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MORGAN GUARANTY TRUST CO. OF NEW YORK,

New York, N.Y., July 14, 1967. Mr. WILLIAM E. ORIOL, Staff Director, Special Committee on Aging, 1.8. Senate, Washington, D.C.

DEAR MR. ORIOL: We greatly appreciate your interest in our discussion of the economics of medical care. I am enclosing a copy of the May issue of The Morgan Guaranty Survey. The article begins on page 3. Cordially,

MILTON W. HUDSON, Editor, Morgan Guaranty Survey.

[Enclosure)

THE ECONOMICS OF HEALTH

In the annuals of American medicine, 1966 will be recorded as the year the l'nited States took the long-debated plunge into governmental health insurance for the elderly. It also made history as a time when the prices of medical care as compiled by the Bureau of Labor Statistics—took one of the largest jumps ever recorded, a 6.6% increase that exceeded the rise in any twelve-month period since 1946-47. Largely because of these two happenings—which in some degree appear to be interrelated—the nation's $45-billion health industry* presently occupies a position of even more than usual prominence in the national spotlight.

Particularly sharp attention is focusing on the swift rise in the cost of medical care-an occurrence that will be explored next month at a conference in Washington to which the Secretary of Health, Education, and Welfare is inviting some 250 persons representing both the medical profession and the public at large. It is expected that the participants in this National Conference on Medical Costs will devote much of their time to discussing and debating various recommendations for using medical resources more efficiently that were advanced earlier this year in the Report to the President on Medical Care Prioes. This document, known as the Gorham Report after the man who supervised its preparation, Mr. William Gorham, Assistant Secretary of Health, Education, and Welfare, is significant mainly because it argues for a variety of efforts to induce rather far-reaching changes in the way that medical care in this country is produced and distributed.

Whatever the outcome of this particular meeting, there can be no question at all as to the desirability of greater discussion and study of the basic economics of medical care. Despite the large dimensions of the health industry, which employs more workers than do the steel, automobile, and aircraft industries combined, it has suffered serious analytical neglect by economists. Unfortunately, misconception and half-truth about the economics of the industry are commonplace, and they constitute a serious threat to the formulation of correct public policy. And in no area of national life is the need for prudent policy-making any more obvious. Worrisome as the health industry's problems may be to many people, no one wants to initiate correctives that will risk curbing its bounty of wonders and marvels. Statistical headaches

The rising trend of medical prices is not easy either to measure precisely or to evaluate. The BLS Consumer Price Index, to be sure, includes not only a medical-care component but also 29 medical-care subcomponents that purport to measure a variety of things that range from the cost of aspirin tablets through hospital operating-room charges to the fees of psychiatrists. Additionally, it is possible to construct estimates of the cost, say, of maternity care or an appendectomy now compared with times in the past. All such data portray a pattern of more or less persistently rising medical-care costs and prices throughout the period since World War II and indicate that recently the trend in this direction has accelerated. For the ten-year period that ended with 1966, for instance, the BLS index of the prices of medical services (which in concept covers all consumer medical-care items except drugs) indicates that such prices rose more than twice as fast as did the over-all cost of living—an average of 3.9% year compared with 1.8% a year. The combined index for medical care, including drugs, rose less rapidly on the average in the ten-year-period (by 3.4% a year), reflecting the influence of a moderately declining trend in the BLS index of prescription-drug prices.

*The $45-billion figure is a rough approximation of the nation's total anticipated expenditures in 1967 for hospital and nursing home care; the services of physicians, dentists, and other professionals; drugs, eyeglasses, and appliances; medical research; and the construction of medical facilities.

Despite the conscientiousness with which such data are assembled, however, they inevitably are marred by some deficiencies that every user should bear in mind. It is clear, for one thing, that they overstate the longer-term rise in the prices of medical services, and probably appreciably, because of the inability of compilers to take account of the considerable but immeasurable quality improvements that have occured over time in medical care. The indices do not measure a fixed and unchanging kit of medical care but instead measure units of medical services that increasingly embody greater and greater know-how and skill. The higher fee a patient pays his doctor for an office visit today, compared with a decade ago, reflects not just a “pure price” increase but also the greater probability that his health will benefit from the call. And the hospital expenses of the maternity patient or the person undergoing heart surgery reflect, among other things, a portion of the cost of having in existence in the modern hospital a variety of services and equipment that guard against complications and fatalities. The quality change reflected in declining rates of maternal and infant deaths pere 100,000 births cannot be measured in a way that permits adjustment of obstetricians' fees and hospital charges, but it clearly should not be disregarded in an analysis of the trends in such prices. While price increases also are undoubtedly overstated for many other components of the Consumer Price Index because of the impossibility of accurately measuring and allowing for quality improvement, the likelihood of such bias is especially great in the case of medical care.

The sharp postwar climb in the prices of medical services, moreover, needs to be viewed in the broad perspective of what has been happening to the prices of services in general. The pattern of increase in the medical area is not an isolated phenomenon, reflective merely of conditions peculiar to the health industry. Rather, virtually all service prices (for personal care, transportation, housekeeping, and so on) have risen much more rapidly since the end of World War II than have commodity prices or the over-all cost of living. The average price of a haircut, for instance, has far more than doubled in the postward period. And for the twenty years that ended with 1966, the general service component of the CPI rose by 91%, compared with an advance of 57% in the commodities component. The underlying reasons for the more rapid rise in service prices are complex and varied, but basically they trace to the fact that the American economy has grown increasingly service-oriented. As levels of affluence have risen, consumers have spent an increasing proportion of their current incomes on intangibles and amenities.

This aggressive bidding by consumers for services has produced upward price pressures in the service area of the economy, particularly because of the limited opportunities that exist in many service industries for expanding output by means of productivity increases. In some areas of medical care-most notably in hospital operations—it has been especially difficult to realize cost savings per ailment or per patient. The American Hospital Association reports that in the past twenty years the number of hospital employees per 100 patients has nearly doubled. In part because the obstacles to “productivity” improvement are espe cially formidable in health care, the prices of medical services have risen even more sharply in the postwar years than have the prices of services in general. Compared with the 91% rise for all services since 1946, prices of medical-care services are up 129%. The difference, however, is one of degree rather than kind, and it is proper and necessary to view trends in the medical-care field within the context of what is happening to services at large. Special prods to demand

Rising prices for medical care must also be judged in the light of several special influences that have powerfully stimulated the demand for medical serr. ices in the postwar period. One of these has been an expansion in the availability of "free" or minimal-cost medical care under both philanthropic and publicassistance programs. Also of great importance has been the remarkable growth in the last several decades of the population's health-insurance coverage-something that clearly is positively correlated with the demand for medical services.

Whereas in the prewar period less than a tenth of the populace was enrolled in voluntary health-insurance programs, today the situation is radically altered. At the end of 1965, 156 million Americans-or four-fifths of the civilian population-had some kind of private hospital insurance, while 146 million carried surgical protection. Some 113 million people, moreover, had regular medicalexpense coverage, providing benefits toward physicians' fees for nonsurgical care given in the hospital, home, or at the doctor's office. And 52 million Americans were covered by so-called major-medical expense policies. In 1965, health insurance payments to beneficiaries totaled $8.6 billion. Although this was only about a third of total personal consumption expenditures on medical care, it presumably covered a substantial part of "big-ticket” outlays.

The evidence is overwhelming that people who have health insurance make appreciably more use of medical services than people who have no coverage. With the financial barrier removed or lowered, individuals tend to seek treatment they otherwise might view as postponable or optional. This no doubt is part of the explanation of the fact that the annual rate of hospital admissions per 1,000 members of the civilian population is now running some 40% higher than in the early postwar period. Somewhat surprisingly, even the incidence of surgery tends to be considerably higher for insured groups than for the uninsured. It seems clear that not only do previously neglected real ailments tend to be treated after a person acquires coverage but also that some people seek and get care where the actual need is marginal.

Of course, where increased demand occurs in the context of underutilized capacity, it will not necessarily prod prices upward. In fact, the tendency will be precisely the reverse, since unit costs will be reduced by spreading overhead expenses over a larger volume of the service rendered. And there have been communities and regions where hospital beds, for instance, have not been fully used, and indeed there still are. But there also are areas where medical facilities have been taxed or where bottlenecks have been significant. And more important than any strain on physical plant has been the chronic shortage of medical workers needed to man facilities—a shortage characteristic of both professional and nonprofessional personnel. Enter Medicare

Significantly, the enlarged demand for medical services that has been brought about by expansion of private health insurance and of subsidized medical care is now being reinforced by the operation of the so-called Medicare and Medicaid programs. Under Medicare, which originated with the Social Security Amendments of 1965 and became operative on July 1 of last year, almost everyone 65 years of age and over is automatically covered for a large part of hospital bills, skilled nursing home expenses, outpatient diagnostic services, and post-hospital home services. Roughly 19 million people come under the program, which is being financed largely by an increase in Social Security taxes. Additionally, these elderly persons can subscribe to voluntary insurance toward physicians' fees and a variety of other medical services and supplies, which is financed by payments of $3 a month from each insured person and matching payments by the federal government. About 18 million have signed up for this feature of the Medicare program.

Under Medicaid, whose significance wasn't fully appreciated by many people at the time of its enactment, a much larger number of Americans, irrespective of age, are potentially eligible for a variety of appreciable medical benefits. The Medicaid program, also a part of the 1965 Social Security Amendments, consolidated and extended the coverage of numerous federal programs of medical assistance. It provides for the federal government to share with state governments the costs entailed in public payments for the medical care of patients who can qualify as “medically indigent," with the federal share of cost varying from 50% to 83% depending on average per capita income within state boundaries. Once the legislation was enacted, various states moved relatively quickly to establish programs, with New York setting an exceptionally liberal standard of medical indigence. For a while it appeared that the number of those eligible for Medicaid benefits might rapidly balloon beyond expectations, involving far larger costs than had been originally anticipated. Congress is now engaged in reconsidering portions of the 1965 legislation, and some tightening is probable. Even so, Medicaid seems certain to assume sizable dimensions, amplifying Medicare's tendency to enlarge the demand for services. Swifter price increases

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It was widely predicted that enactment of the Medicare and Medicaid programs would exert additional upward pressure on the broad structure of medical prices. Actual price experience during the past year has been consistent with that expectation. In the span from June 1966 through March 1967 (the period during which Medicare became operative), the prices of all medical services, according to BLS data, rose at an annual rate of 10%. By contrast, in the year that preceded the beginning of the Medicare program, such prices advanced less than half as rapidly-by 4.7%. The difference is particularly striking, since the annual pace of general price advance, as measured by the overall cost of living, was almost exactly the same in both periods, amounting to 2.5%.

By far the sharpest acceleration in medical prices has occurred in hospital rates. The average daily service charge in hospitals climbed at an annual rate of more than 25% in the nine months that ended with March 1967, triple the rate of advance in the year preceding Medicare's beginning. And the rate of increase in hospital operating-room charges and X-ray fees also has accelerated markedly. Although patient loads have been enlarged somewhat by Medicare, this does not appear to explain all that has happened. Rather, the mechanics of Medicare, requiring hospitals to itemize charges in detail, apparently have prompted numerous hospital administrations to initiate basic re-examinations of their rate schedules. In many instances, the conclusion seems to have been reached that previous rates did not fully reflect real costs.

Physicians' fees also have been rising more rapidly in the period since Medicare began than before, although here the before-and-after contrast is not nearly as marked. Doctors' fees climbed at an annualized rate of 7.9% in the nine months that ended with March 1967, compared with an increase of 5.7% in the year before Medicare started. Whether this difference in the rate of increase can properly be ascribed to the impact of Medicare is uncertain, particularly since fees charged by doctors who specialize in treatment of younger age groups have tended to show the same sort of acceleration recently as have fees charged by doctors with more general practices.

In time, however, one would expect the increase in the demand for medical care implied by the 1965 legislation to push upward on all medical prices, reinforcing the thrust in this direction that has been produced by the spread of private health insurance. Thus, the outlook in the years immediately ahead is for continuing price pressures in the medical area unless the supply of medical and paramedical personnel can be rapidly expanded or unless a major breakthrough can be achieved in the health industry's productivity. The problem of supply

Unfortunately, on the basis of recent trends, it is not possible to be especially optimistic about the supply side of the medical equation. The nation's medical schools, to be sure, have been increasing their enrollments, and the country also has received an inflow of about 1,600 foreign-trained doctors each year recently. These two factors in combination have been sufficient to keep the ratio of physicians to the total population fairly constant during the past decade and a half. Nevertheless, with an increasing proportion of physicians going into nonpracticing pursuits—such as teaching, preventive medicine, and research in the basic sciences—the number of doctors in private practice has not kept abreast of population growth. Because of the growing trend toward specialization, moreover, the number of physicians in general private practice has actually declined in the last fifteen years. This has resulted in increasing patient loads per doctor, made possible by such things as a drastic reduction in the relative frequency of house calls and a pronounced trend toward treating patients in hospitals where so phisticated equipment and auxiliary medical personnel can be employed.

Even with such economizing of time, however, shortages of physicians' services clearly have existed in various parts of the country especially in poorer regions and communities. The precise dimensions of the shortage are impossible to gauge since the criteria of "need” are inevitably arbitrary. Suggestive of the nature of the problem, however, is the fact that in the nation's 88 medical schools about 6% of the budgeted teaching posts have been vacant the past few years. And it is estimated that in hospitals the number of unfilled internships and residencies currently numbers approximately 10,000—equivalent to about a fifth of such positions offered. The war in Viet Nam has contributed to the shortage, since there are now approximately 2,700 more physicians in the Armed Services than there were before that conflict escalated. This is an increase of approximately 20%. Various surveys indicate that nurses and auxiliary medical personnel also are in short supply. A study last year of supply and demand for nurses, technologists, therapists, etc., in hospitals and nursing homes, conducted by the Public Health Service and the American Hospital Association, revealed an "urgent" need for 62,000 registered nurses, or an increase of 15%; for 22,000 licensed practical nurses, or 12% more; and so on down a list of more than twenty occupational classifications.

Widespread recognition that a serious personnel problem was emerging in the medical field developed relatively slowly. When concern finally did set in, however, it moved Congress to provide substantial remedial help. In each year since 183 Congress has passed some significant piece of legislation intended to speed the training of doctors, nurses, and allied health workers. Loan and scholarship programs have been established, and funds have been voted to help finance construction and expansion of educational facilities in the medical field.

Aided by this Congressional action, the training of medical professionals and auxiliaries is expected to quicken in tempo in the years ahead. Not only are many existing medical schools enlarging their enrollments, for instance, but universities also are planning to open twelve new medical schools by 1971-equaling in five years the number of openings in the preceding sixteen. Thus, the number of graduates from medical schools is almost certain to rise faster in the future than it has in the past. Whereas only about 7,400 students received medical degrees in 1965, the American Medical Association estimates that a graduation class of 10,000 might reasonably expected in 1975. And it is not unreasonable to anticipate an even sharper acceleration in the training of nurses and allied health workers, since in these areas the problems encountered in expanding educational programs are less formidable. The outlook

Even with intensified training efforts, however, there still can be relatively little confidence that the complement of medical and related personnel will be numerous enough any time soon to relieve the pressure of demand. The Public Health Service, which puts the shortage of physicians at 50,000 currently, estimates that the doctor shortage will still number about 40,000 in 1975. While this figure rests on criteria that many analysts quarrel with, the belief is widespread that significant manpower shortages will plague the nation's health industry for years to come.

This expectation of continuing personnel shortages is why students of the problem place so much emphasis on the desirability of finding ways to increase productivity in the medical field. Physician productivity has increased in recent Fears in the sense that doctors have found ways to treat more patients per hour or per working day. This has reflected such things as the efficacy of powerful new drugs, increased use of auxiliary personnel, a shift from treatment in patients' homes to treatment in offices, hospitals, and clinics, and a tendency for groups of physicians to work together under one office roof, sharing equipment and personnel.

These in general are the same avenues by which productivity gains can be expected to come in the future, with the reservation, however, that so-called inpatient treatment in hospitals is an increasingly doubtful source of improvement in the efficiency of over-all medical care. In fact, the evidence indicates that the point of diminishing returns-for general health-industry productivity-has already been passed in funneling patients through hospitals. Many persons who could be treated just as effectively in other facilities become hospital inpatients because their health-insurance policies pay only for treatment that takes place in a hospital. It is coming to be recognized that such use of hospitals (advantageous as it may be from the standpoint of the individual) has added sizably to the cost to society of medical care. In some measure, the Medicare program avoids this kind of stimulus to hospitalization by providing benefits for diagnostic services in outpatient clinics, for stays in extended care facilities, for health care in the home, and for visits to the offices of physicians.

General agreement now exists that anything which can be done to discourage inpatient treatment in hospitals in instances where alternatives are feasible will be of importance in holding down total medical costs. The Gorbam Report, for

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