Local exchanges and markets will be better for health care costs than Washington price-fixing.

Jim Bourg/Reuters

It is nobody's fault, but our health finance system has long been a disaster. Since World War II it has slowly evolved, with all the best intentions, into not one but at least three wholly separate entities--each with different infrastructures and different sets of perverse incentives for hospitals, doctors, and other providers. This nutty system of finance is the reason that health care expenses are swallowing the U.S. economy (and federal and state budgets), and that health care is our biggest domestic policy issue. The health care profession has always been quite honorable, but the reality is that these professionals--physicians, nurses, hospital administrators alike--aren't immune to financial incentives, and the incentives created by our current system are completely out of whack.

So what does the average local health care market look like?

1) Medicare: The almost 50 million Medicare beneficiaries (seniors and the disabled) make up about 16 percent of the U.S. population--but account for over 40 percent of the spending for the average health-care system, public or private. Medicare drives everything in local health economics, because seniors consume lots of health care and they are in the hospital often. For three-quarters of Medicare beneficiaries, traditional Medicare programs fix prices nationally. Think about that--every hospital and every doctor gets paid the same thing! Recently there have been minor variations through "Accountable Care Organizations" and other "pay-for-performance" models--but for the vast bulk of services, the worst hospital in town gets paid the same as the best.

Not surprisingly, this crazy pricing scheme incentivizes volume. Physicians try to see more patients; therapists try to do more therapy; hospitals try to book more surgeries. It is predictable human nature, and has been in every society in history. Health care is the only service in the U.S. where the government fixes prices--is it a surprise that volume has exploded?

2) Medicaid: Medicaid is the program for low-income Americans, including the disabled and the elderly (usually in long term care). Actually, Medicaid is not one program, it's 50 totally different state programs. Seventy-seven million Americans were on Medicaid at some point in 2011--almost 25 percent of the population, at a cost of $440 billion. And we plan to begin adding 18 million more Americans on January 1, 2014, for another $120 billion a year, under the Affordable Care Act.

Talk about a mess! Every state provides different coverage, and Medicaid is a chaotic hodgepodge of policy. Even worse, virtually all the states have succeeded in transferring much of the cost to the federal government over the past 25 years through "provider taxes," "intergovernmental transfers," and "upper payment limits," so that no state actually pays anything remotely close to its statutory "match rate." The entire program is a giant state refinancing scam. What initially was a 50-50 federal program, is now more than 70 percent federally financed, with some states, most notably New Hampshire, not contributing a single nickel of state general revenue. This lack of program integrity is a problem, because it makes the program unreformable. There is no policy equity among the states, so any reform proposal will create some winners and some losers, unless you spend even more money. So it will never happen.

States have increasingly moved to Medicaid managed care, but the bulk of daily health services are still paid in the old "fee-for-service" methodology. And guess what: those states also fix prices and pay all providers the same amount, almost always using the Medicare system as the reference payment. If you are a hospital or a health system, you already have 40 percent of your payment coming from Medicare, and in addition you probably have another 12-15 percent of your revenue coming from Medicaid. So 50-55 percent of your payments come from two giant price-fixed national programs--and you get paid the same rates, no matter the performance. How's that for an incentive structure?

3) Commercial Insurers/Blue Cross/Employer Plans: Private insurance generally makes up another 35-40 percent of the health care spending total (the uninsured fill in the remainder). There are a few markets with dominant Blue Cross plans that actually have leverage. But in most markets there are a handful of insurers: rarely does any one player have more than 20 percent of the market, and often it is far less. So why would a hospital care intensely about improving performance, or cutting prices to meet the demands of Aetna, Cigna, or United, when those companies rarely wield significant market share and are bit players compared to Medicare and Medicaid? In fact, most commonly, insurers still pay a percentage of--you guessed it--the Medicare fee schedule. Ask a doctor or hospital what an insurer pays them, and you will likely get "105 percent of DRGs" (the Medicare hospital fee) or "103 percent of RVUs" (the Medicare doctor schedule).

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Health Professionals Will Respond to Incentives, If We Only Let Them