America has the highest health-care costs in the world, and nothing illustrates the problem more clearly than the irrational world of hospital pricing, where the same service with the same outcome can vary exponentially in cost. But the state of California has brought some clarity to this issue, and the rest of the country—both the public and private sectors—is taking notice.

In 2008-2009, executives with the California Public Employees’ Retirement System (CalPERS), which manages the nation’s largest pension and health benefits program, drilled down to find the biggest health-care cost drivers. Given the average ages of their 1.3 million members, arthritis was predictably high on the list. “We dug into it a little more and saw that price variation among hospitals for [single-joint replacement] surgery varied from about $15,000 to around $100,000, with the same outcomes,” says Ann Boynton, deputy executive officer for CalPERS Benefit Programs Policy and Planning. “There really was no excuse for that variation in pricing.”

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So CalPERS asked Anthem Blue Cross, its health insurance carrier, to find a better approach. Analyzing data from hospitals throughout the state, Anthem settled on an average price of $30,000 for single knee and hip replacement. The group identified hospitals—from large medical centers to smaller community hospitals—in each of the state’s 58 counties that could meet both that price point and geographic demand. Beginning in 2011, CalPERS told members that if they went to these approved centers, insurance would cover it all, save for the usual 20 percent coinsurance. If they didn’t, members had to pay the difference.

How did it work? The average amount Anthem paid to hospitals for a joint replacement dropped from $34,742 to $25,611, an overall savings of about $5.5 million during 2011 and 2012, with no loss of quality. Yes, that represents barely a drop in California’s overall $6.6 billion annual health insurance bucket. But the modest savings has led to a more significant revelation: Pricing is not tied to quality, says Boynton. In fact, that’s the problem. It’s still not clear what pricing is linked to. “We want to find things that are market-changing,” she says, “so the people of California can change behavior in a positive direction. That’s an important aspect of what we do as a government purchaser.”

As with any market-changer, there was pushback. Members expressed concern that their doctors didn’t have admitting privileges in the program hospitals or that they would have to travel farther. But no one was concerned enough, Boynton says, that they opted to pay the difference. “We think this was successful because now people had real skin in the game.”

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Surgeons were surprised to learn the wide differences in hospital costs. “They knew what they got paid but not what the hospitals are charging,” she says. “This was a good example of shining a light into a dark corner.”

For other states or localities looking at competitive pricing models, Boynton says that “your plan partner is crucial for success. Anthem’s willingness to participate was very instrumental.” Communication with members is also critical. “You don’t want people getting shocking, horrifying medical bills out of the blue,” she says. “Preauthorization intervention—so members are well informed as they move into this kind of process—you can’t underestimate how important that is.”

Be prepared for serious blowback from high-priced hospitals too. “We had some fairly irritated hospital CEOs,” she says. The upside, though, is that the prices they charged for hip replacements also declined dramatically, from an average of $43,308 in 2010 to $27,149 in 2012.

Funny how competition works. “Government’s ability to find ways to change the economic dynamics by forcing change,” says Boynton, “is incredibly important.”