The Disappearance of Out-of-Pocket Healthcare Spending

The share of healthcare dollars under the direct control of consumers has fallen precipitously since 1960, accompanied by sharp increases in total healthcare costs

• Healthcare financing in the U.S. has rapidly shifted over the last century.

• In the 1920s, direct payments from consumers to providers accounted for approximately 90% of health spending. Even in 1960, out-of-pocket spending still represented the majority of healthcare expenditures. Over the last few decades, the proportions radically flipped; out-of-pocket spending made up only 10% of health spending in 2020.

• The pervasiveness of third-party payments disconnects American patients from the true cost of their care, encourages over-utilization, and contributes to higher total health spending.

Few of us would recognize the U.S. healthcare system as it existed a century ago, and fewer still would want to return to such a world. Medicine’s modern era has brought revolutionary technologies and treatments, adding decades to our life expectancy. But we have lost something too: direct control over our healthcare dollars. And it’s not clear we’re better off for it.

An article in the AMA Journal of Ethics explains what the healthcare industry looked like in 1908:

“...health care was virtually unregulated and health insurance, nonexistent. Physicians practiced and treated patients in their homes. The few hospitals that existed provided minimal therapeutic care. Both physicians and hospitals were unregulated. When patients saw a physician, they paid their modest fees out-of-pocket; they were more concerned about the wages they would lose if illness kept them out of work than about the cost of their medical care. Medical science and technology were primitive, and there was little that physicians could do to treat most illnesses… Commercial insurance companies did not write health insurance policies in 1908...”

It would be more than 25 years before Social Security was established, and another 30 years before Medicare and Medicaid were created. In the rare instances in which a payment for a medical service came from outside the patient’s family, it was more likely to come from a charitable organization, mutual aid society, or employer found responsible for a workplace injury, than from a government program or private insurance company. Although reliable historical estimates are scarce, even by 1929, direct payments for healthcare services accounted for 86% of total spending.

Today, the picture looks vastly different. The private health insurance industry expanded rapidly in the 1940s and 1950s, and public health expenditures grew, too, as federal and state government programs multiplied. Over the last 60 years — the period for which we have continuous annual data — the share of healthcare expenditures controlled directly by consumers and patients has plummeted. As Graph 1 shows, in 1960, out-of-pocket spending (i.e., expenses that aren’t reimbursed by a third-party) accounted for 52% of all health consumption expenditures; by 2019, it was down to 11%, which dropped to 10% amid the COVID-19 pandemic.

The most rapid decline in out-of-pocket spending as a proportion of total healthcare spending occurred from 1960 to 1980, corresponding with the establishment and growth of Medicare and Medicaid. Albeit at a slower pace, the erosion of direct consumer control over health spending has continued steadily to the present.

A more granular look at different categories of care reveals substantial variation in the rate of change, but the general downward trend is unmistakable. Prescription drug expenditures have seen the largest drop in relative out-of-pocket spending (from 96% in 1960 to 13% in 2020), while out-of-pocket spending on “other non-durable medical products” — defined as retail sales of over-the-counter drugs and basic medical supplies like band-aids and cough drops — barely fell, from 100% of total spending in 1960 to 97% in 2020.

There is a strong negative correlation between the share of spending controlled directly by consumers and total spending; that is, as consumers’ direct influence wanes, total spending tends to rise (Table 1). Teasing out causality is difficult, of course. These correlations may partly reflect the fact that as, total spending rose in a certain sector of healthcare, government policymakers and commercial insurers faced increased pressure to cover those services. But we should consider that causality may run in the other direction: that hiding the real cost of healthcare behind a bewildering web of third-party payers and regulations has made consumers less discerning, emphasized procedures over outcomes, encouraged over-utilization, and fueled spending growth.

Out-of-pocket spending creates direct incentives for consumers to care about quality and value, and eliminates many of the distortionary effects of government taxes and subsidies, third-party decision-making, and other barriers to efficiency. Is it a coincidence that the sector in which consumers have lost the most direct influence — prescription drugs — is the area in which costs are most rapidly escalating? And that the sector in which consumers retain the most control — retail purchases of basic medical supplies — functions so well?

The healthcare system increasingly runs on a prepayment model. Most insurance plans don’t just protect against major expenses; they promise to cover the vast majority of medical costs, from inexpensive generic drugs to routine visits to the doctor. It is pervasive to conflate healthcare access with health insurance coverage, as if the two were inextricably linked. As a practical matter, they are (consider a recent post as a case in point). Out-of-pocket spending is now often viewed as intrinsically negative, a sign of a health system failing to meet its goals. But it is a poverty of imagination to think that our insurance-centric health system could not be improved by giving consumers a larger voice. Out-of-pocket spending can put terrible burdens on patients, of course, but so do exorbitant insurance premiums. Third-party payment has made healthcare financing more opaque, but no less expensive.

Stripping patients of control and choice has eroded their incentives to shop for better value. The classic RAND experiment, for example, found that people who had to pay nearly all of their medical bills out-of-pocket spent 30% less on healthcare than those whose insurance covered all their costs, with little or no discernible impact on health outcomes.

For a century, politicians have promised expanded insurance coverage and lower out-of-pocket health expenses, only for costs to soar as consumers lost choice in their own care. Is there a winning strategy in the next decades for returning power to patients?