Interview by Patrick Mullen

Regina E. Herzlinger, Ph.D., is the first holder of the Nancy R. McPherson Professor of Business Administration Chair at the Harvard Business School. An expert in management control and health care, Herzlinger argues that health care delivery in America is ripe for a consumer-driven transformation. In her most recent book, Market-Driven Health Care (Addison-Wesley, 1997), she details how that transformation might unfold. Impatient and demanding baby boomers will lead the charge. To meet the needs of these customers, health care organizations will draw on lessons that other American industries learned over the last 20 years. Integrated delivery systems will give way to "focused factories" that offer all the care needed to treat a particular disease. Third-party purchase of health insurance by employers and government will yield to direct purchase of health insurance by users. Herzlinger received her bachelor's degree from the Massachusetts Institute of Technology and her doctorate from the Harvard Business School. She spoke recently with Senior Contributing Editor Patrick Mullen.

MANAGED CARE: You've written that market forces will fix the health care system just as they fixed other parts of the economy. What leads you to that belief?

REGINA HERZLINGER: The driving force is a generation of consumers who are empowered, pragmatic, narcissistic and manipulative. They're the ones who have changed the rest of the economy and they're very interested in health care. There's no reason for any rational person to believe that they're going to say, "Oh no, leave health care in the hands of these people who are going to tell me what to do." Today's consumers simply won't accept that. The second driving force is technology, which has already vastly increased the quality and lowered the cost of health care.

MC: What technologies will lead the way?

HERZLINGER: This is the age of biotechnology and there will be fabulous changes in that area. Already there's evidence of the efficacy of gene therapy and biomaterials. In the scene in The Graduate where the executive tells Dustin Hoffman the future is in plastics, he should have said the future is in plastic catheters. They've revolutionized surgery and they'll make possible more and more minimally invasive surgery where you don't have to cut people apart in order to fix what is wrong inside.

MC: Surgeons will no longer have to heal with steel.

HERZLINGER: Exactly. I just saw a brain surgery on a tumor, where the surgeon went in through the nose and they didn't have to do a craniotomy. Any time you have to drill through the brain, the recuperative process is lengthy and traumatic. If you can reach the brain through the nose with this instrumentation, it's obviously a great boon. The patient left the hospital in two days and I'm sure had a sore nose but otherwise felt fine. Normally the procedure would take six weeks of hospital recuperation and who knows how much time outside the hospital. Then there's the whole miniaturization of chips that enables monitors and devices that replicate the functioning of organs. I'm sure that implantable pancreata and other organs will be feasible because of the increasing power of computerization.

MC: You argue that industry has learned that big isn't necessarily beautiful, although a number of large banks lately seem to disagree. What went wrong with vertical integration?

HERZLINGER: Well, the jury is still out on these recent deals. A lot of the old-fashioned, vertically integrated companies like Ford used to make everything that went into their end products themselves. Those companies learned to sharply focus on what they do very well and not try to do everything for everybody. That lesson is inescapable in health care. The health care system is organized nowadays to meet the needs of providers rather than consumers. You have physicians, hospitals, nursing homes and home-infusion centers, but if you're sick, you want an integrated system to care for your cancer or your AIDS or your asthma. You don't want to integrate the system yourself. Increasingly, health care is organized by these vertically integrated delivery systems that fly in the face of economic reality. Other American firms have gotten more focused, not more integrated. They learned that that doesn't work, and I think this trend about how companies are organized will change the face of health care. It is an irresistible trend.

MC: Can you give an example of this trend in action?

HERZLINGER: A number of companies that manage diseases integrate the health care system around the needs of consumers. Those companies are the focused factories of health care. They're going to compete against these integrated-delivery systems and there's no way that the integrated-delivery systems can compete with them because these disease-management companies are very focused. They're high quality because they do only one thing, and when you do one thing you do it very well and can do it very efficiently too. They're much more efficient than the everything-for-everybody kind of health care system.

MC: Why do you use the term "focused factory" to describe your vision for health care delivery when that name metaphorically puts physicians in the role of factory workers and is sure to annoy people?

HERZLINGER: Yes, I use the term "factory" purposefully to be provocative. The people in the factories made the changes. They figured out, and continually figure out, how to improve the production process. It's not a top-down process, it's an organic process that's led by the people who actually do the work. An HMO is a top-down process. That's not the lesson from the American economy. The lesson is it's bottom-up. It's the people who actually deliver the services who will re-create the services. My general theme is that focus leads to excellence, and excellence leads to lower costs. Some genius entrepreneurs will figure out how to make that happen.

MC: You talk in your book about Salick Health Care, which runs cancer-treatment centers. How close does it come to your concept of the focused factory?

HERZLINGER: Pretty close but not totally. People think focused factory means specialists; I don't mean that at all. What I mean is quite the contrary. I mean an integrated team, where the focus is not on the providers, because that's yesterday's way of thinking. The focus is on what consumers need. The interesting thing about Salick is it's focused on cancer. It has a total team of providers, not just oncologists. It has oncologists, infusionists and even psychologists, family therapists and financial counselors — anything that the person with cancer may need. Salick Health Care is not a focused factory to the degree that it's limited to one geographic platform, the outpatient site. A true focused factory will deliver health care wherever consumers need it: in the home, in the neighborhood pharmacy, in a community center, in a shopping mall, in a community hospital and in a specialist hospital.

MC: Walk us through a prototypical focused factory.

HERZLINGER: For example in diabetes, ideally you would have somebody who interacts with patients daily to help them monitor and manage their insulin glucose levels. You'd have dialysis centers in convenient community locations because a big co-morbidity of diabetes is kidney disease. You'd have pharmacists who would enable diabetics to monitor their disease status and who would know the patients and give them information and encourage them in dealing with this terrible disease. You'd have specialty hospitals that did things like kidney or pancreas transplants or eye surgery. Unfortunately, all too many diabetics find that their feet or some part of their leg may become gangrenous because of impairment in circulation. You'd have people who do amputations. What characterizes the system is that it exists in many geographic sites, wherever customers need help.

MC: In your book, you call this type of organization a diabetes-focused factory. Would two or more of these compete in a given market?

HERZLINGER: Absolutely, and I'll give you the numbers to show how real this idea is. Roughly $100 billion is spent on diabetes a year, so in the average state, expenditures for diabetes would be $2 billion a year. What can you buy for $2 billion in the average state? You could buy up to ten 300-bed hospitals devoted solely to diabetics plus hundreds of community facilities. So in an average state you could easily have three or more competing diabetes-focused factories.

MC: Let's take a look at where managed care finds itself these days. Do you still belong to an HMO, a staff model?

HERZLINGER: I do. Always will. It's no longer a staff model because they took it away from me. I didn't want to leave it but they stopped offering it.

MC: A lot of people have rejected the staff model because they didn't think they had enough choice, and so plans offered various open-ended options and point-of-service plans. In doing so, did the pendulum swing so far away from the classic HMO model that the types of plans that predominate today are not able to effectively manage care?

HERZLINGER: I think that is correct. The older, larger staff- and group-model plans have a very rich culture that providers and customers believe in. The culture is widely inculcated, which is an effective way of controlling costs. Customers like it and believe in it themselves. But now you have more and more open-ended HMOs without this cultural buy-in to the HMO philosophy. In this model, where are the economies going to come from? Where is the quality going to come from.

MC: Some would argue that economies come from what appears to be rationing of care.

HERZLINGER: Rationing of care or avoidance of sick enrollees — they've got to be the ways to do it. But the best way to make health care more cost-effective is not to deny health care to the American public. It won't stand for it, first of all, and second, it's a lousy way to do anything. The way to do it is to permit entrepreneurial health care ventures and to encourage them to re-create how health care is delivered. That's what these health-care-focused factories are. They don't say "no" to their customers; they deliver health care in a new way. HMOs are not going to do that; they're not the right vehicle for that kind of revolution.

MC: It would appear that a number of large insurance companies at least agree with you that insurance companies are not the vehicle for delivering health care. Prudential is only the latest of many large insurers to say it is getting out of the health insurance business. Aetna for a time thought it should be in the business of owning primary care clinics but fairly quickly changed its mind.

HERZLINGER: The correct insurance response is not to get out of the health insurance business; it's to focus on what they do well. In most industries, if you said that insurers are going to re-create the way the industry does its stuff, you would be laughed out of the room. If you said the automobile insurance people are going to re-create the way automobiles are manufactured, it would be ludicrous. So I don't think it's going to happen to health care either. Insurers are the right people to do underwriting, marketing, putting together various packages and selling them to consumers in a way that consumers understand. Oxford Specialty Management is an example of what might happen. This is a sister company to Oxford Health Plans, the HMO. Oxford Specialty Management contracts with various care groups that do, let's say GI or ophthalmology or orthopedics. The care groups offer their services at a fixed price. Oxford then markets them to its enrollees, but it doesn't just market them. Both the enrollee and the primary care provider get the credentials of every practitioner in that group. They get measures of customer satisfaction with that group. For each group, Oxford employs a group of experts who develop clinical benchmarks about what is the appropriate level of care for whatever the disease is, and they measure clinicians in the group against those benchmarks. So Oxford is now out of the business of micromanaging health care but it's in the business of marketing focused factories to consumers, doing the actuarial analysis and underwriting and collecting information that makes a market possible. Humana is another big outsourcer.

MC: What needs to happen to employee health benefits?

HERZLINGER: I think employers are going to switch to defined-contribution health care plans rather than defined-benefit plans. They're going to have to make it clear to consumers that it's not a take-away or a way of cutting health care costs. Employers thought they found the magic bullet for controlling health care costs with HMOs, but the bullet lost its magic. Health care costs are starting to increase again, consumers don't like HMOs and, with 4 percent unemployment, if your employees don't like their health care, that's a big problem. You want to keep those employees happy. Employers are saying, "Look, I've got a business to run here, I can't run the health care business and my own business." On the other hand, you have these empowered consumers who are saying, "I buy my own stocks out of the 401(k) plan. I do a lot of serious shopping for difficult-to-buy things like computers and cars. Let me buy my own health care." So you have employers moving to defined-contribution plans and employees who want to buy health care for themselves. Combined, this will enable consumers to make their own choices.

MC: So you want to get benefit managers out of the middle of choosing plans because they're not focusing on the things that need to be focused on.

HERZLINGER: They're very good people. We're all God's creatures. But the benefit mentality is on benefits and not on cost-effectiveness. The consumer mentality is always on benefit versus cost, and really only consumers can make that judgment. I wouldn't want you buying my car and you wouldn't want me buying your car. The benefits people could still vet the plans that are offered and make sure that they're solvent and provide the right kind of information to consumers. They could also make sure that consumers are honest and they don't misrepresent their conditions to insurers.

MC: Who do you see performing that oversight function?

HERZLINGER: I see the SEC model as a very interesting one. Now, whether it's the feds or the states, that's very complicated. I don't want my answer to read federal government, I want it to read government. The role of the government is to ensure solvency, to penalize any kind of fraud and make sure that there's good information. In the capital markets, the SEC has these powers and it's given these powers over to private, nonprofit organizations. For example, the group that decides what information ought to be disseminated about publicly traded organizations is FASB, a private nonprofit, but the SEC is the iron hand in the velvet glove. Anybody who screws up is going to have to deal with the SEC, which is very vigilant in its oversight. But the actual promulgation of rules is done by a private-sector organization and I think that's a very good model.

MC: What's your sense of the political appetite for the kind of change here?

HERZLINGER: Very serious. Centrist Democrats at the Progressive Policy Institute have recommended that insurers adopt the Federal Employees Health Benefits Program model, essentially a defined-contribution, multiple-choice model of the sort that I just described. Republicans will soon propose a kind of health care supermarket that medium and small employers can buy into. The supermarket would enable employees to shop among a large variety of health insurers just like people who invest can buy all kinds of mutual funds. So centrists in both parties are essentially espousing variations on the same theme.

MC: Are you optimistic that something can pass this year?

HERZLINGER: I am optimistic. The main force agent in back of all of this is the baby boomers. The baby boomer generation is the most manipulative, self-seeking and effective generation that this country has seen.

MC: I'm sure you say that with the greatest respect and affection.

HERZLINGER: Absolutely. I'm a member of that group. While they were still in college, they got rid of Presidents Johnson and Nixon. In my book, I talk about the 20/80 rule; that 20 percent of patients use 80 percent of health care resources. That rule also works by age, and so most health care resources are consumed by people 55 and older. The baby boomers are heading toward that point. Now, if anybody is going to mount a credible public campaign to make sure that they're in charge of their health care expenditures, it's that particular cohort, so that will nail it.

MC: I thank you for your time.

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