This past week the Bureau of Labor Statistics (BLS) released May’s CPI (inflation) report. Overall, the trend is improving with inflation now, month over month, increasing .1% vs. .2% in April. On a 12 month basis, inflation has risen 2.4% (not seasonally adjusted). See below.
Of the items that continue to run “hotter” than overall CPI, healthcare has been near the top. Energy, particularly gasoline, has fallen substantially, helping to pull down the overall price index. In the chart above, I highlighted the healthcare items.
After BLS releases these reports (CPI), I’m often asked how the price changes for healthcare (or medical care) are calculated. Patients typically have no idea about the costs of services they receive as most are somewhat masked by health insurance plans, purchasing agreements, etc. About the only clear price transparency to service rendered is via elective, non-insured services such as cosmetic surgery. Even then, the price can vary widely among providers and regions (locations).
For this piece, I’m taking a bit of a deep dive into the BLS mechanics that calculate healthcare inflation. I’ve tried to be as non-technical as possible but still, its impossible to convey how many gyrations are used to determine inflation for this element. Its no wonder folks simply don’t understand it. https://www.bls.gov/cpi/factsheets/medical-care.htm
CPI and Healthcare Prices
Medical care prices often rise faster than other prices in the economy. In 2021, non-medical goods and services saw rapid price increases, surpassing medical care growth. While overall inflation has recently cooled, medical prices are now rising quicker again. The CPI shows that from June 2023 to June 2024, overall prices grew by 3.0%, medical care prices by 3.3%, and other prices by 2.9%.
The consumer price index for all urban consumers (CPI-U) measures the U.S city average change in prices consumers pay for goods and services. For medical care, CPI measures total price changes, including both the costs consumers pay out-of-pocket and those insurers (public and private payers) pay to providers and pharmacies. While CPI measures total price changes, the index weights spending to match consumers’ out-of-pocket costs, including consumers’ spending at the point of care and on health insurance premiums. For example, physician and hospital services are 47% of the medical care index.
BLS used new expenditure weights to calculate the CPI starting from January 2023 and will continue to update the weights annually. Previously, BLS updated CPI weights once every two years using two consecutive years of consumer spending data. CPI weights will now be calculated each year using one year of spending data for greater accuracy. \
Healthcare inflation in the Consumer Price Index (CPI) is calculated by measuring the price changes of a fixed basket of healthcare goods and services over time. The U.S. Bureau of Labor Statistics (BLS) oversees this process through the following steps:
Basket of Goods and Services: The CPI includes a specific category for medical care, which is divided into two main components:
- Medical Care Commodities: Prescription and non-prescription drugs, medical equipment, and supplies.
- Medical Care Services: Hospital services, physician services, dental care, eye care, and health insurance.
Weighting: Each healthcare item or service is assigned a weight in the CPI basket based on its share of consumer spending, derived from the Consumer Expenditure Survey (CEX). Medical care accounts for about 8-9% of the total CPI basket.
Price Collection: The BLS collects price data monthly from various sources, including:
- Retail pharmacies for drugs
- Hospitals and clinics for services
- Insurance companies for premium costs
Prices are gathered from urban areas across the U.S., covering roughly 87% of the population.
Health Insurance Adjustment: Health insurance in the CPI is measured using an “indirect approach,” estimating the cost of insurance based on the benefits paid out rather than the full premium. This method avoids double-counting services already priced in the basket.
Challenges in Pricing Health Insurance
Although insurance premiums constitute a significant portion of consumer medical spending, the Bureau of Labor Statistics (BLS) does not directly price health insurance policies. A direct approach would involve tracking the movement of insurance premiums while holding constant the quality of insurance, and using these price relatives to construct the Health Insurance Index. However, the BLS has encountered difficulties in consistently controlling for changes in quality, such as policy benefits and risk factors. Price changes between health plans of varying quality cannot be compared, and any quality adjustment methods to facilitate price comparison would be challenging and subjective. Consequently, the BLS developed an indirect approach known as the retained earnings method.
Retained Earnings Method
This section of the post provides a general overview of the retained earnings methodology; the specifics of each step are detailed in subsequent sections. This method begins by decomposing health insurance premiums into two categories based on their utilization by the insurance company: earnings retained by the insurance company and benefits paid out on behalf of customers.
The earnings retained by the company are essentially the remaining premium income after the payment of benefits and rebates. These retained earnings are used to cover administrative costs or are kept as profit. The BLS categorizes this value as the cost of administering insurance services, including paying out claims, and refers to it as retained earnings. Benefits paid out—or reimbursements to providers for medical goods and services—can be broken down as the average price of medical service claims multiplied by the number of claims filed, also referred to as medical care utilization.
Deconstructing health insurance premiums in this manner illustrates that premiums are a function of retained earnings, utilization, and the price of medical care.
The BLS tracks health insurance premiums by assuming that the quality of a policy can be measured by the ratio of retained earnings to benefits paid. If premiums increase while benefits remain constant, the insurance quality declines relative to its cost. The BLS reallocates the weight for benefits paid out to non-insurance medical care indexes and multiplies it by the monthly change in these indexes to factor in the impact of changing medical prices on premiums and retained earnings.
Process Overview
The process involves:
- Separating health insurance index weights
- Calculating the retained earnings ratio
- Aggregating the health insurance index
- Reassigning health insurance weight
Price Index Calculation: For each healthcare item or service, the BLS calculates a price index by comparing current prices to a base period (typically set to 100 for 1982-1984). These indices are aggregated using the weights to compute the overall medical care CPI.
Inflation Rate: The inflation rate for healthcare is derived by comparing the medical care CPI over time, typically year-over-year.
Seasonal Adjustments: Some healthcare prices may have seasonal patterns, so the BLS applies adjustments to smooth out these fluctuations for more accurate trends.
Key Notes:
- Data Sources: The BLS uses surveys like the CEX and direct price collection from providers, ensuring a representative sample.
- Challenges: Healthcare inflation can be affected by quality improvements (e.g., new drugs) or changes in insurance coverage not fully captured in the CPI.
Yesterday, the 2025 OASDI Trustees Report came out. This is the annual report covering the financial status of Social Security and Medicare. I mention this as in many ways, CPI and the inflationary cost of healthcare via utilization and somewhat price, impact the longevity of funded entitlement programs such as Medicare and Medicaid. In my next post, I’ll cover the Trustees Report. For anyone that wants some background on last year’s report, I wrote a post in January that includes the information, among other data points. https://rhislop3.com/fixing-healthcare-spending-in-the-u-s/