Healthcare payments are unlike anything seen in other industries. In healthcare, every service—whether an office visit, brain tumor resection, or lumbar arthrodesis—is precisely defined and assigned a value by a centralized authority: the federal government working closely with the American Medical Association (AMA). No other industry works like this. The government doesn’t define what constitutes a hamburger, let alone assign a fixed price for it. Yet we accept this system in healthcare, often overlooking the massive market distortions it creates.

At the center of this system is the prospective payment system (PPS)—the backbone of Medicare and, by extension, much of the U.S. healthcare system. Originally designed to control costs and simplify reimbursements, the PPS represented a fundamental shift toward centrally planned, pre-set prices. However, while PPS succeeded in curbing some inefficiencies during Medicare’s early years, it has since disconnected prices from actual costs and patient demand, leading to profound distortions in the healthcare market.

When Medicare was introduced in 1965, healthcare providers were reimbursed on a cost-plus basis: physicians and hospitals submitted their expenses after delivering care, and Medicare reimbursed them for reasonable costs. However, this approach encouraged inefficiency since providers had no incentive to control their spending.

By the early 1980s, Medicare spending had skyrocketed, forcing the federal government to rethink how it paid providers. In response, Medicare introduced the Inpatient Prospective Payment System (IPPS) in 1983. Under IPPS, hospitals were no longer paid based on their actual costs. Instead, they were reimbursed a fixed amount for each inpatient stay, determined by Diagnosis-Related Groups (DRGs). DRGs assigned a fixed payment to each admission based on the diagnosis and expected resource use.

The logic was simple: if hospitals could treat patients for less than the DRG payment, they kept the savings. If the costs exceeded the payment, the hospital absorbed the loss. This centralized pricing model was later expanded to outpatient services, ambulatory surgery centers (ASCs), and, importantly, physician payments.

Physician services are reimbursed under the Resource-Based Relative Value Scale (RBRVS). This system assigns a value to every medical service through CPT codes (developed by the AMA) and pays providers based on Relative Value Units (RVUs). The RVUs account for:

1. Physician work (time, skill, and effort required)
2. Practice expenses (overhead, equipment, and staffing)
3. Malpractice insurance costs

The AMA’s RUC (RVU Update Committee), which helps CMS determine RVUs, wields significant influence over this process. This system creates pre-set prices for every imaginable service, from a 15-minute office visit to a complex surgery. But this level of central planning introduces numerous problems.

As economists Ludwig von Mises and Friedrich Hayek argued, central planning struggles to efficiently allocate resources because it lacks real-time information from the market. In his essay, “I, Pencil,” Leonard E. Read explained the impossibility of a central authority tracking all the inputs involved in producing a simple pencil. The same principle applies to healthcare.

Consider the inputs required for a routine office visit:

• Salaries for medical assistants, nurses, and administrative staff
• Overhead expenses like rent, utilities, and internet
• Capital investments in exam room equipment and computers
• Disposable supplies like gloves, hand sanitizer, and computer paper

All these inputs have shifting costs, determined by millions of transactions in the broader economy. The price of hand sanitizer, for example, reflects not only raw material costs but also global demand. A central authority—no matter how sophisticated—cannot account for all these dynamic changes while setting a static reimbursement rate for healthcare services.

Moreover, demand also influences prices. As patient needs change, prices must adjust accordingly. But under PPS, prices are fixed in advance and cannot respond to shifts in supply or demand, creating market inefficiencies.

There are two ways to allocate resources: market forces or central planning.  The market is much more efficient.  Yet we have chosen central planning in healthcare.  We see the real-life consequences of this in the frustration over short clinic visits, both from patients and physicians.  There is demand for longer clinic visits but the centrally set price does not reflect that. 

Conversely, we see the rise of cash-pay and direct-primary-care (DPC) as a market solution to that inefficiency.  Patients are increasingly willing to pay out of pocket for healthcare services to escape the inefficiencies of the PPS. Cash-pay providers like the Surgery Center of Oklahoma and direct primary care practices (e.g., Atlas.MD) have emerged as market-based solutions to these inefficiencies. 

Central planning also impedes technological development.  It distorts innovation since new procedures not only need FDA clearance, but they need CPT code development and RUC valuation as well.  This gap between FDA approval and Medicare coverage is aptly named the “valley of death.”  It adds costs to drug and device development, stifling innovation and delaying treatments.  Many promising technologies are delayed or abandoned because they don’t fit neatly into existing payment categories.

The prospective payment system has reshaped how healthcare is delivered and reimbursed, but it has done so at a significant cost. By disconnecting prices from market forces, PPS has distorted resource allocation, created inefficiencies, and slowed innovation. Providers must operate within a rigid framework that prioritizes bureaucratic compliance over patient care.

Many of the challenges in today’s healthcare system can be traced back to central planning through Medicare. While PPS was introduced to control costs, it has instead led to price distortions and market dysfunction. Understanding these unintended consequences is essential to developing a healthcare system that better reflects patient needs and fosters innovation.