The 80-20 Rule and Its Unintended Consequences

The disastrous “80-20 Rule” is part of the Affordable Care Act, launched in 2011.  The Rule mandates that health insurers must spend 80 percent of their revenue on the health care costs of their subscribers.  If a health insurance company takes in $1 billion in premiums, for example, then $800 million must be spent on the healthcare needs of subscribers, and the insurer can keep $200 million.  If only $600 million is spent on subscriber health needs, then the insurer can only keep $120 million (20 percent of $600 million) and must return $280 million to subscribers (the difference between $1 billion and $720 million).

Sounds noble, right?  Money flows back to consumers.  Wrong.  The 80/20 Rule actually creates a perverse incentive for insurers.  It’s as simple as this:  20 percent of a bigger number is a bigger number.  Since insurers are limited to making 20 percent over and above what the insurer pays providers for medical services, the only way to make more money is to spend more, not less, on medical services.  Put another way: Why would an insurer police providers and achieve the lowest possible pricing across the board when that assures lower profits?

Let’s take a look at a graphic that illustrates this misalignment of incentives: