Employer-sponsored health insurance (ESI) is the largest source of health coverage for non-elderly U.S. residents. Unlike many other nations, the U.S. relies on voluntary, private health insurance as the primary source of coverage for residents who are not elderly, poor or disabled. Providing health insurance through workplaces is an efficient way of offering coverage options to working families, and the tax benefits of employer-based coverage further enhance its attractiveness. Yet, ESI often results in uneven coverage, especially for those with low wages or those working at smaller firms. Overall, 60.4% of people under age 65, or about 164.7 million people, had employment-sponsored health insurance in 2023. The level of coverage varies significantly with income and other factors, even among working families.
There are several ways people get private health insurance. One is by purchasing coverage directly from an insurer, often with the help of an insurance agent or through an online platform such as Healthcare.gov. Income-based premium assistance is available under the Affordable Care Act (ACA). This is called individual or non-group health insurance. The second is coverage under a policy or plan offered by a sponsoring group, such as an employer, union, or trade association. This is called group health insurance. When an individual is sponsored specifically by an employer (or sometimes jointly by one or more employers and a union, or by a group of employers), it is often referred to as employer-sponsored health insurance or ESI.
The word “insurance” is something of a misnomer here. An employer providing health benefits for workers and their families (“plan enrollees”) can fund them in one of two ways. Employers may purchase a health insurance policy from a state-licensed health insurer, which is referred to as an insured plan. Alternatively, the employer can pay for health care for the plan enrollees directly with its own assets, referred to as a self-funded plan. Employers with self-funded plans often protect themselves from unexpected high claim amounts or volume by purchasing a type of insurance referred to as stop-loss coverage. As discussed below, most ESI plan enrollees are covered by large employers, and most large employers self-fund their health benefit plans.
Another confusing set of phrases used in conjunction with health insurance, including ESI, is “health plan” or just “plan.” The terms can refer to an entity offering coverage (e.g. Aetna) or a particular coverage option offered by an insurer or employer (e.g. the PPO plan option). However, the terms “employee benefit plan” and “plan” have specific meanings in federal law and invoke several legal obligations for employers when they offer certain benefits to their workers and their family members. Under the Employee Retirement Income Security Act, or ERISA, an employee benefit plan, or plan, is created when a private employer creates a plan, fund, or program to provide certain benefits, including health benefits, to employees. ERISA creates a structure of disclosure, enforcement and fair dealing regarding the promises made by employers to enrollees in employee benefit plans. However, ERISA does not apply to the health benefit plans created by public plans or churches, although the word plan is often still used to describe benefits offered in these settings.
ESI plans can be differentiated across several dimensions.
Employers offer different types of health benefit options to employees. These include comprehensive benefit plans, which cover a large share of the cost of hospital, physician, and prescription costs that a family might incur during a year; service-specific benefits, such as dental or vision care plans; and supplemental benefit plans, which may provide a limited additional benefit to enrollees if certain circumstances occur (e.g. $100 per day if hospitalized). The discussion here will be limited to comprehensive benefit plans.
Health plans contract with hospitals, physicians, pharmacies, and other types of health providers to provide plan enrollees with access to medical care at a predetermined cost. Plan enrollees receiving services from one of these providers know that their financial liability is limited by their deductible and other cost-sharing amounts specified in their benefit plan. A closed-network plan is one where, absent special circumstances, an enrollee is only covered if they receive care from a provider in their plan’s network of contracted providers. In an open-network plan, an enrollee still has some coverage if they receive care from a provider not in the plan network, although they will likely face higher cost sharing under their benefit plan, and the provider may ask them to pay an additional amount (known as balance billing). Health maintenance organization (HMO) and exclusive provider organization (EPO) plans are two types of closed network plans. Preferred provider organization (PPO) and point of service (POS) plans are two types of open network plans.
Federal and state laws divide ESI into the small group and the large group market based on the number of full-time equivalent employees (FTEs) working for the employer sponsoring the plan. Federal regulation states that employers with fewer than 50 FTEs are often in the small group market and employers with at least 50 FTEs are in the large group market. However, states have the option to raise the small group market limit to fewer than 100 FTEs. The regulatory requirements for the small and large group markets differ somewhat. Generally, the small group insured market is subject to more extensive rules about benefits and ratings. Large employers are potentially subject to financial penalty under the ACA if they do not offer health insurance coverage meeting certain requirements to their full-time employees.
The drafters of the ACA intended to provide coverage options to those without access to employer-sponsored coverage without encouraging employers to drop coverage. To achieve this balance, the ACA requires that employers with at least 50 FTEs offer health benefits which meet minimum standards for value and affordability or pay a penalty. The so-called ‘employer mandate’ constitutes two separate penalties.
First, employers are taxed if they do not offer minimum essential coverage to 95% of their full-time employees and their dependent children. This generally requires that employers offer major-medical coverage and not a limited benefit plan. Employers face this penalty when at least one of their employees receives an advance premium tax credit (APTC) to purchase coverage on the health insurance exchange markets or Marketplaces. In 2024, this penalty stipulates that employers will be assessed a tax of $2,970 for each full-time employee after their first 30 employees.
Secondly, employers are penalized if the coverage they offer is not affordable or does not provide minimum value. Plans are considered to meet the minimum value standard if they cover 60% of the health spending of a typical population. In 2023, coverage was deemed to be affordable if the employee premium contribution is less than or equal to 9.12% of their household income. Employers may be charged $3,750 for each employee enrolling on subsidized Marketplace coverage.
Defining what constitutes ‘affordable’ has been the focus of considerable attention in recent years. The Obama Administration initially issued rules that workers and their dependents would be considered to have an affordable offer if self-only coverage met the affordability test. With many employers requiring much larger premium contributions to enroll dependents, this meant that as many as 5.1 million people were in households where they had to pay a larger share of their income to enroll in the plan offered by their employers without being eligible for premium tax credits. Recent rules have addressed the so-called “family glitch” by considering the cost of family coverage when assessing affordability. While most large employers offer health benefits, many may encourage spouses and other dependents to enroll in different plans if possible. For more information on eligibility for premium credits, see the Affordable Care Act chapter.
ESI is by far the most common source of private health insurance. There are two primary reasons for this. The first is that providing health insurance through the workplace is efficient, with advantages relating both to risk management and to the costs of administration. The second is that contributions towards premiums by employers and (in most cases) by employees are not subject to income or payroll taxes, providing a substantial federal and state subsidy towards the costs of ESI.
When people have choices about whether to buy insurance and the amount of coverage to buy, it is natural that people with the highest need for coverage (e.g. people in poorer health) will be more likely to purchase and be more willing to pay higher prices. This is called adverse selection. If insurers do not address these tendencies, their risk pools will become dominated by a relatively small share of people with the highest needs, and premiums will increase to levels that only make sense for those with very high expected costs.
There are several ways insurers seek to manage the risk profile of potential enrollees to avoid adverse selection. One is by examining the health profile of each applicant, which typically includes the applicant’s health history and pre-existing conditions. This strategy is reasonably effective, but an expensive and time-consuming process. A much lower-cost approach is to provide coverage to groups of people who are grouped together for reasons other than their health or their need for health insurance. Providing coverage through the workplace is a common way of doing this. Mostly, people choose a job because of the work, not because they need health insurance. Therefore, providing coverage through workplaces provides insurers with a fairly normal mix of healthy and less healthy enrollees if certain conditions are met. These conditions include enrolling a large share of the eligible workers in coverage (typically achieved by the employer paying a large share of the cost) and limiting the range of coverage options (to avoid adverse selection among plan types). Further, as the number of employees grows, the ability to predict future costs based on prior experience also increases, reducing the uncertainty in setting premiums for the group. As uncertainty decreases, insurers can reduce what they charge for insuring the group. Overall, the same scenario generally applies to situations where employers choose to offer a self-funded plan. Therefore, these advantages occur regardless of whether an insurer or an employer is taking on the risk.
In addition to the risk management advantages, ESI has many administrative advantages. Providing coverage through a workplace adds many employees to a risk pool through a single transaction, with no need to examine their health in most cases. Employers also provide and collect enrollment information to workers and collect the employee share of premiums, dramatically reducing the number of transactions and reducing the amount of unpaid premiums that typically occur when individuals purchase insurance directly from insurers.
Federal and state tax systems provide significant tax preferences for ESI. Generally, wages and other things of value employers provide as compensation to their workers are subject to federal and state taxes. The federal government taxes wages and other forms of income through a series of marginal rates that vary with income and the marital and filing status of the taxpayer. For example, the lowest marginal rate in 2022 for a single taxpayer was 10% for income below $10,275 and the highest rate was 37% for income above $539,500. Additionally, wages are subject to federal payroll taxes to support the Social Security and Medicare programs; employers and employees are each assessed 6.2% of wages up to a maximum wage for Social Security and 1.45% of wages with no wage limit for Medicare. Wages are also subject to state income and payroll taxes for unemployment, which vary considerably.
Unlike wages, ESI provided by employers as part of their compensation to employees is not considered income under the federal income tax code, nor are they considered wages subject to federal payroll taxes (See 26 USC sections 105 and 106). Federal law also permits employers to establish programs that exclude employee contributions towards ESI from these taxes. These exclusions lower the cost of health insurance for employees. For example, just considering the federal tax advantages, if an employee earns annual wages of $100,000, an employer can provide the employee with a $20,000 family policy for an additional $20,000 in compensation. However, if ESI were subject to federal taxes, that same employee would need to earn an additional $27,460 in wages to be able to buy a $20,000 family policy with after-tax dollars, assuming a 22% marginal federal income tax rate and a combined 15.3% payroll tax for Social Security and Medicare. Looked at another way, for this employee, for every dollar that the employer raises the employee’s compensation, the employee can get a dollar of health benefits or just under 63 cents in wages after taxes. State tax laws, which follow federal definitions of income and wages in this situation, further lower the cost of ESI for workers, although the impacts are much smaller.
The exclusion of ESI from federal income tax is a long-standing and somewhat controversial part of federal tax policy, first appearing due to a decision by the War Labor Board in 1942, which in turn allowed employers to use fringe benefits to attract workers during the war. In 1954, ESI exclusion was enacted in the tax code. This tax policy, combined with the risk management and administrative advantages of group coverage, contributed to the rapid growth and continued market dominance of commercial hospital and medical insurance during this period. Detractors of the tax exclusion have argued that it encourages workers to over-consume health insurance by demanding health benefits that are richer than what they would want under a tax-neutral approach (e.g. if health benefits were taxed in the same way as wages). Richer benefits, it is argued, contribute to higher health care costs because people with better insurance use more health care than they otherwise would since they are not facing the actual costs of care (sometimes called moral hazard). Another criticism is that the income tax exclusion favors higher-paid employees because they have higher marginal tax rates: the effective income tax benefit for a dollar of ESI is only 10 cents for a worker with very low wages but can be up to 37 cents for those with the highest wages. In contrast, the exclusion of health benefits from payroll taxes has the same dollar benefit for workers at all wage levels (up to the Social Security earning limit), which results in a higher percentage exclusion (share of wages) for those with lower wages. The tax exclusion was estimated to cost the federal government $273 billion (about $840 per person in the US) in income and payroll taxes in 2019.