Consumer prices are rising fast, and healthcare isn’t far behind

| Commentary

Over the last 30 years, consumer prices have rarely risen faster than healthcare inflation, from doctor visits to surgeries and prescription drugs. In fact, the inverse has typically been the case, particularly during economic downturns: after the 2008 financial crisis, for example, overall inflation slowed to almost nothing while medical prices continued to grow at a 2 to 3 percent rate.1

Today, inflation in the United States has reached rates not seen in decades: from December 2020 to December 2021, the overall inflation rate (Personal Consumption Expenditure Price Index) was greater than 5.8 percent.2 In our view, it is only a matter of time before prices for healthcare catch up to this increase. Much higher prices are only being delayed by the unique features of the healthcare industry. In healthcare services, prices, reimbursement rates, labor contracts (which are typically indexed to consumer price inflation), and several other input factors are set two to three years in advance. So, while healthcare delivery systems are facing higher costs—primarily increases in areas with shortages such as nursing and supplies—in our view, there will likely be a lag before consumers experience the same pressures.

We see this situation ultimately playing out in two steps. First, providers will demand higher reimbursement rates, and second, payers will pass along higher costs to employers and consumers, who have already been seeing an increase in costs of over 6 percent every year from 1999 to 2021.3 This lag could result in reduced healthcare benefits and higher out-of-pocket costs for consumers.

In the meantime, healthcare providers and services organizations face significant headwinds right now due to rising labor and other costs, coupled with their inability to increase reimbursements immediately. Also, the finances of many provider systems benefited in recent years from strong capital market returns, but recent volatility may undercut that budgetary support.

The nursing shortage caused by COVID-19 is likely to get worse, leading to an even bigger wage bill, according to a recent McKinsey survey of hospital executives. In our 2021 survey of some 400 frontline nurses, we learned that the workforce is fragile, with 32 percent of the nurses indicating that they may leave their current positions. This level of turnover is costly and disruptive for healthcare systems and will exacerbate an already pressing shortage of qualified talent.4Nursing in 2021: Retaining the healthcare workforce when we need it most,” McKinsey, May 11, 2021. The labor issues are not just limited to the supply of talent; rising costs to replace the workforce are also a factor. For example, most health systems have become more reliant on temporary and travel nurses, who receive premium pay. In addition, the pandemic has led to higher total spending in personal protective equipment and other related supplies.

As a result, a typical health system could see a 1.2 to 2.8 percentage point decline in profit margin, assuming that its ability to raise prices is typically limited to about 3 percent, according to McKinsey analysis.5 Furthermore, extrapolating inflationary impacts on healthcare profit pools suggests significant pressures on stakeholders. For example, if 2022 healthcare inflation catches up to inflation for overall services—implying a 1.5 percentage point increase on top of current levels—healthcare profit pools could decline by about $70 billion.6 A three percentage point rise could result in a $140 billion decline in profit pools. That would mean about a 12 to 24 percent drop in profit pools in 2022 for the overall healthcare industry.

This situation leaves healthcare organizations in a tenuous position. So, what could providers and healthcare services organizations do to address their increasing cost burden? Most have taken short-term actions, such as addressing the immediate labor shortages, seeking federal aid through stimulus packages (which has masked some of the financial burden), and tightening capital expenditures. But we think that’s only a start.

These organizations should immediately begin preparing for the difficult times to come in 12 or more months in two steps: first, by laying the foundation for operational excellence, and second, by building infrastructure to ensure resilience. We believe that these actions could lead to at least 1.5 to 3.0 percentage points of margin improvement (in other words, an improvement equivalent to the gap between medical costs and services or between medical costs and overall inflation).7 In our analysis and experience, this increase would be in addition to the 1.5 to 2.0 percentage point margin improvement that healthcare organizations will need each year to account for an aging population transitioning from higher-reimbursing commercial insurance to Medicare. More broadly, the moment offers a potential opportunity for healthcare organizations to fundamentally reset themselves to achieve greater productivity through the adoption of digital and advanced analytics, as well as through the application of operating best practices.

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Laying the foundation

Services organizations and providers should double down on operational excellence, in particular on improving productivity, optimizing labor and the supply chain, and accelerating the transition to value-based care. These opportunities could total to as much as 1.5 to 3.0 percentage points of savings.

Boosting productivity

Administrative spending accounts for about 25 percent of the nearly $4 trillion spent on healthcare annually in the United States; spending on delivery of care is about three-quarters of this total. There are many ways available to providers and services organizations to save money and add value.8Administrative simplification: How to save a quarter-trillion dollars in US healthcare,” McKinsey, October 20, 2021. For example, they could think about advancing timelines for automation projects in both administrative and clinical functions. Providers could consider not only automating and digitalizing administrative processes like scheduling, patient access, and billing but also adding productivity enablers in clinical care such as decision support, streamlining clinical workflows, and simplifying clinical documentation through the use of artificial intelligence.

Optimizing labor

Pressure will likely arise to quickly rebuild the healthcare workforce to address both rising costs as well as the retention and acquisition of talent. But instead of a focus on “rebuilding,” we propose a “new” build: a vision for the workforce that incorporates learnings and aspirations for the future of work (for example, technology-enabled care models) and creates a realistic plan to make it happen.9Nursing in 2021: Retaining the healthcare workforce when we need it most,” McKinsey, May 11, 2021. We recommend four strategic considerations: make workforce health and well-being part of the cultural fabric, increase workforce flexibility, strengthen talent pipelines, and build skills for the future. In addition, health systems will need to consider also using technology to reduce the demand for labor—for example, through employing analytics to reduce lengths of stay and to shift care to settings that require fewer clinical staff, such as the home, skilled nursing facilities, and telehealth. Transformation of the healthcare model would enable clinical staff to focus on the work they were trained to do rather than on secondary tasks and to change the way current delivery teams are composed.

In our experience, health systems typically factor in a 3 to 5 percent productivity improvement on an annual basis. To meet current challenges, health systems will need shoot for the top end of this range; to succeed, all the actions described above will likely be needed.

Optimizing the supply chain

Every step in the healthcare value chain is confronting inflationary pressure, from raw materials and freight (land, sea, and air) to the labor force. While a role exists for traditional supply-chain strategies (for example, strategic stockpiling, bulk purchasing, and price negotiations) to mitigate impacts, these new approaches, among others, should be considered:

  • Increased partnerships and dialogue with distributors to enhance visibility into future trends
  • Vendor diversification (requiring management of multiple purchasing channels)
  • Optimizing contract terms with vendors (for example, exploring failure-to-supply clauses and locking in longer-term pricing through contract extension)
  • Removing barriers to rapid contracting by adopting request-for-proposal automation and increased legal support to speed up review
  • Investment in upstream visibility through development of tools and processes to support procurement when a shortage in supplies exists (for example, reallocating supplies across a system’s footprint)

Providers will require comprehensive data, including hospital utilization data and transparency into both internal and external inventory availability, to better manage the increasing complexity of the supply chain.

Accelerating transition to value-based care

New and innovative business models can generate greater value and deliver better care for individuals. Common among these new business models are a greater alignment of incentives typically involving risk-bearing, better integration of care, and use of data and advanced analytics. Health systems can accelerate their transition to these newer models.10The future of healthcare: Value creation through next-generation business models,” McKinsey, January 4, 2021.

Administrative simplification: How to save a quarter-trillion dollars in US healthcare

Administrative simplification: How to save a quarter-trillion dollars in US healthcare

Building an infrastructure to ensure resilience

Accomplishing the tasks described above requires an organizational transformation that emphasizes rigorous execution. The goal is to make the organization as resilient as possible.

An important first step to consider is standing up an inflation nerve center, which puts the necessary infrastructure, processes, and governance in place to manage a transformation. The infrastructure allows organizations to create transparency and exposure across the most likely scenarios, as well as the analytics to support a response. It also can track and monitor performance of the actions described earlier by providing a forum and a governance mechanism for rapid decision making. Finally, the nerve center also codifies learnings and puts tools and talent in place to manage such risks in the future.

Providers and healthcare-services organizations are likely facing a difficult next few years as they seek to cope with the price increases that are working their way through the system. The stakes are high, not only for them, but also for consumers—who face higher premiums and out-of-pocket expenses—and employers that offer insurance to their workers. It’s imperative for providers and services organizations to start grappling with the consequences of inflation. To get the most from their efforts, they will need to fashion an organization that emphasizes rigorous operational execution and resilience.

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