Correcting Distorted Incentives in China’s Health Care System

After Chairman Mao Zedong’s death in 1976, China’s political transition was accompanied by an equally important economic transition and rapid liberalization. Deng Xiaoping, serving as paramount leader of the People’s Republic of China from 1978 to 1992, promoted an international, market-oriented economic “reform and opening up” that replaced Mao’s ideologically driven strategy and catapulted China into a 30-year period of unprecedented growth and development.^[1]Although in many ways China has benefited from this transition, the medical benefits that Chinese citizens enjoyed during the Maoist Era have been largely removed during the economic reform. These cuts included significant reductions in medical care subsidies, undoing the Mao Era legacy of low-cost universal health care coverage. Ever since this program was dismantled, China has struggled to provide universally accessible and affordable health care. China’s inadequate social safety net creates a sense of fear and insecurity among Chinese citizens about a future with limited government support for health care financing, which was the third largest expense in Chinese households after food and education as of 2007.^[2] This uncertainty prompts massive amounts of precautionary saving among the Chinese, who are the world’s largest surplus savers, with total saving likely to reach 50 percent of gross domestic product in 2012.^[3]  Excessive precautionary saving has hindered domestic consumption, forcing the production-based Chinese economy to depend on foreign demand. As the impetus for China to balance its economic strategy grows stronger, China must stimulate domestic demand to reduce export-driven reliance on foreign markets.

Reforming the health care system represents not only the potential to radically improve the social safety net and sustain economic development by creating jobs in the services industry, but also provides an opportunity to improve people’s standard of living, labor productivity and social harmony.^[4] Although Chinese leadership has begun to prioritize health care reform in recent years, China still has much room for improvement. A wide variety of factors inhibit affordable and accessible health care. This paper will examine incentive structures that affect behavioral decisions on the part of physicians, hospitals, policy makers and patients in the current Chinese health care system. Based on an analysis of these incentive structures, the paper will conclude by proposing potential health care reform policy initiatives.

During the Mao Era, spanning from the 1950s through the 1970s, China implemented a low-cost universal health care system. Three heavily subsidized medical insurance schemes ensured universal coverage: the Cooperative Medical Scheme (CMS) in rural areas and the Government Insurance Scheme (GIS) and Labor Insurance Scheme (LIS) in urban areas. Focusing on preventive and primary care, relying on a network of modestly trained health care providers, and implementing effective price controls kept costs low for patients.^[5] A large portion of China’s success in providing basic care, while spending only three percent of gross domestic product (GDP) on medical programs, can be attributed to The Communist Party’s ideological fervor and many party members’ backgrounds in medicine.^[6] The Chinese government established village health care centers where many Communist Party members trained “barefoot doctors” for little or no pay.^[7] Barefoot doctors received basic training and provided preventive and primary care, providing a less expensive alternative to more qualified physicians for basic medical needs. Although their training was minimal, usually lasting only a few months, the widespread availability and use of basic medicines contributed to dramatic health improvements.^[8] During the Mao Era, health care was organized into an effective three-tiered system that provided efficient patient referral for treatment of health problems. In rural areas, the three tiers were comprised of village clinics, township health centers, and county hospitals. The first tier, village clinics, and the second tier, township health centers, provided preventive and primary care.^[9] Only the most seriously ill patients were referred to the third tier, the county hospitals, which provided specialty health services and were staffed by fully qualified doctors. The urban medical system was similarly trifurcated into community health centers, district hospitals, and tertiary hospitals, but were staffed by more qualified health professionals.^[10] Physicians were not rewarded on the basis of how many patients they treated, so they would advise patients to seek treatment from a doctor of appropriate skill to treat their medical needs. This cost-efficient referral system ensured that patients did not receive unnecessary and expensive treatment from overqualified doctors.

Beginning in 1978, large-scale economic reform disrupted the Mao Era health care structure. This transition represented a trade-off between government-financed programs and free-market ideology, creating many challenges that persist today for contemporary health care reform.^[11] The shift to a market-based health care system accompanied a decrease in government subsidies as a share of total hospital revenues from more than 50 percent in the pre-reform era to approximately 10 percent in the 1990s, forcing hospitals to focus primarily on maximizing profits to compensate for the loss in funding.^[12]

The elimination of collective agricultural economics in the 1980s and declines in tax revenue from state-owned enterprise reforms in the 1990s help explain why a widespread market-based transformation was necessary during this period.^[13] Tax revenues fell from 35 percent of GDP in 1980 to a low of 11 percent from 1995 to 1996. The immediate effect of this revenue contraction was a significant reduction in government subsidies to health institutions.^[14] Chinese citizens whose medical coverage depended on state-owned enterprises and rural agricultural collectives were left without insurance. The dissolution of collective economies removed funding for the Cooperative Medical Scheme that financed rural health care.^[15] As public funding declined, the urban health insurance schemes incorporated copayments and other associated costs borne by the patients themselves, increasing the cost of coverage. As a result, health insurance coverage fell in both rural and urban areas.^[16] Between 1980 and 2000, the majority of China’s population, eight out of ten people as of 2000, did not have health insurance. By 2006, only ten percent of the rural population and 31 percent of the urban population were insured.^[17] Government subsidies to public hospitals and clinics were reduced from more than 50 percent to about ten percent of total costs.^[18] The remaining coverage costs were earned through fee-for-service payments, a system that remains in place today, by which providers are reimbursed according to a government-controlled price schedule for each service rendered.^[19] Hospitals began rewarding physicians with bonus payments and promotions on the basis of the profits they produced rather than the quality of their care in an effort to maximize revenues to fund hospital expansions and investment in medical technologies.^[20] Access became dependent on ability to pay and vulnerable to the increasingly for-profit market behavior of health-care providers.

One of the most outstanding impacts from the economic reforms on the health care system is the growth of the private share of health care expenditure. Although recent reforms have expanded coverage to encompass 90 percent of the population, they only cover a small share of expenditures.^[21] Government health care expenditure per capita rose from five yuan to 119 yuan per capita in nominal terms between 1978 and 2005, but was offset by even greater increases in out-of-pocket payments, which rose from three to 346 yuan per capita.^[22] Profit-oriented hospitals drive up overall total costs, and individual patients are bearing an increasing percentage of those costs.^[23] As of 2005, patients’ out-of-pocket costs accounted for 52 percent of total health expenditure, compared to 20 percent in 1978. Meanwhile, the government share dropped from 32 percent to 18 percent of total costs.^[24] Currently, the share of medical expenditures paid by individuals is 35 percent (an improvement from the 60 percent figure in 2003) compared to the government’s 28 percent.^[25] Chen Zhu, China’s health minister, has pledged to decrease the private burden to 30 percent while raising the government share to 33 percent by 2015, in line with the objective laid out in the 12th Five-Year Plan.^[26] As long as consumers bear the majority of the cost, there is no urgent financial incentive for the government or medical institutions to reduce costs. 

Despite the ongoing decentralization of China’s health care system, government regulation of market entry continues to preserve the monopoly power of large government-owned public hospitals, impeding true market competition.^[27] This monopolistic structure removes the financial incentives for potential competitors to attempt entering the market. As long as public hospitals are sheltered from competition, there is no incentive to reduce costs or improve quality of care.^[28] The intention behind government ownership of health care institutions is to ensure broad access to basic health care services.^[29] However, conflict arises when the very institutions that regulate the industry are also the only competitors.^[30] As of December 2011, the government owned about 95 percent of Chinese hospital beds but provided only ten percent of hospitals’ recurrent costs, rendering Chinese hospitals dependent on patient charges for their revenue. ^[31] This monopolistic system allows the Chinese government to own Chinese hospitals without providing the funding to run them, removing the incentive to moderate costs. Recent reforms of government-run hospitals have already started to address this issue by soliciting more private investment.^[32]

Because private capital was not allowed into the medical sector until 2009 and still only constitutes a small portion of the market, there is still great opportunity for progress.^[33] In January 2012, the Chinese government relaxed regulations on foreign investment in the health care service industry. Under the new regulations, there is no longer any cap on the proportion of investment in health care institutions provided by foreign sources. Previously, wholly foreign-owned investments were prohibited and foreign investors were limited to a maximum stake of 70 percent in joint-venture health care investments. In March 2012, the Chinese government announced its goal to have 20 percent of hospital beds privately owned by 2015, presenting great opportunity for both local and foreign private investors to enter the market.^[34] The current monopoly conditions in the health care market promote cost-inflationary, profit-oriented incentives that detract from the efficiency and quality of care. Increasing participation by the private sector will allow competition to intensify, which will drive down costs.^[35] China should pursue a balance of market forces and government regulations in order to achieve the most accessible and cost-effective health care system going forward.

In an attempt to keep care affordable, doctors’ salaries have been kept artificially low. Even though reduced subsidies to public hospitals made health care providers reliant on user fees and drug sales to survive financially, the government still set prices for medical services below cost. As a result, patients with minor ailments tend to consult specialists rather than more basic generalists since there is no significant cost differential to the patient, which contributes to overcrowding at large hospitals and escalating costs within the industry.^[36] For example, most doctors’ consultation fees are still under two dollars, even in large hospitals.^[37] Hospitals generally prefer to spend their revenue on infrastructure construction than physician salaries, which are lower than those of government employees on average.^[38] China’s Vice Health Minister, Ma Xiaowei, recently promised that the government would increase investment in hospital infrastructure and equipment to ensure a greater proportion of hospital spending goes to medical workers’ pay.^[39]

To compensate for the below market cost of medical services, the government set prices for new and high-technology diagnostic tests above cost, and a 15 percent profit margin for drugs was allowed.^[40] Price-setting has created a leveraging effect whereby physicians must dispense seven dollars worth of drugs to earn 1 dollar of income. As a result, doctors overprescribe drugs and profitable tests. Consequently, China’s health care expenditure growth has been one of the most rapid in world history, increasing at a rate of 16 percent per year, outpacing GDP growth by seven percent.^[41] For example, 75 percent of patients suffering from a common cold are prescribed antibiotics, as are 79 percent of hospital patients overall. These figures are more than twice the international average and have contributed to massive growth in health care expenditures.^[42]

Artificially depressed physician salaries create an incentive for doctors to order excessive medical tests, overprescribe expensive drugs, and accept bribes. These systemic distortions have created a health care system in which profits are prioritized over the wellbeing of the patients.^[43] Several changes would help curb the cost-inflationary practice of over-prescription. Allowing the price of services, which are currently undervalued, to appreciate would compensate physicians for the loss of income they would incur from prescribing fewer drugs. Capping drug costs and removing drug sale subsidies from the supply-side would make over-prescribing less lucrative for physicians.

In addition to over-prescription of drugs, over-treatment also contributes to inflationary medical costs. Under the fee-for-service system, physicians are reimbursed for each treatment they provide, creating an incentive to deliver more care than is necessary.^[44] The intention of the policy is to improve quality of care and physician accountability for patient health by creating an incentive for physicians to do everything in their power to cure their patients, assuming that ordering additional procedures helps achieve that outcome. The policy deters patient neglect but also encourages over-treatment, which escalates costs unnecessarily. Since the policy rewards physicians for treating more patients, the three-tier referral system breaks down, leading to overcrowding in large public hospitals due to large inflows of patients and underutilization of lower level facilities.^[45] This excess demand for large hospital services removes incentives for hospitals to improve the quality of care and allows them to extort value from patients.^[46]

An alternative payment method could be adopted to correct the distorted incentives associated with the fee-for-service system. Methods of aggregated payment, whereby physicians are compensated with case-based payment per visit or admission for example, provide better incentives to reduce costs. The case-based payment system prevents providers’ incomes from increasing with the provision of more services. In 2011, the national government issued a policy document that advocated local policy experimentation with case-based payment methods, which focus on medical conditions that have defined clinical pathways and health outcomes.^[47] Chinese policy makers could also introduce payment methods with prospectively set rates in order to improve incentives to reduce costs. Under the fee-for-service system, physicians are retrospectively reimbursed for each service they order, which rewards the physician for ordering as many tests as possible. Prospectively set rates provide a reference point for how much a doctor should spend on medical tests, which shifts the burden of financial risk from the customers, including the government, insurance, and individuals, to the providers, the physicians and hospitals.

Prospectively set rates create a standard of spending responsibility for doctors. However, these payment methods have their own set of drawbacks that mirror those of the fee-for-service payment system. By projecting the appropriate cost for treatment and holding physicians accountable to that standard, providers may reduce the quality of care by under-providing treatments to save on costs and refusing to treat sick patients who require expensive treatments. Some of these negative consequences could be offset by the incorporation of a pay-for-performance method, which links payment directly to the quality of care.^[48] Chinese policy makers should aim for a payment policy that balances these conflicting incentives in an attempt to make physicians financially indifferent toward the type of treatment they provide, leaving only their medical expertise and professional ethics as the foundation for their decision-making.

Another challenge that the health care system faces is the epidemiological transition of China’s primary burden of disease from infectious to chronic, non-communicable disease, which has highlighted that curative care is not sustainable.^[49] This economic and public health reality underscores the necessity to develop a more effective primary care system in China. Chronic diseases, such as cancer, heart conditions, and cerebrovascular diseases, are currently the leading causes of death in China. These diseases are more expensive to treat than infectious diseases.^[50] Even if China’s health care system were previously equipped to pay for infectious disease treatments on a curative basis, maintaining that trend will be much more costly for chronic diseases. Focusing on preventive and primary care rather than curative care would benefit China’s economy and the health of its people. Under the current fee-for-service system, health promotion and prevention services are neglected because they yield the lowest profits among the different types of treatment. Instead, physicians favor over-prescription of antibiotics and intravenous injections even for simple health problems.^[51]

To increase the quality of primary care in China, policymakers should consider expanding lower-level health institutions and funding training programs for general practitioners. All Chinese hospitals are categorized by size into three levels: tertiary (500 beds or more), secondary (100 to 499 beds), or primary (20 to 99 beds).^[52] China’s current health care system is largely hospital-based. Smaller health care institutions such as community health centers, village clinics, and township health centers, provide basic public health services such as disease prevention and control, treatment of common health problems, and management of chronic diseases. Expanding these programs would greatly increase the health care system’s capacity to provide the population with preventive care.^[53] Between 2003 and 2007, the central government directed 3 billion yuan toward the establishment of rural health clinics in the central and western regions of China.^[54] In 2010, Vice Premier Li Keqiang emphasized that the pilot-reforms of government-owned hospitals in 2011 would be particularly focused on county-level hospitals in an attempt to reinvigorate the three-tiered system.^[55] The rising prevalence of chronic diseases requires an integrated health care system that can provide all levels of diagnosis, treatment, and follow-up according to the needs of the patient. Different stages and aspects of chronic diseases require different types of medical attention.^[56] If China can reintegrate the tiers of its health care delivery system, it will be better equipped to treat the changing medical needs of the Chinese population.

To accompany the expansion in health institutions for basic care, China will need to train more general practice doctors. In July 2011, the State Council announced that a general practitioner system would be implemented throughout China by 2020. In order for policymakers to deliver this goal, the government needs to provide incentives for physicians to practice general medicine. Part of this plan should involve removing the strong financial incentives to overprescribe drugs and over-treat patients as well as strengthening financial incentives to provide primary care through salary increases.^[57]

Improving physician salaries across the board will also help deter corruption, which pervades the current system and impedes health care reform. In a system that provides financial incentives that are stronger than those for providing quality care, patients often resort to bribery, offering doctors “red envelopes” that contain cash before surgery to secure better treatment during and after procedures.^[58] Recently, China’s Ministry of Health has confronted this issue by ordering patients and hospitals to sign a document agreeing that no bribes will be offered or accepted by the two parties. The documents asked hospitals to strengthen control and supervision of administrative power and practices of medical workers.^[59] These ubiquitous informal “red envelope” payments to doctors are not included in the official calculation of the share of medical expenses paid by individuals, indicating that out-of-pocket expenditures are even larger than the official figures suggest.^[60] By promoting primary care through the implementation of financial incentives and broader access to basic medical training, health care reform can motivate doctors to focus on preventive treatment rather than expensive curative treatment.

Major government subsidies for drug sales have led to higher medication costs and corruption. By reducing dependence on drug sales for income, policymakers can abate corruption.^[61] Hospitals often receive kickbacks from drug companies and medical suppliers for prescribing their products, intensifying the financial incentive among physicians to overprescribe drugs.^[62] Regulation of drug costs and distribution is one area within the health care system that would benefit from more government intervention of an appropriate form. The creation of a national Essential Drug System, which was proposed as part of an implementation plan for the New Cooperative Rural Medical Scheme in 2011, defined price guides for retail drugs and issued a guideline on the essential clinical drugs with the intention to control health care costs and diminish prescription abuse. According to the 2011 Work Plan, the essential drug system will cover all government funded health institutions at the grassroots level. In exchange, these organizations shall follow the principle of a “zero percent mark-up” which will eliminate the cost inflation that occurs in the transactions between drug distribution and prescription.^[63] In 2011, the National Development and Reform Commission put dramatic retail drug price cuts into effect, capping the costs for over 1,200 antibiotics and circulatory system drugs, which decreased prices by 21 percent on average.^[64] These cuts mark a reversal of the government’s previous price-setting initiative, which allowed a 15 percent profit margin for drugs.

Expanding the essential drugs list to include a wider array of drugs would help control costs for customers across the board. In fact, China is set to increase the number of products on its price-controlled essential drugs list from 307 to 700 by the end of 2012.^[65] However, implementing these lower price caps could cause consolidation within the pharmaceutical industry, leading to a less competitive market place. The government could mitigate this risk by reducing drug subsidies and promoting private competition to drive prices down, while managing and gradually removing cost controls. Recently, many experimental initiatives have been launched at the local level as a test for potential national policies. The success of these policies depends in part on their innovation and structure but also depends on the Chinese government to enforce and implement these policies effectively.

The distorted incentives provided under the current Chinese health care system create unintended consequences that are counterproductive to the program’s objectives. Predominantly, lack of effective cost controls and insufficient state funding through subsidies lead to cost inflation of drugs and medical procedures. The incentives that lead to these excessive expenditures also contribute to overcrowding in major hospitals, the disintegration of the three-tiered referral system, and corruption. All of these problems are the direct result of distorted incentives and create a significant roadblock to affordable, quality health care for Chinese citizens. During the economic reform period, the government believed that the economic advantages of reform would compensate for decreased state support.^[66] In some respects, this logic is circular. Precautionary spending is an important issue that the Chinese economy must address in order to forge a path to an economically sustainable future. Improvements in the Chinese social security net will set Chinese consumers at ease, relieving the need to save excessively for future unexpected health costs. Health care reform is a significant component to achieving social stability and boosting domestic consumption.^[67] These important implications of health care reform make it an essential element for China’s future economic success.

Anna Cornelius-Schecter (’14) is an Economics major in Jonathan Edwards College.
Appendix

Note: Prices are in nominal terms.^[68]

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