care (the patient). These changes in
the aggregate, she argued, could impose market discipline on the health

According to the keynote speaker, because patient outcomes are
multidimensional, one should measure and assess not only survival
rates but recovery time, quality of life, and sustainability dimensions.
in structure, and not just a realignment
of incentives. She proposed the value
chain approach as one of the most effective ways to analyze and ultimately
reform the health care system.
Information is a key component in a competitive market. Buyers can shop around
for the most attractive opportunity, while
sellers are forced to compare their costs
with those of others. Information about
health care is not particularly abundant
and often does not provide useful measures of success. Teisberg advocated the
development, collection, and dissemination of health outcome data. Studies
have shown that clinicians in pursuit of
excellence will use this information as a
benchmark for self-assessment, increase
their learning, and direct patients toward
those institutions and/or procedures with
above-average results. Although patients
are not as likely to use the data as doctors
are, their doctors’ actions will lead patients
to receive better health care at lower cost.
Furthermore, involved and informed
patients may take more responsibility for
selecting health procedures, leading to
less invasive and lower-cost procedures.
Teisberg said that a successful health
care system is one that is driven by results; it is also based on values that improve the health outcome of the patient
relative to the cost of achieving this goal.
Much of her research advocating researchdriven and value-based health care is
summarized in the book she co-authored
with Michael E. Porter.7 In essence,
Teisberg is a proponent of increasing
cooperation among the economic
entities along the health care value
chain, of providing current and accurate

care structure and result in improved
quality of service as well as reduced costs.
Teisberg argued that health care outcomes should be measured over the
full care cycle of a disease, rather than
by just a specific procedure. Similarly,
the costs of these specific procedures
should also be measured over the full
care cycle. Ultimately, this will enable
one to measure the health outcome
relative to its actual cost. Typically, the
majority of costs are not measured over
the full care cycle. At present, costs are
billed separately for several portions of
the health care delivery process—e.g.,
office visits, tests, supplies, physician fees,
and hospital expenditures. The costs for
these various portions tend to be averages and may also reflect an arbitrary
allocation of shared costs. In fact, Teisberg
argued that the current system encourages the pass-through of charges, rewarding those who bill creatively rather than
those who actually reduce costs.
Teisberg’s approach to health care allows the effectiveness of procedures
and processes to be measured appropriately. Efficiencies and cost savings
can thus be assessed and the resulting
information disseminated. This approach should aid doctors and patients
to select among alternative procedures,
and it should promote competition
among institutions for the most cost-effective options while stimulating product
or service innovation. The result of
these activities should be optimum value at lowest cost along the value chain.
A benefit of focusing on value over the
full care cycle can be to shift the discussion from controlling spending on

a particular procedure to a discussion of
how best to treat a specific condition or
disease. A full-cycle focus will also place
greater emphasis on scrutinizing factors
such as medications, lifestyle, or environment that provide potential early warning signs of future health problems. Early
detection often leads to easier and less
expensive treatment for a disease.
Because patient outcomes are multidimensional, one should measure and
assess not only survival rates but recovery
time, quality of life, and sustainability
dimensions. Teisberg suggested that both
outcomes and costs must be measured
over the full cycle of treatment, including
rehabilitation and long-term management.
Under this method, an expensive surgery, for instance, may be found to be
more cost-effective than a steady regime
of drugs if the surgery obviates the need
for long-term rehabilitation.
According to Teisberg, maximum value
at least cost in health care delivery can
be achieved by doing a few things well
rather than trying to do everything. For
example, it has been observed that teams
treating a large number of patients with
a particular medical condition give rise
to lower costs and better outcomes. This
would imply that health care should be
delivered through integrated practice
units. More experience of a specific condition will lead to increased accumulation of knowledge, in turn leading to
rising efficiencies, better and moredetailed information, and greater specialization of equipment and procedures.
And in the business arena, it may also
allow for greater leverage in the purchase
of goods and materials. Such improved
results tend to attract more patients, even
those with more serious medical conditions, and draw more medical personnel
who wish to participate in this process.
In short, all of this can bring about a
virtuous cycle of health care delivery.
Role of technology

Eliezer Geisler, Illinois Institute of
Technology, presented his views on the
role of technology in the health care delivery system. He estimated that approximately 20% of health care costs arise
from the use of medical technology.

There is significant potential for increased
(cost-effective) use of technology in the
U.S. health care system. Approximately
15% of hospitals use computerized medication entry forms, only 10% use barcoded administration, and about 5% use
computerized patient records. Approximately 80% of all health care transactions are conducted in a costly fashion
via phone, mail, or fax, and not the
Internet. Although health care delivery
depends critically on communication, it
is estimated that the health care industry spends approximately 2% to 3% of
its total costs on information technology. In comparison, the financial services
industry spends 8% to 10% of its total
costs on information technology.
Geisler attributed this low outlay to various
barriers, including a lack of capital funds
to invest, resistance to change, lack of
standards for procedures and processes,
and lack of compatibility across systems.
According to Geisler, most innovations
in the health care arena are peripheral
to the main products and services and
are incremental in nature rather than
revolutionary. However, the integration
of information technology and telecommunications is incorrectly viewed,
he said, as incidental to the main issues
facing the industry.
Geisler argued that the practical application of value chain principles to
technology adoption in health care is
challenging for a number of reasons.
He noted the somewhat necessary complexity and segmentation of the health
care system, as well as the difficulty of
measuring value and results.
New proposals at federal and
state levels

Peter Pratt, Public Sector Consultants,
summed up the current state of health
care in the U.S. as follows. The problem,
he said, is that many people do not receive medical service that is adequate in
either quantity or quality and that the
costs of the service are inequitably distributed. Pratt then described the health
care plan proposals of the three presidential candidates (at the time of the
forum in April 2008)—John McCain,
Barack Obama, and Hillary Rodham
Clinton—and some initiatives at the

state level. (Since Senator Clinton is no
longer a candidate, we refer to her plan
only briefly in this section.)
The health care plans of both Senators
Clinton and Obama would build on the
current mixed private and public insurance systems. They proposed creating
broad health care risk pools through
expansion of group insurance options.
Regulations would be implemented to
prevent rejection of high-risk individuals
by insurers. Both plans would develop
strategies to improve quality and efficiency
of U.S. health care.
Senator Obama’s plan would create a new
public insurance plan and what his team
calls a “National Health Insurance
Exchange.” The new plan would cover
those who do not have access to employersponsored plans or are not qualified for
Medicaid or the State Children's Health
Insurance Program (SCHIP). Insurers
would be required to offer benefits at
least equivalent to those offered by the
new public insurance plan. The exchange
would evaluate the various plans based
on their different features, including
cost of services. Government subsidies
would be provided to encourage insurance purchase. Employers who do not
offer “meaningful” coverage would be required to contribute a fraction of their
payroll tax to the national plan.
Senator McCain’s plan would place more
emphasis on the individual and increase
patient responsibility for health care
decisions. He proposed tax credits of
$2,500 for individuals and $5,000 for
families, as well as expansion of health
savings accounts (HSAs).8 He would encourage increased competition among
insurance companies while decreasing
reliance on employer-sponsored plans.
To promote greater competition among
providers, pay-for-performance options
would be expanded (both Medicare
and Medicaid currently feature various
pay-for-performance initiatives).
Many states are embarking on their own
health care reform initiatives and not waiting for federal action, Pratt said. Medicaid
is often an important vehicle for expanded coverage. Key features of state programs include expansion of Medicaid and
SCHIP, provision of subsidies to selected

groups, and establishment of insurance
pools to improve bargaining power in
purchasing coverage from insurance companies. The Michigan program, called
Michigan First, aims to cover approximately half a million of the state’s uninsured. Subsidies, on a sliding scale of
income (benchmarked to the poverty
level), will be provided to individuals
and businesses to purchase coverage.
Access to health care information technology will also be encouraged. One proposal in Illinois would offer universal
coverage for all children as well as a
subsidy on a sliding income scale for
families needing coverage.
The states face common problems in
the establishment of these programs.
Expansion of programs critically depends on the availability of funds, in
particular more federal funds. Demand,
particularly in the early phases of the
programs, tends to be higher than expected. The need to control unpredictable costs intensifies as time goes by.
According to Pratt, support from across
the political spectrum often is needed
for successful adoption of these programs.
Shifting health care costs

Ron Gettelfinger, United Automobile
Workers, described the process undertaken during the last labor contract
Charles L. Evans, President; Daniel G. Sullivan,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; Jonas Fisher,
Economic Advisor and Team Leader, macroeconomic
policy research; Richard Porter, Vice President, payment
studies; Daniel Aaronson, Economic Advisor and
Team Leader, microeconomic policy research; William
Testa, Vice President, regional programs, and Economics
Editor; Helen O’D. Koshy, Kathryn Moran, and
Han Y. Choi, Editors; Rita Molloy and Julia Baker,
Production Editors.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2008 Federal Reserve Bank of Chicago
Chicago Fed Letter articles may be reproduced in
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Prior written permission must be obtained for
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ISSN 0895-0164

between the union and the Detroit Three
auto manufacturers (Chrysler LLC, Ford
Motor Co., and General Motors Corp.)
to establish a voluntary employee beneficiary association (VEBA). Under the
agreement, the auto manufacturers will
shift approximately $60 billion to the
union, which will then become responsible for administrating and financing
the health care services of their members. Thus, starting in 2010 the union
will not only be a representative user
of health care services but also an intermediary provider.
Conclusion

The problems of the U.S. health care
system in terms of cost, accessibility, and
1

Congress of the United States,
Congressional Budget Office, 2008,
“Geographic variation in health care
spending,” report, Washington, DC,
No. 2978, February, available at
www.cbo.gov/ftpdocs/89xx/
doc8972/02-15-GeogHealth.pdf.

The collection and dissemination of
information on health care outcomes,
costs, and quality factors are key variables
in the successful shift to results-driven
and value-based health care. It remains
to be seen whether the cost of assembling, evaluating, and disseminating
this information is a significant barrier
to future progress.

These are my calculations based on data
from the U.S. Bureau of Labor Statistics.

2

quality of service are well known. Teisberg
suggested that encouraging competition
based on providing value for the patient
would significantly improve health care
delivery. Indeed, several segments of the
health care system are already moving in
the direction of value-based competition
as the keynote speaker described.

3

4

Linda T. Kohn, Janet M. Corrigan, and
Molla S. Donaldson (eds.), 2000, To Err
Is Human: Building a Safer Health System,
Institute of Medicine, Committee on
Quality of Health Care in America,
Washington, DC: National Academy
Press, p. 26.
Carmen DeNavas-Walt, Bernadette D.
Proctor, and Jessica Smith, 2007, “Income,
poverty, and health insurance coverage

The consensus at this year’s health care
forum was that the current system is
not likely to change significantly in the
near term. On the federal level, little
movement is expected until well after
the presidential election. While states
are attempting to provide assistance,
particularly to lower-income families
and children, they are constrained by
several factors. It is sometimes difficult
for states to garner sufficient political
support for these programs, and finding
sufficient funds to sustain them is a
perennial problem, especially during
an economic downturn.

engines of growth. Clusters are concentrations of interconnected companies,
suppliers, and institutions. Over the
past decade, he and Elizabeth Olmsted
Teisberg, of the University of Virginia, have
focused on how to improve health care
delivery through value-based competition.

in the United States: 2006,” Current
Population Reports, U.S. Census Bureau,
No. P60-233, August, p. 18, available at
www.census.gov/prod/2007pubs/
p60-233.pdf.
5

6

Chris L. Peterson and Rachel Burton, 2007,
“U.S. health care spending: Comparison
with other OECD countries,” CRS Report
for Congress, Congressional Research
Service, No. RL34175, September 17,
p. CRS-54, figure 26.
See Michael E. Porter, 1998, Competitive
Advantage: Creating and Sustaining Superior
Performance, New York: Free Press. Porter
is a professor at Harvard Business School.
His research focuses on how firms, regions,
and states compete and what their sources
of economic strength are. He introduced
the concept of economic clusters as

7

Michael E. Porter and Elizabeth Olmsted
Teisberg, 2006, Redefining Health Care:
Creating Value-Based Competition on Results,
Cambridge, MA: Harvard Business
School Press.

8

These accounts were created by the
Medicare bill signed by President
George W. Bush on December 8, 2003,
and designed to help individuals save
for future qualified medical and retiree
health expenses on a tax-free basis.


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