Modes Of Paying For Health Insurance And Care

Armen Hareyan's picture

There are four ways to pay for health care. They are out-of-pocket payments, individual private health insurance coverage, employment-based group private health insurance and government financing.

Paying For Health Care With Out-of-Pocket Payment

Out of pocket payment is the standard method of payment for almost any good or service. Naturally, it was also the primary method of payment for health care services up until the early 20th century. The idea is simple, each individual consumer pays for the goods or services they consume. You go to the doctor with a stomach ache and you pay for the time spent consulting, whatever lab fees, and any medicines thereafter.

Unfortunately, a health care system built on out-of-pocket payments suffers several glaring weaknesses. First and foremost, health care is a need and not typically a discretionary purchase. Thus, a system which is reliant on out-of-pocket payments can potentially leave many individuals without access to proper health care. Going along with the reality that health care services are not discretionary purchases is the unpredictability of the need for and cost of health care services. An individual cannot predict when and to what degree they will get sick. Furthermore, most individuals do not possess the necessary expertise to understand the health care services that will be provided to them.

As an example, a person is unlikely to be able to predict if and when they'll experience chest pain. If a patient goes to see the doctor about a pain in their chest, the patient himself cannot make a determination of whether or not the pain is just a fleeting discomfort which can be cured with a relatively inexpensive bottle of aspirin or the result of a something more serious which could cost tens of thousands to treat. Furthermore, a patient is likely going to be unable to make a reasonable decision as to whether or not a doctor's decision to put them through a battery of expensive tests is reasonable. This unpredictability coupled with the asymmetry of information between doctor and patient makes out-of-pocket payment a seriously flawed foundation on which to build a health care system, particularly with the increasing complexity of health care.

Individual Private Health Insurance Coverage

Individual private insurance was the first creation response to the increasing difficulties that both consumers and providers were experiencing with out-of-pocket health care payments. Insurance policies allow a group of consumers to contribute to a single fund which manages the payment of each member's obligations. The benefit of these policies is that payment for services can be smoothed through regular premium payments as opposed to the lump sum payments made by those paying out-of-pocket. Furthermore, it offers the opportunity for more information symmetry between provider and payor as the insurance manager is likely to be better versed in medical care.

In 19th century Europe, guilds and mutual societies often set up small benefit funds where participants paid a small premium to the fund with each pay check and the fund would pay for each participant's medical needs when they arose. European immigrants brought the idea of health insurance to the United States in the late 19th century. Massachusetts Health Insurance of Boston became the first comprehensive group insurance policy in 1847[1], but it was not until 1929 when Baylor University Hospital established a comprehensive private insurance plan for its "members" that the idea of private health insurance took off in the United States.


Baylor University Hospital's plan laid the foundation for the Blue Cross/Blue Shield HMO (health maintenance organization) system. These plans restricted care to a particular hospital or group of providers and hoped to control costs for consumers while also providing providers within the plan's umbrella a steady source of income. It is interesting to note that in the United States, as opposed to Europe, health insurance did not truly gain traction until providers joined together to form health insurance plans as opposed to the consumer driven guilds and benefit funds which drove the adoption of private insurance in Europe.

Employment Based Private Health Insurance

Price controls during World War II brought about the use of fringe benefits in hiring and resulted in the creation of new employer based health plans. Basically, an employer would pay most of the premiums for their employees as opposed to pay them a direct salary. The creation of these plans actually exposed two loopholes government mandates. Most obviously, it allowed businesses to adjust compensation to employees despite mandated wage and salary freezes. But, more subtly, the payment of health plan premiums is actually considered a tax-deductible expense. Thus, businesses are, in effect, being subsidized by the government to offer health insurance to their employees. This subsidizing continues until today. In fact, it is believed that the U.S. federal government forgoes nearly $116.5 billion in tax revenues as a result of employer based insurance each year[2].

The growth of employment based health insurance exposed a weakness in the insurance system which is the questions of experience rating versus community rating. Experience rating is essentially the creation of "pools" of insured customers based on their socioeconomic characteristics. This was made very easy with the advent of employment based insurance as a workers in a particular company will typically be of similar backgrounds - white collar workers, truck drivers, etc. Community rating is the insuring of groups of people based on their community - a particular hospital, a localized area, etc - much more similar to that employed by the original individual private insurers like Blue Cross/Blue Shield.

A community rating system is naturally much more redistributive. There is a higher likelihood that a community will include a broad mix of wealthy participants who are more likely to use less health care and less economically well-off participants who are likely to use more health care. In experience rating, an low risk groups and high risk groups are separated and, as such, insurance companies using experience rating can offer low risk groups lower premiums and will either charge much higher premiums or simply not cover potentially high risk groups. The advent of experience rating in health care undermined community rating participants by taking low risk participants away from community rating insurers and leaving them with high risk patients who they would ultimately have to charge more to keep insured. Unfortunately, the shift to experience ration, while lowering costs for many, left high risk groups - the old, the sick, and the poor - less and less able to afford health insurance in the private market.

Paying For Health Care Government Financing

As a result of the shift to an employment based private insurance market as well as increasing focus on experience rating in the insurance industry, high risk populations, those who need health care the most, had no where to turn as their community rating based insurance programs dried up. In the end, the only way to bring "community rating" back to the system was through government health insurance financed by a progressive income tax. Thus, Medicare (for the elderly) and Medicaid (for the poor) were enacted in 1965 and have since become a pivotal feature in United States health care.





Of course, there are many points of disagreement on healthcare reform and numerous difficult decisions and compromises to be hammered out. But there’s also widespread agreement on at least two critical reform requirements. -- Electronic health records (EHR). Bringing together the major medical systems has been a priority of current HHS Secretary Michael Leavitt, and will likely be backed by his probable successor Tom Daschle. EHR adoption is still low, so the opportunity is real and big. -- Evidence-based medicine. Stakeholders agree that all efforts and systems should be based on sound medical science and published literature. The new systems need to assure and deliver quality, consistent care, incorporating the best diagnostic and quality care guidelines. These guidelines need to be available at the patient’s bedside as well as throughout payer and provider organizations. These two concepts give us a starting point for the emerging health reform compromise. I'm looking forward to seeing more points of agreement emerge as the reform conversation gains volume.