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Health care in the twentieth century: a history of government interference and protection.

HEALTH CARE COSTS and coverage have become a dominant force in almost everyone's life over the course of the past fifty years. Before many workers change employment, they must weigh the costs of changes in health coverage. Many people are left out of the insurance market, either because they can't get it or can't afford it. Patients complain that doctors don't listen anymore and are anxious to slap their physician with a lawsuit for the slightest imperfection in care. Physicians are tired of struggling under mountains of paperwork from the government and insurance companies when all they want to do is treat patients.

And the costs keep going up. With health care expenditures expected to reach $830 billion in 1992 and $1.5 trillion by the year 2000, the American public wonders where it is all going.(1) No one can figure out the answer, and all everyone knows is that costs are too high and too many people are falling through the cracks of the health care system.

How have we in the United States come to find ourselves in this kind of a mess? An investigation into the evolution of the medical industry in America will expose not the competitive market that most Americans assume has been operating, but stifling regulation and government control as well as regulations originating from interest groups such as medical organizations and insurance companies. This system is chaotic for both doctors and patients and is one that appears to be a free-market operation but is really an industry legislated and regulated from behind the scenes.


The early years of formalized health care in America (1880-1930) saw the establishment of the medical profession, both through the expanded duties and formal education of the physician and the growth of the hospital system. The start of the twentieth century also witnessed the beginnings of health insurance as a method of prepaying health care costs, and the American Medical Association's (AMA) growing control over the medical marketplace.

By 1930, the United States had as many or more medical, nursing, and dental schools and hospital beds per unit of population as it has today. The Great Depression, however, slowed the expansion of health care facilities and personnel. Many Americans had trouble paying for the medical care they needed. Doctors tried to make allowances for patients in financial straits, but hospitals, with higher fixed costs, had much less flexibility. Between 1929 and 1930, average hospital receipts plummeted from more than $200 per patient to less than $60. Hospitals then began to turn to insurance plans as a way to guarantee a steady cash flow by spreading the financial risk.

The first plan was introduced in 1929 at Baylor University Hospital in Dallas, Texas. By paying a monthly fee in advance, a group of 1,500 school-teachers contracted with the hospital to provide care should they need it. The fee was paid whether or not the individual teacher ever used the services.

Soon, groups of nonprofit hospitals in several cities organized multiple hospital insurance plans. These plans gave subscribers a choice of medical care providers and therefore attracted more patients, strengthening the income to the participating hospitals. This multiple hospital plan served as a model for Blue Cross, established in 1932 in Sacramento, California. These hospital plans changed the concept of insurance and forever changed the American health care system. Unlike other forms of insurance, the primary purpose of these plans was not to protect consumers from large, unforeseen expenses, but rather to keep hospitals in business by guaranteeing them a regular income. While these plans benefited consumers by giving them a predictable method of paying for their medical care, they contained serious flaws that would become increasingly apparent as our health care system developed.

Blue Cross and Commercial Insurance

The institutionalization of Blue Cross/Blue Shield as the dominant provider of health care insurance was due in some part to interference in the market by the government on behalf of the Blues. The AMA and the American Hospital Association (AHA) lobbied for legislation to exempt Blue Cross plans from normal insurance regulations and receive federal tax exemption as nonprofit organizations. These benefits gave the Blues an enormous advantage over other insurers, and until the 1980s the Blues never held less than 40 percent of the entire health insurance market.(3)

The most interesting and devastating contribution made by the Blues was the reimbursement procedure they adopted. This procedure, known as cost-plus, was adopted by other insurance companies in order to compete and was also used by the Medicare program when it came into effect in 1965. Cost-plus allowed physicians to be reimbursed according to "reasonable and customary" charges, and hospitals were reimbursed on a percentage of their costs plus a percentage of their working and equity capital. This system permitted doctors to charge whatever they wanted, knowing they would be reimbursed, and created a perverse incentive for hospitals to increase costs because that meant increased income. Patients have no reason to show restraint either, because the money spent belongs not to them but to a third party. The cost-plus system inevitably led to higher health care costs.

Employer-Provided Health Insurance

The major development in health care during the 1940s was the growth of employer-provided health insurance. World War II brought about a shortage of labor and wartime wage and price controls prohibited employers from increasing salaries to attract workers. However, in 1942 the War Labor Board decided that fringe benefits up to 5 percent of wages would not be considered inflationary. Employers began to offer health benefits as a way of providing additional compensation. Total enrollment in group hospital plans grew from less than 7 million to about 26 million subscribers from 1942 to 1945.(4)

Concurrently, the Internal Revenue Service ruled that the purchase of health insurance for workers was a legitimate cost of doing business and could be deducted from taxable business income. The IRS also ruled that workers did not have to include the value of health insurance benefits in calculating their taxable income. These rulings amounted to a giant tax incentive for both employers and taxpayers and did much to institutionalize employer-provided health care into the system.

The unions soon recognized that employer-provided health care was a desirable benefit and began to negotiate for it in their contracts. In 1941, Chrysler agreed to set up a group health plan with its recently recognized union. The initial plan covered only hospitalization, and employees paid the entire cost through payroll deductions. The CIO declared in 1946 that health insurance was a high priority, and by 1948 ten unions had negotiated health and welfare plans. That same year the National Labor Relations Board (NLRB) ruled that health benefits were a legitimate subject of collective bargaining, which encouraged the spread of plans even after the end of the war.

In the Inland Steel case of 1949, the U.S. Supreme Court ruled that certain fringe benefits, including health care plans, were among the collective bargaining issues the Taft-Hartley Labor Relations Act gave unions the right to negotiate. The number of union workers covered by health plans went from 2.7 million to 12 million by 1955.(5)

Collective bargaining agreements expanded the scope of coverage as well as employers' contributions. By the end of 1954, more than 60 percent of the population had some type of hospital insurance, 50 percent some type of surgical insurance, and 95 percent medical insurance.(6) In 1945 employers paid only 10 percent of health care expenses, but by 1950 collective bargaining agreements were requiring them to pay 37 percent. And, in 1959, the United Steelworkers ended a 116-day strike when a settlement was reached that required the steel companies to pay the entire premium for health insurance. General Motors, Ford, and Chrysler followed with similar agreements in 1961.

An entirely new system of health care financing was created during the decades of the 1940s and 1950s. Government encouraged the development and expansion of provider-oriented insurance plans that ultimately distorted the health care delivery system. Employer-provided plans offering first-dollar (front-end) and routine care coverage contributed significantly to the rise in health care costs. The preponderance of employer-provided insurance worsened the position of those without health plans because of the inflationary effect of third-party payment.

First-Dollar Coverage

Health insurance policies that cover first-dollar expenses pay for routine care. One defect in these policies is the lack of coverage for the medical calamities that economically wipe out a patient and his family. Front-end health insurance operates contrary to all other forms of insurance, like auto insurance, where a driver insures against catastrophic damages and loss, but pays out-of-pocket costs for routine repairs and maintenance as well as for small damages.

Why do people purchase first-dollar, routine care coverage for health care when they wouldn't think of purchasing that coverage for their automobile? Simply stated, they do so because the tax code encourages them to do so. Health insurance plans are viewed as tax-free compensation, not as insurance. Workers then favor coverage that pays for routine care, freeing up their discretionary income for other uses. Insurance is no longer used for its normal purpose of spreading risk, but for tax avoidance.

Besides enacting tax incentives that skewed the insurance market, government intervention generated another problem in the industry -- "experience rating." Because the Blues were protected by government due to their exemption from taxes and reserve requirements, they had a competitive advantage over commercial insurers. Commercial insurers turned to "experience rating" their insurance plans as a way to compete against the Blues. They began to sell insurance to employers with relatively healthy, low-risk employees at cheaper rates than the Blues. Since the Blues often were required by law to use a "community rating" system, they responded to this competition by receiving permission to use a "modified" community rating to reflect experience.(7)

Insurance companies calculated premiums for group plans based on those working for a single employer. As a result, smaller companies with fewer employees over whom to spread costs generally must pay more for insurance. Additionally, they face the risk of large premium increases or even cancellation if only one employee becomes ill. Had the government not intervened on behalf of the Blues and provided them legislative protection, the "experience rating" system might not have developed, a system that results in a significant portion of small businesses not able to afford health insurance coverage for their employees.

Government Health Programs and Legislation

The expansion of employer-provided health care accentuated the medical needs of those without insurance, primarily the unemployed, poor, and elderly. As the 1960s began, pressures began to build for some sort of government health program that would provide care for these groups. Dissatisfied with a piecemeal approach, champions of the New Deal programs of the 1930s began agitating anew for a national health plan, while groups such as the AMA, fearing adoption of such a program, advocated decentralized, state-administered programs that would maintain the autonomy of physicians and hospitals. A compromise was reached in 1965, and the Medicare program was born.

The largest portion of the program, Medicare Part A, was a slimmed-down version of the universal social insurance scheme advocated by proponents of national health insurance. The other section, Medicare Part B, was a voluntary program to cover physician services, paid for by a mixture of premiums and general federal revenues. Medicaid was based on the alternative originally proposed by the AMA. It paid for medical care for the poor, regardless of age, financed by a combination of matching federal and state funds and administered by the states. In an instant, with the passage of Medicare and Medicaid the federal government became the largest single purchaser of health care.

The third-party payment system now dominated the health care industry. Most Americans were covered either by private health insurance or a government program for their hospital and physician costs. But Medicare and Medicaid brought the same defects found in the private insurance industry to the health care landscape, accelerating the rate of medical price inflation already set in motion by cost-plus reimbursement, lack of patient incentive to control costs, and first-dollar coverage.

Hospitals charged Medicare for the "reasonable costs" of treating patients, and doctors were reimbursed for their "reasonable and customary" fees. According to Joseph Califano, a former Health, Education, and Welfare (HEW) secretary, federal adoption of the cost-based, fee-for-service reimbursement system became a blank check for American hospitals and doctors. The rate of increase in hospital spending, which had averaged 8.8 percent between 1960 and 1965, almost doubled, approaching an average annual increase of 15 percent from 1965 to 1970.(8)

Medicare's benefit structure favored the same kind of first-dollar, acute-care coverage as private insurance. Under Part A, patients were charged a small deductible but paid nothing else for a sixty-day hospital stay. After sixty days, Medicare paid a decreasing amount, saddling seriously ill patients with catastrophic costs. The medical care provided to beneficiaries under Medicare and Medicaid was either free or greatly subsidized, and premiums were nonexistent or unrelated to individual or group usage. Consequently, beneficiaries had no incentive to question costs and every motivation to demand more services.

In response to White House pressure to get the plan off to a running start, the Department of Health, Education, and Welfare wrote regulations regarding reimbursement that were extremely beneficial to the medical industry. Not only did doctors get the power to charge "reasonable" and "customary" fees, they also received significant control over how Medicare would set such fees. Hospitals were successful in getting the interest on current and capital debt included in reimbursement costs, and they pressured HEW to pay for depreciation on buildings and equipment that had been purchased with federal funds under the Hill-Burton Act. In addition, government officials agreed to give them a 2 percent add-on to their actual costs for treating Medicare patients. According to Joseph Califano, "the 2 percent was a bribe to get the hospital industry to cooperate with Medicare."(9)


The eruption in health care costs over the past few decades has been staggering. Personal health care expenditures per capita increased from $82 in 1950 to $2,511 in 1990.(10) By the year 2000 the health care bill is expected to top $5,551 for each man, woman, and child in the United States.(11)

Spiraling medical costs have strained government programs. Medicare spending jumped from $25.2 billion to $87.6 billion from 1978 to 1988, a growth in constant dollars of 99 percent.(12) By 1990 costs had risen to $111.2 billion.(13) During the same period, total Medicaid program expenses rose from $18.9 billion to $54.7 billion, a 65 percent increase in constant dollars.(14) At the close of 1990 the Medicaid program cost $75.2 billion.

Higher inflation rates during the 1970s exacerbated weaknesses in the health care financing system. As prices increased, workers demanded higher wages, pushing them into higher tax brackets. Rising tax liabilities made employer-provided nontaxable benefits increasingly attractive. More companies began to offer health insurance plans to workers, and unions demanded additional benefit coverage to make up for losses in disposable income. For example, between 1970 and 1980 the number of Americans with dental insurance plans rose from 12 million to 80 million.(15)

As costs continued to escalate through the 1970s and 1980s, what did government do to rectify the situation? Did it rescind the tax incentives, laws, restrictions and regulations imposed on the health care market that skew behavior and result in increased demand for medical care with little concern for cost?

The answer to this question is No. Instead of removing the controls, incentives and restrictions that were distorting the market, the federal government attempted to stifle the outcome of bad policies with a whole host of new controls and regulations. The focus of all the legislation in recent years has been to control medical prices and hold down costs, specifically by applying additional restrictions to physicians, hospitals, and even patients.

Health Maintenance Organizations (HMO) were created and promoted by Congress in 1973 as a solution to rising costs. They fell under a significant amount of regulation, including requiring all companies with twenty-five or more employees to offer an HMO plan to their workers. As a result of grants and loans to encourage HMO growth, and employer interest in controlling health care costs, HMOs grew from twenty-six plans with about 3 million subscribers nationwide in the early 1970s to 556 plans with 35 million enrollees by 1991.

In 1983 a major effort at controlling Medicare costs was a provision within Social Security legislation that established a "prospective payment system" (PPS) for hospital reimbursement. Under this system, Medicare establishes a fixed schedule of fees that it pays hospitals for the treatment of each of 475 "diagnostic related groups" (DRGs) of illnesses. If the actual cost to the hospital is less than the DRG fee, it keeps the difference; if more, it absorbs the loss. The purpose was to encourage price consciousness and competition among hospitals.

The PPS has caused the same shortages and misallocations that any price control system would cause and has done so by shifting costs to activities not covered by the controls. Not surprisingly, costs in the Medicare program have continued to rise. In the five years following the introduction of PPS, the average annual rates of growth in Medicare spending were 6.5 percent for the Hospital Insurance program and 13.8 percent for the Supplemental Medical Insurance program,(16) much higher than the overall rate of inflation.

Mandated benefit laws are enacted usually as the result of lobbying from health care providers and advocates seeking coverage for various diseases. They require insurance companies to pay for specific medical services. In 1970 there were only thirty state-mandated benefit laws nationwide; today there are at least 800.(17) They are also a major reason why many people lack health insurance -- state-mandated benefits increase the cost of insurance and price many people out of the insurance market. According to a study by the National Center for Policy Analysis, as many as one out of every four uninsured people lacks health insurance because state regulations have increased the price. As many as 9.3 million people lack health insurance because of current government policies.(18)

The Resource Based Relative Value Scale (RBRVS), which replaced the system of "usual, customary and reasonable" charges adopted by Medicare in 1965 and by many other payers after that, became effective in January 1992. The RBRVS is based on a relative value of resources that would typically be expended to provide a medical service, i.e., the time and effort doctors actually devote to each procedure. The new payment schedule means higher fees for doctors in such specialties as family practice, internal medicine and obstetrics, and lower fees for surgeons and radiologists. In addition, the legislation limits "balance billing," the amount doctors can charge above what Medicare allows for a procedure or office visit.

The RBRVS, in reality, is nothing more than a comparable worth program for physicians, except that comparisons are made between physician specialties instead of jobs held predominately by men or women. The concept of comparable worth or the RBRVS is alien to a free market system, where supply and demand have always been the best instruments by which to determine prices, including the price of labor. Labor is not exempt from the same market forces that determine the prices of other commodities.

In addition to the fact that one person may value a surgeon's skill over their family physician's bedside manner while another may not, many other factors go into the prices charged by physicians (i.e., years of school, specialization, residencies and internships, and cost of medical school). The RBRVS will skew the demand for various types of physicians, with the government encouraging more students to become family practitioners and fewer to become surgeons. Isn't that the job of the market, to decide the supply and type of physicians based on demand? If the central planners in Moscow could not get bread to the grocery stores, how can we expect that well-meaning U.S. planners could correctly decide how many radiologists and gynecologists we should have?


In spite of the best efforts of business and the presumably good intentions of government, health care costs are still out of control and rising. The problem remains: Until we change the fundamental defects in the system, no amount of tinkering will result in a significant slowing or reversal in the direction of increased costs. The government's hodgepodge of health care programs, its continual interference into the market, and the protection of its (and the medical communities') preferred methods of care, have distorted the market and created a built-in structure of cost escalation.

Recent calls for overall reform of the health care system have brought forth a plethora of plans. Most receiving attention involve more government control and regulation, such as global budgets and the forced use of managed care. These "solutions" will prove to be bandaids and will not provide a permanent resolution of the health care problem. The only solution to rising health care costs is to allow a system based on the market, one that offers citizens maximum freedom of choice and responsibility in purchasing their health care. Only then will we see a health care system offering sufficient coverage and good quality care at costs that all Americans can afford.

Terree P. Wasley is an economic consultant specializing in health care issues, Washington, DC.


1 Source: Health Care Financing Administration.

2 The history of health care is excerpted from Terree P. Wasley, What Has Government Done To Our Health Care? (Washington, DC: The Cato Institute, 1992), Chapter 3. Significant sources for the history include Paul Starr, The Social Transformation of American Medicine, (New York: Basic Books, 1982); Joseph Califano, Jr., America's Health Care Revolution (New York: Random House, 1986); and Stuart M. Butler and Edmund F. Haislmaier, eds., Critical Issues: A National Health System for America (Washington, DC: Heritage Foundation, 1989).

3 Health Insurance Association of America, Sourcebook of Health Insurance Data, 1984-85, Tables 1.2, 1.3, 1.4, and 1.5.

4 Starr, p. 311.

5 Joseph W. Garbarino, Health Plans and Collective Bargaining (Berkeley: University of California Press, 1960), pp. 19-20.

6 Odin W. Anderson and Jacob J. Feldman, Family Medical Costs and Voluntary Health Insurance: A Nationwide Survey (New York: McGraw-Hill, 1956) p, 11.

7 Since the Blues early-on accepted the role as "insurer of last resort" in order to obtain special privileges and benefits from the government, accepting this role may have contributed in part to the financial trouble some of the Blues plans are currently experiencing. Had they not negotiated to "take all comers," high-risk policyholders might have been spread more evenly throughout the insurance community.

8 Joseph A. Califano, Jr., America's Health Care Revolution (New York: Random House, 1986), pp. 54-55.

9 Ibid., p. 144.

10 Expenditures and estimates are derived from David Holzman, "Medicine Minus a Cost Tourniquet," Insight, 8 August 1988; Meyer, Sullivan, and Silow-Carroll, "Critical Choices," p. 32; and Daniel Callahan, What Kind of Life (New York: Simon & Schuster, 1990), Table 1, p. 268.

11 Ibid.

12 Committee on Ways and Means, U.S. House of Representatives, Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means, 1989 ed., 15 March 1989, pp. 1140-41; and HCFA.

13 1990 figures for the Medicare and Medicaid programs are from the Health Care Financing Administration, National Health Accounts.

14 Ibid., pp. 152, 1139-40.

15 Health Insurance Association of America, Sourcebook of Health Insurance Data, 1984-1985, Table 1.8.

16 Based on data from the Committee on Ways and Means, U.S. House of Representatives, Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means, 1989 edition, 15 March 1989, p. 152.

17 John C. Goodman, An Agenda for Solving America's Health Care Crisis, National Center for Policy Analysis, Task Force Report, 1990, p. 19.

18 John C. Goodman and Gerald L. Musgrave, Freedom of Choice in Health Insurance, National Center for Policy Analysis, Policy Report No. 134, November 1988, p. 20.
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Author:Wasley, Terree P.
Publication:Business Economics
Date:Apr 1, 1993
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