Healthcare leaders are thinking a lot about inflation these days. How could they not? Everyone is talking about it! As carriers look to start their rating efforts for the 2024 benefit year, there are many questions about the underlying cost structure. This paper explores these questions and provides some insights on how the healthcare industry may be thinking about medical inflation, and how the months ahead may be incorporated into an overall healthcare business strategy.
Medical inflation patterns
Although actual medical trends are generally higher than reported through the medical consumer price index (CPI), for the sake of comparison we use the medical CPI as the basis for estimating medical inflation.2 For medical costs, a significant portion of the overall United States economy3, it is unsurprising that changes correlate well with changes in overall costs. This pattern bears out at least as far back as we have data; historically, medical CPI trend (medical inflation) has followed the pattern of the general CPI trends (general inflation). Comparing rolling 12-month average trends back to 1947, we can see that general and medical CPI trends tended to spike and dip around the same time.
Figure 1a: Annual medical vs general inflation since 1947
Under closer review, two patterns emerge from this data:
- Medical inflation patterns often, but not always, follow a similar but lagged pattern to general inflation.
- Annual medical inflation tends to be higher than its general counterpart (1.7 percentage points higher, on average).
As general inflation has risen significantly over the past few years to levels not seen over the past four decades, an important corollary in the healthcare industry is whether (and to what degree) medical inflation will follow.
General inflation vs. medical inflation timing
There is a nuanced relationship between overall inflationary trends and the trends that insurers experience. Perhaps most notably, contracts between providers and insurers are often in force for multiple years, creating a delay between the general inflation associated with employee wages and operating costs and increases from the health plan that are reflected in medical inflation.
We can look at the historical data to measure some of these patterns we are seeing to estimate future trends. The following graph breaks out medical inflation into hospital, professional, and pharmacy services and compares them to overall inflation since 2000.
Figure 1b: Annual medical inflation by type vs. general inflation since 2000
Over the past 75 years of data, medical (non-pharmacy) inflation levels have tended to follow their general counterparts by approximately six to 12 months on average.
Figure 2: Average medical inflation lag – General and medical
We estimate this by applying a time-lagged cross-correlation technique to identify when general and medical inflation are most highly correlated. By applying this methodology and comparing the general and medical inflation trends over time, we can identify the number of lagged months when medical inflation is most correlated to general inflation.
Comparing healthcare professional service inflation and hospital inflation separately, we see that medical inflationary patterns have generally lagged general inflation by between seven and 13 months for hospital services and by between zero and six months for professional services.
Figure 3: Average medical inflation lag – General, hospital, and professional medical
Pharmacy drugs are another key component of medical inflation, but there is more limited data on prescription drug inflation (less than 10 years), and the data is not highly correlated with general inflation (r2 = 0.45). It is possible that this occurs due to the availability of limited data; however, given how prescription drug prices are set among manufacturers, pharmacy benefit managers, drug wholesalers, and retail outlets, the prescription drug market dynamics are unique compared to what we see for other typical healthcare services, and the price-setting relationship has its own impact on general inflation trends.4
Medical inflation tends to be higher than general inflation
Comparing rolling 12-month average trends, medical inflation has outpaced general inflation 87% of the time and has been 1.7 percentage points higher than general inflation on average.
There may be some factors contributing to this historical pattern:
- Stickiness of healthcare costs: Payers and providers generally negotiate fees no more frequently than annually. Because of the infrequent nature of these negotiations, it is harder to “adjust” to new higher cost trends as the normal.
- Consumer price transparency challenges: At the grocery store, a consumer knows exactly how much any good costs and more importantly can compare prices with reasonable alternatives. Lack of price transparency has made these comparisons much more challenging in healthcare, where seeing the cost of services after member cost sharing and comparing them requires significant additional effort on the part of consumers.
- Third-party payers: Consumers pay premiums to carriers which then reimburse providers. Having this interim payment model tends to lead to increased spending and higher medical inflation.5
- The role of labor: Compared to other commodities, healthcare is disproportionally impacted by labor costs; in particular, staffing shortages have resulted in a greater demand for these services6 and higher costs.
- General inelasticity of demand for medical services: Utilization of healthcare services tends to continue even when prices spike. So, while general inflation may fluctuate, medical inflation tends to be less variable.
It’s also important to note that we have not seen general inflation this high in quite some time (and the healthcare industry was meaningfully different back then). The general actuarial caveat that “past patterns may not continue in the future” most certainly applies in this situation.
Drivers of medical inflation
Healthcare comprised 18.3% of gross domestic product (GDP) in 20217 and is expected to grow to close to 20% in coming years.8 It is perhaps unsurprising that medical inflation is easily associated with general inflation; as such, a large component of the economy, it would be surprising if the two inflationary trends were unrelated. Moreover, many components of federal health spending are directly linked to inflation9, and provider contracts are often indexed to inflation, particularly those based on Medicare rates.
However, healthcare has its own idiosyncrasies, and the market certainly doesn’t act like the markets for other goods or services. As consumers, we treat our health (and the health of our families) as sacrosanct; however, as patients, we often don’t know what we need, nor can we properly evaluate different treatment options in terms of quality versus price. Moreover, governmental bodies, insurers, and other external parties have vested interests in these outcomes, and typically are responsible for some (or all) of the payments to the providers—and yet, even these stakeholders have challenges evaluating how quality and price intermingle.
It is important to clearly define terms when discussing medical inflation, because there are multiple lag patterns to consider; for instance, when providers’ costs increase, it takes time for those contracts to be renegotiated to reflect costs and to be seen by insurance carriers; it then requires even more time to incorporate these cost increases into the premium rates offered to policyholders.
Underlying provider costs
The cost of labor is the largest expense provider systems face. In recent years, this cost has increased as systems have tried to attract and retain providers to care for patients. The pandemic had an impact here; healthcare employee average wages have increased by more than 15% from February 2020 to June 2022.10,11
Providers also bear the up-front costs for real estate and new building costs, and many hospital systems are continuing with infrastructure investments despite supply chain issues and the underlying cost of building inputs.12 Although capital improvements tend to lag over multiple years, they are still a factor impacting medical inflation.
Last (however certainly not least), the costs of all medical input items, from standard surgical supplies to durable medical equipment (DME), are essentially subject to the same underlying inflationary factors as the rest of the economy. This includes how prescription drug prices are set, as described above.
One of the key trends in American healthcare over the last 20 years has been the merging (or formal affiliations) of provider groups and hospital systems. As provider systems continue to grow, their ability to negotiate higher reimbursement rates will likely increase. To the extent that these larger provider systems can negotiate higher reimbursement levels, those changes will contribute to increasing medical inflation.13
A March 2020 Medicare Payment Advisory Commission (MedPAC) report to Congress examines both the steady increase in hospital consolidation over the past two decades and the relationship between this consolidation and commercial market prices.14
It is also important to consider that medical inflation and trends vary by region. While we have focused on national inflationary patterns in this paper, it is essential to account for any regional nuances when evaluating the impact of medical inflation on any specific healthcare products or markets.
In addition to the key drivers of medical inflation, some additional considerations represent unique circumstances in our current inflationary economy.
The number of providers and payers entering value-based contracts has increased in recent years. As providers continue to take on more financial risk for treating patients in the healthcare market, the connection among consumers, the services rendered, and the price paid for services narrows. This may be a factor that offsets some of the anticipated medical inflation.
Price transparency data
In addition to provider consolidation, provider reimbursement may be impacted by newly enacted transparency laws that require providers and health plans to share information regarding negotiated reimbursement levels. As the implementation of this regulation continues to develop, price transparency is expected to change the approach for negotiating reimbursement rates in healthcare. Typically, as prices become more transparent in a market, there is an increase of competition that often leads to lowered prices. A similar effect may occur in the healthcare system, offsetting increasing reimbursement rates due to consolidation, at least to some degree.
Finally, the pandemic has had a direct impact on medical inflation as individuals tended to cancel and/or defer care during the pandemic, with a corresponding return towards normal care patterns after the pandemic (in addition to the introduction of care originally deferred). These shifts in how frequently individuals seek medical care has affected the healthcare costs in addition to other areas of the economy that indirectly affect medical inflation. We also are starting to see the myriad impact of both patients with “long COVID,” as well as the first signs of impact from missed preventive care during the pandemic.15
More generally, the pandemic of course affected all areas of the global economy, impacting us in a variety of ways (including some effects that we have not yet identified), and having downstream impacts on underlying medical costs. Two particular areas of interest are the impact on behavioral health resulting from both the virus and the associated societal response16, and the increased focus on telemedicine as a potential treatment venue17.
The relationship between general inflation and medical inflation is well documented and largely consistent. As we continue to monitor how drivers play out over the next few months and years, we will be able to better estimate whether medical inflation will follow historical patterns or if recent unique circumstances will lead to new medical inflation patterns going forward.
1 U.S. Inflation Calculator. Historical Inflation Rates: 1914-2022. Retrieved January 12, 2023, from https://www.usinflationcalculator.com/inflation/historical-inflation-rates/.
3 It’s important to note that the American health system is unique in many ways, including the portion of overall GDP allocated to healthcare. For additional information, see the Society of Actuaries and Kaiser Family Foundation’s Initiative 18|11 https://www.soa.org/programs/initiative-1811/.
4 The correlation factor for the time-lagged cross-correlation analysis is 0.84 for overall medical inflation, 0.77 for hospital inflation, 0.74 for professional inflation, and 0.45 for prescription drug inflation. The higher correlation for medical, hospital, and professional services suggests there is more of a relationship between general inflation and medical inflation than would be suggested with the lower prescription drug correlation factor.
5 Terrell, T. (September 2014). The Role of Third-Party Payers in Medical Cost Increases. Retrieved January 24, 2023, from https://www.researchgate.net/publication/339955682_The_Role_of_Third-Party_Payers_in_Medical_Cost_Increases.
6 Balasubramanian, S (August 26, 2022). The Healthcare Industry Is Crumbling Due To Staffing Shortages. Retrieved January 12, 2023, from https://www.forbes.com/sites/saibala/2022/08/26/the-healthcare-industry-is-crumbling-due-to-staffing-shortages/.
7 Centers for Medicare and Medicaid Services. National Health Expenditure Data: Historical. Retrieved January 12, 2023, from https://www.cms.gov/research-statistics-data-and-systems/statistics-trends-and-reports/nationalhealthexpenddata/nationalhealthaccountshistorical.
8 Centers for Medicare and Medicaid Services. National Health Expenditure Data: NHE Fact Sheet. Retrieved January 12, 2023, from https://www.cms.gov/Research-Statistics-Data-and-Systems/Statistics-Trends-and-Reports/NationalHealthExpendData/NHE-Fact-Sheet.
9 For a broad overview, see Capretta, J (April 18, 2022). Medicare and inflation. Retrieved January 19, 2023 from https://stateofreform.com/commentary/2022/04/medicare-and-inflation/.
10 Wager, E. et al. (August 24, 2022). What impact has the coronavirus pandemic had on health employment? Health System Tracker. Retrieved January 12, 2023, from https://www.healthsystemtracker.org/chart-collection/what-impact-has-the-coronavirus-pandemic-had-on-healthcare-employment.
11 As a reference point, 2022 Q3 Medicare Market Baskets indicate that hospital Prospective Payment System (PPS) and Medicare Economic Index (MEI) physician market baskets show labor wages and benefits to be 53% and 73% of total costs, respectively.
12 Obando, S. (August 29, 2022). Healthcare construction spending surges despite soaring expenses. Construction Dive. Retrieved January 12, 2023, from https://www.constructiondive.com/news/healthcare-construction-spending-surges-despite-expensive-costs/630645/.
13 Schwartz, K. et al. (September 2, 202). What We Know About Provider Consolidation. Retrieved January 12, 2023, from https://www.kff.org/health-costs/issue-brief/what-we-know-about-provider-consolidation/.
14 MedPAC (March 2020). Chapter 15: Congressional Request on Healthcare Provider Consolidation. Report to the Congress. Retrieved January 12, 2023, from https://www.medpac.gov/wp-content/uploads/import_data/scrape_files/docs/default-source/reports/mar20_medpac_ch15_sec.pdf.
15 Teasdale, C.A. et al. (March 19, 2022). Missed routine pediatric care and vaccinations in U.S. children during the first year of the COVID-19 pandemic. Prev Med. Retrieved January 12, 2023, from https://www.ncbi.nlm.nih.gov/pmc/articles/PMC8933962.
16 World Health Organization (March 2, 2022). COVID-19 pandemic triggers 25% increase in prevalence of anxiety and depression worldwide. Retrieved January 12, 2023, from https://www.who.int/news/item/02-03-2022-covid-19-pandemic-triggers-25-increase-in-prevalence-of-anxiety-and-depression-worldwide.
17 Norris, D. and Passwater, K. (November 2020). Telemedicine in the New Health Economy. The Actuary. Retrieved January 13, 2023 from http://theactmagstage.wpengine.com/telemedicine-in-the-new-health-economy/.