Most American patients worry about the cost of health care. In fact, a 2018 survey showed that people are more afraid of medical bills than of becoming seriously ill. To that end, health care businesses need to understand cost drivers. 

Because of the topic’s inherent complexity, a baseline understanding of the economic factors at play can be valuable to health care business professionals. The first thing to know is that — like many aspects of the industry — it’s complicated. 

For starters, pricing in health care does not always follow the same economic rules as in other industries. Pricing can be determined by competition, but not always. Sometimes price is an indicator of quality, but sometimes it isn’t. And amidst the emotional turmoil of a health scare, what makes economic sense in the consumer world might not work the same way in health care.

To learn about unique factors impacting health care costs, we turned to Anupam B. Jena, MD, PhD, for insight. Dr. Jena is an economist, a health care policy professor at Harvard Medical School, and a physician in the Department of Medicine at Massachusetts General Hospital. On top of his clinical and academic work, he is the host of the Freakonomics, MD podcast, a weekly podcast that is part of the Freakonomics Radio Network and explores questions at the “sweet spot between health and economics.” Those questions include: Are higher priced hospitals better? How do costs and quality of care provided by nurse practitioners and physician assistants compare to doctors? And what happens to cardiac patients when cardiologists are out of town at their national scientific meetings?

Here are five facts about health care costs that are important for health care leaders to know:
 

1. The price of therapeutic factors in the cost of the treatments that succeeded (and went to market), plus the cost of those that failed.

Consider pharmaceuticals. It is true that the profits of a blockbuster drug are generally much higher than the total spent on research and development for that drug. That’s because the profit makes up for more than just the cost of producing one successful drug — it covers the cost of developing many other drugs that were unsuccessful. 

Dr. Jena likes to use the lottery as an example. “The winners of multi-million-dollar lotteries, no matter how much they spent during their life, have a huge return on investment,” says Dr. Jena. “But you would never say playing the lottery is a profitable enterprise to enter.”

So, it’s important to recognize that the pricing of drugs and therapeutics is not just reflective of the products that succeed, but also those that fail. 

“It’s necessary to adjust for the risk inherent in the industry,” says Dr. Jena.
 

2. Studies have shown a correlation between expected profits and the rate of pharmaceutical innovation— both of which relate to potential life-years saved.

Nearly all economic studies would suggest that if prices decrease, innovation falls (as measured by the number of new products that are developed). But it’s also true that lowering costs would likely increase drug accessibility to more people.

Economists want to know whether people will lose more years of life in aggregate because of decreased innovation than people will gain by increased access to cheaper drug therapies. 

“There is no free lunch,” says Dr. Jena. “But the question we really want to know the answer to is, is [decreasing prices] worth it?”

The limited studies done to answer this question suggest that the decreased innovation caused by lowered drug prices would reduce total life years more than the benefit of increased accessibility to the drugs. So, lowering drug prices could be expected to result in a decreased life expectancy in the long-term, but the question is still very much an open one.
 

3. The value of a drug is about much more than increased years of life, and the total cost may or may not reflect other sources of value.

Traditionally, value is determined by quality-adjusted life years gained from using a drug and sometimes net increased costs and productivity. But increasingly, health economists say that is too narrow and are using additional concepts of value.

One is “spillover value,” which represents the benefit to society when a person gets a treatment. For example, when someone receives a vaccine, they are less likely to get sick themselves and less likely to transmit a virus to others. Similarly, a cure for dementia would not only benefit the person with the disease but family and loved ones who care for that individual.

Another source is known as “insurance value,” which is the value a treatment provides whether or not it’s used. In terms of health, people don’t know whether they will develop a disease, so it is valuable to them to know that there is a treatment available if needed.

“[Insurance] ends up being more valuable to you if you have to use it,” says Dr. Jena, “but the availability of a treatment is valuable to you, even though you don’t have that disease and you may never use treatment for that disease.”

Industry professionals need to consider these many sources of value. As Dr. Jena puts it, “If we don’t calculate that value right, we’re going to underestimate and underinvest in those areas of health care systematically.”
 

4. In competitive markets, prices of hospitals are a signifier of quality.

Generally, consumers believe price is an indicator of quality. But is that true for hospitals?

A study in the Natural Bureau of Economic Research, “Do Higher-Priced Hospitals Deliver Higher-Quality Care?” sought to answer that question. In competitive markets, it was true. Higher-priced hospitals in those areas had, on average, a 47% lower mortality rate — which is a dramatic improvement. 

As one of the study authors, Zack Cooper, says on a Freakonomics, MD episode, “If I had a device or a drug that lowered hospital mortality by 47%, you’d be giving me a Nobel Prize.”

The same study also found that the increase in spending at the higher-quality hospitals was cost-effective, determined by measuring the additional spending per life saved.
 

5. In less competitive markets, hospital prices are not associated with quality. 

The same study found that price was not a signifier of quality in regions where hospitals do not face local competition. In fact, in those areas — which include half of the country — there is a 52% increase in hospital spending without any measurable reduction in mortality. 

“This might be because, in less competitive markets, hospitals can sometimes have greater market power, which allows them to charge higher prices to insurers and patients,” says Dr. Jena in the podcast. “In those markets, price may simply reflect a hospital’s ability to charge higher prices than a measure of quality.”

The study prompts two important questions for health care business leaders — does the price of your product or service reflect its quality, and is your spending cost-effective considering the products’ value?

Health is incredibly hard to put a value on, but that’s why the work of health economists is so vital — it helps companies in the industry determine prices and reimbursements for services and therapeutics. 

To learn more about health through an economic lens, listen to Dr. Jena on Freakonomics, MD. Additionally, to explore the economic forces shaping U.S. health care, enroll in one of the upcoming online health care economics courses taught by HMS faculty.