What They Are and How They Work
Senior Health Policy Faculty
Department of Health Administration and Policy
George Mason University
Fairfax, VA
Principal, P. R. Kongstvedt Company, LLC
McLean, VA
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Library of Congress Cataloging-in-Publication Data
Kongstvedt, Peter R. (Peter Reid), author, editor.
[Managed care]
Health insurance and managed care : what they are and how they work / Peter R. Kongstvedt. — Fourth
p. ; cm.
Preceded by Managed care : what it is and how it works / Peter R. Kongstvedt. 2009.
Some of the chapters are adapted from previously published works by the same author.
Includes bibliographical references and index.
ISBN 978-1-284-08711-6 (paper)
I. Title.
[DNLM: 1. Managed Care Programs—organization & administration—United States. 2. W 130 AA1]
Printed in the United States of America
19 18 17 16 15 10 9 8 7 6 5 4 3 2 1
New to This Edition
About the Author
Keeping Current
Attribution Note
CHAPTER 1 A History of Managed Health Care and Health Insurance in
the United States
CHAPTER 2 Health Benefits Coverage and Types of Health Plans
CHAPTER 3 The Provider Network
CHAPTER 4 Provider Payment
CHAPTER 5 Utilization Management, Quality Management, and
CHAPTER 6 Sales, Governance, and Administration
CHAPTER 7 Medicare and Medicaid
CHAPTER 8 Laws and Regulations in Managed Care
This fourth edition of Health Insurance and Managed Care: What They Are and
How They Work is significantly changed and updated from the third edition,
beginning with the title.* The reason for the changed title is not because health
insurance was not addressed in prior editions—it always has been part of the
text’s content—but rather because the terms “health insurance” and “managed
care” are now commonly used to refer to the same thing, to the point that many
people simply call any type of health benefits plan “health insurance.”
High-level descriptions of what is new in this edition and what has changed
are found in the New to This Edition section that follows this Preface. First,
however, it is necessary to point out the biggest change affecting every single
chapter: the Patient Protection and Affordable Care Act (ACA), which was
passed by the U.S. Congress and signed into law by President Barack Obama on
March 23, 2010. The ACA is addressed specifically in the Laws and Regulations
in Managed Care chapter, but it is also covered throughout the entire text
wherever it applies, which is pretty much everywhere.
Like this industry overall, the history of the ACA, including its current state,
has been subject to many political forces and regulatory changes, meaning
certain elements of the ACA described in this text may, in fact, change or no
longer apply after the text’s publication. Changes continue to take place outside
the ACA as well, which is why I have provided some sources from which to
obtain updated information (see the Keeping Current section that follows).
As we continue to add new laws, new regulations, new plan designs, new
payment methodologies, and new means of managing utilization and quality, it
becomes increasingly challenging to keep the overall size of this text down. The
only way I have found to address this issue is to focus only on the most
important aspects, and to keep most descriptions at about the same level. As a
result, readers who have no knowledge of how health insurance and managed
care actually work will at times feel overwhelmed with detail. In some cases it
may make sense to complete a chapter and then go back and reread any
confusing sections, which will have become more understandable in the context
of the rest of the material. In contrast, readers who are veterans of the industry
will be struck by how much has been left out. If that second group of readers
wants more detail, they can find it in this text’s big sister, The Essentials of
Managed Health Care, Sixth Edition, also published by Jones & Bartlett
Change is a constant, and whenever you hear someone complain about how
the healthcare system in the United States is undergoing turbulent times, you
should recognize that it has actually been in a state of flux for close to a century.
As one acquaintance of mine remarked, “Health care is in permanent white
water.” Wishing we could return to the calm and placid times in the past is the
same as wishing we could return to the world of Leave It to Beaver; both are
fiction and never actually existed.*
The causes of this ongoing turbulence also continue to change, and not just as
the result of new laws and regulations. Health costs keep rising, but where once
that trend was due primarily to overutilization, it now reflects a great many
factors, including pricing, advances in technology, and changing demographics
and consumer demands. The industry’s dynamic nature is the reason that health
insurance and managed care are now so difficult to distinguish from each other.
It is also the reason for this text, and the reason you are reading it.
While health insurance and managed care might change, the main goal of this
text has not. Its purpose is very simple—to provide its readers with a broad
understanding of how health insurance and managed care actually work. If it
succeeds in doing that, then some who are reading these words right now will be
in a position to better contribute to the future evolution of this dynamic
industry, thereby benefiting us all.
Peter Reid Kongstvedt
McLean, VA
* All of the prior editions were titled Managed Care: What It Is and How It Works.
* The second fantasy—that of living in the world of a 1950s sitcom—does, however, make for a wonderful
movie titled Pleasantville (1998, New Line Cinema), starring Tobey McGuire, Reese Witherspoon,
William H. Macy, Jeff Daniels, Joan Allen, and among many others, the terrific Don Knotts.
New to This Edition
So what new information makes this edition different from previous editions?
Too much to describe fully here. To do so would essentially rewrite the book, so
what follows is a very high-level description of some of the more important
This chapter, cowritten with another author, is probably the least changed
chapter in the book. Obviously, events that occurred after the prior edition was
published are included, but some other historical events have been added and/or
clarified. For example, a rather important new law affecting health insurance and
managed health care—the Patient Protection and Affordable Care Act (ACA)—
was passed in 2010.
Much of this chapter is entirely new. Previously, the focus was on the different
types of insurers and managed care organizations, as well as integrated delivery
systems (IDSs). IDSs have been relocated to the chapter on the provider
network, and updated descriptions of plan types remain in this chapter.
Before getting to those descriptions, however, the chapter now includes
entirely new descriptions and discussions of the following topics:
• Health benefits plans, and defined benefits plans in particular, and the
elements that apply to all of them
• Essential health benefits under the ACA
• Cost-sharing in general, and the related topic of the “metallic level” benefits
tiers under the ACA
• Coverage requirements in the individual market, the small group market,
large groups, and “grandfathered” health benefits plans
• Coverage mandates for individuals and employers
• Guaranteed issue requirements for insurers
• Sources of coverage and ways that coverage is obtained
• Who bears the risk for coverage costs and how it is paid for
• Reinsurance and how it differs from health insurance
This new material provides an added foundation for understanding how and
why the rest of the hugely complex system works.
In prior editions, all of the material in Chapters 3 and 4 in this book were
addressed in a single chapter. In this edition, an updated discussion of what a
network is and how it is managed is now separated from the discussion of how
providers are paid. This reflects better how the world actually works, and it
keeps the issue of money where it belongs—as a distinct issue requiring the
focused descriptions and discussion it deserves.
The concepts of service areas and access standards have been clarified and
updated, as has the discussion on credentialing. The description of IDSs is both
updated and compressed. New types of provider organizations and relationships
have also emerged in the last five years, though one has mercifully disappeared—
the provider-sponsored organization, though even that structure is making a
type of comeback under different labels. We have also seen new types of
provider organizations come into being, such as the accountable care
organizations (ACOs) that are part of the ACA, and some new dynamics
develop around some older approaches such as hospital employment of
physicians. All of these changes affect the larger U.S. healthcare system.
The content of this chapter also provides more detail than is found in other
chapters because this content is so critical to (here it comes again) understanding
the how and why of the hugely complex system’s workings.
The chapter on provider payment is the expanded and updated other half of
what was formerly in a single chapter. Like Chapter 3, it contains more detail
than what is found in other chapters. Unlike all other nations on earth, the U.S.
healthcare system uses about eleventy-eight zillion different payment strategies
and methodologies, and an equal number of variations of each. We have even
created more new approaches by law such as the shared savings program in
Medicare, a new value-based purchasing mechanism, and other new approaches
to payment that were spawned by the ACA.
In the case of payment (and as discussed in this text, the proper term is
“payment,” not “reimbursement”), there is one more reason to describe at least
some of the ways we pay for health care, which is summed up by the
singer/songwriter Randy Newman: “It’s money that matters, in the USA.”*
Besides moving and updating the section on accreditation from a different
chapter, the most significant updates to this chapter deal with the approaches to
managing utilization in special populations, such as people with multiple
chronic conditions. The discussion about medical necessity and its impact on
benefits coverage has been expanded, as has the description of the use of
evidence-based clinical guidelines for coverage determinations. Management of
the prescription drug benefit is also evolving as specialty pharmaceuticals grow
in importance and cost.
As with the other chapters, this chapter is affected by the ACA. In particular, the
means by which health plans underwrite, create and manage premium rates and
rebates, and access the market through sales and distribution channels; the
appearance of new health insurance exchanges for individuals and small groups;
and management of appeals of coverage denials warrant new and updated
descriptions due to the ACA. The discussion of enrollment and billing has also
been expanded, and aspects of financial management have been clarified. The
now-standardized eligibility, special eligibility based on life events, and coverage
extensions are addressed here as well.
Implementation of the ACA has required major updates to this chapter as well,
and the chapter has been essentially rewritten. For example, the ACA changed
how the Part D drug benefit is constructed and managed, and it changed (or
modified) how Medicare Advantage plans are paid, including the Quality Bonus
Program. A section on eligibility and enrollment has been added. Marketing and
sales in these markets are also fundamentally different than the corresponding
functions found in the commercial market, so the chapter now includes a
discussion of what is allowed and what is prohibited. Finally, Medicaid
expansion under the ACA—something that not all states have undertaken—is
addressed, as is the increasing reliance of states on managed Medicaid plans.
Chapter 8 is the only chapter that I did not write or coauthor. It was entirely
rewritten by contributor Tom Wilder and provides descriptions of the major
state and federal laws and regulations affecting health plans. It also provides an
excellent summary of the key elements of the ACA that have an impact on
health benefits plans.
The Glossary has nearly doubled in size in terms of pages, and more than
doubled in the number of entries compared to the previous edition’s glossary.
Along with adding new terms (and even removing a few), changes include
updates and clarifications of some of the definitions, spelling out many of the
acronyms that prior versions included only through their initials, expansion of
some definitions to include new meanings or uses of terms, and modification of
terms due to their redefinitions under the ACA.
Of course not. This breakdown provides only a glimpse of the overall revisions,
updates, and new material in this edition. The health insurance and managed
care industry is always undergoing change, but the combination of the ACA and
the political, social, and economic forces have yet again accelerated the pace of
change since the previous edition’s publication. Said another way, changes and
updates to this text are equal to the changes in the industry, which have been
massive. But if I have done my job right, the new content should all fit together
once again. At least until the next edition comes out.
* Randy Newman, “It’s Money That Matters” from Land of Dreams, Reprise/Warner Bros. 1988.
Although I cannot name them all, because to do so would double the size of this
text, I thank the many colleagues, clients, and friends in the health insurance,
managed care, and consulting industries with whom I have had the pleasure to
work beside over the years. Likewise, I thank my students and acknowledge their
contributions to keeping me on my game. I also want to give sincere thanks to
the many readers of previous editions of this text for their support, kind words,
observations, and suggestions that have contributed to improvements over the
years. Acknowledging the contributions of others does not, however, mean that
any of them contributed to any errors or misstatements; those are solely mine.
About the Author
Courtesy of Peter Kongstvedt
Dr. Peter Kongstvedt is a highly regarded national authority on the healthcare
industry with particular expertise in health insurance and managed health care.
He is principal of the P. R. Kongstvedt Company, LLC, and advises healthcare
executives on strategy, operations, and effective decision making. Dr.
Kongstvedt is also a Senior Health Policy Faculty member in the Department of
Health Administration and Policy at George Mason University. In March 2014,
he was appointed by Virginia Governor Terry McAuliffe to serve on the board
of Virginia’s Board of Medical Assistance Services (Virginia Medicaid).
Dr. Kongstvedt’s unique business expertise comes from the varied roles he has
performed over his long career. Prior to his most recent positions as partner and
senior executive in global consulting firms, Dr. Kongstvedt held the most
seniorlevel executive positions at a number of health plans and insurers. His
roots as a practicing physician also give him firsthand understanding of the
totality of the healthcare profession.
Renowned as the primary author and editor of “the bibles of managed care,”
Dr. Kongstvedt’s books are used by more than 256 graduate and undergraduate
health administration and policy programs. These books include The Essentials of
Managed Health Care, Sixth Edition (Jones & Bartlett Learning, 2013), and
Managed Care: What It Is and How It Works, Third Edition (Jones and Bartlett
Publishers, 2008), now updated as Health Insurance and Managed Care: What
They Are and How They Work, Fourth Edition (Jones & Bartlett, Learning,
As a healthcare industry thought leader, Dr. Kongstvedt has been quoted in
dozens of trade publications and presents frequently at industry conferences and
corporate events. He has consulted to and made several appearances on The CBS
Evening News, and has appeared on NBC’s Today Show, CNN, and National
Public Radio’s All Things Considered. He has also been quoted in the Wall Street
Journal, the Washington Post, and the Los Angeles Times, as well as in numerous
trade publications.
A licensed physician, a board-certified internist, and a Fellow in the American
College of Physicians, Dr. Kongstvedt received his BS and MD degrees at the
University of Wisconsin, where he also completed his internal medicine training
and residency. He resides in McLean, Virginia. Further information may be
found on his website:
Peter D. Fox, PhD
Independent Consultant
Denver, Colorado
Tom Wilder, JD
Senior Counsel
America’s Health Insurance Plans
Washington, DC
Keeping Current
Keeping current on trends and data presents a significant challenge, particularly
in regard to trends and data presented in a book. Fortunately, there are several
useful resources accessible via the web that periodically provide updated data and
trend information, and discussion of important health policy issues relevant to
health insurance and managed health care. Some examples of such sources are
provided here; web addresses were current at the time of publication, but are
always subject to change.
Examples of Federal Sources of Information, the federal exchange portal
Centers for Medicare & Medicaid Services
CMS main page for Regulations and Guidance
CMS’s Center for Consumer Information and
Insurance Oversight (CCIIO)
Department of Labor’s (DOL) Employee
Benefits Administration
Agency for Healthcare Research and Quality
Medicare Payment Advisory Commission


Medicaid and CHIP Payment and Access
Commission (MACPAC)


Policy and Research Organizations That Provide (Relatively) Unbiased Data and Information
Henry J. Kaiser Family Foundation

Home Page

Commonwealth Fund
Robert Wood Johnson Foundation
Publications (may require a subscription)
Health Affairs
American Journal of Managed Care and American Journal of
Accountable Care
Sanofi-Aventis’s Yearly Managed Care Digest Series
Managed Care Online
These and many, many more useful links are also available through my
website. Either navigate to and click on the “Useful
Links” tab, or go directly to (also
current at the time of publication but subject to change).
Attribution Note
Portions of the material in this text are adapted in part from their more detailed
counterparts in The Essentials of Managed Health Care, Sixth Edition (Jones &
Bartlett Learning, 2013). Interested readers wanting additional information
about health insurance and managed care are advised to consult this reference.
In addition, certain portions and exhibits were created and copyrighted by the P.
R. Kongstvedt Company, LLC. All such material is used with permission, but
not always identified or attributed any further.
A History of Managed Health Care and
Health Insurance in the United States*
Peter D. Fox, PhD and Peter R. Kongstvedt, MD, FACP
• Understand how health insurance and managed care came into being
• Understand the forces that have shaped health insurance and managed care in the
• Understand the major obstacles to managed care historically
• Understand the major forces shaping health insurance and managed care today
Health insurance and managed health care are inventions of the 20th century.
For a long time, they were not considered to be “insurance” but rather “prepaid
health care”—i.e., a way of accessing and paying for healthcare services rather
than protecting against financial losses. From its inception, this set of
arrangements has been in a never-ending state of change and turbulence. This
chapter explores the historical roots and evolutionary forces that have resulted in
today’s system. The dates mentioned in this chapter are specific for such events
as the passage of laws and the establishment of an organization but only
approximate for trends.
The years before World War II saw the development of two models of providing
and paying for health care besides the patient simply paying for the service. The
first were early forms of what is now called a health maintenance organization
(HMO), though this term was not actually coined until the early 1970s. Such a
model relied on an organization that was capitated (i.e., that charged a preset
amount per member, or per enrollee, per month) and that provided services
directly through its facilities and personnel, thereby combining the functions of
financing and delivery. The second was the early Blue Cross and Blue Shield
plans, which paid for services provided by contracted community doctors and
hospitals, which also regularly served patients not covered by these plans.
Prepaid Medical Group Practices
The Western Clinic in Tacoma, Washington, is often cited as the first example
of prepaid medical group practice. Started in 1910, the Western Clinic offered,
exclusively through its own providers, a broad range of medical services in return
for a premium (capitation) payment of $0.50 per member per month.1 The
program, which was offered to lumber mill owners and employees, served to
assure the clinic a flow of patients and revenues.
1929 was a remarkable year in the history of health plans. In that year,
Michael Shadid, MD, established a rural farmers’ cooperative health plan in Elk
City, Oklahoma, by forming a lay organization of leading farmers in the
community. Participating farmers purchased shares for $50 each to raise capital
for a new hospital in return for receiving medical care at a discount.2 For his
troubles, Dr. Shadid lost his membership in the county medical society and was
threatened with suspension of his license to practice. Some 20 years later,
however, he was vindicated by a favorable out-of-court settlement resulting from
an antitrust suit against the county and state medical societies.
Also in 1929, Doctors Donald Ross and H. Clifford Loos established a
comprehensive prepaid medical plan for workers at the Los Angeles Department
of Water and Power. It covered physician and hospital services. From the outset,
it focused on prevention and health maintenance.3 For that reason, some
consider it to be the first real HMO. Doctors Ross and Loos were also expelled
from their local medical society for their actions.
Despite opposition from the American Medical Association (AMA), prepaid
group practice formation continued for many reasons, including employers’
need to attract and retain employees, providers’ efforts to secure steady incomes,
consumers’ quest for improved and affordable health care, and even efforts by
the housing lending agency to reduce the number of foreclosures caused by
health-related personal bankruptcies. Two prominent examples from this time
period are the Kaiser Foundation Health Plan in California and the Group
Health Association of Washington, D.C., which subsequently became part of
the Kaiser system. They, too, were opposed by local medical societies.
The organization that evolved into the Kaiser Foundation Health Plan was
started in 1937 by Dr. Sidney Garfield at the behest of the Kaiser Construction
Company. It sought to finance medical care, initially for workers and families
who were building an aqueduct in the southern California desert to transport
water from the Colorado River to Los Angeles and, subsequently, for workers
who were constructing the Grand Coulee Dam in Washington State. A similar
program was established in 1942 at Kaiser ship-building plants in the San
Francisco Bay area.
In 1937 the Group Health Association (GHA) was started in Washington,
D.C., at the behest of the Home Owners’ Loan Corporation to reduce the
number of mortgage defaults that resulted from large medical expenses. It was
created as a nonprofit consumer cooperative with a board that was elected by the
enrollees.* The District of Columbia Medical Society vehemently opposed the
formation of GHA. It sought to restrict hospital admitting privileges for GHA
physicians and threatened expulsion from the medical society. A bitter antitrust
battle ensued, culminating in the U.S. Supreme Court’s ruling in favor of GHA.
In 1994, faced with insolvency despite an enrollment of some 128,000, GHA
was acquired by Humana Health Plans, a for-profit, publicly traded corporation.
It was subsequently divested by Humana and incorporated into Kaiser
Foundation Health Plan of the Mid-Atlantic.
The Blues
1929 also saw the origins of Blue Cross (BC), when Baylor Hospital in Texas
agreed to provide some 1500 teachers with prepaid inpatient care at its hospital.
The program was later expanded to include participation by other employers
and hospitals. State hospital associations elsewhere created similar plans. Each
was independent of the others, as they are today. In 1939 the American Hospital
Association (AHA) adopted the Blue Cross emblem and created common
standards. The symbol and was subsequently transferred to the Blue Cross
Association (BCA) in the early 1960s, and the AHA ended its involvement with
the BCA a decade after that.
The first type of organization that would become the basis for Blue Shield
(BS) plans elsewhere, though it was not itself a BS plan, originated in the Pacific
Northwest in 1939, when lumber and mining companies sought to provide
medical care for their injured workers. Those companies entered into agreements
with physicians, who were paid a monthly fee through a service bureau—a type
of organization that would evolve into the service plans found at the core of
most BC and BS plans today (see the Health Benefits Coverage and Types of
Health Plans chapter).4
Beyond establishing the first appearance of the organizational type that would
be adopted by BS plans, the appearance of the first actual BS plan is somewhat
difficult to establish due to differences among sources. One source states that the
BS logo first appeared in Buffalo, New York, as early as 1930.5 Most sources
state that the first official BS plan was the California Physicians’ Service plan
created by the California Medical Association in 1939.6-8 In all events, other
state medical societies soon emulated this model. Like the BC plans, the new BS
plans were independent of both each other and the BC plans in their respective
states, but were nevertheless associated with them.
The earliest BC and BS plans were also considered to offer prepayment for
health care. However, unlike the prepaid group practices and cooperatives, BC
and BS plans relied on providers in independent private practices rather than
employing physicians or contracting with a dedicated medical group. To define
the payment terms between a BC plan and a hospital, hospitals created costbased charge lists, the forerunners of today’s hospital chargemaster, and BS plans
developed payment rates for defined procedures based on profiles (i.e., statistical
distributions of what physicians charged).*
Initially, BC plans provided coverage only for hospital-associated care
(including skilled nursing home care), while BS plans provided coverage for
physician and related professional services (such as physical and speech therapy).
Over time, many BC plans merged with their local BS counterparts to become
joint BCBS plans, although some remain separate even now. Most of these BC
and BS plans were statewide and did not compete with each other, albeit with
some exceptions; for example, Pennsylvania and New York both have several BC
and/or BS plans. From the beginning, the BC and BS plans, collectively referred
to as the “Blues,” operated independently from each other. In the past few
decades, however, a significant number of BC and BS plans have merged.
Historically, in only a few cases did the Blues plans compete with each other;
rather, they mostly respected each other’s geographic boundaries and cooperated
in selling to multistate accounts. More recently, they have begun to enter each
other’s territory and now do compete, although only one may use the BC and/or
BS logo in a defined territory.
Hospitals and physicians retained control of the various Blues plans until the
1970s. In that decade, these plans changed to either a community governance
model with a self-perpetuating nonprofit board not controlled by the providers
or a structure under which the board was elected by the insureds (i.e., a mutual
insurer). In recent decades, many Blues have converted to publicly owned forprofit corporations.
Importantly, the formation of the various BC and BS plans in the midst of
the Great Depression, as well as the emergence of many prepaid group practices,
was not driven by consumers’ demands for coverage or entrepreneurs’ seeking to
establish a business but rather by providers’ desire to protect their incomes.
In the United States, World War II produced both inflation and a tight labor
supply, leading to the 1942 Stabilization Act. That act imposed wage and price
controls on businesses, including limiting their ability to pay higher wages to
attract scarce workers. However, the act did allow workers to avoid taxation on
employer contributions to certain employee benefits, including health benefits.
Also, health benefits were not constrained by wage controls. The twin effects of
favorable tax treatment and the exemption from wage controls fueled the growth
of commercial health insurance as well as greater enrollment in the Blues. Before
World War II, only 10% of employed individuals had health benefits from any
source, but by 1955 nearly 70% did, although many of these plans covered only
inpatient care.
HMO formation and enrollment growth also continued, albeit at a slower
pace. Newly formed plans included (1) the Health Insurance Plan (HIP) of
Greater New York, created in 1944 at the behest of New York City, which
wanted coverage for its employees,* and (2) Group Health Cooperative of Puget
Sound (GHC), organized by 400 Seattle families, each of whom contributed
$100. GHC remains a consumer cooperative to this day.
The McCarran-Ferguson Act, passed in 1945, exempted insurance companies
from federal regulation. As a result, regulation of health insurance devolved to
the states. The McCarran-Ferguson Act also provided limited antitrust
immunity for certain activities such as pooling of claims data for pricing
purposes. In the absence of federal authority, the regulation of insurance
companies and premium levels became the responsibility of the states, which
varied widely in their level of oversight.
In the 1950s, as a competitive reaction to group practice–based HMOs,
HMOs evolved that resemble today’s independent practice association (IPA)
model. In an IPA, an HMO contracts either directly with physicians in
independent practice or indirectly with an organization that in turn contracts
with these physicians. In contrast, early HMOs had their own dedicated medical
staffs. The basic IPA structure was created in 1954 to compete with Kaiser when
the San Joaquin County Medical Society in California formed the San Joaquin
Medical Foundation. The Foundation paid physicians using a relative value fee
schedule, which it established; heard consumer grievances against physicians;
and monitored quality of care. This organization became licensed by the state to
accept enrollee premiums and, like other HMOs, performed the insurance
function, but under a different regulatory structure than standard insurance. In
most states, HMOs—then and now—have faced different regulatory
requirements than insurance companies.
In the early 1960s, President John F. Kennedy proposed what eventually became
Part A of Medicare. This program, which was financed through taxes on earned
income (i.e., not investment income) similar to Social Security, was intended to
cover mostly hospital services. The Republicans in Congress then proposed to
cover physician and related professional services as well, in what became Part B
of Medicare. This program was financed through a combination of general
revenues and enrollee premiums. Following Kennedy’s assassination, President
Lyndon B. Johnson worked aggressively to achieve some of the late president’s
domestic goals, including covering persons age 65 and older. In 1965, Congress
established two landmark entitlement programs: Medicare for the elderly (Title
XVIII of the Social Security Act) and Medicaid (Title XIX of the Social Security
Act) for selected low-income populations. In 1972, the Medicare Act was
amended to cover selected disabled workers (but not their dependents), mostly
those who had permanent disabilities starting 29 months after the onset of the
disability. The benefits and provider payment structures of Medicare of the time
were similar to those of BC and BS plans, with separate benefits for
hospitalization paid through Medicare Part A and physician services paid
through Medicare Part B. This system remains in place for traditional (i.e., for
beneficiaries not enrolled in capitated health plans, as described below) Medicare
The combination of Medicare, Medicaid, private insurance, and medical care
(other federal programs, for example) resulted in the majority of health care
being paid for by third-party payers. The third-party payment system severs the
financial link between the provider of the service and the patient—a disconnect
that fostered increases in both the price of services and their utilization.
These developments marked the beginning of a long history of healthcare cost
inflation, attributable to the combination of the third-party payment system,
advances in medical science, and increased demand by consumers. To illustrate,
in 1960, 55.9% of all healthcare costs nationally were paid by the patient, but
that percentage has declined steadily, leveling out at 11–12% by 2012.9 At the
same time, national health expenditures as a percentage of the gross domestic
product (GDP) rose from 5.2% in 1960 to 5.8% in 1965, the year before
Medicare was implemented; it reached 7.4% in 1970 and 17.2% in 2012.10
Nevertheless, isolated examples of early attempts to control costs beyond
seeking provider discounts can be cited:
• In 1959, Blue Cross of Western Pennsylvania, the Allegheny County
Medical Society Foundation, and the Hospital Council of Western
Pennsylvania performed retrospective analyses of hospital claims to identify
utilization that was significantly above average.11

Around 1970, California’s Medicaid program initiated hospital
precertification and concurrent review in conjunction with medical care
foundations in that state, typically county-based associations of physicians
who volunteered to participate, starting with the Sacramento Foundation
for Medical Care.*
• The 1972 Social Security Amendments authorized professional standards
review organizations (PSROs) to review the appropriateness of care
provided to Medicare and Medicaid beneficiaries. In time, PSROs became
known as peer review organizations (PROs), and then as quality review
organizations (QIOs). QIOs continue to oversee clinical services on behalf
of the federal and many state Medicaid agencies today.
• In the 1970s, a handful of large corporations initiated precertification and
concurrent review for inpatient care, to the dismay of the provider
community. Some companies took other measures such as promoting
employee wellness, sitting on hospital boards with the intent of
constraining their costs, and negotiating payment levels directly with
Although unrelated to costs, and initially only peripherally related to health
benefits plans or health insurance, another significant event occurred at the end
of this period: the passage in 1974 of the Employee Retirement Income Security
Act (ERISA). Although the focus of ERISA was on retirement benefits, it also
addressed employers’ pretax employee health benefits. Among other things,
ERISA established appeal rights for denial of benefits, requirements for handling
benefits claims, and various other new regulations for employers that self-funded
their benefits plans, topics that are addressed further in the chapters titled Health
Benefits Coverage and Types of Health Plans and Sales, Governance, and
The problem of healthcare costs rising faster than costs in the economy as a
whole, thereby consuming an ever larger share of the GDP, increasingly became
a subject of public discussion in the 1970s. Throughout the 1960s and into the
early 1970s, HMOs played only a modest role in the financing and delivery of
health care, although they were a significant presence in a few communities such
as in the Seattle area and parts of California. In 1970, the total number of
HMOs ranged between 30 and 40, with the exact number depending on one’s
definition. That would soon change.
Between 1970 and 1977, national health expenditures as a percentage of GDP
rose from 7.4% to 8.6%. The acceleration in healthcare cost increases, driven in
large measure by a high percentage of the medical dollar being paid for by
insurance, private or public (notably Medicare and Medicaid), rather than by
the patient became widely discussed and led to the next major development:
managed health care as we know it today. In particular, this period saw the
growth of HMOs; the appearance of a new model, the preferred provider
organization; and widespread adoption of utilization management by health
In 1973, the U.S. Congress passed the HMO Act.13 This legislation evolved
from discussions that Paul Ellwood, MD, had in 1970 with the leadership of the
U.S. Department of Health, Education, and Welfare (which later became the
Department of Health and Human Services)14 as the Richard M. Nixon
administration sought ways to address the rising costs of the Medicare program.
These discussions resulted in a proposal to allow Medicare beneficiaries the
option of enrolling in HMOs, which were to be capitated by the Medicare
program—a change that was not actually adopted until 1982. However, the
legislative debate resulted in the enactment of the HMO Act of 1973. The desire
to foster prepaid HMOs reflected the view that third-party (insurance) payments
on a fee-for-service basis gave providers incentives to increase utilization and
fees. Ellwood is also widely credited with coining the term “health maintenance
organization” at that time as a substitute for “prepaid group practice” because it
had greater cachet.
The HMO Act included three important features:
• It made federal grants and loan guarantees available for planning, starting,
and/or expanding HMOs.
• The federal legislation superseded state laws that restricted the development
of HMOs.
• The “dual choice” provision required employers with 25 or more employees
that offered indemnity coverage to also offer at least one group or staff
model and one IPA-model federally qualified HMO, but only if the HMOs
formally requested to be offered. (Types of HMOs are described in detail in
the Health Benefits Coverage and Types of Health Plans chapter.)
The dual choice mandate was used by HMOs of the time to get in the door of
employer groups to become established. Because the federal mandate applied to
only one HMO of each type, opportunities to exercise the mandate were
limited, although employers were free to offer as many HMOs as they liked. The
dual choice requirement expired in 1995. Nevertheless, even more than the
other provisions, the dual choice mandate is widely regarded as providing a
major boost to the HMO industry at a time when it was in its infancy.
To be federally qualified, HMOs had to satisfy a series of requirements such
as meeting minimum benefit package standards, demonstrating that their
provider networks were adequate, having a quality assurance system, meeting
standards of financial stability, and having an enrollee grievance process. Many
states ultimately adopted these requirements for all state-licensed HMOs.
Unlike a state license to operate, federal qualification as an HMO was
voluntary. However, many HMOs became federally qualified to avail themselves
of the HMO Act’s features and because such qualification represented a type of
“Good Housekeeping Seal of Approval” that employers and consumers would
trust. Although federal qualification no longer exists, it was an important step
when managed care was in its infancy and HMOs were struggling for inclusion
in employment-based health benefits programs. The expiration of federal
qualification inspired the creation of health plan accreditation as a replacement
“seal of approval.”
The HMO Act imposed requirements on HMOs that were not levied on
indemnity health insurers. Examples of requirements that applied to HMOs but
not to standard insurance included the following:
• A level of comprehensiveness of benefits, including little cost sharing* and
the coverage of preventive services, that exceeded what insurers at the time
typically offered
• The holding of an annual open enrollment period during which HMOs
had to enroll individuals and groups without regard to health status
• Prohibiting the use of an individual’s health status in setting premiums
These provisions applied only to federally qualified HMOs, making them
potentially uncompetitive compared to traditional health insurance plans. The
HMO Act was amended in the late 1970s to lessen this problem.
The HMO Act was largely successful. During the 1970s and 1980s, HMOs
grew and began displacing traditional health insurance plans. What was not
anticipated when the original HMO Act was passed was the rapid growth in
IPA-model HMOs. By the late 1980s, enrollment in IPAs exceeded enrollment
in group and staff model HMOs, a difference that has increased over time. This
dynamic accelerated as commercial insurers and BCBS plans acquired or created
their own HMOs, most of which followed the IPA model.
The original concept of using federally qualified HMOs in the Medicare
program finally came into being in 1982 with the enactment of the Tax Equity
and Fiscal Responsibility Act (TEFRA). The intent, which was largely achieved,
was that the ability of HMOs to control healthcare costs would encourage these
plans to offer more comprehensive benefits than traditional Medicare. For
example, the new Medicare HMOs typically required less cost sharing than did
traditional Medicare and offered coverage of prescription drugs and selected
preventive. However, considerable debate arose as to whether HMOs were able
to offer the additional benefits within the Medicare capitation amount because
they were more efficient or because of favorable selection (they attracted a
disproportionate share of healthy patients).
Also in 1982, the federal government granted a waiver to the state of Arizona
that allowed it to rely solely on capitation, and not offer a fee-for-service
alternative, in the state’s Medicaid program.15 A number of states had previously
made major efforts, in some cases under federal demonstration waivers, to foster
managed care in their Medicaid programs but had not done so statewide. That
practice is now widespread. (Medicare managed care is discussed in the Medicare
and Medicaid chapter.)
HMOs were increasingly accepted by consumers, due not only to their lower
premiums and reduced cost sharing but also because of their more extensive
benefits, such as coverage of preventive services, children’s and women’s
preventive health visits, and prescription drugs, most of which were not covered
by the typical traditional insurance or BCBS plans of the time. In contrast,
HMOs were not required to offer coverage of prescription drugs but most did so
to attract enrollees. In response to the competition from HMOs, many
traditional insurance carriers and BCBS plans began to add coverage of
prescription drugs and preventive services to their non-HMO products.
Preferred Provider Organizations and Utilization Management
The growth of HMOs led to the development of another type of managed care
plan: preferred provider organizations (PPOs). PPOs are generally regarded as
having originated in Denver, Colorado. In that city in the early 1970s, Samuel
Jenkins, a vice president of Martin E. Segal Company, a benefits consulting
firm, negotiated discounts with hospitals on behalf of its self-insured clients.16
Hospitals granted discounts in return for enrollees having lower cost sharing if
they used the contracting hospitals, thereby attracting patients away from
competitor hospitals.
The concept soon expanded to include physicians and other types of
providers. The term PPO arose because hospitals and doctors who agreed to
discounted fees were considered to be “preferred” by the health insurance plan.
People covered under the PPO faced lower cost sharing if they saw a PPO
provider rather than a noncontracted, or “out of network,” provider.
Unlike most HMO coverage at the time, PPO benefits did not require
authorization from the patient’s primary care physician (PCP) to access care
from specialists or other providers. PPO providers also agreed to certain costcontrol measures. For example, they agreed to comply with precertification
requirements for elective hospitalizations, meaning that for the service to be
covered, the doctor had to obtain approval before ordering any elective hospital
admission or selected high-cost outpatient service. Precertification programs
remain common today. Second-opinion programs were also instituted, whereby
patients were required to obtain a second opinion from a different surgeon for
selected elective procedures to be covered. Second-opinion programs are rarely
mandated today.
Another development in indemnity insurance, which occurred mostly during
the 1980s, was the widespread adoption of large case management—that is, the
coordination of services for patients with expensive conditions requiring
treatment by multiple providers, but did not coordinate with each other.
Examples include patients who had experienced accidents, cancer cases, patients
with multiple chronic illnesses causing functional limitations, and very lowbirth-weight infants.* Utilization review, the encouragement of second opinions,
and large case management all entailed at times questioning physicians’ medical
judgments, something that had been rare outside of the HMO setting. These
activities were crude by today’s standards of medical management but
represented a radically new role for insurance companies in managing the cost of
health care. They sometimes met with ferocious opposition in the medical
community, with physicians’ complaining that the programs constituted
“cookbook medicine” or interfered with the “right” of the doctor to make
unfettered medical decisions.
Utilization management by HMOs contributed to practice pattern changes,
including shifting care from the inpatient setting to the outpatient setting and
shortening the length of hospital stays. Shortening length of stay was also
strongly encouraged by legislation enacted in 1982 under which the Medicare
payment system no longer paid a hospital’s actual cost (albeit with upper limits
on payments that affected particularly expensive hospitals) but instead paid a
fixed amount per admission within a given class or grouping of diagnoses—an
approach that some private health plans also adopted.
From the mid-1980s through the mid-1990s, managed care grew rapidly while
traditional indemnity health insurance declined, creating new strains on the U.S.
healthcare system. At the same time, new forms of managed care plans and
provider organizations appeared, and the industry matured and consolidated.
That growth was not trouble free, however.
Managed Care Expands Rapidly
HMOs grew rapidly, growing from 3 million in 1970 to over 80 million in
1999.17 Initially, PPOs lagged behind, but by the early 1990s enrollment was
roughly equal: By 1999, PPOs had a 39% market share, compared to HMOs at
28%. This growth came at the expense of traditional indemnity health
insurance. In the mid-1980s, traditional indemnity insurance accounted for
three-fourths of the commercial market; by the mid-1990s, it represented less
than one-third of the market and that share would decline to single digits by
A new product was also introduced during this period—the point-of-service
(POS) plan. In a POS plan, members had HMO-like coverage with little cost
sharing if they both used the HMO network and accessed care through their
PCP; unlike in a “pure” HMO, however, they still had coverage if they chose to
get non-emergency care from out-of-network providers but were subject to
higher cost sharing if they did. Members typically had to designate a PCP, who
approved any referral to specialists and other providers (e.g., physical therapists)
except in emergency situations. Though they were initially very popular, POS
plans would stall out due to their high costs. These and other hybrid products
make statistical compilations related to managed care trends difficult. As new
types of plans appeared, the taxonomy of health plan types expanded and lines
were blurred, with the term managed care organization (MCO) eventually
coming to represent HMOs, POS plans, PPOs, and a myriad of hybrid
arrangements. Medicare and Medicaid also witnessed significant managed care
growth. Medicare enrollment in capitated plans—that is, plans such as HMOs
that set premiums and assumed the risk for the delivery of services—grew from
1.3 million to 6.8 million between 1990 and 2000.19 During that same time
period, Medicaid managed care grew from 2.3 million (10% of Medicaid
beneficiaries) to 18.8 million (56%).20
As is the case with dandelions, rapid growth is not always good. Some MCOs
outstripped their ability to run their businesses, as evidenced by overburdened
management and poorly functioning information systems, resulting at times in
poor service and mistakes. In their quest to continually drive down utilization,
some HMOs became increasingly aggressive. More ominously, the industry
began to see health plan failures or near-failures.
Consolidation Begins
Beginning in the early 1990s, the pace of consolidation quickened among both
MCOs and health systems. Entrepreneurs, sensing financial opportunities,
acquired or started HMOs with the goal of profiting by later selling the HMO
to a larger company. In other cases, they acquired smaller plans to build a
regional or national company, enhancing their ability to issue stock. However,
not all plans could be sold at a profit, and in some cases troubled MCOs made
good acquisition targets, allowing larger plans to acquire market share at
minimal expense. Although uncommon, MCOs that were getting close to failure
might be seized by a state insurance commissioner, who would then either sell
the MCO to another company or liquidate it and divide the membership among
the remaining MCOs.
As the market consolidated, smaller plans were at a disadvantage. Large
employers with employees who are spread out geographically favored national
companies at the expense of local health plans. For smaller plans, the financial
strain of having to upgrade computer systems continually and adopt various new
technologies mounted. In addition, unless they had a high concentration in a
small market, smaller plans found themselves unable to negotiate the same
discounts as larger competitors. At some point, many simply gave up and sought
to be acquired.
Not all mergers and acquisitions were large companies acquiring small ones.
This trend also affected large companies. By 1999, multistate firms, including
Kaiser Permanente and the combined Blue Cross and Blue Shield plans,
accounted for three-fourths of U.S. enrollment in managed care plans.
Another trend saw health plans convert from not-for-profit to for-profit
status. For example, the largest publicly traded managed care company in the
United States is currently United Health Group, the corporate parent of United
Health Care, which started as a nonprofit health plan in Minnesota. Likewise,
US Health Care, a Pennsylvania HMO company, converted from nonprofit to
for-profit status and was eventually acquired by Aetna.
Many years earlier, the actual Blue Cross and Blue Shield trademarks had
become the property of the Blue Cross Blue Shield Association (BCBSA)
representing member plans. The BCBSA created standards that member plans
had to meet to license the Blues trademarks, including a prohibition on being a
for-profit company.
Breaking with that tradition, in 1994 the BCBSA voted to allow member
plans to convert to for-profit status.21 The reasons leading to this shift were
financial. Since their beginnings, Blues plans had been tax-exempt as “social
welfare plans,” but the Tax Reform Act of 1986 revoked that exemption because
Congress determined that Blues plans were selling insurance in an open market.*
At the same time, BCBS plans were losing market share and were not able to
keep up with changing operational demands because of a lack of capital—
something that publicly traded companies were able to obtain through the sale
of stock. Converting to for-profit status would therefore have little impact on
the Blues’ tax status, but would allow them to access capital to improve their
competitive position.
Blue Cross of California was the first to convert to for-profit status under its
corporate name WellPoint. The Indiana Blues soon followed under the
corporate name Anthem. Other Blues plans also converted and were
subsequently acquired by WellPoint or Anthem, and in 2004 Anthem merged
with WellPoint to create what is now the second largest commercial health plan
company in the United States. These conversions required the creation and
funding of foundations, commonly known as “conversion foundations,” holding
the assets of the nonprofit plan. Many of these entities are among the largest
grant-giving foundations in their respective states.
Consolidation also took place among health plans that were not publicly
traded, albeit at a slower rate. By the end of 2013, among the top 10 largest
health plans, four were non-investor owned:22
• Kaiser Foundation Group, with group model HMOs in nine regions, is the
third largest.
• Health Care Services Corporation (Health Care Services Corporation), the
largest mutual health insurer (i.e., owned by its enrollees), which has BCBS
plans in five states, is the sixth largest.
• Highmark Group, with BCBS plans in three states, is the eighth largest.
• EmblemHealth in New York, a company formed through a combination of
Group Health, Inc. (GHI) and the Health Insurance Plan of Greater New
York,23 is the 10th largest.
Provider Consolidation and the Appearance of Integrated Delivery Systems
Among physicians, there was a slow but discernable movement away from solo
practice and toward group practice in the 1990s. There was nothing slow,
however, about the amount of hospital consolidation that began on a regional or
local level in the 1990s. According to a study conducted by the Rand
Corporation, more than 900 mergers and acquisitions occurred during the
1990s, and by 2003 90% of the metropolitan areas in the country were
considered “highly concentrated” in terms of healthcare systems.24 Hospital and
health system mergers and consolidations continued after that study was
Hospital consolidation was commonly justified in terms of its potential to
rationalize clinical and support systems. A clearer impact, however, has been the
increased market power that enables such entities to negotiate favorable payment
terms with commercial health plans (see the chapters titled The Provider Network
and Provider Payment). Consolidation also meant that health plans could no
longer selectively contract with individual hospitals. Systems with “must have”
hospitals or even “must have” services, such as very specialized cardiac or
oncology services, could refuse to enter into contracts that did not cover all of
the services that the health system offered. As a result hospital prices to private
payers rose by a total of 20% nationally between 1994 and 2001 and by 42%
between 2001 and 2008.25
Consolidation, both among health plans and providers, diminished
competition to the point of bringing into question the viability of the
competitive model in the delivery of healthcare services. Instead of competition
among multiple buyers and sellers, what evolved was closer to what economists
call “bilateral monopolies,” with health plans and providers in local markets
having little choice but to reach agreements with each other.
Provider consolidation was not the only response to managed care. In many
communities, hospitals and physicians collaborated to form integrated delivery
systems (IDSs), principally as vehicles for contracting with payers and with
HMOs in particular. Types of IDSs are discussed in the chapter titled The
Provider Network.
Most IDSs were rather loose organizations consisting of individual hospitals
and their respective medical staff, the most common of which was the
physician–hospital organization (PHO). Most PHOs and IDSs required that
health plans contract with all physicians with admitting privileges at the hospital
that met the HMO’s credentialing criteria, rather than with only the more
efficient ones. Indeed, under the fee-for-service method of payment, physicians
with high utilization benefited the hospital financially. Also, physicians were
commonly required to use the hospital for outpatient services (e.g., for
laboratory tests) that might be obtained at lower cost elsewhere.
Some hospitals chose to purchase PCP practices to increase their negotiating
leverage with HMOs, although they did little to integrate those practices. Most
IDSs of the time suffered, at least initially, from organizational fragmentation,
payment systems to individual doctors that were misaligned with the goals of the
IDS, inadequate information systems, inexperienced managers, and a lack of
capital. In addition, hospitals that had purchased physician practices quickly
discovered that physician productivity declined once those doctors were
receiving a steady income, albeit with incentives to enhance volume, and no
longer felt the financial pressures of independent practice. In most cases, those
practices became a financial drag on the hospital and were eventually spun off at
a net loss.
At the time, none of these factors stopped many of the systems from seeking
to “cut out the middleman” and become risk-bearing organizations themselves
—a decision they would soon regret. Provider organizations lobbied hard to be
allowed to accept risk and contract directly with Medicare. The Balanced Budget
Act of 1997 (BBA 97)* permitted them to do so as provider-sponsored
organizations (PSOs) if they met certain criteria. With a few exceptions, these
efforts failed and the PSOs lost millions of dollars in a few short years. The
federal waiver program for PSOs expired, although not until most had failed,
and only a handful exist today.†
Some IDSs and provider systems pursued another route to accepting full risk
by forming a licensed commercial HMO. The existence of hospitals, physicians,
and a licensed HMO and/or PPO under one corporate umbrella is called vertical
integration. For a while, this model was touted as the future of health care. Like
so many future scenarios confidently predicted by pundits, it mostly did not
come to pass. Instead, provider-owned HMOs mostly failed for the same reasons
PSOs failed—namely, the system was conflicted by, on one hand, the need to
promote volume for patients under the fee-for-service system and, on the other
hand, the desire to be efficient in the delivery of services to capitated patients.
Not all vertically integrated organizations failed, however. Those that did
succeed typically managed their subsidiary HMOs as stand-alone entities. Many
HMOs started by large, well-run medical groups also did well and continue to
do so today. The rest were sold, given away, or ceased to operate.
Many large provider systems and physician practice management companies
nevertheless accepted global capitation risk from HMOs, entailing their
receiving a percentage of premium revenues (e.g., 80%) in return for being at
risk for most covered medical services. Most of those also failed, with the
exception of California, the number of provider systems contracting to accept
full risk for medical costs dropped dramatically.
Utilization Management Shifts Focus
As hospital utilization became constrained, the focus of utilization management
shifted to encompass the outpatient setting including prescription drugs,
diagnostics (which have become increasingly expensive with the development of
new technologies), and care by specialists. Perhaps even more important was the
recognition of the large expense incurred by a small number of patients with
chronic, and often multiple, conditions, resulting in significantly more attention
being paid to these high-cost patients.
The role of the PCP also changed. In a traditional HMO, that role was to
manage a patient’s medical care, including access to specialty care. This
“gatekeeper” function was a mixed blessing for PCPs, who at times felt caught
between pressures to reduce costs and the need to satisfy the desires of
consumers, who might question whether the physician had their best interests at
heart in light of a perceived financial incentive to limit access to services.
Likewise, patients might resent the administrative hassle entailed in having to get
the PCP’s referral. The growth of PPOs as compared to HMOs also led to a
shift away from PCP-based “gatekeeper” types of plans. However, most plans
(including PPOs) continued to set lower copayments for services delivered by a
PCP rather than by a specialist, thereby retaining a primary care focus.
The focus of utilization management was also sharpened through the growth
of carve-out companies—that is, organizations that have specialized provider
networks and are paid on a capitation or other basis for a specific service. Among
services that lend themselves to being “carved out” are prescription drug benefits
as well as behavioral health, chiropractic, and dental services. The carve-out
companies market principally to health plans and large self-insured employers
since they are generally not licensed as insurers or HMOs and, therefore, are
limited in their ability to assume risk. In recent years, some of the large health
plans that contracted for such specialty services have reintegrated them, typically
because the carved-out services made it difficult to coordinate services and/or
because the plans had grown large enough to manage the services in question
Industry Oversight Spreads
Health insurance and managed care have always been subject to oversight by
state insurance departments and (usually) health departments. The 1990s saw
the spread of new external quality oversight activities. Starting in 1991, the
National Committee for Quality Assurance (NCQA) began to accredit HMOs.
This organization was launched by the HMOs’ trade associations in 1979 but
became independent in 1990. The majority of its board seats are now held by
representatives of employers, unions, and consumers rather than health plans.
Interestingly, this board structure was proposed by the Group Health
Association of America, which represented closed-panel HMOs at the time.
Many employers require or strongly encourage NCQA accreditation of the
HMOs with which they contract to serve their employees, and accreditation
came to replace federal qualification as the “seal of approval.” NCQA, which
initially accredited only HMOs, has evolved with the market to encompass a
wide range of plan types and services and continues to broaden its programs.
This is also the case with the two other bodies that accredit managed health care
plans: URAC* and the Accreditation Association for Ambulatory Health Care,
also known as the Accreditation Association (AAAHC). (For further discussion
of these organizations, see the Utilization Management, Quality Management,
and Accreditation chapter.)
Performance measurement systems (report cards) were also introduced, with
the most prominent being the Healthcare Effectiveness Data and Information
Set (HEDIS).† HEDIS was initially developed by the NCQA at the behest of
several large employers and health plans. Medicare and many states now require
HEDIS reporting by plans, and the federal government’s involvement in this
effort has grown. Other forms of report cards appeared as well and continue to
evolve as a result of the market demanding increasing levels of sophistication and
At the federal level, the Health Insurance Portability and Accountability Act
of 1996 (HIPAA) was enacted. Among other provisions, it limits the ability of
health plans to (1) deny insurance based on health status to individuals who
were previously insured for 18 months or more and (2) exclude coverage of
preexisting conditions (i.e., medical conditions that exist at the time coverage is
first obtained). A decade earlier, a provision in the Consolidated Omnibus
Budget Reconciliation Act of 1985 (COBRA) allowed individuals who lost
eligibility for employment-based group coverage to continue that coverage for
up to 18 months, although they could be required to pay the full cost plus 2%
HIPAA was designed in part to provide a means for individuals to have
continued access to coverage once they exhausted their COBRA benefits.
COBRA had only limited success because the coverage was usually expensive. In
particular, a young person could often obtain coverage as an individual for less
than the group rate, which was priced to include all individuals in the group,
including older ones, who on average consume more services. Furthermore, the
cost of COBRA coverage was often unaffordable because the loss of employer
coverage often occurred as a result of someone becoming unemployed. However,
until guaranteed issue requirements went into effect in 2014 under the 2010
Patient Protection and Affordable Care Act (ACA), continued coverage under
HIPAA was the only way a person with serious medical problems could purchase
insurance. Even fewer people took advantage of the HIPAA coverage provisions
than was the case with COBRA. More important to the industry were the
standards that HIPAA created for privacy, security, and electronic transactions.
Anti-managed care sentiment, commonly referred to as the “managed care
backlash,” became a defining force in the industry as the United States
approached the new millennium. As a society, Americans expected managed care
to reduce the escalation of healthcare costs but became enraged at how it did so.
In retrospect, why that happened is obvious: Managed health care was the only
part of the healthcare sector that ever said “no.” The emotional overlay
accompanying health care outstrips almost any other aspect of life. The health
problems of a spouse or child causes feeling in ways that a house fire or losing
one’s employment does not.
The roots of the backlash date back to the early 1990s. At that time, most
employers allowed their employees to choose between an HMO and a
traditional health insurance plan, although their payroll deduction was typically
higher if they chose the traditional health plan. Eventually, to control costs,
many employers began putting employees into a single managed care plan
without offering the choice of an indemnity plan.
One source of contention with some consumers—particularly those who had
not chosen to be in an HMO—was the requirement that they obtain
authorization from their PCP to access specialty care. Arguably, this provision
both reduces costs and increases quality by assuring that PCPs are fully apprised
of the care that their patients receive. Also, consumers under the care of a
specialist who was not in the HMO’s network were required to transition their
care to an in-network doctor—another burden resented by individuals who had
not voluntarily chosen to be in an HMO.
There was more to the backlash, however. As noted earlier, rapid managed
care growth increased the risk of problems arising. Some of the problems were
largely irritants, such as mistakes in paperwork or claims processing in health
plans with information systems that were unable to handle the expanded load.
Rapid growth also affected the ability to manage the delivery system. Where
clinically oriented decisions on coverage were once made with active
involvement of medical managers, some rapidly growing health plans became
increasingly bureaucratic and distant from both their members and their
providers, causing the plans to be seen as cold and heartless and the errors, and
delays in payment as intentional.
Sometimes, rapid growth led to inconsistent coverage decisions. The public’s
perception that decisions regarding coverage of clinical care were made by “bean
counters” or other faceless clerks may not have been fair or accurate in the
opinion of managed care executives, but neither was it always without merit.
Some HMOs, especially those whose growth outstripped their ability to manage,
did delegate decision-making authority to individuals who lacked adequate
training or experience and were not supported by the comprehensive algorithms
that are common today. Furthermore, some plans were accused of routinely and
intentionally denying or delaying payment of claims, caving in only when the
member appealed—an accusation disputed by the plans. Regrettably, the
managed care industry during this period did a poor job of self-policing and lost
the confidence of large segments of the public.
Other problems were emotional and not a threat to health, such as denial of
payment for care that was not medically necessary—for example, an unnecessary
diagnostic test or an additional day in the hospital. For doctors and patients who
are unaccustomed to any denial of coverage, it was easy to interpret these actions
as overzealous utilization management, which, indeed, they were in some
instances. How often such denials occurred is impossible to know, not only
because of the turbulence of the era but also because standardized medical
practices were only first coming into being, and there are no studies on which to
Finally, while uncommon, some problems did represent potential threats to
health such as difficulties in accessing care or denial of authorization for
payment for truly necessary medical care, thereby causing subsequent health
problems. Sometimes, the denial was due to the care not being a covered benefit,
as in the case of certain experimental procedures. This occurred with indemnity
health insurance as well but was not viewed the same way. The public expects
low premiums but demands coverage for all medically related services, including
ones that might be judged unnecessary or outside of the scope of the defined
benefits; the public also expects access to any provider an individual chooses to
Whether a service is medically necessary or simply a convenience can be a
matter of interpretation or dispute. Is a prescription for a drug to help with
erectile dysfunction medically necessary? What about growth hormone therapy
for a child who is short because her or his parents are short, not as a result of a
hormonal deficiency? Should fertility treatments be unlimited? Some
interventions may be medically necessary for some patients but not others. For
example, in a patient with droopy eye lids but no impairment of vision, surgery
is primarily cosmetic, although it often progresses until it is medically necessary
because vision is impaired. The most damning of all accusations was that health
plans were deliberately refusing to pay for necessary care to enrich executives and
shareholders—a perception enhanced by media stories of multimillion-dollar
compensation packages of senior executives. Putting aside the fact that financial
incentives drive almost all aspects of health care to varying degrees, this charge
was particularly pernicious for health plans in light of the increasing number of
for-profit plans.
Serious, even if isolated, problems make good fodder for news using the wellproven reporting technique of “identifiable victim” stories in which actual names
and faces are associated with anecdotes of poor care or problems accessing
coverage. Whether the problems portrayed were fair was irrelevant. When added
to the disgruntlement caused by minor or upsetting (although not dangerous)
irritants caused by health plan operations, the public was not liable to be
sympathetic to managed care, particularly given the backdrop that few insurance
companies are loved.
Politicians were quick to jump on the bandwagon, especially during the
debate over the Health Security Act of 1993, legislation proposed by President
Bill Clinton but not enacted. Many states passed “patient protection” laws
specifying prudent layperson standards for emergency care,* stronger appeal and
grievance rights, and requirements for HMOs to contract with any provider
willing to agree to the HMO’s contractual terms and conditions. Whether the
“any willing provider” provision protects consumers is debatable, and not all
states passed laws to require it. Most states did pass laws requiring prudent
layperson standards and appeal rights, which later were incorporated into the
Affordable Care Act.
Another example of a “patient protection” law that arose out of the managed
care backlash was the prohibition of “gag clauses” in HMO contracts with
physicians in which an HMO’s contract supposedly prevented a physician from
informing patients of their best medical options. So prevalent was the belief that
such constraints existed that it made the cover of the January 22, 1996, edition
of Time magazine; that cover showed a surgeon being gagged with a surgical
mask and a headline reading “What Your Doctor Can’t Tell You. An In-Depth
Look at Managed Care—And One Woman’s Fight to Survive.”† The
Government Accountability Office (GAO), an agency of the U.S. Congress,
investigated the practice at the request of then-Senators Lott, Nickles, and Craig
and issued its report on August 29, 1997. The GAO reviewed 1150 physician
contracts from 529 HMOs and could not find a single instance of a gag clause
or any reported court cases providing guidance on what constitutes a gag
clause.27 This report had no impact on public perception, however. Laws
prohibiting “gag clauses” became widespread, and years later this element was
also incorporated into the Affordable Care Act.
The popular press continued to run regular “HMO horror stories.” For
example, the cover of the July 12, 1998, issue of Time magazine showed a photo
of stethoscope tied in a knot and a headline that read “What Your Health Plan
Won’t Cover…” with the word “Won’t” in bold red letters. In another example,
the November 8, 1999, cover of Newsweek magazine featured a furious and
anguished woman in a hospital gown with the words “HMO Hell” displayed
across the image. HMOs were disparaged in movies, cartoons, jokes on late
night TV, and even the comic sections of newspapers. The number of lawsuits
against HMOs increased, with many alleging interference in doctors’ decision
making. Many also alleged that capitation incented physicians to withhold
necessary care, although this charge lacked empirical support, as shown in a
series of research studies discussed in the Provider Payment chapter.
In a futile attempt to counter the rising tide of antipathy, the managed care
industry repeatedly tried to point out the good things it did for members such as
coverage for preventive services and drugs, the absence of lifetime coverage
limits, and coverage of highly expensive care—but there was nothing
newsworthy about that. A reporter for a major newspaper, who did not himself
contribute to the backlash, said at the time to one of this chapter’s authors, “We
also don’t report safe airplane landings at La Guardia Airport.”
In response to public complaints, HMOs expanded their networks and
reduced how aggressively they undertook utilization management. Some
eliminated the PCP “gatekeeper” requirement, thereby allowing members open
access to any specialist, albeit at higher copayment levels than applied visits to
the PCP. To borrow words used a decade earlier by President George H. W.
Bush in his inaugural address, HMOs became “kinder and gentler,” and
healthcare costs began once again to rise faster than general inflation or growth
in the GDP.
The managed care backlash eventually died down. The volume of HMO
jokes and derogatory cartoons declined, news stories about coverage restrictions
or withheld care became uncommon, and state and federal lawmakers moved on
to other issues. However, the HMOs’ legacy of richer benefits combined with
the general loosening of medical management and broad access to providers
collided with other forces by the end of the millennium, and the return of
healthcare cost inflation resulted in the cost of health benefits rising as well,
leading to an increase in the number of uninsured and greater cost sharing for
those with coverage.
Economic growth was steady early in the first decade of the new millennium but
slowed late in the decade, with GDP actually declining in 2008 and 2009 as the
United States entered the “Great Recession.” During that decade, healthcare
costs rose seemingly inexorably, with national health expenditures increasing
from 13.8% to 17.9% of GDP.28 The increases reflected a variety of factors,
including the decline in HMO market share, looser utilization management, the
adoption of new and expensive (and often unproven) technologies, increased
consumer expectations, direct-to-consumer marketing, the provider
community’s quest for new sources of income, and the practice of defensive
medicine by providers who feared malpractice suits. During this decade, many
employers responded to the tight economic situations by increasing deductibles
and other forms of cost sharing and, in some cases, dropping employee coverage
altogether rather than by promoting more tightly managed care. For some
people in the individual market, health insurance became unaffordable, and
healthcare costs strained many family budgets.
The Decline of HMO and POS Market Share
HMOs’ share of the commercial enrollment market stood at 29% in 2000. It
declined thereafter, reaching 25% in 2004, and then hovered around 20–21%
from 2005 to 2009, before dropping further to 13% by 2014. POS plans, which
had enjoyed a 24% market share in 1999, also steadily declined but then leveled
out at around 10% by 2009. PPOs, in contrast, gained market share—growing
from 39% in 1999 to 61% by 2005, before declining slightly after 2009.29
Medicare managed care enrollment also reversed itself, declining from 6.4
million in 1999 to 4.6 million by 2003.30 This trend occurred not because of
the managed care backlash but rather largely as a result of a provision in the
Balanced Budget Act of 1997 that reduced what Medicare paid the health plans,
resulting in those plans’ reducing benefits, which in turn made them less
attractive to Medicare beneficiaries. However, the situation changed with the
enactment in 2003 of the Medicare Modernization Act (MMA), which
increased payment to managed care plans from below the estimated cost of
delivering services in the fee-for-service system to an amount that in years
leading to the ACA exceeded 10% of what Medicare would have spent had
enrollees remained in the fee-for-service system. The MMA also changed the
name of the Medicare managed care program from Medicare+Choice to
Medicare Advantage (MA) and promoted new forms of managed care that were
more like traditional insurance policies than like HMOs. In turn, enrollment
grew to 11 million in 2010 and to 15.5 million in 2014, representing 29% of all
Medicare beneficiaries.31 HMOs remain the largest form of MA plan, however,
accounting for approximately 78% of all MA enrollees.
The MMA also created the first major benefit expansion in Medicare since
the passage of the initial legislation in 1965: the Part D drug benefit.
Interestingly, rather than paying for the benefit on a fee-for-service basis as in
traditional Medicare, the government capitated private companies, some of
which specialized in processing drug claims (such as ExpressScripts and CVS
Caremark) and were known as pharmacy benefits managers (PBMs); others were
insurers or HMOs that had the same capability. This method of administering
the Part D benefit was intended to provide beneficiaries with a choice among
competing plans. Existing MA managed care plans were also required to offer at
least one plan that incorporated the drug benefit. Providing the new drug
coverage benefit entirely through private companies was highly controversial, in
part because it had never been done before. It was also regarded by some at the
time as unworkable. Nevertheless, Medicare Part D’s benefit has survived, albeit
with administrative problems at the beginning.
Growth in the Medicaid managed care program followed a smoother
trajectory. Cash-strapped states increasingly turned to private managed care
plans, whose Medicaid enrollment grew from 18.8 million in 2000 to 42.2
million in 2011, representing 74% of all Medicaid beneficiaries.32 Expanded
Medicaid eligibility under the ACA is also increasing the number of people
covered under managed Medicaid plans.
The Toll of Rising Healthcare Costs33
The toll of rising healthcare costs on the economy in the first decade of the new
millennium was considerable. In the commercial group market, employers
continued to pay approximately 70% of the cost, with the remainder coming
from payroll deductions.* However, with healthcare costs rising so rapidly,
employees’ absolute dollar contribution rose considerably. Rising costs, along
with a weakened economy, resulted in the percentage of Americans without
health insurance rising from 14% in 1999 to 17% in 2009.34 One reason for
this trend was that some businesses, particularly small ones, found coverage to be
unaffordable. Another reason was greater number of employees declining
employer-sponsored coverage so as to avoid the payroll deduction. Although
statistics vary, bankruptcies resulting from medical debt during this period were
also widely estimated to account for more than half of all personal bankruptcies;
whether this will change under the ACA is unknown at this time.
Increasing payroll deductions were not the only way in which costs to
consumers rose. In an effort to limit premium increases, employers also
increased cost sharing, especially the size of deductibles (i.e., the amount an
individual must pay out-of-pocket before benefits are paid). By 2013, more than
28% of large firms and 58% of all small firms had an annual deductible of
$1000 or more, whereas $250 was typical in the prior decade. Cost sharing also
increased for both routine visits and prescriptions. Whereas once the typical
office copayment was $5, it now averaged $23 for visits to a PCP and $35 for
visits to specialists. In addition, coverage of prescription drugs once required a
single copayment no matter which drug was purchased; in the 2000s, this
benefit typically became subject to complex tiered copayments, with lower
copayments required for generic drugs (where available) and higher levels of
copayments required for brand-name drugs. Cost sharing in benefits design is
addressed in more detail in the Health Benefits Coverage and Types of Health
Plans chapter, and management of the drug benefit is discussed in the
Utilization Management, Quality Management, and Accreditation chapter.
The middle of this decade also saw the appearance of high-deductible health
plans (HDHPs) and related consumer-directed health plans (CDHPs), both of
which confer savings in federal income taxes. The main benefit to the enrollee in
such a plan is savings in taxes and premiums. The amount of the minimum
deductible required to qualify for favorable tax treatment has varied over the
years but amounted to $3300 per year in 2014 for individuals and $6550 for a
families. Embedded in CDHPs is the notion that consumer choice and
accountability should be enhanced. The initial focus was to provide members
with better information regarding quality and cost of care along with
information to help them understand their health care. However, such plans are
controversial because, whatever the resulting savings, people with high incomes
disproportionately gain from tax savings because they are in higher tax brackets,
whereas persons with high medical expenses—notably those individuals with
chronic conditions—face higher out-of-pocket expenses, often year after year.
The Patient Protection and Affordable Care Act (ACA, also known as
“Obamacare”), signed into law on March 23, 2010, is the most sweeping
healthcare legislation passed in the United States since 1965, when Medicare
and Medicaid were enacted. It is also the most important legislative development
in the health insurance and managed care industry to occur in this millennium.
It is not, however, the only development of note.
The Patient Protection and Affordable Care Act
At nearly 1000 pages in length, the ACA affects the entire healthcare sector, but
its two areas of greatest impact are on the health plan industry and on access to
coverage. Because the ACA is so sweeping, it is not possible to cover it all within
the confines of this text, much less in this chapter. The specific provisions of the
ACA that are most important to understand are addressed throughout this text.
The ACA affects health insurance and managed healthcare plans in several ways,
with many of the provisions being phased in over time. Particularly important
provisions include the following:
• Health benefits plans are required to cover dependents until age 26.
• Health insurance and HMO coverage is required to be “guaranteed issue,”
meaning health plans cannot deny coverage or vary premiums based on
preexisting conditions or health status. Premiums can, however, reflect
geographic location, age (within prescribed limitations), and tobacco use.
Guaranteed issue is confined to an annual limited period of “open
enrollment” when individuals and groups can apply for coverage.*
• Health insurance “exchanges” are established by states, and by the federal
government if a state either fails or refuses to do so. Such exchanges are
largely computer-based systems where individuals and small businesses can
purchase insurance from private health plans.
• All Americans not otherwise covered are required to purchase an approved
private insurance policy or pay a penalty, with some exceptions, the most
important being individuals deemed to be subject to undue hardship as a
result. Individuals and families with incomes less than 400% of the poverty
level who are not eligible for Medicaid can qualify for premium subsidies.
Ironically, the idea of requiring that Americans obtain health insurance—
which was vehemently opposed by most Republicans as an infringement on
personal liberties—is commonly attributed to the Heritage Foundation, a
conservative think-tank; the Foundation proposed this concept in 1989,
and it was supported by many Republicans at the time.
• The Medicaid program was expanded to cover all families and individuals
with incomes of less than 133% of the federally established poverty line,
with the federal government paying states 100% of the cost of covering the
expansion population in 2014–2016, declining gradually to 90% in 2020
and thereafter.
The ACA, which passed narrowly, was the subject of a hard-fought battle
prior to its enactment and remains controversial. Lawsuits pertaining to its
legitimacy reached the U.S. Supreme Court after being litigated in lower courts.
The two main Supreme Court decisions, both reached on 5 to 4 votes, were that
the mandate that individuals obtain health insurance was constitutional but not
the requirement that states expand their Medicaid programs so dramatically as a
condition for receiving any federal matching funding. According to the Kaiser
Family Foundation, “As of June 2014, 27 states, including [the District of
Columbia], were expanding Medicaid, three states were actively debating the
issue, and 21 states were not moving forward.” The nonparticipating states can
elect to expand their Medicaid programs at any time.
In a later case heard by the U.S. Supreme Court, the court ruled that the
ACA’s provision that all benefits plans must cover contraception did not apply
to certain types of closely held corporations that have religious objections to
covering such care. At the time of publication, there were other outstanding
legal cases.
Taken as a whole, the provisions of the ACA had the effect of expanding the
number of individuals in both Medicaid and private healthcare plans—one
reason why the health insurance industry was generally supportive of the
legislation. Nevertheless, the ACA continues to face challenges, both political
and legal, and the law may even be amended by the time this text reaches
readers; for example, as of this writing, the U.S. Supreme Court has agreed to
hear a case involving the federal government’s ability to provide subsidies to
eligible individuals who purchase coverage through an exchange operated by the
federal government rather than a state, but it has not yet made a ruling.
The Healthcare Market Continues to Evolve
As significant as the ACA is, it is not the only change in the U.S. healthcare
system in recent years. The four examples given here are in many ways
reminiscent of events of 15 or more years ago.
Accountable Care Organizations and Provider–Payer Joint Initiatives
The ACA authorizes the creation of accountable care organizations (ACOs),
which entails a provider entity assuming responsibility for the total costs of the
Medicare Part A and Part B benefits for a defined population of beneficiaries in
the traditional Medicare fee-for-service program, with that entity sharing in any
savings or losses relative to a target. The target is intended to approximate what
would have been spent absent the ACO agreement. What is unique about this
arrangement is that Medicare beneficiaries are attributed to the ACO based on
past utilization patterns rather than their choosing to enroll. Those beneficiaries
can use any Medicare participating provider, unlike in an HMO. In fact, the
ACO is essentially invisible to the beneficiary. The ACO program was included
in the ACA as a permanent (not a pilot) program, despite the fact that it was an
untested model.
Some of the early ACOs have dropped out over what they perceive as long
delays in the Government’s provision of data that determine whether they met
the expenditure targets. In addition, ACOs sometimes questioned the accuracy
of the data. How successful the ACO program will be, and whether it is scalable
nationally, remains to be seen.
Physician Employment by Hospitals
Group and staff model HMOs declined in prominence throughout the late
1980s and into the early 1990s as the market turned toward open-panel HMOs
and PPOs. At the same time, many hospitals that felt threatened by managed
care reacted by purchasing physician private practices, mostly those of PCPs but
of some other specialties as well. The intent was to make it difficult for an HMO
or PPO to exclude the facility in question from its network and to gain
negotiating strength by employing the PCPs whom health plans most needed.
For most hospitals, this expansion was a costly effort that was subsequently
This dynamic has returned in recent years as hospitals have consolidated to
create major health systems. In many cases, the hospitals have once again
purchased practices, increasingly attracting physicians who seek employment
because they recently finished their training programs, require a steady income
to repay student debts, or do not want the burden of practicing privately. One
aspect of this burden is government efforts to induce providers to adopt
electronic medical records, which are beneficial but costly and time consuming
for the provider to learn to use when first installed.
As before, hospitals have purchased private practices, initially at least to
further strengthen their already strong negotiating position with health plans
and thereby obtain more favorable pricing agreements. However, while PCP
practices continue to be acquired, there is now greater focus on specialties such
as cardiology that rely heavily on ancillary services, particularly diagnostic tests
that the hospital offers.
Employed physicians are expected to direct patients to use the health system’s
ancillary services instead of those with potentially lower cost. This expectation
creates a significant problem for both private payers and Medicare. To illustrate
this dilemma, the traditional Medicare program pays more for services and
procedures rendered by physicians at a hospital facility than if the same services
and procedures were delivered by non-hospital-affiliated physicians in their
offices. Proposals have been advanced to change Medicare’s “site of service”
differential, which some view as an anomaly, but as yet this has not occurred.
In many markets, individual healthcare systems may employ more than 1000
physicians—numbers that were unheard of the last time this strategy was
attempted. The consolidation that is occurring brings into question the viability
of the competitive model when large provider systems dominate the market,
leaving insurers little opportunity to select the providers with whom they
While hospital employment of physicians is by far the more significant
dynamic, some health plans have also purchased existing physician practices.
They have done so in some cases to ensure that they would have network
physicians who were not employed by a hospital and in other cases to create an
alternative for medical groups that did not want to become part of a large
hospital system.
“Cutting Out the Middleman” Is Back
Provider interest is growing in “cutting out the middleman” (i.e., the insurance
carrier) by developing health plans that providers fully own and control. Unlike
the last time this phenomenon occurred, the providers in question are health
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