In today’s Senate Finance Committee debate a principal concern among Democrats considering the Public Option (PO) was whether the PO would pay providers who treat PO patients rates tied to Medicare schedules.

Senator Conrad, for example, claimed that since Medicare payments are so far below rates paid to providers by Medicare Advantage and other private plans, it would bankrupt hospitals in his state if they were forced to accept only Medicare payment levels. The PO, he concluded, would put health providers in his state out of business, a threat Sen. Grassley was more than happy to echo.

Sen. Bingaman seemed sympathetic to that argument. While he would support a PO, it would be Schumer’s version which does not tie PO payments to Medicare’s lower rates.

Sen. Rockefeller seemed unwilling to engage this issue. He conceded that his amendment would require the PO to use Medicare rates for the first two years "to get it established," but after that the PO would negotiate rates just like other insurers.

It’s true that Medicare generally pays providers less than private plans, and it’s likely true that some health care providers depend on that difference to make their practices more profitable. But the underlying assumption is that Medicare payment rates are unfair, below "costs," so that forcing more providers to rely on such lower rates would make it impossible for them to continue providing care.

Public option advocates in the Senate would do well to confront this assertion. If, as claimed, Medicare rates are insufficient to cover costs, then Medicare rates should be revised, and that should be the condition for pegging PO rates to Medicare. There’s no doubt providers argue they need more, but what’s missing from the debate is compelling evidence that the assumption is true.

In principle, Medicare’s administrators are charged with ensuring that rate schedules fairly cover provider costs. The rates need to be sufficient to sustain sufficient providers for everyone who needs Medicare services. That’s just standard "cost-of-service" rate making. And if they need to pay primary care doctors more and some specialists less, so be it. The administrators are not told to set payment rates at levels that require indirect subsidies from private systems to keep the providers solvent.

The Medicare Payment Advisory Commission (MedPAC) does not agree with the assumption that providers are systematically paid below costs. As Sen. Kerry argued today, needlessly higher payments asked by inefficient providers (large hospitals) and allowed by private insurers are the source of the difference, not "underpayment" by Medicare. Whether that’s true and why are empirical questions, but MedPAC disputes the assumption and the debate needs to focus on the evidence.

And we should not forget that the payments providers want to receive are not derived from anything remotely resembling a competitive market. Like any quasi-regulated entity, hospitals have no reason to be totally transparent about their real costs. No utility ever is.

To be sure, hospitals do compete for patients, and they advertise extensively about how terrific their treatment programs are. But that doesn’t create an efficient market with competitive pricing. There is no meaningful price competition; indeed prices are mostly unknown by patients who have insurance, and patients learn about prices only after the fact when they get the hospital and doctor bills not covered by their insurance.

It’s just as plausible to believe that as hospitals become more consolidated, they will use their local market power to force higher payment schedules on private insurers and uninsured patients. That will have less effect on Medicare which has its own market power. This isn’t competitive pricing; it’s market power against market power.

So the notion that Medicare is paying something less then the competitive market rates needed to sustain sufficient care over time is not a given. There is no competitive market price, and provider prices are set in non-transparent ways by entities with market power.

In such a system, Medicare has no choice but to set payment schedules administratively, based on cost-of-service studies to determine what payments providers should receive to enable them to provide and sustain required Medicare services. As the guest post at Maggie Mahar’s blog (see links below) points out, this costing system is enormously complicated, and there are arguments for and against specific instances of over- or under-payments. But the public debate so far hasn’t produced any evidence that Medicare is systematically underpaying providers.

The question is fundamental to the viability of a national public option. If Medicare’s decades of studying cost-of-service can’t be the basis for setting PO provider rates, then what should the PO use, and how hard would it be to start over? It’s hard to imagine how such a disadvantaged new entrant in the market could even get started.

If there are credible studies of actual cost-of-service findings that settle this one way or another, that would be interesting. Until then, arguments to separate the PO from Medicare cost-of-service rate-making seem badly misguided and will reward only those providers with market power and doom the public option.

More on the debate:
CAF, MedPAC debunks hospital cost-shifting claims
Volsky, Think Progress-WonkRoom, How are Medicare rates set?
NYT, earlier history of underpayments fixed, here and here
Ezra Klein, Does Medicare Pay Below "Cost?"

Must read: Maggie Mahar, guest post, Does Medicare Underpay Hospitals?