Economic implications of Defined Contribution Health Plans: Their impact on employers, insurers, employees, and healthcare providers

Business Economics, Jan, 2002 by Eric W. Ford

Employee health benefits are a major payroll expense for companies that provide them. During the 1980s and 90s, many employers moved workers into managed care programs to control costs. However, the ability of those mechanisms to contain healthcare inflation has run its course. Significant rate hikes in 2002 will cause some large employers to increase employee contributions anywhere from thirteen to twenty percent. Further, new legislation threatens to increase the pace of healthcare inflation and possibly make employers liable for the plans they offer. Therefore, some firms have already turned to Defined Contribution Health Plans (DCHPS) to control health benefit costs and limit their legal exposure. This paper describes two types of DCHPs that have emerged and analyzes their impact on employers, insurers, employees, and healthcare providers. The first type, based on individual Medical Savings Accounts (MSAs) plus group-based catastrophic health insurance, may be workable if forthcoming legislation provides appropriate tax shelter treatment for both employers and employees. The second type, which involves straightforward voucher payments, is unlikely to work because it removes all vestiges of community rating and would therefore leave many classes of workers unable to obtain affordable health coverage.

Employer-based health insurance has been a central element in U.S. compensation systems since World War II. Because of wage controls and severe labor shortages during the war, employers offered healthcare benefits to attract skilled workers. In order to expand the availability of employer-provided health insurance after the war, Congress created tax incentives that allowed employers to treat such benefits as tax-deductible costs. This lowered their corporate income tax liability on such benefits. However, by the turn of the century, the once modest cost of these benefits came to represent a major open-ended expense for many companies. In addition, employers are under pressure from employees dissatisfied with their access to healthcare. Political leaders at both the state and federal levels have responded to this concern by mandating high levels of specific healthcare services and by exposing insurers and employers to increased litigation risks for denial of services. The net effect of such legislation will a lmost certainly lead to increased health insurance expenses for both employers and their employees.

The initial cost savings realized from the development of managed care organizations in the late 1980s and early 90s also now appear to have run their course. As a result, the cycle of health insurance premium increases are again moving back well above the general rate of inflation (Gabel et al., 2000). Therefore, employers are now looking for alternatives that will allow them to continue to provide healthcare benefits that better control their payroll costs and extricate them from the potential legal liabilities involved in proposed "patient bill of rights" legislation. Such alternative approaches must also retain the tax advantages associated with traditional managed care programs.

One such emerging model is the defined contribution health plan (DCHP). Under the DCHP format, employers no longer directly offer one or more health insurance programs to their employees on a shared-cost basis. They simply provide a fixed-dollar wage supplement (the defined contribution), which employees can then use as they see fit to purchase their own healthcare services. Under this approach, the healthcare incentives and costs facing various cohorts of employees will undergo significant changes. Although the direct costs to employers may be stabilized, or possibly reduced in the short run (Battistella and Burchfield 1999), the long-run effects are not well understood. In addition, the overall employee cost of obtaining comparable healthcare may actually increase. Alternatively, consumers may elect to forgo many medical encounters, including some cost-effective visits, which may reduce the overall health status of the workforce. Identifying and analyzing such changes that DCHPs may create--for employers, insurers, employees, and healthcare providers--is the subject of this article.

Recent Trends in Employer-based Healthcare Benefits

During the last quarter of the twentieth century, most private and public employers that offered employee health benefits migrated from full indemnity plans toward managed care programs in an effort to contain their rising healthcare costs (Jensen et al., 1997). Under earlier full indemnity health programs, employers, via their insurers, allowed employees to choose their own healthcare providers and simply covered all or most of the costs they incurred on a fee-for-service basis. Co-payments were then introduced to create incentives for employees to help control healthcare expenses.

As employee healthcare costs continued to spiral upward during the 1970s and 80s, employers migrated toward managed care programs in an effort to better control their health-related payroll expenses. Health maintenance organizations (HMOs) emerged as the first major form of managed care. HMOs directed employees toward gatekeeper providers, usually in centralized locations, who in turn controlled healthcare costs by reducing the use of specialists, and other means. Most HMOs received fixed insurance (i.e., capitated) premiums that were either wholly or largely paid by employers. However, during the 1980s and 90s, many employees became disenchanted with HMOs because of the limited service levels and choices of providers they offered. Employers, in addition to having dissatisfied workers, were bearing the brunt of premium inflation rates for HMO coverage at the expense of corporate profits.