Regina E. Herzlinger

Consumer-driven health care offers salvation to a healthcare industry that penalizes providers that dare to be innovative.

At a Glance:

Corporate entrepreneurs drive improvements in a productive economy and are rewarded financially. The U.S. healthcare industry, on the other hand, allows payers to dictate prices and punishes any providers that try to create better, cheaper goods and services. The result is missed opportunities for innovation. Consumer-driven health care (CDHC), however, allows providers to innovate and offers consumers choice. Basically, CDHC matches supply and demand while rewarding skilled entrepreneurs.

Can you imagine a major industry whose executives are not permitted to create the goods or services they offer? Or one in which they cannot quote their prices, but, instead, are forced to accept the price quotes of their customers?

After the implosion of the centrally managed Union of Soviet Socialist Republics, or USSR, and Chinese economies, most observers would find this scenario ludicrous. After all, those economies essentially collapsed because their central planners strangled entrepreneurs.

But these observers would be ignorant about the workings of the U.S. healthcare sector. In it, the payers hold all the cards. The U.S. federal government's Medicare program, which in 2002 accounted for 31 percent of all hospital payments, dictates not only prices but also the exact formulation of the services for which it will pay. Private health insurers, who account for 34 percent of hospital expenditures, follow Medicare's lead, as does the state-run Medicaid program.a The only differences among them are that private insurers generally pay a little more than Medicare, while Medicaid pays considerably less.

As a result, the innovators-the hospitals, physicians, and other providers-who could create better, cheaper goods and services, like the entrepreneurs in other sectors of our economy, are bashed in the teeth in the healthcare sector.

Henry Ford created the better, cheaper automobile, which revolutionized a product once affordable only to the very rich, and made it widely accessible because of its lower costs and higher reliability. Along the way, he reaped the financial rewards that enabled the creation of the Ford Foundation.

How do the Henry Fords of health care fare? Consider the case of Duke Medical Center, which created a new integrated program for the victims of congestive heart failure. In one year, the program saved more than $8,000 per enrollee. Like Henry Ford's Model T, the savings were achieved by creating a better product: enrollees with substantially improved health status had less need for hospital admissions and, when admitted, stayed for shorter periods of time.b Did Duke Medical Center achieve the monumental rewards that accrued to Henry Ford?

Au contraire.

In our current healthcare system, Duke was penalized. Duke is paid for hospital days, not improvements in health. So, the more it improved health status, the more money it lost. Or consider Dean Ornish, a California-based cardiologist whose low-fat, low-calorie diet program reverses heart disease. Unfortunately, the diet is so onerous that most participants cannot adhere to it, absent a support program, which costs roughly $4,000.c Ample scholarly evidence verified the program's cost-effectiveness, and Ornish is an entrepreneurial person with a knack for public relations-he was even featured on the cover of a national news magazine. But despite these pluses, he had to spend nearly a decade convincing Medicare and one other insurer to offer coverage of the program. And only on a trial basis at that.d

In other words, unlike Henry Ford, Sam Walton, Bill Gates, and the other entrepreneurs who continually drive the improvements in our amazingly productive economy, Duke could not freely price its innovative new product and Ornish could not even obtain coverage. To the contrary, they were penalized for their creativity.

The consequences for the healthcare sector are disastrous. After all, it is the Henry Fords of health care-the physicians, hospitals, and other direct providers-who are most likely to make it better and cheaper. While health insurers play an important role in the system, they cannot innovate products. Who, for example, would rely on GEICO, an excellent automobile insurer, to make automobiles better and cheaper? No one! But, under our present payment system, entrepreneurs are punished, and only health insurers have the power to define and price new products.

Missed Opportunities for Innovation

The most promising innovations are those illustrated in these examples.

Duke's program is an example of a class of innovation that I called "focused factories"- integrated health services that focus on the needs of costly, underserved populations. Focused factories can, for example, integrate the many needs of victims of chronic disease, or those with debilitating disabilities, or those whose special needs are all too often overlooked in the present system, such as African-Americans or women. When the diverse needed resources are integrated on a focused problem, quality invariably goes up and costs go down, as the Duke case illustrates.e

Although health insurers are now beginning to integrate the provision of healthcare services through top-down disease-management programs, these innovations are neither organic nor typically refined through feedback. But the best innovations typically come from the bottom up, created by entrepreneurs and continually refined in a learning organization.

Ornish illustrates the second class of innovation-helping people to reverse destructive lifestyles. Private insurers may not wish to invest in these programs because with their 20 percent annual churn rates, they are concerned that the enrollees will be long gone when the improvements to their health status, paid for by the insurer in year one, become manifest many years later in lowered healthcare costs. But, ironically, even Medicare, whose enrollees will be with the program for the rest of their lives, is reluctant to invest in such programs, as Ornish's struggle illustrates.

Consumer-Driven Health Care

Fortunately, the consumer-driven health care (CDHC) system now being adopted offers salvation. Under CDHC, providers can freely create and price their services and consumers can freely choose them. CDHC not only enables suppliers to innovate but also enables consumers to choose the services that best meet their needs. In other words, CDHC performs the job of all market-based systems-it matches demand and supply, rewarding skilled entrepreneurs along the way.

To implement it, employers offer a wide variety of health insurance plans, unlike current one-size-fits-all offerings, and empower their employees to choose the one that offers best value for the money by subsidizing all plans equally.f For example, the Minneapolis-based Buyers Health Care Action Group (BHCAG) plan offers enrollees a wide variety of providers, including the Mayo Clinic, which are free to innovate their services as they choose. Enrollees receive a fixed sum of money that enables them to pay for the plans that offer them the best value for the money, such as the Mayo. If they choose a costlier system of care, they must pay the difference out of their own pockets.

In BHCAG's history, enrollees have moved from high-cost plans to lower-cost ones and suppliers have transformed themselves from high-cost to lower-cost status. Because BHCAG risk-adjusts its suppliers, innovations in programs that focus on the sick-such as Park-Nicolette's acclaimed diabetes program-were rewarded, not penalized.g

How to Make CDHC Happen

CDHC will enable competent providers to break out of a straitjacket that penalizes helpful innovation.

What will make it happen?

  • Focusing on creating new programs for high-cost, underserved healthcare needs for which better, cheaper care can be provided: patients with complex diseases (e.g., AIDS, diabetes, and cardiovascular ills), which require integration of the many diverse providers needed for treatment of the disease; underserved communities, such as African-Americans, women, and children; and people with intractable disabilities (e.g., back pain)
  • Offering a fixed price for the needs of all the users, adjusted for their risk status
  • Measuring the effectiveness and efficiency of the program relative to its peers

This CDHC combination of innovation and accountability will shatter the chains in which providers now live.

Sure, consumer-driven health care is frightening. Offering new services at a fixed price and being liable for measuring its results is a scary prospect. After all, prices may be relatively high and results relatively poor.

But which is better? A Goliath shackled by the constraints of the present system? Or a Henry Ford liberated by a consumer-driven one?

Regina E. Herzlinger, DBA, is the Nancy R. McPherson Professor of Business Administration, Harvard Business School, Boston. She is the author of Consumer-Driven Health Care (San Francisco: Jossey-Bass, 2004). Her 1999 book, Market-Driven Health Care, presciently predicted the collapse of managed care and the difficulties of vertically integrated healthcare systems.

Questions or comments about this article may be sent to the author at


a. In 2002, total hospital care expenditures were $486.5 billion, of which $165.0 billion was paid by private health insurance, $149.2 billion by Medicare, and $83.1 billion by Medicaid. The percentages work out to be: private health insurance, 33.9%; Medicare, 30.7%; and Medicaid 17.1%. Source: CMS, Office of the Actuary, National Health Statistics Group, t5.asp.

b. Whellan, David J.; Gaulden, Laura; Gattis, Wendy A.; and others, "The Benefit of Implementing a Heart Failure Disease Management Program," Archives of Internal Medicine, October 8, 2001, pp. 2223-8.

c. Herzlinger, Regina E., Battle of the Bulge, HBS No. 304-009, Boston: Harvard Business School Publishing, 2003.

d. Ornish, Dean, MD, founder and president, Preventive Medicine Research Institute, clinical professor of medicine, University of California, San Francisco, in Section II, Chapter II of Herzlinger, Regina E., Consumer-Driven Health Care, San Francisco: Jossey-Bass, 2004, p. 484.

e. Hagland, Mark, "Strategic Issues for Diverse Focused Factories," Healthcare Strategy, January 1999, pp. 8-9.

f. Herzlinger, Regina E., Consumer-Driven Health Care: Medtronic's Health Insurance Options, HBS Case No. 302-006, Boston: Harvard Business School Publishing, 2001.

g. Ann Robinow, president and chief operating officer, Patient Choice Healthcare, Inc., St. Louis Park, Minn., in Section 2, Chapter 1 of Herzlinger, Regina E., Consumer-Driven Health Care, San Francisco: Jossey-Bass, 2004, p. 179.

Publication Date: Monday, March 01, 2004

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