econ lecture 9

1. Topic 9: Health Care Funding

2. Funding and Remuneration
Funding and Remuneration concerns the way that
money is allocated to organizations and providers in
exchange for health care services
Funding:
allocating money to organizations
Remuneration:
allocating money to individuals
Payment:
a term applying to both “funding” and
“remuneration”
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3. Importance of Health Care Funding
Funding influences system performance because the
chosen funding methods create financial incentives
regarding
who provides services
what services are provided
the quality of the services provided
where services are provided
to whom services are provided
Designing funding schemes that encourage
efficiency in the production and distribution of
health care services has consequently been a central
concern of health economics and health policy. 3

4. Important Policy Trade-Offs
In FINANCING we trade off between:
Insuring against risks
VERSUS
Avoiding moral hazard
In FUNDING and REMUNERATION we trade off:
Productive efficiency
VERSUS
Avoiding strategic selection
4
Insurance benefits people by
reducing risk but creates problems of
moral hazard
In this topic we will discuss how
payment schemes that encourage
efficiency also create chances for
health care providers to act
strategically (which may ultimately
result in sub-optimal HC treatment)

5. Principal-Agent Framework
Most of the design of funding schemes in health economics
relies on a more general framework of economic problems
called “Principal-Agent” models
The principal-agent framework describes a situation in
which an individual (the principal) would like to accomplish
some task or goal but must contract with another individual
(the agent) to do the work required
This is common in the everyday workplace: A firm seeks to
maximize profits, yet must hire employees without knowing
for certain their abilities or the level of effort expended
For health care funding, the principal is usually a
public/private insurer and the agent is a provider (hospital or
physician). The funder wants a provider to efficiently meet
the health care needs of beneficiaries. 5

6. Payment/Funding Scheme
6
Describes the “who, what, when, where and how” of a
funding or remuneration policy
For analytic purposes, we distinguish three parts:
Participants: Who pays whom to care for whom?
 This includes parties to the exchange/transfer of funds (ex.
government, insurers, providers, health care organizations,
beneficiaries/patients etc.)
Services and activities: What is being paid for?
 Can range from a narrow subset of services (ex. only drugs) to
a broader basket including primary care and non-care
activities such as risk-bearing
Payment/Funding Mechanism: How is it paid for?
 Refers to the methods by which funds are transferred between
participants in a funding scheme

7. Common Scheme Examples
The funding scheme indicates who has financial incentive to
do what in the health care system
Funding primary care through a system where a physician
receives a payment each time they provide a reimbursable
service (called fee-for-service payment) encourages the
provision of care listed in the fee schedule and discourages the
provision of care not explicitly defined in the fee schedule
 The incentives change if this scheme were replaced by a
capitated system in which the provider receives a fixed sum of
money each period per patient enrolled in the practice
(regardless of if or how much they seek care), with the
responsibility to meet all defined health care needs of the
enrollees . There is now an incentive to minimize the provision
of unnecessary services and to increase the provision of
preventive services that will reduce future need for care 7

8. Financial Intermediaries are…
Organizations that collect money and pay for health
care services on behalf of beneficiaries
Ex. Governments (Federal, provincial ministries etc.)
Ex. Insurance Company
Ex. Charitable Organization
Note: Intermediaries are not always present. For
instance when purchasing health care goods/services
that are not covered by private/public insurance, ex.
crutches, chiropractor services, etc. (or for most
other out-of-pocket medical expenses).
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9. Beneficiaries are…
Individuals who receive the health care services paid
for under a payment scheme
Ex. patients covered by a health plan
Ex. patients of a health centre or clinic
Ex. cash paying patients
Ex. residents of a province
The key is that each payment scheme must properly
specify who the potential beneficiaries are
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10. Providers are…
Whomever it is that can (or must) provide care in
exchange for payment
Ex. Individual professions (physicians etc.)
Ex. Groups of professionals (organizations, companies,
hospitals etc.)
They may range in size
They may be private or public, for-profit or not-for-
profit (we will discuss these alternative in the next
topic focusing on health care suppliers)
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11. Funding Flow Diagram
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U.S. or Canadian
uninsured health
services
U.S. health services
through private insurer
with co-payments
Canadian health services
through federal and
provincial governments
(Private Insurer)
(Federal gov’t)
(Provincial gov’t)

12. Funding/Payment Mechanisms
What is paid for, and how?
The “what” in this definition may include health care
procedures, products, administrative services, risk-
bearing responsibilities, etc.
The “how” relates to financial terms of the contract. It
includes timing of payments, fees per unit of services,
limits on total payment, duration of contract, etc.
A relatively small set of funding mechanisms dominate in
health care, but no one single mechanism is used for the
whole of a health care system
Details of each type of payment mechanism will be given
in the following slides…
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13. Prospective vs. Retrospective Payments
Prospective Payments: Terms of payment
determined before service delivery
Higher degree of prospective payment means more
financial risk born by the provider not the funder
Will minimize cost of components paid for on a
prospective basis
Retrospective Payments: Terms of payment
determined after service delivery
Higher degree of retrospective payment means more
financial risk born by the funder
Will maximize volume of services paid for on a
retrospective basis
13
Very important since the provider might not be able to
handle the risk and may try to avoid this risk

14. Payment by “Fee-for-Service” (FFS)
The provider or organization is given a fixed amount of money
for each unit of a service that they provide
Fees are only given for specified services (different fees for
different services)
The fee per service is pre-determined (in a “fee schedule”)
Total payment depends on the number of services rendered
It is for funding or remuneration
Mostly a retrospective payment system
It creates an incentive for providers to produce each service
rendered in the least-cost way (since the difference between
the fee and their costs determines their income/profit)
Paying Fee-For-Service biases providers toward inefficient
over-provision of reimbursable services and under-provision
of services not listed in the fee schedule 14
Historically dominated funding for physician services in Canada, France,
Australia, Germany and other countries although its role is diminishing

15. Payment by Capitation
The organization/provider receives a fixed sum of money per period
for each individual (enrolled) under its care
Fee is for all “covered services” required by persons under care in
the period
The fee per person per period is pre-determined
Total payment depends on the number of persons on the “roster”
(enrolled with the provider/organization) regardless of their
utilization or number of visits/services needed
It is for funding or remuneration
Mostly prospective payment
The capitation payment is usually risk-adjusted to reflect the differing
needs of individuals (age and sex risk classes are common factors)
It creates incentive to under-provide care (called “skimping”) and to
engage in risk selection to attract relatively low-risk, healthy
individuals within each risk class 15
Dominates for primary care in the U.K. and is growing in Canada

16. Payment by Case/Diagnosis
The provider or organization receives a fixed sum of money
each time they treat a case of a particular diagnosis (ex. treat a
case of appendicitis)
Payment is for all services required to treat diagnosis
The fee for each case is pre-determined
Total payment depends on the number of cases treated
It is for funding or remuneration
Combines prospective and retrospective payment terms
It gives incentive to produce services in the least-cost manner
and to provide only necessary services
It also creates incentive to under-treat patients, to select
only the less severe cases within a diagnostic category, and to
strategically classify diagnoses so as to maximize payments 16
Primarily used for funding U.S. hospital care, where a case is defined as a hospital
admission and the payment varies according to the diagnosis of the individual admitted

17. More on Case/Diagnosis:
DRGs/ACGs/ADGs
In order to fund providers based on the thousands of diagnosis
of each case admitted, individual diagnoses are put into groups
with other diagnosis which tend to cost the same to treat
Diagnosis-related groups (DRGs) are a patient
classification scheme based on demographic and diagnostic
characteristics used in Case/Diagnosis based funding
schemes (based on past doctor/hospital records of patient)
Researchers at Johns Hopkins have developed a DRG system
that most believe best captures the costs of patients with
complex case-mixes (multiple co-morbidities)
Adjusted Clinic Groups (ACGs) (93 mutually exclusive
groups)
Aggregated Diagnosis Groups (ADGs) (32 independent
ACG building blocks) 17

18. More on ACGs and ADGs
ACGs: Adjusted Clinical Groups
ACGs assign a person to unique morbidity category based on
patterns of disease and expected resource requirements. A
person falls into one of 93 mutually-exclusive ACG health
status categories based on a combination of ADGs, age, and
gender
ADGs: Aggregated Diagnosis Groups
ACGs are based on building blocks called ADGs. Each ADG
is a grouping of diagnosis codes that are similar in terms of
severity and likelihood of persistence of the health condition
over time. All ICD-9 diagnosis codes assigned by
doctors/hospitals are assigned to one of 32 ADGs. A person
may have multiple ADGs.
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ACG examples: ACG0200 is “one or more acute minor conditions only: age 2-5” while ACG1732
is “pregnant, not delivered, with 2-3 different ADGs, of which one or more is a serious or major
condition”
ADG examples: ADG14 is “chronic, stable medical conditions” while
ADG22 is “recurrent or persistent, unstable psychosocial conditions”

19. Payment by Global Budget
The organization is provided a fixed budget for a
given period
The budget size is pre-determined
Budget size is the total payment
Budget comes with some pre-specified expectations
It is for funding only
Mostly prospective payment
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In Canada it has historically been the dominant way to fund hospitals.

20. Payment by Salary and Wage
Salary: The provider receives a fixed sum of money for
a given period
Wage: The provider receives a fixed sum of money per
hour worked
The salary/wage-rate is pre-determined
The salary/wage comes with pre-specified expectations
Total payment is equal to either the salary or wage times
hours worked
It is for remuneration only
Salary is mostly a prospective payment
Wage has elements of both prospective (wage element)
and retrospective (hours worked element) payment 20
Common for hospital doctors in the U.K.

21. Bonus or Incentive Payments
Managed care organizations in the U.S. often use
bonus payments to encourage lower-cost utilization
patterns among affiliated providers
physicians who’s utilization rates fall below a target
receive a bonus payment
More recently, bonus payments have been advocated
as part of performance-based payment schemes to
improve quality of care
Bonus for providers using effective techniques (ex.
prescribing beta-blockers to post-heart attack victims)
Bonuses for providers located in rural locations where
supply is needed (ex. Northern Ontario)
21
Sometimes called “Performance-based payments”

22. Physician Payment BreakdownSource: Kantarevic (2010)
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23. A Model of Health Care Costs
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24. Selection vs. Efficiency
Funders face an efficiency-selection trade-off:
A fully retrospective system of payment encourages
inefficient over-provision of services but provides little
incentive to engage in risk selection and care skimping
A fully prospective system of payment discourages
inefficient over-provision but provides incentive for
risk selection (cream skimming and dumping
[devising polices that discourage bad risks]) and care
skimping
In the face of this trade-off, blended funding
approaches maybe optimal
Under blended funding a provider’s total funding
comprises a mixture of payment mechanisms, with the 24
Pro: Avoids selection problems
Pro: Is efficient

25. Risk Adjustment
Incentives for strategic response by providers stem from
variability in patient-specific costs that are not reflected in
prospective payment rates.
To reduce this incentive, efforts are made by the funder to
adjust payments (e.g., capitation payments) to reflect the
health status of individuals.
Variables used to adjust risk must be
observable by the financial intermediary
predictive of expected health costs
not “gameable” by providers
Some common risk adjustment variables are Age and Sex (these
are used in Canada) but Diagnoses (DRGs/ACGs/ADGs) are
popular in the U.S. (in some sense DRGs may be “gameable”) 25
“Gameable” means that the variable is under the control of the provider. When this happens the
provider can strategically manipulate the variable to increase payments received

26. Questions for Optimal Funding
Balance prospective and retrospective payments
Ensure that those who bear risks can pool them
effectively (i.e. do not put unfair amounts of risk on
individual doctors)
Ensure that the administrative and managerial
capacities required to run the payment system
effectively are available
Ensure that the payment mechanism matches the
context
Minimize the scope for self-interested strategic or
manipulative responses by providers
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27. Self-interested Strategic Responses
In addition to over-provision under FFS and risk
selection under capitation there are two other important
strategic responses that providers can have:
Strategic up-coding to garner more payment than is
appropriate (ex. in FFS, billing an intermediate
assessment rather than a minor assessment; in case-
based funding, choosing the diagnostic category that
will maximize the reimbursement amount)
Strategic referral patterns (ex. when capitation
applies to primary care only, a primary care physician
can more frequently refer a patient to a specialist,
shifting the costs on to separate funding stream)
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Because it is impossible to remove all incentive for strategic responses, development of
effective monitoring mechanisms that dissuade providers from responding to those incentives is
crucial

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