(FORTUNE Magazine) – EPOCHAL EVENTS often go unnoticed at the time they occur. The morning after the Wright brothers proved that heavier-than-air machines can stay aloft, no metropolitan dailies proclaimed MAN FLIES in three-inch letters on the front page. Right now, only a handful of experts are excitedly talking about another ''impossible'' feat in American medical care, one worthy of the headline COMPETITION WORKS. But it could profoundly alter America's $820-billion-a-year health industry, whose runaway costs are devouring roughly a fourth of the increase in GDP in a normal year. In an unheralded breakthrough, Xerox and several other employer groups have used a novel pricing policy to wrestle down the inflation rate in workers' medical benefits. Formerly, since it cost a Xerox employee nothing extra to pick an expensive and inefficiently run health insurance plan, premiums were rocketing at a 20%-a-year clip (see chart). But beginning last year, the copier company began pegging its contribution to the cost of the most efficient health maintenance organizations. At Xerox, if you want health coverage that's more expensive than your local ''benchmark'' plan, you pay a substantial difference. Result: Many employees have switched to the benchmark HMOs, whose average premium rose only 7.7% in 1992 and next year will climb a mere 5.5%. Those numbers, painted big and in red, should be tacked to the office walls of President-elect Clinton's transition team. They show that, with the proper incentives, market forces alone can contain medical care outlays, just as they determine what is spent on cars, food, and housing. Xerox's cost-conscious pricing system is the first up-and-running example among FORTUNE 500 companies of ''managed competition.'' In essence, managed competition is designed to force HMOs and other managed-care systems to battle more vigorously for customers. It is the key element of a blueprint for reforming the health system developed by the Jackson Hole Group of experts and executives after two years of meetings in Wyoming. Several other companies, among them GTE and Digital Equipment, are working on programs similar to Xerox's. Some big government employers, such as California's Public Employees' Retirement System (Calpers), already have managed-competition plans. Economist Alain Enthoven of Stanford University, a co-author of the Jackson Hole proposals who coined the term and helped refine the concept, believes that the successes at Xerox and elsewhere are only a foretaste of what's possible. If managed competition became the rule rather than the exception in the U.S., Enthoven says, HMOs and other network-type health plans would dramatically step up their efforts to purge waste while enhancing quality. Says he: ''There are a whole lot of ideas out there that are ready to go on how health care can be delivered a lot more economically.'' Bill Clinton has promised to introduce a plan during his first 100 days to reform the health system and cover the country's 36 million uninsured. But the details are yet to come, and a major conflict must be resolved. In the latter months of the campaign, the Arkansas governor embraced managed competition as a general proposition. Yet he also espouses ''global budgets'' -- federally set spending targets that might include cost controls -- as the only way to contain total medical outlays. If Clinton opts for controls, as most of his advisers are urging, he will alienate a group of moderate and conservative Democrats, led by Representative Jim Cooper of Tennessee, who have introduced legislation along Jackson Hole lines. Dr. Paul Ellwood, head of a think tank called InterStudy and another Jackson Hole co-author, views health policy as the acid test of whether Clinton is the market-oriented Democrat he claimed to be during the campaign -- in Ellwood's words, ''whether he's a guy who interferes in the market or facilitates its working.'' MORE THAN two decades ago Ellwood, who coined the term HMO, advocated rivalry among prepaid plans as the way to get the country's health costs under control. Unlike conventional fee-for-service insurance, which offers almost no incentive to stint on costs and has thus fueled the sharp rise in medical spending by encouraging sick people to demand the costliest care, HMOs restrict a patient's choice of doctors and hospitals and strive to limit unnecessary procedures.

HMO membership rose rapidly during the Eighties, from eight million in 1979 to a present 39 million. Despite this growth, competition, innovation, and even cost saving have been feebler than Ellwood had hoped. Apart from a few regional business coalitions, employers have been loath to play hardball with HMOs on price. Even when labor contracts didn't require it, companies pegged their health benefits to the more expensive traditional plans. This encouraged HMOs to ''shadow price'' their product, making it cheaper -- but not much cheaper. HMO premiums are only about 15% lower, on average, than those of fee- for-service plans, according to a study by the Foster Higgins consulting firm. John Erb, a principal in the firm's managed-care practice in New York City, is underwhelmed: ''Here we are, 20 years later, and they're saving only 15%!'' The key to realizing the cost benefits that HMOs can offer, as Xerox has learned, is to offer a menu of options and then make sure that employees either pocket the savings offered by more efficient plans -- or pay for choosing more wasteful ones. While that sounds sensible, it wasn't initially obvious. Recalls Patricia Nazemetz, benefits director at Xerox: ''When I was looking at developing this around 1986 and 1987, there was a big push among employers to move faster into other kinds of things.'' One hot idea was single-sourcing, with which Allied-Signal dramatically lowered its health costs by awarding all its business to Cigna, the insurer. Cigna, which runs a network of open-ended HMOs that allow patients to go outside the system if they pay extra, has guaranteed that it will keep Allied's health care inflation considerably below 10% for the next two years. But finding a single source would have been difficult for Xerox, which operates at 250 locations in the U.S. Even if the company could have selected the ideal health care network to serve all its employees, Nazemetz says, the change would have been disruptive. Many workers would have been required to give up their doctors and start seeing new ones. She has another objection: If the relationship with the single supplier later breaks down, ''you run the risk of forcing everybody to move someplace else for their health care.'' Many other companies were pooh-poohing the idea of letting employees choose their health plans and allowing them an annual chance to switch. ''When you hear often enough that your idea is crazy,'' Nazemetz says with a laugh, ''you start to think that maybe it is crazy.'' But 40% of Xerox employees were already in HMOs, particularly in California and Rochester, New York. The HMOs thought Nazemetz was on the right track, and so did Enthoven, who met her early in 1989 and cheered her on. Competition among HMOs at each site was to be the cornerstone of Xerox's plan. But they couldn't be just any prepaid organizations; they had to meet quality standards akin to what Xerox, a Baldrige Award winner, expects of suppliers in its manufacturing plants. Because screening the 160 HMOs already serving Xerox at the time was beyond its capabilities, the company picked six managers -- among them Kaiser, U.S. Healthcare, PruCare, and Blue Cross of Rochester -- to do the selecting. Only 94 HMOs had passed muster when the company launched its HealthLink program for 1990. Others have since won approval, boosting the total to 185, but five have dropped out or were found wanting. Employee cost-consciousness did not come into play until the annual sign-up period in the fall of 1991. HMO membership grew, just as Xerox had hoped, from 52% of its U.S. work force to 59%, and the proportion in benchmark HMOs virtually doubled to 23%. Helen Darling, who runs the health program, says the latest annual migration is smaller, with the HMO contingent edging up to 62%. But the premium increases both for all HMOs and the benchmarks have fallen significantly. Xerox employees contacted for this article seem fairly content with their varied choices. Peggy Petrone, an administrative assistant at headquarters in Stamford, Connecticut, pays more than the benchmark amount to be in an HMO reputed to have some of the best doctors in the area. One drawback is that she has to pay half the cost of visits to her allergist, Dr. Paul Lindner. But she likes him and doesn't need to go through a ''gatekeeper'' family doctor to clear appointments with specialists, as most HMOs require. Compared with Xerox's fee-for-service option, Petrone says, ''I come out ahead.'' Mat Amundsen of Salt Lake City, on the other hand, says his wife had a bad experience with an HMO more than a decade ago. So he plans to stick with Xerox's fee-for-service plan as long as he can afford it, even though the premium costs him $1,406 a year extra. Meanwhile, Kaiser Permanente, the benchmark HMO in Ellie Garcia's part of Southern California, suits her just fine. Kaiser has made strides in overcoming its image as an impersonal chain of clinics, says Garcia, who runs Xerox's Western product distribution center: ''When I go there, I don't get the feeling of being herded through.'' Not content to rely on price competition alone, Xerox keeps honing the standards by which its HMOs are deemed eligible for HealthLink. A broad slice of the work force is surveyed annually on far more than overall customer satisfaction, which ranges from 70% for the least-liked HMO to 95% for one in Rochester. Employees are also queried on whether doctors ask them the right questions during checkups. Darling, who meets regularly with the six organizations that monitor the HMOs, says she spends half her time developing better quality measurements. Although Xerox offers the most striking evidence that managed competition can work as advertised, it is far from the only one. In 1989, Minnesota's state government became the first big employer to base its health care contributions for 120,000 employees and dependents on the lowest-priced HMO in each county. John Klein of the state's employee insurance division says that where the price differences on the menu are significant, ''employees are quite price-sensitive and move toward the lowest-cost plans.'' Not until this year did most of the plans' premium increases reach the promised land of single digits. Next year the premium of the lowest-priced HMO, Group Health of Minneapolis, will rise only 5.5%. Big companies like Xerox, or giant employers like the state of Minnesota, can carefully shop for health plans on their own. But what happens to the small fry under a managed-competition regime? The Jackson Hole crowd calls for the creation of new organizations, known as ''health insurance purchasing cooperatives'' (HIPCs), that would use their sophisticated knowledge and buying clout to procure HMO coverage at the best possible rates on behalf of a group of small employers. Calpers, which despite its name negotiates prices primarily on behalf of active employees of state and local government entities, already operates as a ''prototypical HIPC,'' according to Enthoven. He ought to know since he heads its health benefits advisory council. All told, Calpers lines up health coverage for 874,000 workers, retirees, and dependents at 784 public employers, including some as small as the Antelope Valley Mosquito Abatement District, which has two workers. Signing on with Calpers allows these smaller employers to buy insurance at rates that they could never get on their own. Boasts Tom Elkin, the Calpers assistant executive officer in charge of health benefit programs: ''We aggressively negotiate premiums, taking advantage of our $1.3 billion purchasing lever.'' Early in 1992, with the recession still squeezing state and local governments, Calpers sought a zero increase in HMO rates and was able to hold all but two health plans to an average increase of 3.1% for the 12 months beginning in August. That saved the system $90 million. The holdouts were California's two big Kaiser Permanente HMOs, which refused to budge from proposed increases averaging 10.5% and were disciplined with a one-year freeze on new enrollments. ''The freeze captured their attention,'' says Elkin, who reports he's ''optimistic that they will be more amenable'' in 1993 negotiations. Thanks to a recent standardization of benefits in Calpers's different plans, future competition on price and quality will no longer be blurred by a hodgepodge of different coverages. The high-cost option, says Elkin, ''will now stick out like a sore thumb.'' Stanford University's health benefits program is another competitive proving ground. Starting in 1992, the program, which was designed by Enthoven, requires every worker to contribute a token amount even to the cheapest of the four health plans on the menu. The Kaiser Permanente plan will cost $17 a month in 1993 for a single individual and $105 for a married couple with children. For the highest-price option, a preferred-provider organization (PPO) that allows unlimited choice of doctors outside the network, subject to co-payments and a stiff deductible, the corresponding contributions are $46 and $210. Two other offerings, both HMOs with broader choice than Kaiser, are priced in between. Jim Franklin, who runs the program, says employees have been migrating heavily out of the PPO. Managed competition has paid off in another way for Stanford. One of the two middle-priced HMOs originally proposed a 16% increase for next year, but after some university jawboning it fell in line with the other's 8% boost. Asked what his reaction was when he learned of this $900,000 concession, Enthoven says, ''Hooray!'' How much money could a nationwide system of true competition save? Answer: loads. Dr. David Lawrence, CEO of Kaiser Permanente's parent foundation, says his organization is beginning to apply the same analytical techniques that have boosted quality and cut costs at manufacturers like Hewlett-Packard and Motorola. ''Every time we roll over a rock,'' Lawrence says, ''we find startling things.'' One example is Caesarean operations, which are overdone in the U.S. Most women who have them assume that all subsequent babies must be born by C-section. But Kaiser has learned that 75% can have normal births, at less cost and less risk to mother and child. To spur the industry to look for similar savings, managed-competition advocates are calling on Bill Clinton and Congress to turn up the cost- consciousness dial. They would like to bar employers from deducting the cost of health premiums above those of benchmark health plans in a geographical area. In addition, workers who chose to spend their own money on costlier options, like Mat Amundsen in Salt Lake City, would have to pay the difference in after-tax dollars. In a major shift, both ideas have just been endorsed by the directors of the Health Insurance Association of America. National unions, which generally object to the concept of making workers pay extra for costlier plans, remain opposed. Local unions, however, have not obstructed any of the managed-competition arrangements already in place, and labor might in the end go along in return for making quality health care available to all the citizenry. The more serious worry is whether the health system can reform itself sufficiently, and fast enough, to produce the savings envisaged by Jackson Hole. ''I'm not sure managed competition alone will do it,'' says William Boyles, editor of the Health Market Survey, a Washington newsletter. BUT THE RISKS in putting bureaucratic constraints on an industry bigger than automotive, aerospace, and computer manufacturing combined are enormous. Nobody knows that better than Lynn Etheredge, a Washington health care consultant who is the other member of the Jackson Hole trio. Etheredge, a consultant to the Clinton transition team, is trying to find a way to adopt global budgets without imposing an innovation-stifling straitjacket. ''If Washington comes on like Attila,'' he says, ''I doubt if you'll ever get the reorganization of the system.'' So what should Clinton do? The most obvious step is to limit controls, if control he must, to relatively harmless expenditure targets. That would still keep alive the threat of sterner stuff, which is already concentrating minds in the health care industry. Following Clinton's election victory, an assemblage representing chiefs of every segment of the industry met at Jackson Hole and achieved what Paul Ellwood describes as a ''remarkable degree of consensus'' on how to push ahead with reform. That consensus, he says, was partly prompted by the dread of price controls. If history is any guide, controls are worth dreading. A few weeks ago, in an ironic juxtaposition, a New York Times editorial opposing bureaucratic controls on health costs ran side by side with a letter from an economist seeking to explain the Soviet Union's defeat in the Cold War. What did the Soviets in, says Franklyn Holzman of Tufts University, was ''an economy . . . without the incentives to be efficient enforced by market competition.'' Whether it's Russia, health care -- or the aircraft industry after the Wright brothers -- messing with the market is a bad idea.

BOX: CLINTON: WHAT TO DO

DO FOSTER cost-consciousness. Persuade Congress to cap the tax deductibility of health insurance plans that cost more than the most efficient managed-care networks.

DO USE your bully pulpit to encourage corporations to offer employees a menu of health plans. Workers who choose expensive plans should pay the difference between them and the ''benchmarks.''

DON'T IMPOSE national and state spending ceilings to slow the growth in health care costs. (But if you do, just make them targets.)

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: MANAGING COSTS DOWN AT XEROX Health benefit premiums were shooting up until the copier company, in January 1992, began pegging its contributions to the cost of the most efficient, benchmark HMOs. The increases shown above include the employee's share of the premium.