America's health care system has produced an impressive stream of medical technologies for diagnosing and healing the sick -- but at an enormous cost.

Now, future advances in laser surgery, computer-aided diagnosis, artificial limbs and implants, and other technologies are threatened by new federal regulations designed to curb medical care costs, health policy analysts and industry leaders warn.

"The impact will vary from company to company," said Jerry Robertson, president of Minnesota Mining and Manufacturing Co.'s health products and services division, "but there will be a quantitative slowing of the growth of research and development investment."

"We're concerned about the constraints on the development of beneficial medical technologies," said Robert Molitor of General Electric Co.'s medical systems group, a leader in the $20-billion-a-year medical instrument industry. "The risk is that we'll wait until, with hindsight, we're able to document the horror stories."

These worries illustrate how difficult it now is to advance health care quality while containing medical costs. Many experts contend that a decline in innovation may be a necessary trade-off in the battle to trim the nation's $360-billion-a-year health care bill.

The new regulations, now being phased into the Medicare system, are intended to limit the amount a hospital can be reimbursed for treating a patient. There are now 467 of these treatment categories, known as Diagnosis Related Groups, covering a wide range of illnesses and procedures. The DRGs give hospitals a powerful incentive to cut costs, because they will not be paid for expenses that exceed a specific DRG cost limit. Private insurance companies also are exploring the DRG concept.

This method of reimbursement represents a radical shift from the old cost-plus system where hospitals were compensated for virtually every test and treatment given to a patient. Although this system spawned a great deal of excess treatments and waste, it also gave hospitals an economic incentive to purchase new, better and more expensive technologies for diagnoses and treatments. This, in turn, prompted medical technology companies to invest heavily in research and development for product innovation.

The new system encourages hospitals to be much more cost conscious when they buy or replace equipment. For example, many hospitals are planning simply to hold on to their existing technologies for a few more years. A technology that works better but costs more may not find its way into the hospital if the cost pushes it too close to the DRG reimbursement cap.

All this is having a direct impact on the medical technology industry. Many companies are de-emphasizing new product innovation in favor of developing lower-cost products.

"Economics is the primary motivator now," said Brian Dovey, president of the Rorer Group's surgical products division. "There's ample evidence that medical companies responded to the past system of incentives, and we are now responding to the current system.

"The discussion used to be with how the patient will benefit. Now we spend a lot more time documenting on how the technology is cost effective," Dovey said.

But "cost effective" is a subjective term. Many argue that DRGs focus more on short-term costs than long-term effectiveness and raise a significant barrier to technologies that ultimately may be better investments.

For example, GE's Molitor said that "there are various kinds of prostheses and implants that last longer than other kinds, but there is no incentive under DRGs to use them because they would put costs over the DRG limits."

"This is the classic problem with regulation," asserted Roger Noll, a Stanford University economist who has analyzed the impact of regulation on technology in telecommunications and health care. "When you . . . regulate technology, all kinds of economic perversities get introduced. Some things will be retarded; some things will be unacceptably encouraged. Arbitrary accounting principles will drive the pattern of technological change."

Part of the problem is that, until the imposition of DRGs, neither the hospitals nor the medical technology industry had many incentives to reduce their costs. "Me-too" products and products with only marginal improvements poured out of the labs and were snapped up by hospitals that could afford not to be discriminating.

"Newer is not necessarily better," said Dr. Robert Rubin, formerly the assistant secretary for planning and evaluation at the Department of Health and Human Services and one of the architects of DRGs. "One sees a lot of excess technology that drives up the cost."

He argues that patients have been paying more and more for only marginal improvements in the technologies. That's just not cost-effective, he maintains.

Industry executives widely concede that they have given low priority to cost factors but argue that the new regulations will do more than just remove the excesses.

"I think Rubin is underestimating the economic incentives of the reimbursement system," said Frank E. Samuel Jr., president of the Health Industry Manufacturers Association. "The focus is now cost per case. We see research and development investments directed that way. Products that may be quality-improving but cost-adding will be second-class citizens."

"In a retrospective-reimbursement environment, we would find a product that meets an unmet need in the market," said Steven Lazarus, senior vice president for research and development at Baxter-Travenol Laboratories. "What I look at today is very different."

Baxter Travenol and other medical technology companies are exploring how they can use technology to reduce the cost of patient care. Because labor is by far the largest chunk of health care costs -- some estimates place it as high as 65 percent -- companies are looking for ways to substitute technology for labor. For example, Baxter Travenol has developed an intensive-care-unit technology for premature babies that requires less direct human supervision and is thus cost-saving.

"There will be innovation tied to reducing the cost of a procedure," said Rorer's Dovey. "We have a great opportunity to replace labor and overhead with our product."

However, industry executives concede that swapping technology for labor may reduce the cost of health care, but not necessarily improve its quality.

But others maintain that the new regulations will have only a minimal impact on medical technology development. "I don't think DRGs will have any negative effect on research and development investments for medical technology companies," Rubin said. "What I'm suggesting is that innovation doesn't have to be stymied by cost."

Moreover, he said that various bodies such as the Prospective Payment Assessment Commission have been established to evaluate the potential of new technologies to assure that the new regulations don't pose a barrier to possible medical breakthroughs.

"We are set up in a way to keep the vitality of the industry moving forward," said Stuart Altman, chairman of the commission. "That doesn't mean that we're going to recommend every new technology just because it's new. We will be trying to bring on line those technologies which are valuable even though they are expensive. The idea that this system will seriously erode high quality and important technology, I find hard to accept."

Altman pointed out that review mechanisms are in place to encourage technology introduction and increase the DRG reimbursement levels to account for new technology improvements.

But GE's Molitor insists that "there's a Catch 22 in the recalibrations system. Things are based on two- or three-year-old data at best, and then it takes another two or three years to recalculate DRGs." He said that the result is a significant time lag for introducing new technologies.

That could hurt innovation in another way, 3M's Robertson said. "One of the changes caused by this revolutionary environment is that it's going to be tougher on smaller companies. The trend of the DRGs is to favor the more established, full-line companies."

Executives at the larger medical companies agreed that they are in a better position to wait out the delays in technology introduction. Moreover, because they are more diversified than newer, smaller companies, their research and development investment risk is similarly spread out.

A recent Office of Technology Assessment study on the medical devices industry asserted that smaller companies tend to be more innovative than their larger counterparts.

The emphasis on low-cost technology also may provide a competitive advantage for Japanese and European medical technology companies.

"We're one of the few manufacturing sectors with a $1 billion trade surplus," said HIMA's Samuels. "We export twice as much as we import. It's clear that our success is innovation-based. Quality is what sells you abroad."

However, it is clear that the new cost emphasis is going to force medical technology companies to be both innovative and cost-conscious.

"This industry had no economic barriers," Propac's Altman said. "To the extent that we introduce barriers, that's not all bad. I'm not prepared to accept the knee-jerk reaction that it is. Hospitals are going to be looking at technologies much more carefully now."