Freakonomic Contracting in the Healthcare Supply Chain

The economics underlying the healthcare industry in our country today are staggering. Healthcare spending in the US consumes over 17 percent of GDP, or about $3 trillion. According to the supply chain arm of the American Hospital Association (the Association for Healthcare Resource & Materials Management, or AHRMM), medical supplies will outpace labor as the single biggest expense category for hospitals and health systems by 2020.

Here’s where it gets even crazier: Based on testimony from the Congressional Budget Office, nearly one in three dollars spent on medical supplies is wasted on products that do nothing to improve patient outcomes.¹⁾Based on Peter Herzog’s testimony to the House Budget Committee in 2008, “…roughly $700 billion each year – goes to health care spending that cannot be shown to improve health outcomes.”  Using CMS’s National Health Expenditure data and assuming correlated year-on-year growth rates, the estimate for waste in 2014 becomes $883 billion. Comparing that value against 2014’s total US healthcare spend of just over $3 trillion, approximately 29% of all US healthcare spend is wasted – or nearly one in three dollars. At today’s levels of spending, we’re talking roughly $47 billion in supply spend that’s being wasted each year.²⁾The US Census Bureau reported $943 billion in revenue for general medical and surgical hospitals in 2015. Using an imputed supply cost ratio weighted by hospital type (investor-owned vs. nonprofit/government) of 17%, approximately $161 billion was spent on medical supplies in 2015.  Assuming that wasted healthcare spend is 29% of the healthcare industry and that waste is uniformly distributed, approximately $47 billion was wasted on medical supplies in 2015. A promising approach in how healthcare providers and suppliers engage each another may hold the key to tackling this waste head on.

The 2016 Nobel Prize in economics was awarded to two individuals for their contributions to the field of contract theory: Dr. Oliver Hart of Harvard University and Dr. Bengt Holmström of the Massachusetts Institute of Technology. In a nutshell, contract theory studies how people or organizations develop contracts with one another. The tricky part is that, in most cases, one or the other party in the contract negotiations will have access to different information. This is what’s referred to by the theory as information asymmetry.

The key in these situations—and this is what the theory tries to help uncover—is figuring out the right incentives that will get both parties to want to play ball with each other. If the incentives are right and they play ball, both parties know they’ll each get more value out of the contract. This is the classic win-win.

Conversely, in poorly-designed contracts, one party can be tempted to take bigger risks than they otherwise would. This is because if something went wrong while taking on the bigger risks, that party wouldn’t be on the hook to absorb the fallout—the other party would. This is typically referred to as moral hazard and it’s one of the core issues addressed in contract theory.

In the US, moral hazard has been cited as a driving factor in why healthcare costs have increased so dramatically over the past several decades. A widely-used example involves people with health insurance where the cost of the insurance is fully covered (e.g. by their employer, as has traditionally been the case since World War II when wage controls were put in place to help stave off the risk of severe post-war inflation). In this example, insured people would order all sorts of extra procedures regardless of the actual impact on their health simply because, as far as they were concerned, the cost was zero. And, in the traditional fee-for-service model, providers would be more than happy to perform those extra procedures since it translated into more revenue for them.

These perverse incentives to provide a lot of services without stopping to think about the impact those services were having on health outcomes has, over the years, manifested itself in a slew of disappointing health-related statistics for the US. Even though the US is number one in health spending as a percentage of GDP, or 2.5X the OECD average, the outcomes don’t reflect these significant financial expenditures:

• 31st for life expectancy;
• 44th for infant mortality (behind Cuba, incidentally, which ranks 39th);
• 12th for obesity (top 10% of most obese countries in the world);
• 10th for cardiovascular disease deaths;
• And so on…

Obviously, the cost-benefit ratio is not in our favor by any stretch of the imagination. Thankfully, the shift to value-based reimbursement models is finally addressing those massive issues related to moral hazard. How? By changing the incentives so that providers are paid more for higher quality care rather than simply performing more procedures.

Of course, the shift to value-based reimbursement models touches on another major aspect of contract theory, pay-for-performance. This is where we start seeing the connection between contract theory and key emerging trends in the corner of the healthcare universe that we at Mondopoint call home: the healthcare supply chain and the relationships between healthcare providers and suppliers. In a nutshell, pay-for-performance for the healthcare supply chain is just like pay-for-performance anywhere else in the healthcare industry: it’s all about tying reimbursements to patient outcomes and quality of care.

In the case of the healthcare supply chain, suppliers are constantly developing new innovations in medical products that are intended to have a positive impact on a provider’s clinical outcomes. Under the old fee-for-service models, providers would pass through the price premiums for newer technologies. With the transition to value-based reimbursement models, providers are feeling the financial squeeze because they’re increasingly on the hook for delivering higher levels of care at lower costs.

This pressure is prompting providers to reconsider taking on the upfront risk of betting sizable chunks of their supply budget on new product technologies that may or may not perform as suggested by a supplier’s whitepapers. Instead, providers are now starting to ask their suppliers to share that risk in the form of contracts that link the net price paid for a product to the impact that the product has on a provider’s patient outcomes and quality of care.

At Mondopoint, we refer to this type of contract as a risk-sharing agreement (or RSA for short). We’ve also seen it occasionally referred to as a value-based or outcomes-based agreement. Whatever the terminology, they all pertain to suppliers sharing risk (and reward) with providers based on the clinical performance of their medical products. Going back to the theory itself, it describes optimal contracts as those where payments to a party are tied to outcomes that can offer information (or insight) into the actions taken by that party to fulfill their contractual obligations.

With an RSA, tying payment terms to product performance, or impact on patient outcomes, can demonstrate the value of a product for a particular clinical environment and suggest information about the quality of the supplier’s R&D efforts in bringing the product to market. Contract theory refers to this as the informativeness principle and goes on to say that pay shouldn’t just be determined by outcomes that can be directly influenced by the parties but can also be influenced by exogenous factors.

Let’s say that a provider agrees to purchase a new medical product from their supplier using an RSA. At the time the contract is negotiated, the supplier agrees to certain performance thresholds. If the product doesn’t meet those thresholds, the provider pays less. On the flipside, if the product meets or exceeds those thresholds, the supplier gets a premium. In this hypothetical example, if the product’s agreed-to performance thresholds are based on certain assumptions about the composition of the provider’s patient population, what happens if that composition changes during the lifetime of the contract? Should the provider get more of a discount, or should the supplier get more of a premium, for shifts in demography that, at a fundamental level, are totally unrelated to the intrinsic efficacy of the product itself?

This kind of potential situation tees up another key element in contract theory referred to as incomplete contracts. The basic idea is that, in most real-world situations, the parties negotiating a contract can’t realistically conceive of every possible eventuality in advance. With that being the case, it’s then all about coming up with the best “placeholder” contract. Contract theory says that, instead of trying to anticipate all possibilities, the contract should spell out who gets to decide what to do when the parties can’t agree on something in the future.

Going back to the hypothetical example above, if the provider is suddenly enjoying unexpected discounts or the supplier is owed unexpected premiums, they might have a stipulation in the RSA that lets one party or the other call a timeout. Then, during the timeout, they get to reevaluate how performance thresholds and allocation of risk and reward are determined based on an updated understanding of patient population composition and/or other relevant “environmental” factors.

A significant aspect of my work at Mondopoint, in collaboration with my co-founder, Jim Ivers, has been focused on developing an analytical framework that enables providers and suppliers to collaborate on developing effective risk-sharing agreements (see our whitepaper, “The State of Risk-Sharing in Medical Device Contracting,” to learn more). Our framework rests on four pillars that correspond to core features of contract theory. Some of those features were touched upon in this post, including pay-for-performance, the informativeness principle, and incomplete contracts. Other features of contract theory, particularly how they relate to risk-sharing agreements between providers and suppliers, will be explored in other posts—especially the challenge of measurement in the context of moral hazard.

Broadly speaking, we at Mondopoint believe that risk-sharing agreements will be an indispensable tool for contract development between healthcare providers and suppliers in a value-based world. The Norwegian Nobel Committee awarded the 2016 Prize in Economic Sciences for contributions to a field of study that corroborates the fundamental aspects of our RSA analytical framework. I see this as an affirmation of our approach to risk-sharing in healthcare supply chain management and look forward to seeing how this contracting paradigm evolves as more organizations begin putting it to effective use.