Unbiased Analysis of Today's Healthcare Issues

Medicare’s (true) Administrative Costs

Written By: Jason Shafrin - Jul• 27•06

A common justification for Medicare is that the public health insurance system has an overhead cost which is about 2% of claims, while the private sector has administrative costs between 20%-25% of claims.  This tells us that Medicare is the best system for America…right?

Merrill Mathew’s of the Council for Affordable Health Insurance (CAFI) summarizes the findings of Mark Litow’s paper “Medicare’s Hidden Administrative Costs.”  Litow finds that taking into account extra legal costs from Medicare adjudication and CMS salaries, the administrative cost ratio increases to 5.2%. 

Private Insurance on average has administrative costs of 16.7% (varying between 30% for individual policies to 12.5% for large group policies).  Yet these figures are inflated.  If we exclude taxes and profits, as well as sales commissions, then the total administrative costs decrease to 8.9% overall and 8.0% for large group policies.  I do not agree that commissions should be deducted from this this figure but profits and taxes certainly should.  Medicare does not pay taxes and does not make a profit so any fair comparison should exclude these items.  Further, tax revenue from insurance companies adds to the public’s coffers; profits should be seen as a cost of capital. 

Even with Litow’s manipulation of the numbers, Medicare seems like a better deal.  Let’s see why:

  • Economies of scale: There are large economies of scale in the insurance business; however ,large insurance companies can certainly replicate the majority of the scale economies Medicare enjoys.
  • Cost of Capital: Medicare incorrectly counts its cost of capital as 0.  The true cost would take into account the direct cost of hiring IRS workers to collect the taxes which pay for Medicare as well as taking into account the distortionary effects of income taxation on workers labor supply decisions.  For the private sector, the costs of capital is transparent: it is simply the interest rate. 
  • Demographics: Medicare serves the elderly population and thus has a high cost per enrollee.  In 2003, the average medical cost for Medicare was $6,600 per person per year, while the same figure for private insurance was $2,700.  Thus, if public and private health insurance had the same administrative cost per person, Medicare would still be seen as ‘more efficient’ since Medicare’s administrative cost ratio would be less than half the size of the private insurance’s cost ratio.

Finally, we need to realize that administrative costs are like people: some are good, and some are bad.  What if a private insurance company raised its administrative costs by 1% , but was able to reduce fraudulent claims by 10% and reduce the premium charged to customers by 8%.  This is an example of how an increase in the administrative cost ratio can add value.  It is likely that private companies try to avoid paying for unnecessary medical treatment and are more vigilant to detect fraudulent claims then Medicare. 

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13 Comments

  1. BC says:

    If New York’s Medicaid program is any indication, fraud is a very significant cost for publicly financed programs whereas it is (presumably) vastly smaller in the private insurance market. If one added Medicare (and Medicaid’s) excess fraud costs (vs the private sector) to its adjusted administrative costs, it may well have no administrative cost advantage at all.

    There is also considerable potential within the private sector to shrink administrative expense by further consolidation within the industry, greater use of common forms, and simplifying claims paying such as paying a given provider the same price for the same service no matter which of its numerous insurance offerings the patient happens to have. More widespread use of high deductible plans could potentially eliminate millions of small claims for routine care if patients could be assured that they will be charged the contract rate (not the full list price) without having to run the claim through the insurer’s claims processing organization. This would, of course, require that insurers clearly let providers know ahead of time what they will consistently be paid for covered services, and providers agree to bill patients at that rate.

  2. Matthew Holt says:

    And why do we need private firms to make a profit? Especially at the level health plans make them?

    And how much cheaper would Medcare be if everyone was in it?

    What about the costs imposed by both private and public plans on providers? Some say that’s 25% more, so that’s where the real costs

    This is a series of bullshit arguments that sensible people should stay away from–sensible markets don’t make that distinction between “admin” and “real costs”–they’re all costs

    Concentrate instead on how the incentives of the financing system screw up the delivery system

  3. Rick says:

    I second Matthew. Removing profit to make the numbers appear more competitive is disingenuous, since profit is part-and-parcel of the private system, unless you require that all hospitals and insurers be nonprofit. As radical a change as “Medicare For All” might be, we’ll see it long before we see all-nonprofit hospitals and insurers.

    Further, I don’t buy the argument that “It is likely that private companies try to avoid paying for unnecessary medical treatment and are more vigilant to detect fraudulent claims then (sic) Medicare.” Private insurers tried to do this with HMOs, and the result was a public backlash that defanged medical management, and made PPOs the design of choice. Also, so-called “unnecessary medical treatment” and “fraudulant claims” are just more business activity in a fee-for-service environment, so there is little incentive to stamp them out. Got a bad image on that last $1,000 CT scan? Come on in for another! Ch-ching, another $1,000.

  4. Bob says:

    There are several points that are overlooked in this situation. One very important one is this. Who adjudicates Medicare claims?

    Private carriers.

    The same folks who adjudicate claims for folks like GM, Coca Cola and Home Depot adjudicate for Medicare.

    As for the profit motive of carriers vs. the alleged non-profit of government entities, I suspect you do not know how the budgetary process works within government. Any money allocated for a program that is not spent by the end of the fiscal year is then cut from the following years budget.

    So what is wrong with that you may ask?

    If an entity want’s more money for the following year, including money for pay raises, they must spend MORE than was allocated in order to receive more money for the following fiscal year.

    So where is the incentive to save money in government?

    It simply does not exist.

    And when have you ever heard of a tax decrease?

    As for Medicare, the costs in fact are increasing every year in not so subtle ways.

    Every year the deductible for Medicare participants increases. CMS also adjusts their reimbursement rates on a regular basis which create more of a disparity between what the rest of the public pays for health care vs. Medicare recipients. As reimbursements fall, or at least fail to keep pace with medical inflation, there are fewer providers willing to accept Medicare patients.

    You speak of unnecessary medical treatment and fraudulent claims. You must not be aware of the fraudulent Medicare claims that are filed with regularity and the number of providers that are on the 6 o’clock news as they are hauled off to jail in handcuffs. More often than not they are not arrested for scamming private carriers but Medicare. Wonder why? Could it be because it is EASIER to defraud Medicare than private carriers?

    All of these items add to the overall cost of Medicare and must be factored in along with the alleged savings for administration of Medicare claims.

    When you focus solely on the administrative costs you ignore the bigger picture. If you truly want to save on the cost of health care you don’t fixate on the 8 – 10% side of the equation but rather the remaining 90%.

    And there is the issue of taxes.

    Premium taxes hold one of the top 3 spots in state revenue. In some cases they are the largest single source of revenue. Eliminate private carriers from the mix and states have to find a new source of revenue.

    So when you want to cut out the private carrier from health care, don’t forget to factor in loss of tax revenue, fewer providers who are willing to serve the Medicare participants which leads to even more rationing, and a larger increase in cost shifting to those in the Medicare system through higher deductibles and fewer covered services.

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