Reducing care costs will not translate to lower prices

One person’s cost is another’s price. Cost reductions won’t likely result in savings for consumers in the form of lower prices but instead contribute to the profits of healthcare enterprises. Thus, the dilemma is not just about reducing the cost of care but also how savings are allocated.

To address this question, we must explore the opportunities offered by two healthcare ecosystems as the primary funders of care: (1) the legacy sick-care system funded by health insurers or the government (Medicare, Medicaid, Tricare) and (2) a new one funded by self-insured employers leaning toward a wellness system (see Exhibit 1).

Each connected healthcare ecosystem is shaped by different cost drivers, necessitating different strategies to ensure it does not compromise one’s health. In this “reducing cost of care” themed research, we examine the costs within the legacy ecosystem and explore opportunities to not only remove them but pass the savings back to consumers.

Exhibit 1: The new healthcare ecosystem may be the answer rather than the perpetual and onerous task of removing costs from the legacy ecosystem

Source: HFS Research, 2024

Addressing acute care costs will have the biggest impact on the total cost equation

The Affordable Care Act (ACA) requires health insurers to spend 80% to 85% of premium dollars on medical care (clinical services and quality improvement) as a function of the medical loss ratio (MLR). So, right off the bat, the biggest driver to cost is in the care bucket. Consider the four key care segments illustrated in Exhibit 2—acute care accounts for a third of the total US healthcare spending and is the top contributor to national health expenditure compared to all other care segments.

Exhibit 2: Approximately $1.4 trillion was attributed to hospital expenditure in 2022

Source: CMS, AMA, HFS Research, 2024

From hospitals’ perspective, the cost drivers in the acute care segment are labor (clinical and non-clinical), operations (technology, infrastructure, billing, payer relations, patient experience), supplies (sourcing, supply chain), and drugs.

Labor: 60% of a hospital’s costs are attributed to labor (see Exhibit 3). This number is likely higher, given that physicians spend 60% of their time seeing patients. The rest is allocated to “in-box” activities, i.e., administrative tasks. While overall healthcare-related compensation has stayed below nominal inflation post the pandemic, it has increased by 21% for physicians since 2022. As hospitals focus on complex disease conditions to target higher reimbursement, they must attract specialists and experts who will add to their costs. The estimated shortage of 100,000 clinicians in the next decade remains a headwind to all cost-saving efforts.

Operations: The operations bucket embraces infrastructure (facilities, security, fleet), technology (devices, applications, connectivity), billing, patient engagement (appointments, discharge, post-acute resources), and everything else that is non-clinical. So far, 19% of hospital costs are attributed to operations that ensure safe and smooth functioning of hospitals. However, this number will likely increase due to cybersecurity challenges, sub-optimized self-service capabilities, and social factors (inequities, race, economics) that could affect their expense equation.

Supplies: 13% of hospital expenses are associated with supplies, which include non-durables such as gowns, gloves, slings, bandages and more complex items such as artificial joints, MRI machines, and surgical equipment. It’s anticipated that the costs will likely be better managed as technology evolves, making equipment less expensive, and that scientific advancements will improve the supply quality.

Drugs: The cost of drugs accounts for a fairly low 8% of total cost (see Exhibit 3) but could spiral higher. At the same time, there is a looming threat of a perennial shortage of generics, forcing hospitals to switch to non-traditional suppliers at a premium that could add up to 20% to a hospital’s budget, according to the American Society of Health-System Pharmacists (ASHP). Moreover, the cost of new drugs (the median price in 2023 was $300,000) can be very steep.

Exhibit 3: Labor is the biggest opportunity to address the cost of care across the four dimensions of hospital costs

Source: American Hospital Association; HFS Research, 2024

All indications point to increased costs due to tightening supply (shortage of clinicians, drugs, talent) and growing demand (increased population of sicker and older people and bad actors driving complex cybersecurity). Also, it is hard to envision ways to reduce them and share the savings with health consumers in an insurance construct.

Cost can be managed, but levers to reduce it are really constrained

Labor: There is an active movement to shift certain treatments from inpatient to outpatient facilities, such as behavioral health, supported by both government payers (CMS) and commercial payers. This is mainly driven by the need to save costs, the flexibility offered to clinicians, and the technology evolution to support treatments in alternate facilities. However, as Exhibit 4 shows, the cost advantage for outpatient services appears to diminish over time for all complexity levels. The other option is to increase the clinician’s utilization above the typical 60% by incorporating self-service for in-box items.

Exhibit 4: Outpatient higher complexity visits (levels 4 and 5) get billed at a higher rate over time

Source: Peterson-KFF; HFS Research, 2024

Operations: Technology will be essential for improving the efficacy of hospital operations—manifesting into increased automation (to enhance patient management), streamlined compliance activities, improved AI-enabled decision-making, optimized infrastructure (including medical device management), and strengthened cybersecurity. These steps will likely bring hospital operations on par with the efficacy levels in other industries such as banking and retail. Given the investments required and the long amortization schedules, it is unlikely that material cost modifications will be made any time soon.

Supplies: Embracing dynamic supply chains that enable selecting suppliers in real time, crafting creative contracts to incentivize suppliers for quality, timeliness, and quantity, and optimizing inventory management, will help. Many hospitals are attempting these strategies with varying degrees of success, given that hospital procurement approaches tend to be archaic and risk-averse. At the same time, the supply chain dynamics post the pandemic is forcing hospitals to accelerate adoption and find new ways to exploit opportunities.

Drugs: Two critical market disruptions are occurring: (1) new players, such as Mark Cuban Cost Plus and Amazon, and the Centers for Medicare and Medicaid Services (CMS) are stepping in to negotiate drug prices, and (2) the administration is forcing price controls, such as for insulin. These drivers will significantly alleviate costs and potentially address chronic supply shortages. Hospitals must still be creative and bold in leveraging such market forces to solve drug issues. However, given the size of spend, drugs are unlikely to change the cost trajectory.

The Bottom Line: Attempting to reduce acute care costs to lower the cost of care is a fool’s errand… it won’t happen in the sick-care paradigm

It’s unlikely that hospitals can reduce cost. If they do, the savings will probably be retained by healthcare enterprises instead of being handed back to consumers.

Avoiding acute care is the most common got-to approach for reducing costs, but all it really does is help consumers and payers save money. It doesn’t reduce the actual cost of care, as hospitals have fixed operating costs and delayed care could turn more expensive.

We sincerely thank the following individuals for their valuable contributions and collaborative efforts throughout the development of this report.

Dr. Natasha Bhuyan, National Medical Director and Vice President, One Medical
Viral Chhaya, former Vice President – Enterprise Business Services Strategy and Capabilities, Kaiser Permanente
Joshua Zalen VP, IT Service Operations, Independent Health
Leslie Graham President & CEO, Primary Care Coalition