The latest Mirror, Mirror 2024 report from the Commonwealth Fund—a nonprofit organization that conducts independent research on global healthcare issues— delivers a grim diagnosis for American medicine.
Despite spending more on healthcare than any other country, the U.S. ranks dead last in health system performance among 10 high-income nations. Americans live nearly five years less than the average citizen of these nations and experience the highest rate of preventable deaths.
Although multiple factors contribute to these poor results, the root of this underperformance is the way we pay for care. For decades, the U.S. healthcare system has relied on a fee-for-service (FFS) model, where doctors and hospitals are compensated for every procedure, test and treatment—whether or not they improve patient health.
This model rewards quantity over quality. For instance, doctors earn more by seeing patients twice for problems that could be resolved in one visit. Moreover, treating complications from diabetes, such as heart attacks or kidney failure, is far more lucrative than preventing them.
As Warren Buffett’s longtime business partner, Charlie Munger, famously said, “Show me the incentives, and I’ll show you the outcomes.” Nowhere is this more evident than in healthcare. Thus, if we want better outcomes, we need to change the way we pay for medical care.
Capitation As The Cure
Capitation flips the traditional fee-for-service (FFS) payment model on its head. Instead of paying healthcare providers based on the number of procedures or tests they perform, capitation rewards doctors and hospitals when they keep patients healthy. Their focus shifts from simply treating illnesses when they arise to preventing costly, life-threatening conditions like heart attacks, strokes and kidney failure in the first place.
Under capitation, providers receive a fixed annual payment to manage the health of a defined group of patients. This prepaid structure encourages preventive care and patient safety—practices that not only improve outcomes but also lower overall healthcare costs.
According to recent data from the Centers for Disease Control & Prevention (CDC), better management of chronic conditions like diabetes and hypertension could prevent 30-50% of heart attacks, strokes, cancers and kidney failures. This level of control would not only save tens of thousands of lives each year but also dramatically reduce healthcare costs. In a capitated payment model, doctors and hospitals are motivated to prioritize chronic disease management, benefiting both themselves and their patients.
For capitation to work effectively, however, it must be applied at the delivery-system level, meaning that both doctors and hospitals need to be paid this way—not just the insurers.
Currently, most so-called capitated models pay insurers a flat fee, but those same insurers then compensate healthcare providers using the FFS system. This creates a vicious cycle: insurers drive down unit prices, doctors increase the volume of services to compensate, insurers respond with prior authorization requirements that delay care in an effort to control costs, and providers, in turn, find ways to provide more expensive services, even when less costly options would suffice.
However, despite the clear drawbacks of the fee-for-service model and the benefits of capitation, the transition has been slow. To understand why the U.S. healthcare system has resisted this shift, we need to examine the issue through the lens of behavioral economics—specifically, game theory.
Game Theory: The Imperative For Healthcare Cooperation
At its core, game theory helps us understand how individuals or organizations make decisions when their actions affect one another.
In a classic study, two volunteers are placed in separate rooms, with no way to communicate. Each is given the option to request $50 or $100. If both ask for $50, they each walk away with that amount. However, if one person asks for $100 while the other requests $50, the person asking for $100 gets the full sum, and the other receives nothing. But here’s the catch: if both ask for $100, neither person gets anything. This dynamic often leads to one party being greedy at the expense of the other, resulting in a “win-lose” outcome.
This model reflects the current dynamics of the U.S. healthcare system, where payers (insurers) and providers (doctors and hospitals) engage in adversarial negotiations. Insurers seek to minimize costs by lowering reimbursement rates and limiting expensive procedures, while providers attempt to increase the prices and their volume of services to maximize revenue. This creates a “win-lose” environment, which erodes trust and collaboration. As each party focuses on short-term financial gains, the result is inefficiency, excessive costs and suboptimal patient outcomes.
Now, imagine if this game were played not once, but 20 times. In a single round, it might be tempting for one player to grab the $100, but in a multi-round game, trust and cooperation matter more. If one person tries to take $100 in the early rounds, the other is likely to retaliate, and both walk away with nothing in future rounds. However, if both consistently choose $50, they earn far more over time.
Game theory demonstrates that when interactions are repeated, collaboration becomes the superior strategy, leading to better outcomes for everyone involved.
Capitation turns healthcare into a multi-round game, where long-term cooperation becomes essential. Under a capitated model, insurers and providers share the financial risk and benefits of patient outcomes. Rather than focusing on short-term profits, both sides are encouraged to keep patients healthy, prevent chronic diseases from worsening and reduce costly life-threatening complications like heart attacks, strokes and kidney failures. Just as in the multi-round game theory example, the more both sides cooperate, the better the outcomes for everyone—especially patients.
Capitation aligns the incentives of all players in the healthcare system by rewarding prevention and proactive care, rather than encouraging costly interventions, as is typical of FFS. Over time, capitation builds trust, with both payers and providers benefiting financially as patients stay healthier and require fewer treatments.
The Impending Crisis In Healthcare Affordability
American businesses, which privately insure 155 million people (nearly half the country), are approaching a financial tipping point. They face the prospect of 7% to 9% increases in health insurance premiums by 2025 and are unsure how they will manage these rising costs. With half of the U.S. population already unable to afford out-of-pocket expenses in the event of a serious illness, employers are running out of ways to shift these additional costs onto their workers.
When it comes to solving the healthcare affordability crisis, game theory demonstrates why capitation succeeds where fee-for-service (FFS) fails.
In the current FFS model, interactions between insurers and providers resemble a single-round game, with each side trying to maximize short-term gains at the expense of the other. When they negotiate, each focuses on getting a bigger piece of the pie. This win-lose dynamic leads to inefficiencies and higher costs for both sides; not to mention worse outcomes for patients. In contrast, when capitation replaces fee-for-service at the delivery system level, insurers and providers look for ways to make the pie bigger, maximize people’s health and share the cost savings. Everyone benefits, especially patients.
Unlike traditional game theory experiments where players can’t communicate, healthcare’s players—insurers, hospital administrators and physicians—have the power to collaborate directly. Few have taken full advantage. Game theory shows the flaws of the current system and why the time for change is now.
