What Is Medicare?

The US Medicare program began in 1965 to address issues of access to care for three groups of Americans: the aged, the disabled, and people with end-stage renal disease (ESRD) or amyotrophic lateral sclerosis (ALS or Lou Gehrig’s disease). (The Medicaid program, also begun in 1965, covers low-income Americans.) Enrollees in Medicare are referred to as beneficiaries. Some beneficiaries are eligible for both Medicare and Medicaid and are referred to as dually eligible beneficiaries.

Beneficiaries become aged eligible for Medicare at the age of 65 years. Those under the age of 65 years can qualify for Medicare if they are entitled to disability benefits under the Social Security Disability Insurance (SSDI) or Railroad Retirement. ESRD eligibility is open to Americans who have ESRD or ALS and who have met the required work credits for, or are receiving, Social Security or Railroad Retirement benefits, or are the spouse or dependent child of a person receiving those benefits.

The Medicare program is divided into four different ‘Parts,’ due largely to historical and political influences. Part A covers primarily hospital charges, but also home health, hospice care, and care in skilled nursing facilities. Part B covers primarily medical expenses (including many physician charges incurred during hospitalization). Part C covers the payment of private health plans in Medicare – originally referred to as Tax Equalization and Fiscal Responsibility (TEFRA) risk plans, then Medicare þ Choice, and now Medicare Advantage (MA) plans. For many years, Medicare did not cover outpatient prescription drugs, except through some MA plans. That changed with the introduction of Medicare Part D in the 2003 Medicare Modernization Act (MMA) legislation. Part D coverage was first offered in 2006. Long-term nursing home stays are not covered by any part of Medicare.

The basic Medicare entitlement benefit package reflects health insurance coverage in the USA in 1965. In 2013, beneficiaries face a deductible of $1184 per hospital stay during a ‘benefit period,’ plus $296 per day for days 61 through 90, $592 per ‘lifetime reserve day’ over day 90 for each benefit period up to a maximum of 60 lifetime reserve days. Part D has a complex coverage structure that includes a coverage gap (referred to as a donut hole) that extends from total spending equal to $2970 to $6733.75 in 2013.

The entitlement benefit package, which reflects typical insurance benefits in 1965 when the program was established, has been criticized for its meager level of coverage. Medicare beneficiaries face the possibility of unlimited out-of-pocket expenses. As a result, approximately 90% of beneficiaries in fee-for-service (FFS) Medicare purchase private supplementary insurance or ‘Medigap’ policies that cover the coinsurance and deductibles for Medicare-covered services. These policies add to total Medicare costs because the effect of supplementary insurance is to reduce point-of-purchase cost sharing – in some cases to zero. The result is increased demand for services, and the Medicare program picks up approximately 80% of that additional cost, whereas the premiums for supplementary insurance reflect only the 20% paid by the supplementary insurer. Reform of the Medigap market is a topic of perennial policy interest, but there have been no substantial changes till date.

Although Medicare often is thought of as a ‘public’ insurance plan, its administration and delivery of services occur primarily through private health-care providers, health plans, and claims-processing firms under government contract. The traditional Medicare program contracts with private firms to pay health-care providers on a FFS basis and thus is referred to as FFS Medicare. Beneficiaries enrolled in MA plans are referred to as MA enrollees. Part D coverage is offered either through MA plans or by private stand-alone companies selling outpatient prescription drug coverage.

MA enrollees pay the same Part B premiums as beneficiaries in FFS Medicare, and MA plans receive a per-capita rate for each beneficiary they enroll. The level of capitation payment has been a source of controversy over the years. MA and Part D plan switching is limited to annual open enrollment periods.

How Is The Medicare Program Financed?

There are two trust funds through which Medicare funds flow: the Hospital Insurance (HI) and Supplementary Medicare Insurance (SMI) trust funds. Part A expenses and the costs of program administration appear in the HI Trust Fund, whereas expenses for Parts B and D appear in the SMI Trust Fund. Administrative costs of running the Medicare program are represented in trust funds. The trust funds are administered by a Board of Trustees for Medicare that issues annual reports describing the state of the funds.

The trust funds are used solely for accounting purposes. Revenue and expenses do not actually flow through the trust funds. However, the HI Trust Fund balance is ‘real’ in the sense that Part A Medicare payments cannot be made if there are not adequate funds credited to the HI Trust Fund.

Part A is financed primarily through payroll taxes. The current payroll tax rate is 2.9%. Parts B and D are financed primarily through general taxes and beneficiary premiums. Beneficiary premiums are set at 25% of Part B and Part D costs. Part B premiums are means tested (increase with income) for beneficiaries whose incomes exceed $85 000 or $170 000 for a couple. The base-level monthly Part B premium in 2013 was $104.90 but rose to $335.70 for beneficiaries with incomes greater than $214 000, or couple with incomes greater than $428 000. The Part B deductible in 2013 was $147 per year.

Because Part A revenue is limited by the total level of taxable payroll income for the nation’s workers, it is technically possible for the Part A trust fund to become insolvent. Parts B and D have access to general tax revenue and thus they cannot become insolvent in the same sense as Part A, although increased Part B and Part D spending can limit other types of government spending. Thus, the most closely watched portion of the annual trustee report is the projected number of years until Part A payments will exceed the amount of money credited to the HI Trust Fund. That time span has varied from as little as 2 years in the early 1970s to the high 20s in early 2000s.

Since the introduction of capitated private health plans in the mid-1980s, payments to MA plans have been based roughly on a percentage of the cost of caring for beneficiaries in traditional FFS Medicare in the same county, adjusted for a set of risk factors. Because the average cost of caring for beneficiaries in FFS Medicare varies dramatically from one county to another, even when the counties are geographically proximate and after adjusting for the health risk of beneficiaries, government payments to MA plans also have varied dramatically.

MA plans must provide the entitlement benefit package, but are free to use any excess revenue to offer additional supplementary benefits to their enrollees. As a result, the amount of supplementary benefits offered by MA plans also varies dramatically from one county to another. In counties with low FFS spending levels, beneficiaries must pay an additional out-of-pocket premium above and beyond the Part B premium for the same benefits received for free by beneficiaries in counties with high FFS spending. The geographic disparity in government-financed benefits is a source concern due in part to issues of equity and in part to the lack of evidence that higher FFS spending is associated with either higher health risk or better health outcomes among FFS Medicare beneficiaries.

Expenditures And Cost Trends In Medicare

In 2010, approximately one-third of Medicare spending was for services covered only by Part A, whereas one-fifth was for services covered only by Part B. Payments to MA plans accounted for 23% of spending and Part D expenditures were approximately 11% of spending. Areas of particularly high growth in recent years have been home health-care and imaging services.

Cost concerns surfaced in the earliest days of the Medicare program. In 2012 Medicare’s unfunded obligation over the next 75 years was $27.2 trillion. The US federal debt currently exceeds the US gross domestic product. As the mass of Americans born after World War II (‘baby boomers’) begin to reach the age of 65 years, the Medicare population will roughly double. Taxable income, particularly payroll income, will fall dramatically as the ‘boomers’ retire, as will the number of workers per Medicare beneficiary.

The geographic variation in FFS Medicare costs remains a controversial topic. Some analysts have found that much of the variation in cost is unrelated to either the health status or health outcomes of beneficiaries, whereas others find that sociodemographic characteristics explain a large proportion of the variation.

There have been several important responses to cost concerns over the life of the Medicare program. During the early 1980s, Medicare switched from cost-based reimbursement for inpatient care to a prospective rate per admission for Part A expenses. The Resource-Based Relative Value Scale introduced in the late 1980s was an attempt to reweight the fee schedule toward the work performed by primary care physicians.

Payments to providers and MA plans were reduced significantly in the Balanced Budget Act (BBA) of 1997, but some of the cuts were restored in subsequent legislation. The 1997 BBA legislation introduced the sustainable growth rate (SGR) legislation that mandated across-the-board reductions in physician fees if expenditures on physician fees grew too rapidly. Physician fees actually were cut by 5.4% in 2002, but since then, Congress has found ways to circumvent the mandated cuts. As a result, the SGR legislation now requires roughly a 30% cut in physician fees. A fee cut of that size likely would reduce physicians’ willingness to see Medicare patients. Thus, each round of budget negotiations includes discussion of ways that the SGR ‘problem’ could be ‘fixed.’ Doing so, of course, would add to Medicare’s projected unfunded deficit.

There was some hope in the 1980s that the introduction of capitated private plans would reduce the rate of cost growth in Medicare. Instead, paying MA plans a percentage of FFS Medicare costs, coupled with an inadequate risk adjustment system, resulted in private plans costing the program more money – a problem that continued through the 2000s, when private plans in low-cost areas were given supplementary payments in response to the geographic disparity in supplementary benefits offered by MA plans.

Options for cost reduction are more limited in FFS Medicare than in private health plans. FFS Medicare lacks the statutory authority to intervene in the patient care process, for example, by installing disease management programs except as demonstration experiments. Medicare does have an approval process for new technology, but continues to pay for many treatments that have been shown to provide no medical benefit to beneficiaries. Early attempts to design preferred provider systems in FFS Medicare – systems that featured varying coinsurance rates favoring lower cost or higher quality providers – were stymied by pervasive Medigap insurance that protected beneficiaries from the effect of coinsurance. Medigap also exacerbates FFS Medicare’s cost problems by eliminating point-of-purchase cost sharing, thereby increasing the demand for services, and FFS Medicare pays approximately 80% of the cost of those additional services rather than having them reflected in Medigap premiums paid by beneficiaries.

The MMA of 2003 required an annual computation of the percentage of Medicare program revenues that come from general tax revenues. If that percentage was projected to be greater than 45% over the subsequent 7-year period, the Board of Trustees must issue a warning. If such a warning is issued for two consecutive years, the President must propose legislation to reduce the projected percentage to 45%. Although such warnings have been issued every year since 2007, Congress has taken no action.

Future Policy Options

Medicare faces daunting fiscal challenges in the coming years due to inefficiencies in the way the program is administered and inadequate accumulation of revenue to cover the expenses of the mass of Americans who are beginning to become aged eligible for benefits. Medicare’s unfunded obligation is an important part of the entitlement problem in the USA and a major contributor to long-run growth in the federal debt.

Current policy proposals cover the full range of revenue increasing and cost-reducing options. Tax increases are a contentious alternative during a recession. However, the payroll tax was increased in January 2013, and further increases plus increases in beneficiary out-of-pocket premiums and cost sharing, as well as more aggressive means testing, remain viable but controversial options.

Cost-reducing options must operate through a reduction in the number of beneficiaries or the cost per beneficiary, which in turn is a function of the services delivered to each beneficiary times the unit prices of those services. One way to reduce the number of beneficiaries is to raise the age of eligibility. Current estimates suggest that the savings would be modest. Current legislation calls for significant reductions in provider fees or the rate of increase in provider fees. Hospitals will be penalized for excessive readmissions and hospital acquired conditions. Payments to ‘disproportionate share hospitals’ will be cut, as will payments for graduate medical education. Official assessments of the fiscal health of the Medicare trust funds are required to assume that Congress and the administration will adhere to the laws that Congress has passed, even though few analysts actually believe that is the case.

Medicare fees currently average approximately 80% of fees paid by private insurers in the commercial (private) insurance market, whereas fees under the Medicaid program for low-income Americans typically are lower than Medicare fees. The 2010 Patient Protection and Affordable Care Act is estimated to add 33 million Americans to the ranks of the insured, and many of the newly insured will be purchasing private insurance. At the same time, there is no significant change to the supply of services by health-care professionals. Thus, a dramatic increase in the privately insured could result in severely reduced access for Medicaid beneficiaries, followed by difficulties for Medicare beneficiaries.

Although large across-the-board fee cuts in the Medicare program may prove infeasible, there are three other alternatives. The first is increased use of ‘bundled payments’; for example, bundling postacute care into the prospective payment for hospital admissions is an approach to reduce excessive use of services. The implementation of prospective hospital payment into diagnosis-related groups adjusted for medical severity (MS-DRGs) provides an encouraging precedent. Of course, the ultimate ‘bundle’ is capitation payment, as implemented in the MA program. Accountable care organizations (ACOs) are another attempt to place providers at greater risk for the cost of care. One difficulty with the ACO approach in the traditional FFS Medicare program is that beneficiaries remain free to see any provider they like, despite the ACO provider being at some risk for the cost of their care.

A second alternative payment reform is competitive bidding for some health-care services. The Medicare program has had some demonstrated success with competitive bidding for durable medical equipment.

The third alternative is ‘value-based purchasing.’ The PPACA legislation requires the Medicare program to design value-based purchasing programs for hospital and physician services. Limiting fee increases to providers who meet certain cost and quality benchmarks could provide a way to reduce average fees without compromising access or quality. Assessment of physician quality may improve with full implementation of the Physician Quality Reporting System (PQRS) that allows physicians to report clinical outcomes such as the patient’s blood pressure on a standard claims form. Participation in the PQRS system has been voluntary since its inception in mid-2007, and physicians were paid a bonus for participating. Beginning in 2015, however, nonparticipating physicians will face a financial penalty.

The PPACA legislation also establishes the Independent Payment Advisory Board (IPAB), a federal board charged with making recommendations to limit the growth in Medicare spending. Although IPAB has considerable power and discretion – either its recommendations must be implemented by the Department of Health and Human Services, or uHCongress must substitute equivalent cost saving – the scope of measures that it can recommend is severely limited. For example, it cannot recommend denial of care, or changes in eligibility standards, taxes, or beneficiary cost sharing.

There are numerous proposals that involve more basic restructuring of the Medicare program. Medicare beneficiaries currently are entitled to both a specific package of benefits (coverage) and the traditional FFS delivery system with out-of-pocket premiums limited to the national Part B premium, regardless of the actual level of FFS costs in their local market area. Conversely, MA enrollees face an additional out-of-pocket premium in areas with low FFS spending levels and subsequently low MA payment rates. One policy option is to retain the entitlement benefit package but to have both MA plans and FFS Medicare submit bids for that package and set the government’s contribution to premiums equal to the lowest or second lowest bid in each county. That would mean that beneficiaries might have to pay an additional premium above and beyond the Part B premium for FFS Medicare, as they do now for MA plans in some market areas. In such a ‘competitive pricing’ or ‘premium support’ system, MA plans might have an advantage in areas where high FFS costs were due to inappropriate overuse of services that could be reduced through more aggressive selection of efficient providers or more careful management of care. However, FFS Medicare might have an advantage in areas with higher provider market concentration and subsequent market pricing power, if FFS Medicare’s administratively determined fee levels were substantially lower than the prevailing rates charged to private insurers.

Although the list of policy options is broad, its ability to produce a significant reduction in Medicare spending per capita is limited by the resolve of elected officials to make difficult decisions. The history of congressional self-discipline through initiatives such as the SGR and ‘45 percent rule’ is not encouraging. In fairness, however, congressional resolve is limited by the voter’s preference. The US Medicare program faces many of the same long-term challenges as government provided benefits in other countries – a discrepancy between public demand for more generous benefits and the public’s willingness to pay for those benefits. The problem in the USA is exacerbated by the high unit prices paid by the government and the government’s inability to control utilization. The result, to date, has a massive projected unfunded deficit that, in the absence of serious reform, will have to be paid by future generations, born and unborn, who are not able to vote on current policy.


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