Selective Contracting

Overview

The basic idea surrounding selective contracting is that insurers contract with hospitals, physicians, pharmacies, and other healthcare providers based on factors such as services, quality, amenities, location, and, potentially, price. In the 1970s and 1980s, competition in healthcare was characterized as a medical arms race. More competitors in a market, measured as more hospitals in a geographic area, were associated with higher, not lower, prices as simple economic theory would predict. In as much as consumers were reasonably well insured and insurers entered into contracts with all local providers, there was little reason for a provider to offer a lower price. A lower price would garner little additional patient volume. Instead, more services, greater quality, and additional amenities attracted physicians and their patients. Thus, costs were higher in areas with greater nonprice competition.

Empirical Evidence

Efforts largely beginning in California began to change the medical arms race. California's state legislature passed laws that made it clear that insurers did not have to contract with all licensed providers in a market. Prior to the laws, hospital costs were higher in highly competitive markets in California. However, after enactment of the laws, cost increases were much smaller in the more competitive hospital market areas—the opposite of the medical arms race scenario.

Even more compelling evidence was found in an analysis of the hospital prices that were negotiated by the Blue Shield of California preferred provider organization (PPO). An analysis of the medical-surgical price per day that the PPO negotiated with 190 California hospitals showed that the PPO was able to obtain a lower price when there were fewer hospitals in the market; when the PPO had a larger share of a hospital's admissions; when a hospital had only a small share of the PPO's local book of business; and when there was idle capacity in the hospital or, indeed, in the local hospital market. These findings were strong evidence that the standard economic model was functioning in the hospital market. A number of other recent studies have generalized these findings beyond California.

Managed Care

The success of managed care in reducing healthcare costs is attributed to selective contracting and the reduction of expensive services on the part of managed-care plans. There is substantial evidence that managed-care plans, particularly health maintenance organizations (HMOs), have attracted lower utilizers of healthcare. It is less clear, however, whether this reduction comes about as a result of actions that the health plans take to enroll lower utilizers and shun high users or whether their enrollment reflects individuals who disproportionately like the concept of health maintenance and who dislike interacting with the healthcare system. The evidence that managed-care plans discourage the use of expensive services is scarce.

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