from Guide to Adulting on Oct 22, 2023

How health insurance works

Medical care in the United States is expensive, making health insurance a necessity. In turn, this makes picking the right health plan very important — either at the start of a job or during "open enrollment" periods.

Do I need health insurance?

At a surface level, health insurance might seem spurious if you don't see the doctor very often. Premiums, or the amount you pay for insurance, are charged monthly and range from $10 to $50 or more. So this begs the question: Do I even need health insurance?

Yes, medical costs add up much more quickly than you might think. The US Department of Health found that the average cost of an office-based physician visit in 2016 was $265, in Statistical Brief #517. A recent visit to my local dentist's office saw a dental deep cleaning that cost upwards of $2,500.

These aren't costs you'd normally notice if you're insured. My dental visit's cost was reduced by roughly 80%. Similarly, most primary care visits end up costing only $20-30 for an insured individual. However, there are a number of caveats that can make your medical bills skyrocket.

Below, we'll talk about those considerations that can affect how you pick a health insurance plan — and how that affects the doctors you visit.

Pick a deductible and out-of-pocket maximum.

Health insurance generally provides fixed-cost or no-cost coverage for a few common services:

Preventative services: Vaccinations, screenings, and annual check-ups are generally free, incurring no cost for you.
Co-payments: These "copay" charges are usually fixed costs associated with certain services, like a visit to your primary care doctor, formally called a Primary Care Physician (PCP). For example, UC Berkeley's Student Health Insurance Plan (SHIP) charges a $15 co-pay for primary care and a $25 co-pay for specialist visits.

For services that don't fit into one of the categories above, there are three tiers of "costs".

Stage 1 — You pay 100% of all medical costs.
1. Up until a "deductible": You continue to pay the entirety of medical costs up until you reach a certain amount for the year, called a deductible. For example, say your deductible is $450; this means you pay the first $450 of medical costs on your own.
2. Be aware of what costs count towards your deductible: Co-payments might not count towards your deductible and may remain fixed in cost regardless of you hitting your deductible or not. Other costs such as balance billing, which we discuss below, may not count towards your deductible either.
3. Example: Using the SHIP example above, say you visited specialists 18 times this year, so you paid 18 x $25 = $450 in co-pay. However, (a) you might still need to pay the first $450 out-of-pocket for a surgery bill, because co-pays might not have counted towards your deductible and (b) even if you did pay $450 out of pocket, your next specialist visit might still cost $25, as specialist visits cost a fixed-cost co-payment.
Stage 2 — You pay partially for medical costs, with support from insurance.
1. Pay a fixed percentage "co-insurance": At this stage, you've exceeded your deductible; continuing our example from before, this means you've already paid $450 in medical bills. From this point on, you share costs with your insurance company. The percentage of medical costs that you pay is called co-insurance. This percentage is usually 20-30%.
2. Up until an "out of pocket limit": You'll continue to pay co-insurance up until a fixed maximum, called an "out of pocket limit". If your total medical costs for the year, paid out of pocket, exceeds the "out of pocket limit," insurance kicks in fully and covers all remaining medical bills.
3. Example: Say your out-of-pocket maximum is $1000 and your co-insurance is 20%. This means for the next $550 of medical costs, after the initial $450 you've already paid, you'll pay 20% of that or up to $110.
Stage 3 — You pay nothing, subject to some terms and conditions.
1. Be aware of what costs count towards your out-of-pocket limit:Again, not all medical costs qualify and contribute towards this out-of-pocket limit, so be aware of what each insurance plan includes. For example, balance billing in our previous example may not count towards out-of-pocket limits.

In sum, your insurance kicks in to cover more and more of your medical costs, as your medical bills grow. Here's a visual summary of the above three tiers of costs, using the amounts we discussed in our examples.

Now, how does this affect your decision making? Depending on your expected frequency of medical treatment, you may pick different plans based on their deductibles and out-of-pocket maximums.

For example, say your insurance charges co-payments for primary care and special visits — additionally, these co-payments are the same whether or not you hit your deductible. If you think your medical care won't require much more than those two services the coming year, then a cheaper health insurance with a higher deductible may work for you.

Do you have in-network providers near you?

In each health insurance plan, the above cost structure differs whether you're seeing in-network or out-of-network providers. There are a few differences between the two sets of providers.

Coverage: At the core of these differences is in what it means to be "in-network". An "in-network" doctor's office has made an agreement with your insurance company about what prices can be charged for what services. An insurance company may as a result completely refuse to cover an out-of-network provider.
Balance billing: As we mentioned above, "out-of-network" doctors haven't contractually agreed on a pre-determined price. As a result, you may end up paying more for the same service when seeing an out-of-network provider, as opposed to an in-network provider. The difference between an in-network service charge and an out-of-network service charge is called balance billing. You can learn more on Aetna's "Cost of out-of-network doctors and hospitals" page.
Different cost structure: Your deductions and out-of-pocket limit is both higher and separate for out-of-network providers, when compared with your deductions and out-of-pocket limits for in-network providers. This means that if you reach your out-of-pocket limit for in-network providers, out-of-network services would still require out-of-pocket payments.

As a result, you should always look for in-network providers, to lower medical costs. Check with your doctor's office beforehand, to see if (a) your insurance is accepted. This means your insurance will at least lower your medical costs, but you additionally need to check if (b) that office is considered in-network. You can call the customer service number on the back of your insurance card to verify as well.

Always look for in-network providers, to lower medical costs.

Pick a type of health insurance plan

Based on your proximity to in-network providers, you can then decide on a health insurance plan. There are a few common types of insurance plans, with two being most prevalent:

Health Maintenance Organization (HMO): HMOs require covered individuals to use in-network providers, and out-of-network services must be paid out of pocket. Furthermore, HMOs require referrals from a Primary Care Physician (PCP) for you to see a specialist. However, in exchange, HMO premiums and out-of-pocket limits.
Preferred Provider Organization (PPO): PPOs cover both in-network and out-of-network providers, although the latter costs more. PCP referrals are not required but feature higher premiums and out-of-pocket limits.

In this sense, HMOs are cheaper but less flexible, while PPOs are more expensive but more flexible. There are also government-sponsored insurance plans, such as Medicaid for low-income individuals and families, as well as Medicare for individuals with disabilities or over 65 years old. Other insurance types such as Point of Service (POS) combine parts of HMOs and PPOs.

You can learn more about these types of insurance plans from Investopedia's HMO, PPO, and POS pages. For now, we'll discuss just one more type of health insurance, which offers a unique tax-saving savings account.

Health Savings Accounts

Some health plans charge low monthly premiums in exchange for a high deductible. If the deductible exceeds $1,500 and the out-of-pocket maximum exceeds $7,500 for an individual in 2023, the IRS considers that health plan a High Deductible Health Plan (HDHP).

Any individual with an HDHP in turn qualifies for a Health Savings Account (HSA), which offers federal tax benefits — much like the retirement savings accounts we discussed in How retirement savings work. Specifically, there are three benefits to an HSA:

Contributions are tax deductible.
Contributions grow tax-deferred.
Qualified withdrawals are tax-free.

Note that there are also several limitations for an HSA:

The maximum annual contribution is $4,150 for 2024.
Withdrawals are tax-free only for health expenses, such as physical therapy, birth control treatment, wheelchairs, personal protective equipment (PPE), crutches and more.

In this sense, HSAs are another investment vehicle that can help reduce taxes, specifically for income spent on health expenses.

Takeaways

In summary, to lower medical costs, there are several critical ideas to understand:

You pay out-of-pocket until a deductible, then pay co-insurance until an out-of-pocket limit.
Out-of-network providers are more expensive than in-network providers due to coverage, balance billing, and different cost structures (e.g., deductible, coinsurance, and out-of-pocket limits are higher for out-of-network services)
An HMO charges lower premiums but requires you to see in-network doctors and requires referrals for specialists. A PPO charges higher premiums but has no such restrictions.
HDHPs offer Health Savings Accounts (HSAs), which operate similar to retirement savings accounts. HSA contributions are tax-deductible, growth is tax-deferred, and qualified withdrawals for health expenses are tax-free.

Using the above, you should now have enough information to decide on a health plan. My own two cents here: I personally err on the side of caution when it comes to health, and this is one area I'm more willing to spend money on. Given that, I always pick PPO.

For more resources, make sure to read your official insurance policy. The post gives you enough information about the basics to understand the different components of health insurance and what to learn more about. You can also see Investopedia's guide on the topic of Health Insurance: Definition, How it Works.

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