What is a Health System? Why Should We Care?

By

William C. Hsiao
K.T. Li Professor of Economics and Health Policy
Harvard School of Public Health

August, 2003
 What Is A Health System? Why Should We Care?

Abstract
Health system reforms and health system comparisons have been popular topics
of discussion for the policy and research communities. Yet, there is no clear concept and
definition for a health system. As a result, comparisons are often made between apples
and oranges, resulting in confused discourses and misleading conclusions.
This paper argues that for policy and economic research purposes, it is most
useful to conceptualize a health system as a set of relationships in which the structural
components (means) and their interactions are associated and connected to the goals
the system desires to achieve (ends). The model identifies three common goals and
five means that nations use to achieve their goals. The differences in the structural
components may explain the variety of observed system outcomes.

Keywords: health systems comparisons, health system performance, reforms, policy

model
Acknowledgement
The paper benefited greatly from discussions with my colleagues Peter Berman,
Michael Reich, Marc Roberts, and Winnie Yip, and from the comments of the
participants of the annual World Banks Flagship Courses since 1997. Carrie Thiessen
improved the paper immensely by her insightful comments and her able research
assistance. Any error remains the sole responsibility of the author.
Introduction

Globally, the policy and research communities have heatedly debated health
system reforms. Health systems have been dissected, analyzed, evaluated and compared.
However, there is no common and consistent answer to the question what is a health
system? The term health system has been defined differently for different purposes.
The ambiguous concepts and meanings of a health system have caused confusion in
public debate and misled policy deliberations. Policy makers have a specific interest in
the development of an adequate and consistent definition that will enable them to
understand what instruments (interventions) are likely to improve the performance of a
health system. At the same time, they want to learn from the better systems to reform
their own. Researchers want to investigate what structural components cause the varied
outcomes.
Health systems have been conceptualized and defined in various ways.
Traditionally, health systems were described in terms of capacity indicators and activities
(e.g. number of hospital beds, physicians and nurses, government programs.) [1], [2].
Roemer also argued that a health system should be described by five characteristics:
productive resources, organization of programs, economic support mechanisms,
management methods and service delivery. However, his conceptualization of health
system does not adequately explain why these categories of activity matter or what
difference it makes when the configuration of these characteristics varies. Hurst took a
different approach, describing health systems as a series of fund flows and payment
methods between population groups and institutions [3]. Both approaches are
informative, but neither explains why and how a particular system produces a set of
outcomes.
Another body of literature presents a health system as a set of functional
components. Londono and Frenk [4] argued a system consists of four functions:
financing, delivery, modulation and articulation. Applying this concept to health systems

1
financed through social insurance, they proposed a new organizational model to carry out
these functions. Anne Mills [5] also conceptualized health systems as loose framework of
actors and functions. The functions she identified are financing, regulation, resource
allocation, and service provision. While these approaches help classify and analyze a
health system by its internal functions, they do not make explicit what goals the functions
aim to achieve, how the functions effectuate them, how the functions interrelate, or how
variations in organizing the functions affect outcomes.
The World Health Organizations World Health Report 2000 [6] defined health
systems by the boundary of activities they encompass. Unlike the approaches discussed
above, the majority of the Report focused on the performance (ultimate outcomes) of
health systems and performance measurement. The Report described health system
functions (stewardship, resource creation, service provision, and financing), emphasizing
the stewardship role of the government. However, the Report did not adequately address
the relationships between the key functions and health system performance. More
importantly for policymakers, it does not explain why a particular system yields a given
outcome, what features of that system contributed the most to producing the outcome, or
how one could restructure the system to achieve a preferable outcome.
To investigate this why and how, health economists have largely applied
economic theories of supply and demand to model and analyze actions in the various
markets that comprise the health system [7], [8]. A health system can be conceptualized
on at least two levels: macro and micro. The macro-level focus is on overall dimensions
of health sector, the total size, shape, and functioning of the elephant, that is the health
sector, while the micro-level explores behavior and dynamics of individual firms and
households [9], [10]. Ideally, the aggregated behavior of individual households and firms
predicted by microeconomic theory would explain macro-level phenomena. However, at
least a dozen markets compose the health sector, and the interactions among them are not
well understood or adequately studied. Consequently, microeconomic theory has offered
little insight into or explanation for macro-level outcomes such as overall health status

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[11]. Moreover, microeconomic theory has not been able to offer adequate explanations
for major structural features that are common to most health systems and that influence
macro-outcomes.
This papers objective is to develop an analytical framework that models the
systemic aspects of a health system, i.e. the major components of a health system that are
related and can explain aggregate outcomes. Stated another way, it is a causal model
whose major components (i.e. explanatory variables) can largely account for observed
outcomes (i.e. dependent variables). Such a model can assist us in understanding the
major factors that may explain varied system outcomes, provide a framework to compare
health systems and test hypotheses, and offer instruments for policymakers to manage
their health systems performance.
The paper represents the culmination of several years of research, initiated a
decade ago [12], [13], [14], [15] and builds upon the work of other researchers. The
paper is organized in four sections. The first section examines the fundamental principles
used for modeling health systems. Applying these principles, we clarify and answer the
question, what is a health system? Section II presents the final goals of a health
system. The next section discusses the five fundamental structural components of a
health system in some detail. The last section summarizes how this model can assist
policymakers, researchers and the public engaged in the search to structure better health
systems.

I. What is a Health System?

Health systems, like other socioeconomic systems, evolve in unique historic,
cultural and political contexts. Nonetheless, every system is structured by state actions or
non-actions to serve certain social purposes. The system exists and evolves to serve
societal needs. Simply put, a health system is a means to an end. Applying a long-
standing paradigm in industrial organization economics, we hypothesize that the
structural components of the system affect the behavior of individuals and firms in that

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system, and that their behavior and interactions determine the observed outcomes. Under
this paradigm, a health system is a set of relationships in which the means (i.e. structural
components) are causally connected to the ends (i.e. goals.) In this context, then, we have
to analyze the goals and structural components of a health system.
What goals do nations want their health systems to achieve? A myriad of
programmatic goals has been discussed in the literature. Every evaluation study of health
programs specifies the goals by which the program will be assessed. However, goals are
heterogeneous, depending on the purpose of a program. Some programs seek to increase
average health status, some to maximize efficiency, some to prevent impoverishment,
some to improve quality of service. They are not all ultimate goals. Some are
intermediate outcomes or some pertain only to a selected disease or population.
At the systemic level, we must clarify what ultimate outcomes matter to a nation
and distinguish them from intermediate outcomes. While the latter are important and can
affect the final outcomes, they are only intermediary and partial results. We examined
multiple countries health-related legislation, policy papers, and reports to identify
the explicit and implicit goals of their health systems. The goals thus identified are:
improving health, financial risk protection, and public satisfaction.
As for the means, there are many possible structural variables that have some
power to explain observed outcomes. How can we sort out which ones are essential and
which ones are peripheral? We use three criteria. First, since our aim is to develop a
model that is useful for policy analysis, we will examine and select only those structural
variables that can be altered by policy. Because we are developing an ends-oriented
model, we focus on the elements that can be used as policy instruments to achieve
societal goals for the health sector. We exclude those variables that cannot be changed
except in the long term, such as culture. Finally, taking advantage of many nations
policy experiments to improve their health systems outcomes, we identify plausible
explanatory variables based on empirical observations. The key means, which we call

4
control knobs, include financing, payment, macro-organization of health care delivery,
regulations and persuasion.
In sum, a health system, defined for policy purposes and economic research, is a
set of relationships in which the primary variables are causally associated and linked with
the outcomes. We limit the variables to those that can serve as policy levers. Using this
set of criteria, we propose a new health system definition.
A health system is defined by those principal casual
components that can explain the systems outcomes. These
components can be utilized as policy instruments to alter the
outcomes.

We adopt the WHOs description of the boundary of the health system as all the
activities whose primary purpose is to promote, restore, or maintain health. [6].

II. GOALS

Health Status
What socioeconomic ends are served by health systems? Despite the fact that
nations structure their health care systems very differently, most nations do share certain
basic beliefs: one, good health is of intrinsic value to people; and two, certain health
services are necessary to sustain life and to relieve intense suffering. Although some
researchers have argued that health maximization should be considered the sole goal of a
health system [16], there is now consensus that health systems have multiple purposes.
We have identified two additional health systems goals common to most countries.

Financial Risk Protection

The first of these is financial risk protection. National health insurance systems
explicitly places risk protection as a final goal. The earliest health insurance systems

5
such as the German krankenkassen began as a facet of national program to minimize the
risk of absolute impoverishment among the working class due to disease, disability, and
unemployment [17]. National Health Service systems implicitly offer risk protection by
providing free (or nearly free) expensive ambulatory and hospital services. The British
National Health Services can trace its roots to the Poor Law of 1911 [18]. The Beveridge
Report, which provided the framework for the NHS, recommended the development of a
social insurance scheme to provide a minimum income needed for subsistence in all
normal cases [19].
Many countries include affordability as a policy objective of the health system.
The affordability of a good is defined by the consumers ability to purchase it without
excessive financial burden. Health care is characterized by uncertainty of high medical
costs, hence affordability is determined by the extent of the insurance function of the
health system. Therefore, countries affordability objective is more properly defined as
the goal of attaining adequate financial risk protection for citizens.
Instead of risk protection, the WHR identified fairness of financial contribution
as a health system goal [6]. Fairness of financial contribution measures the share of
households non-food expenditure spent on health. It does not assess whether services
are affordable to the poor or how well all citizens are protected against financial
catastrophe. On the other hand, financial risk protection is precisely what concerns most
countries. As a result, recent international research focuses on financial risk protection as
a basic health system goal [20].
Public Satisfaction
Its self evident that public satisfaction is a goal for political leaders and
policymakers of democratic societies. Even leaders of authoritarian states have to satisfy
the public in the long run. Economists often call this goal individual utility improvement
[21]. Governments are increasingly cognizant of the fact that the stability of the health
system is not assured without adequate public satisfaction. Blendon et al [22] concluded
that public dissatisfaction with health system performance contributes to political

6
pressure for health system reform: dissatisfaction with the status quo is highly correlated
with public opinion that the health care system requires fundamental change or complete
overhaul.
Governments have also relied on opinion polls to guide its policy decisions.
When the British National Health Services was debated in 1942, Beveridge stated:
This desire is shown both by the established popularity of compulsory
insurance, and by the phenomenal growth of voluntary insurance against
sickness, against death and for endowment, and most recently for hospital
treatment. It is shown in another way by the strength of popular objection
to any kind of means test. (emphasis added, [19])

More recently, UK explicitly undertook reforms to make services patient-centered and

implemented plans to monitor patient attitudes with surveys and focus groups. (NHS,
2000). At the same time, private insurance providers have adopted patient satisfaction
(and patient experience) as performance measures [23].
The WHR rejected satisfaction as a health system objective, arguing that
satisfaction confounds expectations with accurate assessment of the present
circumstances [24]. However, this component of expectation in public satisfaction is
precisely what helps defines the goals toward which reform is oriented.
The role of equity
Equity is widely defined as a health system objective, often expressed in terms of
universal equal access to health care. We consider it a principle be applied to the
achievement of the three goals of health status, financial risk protection, and consumer
satisfaction. In sum, there are two dimensions to each of the three goals: level and
distribution. We can illustrate these declared goals in Fig. 1, noting that these objectives
go beyond the usual concerns of economic analyses that tend to focus exclusively on
efficiency and remain silent on equity [25].

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 Fig. 1 around here
The goals are not entirely independent of each other. Greater achievement in one
goal may further another; likewise, poor performance in respect to a goal may limit
ability to attain another. For example, Blendon et al. conclude that inadequate financial
protection is one of the primary causes for public dissatisfaction with the American
health care system [22].
All nations common objective is to achieve multiple goals with a given resource
constraint. Every nation must make difficult trade-offs when it wants to achieve multiple
objectives with limited resources. A nation wrestles with two types of trade-offs: inter-
sectoral and intra-sectoral. First, a nation has to make trade-offs between health-system
goals (e.g. improving the health status of the population) and other economic, political
and social goals (e.g. providing education for all children). Consequently, the level and
distribution of health status, financial risk protection, and consumer satisfaction depend,
in part, on a nations economic resources. In common parlance, it depends on what is
affordable.
The second type of trade-off takes place when a nation tries to achieve different
goals within a health system. For example, on the margin a nation has to make trade-offs
between health status and public satisfaction (e.g. no waiting lines.) But rarely do nations
make these inherent trade-offs explicit. Historical processes and fundamental social
values create implicit boundaries to trading off different objectives, limiting the range of
available reform options. Health care systems in European nations, for example, are
deeply rooted in egalitarian traditions. Policy proposals violating this basic foundation of
solidarity have little overall appeal regardless of how much they would enhance
efficiency [26]. On the other hand, the health care system of the USA is rooted in
libertarian traditions. Compulsory health insurance to cover all Americans remains
elusive after more than sixty years of public debate [27].
We often confuse intermediate outcomes with the ultimate goals we care about.
Targeting health polices and programs to improve access, quality and/or efficiency are

8
important, but they are of derivative importance to the ultimate goals of a health system.
We are interested in pursuing higher technical quality of health services because it has a
positive effect on health status. Improving service quality of health services is desirable
insofar as it affects patient satisfaction and health outcomes. Maximizing allocative
efficiency enables improvements in health status and risk protection under budgetary
constraints. Ultimately, a nations success in attaining these intermediate outcomes
should be assessed in terms the extent to which they contribute to the final outputs. Fig.
2 illustrates the relationship between means, some intermediate outcomes and final goals
of a health system.
Fig. 2 around here

III Control Knobs (Means)

Many nations have tried different policy experiments to improve their health
systems performance. These natural experiments have tested different state and market
actions [3], [26], [28], [29]. Analyzing these experiences indicates which structural
components of a health care system impact each of the final goals. We identify five
major components which states can modulate to affect ultimate outcomes. In the policy
context, we term these components the control knobs of a health system [15]; each
consists of several instruments with optional settings, as explained below.

A. FINANCING AND ITS INSTITUTIONAL ORGANIZATION

Financing refers to the way in which money is mobilized and how it is used. It is
a major control knob that affects outcomes such as health status and its distribution, and
risk protection. Financing consists of at least four principal instruments: financing
methods, allocation of funds, rationing, and institutional arrangements for financing.
Financing methods: There are five financing methods. They include general
revenue, social insurance, private insurance, community financing and out-of-pocket
payment. The choice of the major methods of financing determines the amount of funds

9
available for health care, who controls the resources and who bears the financial burden.
Since numerous public programs compete for general revenue financing while social
insurance relies on earmarked revenues from employers and employee paid premiums, a
program financed by social insurance is likely to have more funds. In general revenue,
social, and private insurance financing systems, the ministry of health, social security
agency, or private insurance firms, respectively assume major control of the financial
resources. Each agency allocates the funds differently thereby altering the systemic
outcomes in response to its unique objectives, interest groups, and political or market
constraints. Obviously, financial burdens fall on different groups of people when health
care is financed by taxes or by patients pay directly out of pocket.
Funds allocation: Allocation of funds among prevention, different health
services, medical training and capital investments determines the technical efficiency in
the production of health outcomes. Fund allocation also crucially affects the level of
financial risk protection. For example, when an insurance financing scheme excludes
certain services from its coverage, patients financial risk protection is eliminated and
they face 100% of the charges. When public facilities do not provide certain services free
(or nearly free), then patients have to pay. Alterations in insurance coverage or in the
supply of medical services affect patients access to and utilization of health services,
which influence their health status and consumer satisfaction. Direct public funding for
medical education, hospital construction, and medical research influences the quantity
and type of medical services supplied.
Rationing: No nation, rich or poor, is able to fund every health service wanted by
its population. At the minimum, a portion of health care has to be rationed. Health
services can be rationed by price, waiting time, competency of providers, right of patients
to choose physicians, availability of complementary goods such as drugs and surgical
supplies, and friendliness of providers. Rationing is primarily accomplished through the
financing control knob by deciding what services are funded, and how much to pay. The
rationing method chosen has significant effects on equity in health status, patient

10
satisfaction and risk protection. For instance, rationing health care by price means the
poor have less access than the rich, while rationing by waiting time disfavors the rich
because their opportunity cost of time is generally higher. Of course, the rich can go
outside to non-contracted providers for service and pay-out-of pocket.
Institutional arrangement for financing: Among a nations options are (i)
relying on public monopoly or competition to provide insurance, and (ii) centralizing or
decentralizing public financing. Under social insurance a nation can either organize the
insurance plan as a public monopoly or allow many for-profit and non-profit insurance
plans to compete, thus altering administrative efficiency. More importantly, the extent of
competition in financing determines the degree of adverse and risk selection in financing,
which in turn affects risk pooling. All advanced economies have found it difficult to
achieve equity goals and to ameliorate adverse and risk selection through a voluntary
insurance system. Consequently, all advanced economies (other than the USA) rely on
general revenue or on compulsory social insurance to finance health care.
Tax or social insurance premium financed programs can be centralized or
decentralized to regions. Under decentralized financing arrangement, the relationship
between the amount of taxes or premiums paid and the services is more immediate and
readily observable, it is easier for voters in each locality to calculate costs and benefits.
They will have more information with which to decide how much taxes they are willing
to pay, and for what services. However, regions have different tax bases. The poor areas
may not be able to finance adequate services unless the central government takes
remedial action. If a systems financing is decentralized and no mechanism is put in
place to redistribute between regions or risk groups, decentralization can decrease equity
in health and financial risk protection.
Figure 3 depicts the relationship between financing and selected intermediate
outcomes and final goals. As the figure shows, sometimes financing has a direct impact
on final outcomes and other times financing impacts intermediate outcomes such as
access and quality, which in turn affect health status and public satisfaction. International

11
experience tends to show that financing is the major determinant of the level and
distribution of two final outcomes: health status and financial risk protection [28].

B. MACRO-ORGANIZATION FOR DELIVERY OF HEALTH CARE

Macro-organization refers to the broad structure used to organize health care
provisions. It primarily affects how individual organizations are organized and managed,
thus impacting efficiency, quality and availability of health services. There are four
fundamental decisions regarding the macro-organization of provision: competition,
decentralization, integration, and ownership.
Public monopoly vs. competition The most important decision is whether to rely
on public monopoly (i.e. publicly-funded government facilities) or competition among
public and private providers to provide health services. International experience
demonstrates the limitations of public monopolies. In a public monopoly, politics often
intrudes, diverting organizations from the pursuit of the general public interest [30], [31].
In addition, public monopolies often lack adequate external checks and balances. Over
time, these monopolies may place their own staffs interests over their clients.
Alternatively, a nation can use competition to organize health services providers.
Serious market failures common in the health service market are well-documented.
Avoiding these market failures and maintaining effective competition requires many
prerequisites that are difficult, if not impossible to establish for most low- and lower-
middle income nations [13]. In addition, a system of effective competition often entails
large transaction cost such as those evidenced in the USA [32].
Recently, economic theorists have suggested that competition induced by
government contracting for services should increase efficiency and organizations
responsiveness to patient demands [33]. The UK and Sweden have created internal
markets to force publicly-owned hospitals to compete for patients [26]. However,
empirical evidence shows mixed results on the ability of contracting and internal markets
to significantly improve efficiency and quality of health services [34].

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 Decentralization: When a nation chooses to rely on a public monopoly to provide
health care, it has to decide which level of government should be responsible and held
accountable for managing performancecentral, regional/state, or district. Some
theorists suggest that public power, responsibility, and accountability should be delegated
to the lowest level, where voters have most direct knowledge and information about
public health services efficiency and quality [35], [36]. Unfortunately, local
governments often lack sufficient capacity and human resources to manage the public
health services.
Vertical integration: The third major issue in macro-organization is how to
integrate preventive, primary, secondary, and tertiary care services. Most common
illnesses can be diagnosed and treated at the primary care level, but more complicated
diseases may require specialists and/or inpatient services, and the most serious illnesses
may require tertiary care. A nation has to decide whether health services will be provided
by separate and independent clinics and hospitals or by integrated networks of providers
with clear referral guidelines. This macro-organization decision influences quality and
efficiency of health care. When health services are fragmented, laboratory and diagnostic
tests often have to be duplicated at each level. More importantly, each level may not
know what tests and treatments the patient has already received. Consequently, patients
can suffer from gaps in services or treatment delays and errors.
Ownership: The fourth issue in macro-organization involves ownership of health
facilities. Ownership determines to whom and for what an organization is held
accountable. There are three types of ownership: public, private non-profit and for-profit.
Each behaves somewhat differently [37], [38]. For-profit insurance companies or
hospitals are responsible for producing profits for their owners. Thus, it is logical and
expected that for-profit private insurance plans will avoid covering high-cost patients,
and for-profit hospitals will deny services to those unable to pay. Public and non-profit
institutions often have multiple and ambivalent objectives, such as maintaining financial
solvency while serving community interests [37]. Since outcomes such as community

13
interests are hard to measure and monitor, public and non-profit institutions may
experience greater administrative slack in their operations.
International experience shows that macro-organization decisions significantly
impact the efficiency and quality of health services. They in turn affect health status and
public satisfaction.

C. PAYMENTS (INCENTIVE STRUCTURE)

Payment refers to the methods by which money raised by financing is paid out to
individuals and organizations. The payment modality is the principal control knob for
establishing incentives in the provision of health services, acting like a gravitational
force, to pull individuals and organizations in a certain direction without coercion.
Appropriate incentives can have measurable positive effects on provision and use of
health services. Recent reforms around the world have focused on establishing correct
incentives to promote efficiency and quality, with an emphasis on implementing supply-
side (rather than demand-side) incentives [39]. A payment system for health providers
has two parts: first, the method of payment, and second, the amount of payment per unit.
Payment method creates two different kinds of incentives for the patients and providers--
financial reward and risk bearing. Different payment methods shift financial risk to
different players in the system. In structuring payment systems, we focus on the four key
players in the demand and supply of health services: patients, health professionals,
institutional providers, and pharmaceutical suppliers.
Incentives for Consumers: The price consumers have to pay influences the nature
and quantity of services they will purchase. For ordinary goods, economic theory shows
that efficiency can be enhanced when consumers are required to pay the marginal costs of
the goods. However, health care is not an ordinary market good. Serious illnesses are
uncertain and their treatment entails large health expenditures. Usually, 10% of the
population accounts for 60% or more of a countrys total health care expenditures. Some
type of insurance is generally desired to spread this risk of catastrophic illness.

14
Insurance, however, leads insured patients to demand more services, some of which may
have little beneficial effect. To reduce this inefficiency resulting from insurance, a nation
can require the patients to pay a share of health costs out-of-pocket. Unfortunately, the
financial burden of cost sharing may prevent poor and low-income households from
seeking necessary health care, thus creating inequitable financial burdens and disparities
in health status.
Incentives for Suppliers: The incentive structure established for providers affects
cost, efficiency and quality of health services. For ordinary commodities, nations usually
allow prices to be set by a competitive market. Unfortunately, international evidence
shows that in the health care market, providers possess strong monopolistic power; hence,
the health provision market is not competitive [13], [40]. Unless governments (or
organized purchasers) intervene, providers can charge high monopolistic prices and induce
demand. We explain the incentive effects on four major categories of suppliers:
(i) Practitioners: The method by which practitioners are paid, and the amount of
compensation received, influences what treatment modality practitioners will select how
services will be produced, how many hours practitioners will work, and how many
qualified people will enter the market to supply services. Physicians can be paid on the
basis of fee-for-service, capitation, or salary. Each method creates different financial
rewards and risks for physicians. Physicians paid on a fee-for-service basis bear little
financial risk. Their income rises with the volume of services provided, creating an
incentive to increase service provision and resulting in health expenditure inflation. On the
other hand, capitation shifts financial risk to physicians, motivating them to minimize
services and select healthier patients. Table 1 shows the incentives imbedded in various
payment methods for practitioners and compares their potential impacts on efficiency,
quantity of services and risk selection.
Table 1 around here
When a nation relies on both public and private sector provision, the relative wage
rates paid by public and private sectors influences how physicians split their hours working

15
in public and private facilities. The relative wage rate may also determine whether
physicians will encourage patients to pay under the table. Similarly, relative compensation
paid to specialty versus primary care services affects the proportion of medical graduates
entering specialty training [41].
(ii) Hospitals: Financial incentives constitute one of the most powerful levers
with which to influence quality and efficiency of hospital services. A hospital organizes
and manages its activities and staff differently changing quality of care and technical
efficiency -- depending on whether it receives a fixed budget, fee-for-service
reimbursement, or case-based payment. These organizational decisions impact the
quality and technical efficiency of hospital services.
Prior to 1997, each hospital in Germany negotiated a global budget, based on the
expected number of hospital days to be provided. De facto, then, hospitals were paid on
a per diem basis. This per-diem payment method created incentives for providers to
increase length of stay. Its not surprising the mean length of stay in Germany is the
highest among OECD nations [42]. In contrast, American hospitals are mostly paid on a
per admission basis, adjusted for case-mix (i.e. the DRG payment method), with payment
rates set prospectively. If a hospital can treat a patient at a lesser cost than the
prospectively set payment rate, the hospital keeps the difference as a profit. With this
incentive in place, mean length of stay in US hospitals has become the lowest in the
world [42]. However, case based payment for inpatient hospital services may increase
admission rate [43].

(iii) Pharmaceuticals: As the relative health care expenditures attributed to drugs

increases, pharmaceutical companies have become a major health system supplier.
Patents grant a pharmaceutical company a monopoly on a particular drug. Many
countries found it necessary to set payment level to reduce monopolistic profits. For
example, Germany first introduced reference pricing in 1989, in which a statistical
formula distinguishes an average price for 3 tiers of drugs. The introduction of reference
prices led to a drop in drug prices of 20.6% in the first half of 1993. While effective,

16
reference pricing does have loopholesthere was an increase in overall expenditures on
drugs because of a switch to new products that were not covered under the reference
pricing system [44], [45].

D. REGULATIONS

Regulation, in a narrow and clear sense, refers to the governments use of

coercive power to impose constraints on organizations and individuals. Regulatory
instruments may include laws, decrees, orders, codes, administrative rules, and guidelines
issued by governments and by non-governmental bodies, such as self-regulatory
organizations, to whom governments have delegated regulatory power [46]. The use of
incentives or persuasion (e.g. indoctrination) to affect organizational or individual
behavior is not regulation. An effective regulation requires good design and wording as
well as governmental ability to implement and enforce the regulation. There can be many
failures in establishing and executing regulations. Serious regulatory failures can make
the situation worse than if there had been no regulation in the first place. One key
regulatory failure occurs when a regulatory agency is captured by its regulatees (i.e.
those organizations the agency is supposed to regulate). Instead of advancing the public
interest, the captured regulatory agency promotes regulated benefits.

In health systems, regulations are established for four major purposes: (a) to
provide safety protection for the general population to improve health, (b) to set the rules of
game for transactions and exchanges to improve efficiency and quality of health services,
(c) to enhance social equity by assuring everyone has access to basic health care, and (d) to
correct market failures to enhance efficiency and quality of health care and insurance
products.
The nature of health care makes difficult to regulate health professionals. Nations
often rely on self-regulation to assure better quality of care, curbing induced demand and
billing abuses.

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 A complete discussion of the range of regulatory initiatives is beyond the scope of
this paper. Therefore, we have organized the categories health with selected examples in
Table 2. Those regulations for protecting public safety have a direct impact on the
populations health status. International experience seems to show that regulation has a
limited role in enhancing equity.

Table 2 around here

D. PERSUASION
The private sector and the government have another powerful means to achieve
health system goals: influencing peoples beliefs, expectations, lifestyles, and preferences
through advertising, education, and information dissemination. Private commercial firms
have long used advertising to inform the population and to sell their products. Our beliefs
and preferences are shaped substantially by these advertisements [47]. Besides providing
factual information, advertisements try to influence our tastes and preferences by appealing
to our desires, fears, imaginations, and hopes. Symbols, hero figures, and role models are
often used.
Governments also influence our beliefs, expectations, likes, and dislikes. They do
so directly through education, jaw-boning by public officials, selective release of certain
information while withholding others, and outright propaganda. While education,
information, and indoctrination can be powerful instruments in altering peoples beliefs
and preferences, it usually takes a long time before people change their behavior. A good
example is the tobacco campaign in the USA, which only showed a measurable impact
on consumer preferences and behavior two decades after it began [48].
In the health sector, persuasion through an intermediary is also possible. One
effective intermediary in influencing consumers preferences is the medical profession.
For example, manufacturers intensely market new technology and drugs to physicians.

18
Physicians in turn recommend these technologies and drugs to their patients, who rely
upon them for professional advice and medical information. Under managed care in the
USA, managed care plans scrutinize physicians use of pharmaceutical products. In
response, the pharmaceutical companies have turned to advertising directly to patients to
influence their demand for new expensive drugs that may have limited marginal benefits
[49].
Persuasion also has a powerful impact on the supply side. In many countries,
governments organize and fund medical education, and influence medical ethics.
Physicians knowledge and beliefs affect their behaviors. A profession is distinguished
from a trade guild by its social mission. A profession instills in its members beliefs about
some noble purpose for which members should sacrifice their self-interests [50]. The
dedication engendered by these professional beliefs is illustrated by the behaviors of
physicians and midwives in Sri Lanka, who continue to perform their duties quite
faithfully for public facilities despite low pay and poor working conditions. In short,
availability, efficiency and quality of health care are greatly affected by medical ethics
and beliefs.
C. Summary of Ends and Means
In Table 3, we illustrate the relationship between the structural components (i.e.
control knobs) and outcomes. For example, while equity is largely affected by financing,
efficiency is mostly affected by payment, and macro-organization of provision and
financing. Although not explicit in Table 3, the extent to which societal goals are achieved
also depends on the interactions among the control knobs. Often, the effectiveness of a
particular knob requires the correct setting of another knob. For example, the effectiveness
of using social insurance as the financing modality depends on the macro-organization of
the delivery system. It is beyond the scope of this paper to discuss interactions among, and
the correct combination of, the control knobs.

Table 3 around here

19
IV. Why it Matters How a Health System is Conceptualized and Defined?
In short, this paper develops an analytical model of health systems, focusing on
their ultimate system goals and the major structural components that explains different
systems performances. The model provides a new paradigm for the policy and research
communities to understand and analyze health systems and allows the derivation and
testing of hypotheses. The model also offers policymakers and researchers a framework
to foster systematic and clear thinking, preventing mistaken conflation of effects and
causes.
Furthermore, like marco-economics, the model focuses on the systemic aspects
rather than individual- or firm-level behaviors. Similarly, where macroeconomics
concentrates on the aggregated outcomes and several key policy instruments such as budget
balance, interest and exchange rates, and current account balances, this health system
model concentrates on the final goals and five major instruments (control knobs) that can
impact the performance. Policymakers can focus their attention on these control knobs.
This model also provides a framework to distinguish intermediate and final
objectives, enhancing comparative analysis of health systems. The muddled debate in the
USA argues we have the best health care system because we offer choice, but the effect
of choice on the final goals never clarified [51] Other proponents of the American
system argue that it has higher quality of services than other systems. While their claims
may be true, these individuals have confused the intermediate outcome with final
outcomes. The superior intermediate outcomes such as higher quality of services are
limited to those who are well insured or rich, and their higher spending for better quality
of medical services may have been realized at the expense of having many citizens
uninsured, and less funding for disease prevention. As the final outcomes show, the
health status and public satisfaction of US citizens compare poorly with other advanced
economies [52].

20
 Governments always have a health policy, whether active or passive. Non-policy
simply means defaulting to a laissez-faire position. In that case, natural socioeconomic
forces shape the health system. Patients purchase health care according to their ability
and willingness to pay. Because of income differences in a society, the populations
health status and risk protection will reflect the inequity in that society. Likewise,
because of market failures, such as asymmetry of information and imperfect agency
relationship, a monopolistic, high cost, provider-driven health services market will
emerge. Its imperative for policymakers to understand the consequences of their action
and non-action. This model of a health system as a means to an end offers policymakers
a conceptual tool to assess and design those essential parts of a health system that they
can alter to improve their countries health system final outcomes.

21
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24
Hsiao, Fig. 1, Multiple Objectives of A Health System

Financial Risk Consumer

Health Status
Protection Satisfaction

Average Level

Equitable Distribution
Hsiao, Fig. 2, Means, Intermediate and Final Ends of A Health System

Means Intermediate Final

outcomes Goals
Health Status
Financing Access
Macro-org
Payment Quality Financial Risk
Regulation Protection
Persuasion
Efficiency

Consumer
Satisfaction
 Hsiao, Fig. 3, Relationships Between Financing Instruments and Goals

Means Intermediate Outcomes Final Goals

Access
Financing Health Status

Methods
Quality of
Funds
services
allocation Financial Risk
Protection
Rationing
Equity in
Institutional Financing
arrangement Consumer
Satisfaction
Efficiency
Hsiao, Table 1, Payment Mechanisms for Practitioners: Financial Risks and Incentives
Payment Basket of services Risk borne by: Incentives to:
Mechanism paid for Payer Practitioner Increase Decrease Increase Select
(Insurer or number of intensity of reported illness healthier
employer of patients services per case severity patients
practitioner)

Fee for Service Each item of service All risks None Yes No Yes No
(FFS) and consultation

Salary One week or one month All risks None No N/A No No

work

Salary and Bonus based on number Salary portion Bonus portion No N/A No No
Bonus of patients

Capitation All covered services for Amount above Up to stop-loss Yes Yes No Yes
one person in a given stop-loss ceiling ceiling
period
Hsiao, Table 2, Selected Examples of Regulations in Health Services by Category of
Regulation

Category of Regulation Examples

Public Safety a. Standards for food hygiene, purity of drugs.
b. Licensing of physicians, nurses and pharmacists.
c. Accreditation of laboratories, hospitals.
d. Labeling.
Rules of the Game a. Advertisement restrictions.
b. Negligence and malpractice liabilities.
c. Property rights protection and patents.
d. Solvency and bankruptcy laws for health service institutions.
e. Patients rights.
f. Professional ethics.
Equity Promotion a. Assignment of new medical graduates to serve in under-served
areas.
b. Patients rights to emergency services.
Market Failures Correction
1. Manpower a. Limits on training slots and billing numbers.
b. Foreign medical school graduates entry restrictions.
2. Capital Investment a. Adoption/construction of new technology/facility approvals.
3. Information Disclosure a. Conflicts of interest disclosure.
b. Advertisement restrictions.
4. Monopoly a. Anti-trust laws.
5. Quality a. Practice guidelines.
b. Standard quality report cards.
6. Price a. Price schedule for services.
b. Reference prices for drugs.
 Hsiao, Table 3, Relationship Between Structural Components and Societal
Objectives

Control Knobs Financing Macro- Payment Regulation Persuasion

Organization
of Provision

Societal Objectives
Final Goals:
Average level health status X X X X

Av. level risk protection X

Av. level consumer X X X X X

satisfaction
Equity in health status X X

Equity in risk protection X X

Equity in consumer X X X
satisfaction

Intermediate Outcomes:
Equity in financing X

Allocative efficiency X X X X X

Technical efficiency X X X X X

Quality of health services X X X X X

Management of total health X X X X

expenditure