Every well-informed executive knows that the cost of providing health care for employees is on the rise. But few realize just how quickly the cost is growing and its impact on the bottom line. Employee benefits now represent a company's third-largest expense—after the cost of goods sold and the non-manufacturing payroll—and health insurance is the fastest-growing component (Exhibit 1). Some economists are even beginning to point to the prohibitive cost of providing health care benefits as a reason for the reluctance of companies to hire more aggressively.

It's not as though they haven't tried to deflect the one-two punch of rising health care prices and growing consumption: most have shifted more of the cost to their employees through higher co-payments and deductibles. Some have tried to contain costs by slashing benefits and searching more aggressively for cheaper health care coverage. Still others have introduced programs to prevent and manage disease in hopes of helping employees avoid expensive trips to the doctor. While these approaches have helped, they have failed to get health care costs under control. In fact, we estimate that in the absence of extraordinary economic growth, by 2008 the average Fortune 500 company will be spending as much annually on health benefits as it earns in profits (Exhibit 2).

The approaches used to date have failed largely because the health care plans of most corporations are so fragmented, and many of them are reluctant or ill equipped to tackle two tough issues: the design of benefits and incentives for providers. Consider the problem facing the average Fortune 500 company, which has thousands of employees working in dozens of locations and covered by nearly as many insurance plans, all regulated by different state laws.¹ And while the company fends off competitors keen to poach its best people by offering more attractive benefits, it must also wrestle with powerful unions that typically oppose most changes to health plans.

In our experience, companies intent on cutting a path through this mind-numbing array of variables and constraints can develop a comprehensive approach to diagnose and redesign health benefits. The objective is to home in on the factors driving up expenditures—the growth in unit costs and utilization—and to strike a more sophisticated balance between containing costs and meeting the needs of employees. Executives need to know where the money is going and why, what employees want, and the value they place on their present health care benefits. Only with the answers to such questions will it be possible to navigate more effectively through federal and state regulations, union contracts, competing benefits packages, and the availability of health care providers in different areas.

Corporations that take a more strategic, integrated approach can capture big short-term savings: we estimate that they could reduce their health care spending by up to 20 percent and slow its rate of growth by as much as 2 percent a year. They are also likely to end up with more satisfied employees. In a recent Wall Street Journal poll, 61 percent of the respondents viewed stable health care benefits as more important than higher salaries.

A Gordian knot

Managing health benefits is complex. Numerous variables and constraints make it hard to develop a corporate-wide strategy. One diversified manufacturing company, for example, has thousands of employees—young and old, male and female, full- and part-time, blue- and white-collar, unionized and nonunionized—all with different needs and preferences for health benefits. Like many companies, it has been left by a series of mergers and acquisitions with nearly as many legacy health plans as operating units.

A universal set of external complications makes attempts to undo this tangle more difficult. Payers and providers vary from market to market, so it is challenging to find plans that can meet a company's needs effectively across all locations. Rapidly changing regulations differ from state to state: some, for instance, have laws that specify the benefits and procedures insurers must cover. What's more, in unionized locations, executives face a surprising level of intransigence over health benefits. Even when tempted with offsetting wage increases, most unions fiercely resist changes in the level of benefits or the portion that employees pay. Last July, for instance, during contract negotiations with the Big Three car-makers, leaders of the United Auto Workers took health insurance off the table, despite the carmakers' stated intention of reducing medical costs.

A day late and a dollar short

Many companies have been reluctant to tackle the underlying causes of rising health care costs, preferring instead to increase the amount their employees cover through higher co-pays and deductibles. While such efforts can yield onetime savings of 5 to 10 percent, they have clear limits. Fearing a backlash, most employers are uncomfortable shifting more than 25 percent of the cost of health benefits to employees.²

Other companies have insisted on the use of cheaper generic drugs or have eliminated certain benefits, such as dental or optical care—in some cases without knowing their cost and whether employees valued them highly. Reducing the level of such nonessential benefits can cut health benefit costs by 2 to 4 percent. Still other companies have negotiated more aggressively with health plans in order to consolidate offerings and obtain multiyear agreements in exchange for lower premiums or administrative costs. That approach has produced savings of 1 to 3 percent. Last, some companies have tried to channel employees and their dependents to certain insurers through preferred-provider or other "closed" networks.

While these tactics can be effective in the near term, particularly for a company that hasn't managed the cost of its health benefits proactively, they rarely go far enough. Even if the average Fortune 500 company pursued costs aggressively, its spending on health benefits would still exceed corporate profits within three to five years. Worse yet, such short-term savings can have long-term consequences. Some of the changes risk alienating employees and discouraging them from seeking preventive care for complications associated with chronic diseases—one of the main causes of the nation's growing health care burden. Although higher co-pays and deductibles can be a powerful lever to influence consumer demand for health care services, they may discourage some employees from taking important medications and, in certain cases, make them hesitate to seek medical care they need.

An integrated approach

Reordering such a complex mix of factors calls for a comprehensive approach to identify and address the problem's cause: the increase in unit costs and utilization. Until a company knows what it will spend, today and tomorrow, and what its employees want, it can't begin making the necessary trade-offs to satisfy their needs while managing its long-term health benefit costs.

A sequence of steps to reform the present system should begin with the mapping of current expenditures and with surveys of employee preferences. Companies should then develop an organizational structure in which some decisions can be made centrally to gain efficiency while others are tailored to meet local needs. Such a structure can lower costs by allowing companies to source their health care more effectively and to develop incentives that make employees and providers use their resources more prudently.

If the average Fortune 500 company followed a more strategic, integrated approach, we believe it could reduce spending on health benefits by up to 20 percent within the first year and potentially slow the rate of annual cost increases by as much as 2 percent. Over an eight-year period, these measures would capture savings of approximately $220 million in present value—more than double those of traditional approaches (Exhibit 3). And that figure doesn't include the potentially incalculable benefits from improvements in labor productivity (such as the number of sick days employees take) or from more satisfied employees.

Know your spending

Corporations need to start by developing a much clearer picture of their current and projected health care spending. This task is hardly a small one, and few of them even understand the problem's scope.

How would a company such as the diversified manufacturer mentioned earlier proceed? The CEO might bring together the chief officers of finance, human resources, and purchasing to gather information from each business unit and develop a complete picture of company-wide health care expenditures. The data can be used not only to set clear goals for spending but also to establish a baseline for measuring progress.

Most companies will struggle to link their spending to a set of metrics that would help them evaluate the return on their health care investments. But these metrics can shed light, for example, on the number of sick days employees take as well as the effect of health benefits on labor productivity and the retention of top performers. One consumer products company managed to pinpoint, as the most important reason for the growth in its health care spending, a near epidemic of diabetes among its employees. It also discovered that its costs ran much higher than industry benchmarks and that the disease was starting to hinder the company's productivity.

Listen to your employees

The next step is for a company to survey its employees to determine what, if any, gaps exist between their needs and its benefits. The same techniques used in marketing products can be effective here. A combination of interviews, focus groups, and surveys can show the company how its employees perceive various benefits, how its health plans compare with those of competitors, and how to segment employees into categories such as "cost-conscious high utilizers" and "price-insensitive choice seekers."

That process often takes a few months. When completed, it can offer valuable insights into what employees really want from their health care and other benefits. One financial institution, after conducting such research, discovered that many of its relatively young employees were disappointed by the lack of dental coverage but had underestimated the value of (and the likelihood of needing) its generous catastrophic-care insurance. By contrast, a manufacturing company with older, lower-paid workers might find the opposite—that its employees placed an excessively high value on coverage of catastrophes because older workers tend to overestimate the probability of such illnesses.

As savvy negotiators know, addressing issues one at a time encourages purely "win-lose" situations. Only when a company evaluates a number of issues simultaneously can it see how to produce wins for both parties. The financial-services firm, for instance, could pay for a more generous dental plan by increasing the deductible and stop-loss levels on its catastrophic-care insurance.³ These changes would reduce the net cost of benefits by 10 percent while making employees more satisfied with the overall benefits plan. Such trade-offs can be made either among all the benefits in a company's package (for instance, life insurance, health care, disability insurance, and vacations) or solely within health benefits (such as vision, dental, and acute care).

Think centrally

Corporations must then ensure that their organizations have been set up to rein in spending while they simultaneously manage the host of external factors that make health benefits such a vexing problem. The financial-services firm had it relatively easy—most of its employees worked in one location, so there were few complications—but for most other companies, this step can be the hardest to take.

Companies that tackle the problem conclude that no one owns health care across the whole enterprise

In our experience, companies that have tackled the problem come to a troubling conclusion: nobody owns health care across the whole enterprise. At the manufacturing company, no one in the corporate center understood (let alone had accountability for) the problem of health care. The managers of the various business units were accustomed to seeing it appear as a regular but growing charge against profit-and-loss statements yet felt helpless to change the system significantly.

In general, the solution is to centralize when possible and then to customize at the local level if necessary. While this approach may sound like a classic corporate-center-design answer, health care by nature presents interesting complications. Consider again what the manufacturing company might do. As part of its long-term plan, management must define an overall approach to health benefits, maintain a comprehensive set of financial reports and projections, achieve economies of scale where possible through centralized purchasing, set guidelines for local customization, track returns on investments in health care benefits, and provide guidance on necessary course corrections. The business units should contribute detailed information on their employees' needs and consumption patterns, the availability and quality of local payers and providers, and the attitudes of local union representatives. The local business units should also keep an ear to the ground for changes in state regulations that might have implications across the company.

At the consumer products company facing a diabetes epidemic, the right combination of national and local initiatives helped manage the growing cost of the disease. Thanks to a national perspective, the company's central office could partner with a top disease-management program—an option that wouldn't have been cost-effective for any one corporate division. Meanwhile, the local offices customized support services in a way that helped employees manage their condition more successfully.

Some companies that made these changes encountered resistance from business-unit leaders seeking to maintain local control. While benefits are being centralized, business units may request assurances that they will retain a voice in designing such a significant cost lever and demand proof of tangible cost reductions.

Source as though you mean it

The right organizational structure enables companies to source health care and clamp down on price increases more effectively. We won't review purchasing best practices⁴ extensively here, but it is worth touching on the basics. Companies first need to analyze their health benefits' total cost of ownership to identify the most expensive items. They should then leverage their scale by offering up these high-impact categories for competitive bidding, bundle their benefits plans when possible, and negotiate discounts based on their scale and experience. The consumer products company, for example, saved 3 percent on the cost of its projected health premiums. It reduced by 80 percent the number of health care plans available to its employees and then used volume discounts to shrink its costs and simplify the administration of its plans—all without changing the benefits its employees received. By introducing more portable (indeed, nearly universal) health coverage, it also improved the parity of benefits among its employees and made it easier for them to move from one location to another.

In addition, the process highlighted some of the nuances of sourcing health care: taking steps to consolidate vendors isn't the only way of exploiting scale. Since the consumer products company was by far the largest employer in several of its rural locations, it saved more by negotiating aggressively for contracts with local providers than it would have gained by bundling rural employees into one of its national plans.⁵ Moreover, managers could evaluate the price and quality of their plans against not just external benchmarks but also such metrics as the number of sick days taken by employees with chronic diseases.

Get the incentives right

Last, companies need to give all parties incentives to increase the cost-effectiveness of health benefits. To reduce the substantial long-term expenses associated with chronic disease (such as diabetes, congestive heart failure, and depression), employees must be encouraged to take advantage of the health package. The process begins with an understanding of how they use health insurance over time and the level of chronic disease occurring among them. Co-pays, deductibles, and access can be designed to ensure that employees seek care in potentially life-threatening situations, such as heart attacks, but are dissuaded from incurring expensive emergency-room charges when a call to a nurse triage line might suffice. Employers should also work with health plans and providers to guarantee that employees get good, reliable information.⁶

As for providers (including physicians and hospitals), the quality of care may vary widely, and so do definitions of quality. Employers should in large part leave these assessments to the clinical professionals and focus on establishing pay-for-performance incentives based on generally accepted standards. This is best done in close collaboration with health plans. Many of them are experimenting with such incentives, which have been correlated with improved long-term health.

Take the nationwide diabetes problem. Health plans and employers could reward physicians for keeping their patients' levels of glycosylated hemoglobin to 7 percent or lower—a measure regarded as a good indicator of a well-managed condition and a way of predicting expensive longer-term complications associated with the disease. The National Committee for Quality Assurance estimates that if blood glucose levels were controlled in 95 percent of all patients, 1,473 lives could be saved each year and 1.4 million sick days avoided, for an annual savings of $164 million. These estimates are based on the experience of a handful of companies involved in a program that uses incentives to spur better performance.⁷

In addition, self-insured employers might consider seeking multiyear health-care-administration contracts linking part of the compensation to the effective management of long-term medical expenses. This type of commitment would give health plans a more stable member base and encourage greater accountability in the treatment of chronic disease, which involves costs that can take many years to materialize fully.

Many companies are exploring some of these levers. Sadly, few are taking all of the steps required to make a significant difference. Only a more strategic, comprehensive redesign effort will prevent the soaring cost of health benefits from adversely affecting a company's profits, talent pool, and strategic flexibility.