Achieving Progress on Medicare

Report Health Care Reform

Achieving Progress on Medicare

February 26, 2003 23 min read
Stuart Butler

America is once again embroiled in a bitter dispute about Medicare. This is not an issue of one side "for" good medical care for the country's seniors and the other side "against" that goal. Nor, more narrowly, is it a dispute over whether or not a modern Medicare program should cover prescription drugs. That is not in dispute. At the heart of the debate is whether improvements in Medicare should go hand-in-hand with structural reforms of Medicare.

The argument for linking improvements to reforms flows from two questions about the state of Medicare:

  1. How can we add new benefits when we cannot afford today's benefits for much longer? A glance at the current projections for the Medicare program is chilling. Huge future liabilities will require heavy taxes on future generations--even without any new benefits. This raises questions about the nature of the Medicare "social contract." Should we continue a program in a form that allows Bill Gates, when he retires, to receive essentially the same benefits as a checkout clerk? Or should limited resources be focused more on those who need them most?
  2. Why is Medicare so out of date that in 2003 we even have to discuss adding a drug benefit? Many analysts and lawmakers are concerned that the process of designing and updating Medicare benefits is dysfunctional and that simply adding, for example, a drug benefit does nothing to address the underlying problem.

Congress must not add to Medicare's current benefits without addressing these questions and the underlying problems in the management and financing of Medicare. Failure to link benefit improvements with needed reforms will simply lead to a Medicare program that is inferior and fails to provide enough help to those who need it while passing a huge financial burden on to future generations.

To address these issues, Congress needs to take a number of steps, including the following:

  • Improve the process for modernizing benefits throughout the Medicare program. Congress should set up a more independent process for improving benefits, based on a Benefits Board, to assure constant modernization of benefits within reasonable budget constraints.
  • Empower the traditional fee-for-service program to be as competitive as possible. Congress should take steps to permit Medicare's managers to be more creative and efficient in satisfying beneficiary needs. This means making the entire program operate in a more efficient, competitive, and customer-oriented way, but it also means ensuring that the traditional fee-for-service (FFS) program can compete effectively with managed care plans. To do this, Congress should split the management of the FFS program from the management of the entire Medicare program and give FFS managers greater flexibility in operating the program. Congress should also ensure that the traditional FFS program's budget reflects the costs of the beneficiaries enrolled in that part of the program.
  • Focus more help on lower-income enrollees. Recognizing that there is not enough money to give the same benefits to rich and poor alike while assuring adequate health care to lower-income seniors, Congress should begin to adjust the structure of benefits according to income.

If Congress were to combine these steps with, perhaps, more immediate actions to address the demand for a prescription drug benefit, it could set the program on course to become a constantly up-to-date health care program that the nation could afford.


Fairness and the Funding Crisis

Medicare is an entitlement program with a hybrid funding system. Workers pay income-related payroll taxes during their years of employment, and when they retire (or become disabled), they are entitled to a range of primarily hospital benefits under Part A of Medicare. In addition, when they retire, they can enroll in Part B, a government-sponsored insurance program covering primarily physicians' costs.

In broad terms, everyone enrolled in Part A and Part B receives the same benefits. The Part B premium is the same for everyone, but the premium is heavily subsidized out of general tax revenues, and each enrollee--regardless of income--pays the same amount, which is designed to cover 25 percent of Part B costs.1

Medicare's premium and payroll tax revenues are credited to trust fund accounts. In practice, these revenues immediately flow out of the trust fund to pay for current Medicare benefits. Since Medicare is a pay-as-you-go social insurance program, the trust funds really are an accounting tool used to indicate the program's financial obligations. The Medicare trustees--government officials and private representatives who oversee the program's finances--offer long-term projections of the program's income and liabilities.

These long-term projections cause alarm among many analysts and lawmakers because they indicate that the program is fundamentally out of balance, with trillions of dollars in general taxes needed to honor even existing benefits, let alone any new benefits. The Medicare trustees' 2002 report painted a dire picture of the program's finances, with expenditures rapidly outstripping dedicated revenues in future decades.2

Chart 1, taken from the trustees' report, shows the 75-year projections for the combined Part A and Part B elements of Medicare. The projections are based on middle-of-the-road assumptions about such factors as, among others, medical costs and, longevity and assume that no drug benefit is added to Medicare. As the chart indicates, when a young worker of today retires in 2053, for example, the program's expenses will outstrip dedicated payroll tax revenue and enrollee premium payments by approximately 4 percent of gross domestic product (GDP).

What does this mean in dollar terms? One way to appreciate the scale of the funding gap is to consider that if that were the situation today, 4 percent of GDP would be approximately $400 billion, or about $4,000 per household, allocated in the form of taxes to supplement the premiums and payroll taxes. In 2053, the equivalent dollar burden of extra taxes per taxpaying household would be on top of payroll taxes being paid by workers for their own future Medicare benefits. Furthermore, this extra tax burden just to pay for the funding gap ignores the large tax burden facing future workers because of the looming unfunded financing imbalance in Social Security. Moreover, the funding gap in the trustees' report does not include the cost of any drug benefit or other improvements Congress might enact this year or in the future.

In light of this picture, it is perhaps not surprising that some lawmakers are reluctant simply to add a drug benefit to Medicare that could cost hundreds of billions of additional dollars over the next decade alone (assuming that the cost estimates of a drug benefit, notoriously underestimated in the past, are accurate). Faced with this scenario, they suggest two things:

  1. At the very least, a new drug benefit should initially be restricted to those who cannot otherwise afford prescription drugs (many elderly currently have private drug coverage). A permanent and standard drug benefit for Medicare should be considered only alongside major reforms designed to rein in future program costs.
  2. Given the financial outlook, it is time to consider whether everyone should still receive basically the same Medicare benefits, especially as many lower-income seniors receive inadequate assistance while richer seniors do not need all their benefits. Thus, benefits should at least partially reflect actual need in a more systematic way.
The Dysfunctional Process of Designing Benefits and Managing the Program

When Medicare was created in 1965, its benefit package was based on the prevailing Blue Cross/Blue Shield package for working Americans in large firms and was seen as state-of-the-art coverage. Since that time, however, the benefits for Medicare recipients have gradually slipped further behind the benefits routinely available to working Americans. For example, Medicare provides no outpatient prescription drug benefit. Today, it is virtually unthinkable for a large corporation to offer its workers a plan without at least some coverage for outpatient pharmaceuticals or, for that matter, protection against catastrophic medical costs.

The Politics of Setting Benefits

The main reason that Medicare's benefits package is out-of-date--despite the general awareness that it needs to be updated--is that all major benefit changes require an act of Congress. Consequently, discussions about changing benefits (especially about introducing new benefits by reducing coverage for less important ones) are entangled in the political process. Providers included in the existing package fight diligently--and usually effectively--to block serious attempts to scale back outdated coverage for their specialties. Meanwhile, talk of upgrading the Medicare benefits package unleashes an intense lobbying battle among other specialties that seek to be included in the Medicare benefits package.

Invariably, the result depends as much (if not more) on shrewd lobbying than on good medical practice. The understandable reluctance of most lawmakers to subject themselves to this pressure further slows the process of modernizing benefits.

Formula Payments

Medicare today uses complex formulas to determine its payments to managed care plans serving beneficiaries and to physicians and hospitals under the traditional FFS program. Through legislation and regulation, the government tries to create a payment schedule that will work in all parts of the country and takes into account local conditions. However, as is typical of government attempts to set payments by formula, these schedules rarely match the actual market, which constantly changes.

As a result, policymakers and health care providers constantly grumble that the formulas systematically and wastefully overpay some plans and underpay others and that many payments to physicians and hospitals are far out of line with the cost and difficulty of providing specific services.

Bureaucratic Decision-Making

Just as arcane and problematic is the complex administrative process used by the Centers for Medicare and Medicaid Services (CMS) to modify benefits, determine which medical treatments and procedures are to be covered under Medicare, and define under which conditions or circumstances services are to be delivered and paid for. This bewilderingly complex process is marked by intense pleading by medical specialty societies and a degree of congressional micromanagement that makes efficient management of the program impossible.3

Any long-term reform of Medicare must amend this structurally inefficient and politicized process of changing or modifying benefits over time. If Congress does not do so, Medicare will always be hopelessly out-of-date.

Combining Medicare improvements with reforms

Addressing Medicare's benefit shortcomings without beginning structural reforms would be little more than a Band-Aid. Failure to reform the way Medicare benefits are updated means the program would continue to fall behind as medical practice evolves. And adding a hugely expensive drug benefit onto a program that faces staggering unfunded future liabilities would be unconscionable.

A prudent approach would seek instead to accomplish three goals:

  • Improve the process for modernizing benefits. While incorporating at least a modest prescription drug benefit into the program, Congress should set up a benefit improvement structure based on a Benefits Board to assure constant modernization of benefits within reasonable budget constraints.
  • Empower the traditional FFS program to be as competitive as possible. Congress should permit the CMS management of Medicare to be more creative and efficient in satisfying beneficiary needs. Congress should also make sure that that the traditional FFS program's budget reflects the costs of beneficiaries enrolled in that part of the program.
  • Focus more help on lower-income enrollees. Recognizing that there is not enough money to give the same benefits to rich and poor alike while also assuring adequate health care to lower-income seniors, Congress should begin to adjust the structure of benefits according to income.

Improving the Process of Modernizing Benefits

To keep Medicare constantly up-to-date, core benefits must be adjusted steadily over time, but that has proven impossible given the current hands-on benefit micromanagement role of Congress. This includes not only statutory benefit decision-making, but also periodic, often informal interventions into the complex processes of the Medicare bureaucracy, which affect both the managed care plans and the traditional FFS program. The problem is particularly frustrating in the FFS program, where Congress becomes involved in the procedures to evaluate, code, and price medical benefits, services, treatments, and procedures.

As long as lawmakers make detailed medical benefit design decisions in this way, they will face enormous political pressure when they try to adjust benefits--especially if they try to trim back less valuable benefits to make way for new health services. This provider-driven pressure typically thwarts the goal of sensible and economical improvement.

Creating a Benefits Board

To break out of this impasse, Congress needs to alter its role. Instead of voting on individual benefit changes and attempting to function as if they were medical experts, Members of Congress should instead transfer detailed benefit decisions to an expert body, limiting themselves to a yes-or-no vote on a proposed package of modernizations.

Specifically, Congress could create an independent "Benefits Board" to propose annual changes in the core benefits for Medicare beneficiaries.

  • The Administration and Congress would select Board members for specific terms, and the membership should be drawn from medical experts, health analysts, and a fair and balanced representation of the elderly and disabled.
  • Congress would provide the Board with budget constraints, and the Board would seek to develop the best combinations of benefits within that budgetary framework. Typically, each proposed annual revision would contain only small changes, but over several years the benefits package could undergo significant revision and improvement.
  • The Board would present the annual package of recommendations to Congress, and the entire package would be subject to an up-or-down vote without amendment. If the package were rejected, the existing benefits would remain in force, and the Board would present a modified package for a vote later in the session. This process would retain Congress's critical role of reviewing and agreeing to Medicare benefit changes, but it would sharply reduce political pressures on benefit decisions by lawmakers.

A Temporary Drug Benefit

If a Benefits Board had been in place during the past 20 years, it would likely have found an imaginative and economical way to introduce a prescription drug benefit, or catastrophic protection, into Medicare. If such a Board were established and Congress provided it with broad budgetary targets, it is easy to imagine that the Board would design an acceptable permanent drug benefit far more rapidly than Congress could ever manage.

If Congress determines that it must take the initiative on a drug benefit, however, it should focus on a temporary and narrow benefit, aimed at those who need help the most, and leave the development of a permanent benefit to the more deliberate and politically independent procedures of a Benefit Board.

In creating a temporary benefit in both the traditional FFS program and managed care plans, lawmakers should remember that many senior citizens already have drug coverage through former employers, supplemental insurance, or another government program. The Medicare drug access problem is concentrated among low-income seniors who cannot afford such coverage and are ineligible for assistance through Medicaid or other public programs.

An interim solution is to target subsidies to this population to help them get prescription drugs. While pursuing a modernization of the current Medicare program, there are two ways to do this:

First, Congress could revitalize President Bush's original proposal to transfer funds to the states to supplement or encourage state efforts to secure prescription drugs for low-income seniors. Unveiled in 2001, Bush's "immediate helping hand" initiative would have channeled $48 billion to the states over a four-year period to assist this population.

Second, Congress could directly target subsidies to modest-income seniors through a prescription drug account. For example, federal officials could make an initial deposit of between $600 and $800 per year to help seniors with their routine drug expenditures, coupled with a federally subsidized catastrophic insurance for high drug costs. Seniors could use a debit card in purchasing drugs, allowing the pharmacist to swipe the card against the person's prescription drug account. Seniors also could keep unspent funds and roll them over from year to year in the account, and state officials could supplement these funds through the state-based drug assistance programs. Health policy analysts from the American Enterprise Institute and the Galen Institute have developed the details of this approach.4

Empower the Traditional FFS Program to Be as Competitive as Possible

The second key step in reforming Medicare while improving its benefits is to give CMS the power to operate the traditional FFS program as efficiently and effectively as possible in competition with managed care plans. The managers of the traditional program should be empowered to run that part of Medicare as an aggressive competitor to the managed care plans. The FFS program should become an analog to charter schools--public schools in which managers are given the freedom and incentive to compete with private schools.

Turning the FFS program into the health care equivalent of charter schools would require several steps. Among them:

  • Create a Medicare Board. Currently, CMS is responsible both for operating the traditional FFS program and for establishing the arrangements under which the FFS program must compete with managed care plans. But that dual role is inherently problematic.

    For one thing, refereeing a competition is very different from being an aggressive competitor. Over the years, CMS (like its predecessor agency, the Health Care Financing Administration) has developed a culture and expertise that focuses on regulating prices and services and identifying fraud and abuse. The training and skills of the staff reflect these general functions. Staff members lack the experience and skills needed to establish ground rules for a competitive market, develop businesslike relationships with competing private health plans, and provide consumers with the information they need to get the best value in such a market.5

    Even if the agency's staff actually possessed the skills to turn the FFS program into an effective competitor, it is extremely unwise to permit an organization to set the rules of a competitive market when it also has a direct interest in the success of one of the competitors. So long as CMS runs the FFS program, it cannot be expected to fairly referee a market in which other plans compete directly with its FFS program.

    Thus, to make the FFS program as efficient as possible, Congress should clearly separate the function of running FFS from the function of overseeing the market in which FFS must compete. One way to do this would be to establish a new Medicare Board to run the overall Medicare program while giving CMS greater powers to run the FFS program in a more competitive way. The Board might report directly to the Secretary of Health and Human Services (HHS). An alternative would be to confine CMS's role to the oversight and operation of the overall program and create a new body within HHS--separate from CMS--to run the FFS program. In either case, the body running the overall program and the body running FFS would--although separate--be answerable to the Secretary of HHS and Congress.

  • Give the FFS managers the flexibility to compete with the managed care plans. Congress should refrain from its increasingly onerous and ineffective micromanagement of the FFS program. Instead, Congress should give CMS greater flexibility to run the traditional FFS program in ways that would make it an aggressive competitor to managed care plans and other emerging private-sector health care options in the next century.

    Whenever a competitive market is introduced, a government-provided service must be given every opportunity to redesign itself to compete effectively. Public enterprises can be surprisingly competitive and entrepreneurial when they have the freedom and incentive to do so. This is true in education; it should be the case in Medicare as well. Thus, CMS should be permitted to introduce innovations into the management of traditional FFS Medicare, and Congress should give FFS managers greater discretion.

  • Replace formula payments with a system of negotiation and "jawboning." Rigid formula payments to health plans deny CMS managers the opportunity to negotiate levels of payments to managed care plans that balance budget control with securing adequate service levels. Congress would be wise to extend to Medicare the same flexible payment-setting and service-setting process used in its own health program, the Federal Employees Health Benefits Program (FEHBP).

    In the FEHBP, a "call letter" is sent each spring to health plans by the Office of Personnel Management (OPM), which administers the FEHBP, requesting them to submit proposals for providing a broadly defined set of benefits to federal workers, their dependents, and federal retirees. The plans must state the services they propose to cover as well as the premium they intend to charge. After these proposals are received, OPM engages in rounds of negotiations with plans until final proposals are made and accepted.

    The negotiations between OPM and the plans involve the design and scope of benefits, the premiums, the geographic area in which the plans will operate, and other conditions under which services will be delivered. Through this negotiation system, a set of benefits and prices is determined that is very close to market conditions. After the negotiations are complete, OPM sends out standardized information on all plans to federal workers and retirees in the late fall of each year, and FEHBP beneficiaries choose the plan in which they wish to enroll for the following year.

    In this system, plans feel pressure to compete with one another; they also feel pressure from the government and federal workers to provide the best services for the price. Unlike a system of pricing based on formulas, plans cannot easily profit by exploiting a regulation or a poorly designed pricing formula; nor is the government required to overpay or underpay simply because of a legislated rule. If Medicare were run on similar principles, the government could negotiate payment levels for plans that reflected local market conditions and avoid the mismatch between payment levels and market conditions in many areas.

  • Risk-adjust the FFS budget. If the managers of FFS were given the power to improve the operation of that part of Medicare and market it more effectively, they would face the classic dilemma of insurers--"no good deed goes unpunished." Specifically, improving FFS would likely make it even more attractive to higher-risk, higher-cost enrollees.

    This fear that strong competition between managed care plans and FFS could result in "adverse selection" and a heavy cost burden on the traditional program constantly haunts those who are skeptical of wide plan choice in Medicare. Giving CMS greater power to negotiate payments with managed care plans would reduce this concern within the managed care sector, because the agency could negotiate payments that reward plans taking on higher-cost enrollees while offering lower payments to plans that generally attract lower-cost seniors.

    The way to protect the FFS sector is to adjust the general annual budget allocation for FFS and the managed care plans, based on a sampling of the average enrollee costs in each sector. This sectoral "risk-adjustment" budgeting would alter the portion of the projected Medicare budget going to each Medicare sector according to the choices made by enrollees and help insulate each sector from a disproportionate volume of higher-cost enrollees.

Focusing More Help on Lower-Income Enrollees

Given the daunting task of financing Medicare's future benefits under current law, let alone adding new benefits such as prescription drug coverage, Congress should expand its so-far modest steps to focus available funds on those who most need assistance.

The federal government and the states currently provide some assistance to lower-income seniors to cover part of their out-of-pocket Medicare costs. For instance, states can use Medicaid funds to enroll eligible seniors in Part B of Medicare. The Qualified Medicare Beneficiary program and the Specified Low-Income Medicare Beneficiary program provide financial assistance to eligible low-income seniors to help them afford out-of-pocket Medicare costs. In addition, the insurance value of some Medicare benefits is taxable for upper-income elderly Americans.

These steps have already begun to transform Medicare from a classic social insurance program with equal benefits for all into a hybrid program with a social insurance foundation but slightly different benefits for the rich and the poor.

This transformation of Medicare into a hybrid program needs to continue if Medicare's limited designated future funds are to be used to help those who need assistance the most. As noted earlier, Americans reaching retirement can enroll in a heavily subsidized insurance program (Part B of Medicare) without regard to their income. This part of Medicare is not a true social insurance program because beneficiaries do not contribute to Part B during their working lives.

It is an injustice for millionaires to receive the same 75 percent subsidy for this part of Medicare that modest-income seniors--who in many cases find the out-of-pocket premium and other costs of Part B onerous--also receive. Congress should start to address this unfairness by reducing the Part B premium subsidy for upper-income seniors while increasing it for additional lower-income seniors.

Congress should take similar steps to reduce the financial value of hospital benefits for upper-income beneficiaries, such as increasing the deductible and other costs. And if a drug benefit is added to Medicare, the subsidy should be restricted to those who need it. Most middle-income and upper-income seniors already purchase supplementary private insurance to reimburse many Medicare out-of-pocket costs. Tapering down the value of benefits for these Americans would likely lead to an increase of such supplementary coverage.

Opponents of such income testing for Medicare make three broad arguments. First, they say that an income-related benefit violates the social insurance design of Medicare. As already noted, however, special assistance already is given to some lower-income beneficiaries, and Part B was never even designed on social insurance principles.

Second, some argue that altering the benefits in this way would break up the broad coalition supporting Medicare, leading to an erosion of upper-income support and a decline--rather than an increase--in help to lower-income beneficiaries over the long term. While this argument is plausible in theory, there is little indication that it will materialize in practice, any more than taxing Social Security benefits for higher-income retirees has undermined support for that program. Medicare has rock-solid support, as every politician knows, which will not be eroded by expecting upper-income Americans to pay for more of their benefits.

The third argument is that income adjusting is either too draconian, and thus politically impossible--if it is to lead to significant program savings in the near future--or an insignificant offset, and thus unnecessary if it is introduced in modest ways. In truth, however, small changes introduced now, such as a sliding scale Part B premium, may have a small immediate impact but can lead to large savings over the decades to come. Thus, even small adjustments should be set in motion as soon as possible.


Medicare, with Social Security, is the nation's most popular federal program. But although it is popular, Americans grumble that it does not contain many of the most basic benefits one would expect in a modern health plan. Despite these gaps, Medicare faces a financing gap in the decades to come that will impose huge tax burdens on future workers in addition to their own Medicare contributions.

It would be unconscionable of Congress simply to add new benefits to Medicare without addressing the dysfunctional process of upgrading Medicare benefits, the inefficient management of the program, and the unfair distribution of benefits among seniors of different incomes and needs.

Stuart M. Butler, Ph.D., is Vice President for Domestic and Economic Policy Studies at The Heritage Foundation.

1. Some lower-income beneficiaries are also eligible for Medicaid, which covers the cost of their Part B premiums.

2. 2002 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Insurance Trust Funds (Washington, D.C.: U.S. Government Printing Office, 2002), p. 10.

3. For a recent review of management problems arising from congressional micromanagement, see Kathleen M. King, Sheila Burke, and Elizabeth Docteur, eds., Matching Problems with Solutions: Improving Medicare's Governance and Management (Washington, D.C.: National Academy of Social Insurance, 2002), pp. 39-42.

4. See Joseph R. Antos, Grace-Marie Turner, and Robert E. Moffit, "Time for a Sensible Medicare Drug Benefit," Heritage Foundation Backgrounder No. 1573, July 23, 2002.

5. The General Accounting Office has frequently faulted the agency's ability to serve its customers. See U.S. General Accounting Office, Managing for Results: Federal Managers' Views on Key Management Issues Vary Widely Across Agencies, GAO-01-592, May 2001. See also Robert E. Moffit, "Congress Should Think Twice About Allowing the Medicare Bureaucracy to Manage a Drug Benefit," Heritage Foundation Backgrounder No. 1583, September 9, 2002.


Stuart Butler