The Potential of Reference Pricing to Generate Health Care Savings: Lessons from a California Pioneer

HSC Research Brief No. 30

December 2013

Amanda E. Lechner, Rebecca Gourevitch, Paul B. Ginsburg

Amid rising health care expenditures and substantial variation in what hospitals charge, purchasers are looking for strategies to motivate consumers to choose providers based on price. In 2011, the California Public Employees’ Retirement System (CalPERS) implemented a strategy called reference pricing to steer enrollees toward hospitals performing hip and knee replacements at or below a specified price threshold. Earlier research showed the CalPERS reference pricing initiative reduced spending without shifting major costs to enrollees or compromising care quality. Until now, however, there has been limited understanding of how CalPERS carried out the program and whether the model could be adopted successfully by other purchasers.

Based on a qualitative analysis by the Center for Studying Health System Change (HSC), the CalPERS reference pricing program required robust outreach to enrollees and encountered minimal pushback from them. In addition to channeling patients toward lower-priced hospitals, the CalPERS experience suggests reference pricing may motivate hospitals to lower their prices. The CalPERS model has thus far been limited to what might be considered “low-hanging fruit”—procedures that are relatively standardized, are planned in advance, can be compared across hospitals based on price, and involve substantial price variation. Other pioneering purchasers have taken steps to expand reference pricing to more complex services, including outpatient surgery, laboratory and imaging services, and pharmacy. If other purchasers pursue these and similar strategies, the potential for aggregate savings could be substantially greater than what CalPERS has achieved on its own.

Background

In the current health care environment, patients are increasingly required to make their own decisions about where to go for health services. In recent years, consumers have faced ever-expanding choices that affect the cost and quality of their health care. The growth of narrowed provider networks, insurance exchanges, and benefit designs that increase patients’ financial responsibility for their choices creates both an opportunity and an imperative for market-driven approaches to spending. Yet, while substantial evidence demonstrates wide variation in hospital prices, there is currently no national or state-level requirement for hospitals to publicly disclose what they charge for common procedures—leaving patients with little ability to compare their options.

For purchasers, including employers, private health plans, and state employee benefits programs, this price variation presents a concrete opportunity to reduce spending. The basic challenge is to design a benefit that directs patients toward lower-priced providers—without undermining quality or imposing undue financial hardship on the patients who use more expensive providers.

One prominent strategy for addressing this challenge is reference pricing. Under a reference pricing arrangement, the purchaser or plan sets a maximum amount (“reference price”) it will pay for a given procedure. If a patient selects a provider charging more than the reference price, the patient pays the full difference. If the patient selects a provider at or below the reference price, the plan covers the cost, subject to the usual cost-sharing provisions. By exposing patients directly to price differences, reference pricing aims to harness consumer behavior to put downward pressure on hospital prices.

CalPERS, which administers health benefits for approximately 1.3 million California state and local government employees, retirees, and their dependents, became a national leader in reference pricing when it applied this strategy to hip and knee replacements in 2011. At that time, prices for these procedures at California hospitals in CalPERS’s preferred provider organization (PPO) network ranged from $15,000 to $110,000. CalPERS set a reference price of $30,000 for hip and knee replacements and informed enrollees that they would be responsible for costs above that amount at higher-priced hospitals.

Key Findings from CalPERS

An earlier quantitative analysis by researchers at the University of California, Berkeley, documented substantial savings from the CalPERS reference pricing program. Over the first two years (2011–2012), CalPERS achieved estimated savings of $5.5 million on joint replacement procedures, as compared with projected spending in the absence of the reference pricing initiative. During this period, the share of CalPERS enrollees choosing hospitals priced at or below the reference price increased from 63 percent to 78 percent, suggesting that enrollees responded to the financial incentives created by the program.

Importantly, the savings were not primarily driven by shifting costs to enrollees. Most enrollees who had previously used high-priced hospitals switched to hospitals at or below the reference price, rather than paying the additional costs. In addition, some hospitals lowered their prices to fall below the reference threshold, further contributing to aggregate savings. Researchers found no evidence that the program compromised care quality, as measured by readmission rates and complication rates at hospitals that experienced an influx of CalPERS patients.

How CalPERS Implemented the Program

HSC’s qualitative analysis provides new insights into how CalPERS implemented its reference pricing program and the practical challenges involved. A series of in-depth interviews with CalPERS administrators, benefits consultants, health plan representatives, and independent policy experts revealed several key factors that contributed to the program’s success:

Enrollee outreach was central to the program’s design. CalPERS sent multiple communications to enrollees ahead of the program’s launch, explaining how reference pricing works, which hospitals were priced at or below the reference price, and what enrollees should expect in terms of out-of-pocket costs. CalPERS also set up a telephone hotline for enrollees to ask questions. Interviewees emphasized that the clarity and frequency of communications were critical to gaining enrollee acceptance.

The program focused on procedures where price variation was substantial and quality was relatively uniform across hospitals. Hip and knee replacements were selected because hospital prices for these procedures varied enormously, while quality metrics such as complication and readmission rates were broadly comparable across high- and low-priced facilities. Interviewees noted that CalPERS deliberately chose a starting point where the case for directing patients to lower-priced hospitals was strong and the risk of quality trade-offs was minimal.

CalPERS leveraged its large purchasing power. With more than 1.3 million covered lives, CalPERS had sufficient volume to attract hospital attention and negotiate favorable pricing. Several interviewees pointed out that smaller purchasers might face greater difficulty replicating this leverage, particularly in markets where one or two hospital systems dominate.

CalPERS worked closely with its health plan administrator, Anthem Blue Cross, to obtain and analyze claims data on hospital pricing. Access to reliable pricing data was essential to setting an appropriate reference price and identifying which hospitals fell above or below the threshold. Interviewees observed that data access remains a significant barrier for other purchasers considering reference pricing, particularly those that do not self-insure or lack direct access to claims data.

Enrollee Response

CalPERS reported that enrollee pushback was minimal. Most enrollees who received communications about the reference pricing program either chose a hospital at or below the reference price from the outset or switched to one after learning about the price differential. The telephone hotline received a manageable volume of calls, and most were informational rather than complaints. Interviewees attributed the low level of resistance to several factors: the communications were clear and timely, the financial incentive was strong enough to motivate behavior change, and the availability of quality hospitals below the reference price gave enrollees viable options.

However, some concerns were raised about the potential impact of reference pricing on enrollees who lack the ability to travel to lower-priced hospitals or who have strong physician relationships at higher-priced facilities. These equity considerations are relevant to the broader debate about consumer-directed health care strategies and their distributional effects.

Hospital Response

One of the most significant findings from both the quantitative and qualitative analyses is that hospitals responded to reference pricing by lowering their prices. Several hospitals that were initially priced above the $30,000 threshold subsequently reduced their prices to fall at or below it. This competitive response amplified the savings generated by the program beyond what would have been achieved solely through enrollee switching.

Interviewees observed that the hospital response was driven in part by a desire to maintain patient volume. Hospitals that lost CalPERS patients to lower-priced competitors had a financial incentive to reduce their prices to remain competitive. This dynamic suggests that reference pricing can function as a market mechanism that puts sustained downward pressure on prices, rather than simply a one-time cost shift to consumers.

Expansion Beyond Joint Replacement

CalPERS subsequently expanded its reference pricing program to cataract surgery and colonoscopies—procedures that share the same characteristics that made joint replacement a suitable candidate: high price variation, standardized procedures, and broadly comparable quality across providers. While it is too early to draw definitive conclusions about the results of these expansions, early indications suggest similar patterns of enrollee switching and hospital price reductions.

Other purchasers have taken steps to apply reference pricing to additional categories of health services. Safeway, a national grocery chain, implemented reference pricing for laboratory tests and advanced imaging, achieving reported savings by steering employees to lower-cost providers. The state of Oregon explored reference pricing as part of its Medicaid reform efforts. These developments suggest that the applicability of reference pricing extends beyond the narrow set of inpatient procedures where CalPERS has focused.

However, interviewees cautioned that extending reference pricing to more complex services introduces new challenges. For services where quality varies more substantially across providers, or where the procedure itself is less standardized, setting an appropriate reference price is more difficult. There is also a risk that reference pricing could inadvertently steer patients away from higher-quality providers if price and quality are not well correlated.

Barriers and Limitations

Despite the promising results from CalPERS, several barriers may limit the broader adoption of reference pricing. The HSC qualitative analysis identified the following key challenges:

Data access is a major obstacle. Many purchasers lack direct access to the claims data needed to determine hospital prices and set reference levels. Self-insured employers that contract with third-party administrators may have more access, but fully insured employers typically do not receive provider-level pricing information from their health plans.

Legal and regulatory uncertainty persists. Some purchasers are concerned about potential liability if enrollees experience adverse outcomes at lower-priced hospitals to which they were effectively directed by reference pricing. While CalPERS has not faced legal challenges, the legal landscape remains uncertain, particularly for private employers operating across multiple states with different regulatory frameworks.

Market concentration may limit effectiveness. In markets where one or two hospital systems dominate, there may be insufficient competition to generate meaningful price variation or hospital price reductions. Reference pricing is most effective where enrollees have a genuine choice among multiple providers at different price points.

Purchaser capacity varies widely. Implementing a reference pricing program requires analytical expertise, administrative infrastructure, and the organizational will to make significant changes to benefit design. Smaller purchasers may lack the resources to develop and manage such a program, even if they see the potential for savings.

Policy Implications

The CalPERS experience offers several lessons for health care policy. First, reference pricing demonstrates that consumer-directed strategies can generate real savings without simply shifting costs to patients—provided the program is well designed and carefully communicated. Second, reference pricing can create market incentives for hospitals to compete on price, potentially producing savings that grow over time as hospitals adjust their pricing behavior.

Third, the CalPERS model underscores the importance of price transparency. Reference pricing cannot function effectively unless purchasers and consumers have access to reliable pricing information. Policy efforts to require hospital price disclosure—such as the Affordable Care Act’s requirement that hospitals publish their chargemasters—may support the adoption of reference pricing by making the underlying data more readily available.

Finally, the potential for aggregate savings depends on the extent to which reference pricing is adopted by multiple purchasers across multiple service categories. CalPERS’s results, while encouraging, reflect the experience of a single large purchaser applying the strategy to a small number of procedures. If many purchasers adopted reference pricing for a broader range of services, the combined effect on hospital pricing behavior could be substantially larger.

Conclusion

Reference pricing has shown genuine promise as a tool for reducing health care spending by harnessing consumer choice and market competition. The CalPERS experience illustrates that a well-implemented reference pricing program can achieve meaningful savings, encourage hospitals to compete on price, and do so without compromising care quality or imposing excessive costs on enrollees. At the same time, significant challenges remain in scaling this approach—including data access, legal uncertainty, market concentration, and the administrative demands on purchasers.

For policymakers and purchasers, the key takeaway is that reference pricing is not a silver bullet, but it is a viable and evidence-based strategy that deserves serious consideration as part of a broader effort to address health care cost growth. The lessons from CalPERS provide a practical roadmap for implementation, while the experiences of other purchasers suggest that the model can be adapted to a wider range of health care services.

Data Source

This Research Brief is based on HSC researchers’ interviews with eight market observers and individuals involved in carrying out CalPERS’s or other purchasers’ reference pricing initiatives. The interviews were conducted by a two-person research team between May and August 2013, and notes were transcribed and jointly reviewed for quality assurance and analytical consistency. The analysis was supplemented by a review of published quantitative findings on the CalPERS reference pricing program, internal program documents shared by CalPERS, and secondary literature on reference pricing strategies in other U.S. and international settings. All sources were cross-referenced to ensure accuracy and to identify convergent and divergent themes across informants.

Funding Acknowledgement

This Research Brief was funded by the National Institute for Health Care Reform. The Institute is a 501(c)(3) nonprofit, nonpartisan organization established by the International Union, UAW; Chrysler Group LLC; Ford Motor Company; and General Motors. The Institute contracts with the Center for Studying Health System Change (HSC) to conduct health policy research and analysis that helps inform the national debate on how to improve the U.S. health system.

Sources and Further Reading

Health Affairs — Reference Pricing Research — Peer-reviewed studies on reference pricing programs, including CalPERS outcomes for joint replacement and other high-cost procedures where price variation across facilities is substantial.

Kaiser Family Foundation — Health Costs — National data on employer-sponsored health insurance costs, out-of-pocket spending trends, and the role of benefit design strategies like reference pricing in controlling premium growth.

CMS — Hospital Price Transparency — Federal requirements for hospitals to publish standard charges, a policy development that builds on the price transparency principles underlying reference pricing initiatives like the CalPERS program.

NIHCM Foundation — Research and policy briefs on health care cost drivers, purchaser-led cost containment strategies, and the effectiveness of consumer-directed approaches to reducing spending on hospital services.

Commonwealth Fund — Analyses of health system performance, insurance benefit design innovation, and how large purchasers like CalPERS have used competitive pricing strategies to steer enrollees toward lower-cost, high-quality providers.