Reference pricing is not a substitute for competition in health care

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In recent years, the U.S. health care sector has seen numerous innovations in the way care is organized and reimbursed (e.g., accountable care organizations, bundled payments, etc.), all with the goal of reducing expenditures and improving quality. One innovation that has received a great deal of attention recently is reference pricing. Reference pricing is a type of health benefit design that gives consumers seeking health care services an incentive to shop around for the best deal. Under a reference pricing insurance plan, the health insurer sets a “reference price” for certain elective treatments and procedures (e.g., knee replacement) that represents the maximum amount the insurer will pay for the treatment or procedure regardless of the health care provider selected by the patient. If the patient selects a provider who has negotiated a price with the insurer that is at or below the reference price, the entire price is covered by the insurer and the patient owes nothing. If the patient selects a provider whose price is higher than the reference price, the insurer will pay the reference amount, leaving the patient responsible for the difference.

Reference pricing can be a powerful tool for health insurers and employers to promote higher quality at reduced prices by giving patients an incentive to “vote with their feet,” and giving providers an incentive to improve the value of their services. Private health insurance plans have received approval to use reference pricing under the ACA, subject to further study of its impacts. However, we believe some important points are missing from the existing discussion of reference pricing.

First, some of the advocates of reference pricing seem to imply that reference pricing will increase competition between providers and “shift significant market power from the supply side to the payment side of the health sector.” On the contrary, reference pricing does not and can not create provider competition or change a provider’s market power. Reference pricing is simply a tool health insurers and employers can use to harness whatever provider competition may already exist.

For instance, consider a hypothetical market with only one provider of hospital services, which has used its monopoly position to negotiate a high price for its services. Suppose a health insurer introduces a reference pricing plan in this market and sets a reference price for, say, knee replacements, that is well below the hospital monopolist’s price. Given that there are no other choices available for knee replacements, reference pricing cannot make patients choose lower-priced providers. If a monopolist faces no competition, reference pricing cannot create an incentive for it to lower its price for fear that business will be lost to competitors. Reference pricing has not changed the monopolist’s underlying market power.

Other advocates of reference pricing argue that it is an “appealing alternative” to the so called “doc shock” of narrow network health plans because it preserves the patient’s ability to choose among providers. However, these same advocates acknowledge that reference pricing might be abused “if the reference price were set so low that no providers would accept it as full payment.”

We believe there is little difference between the price reduction and quality improvement incentives associated with narrow network health plans compared with reference pricing health plans. A health insurer could create a narrow network plan to give providers an incentive to reduce their prices and improve their quality in exchange for inclusion in the network and the increased patient utilization associated with this inclusion. Alternatively, the health insurer could create a reference pricing health plan and set a relatively low reference price that would mimic the incentives and utilization of the narrow network plan. The only difference between the two plans is that, in the former, providers compete in price and quality to be included in the network, while in the latter, providers compete directly for the patients.  Lost in the discussion is the possibility that some patients may prefer to delegate the responsibility for selecting low-price, high-quality providers to their insurance company instead of shouldering the burden of evaluating the relative price and quality of various providers.

Whether health insurers and employers use selective contracting, reference pricing, or some other health benefit design to cover their insured members and employees, there is a trade-off between the price of the plan and its breadth of coverage. If consumers desire lower-price health insurance options, these can be achieved with benefit designs, like narrow networks and reference pricing, that harness the power of provider competition to lower prices and improve quality, but only if meaningful provider competition already exists.

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