This post first appeared in the Health Affairs Blog.

America’s health care market does not work well.  It is inefficient, asymmetric, and in most cases not particularly competitive.  The Affordable Care Act (ACA) legislated a myriad of changes to reform and improve insurance markets with exchanges as a centerpiece.  While exchanges and reforms like subsidies, guaranteed issues, age bands, community rating, reinsurance, and risk adjustment are all helpful, a huge opportunity remains to segment the health care market around different categories of patient demand.

Basic economic theory states that a well-functioning market is aligned between supply and demand.  Ideally, suppliers and customers align around the preferences of the customers – the unit of alignment is driven by the demand side.  When we examine health care, we see demand falling into three segments:  healthy people who have episodic needs, chronic disease patients with predictable needs, and highly complex patients with less predictable needs.  Given the high variance between the three submarkets, we believe that each of these segments should be thought of as a discrete market and served by different types of insurance products, payment models, and health care providers.

We believe that this is necessary since each of these segments values providers differently.  For a healthy patient with periodic needs, convenience and experience are likely to matter more than continuity with a provider and care team.  Conversely, chronic disease patients are likely to value clinical outcome attainment, complication avoidance, and care coordination very highly.  And complex patients will need and value the customization, access to research, and specialization that the latest medical breakthroughs can deliver.  Not only are the sources of value different, but so are the delivery systems and payment models needed to align incentives for value.

Re-Envisioning The Health Care Market

Healthy patients.  For healthy patients with periodic needs, an episodic approach is also the most economically efficient.  These patients do not require the fixed cost of a large system of care and instead should purchase discrete specific services — ideally a bundle of care to deliver a specific pre-defined outcome.  In this model, a patient buys insurance and broad access to providers and, when a health need arises, receives a budget for his or her episode of care.  We favor reference-based pricing so the patient can purchase an episode outcome without additional cost sharing while retaining the option to pay more if he or she chooses.  The market is thus incentivized to manage to a specific outcome in the most cost-effective way and to compete on delivering extra value for those patients who are willing to pay more.

To meet demand for bundled payments organized around episode outcomes, the supply-side should realign into specialized care units that focus on a few procedures, organ systems, or disease areas — a broad PPO network.  This has historically proven successful for elective conditions: the Dartmouth Spine Center has a surgery rate of 10 percent –- lower than the national rate –- with 100 percent of patients reporting their needs were well met.  Other examples of episodic providers include ambulatory surgery centers, orthopedic and cardiovascular specialty hospitals.  We also foresee capitated systems managing population health procuring discrete episode services from specialty providers, since these providers should be able to offer equal or better outcomes at lower prices than an Accountable Care Organization (ACO), integrated delivery system, or multispecialty group.

Patients with chronic disease.  For chronic disease patients, the primary outcome goal is to minimize a condition’s short-term inconveniences and long-term complications.  The market should thus incentivize a long-term perspective centered on patient engagement, adherence, and side-effect prevention.  On the demand-side, customers should purchase care from a provider able to care for all aspects of a patient’s condition, which creates incentives for all players –- patients, doctors, providers, and drugmakers –- to manage cost.  The basis of competition should be the ability to deliver annual health and complication avoidance at lower costs.

In this model, incentives are most aligned when providers are paid using a risk-adjusted capitated payment.  To compete, providers should organize in organizations such as ACOs, Patient-Centered Medical Homes (PCMHs), multispecialty groups, or integrated delivery systems with strong capabilities in managing risk, population health, and costs.  Examples of these types of systems are Group Health, Geisinger, Kaiser Permanente, Healthcare Partners, and CareMore.  In this model, incentives for patients to adhere to treatment plans, and remain in the system of care, are reinforcing.

Complex patients.  Finally, there are certain conditions that are too complex to fit into either market, such as complex cancers, high acuity conditions, and rare diseases.  These conditions often exhibit both chronic condition and episodic characteristics and are best managed by academic medical centers or high-acuity specialty facilities like comprehensive cancer centers and children’s hospitals.

Our view is that the current fee-for-service system is the best approach for handling these cases.  To constrain inflation and encourage competition, fee for service should be coupled with utilization review, incentives to use evidence-based care, and transparency around risk-adjusted outcomes and expected out-of-pocket costs.  Paying for these as episodes will not work because high patient heterogeneity exists and the size of the market cannot support competition at the episode-level.  Moreover, it is hard to define quality and value for many of these types of patients and conditions.

The Way Forward: Turning Theory Into Practice

These payment models and provider organization approaches maximize value by encouraging healthy patients to get their conditions fully resolved for a fixed price, chronic disease patients to access a care team rewarded for avoiding complications, and complex patients to receive customized care and access from specialists.  Furthermore, each of the three submarkets –- healthy patients, chronic disease, and complex and rare conditions –- is large enough to be self-sustaining and attractive.  We estimate that the chronic condition market is $1.1 trillion, the episodic care market is $760 billion, and the residual fee-for-service complex and rare conditions market is $900 billion in 2011.

The three markets are growing at similar rates.  (See exhibit 1, click to enlarge.)  If the economics are aligned, they will also be able to create growing value for patients through productivity gains, falling prices, better outcomes, and far better patient experiences.  Fortunately, each of these markets and provider models exist today in many geographies.  They are just not widespread enough or coexistent.

Giving consumers more insurance options.  Transforming theory into a tangible system presents certain challenges, which we believe will be overcome in the next few years.  First, patients need insurance product choices.  The advent of state exchanges and community rating are catalytic events that could lead to this reorganization if exchanges permit reference-based pricing plans and allow integrated delivery offerings with narrow networks.  The employer market is already moving down this path with the marked increase in defined-contribution health benefits supported by private exchanges, where higher cost sharing and narrow network plans are often offered.  We are also seeing many more employers shifting to reference-based pricing and episode bundling approaches for elective conditions to rewards employees for selecting high-quality, lower-cost providers, and to encourage providers to offer a full course of care for a bundled price.

Provider restructuring.  On the provider side, theoretically overhead should not increase, but should decrease.  The largest providers that can pull in adequate populations will focus on patient and population health, a trend already being seen with groups like Partners Healthcare shifting to an ACO and capitated payment orientation.  Competition will also lead to emergence of more specialized providers for acute and episodic care among community hospitals.  Already for complex and rare conditions, regional centers like the Mayo Clinic and traditional academic medical centers exist.  The push to submarkets should accelerate the provider landscape transformation and reduce the extraneous providers that lack focus and a niche.

The biggest barrier today is linking benefit designs and reimbursement models with patient segments.  Once commercial payers approach providers with products that segregate patients into these segments with corresponding reimbursement, providers will rapidly reorganize to serve the segments that they are most competitive at supporting.  While this approach does generate more ACOs and PCMHs, the past year has shown that these can be formed relatively quickly to meet demand.  The emergence of retail-oriented primary care providers also indicates that episodic care models are able to proliferate and scale in response to demand.

Addressing changes in consumer health needs.  One additional challenge will be how patients react when health needs change mid-year.  All patients regardless of submarket will have certain basic aspects:  insurance, preventive care, and consumer protections.  The value in longitudinal care is irrespective of submarket and hugely valuable to reducing the growth of health care costs. As health needs adjust for patients during the year, we see two potential solutions. First, patients will still have access to other submarkets to receive the necessary care.  Second, the pool of patients who will need product adjustments will be significant, and the value cannot be ignored by payers. Thus, some supplemental plans may emerge that enable patients to gain access to additional types of providers.

Matching patient needs and demand with specific types of providers and reimbursement approaches is better for patients.  If incentives are aligned with the types of value desired by different types of patients, price increases should no longer outpace value creation, and providers will compete and differentiate in ways that are most valued by their core patient constituencies.   Doing this through the creation of well-functioning submarkets — instead of forcing a single, ill-functioning market — should also unleash productivity gains as providers specialize around narrower segments and stop investing in services that they do not do well, do at scale, or need.

Overcoming the barriers will be a significant challenge.  However, we are already seeing some shifting in the health care landscape, in addition to certain provisions in the ACA which will come online in the upcoming years and add further movement.