After the birth of my (David’s) first child, my wife and I noticed we were being billed for a very expensive bedpan and box of tissues that we had never used.

We challenged the charges and were told not to worry. Because of our fixed copay, these items did not cost us anything. Although we were skeptical, they told us we were free to take these items home. They could not reuse them and our insurance would pay for them.

Along with our newborn, we put the tissues and bedpan in our car. For years, we used the expensive bed pan as a cheap sand toy, compliments of our health insurance.

Michael Kirsch, a practicing physician and newspaper columnist, laments that there are questions he can never answer satisfactorily for his patients. His questions are central to the public policy debate increasingly being decided by voters and politicians rather than physicians and economists.

Our answer to Kirsch’s first question about why drugs are cheaper in Canada appears on our blog. His second question is “How can a hospital charge exorbitant fees for simple items that would cost a few bucks at CVS?” In other words, why would the hospital charge each new mother $100 for a $1 bedpan?

The answer is found by examining the economics of the payment system and pseudo price controls found in the industry.

Our health care industry is based on a third-party payer system. The person who pays for some or all of the service is neither the patient nor the provider. The payer is a third party whose involvement is not represented by either the supply or the demand curve.

The patient demands the services, the doctor supplies the service and the third party that pays is the health insurance. In this separation of patient and payer lies the rub.

To understand the economics of why this drives up prices, imagine that the normal supply-and-demand market equilibrium for a doctor’s visit is servicing 16 patients per day (the quantity) for $50 each (the price). This equilibrium demonstrates the balance between the doctor’s abilities, costs and needs and the patient’s interest and free capital.

Now enters health insurance, the third-party payer. They require a copayment of $15 from the patient for a doctor visit and cover the rest.

Although acute care has inelastic demand, meaning you’ll purchase it regardless of the price, most other health care services are elastic and the amount of demand is heavily driven by the price. Home visits, psychotherapy sessions and physical therapist evaluations, for example, are all elective health care expenditures and therefore elastic. Even the demand for doctor visits about cold symptoms depends on the cost to the patient.

As a result, when health insurance reduces the cost to the patient from $50 to $15 per doctor’s visit, suddenly doctors have increased demand for their services, perhaps up to 48 patients per day. The lower price incentivizes more people to partake in the service.

When the doctor’s office only had demand from 16 patients per day, they had to service a patient every 30 minutes. With 48 patients demanding their services, they now must service a patient every 10 minutes or have shortages.

If prices remain at $50 per doctor’s visit, with the patient paying $15 and the health insurance paying the rest, doctors won’t have the incentive to work harder than before and provide aid to the additional patients. If the prices stay the same, 32 patients who want doctor’s visits would have to go without them.

However, if the price increases to incentivize doctors to endure a more strenuous day or hire additional help, the shortages can be avoided. Because of the 32 additional demanding patients and a third-party payer willing to make up the difference, the market’s forces will naturally avoid the shortage and meet demand curves. Doctors will naturally increase their prices up to, say, $150 to compensate them for the additional work or new hires.

This is how a third-party payer drives up the prices. You can imagine how much more of an impact the third-party payer has on the system when, rather than merely a copay, they offer to foot the bill at no additional cost.

Under the third-party payer system, patients are incentivized to receive as many free or cheap benefits as possible even if those procedures or services have little actual value.

These conditions drastically warp the normal equilibrium of the industry’s natural supply-and-demand curve. Then, to top it off, the industry’s price inflation is only made more intense by the influence of Medicare.

Medicare is the third-party payer system for the largest consumers of health care, Americans age 65 and older. Its patients represent the largest portion of the health care demand curve. Because of that power, they are able to place pseudo price controls on the health care industry and determine most of the health care prices.

In an effort to control costs, the federal program fixes the amount it will reimburse for each type of treatment using diagnosis-related group (DRG) codes. After setting reimbursement levels, they ask if the provider will accept Medicare and, more importantly, its pricing.

Most hospitals are coerced by the government to accept Medicare. Then, following Medicare’s lead, other health insurance companies also negotiate what they will pay for each service and then ask the provider if they will be “in their network.”

Hospitals often find they are losing money on some of their procedures and making money on others. However, whether they make or lose money varies by the insurance company paying.

To increase their odds of being profitable or breaking even despite the variable payments, health care providers must charge the maximum allowed by the payer on everything.

Thus prices are inflated above normal equilibrium because a third-party payer makes more patients demand the supplier’s services. Then, thanks to the pseudo price controls of insurance companies, prices are inflated again to meet the highest offer of insurance companies so that their average reimbursement will equal or surpass their costs.

In addition, every submitted DRG code needs to be accurately documented and justified to receive payment. Insurance fraud is often a failure on the part of the doctor to document adequately the services performed and therefore justify charges to the third party.

So how does this relate to the bed pan?

A plastic bedpan might be very inexpensive, but documenting and justifying its distribution to patients to get reimbursed can be very costly. Hospitals that only provide a bedpan upon request must also take the time to document its use and delivery or face charges of insurance fraud.

Hospitals that distribute standard items to all their patients both simplify the process of being reimbursed and gain extra revenue to add to their profitability. With the hefty markup, they are wisely following the strategy of maximum charge to overcome the pseudo price controls.

Trying to get paid by insurance companies, Medicare included, is responsible for up to half of the costs incurred by routine visits to the doctor. Doctors by law are not allowed to provide a cash discount, so those without insurance end up subsidizing part of the third-party payer system.

The bottom line is that simple items have exorbitant fees because of how the American third-party payer system works. If patients were the payers, both demand and prices would be much lower.

This blog post is part of “The Economics Of Healthcare series“.

Photo by Ken Teegardin used here under Flickr Creative Commons.