Health Care Financing

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The methods used to finance personal health care service play a major role in shaping a country's health care system. Personal health care include services such as hospital care, physician care, dental services, and drugs that are provided directly to individuals. How this care is financed influences how people access health care, the types of health care provided, and the mechanisms used to allocate health care services. Financing methods also influence how the costs of health care are distributed among members of society by income and by health status. Two aspects of health care financing are the focus of this section: the sources of funds for health care services, and the mechanisms used to pay health care providers.


In most markets, buyers and sellers trade directly. A person who wants to buy a loaf of bread pays the merchant for that bread. A person who wants to buy an automobile pays the dealer for the car. This concept of direct exchange between the buyer and the seller is not repudiated by the existence of credit. The health care market, however, is quite different. A basic characteristic of health care systems in all developed countries is that the majority of payments for medical services flows through third parties. A third party is an entity, usually an insurance company or government agency, that pays for medical services but does not receive or provide health care services. In general, third-party financing arose for two different reasons: (1) people wanted to insure against the large and uncertain cost of illness, and (2) governments wanted to assure access to health care for its citizens.

Figure 1 presents a diagrammatic representation of the various aspects of health care financing systems. If there were no third parties, then only the bottom part of the figure would apply. Individuals would pay providers directly for health services at prices set by those providers. With the presence of third parties, the situation becomes more complicated. Each third party (the insurance plan or government agency) has its own rules determining the source of funds, who is eligible to enroll, what medical services will be provided, and how medical providers will be paid. As a concrete example, consider a group of employees who are all covered by an insurance plan obtained through their employer with part of the cost of the insurance (the premium) paid by the employer and part by the employees. The insurance plan will indicate who (employee and/or their dependents) is covered by the plan; what services (such as hospital stays, physician visits, medical tests, drugs) are covered under the plan; what payment limits (such as a maximum number of hospital days per year) if any, are imposed; which medical providers (such as a roster of providers who participate in the insurance plan) will be paid under the plan, and how medical services are obtained (for example, whether a medical specialist can be consulted without authorization from the plan). An insurance plan also dictates the cost-sharing arrangements, that is, how much of the cost of care is to be paid directly by the patient and how much by the plan. Examples of common types of cost-sharing arrangements are deductibles (i.e., a specified amount for medical care before the plan makes any payments), co-payments (i.e., a fixed amount for each clinic visit or service), or coinsurance rates (i.e., a percentage at the total medical bill). Additionally, most insurance plans place limits on the maximum amount of direct health care costs patients will be responsible for paying in any given year. Finally, insurance plans set rules to govern how medical providers are paid for their services.

The nature of health care financing systems varies widely across developed countries. With the exception of the United States and South Africa, all of the developed countries have implemented some kind of national health insurance system; that is, they have established programs to ensure that the majority of their citizens have access to

Figure 1

health care services with minimal cost-sharing. Some countries (such as Germany and France) require employers to offer and employees to purchase a health insurance plan with payroll taxes as the major source of funding for this. In other countries, such as Canada, general tax revenues supply the major source of funding for their health insurance systems.


Health care financing in the United States is fundamentally different from that in most other developed countries because there is no national health insurance plan. There are a variety of third-party payers such is government programs (Medicare and Medicaid), insurance companies (which can be either for-profit and not-for-profit), self-insured plans operated by employers and provider sponsor organizations (providers that contract directly to provide health care services). Each of these types of third-party payers offer different health plans that have different financing "rules."

In the United States the majority of employed people and their dependents obtain health insurance through their employment. However, the provision of health insurance by employers is strictly voluntary (other than the state of Hawaii) with few regulations governing how insurance is provided. Some employers do not offer insurance at all, while others pay anywhere from all to none of the insurance premium. Employers may offer only one insurance plan or a multitude of plans for employees to choose from. Insurance plans are not standardized and can vary widely with respect to covered services, cost-sharing arrangements, and procedures for accessing medical services.

Active competition exists among insurance companies in the employment-offered health insurance market. Employer-offered plans are often experience rated, that is, the premium (or price of the plan) for employees of a particular employer are determined primarily by the past cost of medical care used by employees of that employer. When premiums are experience rated, they are lower for employers with healthier employees. However, premiums for some plans are community rated; that is, they are determined by the past cost of medical care for all people covered under a plan regardless of their employer.

Individuals may also purchase health insurance in either the individual insurance market or through groups that were formed independent of employment, such as professional associations. In this case, the premiums are generally experience rated and reflect the average, expected cost of illness for individuals within the defined group covered by a particular plan. The sicker the group of individuals covered by an insurance plan, the higher the premiums. There is tremendous variation in the types at insurance plans sold with respect to the characteristics such as cost-sharing, and access to services.

Although the United States does not have national health insurance for all its citizens, it does have a number of public programs that provide health insurance or other types of health programs for the poor, the disabled, and the elderly. The three most important public programs are the Medicare program, the Medicaid program, and the State Child's Health Insurance Programs (SCHIP).

The Medicare program is a federal program that was enacted in 1965. Medicare covers almost everyone who is sixty-five years of age and older, as well as a small subset of the general population who have been receiving Social Security Disability payments for two years and almost everybody who has end-stage renal disease (kidney failure). The Medicare program covers a wide range of services, although it does not cover most outpatient drugs and its coverage of long-term care services is limited. There is also cost-sharing on covered services. The Medicare program is funded through a combination of payroll taxes, general tax revenues, beneficiary premiums, and direct beneficiary payments. Medicare beneficiaries can privately purchase additional insurance (Medigap) that covers some (or all) of the beneficiary cost sharing for covered services as well as some additional services.

Medicaid was also enacted in 1965 to provide medical care for certain vulnerable and needy individuals with low incomes and assets. Jointly funded by the federal and state governments, it is subject to broad national guidelines and state-specific rules, which can vary by eligibility criteria as well as the type and intensity of services. Payment methods also may vary by state. In general, the Medicaid program covers a wide range of services with very little cost-sharing imposed on the patients. The federal share of the Medicaid program is funded through general tax revenues, the states fund their programs in a variety of ways (such as general taxes, provider specific taxes, and tobacco taxes).

The SCHIP program, first established in 1996, provides health insurance for children in families with low incomes but not low enough to qualify for family coverage under Medicaid. In essence, it increases the number of low-income children eligible for public insurance. It covers a broad range of services and requires some limited cost-sharing. It is funded by federal and state taxes. The federal share of these taxes is provided through general taxes, while states use a variety of methods to fund the program.

In addition to these programs, a number of smaller programs finance medical services for targeted populations. For instance, some states, such as Pennsylvania, provide funding for drug coverage for low-income senior citizens who do not qualify for Medicaid. In Pennsylvania, this program is funded by state lottery sales.

In 1998, some 44 million people in the United States under the age of sixty-five (18.4% of the population) did not have a health insurance plan, although some of them may have been eligible for medical services through specially targeted public and private programs (Fronstein, 2000).


In 1998, expenditures on personal health care services totaled $1 trillion with 19.6 percent paid directly by patients (out-of-pocket payments) and 80 percent paid by third parties (Health Care Financing Administration, Third parties paid for 97 percent of hospital care but only 55 percent for drugs and other services. This discrepancy reflects the nature of insurance coverage. While almost all insurance plans provide some level of payment for hospital services, payments for drugs is less universal. The amount of cost-sharing varies by type of covered services, but patients typically pay a larger share of outpatient clinic costs and inpatient hospital costs.


The total payments made for health care are sometimes referred to as the "cost" of personal health care. Two aspects of the distribution of the cost of care are frequently examined: the distribution among individuals with respect to their income and among individuals with respect to their health.

Analysts classify funding sources with respect to income as progressive, regressive, or proportional. A funding system is considered progressive if the fraction of a person's income paid to the system (for example, in taxes or premiums) rises as income rises; a funding system is considered regressive if the fraction of a person's income paid to the funding system declines as income rises; and a funding system is proportional if this fraction of income paid to the funding system remains constant regardless of incomeevery person pays the same proportion of his or her income.

As indicated by Figure 1, all health care is funded either directly or indirectly by individuals. Individuals ultimately pay for the premiums to insurance companies and the taxes to governments that in turn pay for health care services. Aid in the employers often pay for a large share of insurance premiums and/or taxes, the amounts paid by employers are passed on to individuals and households through lower wages for the employees, higher prices to consumers for the employers' goods or services, or lower returns to investors on capital.

In general, health insurance programs funded predominantly through income taxes are the most progressive with respect to income. People with the highest incomes pay proportionately more than people with the lowest incomes, regardless of their use of medical services. On the other hand, insurance funded mainly by premiums is the most regressive because people with lowest incomes pay a higher proportion of their total income than people with high incomes. In general, payroll taxes are moderately regressive because the percentage of an individual's income that comes from wages (as opposed to personal investments or other sources of income) tends to decline as total income rises. Insurance programs funded by lotteries are also considered regressive because most lottery tickets are purchased by those with low incomes.

The broader the segment of society that forms the funding base for health insurance programs, the more the financial cost of illness is shifted from the sick to the healthy. If all health care is paid for only by patients, then the financial cost of illness is born exclusively by the sick (or users of health care). On the other hand, if a broad segment of society (healthy and sick) is supplying funds for health insurance programs, then the financial cost of illness is shared among those individuals and less financial burden is borne by the sick. Likewise, the more out-of-pocket payments (direct patient payments) that serve as the source of funds for health care, the more the financial burden of illness is borne by the sick. When experience rating is used to set premiums, the sick bear a higher financial burden of illness then when community rating is used. Thus financing methods greatly influence the financial burden of illness in a society. For example, under national health insurance systems such as those of Great Britain, Germany, and Canada, the financial burden of illness is broadly spread across society and the actual expenditures made by the sick (in the form of out-of-pocket payments and disproportionately high premiums) are much less than the actual cost of their medical care. By contrast, in the United States a higher proportion of medical expenditures is paid directly by the sick and many insurance plans are experience rated, thus the financial burden of illness is more concentrated on the sick.


A number of methods exist for paying health care providers (physicians, hospitals, clinics, labs, and other individuals and firms supplying health care services). This section presents an overview of the most important of these payment methods.

Paying for Care: Physicians and Other Health Care Professionals. Physicians and other health care professionals are generally paid using one of three payment methods: fee-for-service, capitation, and salary. In many cases, professionals are paid by more than one method. For example, a third-party payer may use a combination of payment methods or a professional might be paid by several different third parties, each using a different payment method.

Fee-for-service. Under the fee-for-service method of payment, professionals receive a fee (or payment) for each service they provide. The actual medical service is the unit of payment and there is some discretion regarding what constitutes a medical service. A service unit can be very distinct (i.e., urinalysis test) or relatively comprehensive (i.e., an appendectomy where the physician payment covers all care associated with the procedure including the preoperative visit, the surgical procedure itself, and some follow-up care). Thus, the service for which payment is made can actually be several separate, discrete services.

Fee-for-service payments to professionals are based on charges that are either set by professionals or by third-party fee schedules. A fee schedule defines the maximum acceptable charge for medical services. One of the most widely used the schedules in the United States is the Medicare Fee Schedule, which was developed by the Medicare program to pay professionals for care used by Medicare beneficiaries.

Capitation. The capitation method of payment provides professionals with a defined, periodic, per-patient payment (usually monthly) for every individual enrolled in insurance plan, regardless of how many individuals seek care or how much care is provided. Capitation agreements with providers specify what services are covered and those can vary considerably among agreements. The capitation payment may be based on the characteristics of individuals (such as age) enrolled in the plan. This helps compensate providers for differences in the expected use of medical care by groups of patients with similar characteristics.

Salary. The salary method of payment provides professionals with a fixed payment or salary (usually monthly or yearly) that does not vary with the number of people in the plan or the number of patients treated or the number of services provided. In the United States, this method is frequently used for nonphysician professionals in a variety of the employment settings. Physicians working for government agencies, some HMOs, or large group practices may also receive payment by the salary method.

A professional can receive payment under a single payment method while third-party payers make payments for that professional's services using several different payment methods. For example, a physician belonging to a large group practice may receive a salary from the group practice while the group practice receives payments for the physician's services from third-party payers using a capitation method.

Paying for Care: Hospitals and Other Institutional Providers. Numerous methods are used to pay for hospital services, such as payment based on established charges, retrospective costs, per-diem rates, per-case rates, capitated payments, or budgets. Countries, such as the United States, with many different third-party payers use a broader mix of these methods.

Charge-based payments. Prevalent only in the United States, the charge-based method requires hospitals to define a price or "charge" for each hospital service. This hospital-established charge is then paid either directly by the patient or the patient's health insurance company. Under this method of payment, hospitals determine the charge. This method is not used by government payers.

Cost-based payments. The retrospective cost-based method is designed to pay the actual costs of hospital services as opposed to whatever charge hospitals may request. Under this method, a set of accounting rules defines what the hospital costs are for a defined group of patients. Although relatively common in the United States from 1966 to 1983 because it was used by the Medicare program, most state Medicare programs, and some large insurers, this method has lost importance since the mid-1980s.

Per-diem payments. Hospitals paid by the perdiem method receive payments based on the number of days a patient spends in the hospital. This payment is usually not adjusted to allow for differences in patient characteristics (i.e., the same payment is paid for patients undergoing heart surgery as for maternity cases). However, per-diem payments may vary by hospital. The payment is agreed upon through negotiations between a third-party payer and a hospital. The per-diem method is relatively common in Europe.

Per-case payments. The per-case method pays hospitals a fixed payment for each patient the hospital discharges. In the most extreme form of the per-case method, the payment is the same for all patients regardless of a patient's medical condition. More commonly, patients are classified into groups based on expected costs for necessary care (known as case-mix formulations) and payment varies according to a patient's group classification. The payment may also differ for different types of hospitals (teaching hospitals, community hospitals). Per-case payment methods may contain provisions for additional payments for patients whose treatment costs are exceptionally high (called outlier payments). The Medicare program uses the per-case payment method and payment is based on a patient classification system called DRGs (diagnosis-related groups).

Capitation payments. Under the capitation method, the hospital receives a fixed monthly payment for person enrolled in a health plan. This payment method shifts financial risk from the third-party payer to the hospital itself and the use of this method for hospitals is relatively rare.

Budget payments. The budget method provides hospitals with a global budget or payment designed to cover all services provided by the hospital over the course of the year. The global budget may be unilaterally set by government agencies or established by formulas that account for inflation and expected changes in the size of the inpatient population or negotiated between a payer and a hospital. In some countries, global budgets account for expected differences in patient illnesses. This method is used in United States primarily for hospitals owned by the federal government.


Financing methods can influence consumers' decisions to seek medical care and how much and what type of medical care they seek. Consumers with no cost-sharing requirements are more likely to seek and use care because they don't have to make direct payments for their care. Likewise, consumers with high cost-sharing requirements are somewhat less likely to seek and use care. Financing methods may influence medical providers' decisions as to what treatments to offer and how frequently to interact with patients. Providers paid under capitation get the same payment to the regardless of whether or not they see a patient. This payment system discourages providers from requiring unnecessary visits. In these ways, financing methods influence the delivery of medical care to individuals.


In addition to the financing methods discussed above, the health care system in all countries is shaped by the general regulatory environment within which consumers make decisions about accessing the health care system and providers make decisions about the types of treatments to provide or recommend. There are significant differences across countries regarding the extent of centralized regulation over the number and location of hospital beds, the number and specialties of physicians in training, physician licensing, practice location and mobility, and the ability of hospitals or providers to establish clinics or purchase advanced technology. Additionally, the level of control government authorities have over aggregate health care budgets varies across countries. In general, the more a health care system is directly funded by the government, the more governmental control there is over the size of the health care system (subject of course to the give and play of the political environment). In cases were governments regulate the price of care (per service, per day, or per case), providers can still influence the flow of payments by altering the types or intensity of medical care. However, it is possible to impose budgetary control in a system where prices are directly controlled. For example, in the United States the Medicare program imposes physician expenditure targets called volume performance standards and bases the Medicare fee schedule in part on how well physicians (in the aggregate) meet the volume performance standard. Likewise, in the Canadian province of Ontario, the government imposes income limits for physicians and as payments to a physician approach the income limit, the proportion of the fee paid decreases. In general, there is much less aggregate control over the health care delivery system in the United States and there is in other countries.


National health expenditures are defined to include health care services and supplies, research, and construction supplies related to health care. Health care services and supplies include personal health care services, the cost of administering private and public health insurance programs, and government public health expenditures. Personal health services are by far the largest component of national health expenditures. Data on the national health expenditures for 1998 are presented at

The Health Care Financing Administration's web site,, presents detailed statistics on health care expenditures in the United States and the source of funds.

Judith R. Lave

Pamela B. Peele

(see also: Access to Health Services; Health Care Financing Administration; Health Maintenance Organization [HMO]; Managed Care; Personal Health Services )


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