At first glance, Japan’s health care system, like its people, seems to be in remarkably good shape. The country’s National Health Insurance (NHI) plan provides generous, universal coverage. The Japanese suffer relatively low rates of disease and have among the highest life expectancy in the world. And spending on health care is lower than in most Organisation of Economic Co-operation and Development (OECD) countries, thanks to strictly controlled reimbursement levels.

But Japan, like many other economically advanced countries, faces mounting health care expenses that will be difficult to support using current methods. The most important cause isn’t Japan’s much-discussed aging population. Instead, new research from the McKinsey Global Institute (MGI) indicates that most of the increase will result from technological advances in medical care, which drive up the cost of treatment, and from rising wealth levels, which lead individuals to seek care with greater frequency as well as making them more willing to pay for higher-quality treatment. These factors, combined with changes in demographics and treatment patterns, present a challenge so large that the conventional levers used to finance health care, such as increasing copayments¹ or insurance premiums, can’t overcome it.

Three other options offer promise: restructuring the reimbursement system to reduce wasteful spending; introducing a financing system that allows patients to pay more for elective procedures; and raising overall contribution rates to bridge the remaining shortfall. Government efforts to consolidate the vast number of dispersed medical centers may also help to reduce costs. While none of these options will single-handedly solve Japan’s health care financing challenge, in concert they should help close the gap.

The funding gap

If Japan’s current health care policies continue, a wide gap will open between the revenues the NHI system collects and the amount it spends. Our research indicates that total health care expenses borne by NHI will rise from ¥33.1 trillion (6.6 percent of GDP in 2005) to as much as ¥62.3 trillion by 2020 and ¥93.6 trillion (13.5 percent of GDP) by 2035: within 30 years, spending as a proportion of GDP will have doubled (Exhibit 1). Absent changes in the nature and collection rate of Japan’s current health care financing mechanisms (a mix of copayments, employment-based insurance premiums, government subsidies taken from consumption taxes, and taxes on income and real estate), the system will generate no more than ¥43.1 trillion in revenues by 2020 and ¥49.4 trillion by 2035, leaving a funding gap of some ¥19.2 trillion in 2020, widening to ¥44.2 trillion by 2035.

Sources of the gap

Four factors will contribute to the surge in Japanese health care spending (Exhibit 2):

• Advances in medical technology, such as targeted therapies for cancer and applications based on genomics and proteomics, will continue to make health care more expensive. These treatments are projected to increase spending by ¥6.2 trillion to ¥9.4 trillion by 2020 and by ¥15.4 trillion to ¥23.7 trillion by 2035. This category represents 40 percent of the system’s total increase in costs.
• Growing economic wealth will allow people to seek more health care services. As a result, spending on medical care by both the government and the public is projected to increase by ¥6.8 trillion to ¥9.1 trillion by 2020 and by ¥15.3 trillion to ¥16.8 trillion by 2035—representing approximately 26 percent of the total increase in the country’s health care costs.
• Japan’s aging population is expected to increase the system’s medical costs by an estimated ¥7.1 trillion to ¥7.4 trillion by 2020 and by ¥10.2 trillion to ¥10.6 trillion by 2035. Aging accounts for 18 percent of the total rise.
• Finally, new treatment patterns caused by a changing mix of diseases, such as an increase in cancer and decrease in infections, are likely to add between ¥3.1 trillion and ¥3.3 trillion in spending by 2020, or ¥9.1 trillion and ¥9.4 trillion by 2035. At 16 percent, this category represents the smallest portion of the total increase in health care costs.

Dramatic as these cost increases sound, they may in fact underestimate the challenge Japan faces: they do not account for the impact of changing lifestyles—including less physical activity and a westernization of diet—that would lead to a deterioration of the population’s health. As the repercussions of lifestyle changes play out over time, the demand for medical care could become even greater than we have projected.

The factors driving the increase in costs can’t be addressed directly, however: no country wants to curtail economic growth or reduce the longevity of its population. And slowing down the development or introduction of advanced medical technology could reduce the quality of care. Indeed, a recent slowdown in the introduction of new drugs and devices in Japan has become a matter of increasing public concern.

The burden on Japan

The full extent of the challenge becomes even more apparent when we estimate how it will affect the average employee. Households currently spend just 6.6 percent of their total income on medical care, but this figure could rise to as much as 22.5 percent by 2035. Such an increase, combined with the estimated trajectories of social-security contributions and taxes, could raise the total sum that workers pay to the government and social security from 18 percent of household income today to 37 percent by 2035.² This level of mandatory contributions would exceed the burden paid by many workers in countries with some of the highest social-security contribution rates on household income in the world, such as Sweden (36 percent) and Germany (40 percent).

If unaddressed, a financial burden of this magnitude could make the country a less attractive place to create and maintain private-sector employment, threatening Japan’s long-term economic performance. What’s more, the prospect of such a financial drain could lead the working population to boost savings and cut consumption, which would further dampen economic growth.

No easy answers

To ease the burden of rising health care costs, Japanese policy makers need to seek out alternatives. Unfortunately, the idiosyncratic nature of Japan’s health care system makes doing so a formidable task.

The limits of current financing mechanisms

Consider the political and economic limitations of current financing mechanisms (copayments, insurance premiums, and subsidies from taxes). If Japan kept copayments at current levels, for example, it would have to institute a significant increase in premiums, consumption taxes, or a combination of both by 2035. As Exhibit 3 shows, to meet shortfalls through premiums alone, policy makers would have to raise those rates to 24 percent, from 8 percent. Adjusting only the tax subsidies would require increasing, for example, the consumption tax to 13 percent, from the current 5 percent. A combined adjustment might involve raising premiums to 13 percent while boosting the consumption tax to 10 percent.

Any increase in premiums is likely to encounter opposition from both employers and workers. While the current consumption tax rate of 5 percent is low by international standards, policy makers are concerned that any increase would throw the economy into recession—the result in 1997, when the rate jumped to 5 percent, from 3 percent.

Alternatively, policy makers could raise copayment rates, although today they are among the highest in the world. Copayments for people aged 3 to 69 hit 30 percent in 2003. For citizens 70 or older, the government recently considered doubling copayments to 20 percent, from 10 percent. Even if copayment rates increased to 40 percent across the entire population,³ they would cover just 25 percent of medical expenditures, compared with 14 percent today. To close the funding gap further would require additional measures, such as boosting consumption tax rates to 11 percent or raising insurance premiums to 20 percent (from the current 8 percent), or by combining the two levers by increasing the consumption rate to 8 percent and insurance premiums to 13 percent.

Other funding levers are available, but they raise similar problems. For example, the government could raise income tax rates to close the funding gap. This measure would have to be done rapidly to produce the necessary effect, however, creating another set of political and economic challenges.

To be sure, Japan can—and will need to—raise some additional financing by increasing premiums, copays, taxes, or a combination of these categories. Political and economic conditions will determine which approach will be feasible (making it difficult to calculate precisely how much of the funding gap policy makers can close with each lever). But given the challenges of solving the problem through these means alone, the country will need to consider alternatives.

The system's unique features pose further challenges

Besides the sensitivities surrounding these traditional levers, Japan’s unique health care system makes it difficult for the government to introduce financial mechanisms that are available in other countries.

Most OECD countries, for example, limit health care costs by excluding items that are deemed elective or by mandating a more cost-effective treatment system. Several advanced economies, such as Germany and Switzerland, have also used voluntary-payment systems to raise funds. In Japan, however, a focus on constraining costs rather than the scope of treatment, the absence of gatekeepers and institutional checks, and weak coordination among entities that allocate medical resources impedes the pursuit of these options.

A focus on fees charged, not scope of treatment. While many countries rein in costs by limiting the scope of medical care, Japan has focused on constraining the cost of treatment. Since 1990, the government has implemented a relatively strict policy that has capped increases in both medical-treatment fees and the price of drugs to around 2 percent annually since 1995—far below that of other OECD countries. The government recalibrates reimbursement fees every two years at a level that allows it to meet its national health care budget. How long Japan can pursue this strategy without making some treatments unprofitable for providers, thus compromising the quality of care, is unclear.

No gatekeepers. To date, Japan’s NHI lacks a gatekeeping system to determine whether patients require the treatment they seek, and NHI rules prohibit institutions from turning away incoming patients. NHI’s comprehensive coverage allows someone with a cold to seek treatment at a university hospital when he or she could be treated more efficiently at a clinic or with over-the-counter medications. The only disincentive for patients pursuing this course is the long waiting time—often a few hours—before they can see a doctor in a hospital. While most developed countries provide easy access to required medical services, Japan is unusual in that it doesn’t verify the necessity of medical procedures beyond initial, general approval.

No institutional checks. Although Japan’s health care system aims to control costs by requiring all providers to choose from an approved set of treatments for the same diagnosis, it lacks institutional checks on whether these treatments are reasonable and cost effective.

What’s more, standardized care leaves little room for providers to offer premium or alternative services to consumers who would be willing to pay for them. Although Japan has very recently started to allow private payments at NHI institutions (for instance, for out-of-hour consultation and treatment), it continues to limit the choices patients have for privately funded health care.

Uncoordinated medical resource allocation. Given that medical services and their reimbursement are so tightly regulated, one might expect that most of the institutions providing health care would be publicly owned and operated. Not so in Japan, which has a larger proportion of privately owned medical institutions than in even the United States. This climate is the product of a government policy following World War II that encouraged the expansion of medical provision primarily through private initiative and ownership. Most medical practices and hospitals, despite being private enterprises, rely overwhelmingly on fees received from the publicly regulated NHI.

With the exception of NHI reimbursement schedules, the Japanese government’s regulation of medical institutions is rather loose by international standards. Practices and hospitals may be opened anywhere, irrespective of existing geographical coverage and treatment area. Indeed, no authority controls how providers allocate medical resources. Given the relatively uncoordinated allocation of resources within the system, it is difficult to reduce overall costs, for instance, by rationalizing capacity.

Reforming the system

The idiosyncrasies of Japan’s health care system provide some direction for the path forward. Several reforms, if enacted in concert with some adjustments in current funding mechanisms, can go a long way toward helping Japan reduce waste, raise funds, and close its health care funding gap.

Limiting the scope of reimbursement

As we have seen, there is evidence that NHI is financing medical treatments and services—the excessive diagnosis and treatment of minor ailments such as colds, for instance—that ultimately provide little benefit for patients. To achieve higher productivity and cost efficiency, Japan should consider introducing some limitations on reimbursement.

The government might implement a system that offers incentives to treatment centers, encouraging them to avoid providing medical services it deems unnecessary, or one that even precludes them from doing so entirely. Medical spending would decrease accordingly. Some countries, such as the United Kingdom, have gone even further by refusing to reimburse treatments that are not considered cost effective compared with alternatives.

Shifting some of the burden from the reimbursement system to patients could change their behavior and help reduce spending on unnecessary medical services. If patients 70 years and older, for example, had a higher copay than just 10 percent, more of them might request lower-priced generic drugs. Similarly, requiring clinics to set budgets that allocate resources in the most effective way could help to contain overall spending.

Notably, only reimbursement changes that actually reduce spending will help Japan address its funding challenge. Reforms that simply force patients to pay a larger share out of their own pockets alleviate some of the burden on the reimbursement system but do not decrease medical spending. Nor does shifting the burden from insurance companies to patients eliminate Japan’s challenge of paying for the increased demand for health care.

Adjusting the scope of medical resources

Another option is to reduce the number of treatment facilities in Japan, an approach that some countries, such as Sweden, have followed. Consolidating hospitals and clinics may help remaining facilities operate more effectively. Plenty of evidence from Japan and elsewhere indicates that more procedures in the same facility can improve a physician’s skills and lead to better outcomes. Presently, almost half of all heart bypass operations in Japan are performed at hospitals that complete fewer than 50 such procedures each year. Patients at these facilities, moreover, suffer higher mortality rates. For this reason, countries such as Germany do not allow institutions that are considered subscale to offer these surgeries.

Concentration does have its downsides, however. Patients must travel farther for treatment and, in some cases (as in Sweden and the United Kingdom), face waiting times of up to several months before they can see a specialist or undergo a certain procedure. But citizens may well prefer these costs rather than having to finance a crushing medical burden.

Introducing voluntary-payment schemes

A number of countries struggling with the cost of health care have implemented voluntary-payment schemes to increase revenues. Several governments are gradually increasing the share of financing raised from such schemes (Exhibit 4). Many of these countries, such as Germany and Switzerland, have health care systems where individuals can influence the amount of money they spend on health care, either up front through their insurance policies or through discretionary out-of-pocket payments.

These health care systems benefit from the fact that some individuals are willing to pay significantly more than others for medical services, though often for only a few extras on top of the basic coverage. A system with a voluntary-payment component can contribute to the overall viability—and potential improvement—of universal health care.

Japan is currently engaged in a public debate about whether the country should adopt a mixed-payment system. Some have voiced concern that if private expenditures paid for access to medically necessary services, it would reduce access for those not able to afford them. However, it should be possible to design a system in which private payments cover only elective services.

In Germany and Switzerland, for example, private patients (those covered by private health insurance or paying out of pocket) mostly visit the same hospitals and clinics, are seen by the same doctors and nurses, and receive the same standard of care as public patients. However, in return for paying higher rates, private patients can, for instance, stay in single rooms, request diagnostics and treatments that are not deemed strictly necessary on medical grounds, and demand to be seen by the head physician even when their medical condition does not require this level of expertise. Voluntary payments from private patients go largely to the same doctors and institutions that public patients frequent—benefiting private and public patients alike. While the impact of a voluntary-payment scheme on most patients may sound subtle, its financial implications are substantial. Augmenting the standardized care currently mandated under NHI with a system that encourages voluntary payments has the potential to close the health care funding gap by up to 25 percent by 2035.

Japan’s choices are daunting, but it is not alone in coping with the need to raise health care financing. Several other advanced economies have faced the same issue and equally challenging political and economic constraints, and most have managed to improve financing using the measures we advocate here. Japan can also tackle the funding gap through informed debate and careful decision making. The first step is recognizing that the financing mechanisms currently in place will not suffice. Broader reform—involving a restructuring of the reimbursement system and the rates at which individuals, particularly those with greater financial means, contribute—is the most promising solution.