Designed to operate as a federally run health insurance program
for America's elderly, Medicare was heralded by proponents as both
"historic" and "fiscally responsible."1 Now, however, Medicare is
essentially bankrupt, and its ability to maintain the quality of
its services is in doubt. According to the 1995 Trustees Report, if
Medicare is not reformed the cash flow of the HI trust fund (Part
A), which finances hospital benefits for the elderly, will go into
the red in fiscal year 1997 and the fund will run out of money and
become insolvent in the year 2002.2 The report provides some
sobering information on how payroll taxes (which finance the HI
program) would have to rise to keep the program afloat without
reform. "To bring the HI program into actuarial balance even for
the first 25 years,"3 a new 1.3 percent payroll tax would have to
be added on top of the current 2.9 percent Medicare payroll tax.
Based on the trustees' estimates for revenues under the current tax
rate, this would raise payroll taxes -- and hence the cost of
employing Americans -- by an estimated $263 billion over five years
and $388 billion over seven years. A worker earning $45,000 would
have to pay an additional payroll tax of $585 per year.
To achieve long-term actuarial balance of the HI trust fund
without reforming the program -- that is, to put it on a
permanently sound footing -- an immediate additional payroll tax of
3.52 percent would need to be levied on top of today's 2.9 percent
rate. That would raise t axes by $711 billion over five years and
$1.050 trillion over seven years. The payroll taxes of a worker
earning $45,000 would increase by $1,584 per year.
And this is only to bail out the hospital program and enable
those benefits to be paid. Part B also will require a rapidly
increasing subsidy from general revenues to continue paying for
physician services. "Growth rates have been so rapid," explain the
trustees, "that outlays of the program have increased 53 percent in
aggregate and 40 percent per enrollee in the last five years. For
the same period, the program grew 19 percent faster than the
economy despite recent efforts to control the cost of the
program."4 With the trustees' "intermediate" estimates of future
program growth, the annual taxpayer subsidy will grow from an
estimated $38 billion in this fiscal year to an estimated $89
billion in five years and $147 billion in FY 2004.5
Trying to hold down Medicare's costs through price controls on
health providers and through stringent regulations is no answer.
Not only has this strategy failed to control costs, it encourages
physicians and hospitals to "game" the government rather than
properly serve their patients. Moreover, price controls have
shifted costs to the private sector, driving up premiums for
working individuals and families.
Instead of trying to tighten current controls and regulations,
the proper reform is to create a very different dynamic and set of
incentives to drive the Medicare program. Specifically, the
bureaucratic, standardized, command-and-control structure of
today's Medicare must be replaced with consumer choice among
competing plans offering different benefits. This is the same
dynamic that has allowed health costs to be brought under control
while improving quality in the private sector -- and in the
government-sponsored health plan enjoyed by Members of Congress and
other federal employees.
The way to achieve the same results in Medicare is to pattern it
broadly after the existing Federal Employees Health Benefits Plan
(FEHBP), which covers almost nine million federal employees,
families, and retirees, including present and former Members of
Congress. This new program, perhaps renamed "Medi-Choice," would
replace today's defined benefit program with a defined contribution
program that gives America's seniors an unprecedented opportunity
to choose their own health plan and range of benefits, just as
retired Members of Congress and other federal retirees do. Under
such a system, unlike today's Medicare program, the nation's
elderly and disabled could choose sound health insurance from a
variety of managed care and fee-for-service arrangements. And
retirees could choose coverage for services not covered by today's
standardized Medicare program -- such as a prescription drug
benefit -- by accepting, say, higher copayments for other covered
services. One of the great ironies of the Medicare debate is that
those who oppose reform are denying the elderly the chance to
receive many basic medical services already available to working
Americans, and even to the indigent.
The key financial difference is that the government would make a
defined financial contribution to the plan of the retiree's choice,
rather than reimburse each Washington-approved service according to
a fee schedule that defies comprehension and ignores market
realities.6 This incentive encourages beneficiaries to pick plans
with the best value for money, pocketing part of the savings from
choosing more efficient coverage. It already has enabled spending
in the FEHBP to increase at half the rate of Medicare, in addition
to which federal workers and retirees this year were treated to
premium reductions averaging 3.3 percent. Introducing the same
incentive system into a reformed Medicare program would save
hundreds of billions of dollars over the next decade, putting the
program on a sound financial footing so that it can serve both
today's elderly and the next generation of Americans.
Congress in reality has only two choices when considering the
future of Medicare. One choice is to make no significant change in
how Medicare is run and try to pay for future trust fund shortfalls
either by raising payroll and other taxes or by diverting money
from other programs. This means Medicare survives only by draining
money from the rest of the budget or by raising taxes
The second choice is to change the way Medicare is run so that
benefits are delivered more efficiently, avoiding future tax
increases or a diversion of money from other programs. Making the
program more efficient not only will reduce the financial burden
Medicare places on the next generation, but also will improve the
quality of benefits and choices available to America's senior
HOW TODAY'S MEDICARE SYSTEM WORKS
Today's Medicare program pays doctors, hospitals, and other
health care providers for inpatient hospital care, some inpatient
care in a skilled nursing facility, home health care, hospice care,
physician and supplier services, and outpatient services. In
providing these services to the elderly and disabled, the program
is divided into two parts. Part A finances the hospital insurance
(HI) portion. Part B finances the supplemental medical insurance
(SMI) portion, which covers physicians' fees.
Part A of Medicare provides premium-free coverage for part of
the costs associated with certain hospital stays and limited
follow-up services. Part A is financed currently through mandatory
payroll taxes, which are paid into a trust fund by both employers
and employees. When Medicare began in 1966, federal actuaries
estimated future expenditures for Part A so that a payroll tax
could be established based on potential costs. But the government's
estimates fell far short of the actual costs of running this
portion of the Medicare program.
The Medicare trustees recently issued a stunning report which
reveals that the Part A trust fund will be insolvent by the year
2002. The reasons for this looming fiscal crisis include
congressional mandates expanding covered benefits (such as adding
coverage for the disabled population beginning in 1973) without
providing offsetting changes in copayments or coinsurance, general
medical inflation, and increased utilization by an aging population
with longer life expectancies.
Part B is voluntary. All persons age 65 or over may choose to
enroll in the supplemental medical insurance program by paying a
monthly premium. The current contribution level ($46.10 per month
as of January 1, 1995) constitutes just 29 percent of the actual
cost of the Part B program. The remaining 71 percent is provided by
the taxpayers. Part B covers physician services, laboratory
services, outpatient hospital services, and other medical services.
The program pays 80 percent of the allowed charge (after the annual
$100 deductible is met); beneficiaries are responsible for the
remaining 20 percent coinsurance required by law. In sharp contrast
with typical plans in the private sector, as well as the FEHBP
which covers retired Members of Congress and federal workers,
Medicare has all of the undesirable features of a bureaucratic
1) Medicare relies on ineffective price controls to try to curb
Medicare is a classic example of the failures of price controls
to slow the growth of prices and expenditures. Not surprisingly,
the program exhibits all the chronic distortions and inefficiencies
that typically accompany a price control system.7 It is ironic that
as countries around the world are abandoning price controls and
central planning, America tries to use them to deliver health care
to the elderly. It is also rather astonishing to find some
lawmakers surprised at the inability of these tools to keep
Medicare's expenditures under control.
Price controls in Medicare take such forms as the diagnostic
related group (DRG) system for hospital payments and the
resource-based relative value scale (RBRVS) system for physician
services -- the latter remarkably similar to the obsolete labor
theory of value, which is the basis of socialist economics.8 Under
the DRG system, hospitals are reimbursed according to a complex
system of fees based on the illness being treated, while physicians
are subject to a fee schedule according to the procedure being
used. The "value" of a doctor's labor, along with the "value" of
other statistically weighted "resource inputs" into the provision
of a medical service, is calculated according to the statistical
methods of social sciences. Fees are set on the basis of this
statistical calculation, as applied to each of approximately 7,000
medical procedures, as measured and weighed by experts at HCFA.9
Needless to say, the consequences, such as cost shifting and
similar distortions, have not proven any different from those
resulting from the imposition of price controls in any other sector
of the economy.10 Controls have not worked, and the SMI program is
growing at an unsustainable rate under current legislation and
This elaborate system of controls has failed to hold the rate of
growth in Medicare expenditures to a degree comparable to the
private sector. For example, Medicare has experienced 10 percent
overall growth and is projected to grow at approximately the same
rate over the next five years. Contrast this with the private
sector, where employer health premiums in 1995 dropped by 1.1
percent while medical inflation increased by only 4.7 percent.
Price controls also have led to distortions and inefficiencies
familiar to any student of such controls. For example:
- Government action to squeeze payments to Medicare hospitals and
physicians has led to significant cost shifting (or, more
accurately, "price shifting") to non-Medicare services.
- Price controls have encouraged providers to try to make up for
low fees by increasing the volume of services (such as calling
patients in for additional office visits or conducting tests of
marginal value) or by such actions as reducing the average duration
of office visits. The government's response -- typical of responses
to this form of price control evasion -- has been to introduce
elaborate "expenditure controls," with the result that honest
physicians are penalized for hard work and attention to their
- Diagnosis codes are modified subtly by physicians and hospitals
to qualify for better payments. Indeed, software packages are
marketed routinely to hospitals and doctors to show them how to
maximize reimbursements from Medicare by choosing one diagnosis
code rather than another for the same medical problem.
The experience of price controls in Medicare is the experience
of price controls throughout history. Providers, and sometimes
patients, react to each control by seeking ways to evade it, with a
general loss of efficiency; then government introduces a new, more
elaborate control in an attempt to address the deficiencies of the
first. The cycle continues as the providers find a way around that
control. Meanwhile, efficiency suffers and expenditure targets are
2) Government limits the benefits available to the elderly.
Unlike congressional and federal retirees, who are covered under
a variety of plans in the FEHBP, most other senior citizens are
locked into the "one-size-fits-all" Medicare program. There is no
freedom to choose levels of benefits, or to choose alternative
benefits, within today's Medicare. Beyond electing to participate
in the voluntary supplemental insurance program (SMI, or Part B)
with its standardized benefits, the only choice most elderly
Americans make in health insurance is whether they will purchase a
"Medi-gap" policy for services and benefits not covered in the Part
B program. But retired Members of Congress and federal workers,
just like active members of the federal workforce, can choose from
health insurance plans ranging from fee-for-service coverage, to
union-sponsored plans, to various forms of managed care. Moreover,
they can choose plans with different covered services, such as
dental benefits and drug coverage, that generally are not available
Another important benefit found routinely in private plans but
not in Medicare is catastrophic coverage. This crucial benefit
protects individuals against high costs associated with
catastrophic illness or accidents. Among the other benefits not
covered by Medicare but covered by the FEHBP's popular Blue Cross
Blue Shield Standard Plan are (to take one example):
- Preventive screening, stool tests for blood, prostate specific
antigen tests, and related office visit charges.
- Routine physical exam, including a history and risk assessment,
and a serum cholesterol test, once every year.
- Home nursing care.
- Smoking cessation.
- Home physician visits.
3) Medicare resists innovation in the delivery of care.
In addition to its implicit distortions and evasions, a price
control system fails to control costs because its bureaucratic
nature reduces the pace at which efficiency-improving innovations
are introduced. In a competitive market-based system, choice and
competition lead to a decentralized, continuous, and rapid
introduction of ideas to improve the ratio of quality to price.
These are accepted or rejected to the degree that buyers and
sellers agree they are an improvement.
In a centrally planned system like Medicare, the process is
entirely different. Proposed changes must "trickle up" to senior
officials responsible for the program, after which they typically
must be evaluated by bureaucrats and boards, proposed to
politicians, and subjected to the pressures of competing interests
before they take effect. The result is slow and encourages
politically influenced decisions. Moreover, private sector managers
are motivated by competition to find the best way to satisfy the
patient at the lowest cost. Bureaucrats are motivated by the
incentive to avoid risk and controversy, which results in the
denial of many new services and procedures to Medicare
Medicare is run by the Health Care Financing Administration
(HCFA), an agency of the U.S. Department of Health and Human
Services. HCFA's more than 4,000 employees issue and enforce
hundreds of pages of regulations and thousands of pages of
guidelines, managing virtually every aspect of the delivery and
financing of the health care to the elderly.11 While Medicare
claims an overhead cost of just three percent, the rules and
regulations emanating from HCFA merely shift large administrative
costs to hospitals and physicians. Moreover, Medicare requires far
more federal administrators and rules for its operation than does
the FEHBP, which also is run by the government -- but on very
In keeping with Medicare's central planning/price control
design, Congress and HCFA systematically fail to introduce service
delivery innovations while depriving seniors of state-of-the-art
medical technology. For example:
Medicare will refuse all reimbursements to hospitals conducting
clinical studies on Medicare patients, so seniors are denied access
to medical innovations developed in the United States. As
highlighted in USA Today, "Faced with possible federal charges and
potentially millions of dollars in fines, hospitals slammed on the
brakes... shutting down all device studies or excluding Medicare
patients from them. Doctors were no longer able to provide what
they considered the latest treatments to many older
This happens not only because HCFA must formulate guidelines for
every category of medical equipment, but also because it must
decide whether each new medical device or treatment meets the
criteria for coverage under Medicare Part B. This highly regulatory
process has proven extremely expensive for taxpayers and dangerous
Dr. John Rowe, President of New York's Mt. Sinai Medical Center,
recently gave the Senate Finance Committee a graphic example of
what this means in practice. He asked the committee to consider a
hospital performing major heart surgery under Medicare and a
patient who needed a pacemaker inserted on his twentieth day in the
hospital. If a clinical test happened to be underway on pacemakers
to test the effectiveness of alternative electrical leads, HCFA
might well rule this treatment experimental and deny reimbursement
for the patient's stay in the hospital.13
Medicare is essentially a "fee-for-service" program. It has made
little progress in allowing, as an option to the elderly, managed
care plans such as health maintenance organizations (HMOs) or
competitive medical plans (CMSs). Moreover, with the rigid
guidelines established by the HCFA, Medicare's payment scheme to
HMOs is crude.14 As a result, former HCFA Administrator Gail
Wilensky has testified before the House Ways and Means Committee
that inadequate adjustments appear to have produced large
overpayments to many HMOs and underpayments to others.15
Non-HMO managed care options are very limited. For example,
risk-based "carve-outs" like the package-priced heart bypass
operation are not allowed except on a demonstration basis.
Slow service design innovation is endemic to Medicare's price
control/central planning system. While the process conceivably
could be accelerated, it cannot even theoretically match the pace
of innovation in a competitive marketplace.
THE SCOPE OF MEDICARE'S FINANCIAL CRISIS
According to the Medicare Trustees, the financial soundness of
the HI and SMI trust funds is of great concern due to their past
and projected rapid rates of growth. This concern is heightened by
the major demographic shifts in the workforce which supports the
Medicare population. Currently, 4.7 workers support each
beneficiary, but this ratio is expected to decrease significantly:
by the year 2030, only two workers will be supporting each
beneficiary. Given the trust funds' inadequate level of reserves
and weak financing structure, however, the HI trust fund is
projected to reach insolvency long before this demographic change
Medicare has become the second largest entitlement program,
after Social Security, in the federal budget. It is in long-term
financial crisis because payroll taxes and other revenues do not
cover costs, so net outlays must be covered by new taxes or by
diverting money from other programs in the budget. Such net outlays
totaled $144.7 billion in 1994. Government actuaries project that
under current law Medicare will cost taxpayers $198.7 billion by
1997 and $263.6 billion by 2000. It is little wonder that the
trustees, who include three Clinton Administration Cabinet
secretaries and two other senior Administration officials, called
on Congress to take "prompt, effective and decisive action" to curb
the program's escalating costs.16
These general problems appear in both parts of the Medicare
The Mess in Medicare Part A (HI)
Medicare Part A (HI) is financed through payroll taxes on
current employees, their employers, and the self-employed. Before
January 1, 1994, HI tax rates of 1.45 percent on employees, 1.45
percent on employers, and 2.9 percent on the self-employed were
applied on earnings up to $135,000.17 As part of his
Administration's effort to reduce the deficit, President Clinton
proposed that all earnings be subject to the HI tax, beginning in
1994. But despite lifting the limit on earnings subject to the HI
tax to yield additional revenues, the Administration targeted the
additional tax toward deficit reduction, not the HI trust fund.
Since the HI tax took effect in 1966, the maximum taxable income
level has been increased 23 separate times.18
Contrary to widespread belief, HI revenues and expenditures do
not go through a real trust fund. As a matter of fact, no trust
fund with money in it actually exists.19 The "fund" is merely an
obligation on the government to find the money, through taxes, to
pay for future benefits. As the Annual Report by the Board of
Trustees of the Federal Hospital Insurance Program explains, the
government has never saved the necessary tax revenues to cover the
future health care needs of private sector employees. The reason:
Medicare began paying out HI benefits at the same time it began
collecting taxes.20 Younger workers on average contribute more to
the Social Security and HI fund each year as their earnings
increase. These contributions, however, are not saved. Instead,
they are transferred and spent almost immediately on the current
Medicare population.21 Moreover, the elderly typically receive far
more in benefits than they have paid in payroll taxes.
Long-range HI projections show that Medicare hospital costs will
rise much more quickly than inflation. The most recent projections
by the Board of Trustees of the HI trust fund use three alternative
sets of assumptions: low cost, intermediate, and high cost. The
intermediate set of assumptions is said to represent the trustees'
best estimate of the future economic and demographic trends that
will affect the program's financial status. Under this option, the
present financing structure is sufficient to ensure the payment of
HI benefits only over the next seven years: "As a result, the HI
trust fund does not meet the trustees' short-range test of
financial adequacy."22 Under the high cost (pessimistic) option,
the fund will be exhausted in 2001. Under the low cost (optimistic)
option, the fund will be exhausted in 2006. When the trust fund is
fully depleted, Medicare is legally obliged to stop reimbursing
Medicare Part B's Exploding Costs
Congress established the Medicare Part B (or SMI) program in
1966 to create a taxpayer subsidy for the premiums paid by the
nation's elderly, setting it at 50 percent of premium cost. Until
1973, SMI premiums continued to finance 50 percent of the benefit
and administrative costs of the program, plus a small contingency
amount in a separate trust fund.
When Part B costs began to increase faster than inflation,
Congress decided to limit increases in the premium to the same
percentage as Social Security cost of living adjustments. Under
this new formula, revenues from Part B premiums for beneficiaries
decreased from 50 percent to 25 percent of the expenditures because
costs increased at a faster rate than inflation as measured by the
Consumer Price Index (CPI), used to calculate Social Security
adjustments. Beginning in the early 1980s, Congress has voted
consistently to set Part B premiums at a level which would cover
only 25 percent of costs. As a result, Medicare enrollees in 1995
pay only $46.10 per month for generous insurance that covers 80
percent of allowable charges with a deductible of only $100. The
illusion that comprehensive health insurance is inexpensive means
that Americans aged 65 or over have no incentive to control
In their report to Congress, the trustees "[n]ote with great
concern the past and projected rapid growth in the cost of the
program. Growth rates have been so rapid that outlays of the
program have increased 53 percent in aggregate and 40 percent per
enrollee in the last five years. For the same time period, the
program grew 19 percent faster than the economy despite recent
efforts to control the cost of the program."23 As a result of the
escalating cost of this portion of Medicare, expenditures are
projected to increase from 0.93 percent of the Gross Domestic
Product (GDP) in 1994 to 4.29 percent of GDP in 2069. With the
trustees' "intermediate" estimates of future program growth, the
annual taxpayer subsidy will rise from an estimated $38 billion in
this fiscal year to an estimated $89 billion in five years and $147
billion in FY 2004.24
HOW TO REFORM MEDICARE
In grappling with Medicare's emerging fiscal crisis, Congress
needs to pursue both short-term budgetary measures and a long-term
strategy of structural change. Short-term measures are needed to
deal with the program's injustices and glaring shortcomings.
Long-term reform is needed to deal with structural financial
problems and to improve the quality of care for America's seniors.
Moreover, to deal with public confusion about the status of the
Medicare system and the purpose of reform, Congress must educate
the American people about the true dimensions of the problem,
including the potential tax burden facing working Americans if
action is not taken. This can be accomplished in two ways:
First, Congress should order the Health Care Financing
Administration (HCFA) to notify America's senior and disabled
citizens that their Medicare hospitalization program faces
bankruptcy as early as 2002, according to the Medicare Trustees
Report. HCFA should explain that to keep the program going without
reforms will mean billions of additional tax dollars taken from the
paychecks of working Americans or diverted from other programs.
Second, Congress should order HCFA to inform the elderly that
the premiums they pay for their Medicare supplementary insurance
Part B represents only 25 percent of the premium income for those
services and that their children and grandchildren, young working
families, are paying for the bulk of these Medicare benefits out of
general tax revenues. Most elderly believe that they are paying the
full cost of their Medicare benefits; the truth about Medicare's
financial condition and circumstances can only improve the quality
of the necessary public debate.
Short-Term Reform of Part
Congress should act immediately to reduce the heavy taxpayer
subsidy of Medicare's Part B premiums.
OPTION #1: The simplest, though not necessarily the best, option
would be to restore the premium to the original 50 percent level.
This could be done by gradually phasing down the current level of
taxpayer subsidies by five percent per year over a five-year
period, which would save taxpayers approximately $37.27 billion
over the next five years.25 By financing one-half of Part B program
costs, Congress would return to the spirit of the original 1965
"contract" with America's taxpayers.
Reducing the taxpayer subsidy would encourage many enrollees to
compare the costs and benefits of more efficient private
alternatives with the costs and benefits of the Part B program. The
more the subsidy is reduced, the more level the playing field
between the private sector and government. The elderly would have
incentives to choose more efficient plans in the private sector.
The likely result: not just a reduction in the subsidy, but also a
significant reduction in gross budget outlays for Medicare Part
One problem with simply reducing the subsidy across the board is
that it would impose some hardship on many lower-income Americans
while continuing taxpayer support (albeit reduced) for the more
affluent. It also would raise the cost to states of enrolling in
Medicare some individuals already on Medicaid.
OPTION #2: An alternative would be to reduce the current subsidy
as income rises and perhaps raise the level of subsidy for the
elderly with very low incomes. The savings from such a change would
vary widely, depending on what method of means-testing was
introduced. At, say, $65,000 adjusted gross income for individuals
and $85,000 for couples, the subsidy might be phased out in
increments of three percentage points per $1,000 of income above
the threshold. The full premium would be paid by individuals above
$98,000 in AGI and couples above $118,000 in AGI.
Not a Tax. Contrary to what liberals in Congress may say, a
higher Part B premium represents not an increase in taxes, but a
reduction in a large direct subsidy. It is not a tax increase
because Medicare Part B is a voluntarily chosen service that can be
provided just as easily by the private sector. Part B is a
subsidized commercial service provided by the federal government in
competition with the private sector. If Members of Congress believe
it necessary to give high levels of subsidies to enrollees, those
subsidies should be targeted not to everyone over 65, but to
elderly citizens who cannot afford an acceptable level of physician
services and other services now available under Part B.
A POSSIBLE MODEL FOR LONG-TERM REFORM -- THE
Members of Congress searching for an alternative model for
Medicare reform do not have to look far. For well over three
decades, Members of Congress and federal employees -- and federal
retirees -- have been enrolled in a unique consumer-driven health
care system called the Federal Employees Health Benefits Program
(FEHBP). Unlike Medicare, it is not run on the principles of
central planning and price controls. Instead, it is based on the
market principles of consumer choice and competition.26 Beginning
in 1960 with 51 plans for the federal workforce, the FEHBP now
encompasses over 400 private health insurance plans nationwide,
ranging from traditional indemnity insurance and fee-for-service to
plans sponsored by federal unions and employee organizations to
different forms of managed care, including health maintenance
organizations (HMOs) and preferred provider organizations (PPOs).
In the Washington, D.C., metropolitan area, half of all persons
with health insurance are covered by one of the 35 plans competing
in the FEHBP.
The FEHBP is entirely different from Medicare. For one thing,
Medicare is a defined benefit program, meaning each enrollee has
access to a specific set of health services which are paid for, in
total or in part, by the federal government. The FEHBP, on the
other hand, is a defined contribution program in which the
government agrees to provide federal workers or retirees with a
financial contribution they can use to purchase the health coverage
of their choice.
Even more important, and unlike Medicare, the FEHBP does not
attempt to constrain costs by controlling prices and specifying a
comprehensive set of services. It sets only minimal guidelines over
how plans must be structured and marketed. The law specifies only a
brief category of core benefits, permitting federal workers and
retirees to choose the plans and benefits that are right for them.
Cost restraint is achieved not with an army of Medicare-style price
controllers, but through the operation of consumer choice in a
market of competing plans. That is why FEHBP spending is projected
to increase at about 6 percent per year while spending for Medicare
is expected to grow at 10 percent per year.
Choices for Federal Retirees. The FEHBP is open to all
congressional and federal retirees who retired after July 1, 1960.
Under current rules, congressional or federal retirees are eligible
to enroll in an FEHBP plan if they retired on an annuity with at
least five years of continuous service at the time of retirement,
or if they retired on a Civil Service disability. They also can
assure coverage for spouses by electing survivor benefits, and any
survivor annuitant can request coverage for grandchildren, under
certain conditions, on or after August 11, 1994.27
Significantly, while private sector firms have been cutting
back, or even eliminating private health insurance for retirees
altogether, the FEHBP has improved its coverage. Moreover, while
the number of active employees has remained fairly constant over
the past ten years, the number of retirees has grown from 1.3
million to 1.6 million.28 Congressional and federal retirees and
their dependents now make up 40 percent of total enrollment,29
enjoying access to choices and services denied to Americans
enrolled in Medicare. Among the features of the FEHBP:
Wide Choice of Health Plans. No other group of Americans enjoys
the range of personal choice over health plans available to active
and retired congressional and federal employees. Their private
plans range from fee-for-service to managed care. They can obtain
plans through organizations they trust. Plans sponsored by federal
unions and employee organizations are particularly popular among
federal workers and retirees -- almost one-third are enrolled in
such plans. Among the managed care plans, which have become quite
popular in recent years, there are many different options,
including "point of service" plans in which retired federal and
congressional workers can choose to use a personal physician
outside the HMO network for a higher copayment.
The FEHBP is very popular among federal retirees -- so popular
that a significant number of federal retirees who enroll in
Medicare keep their existing federal coverage as a "wraparound"
plan. While Medicare is their primary source of insurance, the
additional benefits included in the FEHBP (such as prescription
drugs, catastrophic coverage, and preventive care) serve as more
than adequate protection. As the National Association of Retired
Federal Employees states in its 1995 guide to federal health plans
for retirees, "All FEHB plans are good.... You can't make a serious
mistake in choosing a FEHB plan unless you choose a high cost plan
or option when you don't need one."30
Choice of Health Benefits. Federal retirees do not have merely a
choice of plan. Unlike virtually all other Americans, active or
retired, congressional and federal retirees also have the freedom
to choose the services they want. Unlike Americans enrolled in
Medicare, they are not locked into a single,
government-standardized benefits package. Beyond the normal range
of typical hospitalization and physician services, they can pick
from a variety of plans that cover such items as skilled nursing
care and home health care by a nurse, dental care, outpatient
mental benefits, routine physical examinations, durable medical
equipment and prostheses, hospice care, chemotherapy, radiation,
physical and rehabilitative therapy, prescription drugs, mail order
drugs, diabetic supplies, treatments for alcoholism or drug abuse,
acupuncture, and chiropractic services. And FEHBP plans include
catastrophic coverage -- in sharp contrast to Medicare.
Advice and Consumer Information. Congressional and federal
retirees are not on their own in making a choosing a plan. They
receive advice from private federal employee and retiree
organizations on the best plans and best benefit options.
In particular, retirees and workers are advised by consumer
organizations such as the National Association of Retired Federal
Employees (NARFE). Washington's Consumer Checkbook, a consumer
organization, advises retirees on the best options, such as
enrolling in plans that coordinate with Medicare. Various other
groups rate plans and provide information on services, quality, and
levels of benefits.
For example, NARFE advises federal retirees on the range of
catastrophic coverage options available to them. Among other tips,
it points out to retirees that the High Option Blue Cross Blue
Shield plan, while expensive, has "home health care benefits that
the Standard Blues plan doesn't have"; that the Alliance Plan
covers up to 90 Cardiac Rehabilitation visits for angina pectoris,
myocardial infarction, and coronary surgery; that the most
comprehensive dental coverage is available from the Mail Handlers
high option plan, as well as the Postmasters and National
Association of Letter Carriers high option plans; that the
Government Employees Health Association offers the best value in
home health care services; that the Blues offer the best hospice
care; and that the best skilled nursing benefits are offered by the
Choice of Price. Unlike the limited or non-existent choices
available to private sector workers and retirees, and unlike the
rigidly controlled pricing under Medicare, FEHBP premiums,
coinsurance, or copayments represent a wide range of options. Under
the FEHBP's financing formula, the federal government will
contribute up to 75 percent of the cost of a plan, up to a maximum
of $1,600 for individuals and $3,490 for families.
If congressional and federal retirees wish to choose a very
expensive "Cadillac" plan with a rich set of benefits, they may do
so, but they make the decision to pay extra. If, on the other hand,
they pick a less expensive plan, they save money on their portion
of the premium. Private health plans compete directly for these
Needless to say, the dynamics of a competitive market in the
FEHBP have had a positive impact on premium prices for federal
employees and retirees. According to the Congressional Budget
Over the past five years, FEHB plan premiums have
increased an average of 6.8 percent a year, whereas the premiums
paid by medium and large firms surveyed by Hay/Huggins Company, a
benefits consulting firm, increased by 10.8 percent a year.
Furthermore, FEHB premiums are expected to decline by 3.3 percent
in 1995; the Congressional Budget Office projects, however, that
aggregate private health premiums are likely to rise by about 5
According to the CBO, Medicare hospitalization (HI) costs will
rise 8.4 percent per annum between 1995 and 2000, and Medicare
supplemental medical insurance (SMI) costs will rise at 12.9
percent per year.33
Deficiencies of the FEHBP. The FEHBP is not without
deficiencies.34 The most significant is that plans must offer a
form of community-rated premiums, meaning they must offer a plan to
a healthy 19-year-old at exactly the same premium as a very sick
89-year-old. This inevitably leads to adverse selection. Still, the
FEHBP functions so well that even this problem does not undermine
the program, although it does introduce distortions and perverse
incentives that prevent it from functioning as effectively as it
should. A wise reform would be to vary the degree of assistance to
FEHBP enrollees at least according to their age and to permit plans
to vary premiums, also by age. That would allow plans to compete
more effectively and to offer services with less vulnerability to
A REFORM AGENDA FOR MEDICARE
Congress has committed itself to curbing the growth of Medicare
spending in order to restore financial stability and prevent
out-of-control spending from draining money from other programs or
forcing huge increases in taxes. To carry out this wise commitment,
Congress can proceed in two ways. It can impose tighter regulation
and stricter price controls while cutting medical services for the
elderly, as it has in the past. But experience shows that this
strategy yields only short-term spending reductions at best. In the
long run, it does nothing to curb runaway spending and undermines
the quality of care for the elderly.
The other option for Congress is to achieve spending restraint
by giving the elderly greater control over their Medicare dollars
and greater opportunity to use their dollars to select the health
care plans and services that are right for them. Such a reform,
modeled after the system serving federal retirees, would use
consumer choice and competition to curb waste and improve care.
Such a reform would include three principles:
- PRINCIPLE #1: Medicare should be changed from a defined benefit
program to a defined contribution program.
- PRINCIPLE #2: The elderly should be allowed to use their
Medicare dollars to enroll in a plan with health services that they
choose, not services that bureaucrats or politicians have chosen
- PRINCIPLE #3: Cost control should be achieved through consumer
choice and competition, not central planning and price controls.
HCFA's complex system of price controls and other restrictions
should be phased out.
One reform incorporating these principles would be to provide
Americans eligible for Medicare with a voucher to purchase the
Medicare plan of their choice. The sum provided would be the
combination of two amounts, reflecting the financing of today's
Part A and a reformed Part B. The two elements of the voucher would
Portion (A) Part of the voucher would be an amount -- adjusted
by age, sex, reason for entitlement (age or disability),
institutional status, ESRD (end-stage renal dialysis) status, and
geography -- intended to cover the actuarial equivalent of the
hospital and other services in today's Part A of Medicare. This
portion would not be means-tested.
Portion (B) The other part of the voucher would be based on an
amount -- adjusted by age, sex, and geography -- intended to cover
the actuarial equivalent of the services currently in Part B. This
base would be means-tested to determine the dollar amount of this
element. Since today's Part B is voluntary, the elderly should be
allowed to decline this portion of the voucher if they so
An alternative form of defined contribution would be for
Medicare to cover a certain percentage of the premium for the plan
of the elderly's choice, up to a maximum dollar amount. This would
be more like the FEHBP but would mean somewhat less financial
assistance for the lower-income elderly.
The elderly could use the voucher (or percentage contribution)
to purchase a Medicare-approved health plan of their choice.
Medicare would distribute information on the plans to the elderly,
as well as a checklist from which they could pick the desired plan.
Medicare would then inform the appropriate plan of the retiree's
These plans, somewhat like those offered through the FEHBP to
retired federal workers, would have to meet certain requirements to
be marketed as Medicare-approved:
Plan Requirement #1. A plan would have to meet certain financial
requirements to assure solvency. It would also have to be licensed
in the state in which it provided coverage to Medicare
Plan Requirement #2. The plan would have to specify its services
and costs in a standardized manner to enable the elderly to choose
without confusion. It would also have to make this information
available to the government for distribution to Medicare
Plan Requirement #3. Each plan would have to contain a core set
of benefits, including basic hospital and physician services with
catastrophic coverage. This core would be leaner than today's
Medicare, thereby permitting the elderly to purchase a less
expensive basic plan and supplement it with optional services or --
with the help of the voucher -- to buy those services directly from
providers. As an option, plans could include a Medical Savings
Account from which the enrollee could pay directly for services
with insurance only for catastrophic expenditures. Funds in a
Medical Savings Account could be used only for health care
The core benefits for those declining the Part B portion of the
voucher would be less extensive and focused on hospital services.
Seniors who declined the Part B portion could buy additional
insurance or pay for benefits without any requirement that these
additional services comply with federal guidelines. Thus, the
equivalent of Part B coverage would continue to be
An alternative would be for Congress to require that, at a
minimum, each plan contain the specific services available today
under Medicare, yet allow plans to offer additional services --
with perhaps higher copayments for services currently in the
States would be precluded from mandating any benefits or premium
structures for plans serving the Medicare population.
Plan Requirement #4. Each plan would have to set premiums
according to limited underwriting principles: age, sex, reason for
entitlement (age or disability), institutional status, ESRD status,
and geography, but not health status.35 One possible exception
might be to permit "lifestyle" premium discounts for seniors
willing to enroll in sickness prevention and health promotion
Plan Requirement #5. Each plan would have to accept any
Medicare-eligible applicant for coverage at its published terms
during an annual "open season" enrollment period.
The government's role -- particularly HCFA's -- would be limited
but important. HCFA would be precluded by law from regulating
either the prices of medical services to the elderly or the
premiums for plans. It would have three very important
a) The government would create a federally sponsored corporation
to offer a "Medicare Standard Plan" which would offer the standard
Part A and Part B benefits available today. The Medicare Standard
Plan would be assigned a premium, and any Medicare enrollee would
be able to choose it in preference to any of the private plans.
Enrollees would have to apply their vouchers toward the plan
premium. The standard plan would have to comply with exactly the
same disclosure and other requirements as any private plan.
b) Each year HCFA would be responsible for running the "open
season," the period in which the elderly and disabled in Medicare
chose the health plan they wanted for the following year. Just
before the open period, HCFA would send all enrollees information
on which to base their choice: the value of their voucher, a list
of Medicare-approved plans in their area with a standardized
listing of benefits and premiums, and a form for indicating their
choice. This is virtually identical to the role played by the
Office of Personnel Management in the FEHBP.
c) Once a Medicare retiree had made a choice and returned the
form, HCFA would send the voucher to the chosen plan if the premium
exceeded the value of the voucher. The enrollee would be
responsible for the difference but could choose to have HCFA send
the entire premium, paying for the difference by reducing the
amount of his Social Security check (this is how most of the
elderly now pay their Part B premium). If an individual chose a
low-cost plan which cost less than the voucher, HCFA would deposit
the difference in a Medical Savings Account of the enrollee's
choice. This money could be used only for health care payments.
ADVANTAGES OF THE REFORM
A reform based on this consumer-choice approach would have
numerous advantages for the elderly and the taxpayer.
Freedom to Choose Plans and Benefits. Under a consumer choice
Medicare system, elderly Americans could choose the private health
insurance that best meets their individual needs. With the advice
and counsel of their doctors, they could pick not only the level of
benefits above a basic set of hospital and physicians services, but
also a broad range of medical services and treatments available on
the free market -- for instance, a plan with drug coverage or
dental care -- which they do not get under Medicare. Consulting
with their doctors, rather than waiting for approval from HCFA
bureaucrats, also means the elderly could take advantage of changes
in treatments, medical procedures, and service delivery innovations
-- something lacking in today's Medicare. The only large elderly
group with access to similar breakthroughs today are retired
Members of Congress and federal employees.
Value for Money. Like federal and congressional retirees,
Medicare beneficiaries would be able to pocket any savings from
their personal decisions. While the cost of health care is
considerably higher for the elderly than for active workers and
their families, the government contribution to their health plans
also would be higher, depending on differences in age, sex, and
Controlling Costs. While by no means a perfect market, the FEHBP
has been able to control costs better than either private,
employer-based insurance or the current Medicare program, according
to the Congressional Budget Office and such private econometric
firms as Lewin-ICF.37 This success is due in large part to the
ability of Members of Congress and other federal workers, families,
and retirees to shop among the various health plans in their
geographic regions to get the best value for their money. In recent
years, even though the FEHBP enrolls approximately 1.6 million
higher-cost retirees and dependents and includes progressively
higher benefits, outlays have increased at a much slower rate than
the Medicare program's.38 With the establishment of a Medi-Choice
system similar in structure to the current FEHBP, the powerful
market forces of consumer choice and competition should produce
similar dynamics and results in the Medicare program.
Reduced Red Tape and Bureaucracy. To improve administration,
Congress could relieve the Health Care Financing Administration of
trying to dictate the minutiae of virtually every facet of health
care financing and delivery for the nation's elderly. Instead of
administering complex, cumbersome, and economically inefficient
price controls or promulgating a seemingly endless stream of rules,
regulations, and guidelines, HCFA could simply transmit defined
contributions, either as vouchers or through electronic
transmissions, to the plans chosen by enrollees, certify private
plans as meeting basic hospital and physicians benefits, meet
fiscal solvency requirements, and guarantee catastrophic coverage
(a benefit Medicare does not provide). Moreover, HCFA could
promulgate and enforce rules protecting elderly citizens from fraud
by insurance companies.
An AARP Health Plan?
Much like the National Association of Retired Federal Employees
(NARFE), which rates and grades the quality and benefits of plans
offered to congressional and federal retirees, the American
Association of Retired Persons (AARP) and other senior citizens'
organizations could play an important role in a revamped Medicare
system by rating and approving competing plans on the basis of
price, service, quality, and benefits. In fact, there is every
opportunity for organizations like the AARP to sponsor and market
their own health care plans in competition with established
insurance carriers, as do certain federal unions and employee
organizations within the FEHBP.
Unless Congress acts soon, Medicare costs will continue to rise
at unsustainable rates and the program will become insolvent. The
Medicare program is structurally unsound. It provides a false sense
of security for the nation's elderly. Attempts to hold down annual
cost increases of more than 10 percent per year through arbitrary
price controls have failed. The Health Care Financing
Administration has become entrenched, intrusive, and overly
bureaucratic, issuing volumes of rules, regulations, and guidelines
that are confusing not only to the public and lawmakers, but also
to doctors, hospital administrators, and patients.
The new debate over Medicare reform is one of the most important
since Congress debated comprehensive health care reform last year.
Congress must make decisions that affect the lives of every
American, working or retired, rich or poor, healthy or ill. It is
imperative that participants in this debate, particularly Members
of Congress, focus their attention not only on the financial
health, but also on the administrative structure, including the
regulatory details, of the Medicare system. While pursuing
necessary spending restraints in Medicare and other government
programs in order to secure an end to ruinous deficits, lawmakers
also must begin a fundamental restructuring of the program with a
view toward improving the quality, availability, and security of
health services for the elderly well into the next century.
If Congress fails to institute fundamental reform, either the
elderly will be faced with a dramatic reduction in the quantity and
the quality of their health care coverage, or already overburdened
working families will be forced to pay sharply higher payroll taxes
just to maintain the current level of benefits. Either consequence
is tantamount to fiscal and political disaster. But if Congress
uses this historic opportunity to create a new Medicare system
based on consumer choice and competition, it will mean health care
choice and security for today's elderly and a strong and solvent
retirement health care system for future generations of Americans
(1) House Speaker John W. McCormack (D-MA), during floor debate in
the U.S. House of Representatives on April 8, 1965.
(2) 1995 Annual Report of the Board of Trustees of the Federal
Hospital Insurance Trust Fund, pp. 2, 8.
(3) Ibid., p. 27.
(4) 1995 Annual Report of the Board of Trustees of the Federal
Supplementary Medical Insurance Trust Fund, p. 3.
(5) Ibid., p. 9.
(6) Edmund F. Haislmaier and Robert E. Moffit, "The Medicare
Relative Value Scale: Comparable Worth for Doctors," Heritage
Foundation Backgrounder No. 732, October 25, 1989, p. 11.
(7) See Stuart M. Butler, "The Fatal Attraction of Price
Controls," in Robert B. Helms, Health Policy Reform: Competition
and Controls (Washington, D.C.: The AEI Press, 1993).
(8) See Haislmaier and Moffit, "The Medicare Relative Value Scale:
Comparable Worth for Doctors."
(9) For a discussion of the physicians Medicare reimbursement
system, see Robert E. Moffit, "Back to the Future: Medicare's
Resurrection of the Labor Theory of Value," Regulation, Vol. 15,
No. 4 (Fall 1992), pp. 54-63.; Robert E. Moffit, "Comparable Worth
for Doctors: A Severe Case of Government Malpractice," Heritage
Foundation Backgrounder No. 855, September 23, 1991.
(10) For a fuller discussion of the unworkability of price
controls in the health care sector of the economy, see Edmund F.
Haislmaier, "Why Global Budgets and Price Controls Will Not Curb
Health Costs," Heritage Foundation Backgrounder No. 929, March 8,
(11) Robert E. Moffit, Ph.D., "Open Season for America? A
Symposium on the Federal Employees Health Benefits Program,"
Heritage Lecture No. 431, November 9, 1992, p. 1.
(12) Tim Friend, "Clinical Trials in U.S. Called Endangered," USA
Today , May 10, 1995, p. 2A.
(13) Response to questions by John Rowe, M.D., before Senate
Finance Committee, May 16, 1995.
(14) General Accounting Office, "Medicare, Health Maintenance
Organization Rate-Setting Issues," GAO Report to Congressional
Committees, January 1989, GAO/HRD-89-46, p. 4.
(15) Gail R. Wilensky, testimony before Subcommittee on Health,
Committee on Ways and Means, U.S. House of Representatives,
February 7, 1995.
(16) 1995 Annual Report [HI], p. 4; 1995 Annual Report [SMI], p.
(17) In reality the 1.45 percent tax on employers is a tax on
employees, since businesses see it as a cost of employment to be
deducted from the wages they are willing to pay.
(18) The HI tax was first levied in 1966 at a rate of 0.35 percent
(on both employee and employer) on earnings up to $6,600 a
(19) David Koitz, "Medicare: President Clinton's Proposal to
Eliminate the Hospital Insurance Taxable Earnings Base," CRS Report
for Congress, Congressional Research Service, Library of Congress,
May 5, 1993, p. 4.
(20) Michelle Davis, "Medicare's Self-Destruction," Citizens for a
Sound Economy, Economic Perspective, January 22, 1993, p. 4.
(21) C. Eugene Steuerle, testimony before Committee on the Budget,
U.S. House of Representatives, March 22, 1995.
(22) 1995 Annual Report [HI], p. 3.
(24) 1995 Annual Report [SMI], p. 3.
(25) Ibid., p. 9.
(26) This and other short-term budgetary proposals for dealing
with the Medicare system are discussed in Scott A. Hodge, ed.,
Rolling Back Government: A Budget Plan to Rebuild America
(Washington, D.C.: The Heritage Foundation, 1995).
(27) See Robert E. Moffit, "Consumer Choice in Health: Learning
from the Federal Employees Health Benefits Program," Heritage
Foundation Backgrounder No. 878, February 6, 1992.
(28) Whether or not a child will be added to a family plan of a
survivor depends upon the family status: "The deciding factor now
is whether or not the grandchild would have qualified as a family
member if the retired employee were still alive." See National
Association of Retired Federal Employees, Federal Health Benefits
Information and Open Season Guide, 1995 (Washington D.C., 1994), p.
(29) Carolyn Pemberton and Deborah Holmes, eds., EBRI Databook on
Employee Benefits (Washington D.C.: Employee Benefit Research
Institute, 1995), p. 278.
(31) See NARFE, Federal Health Benefits Information and Open
Season Guide, 1995, p. 11.
(32)Ibid., pp. 55-62.
(33) Congressional Budget Office,Reducing the Deficit: Spending
and Revenue Options, A Report to the Senate and House Committees on
the Budget (February 1995), p. 184.
(34) Ibid., p. 225.
(35) For example, rather than simply approving insurance carriers,
OPM still tries to negotiate rates and benefits for hundreds of
plans -- although premium prices in reality must meet the test of
market demand. Moreover, reversing a historical pattern of "passive
management," the Clinton Administration has in some instances
required the inclusion in plans of certain controversial services.
And Congress recently imposed the Medicare fee schedule, although
it restricted it to services for federal retirees.
(36) The authors believe that the demographic risk factors are
sufficient to protect health plans from undue "adverse selection."
However, if Congress determined that additional risk adjusters were
needed, they could be added.
(37) As noted earlier, one central weakness of the FEHBP is its
outdated insurance underwriting practices. It currently uses a
crude form of community rating, with no distinction in premium
payments for active and retired federal workers and their families.
This arrangement also contributes directly to the persistent
problem of "adverse selection" in the FEHBP. The problems could be
largely eliminated by an adjustment in the FEHBP premium structure
that instituted higher premiums for retirees than for active
workers, along with an increase in the government contribution to
retirees' chosen plans or a tax credit for federal retirees to
offset the increased cost. For a discussion of how to improve the
FEHBP, see Moffit, "Consumer Choice in Health: Learning from the
Federal Employees Health Benefits Program," pp. 17-19; see also
Stuart M. Butler, "Reforming Health Insurance: Analyzing Objections
to the Nickles-Stearns Bill," Heritage Foundation Issue Bulletin
No. 193, June 14, 1994.
(38) Allen Dobson, Rob Mechanic, and Kellie Mitra, Comparision of
Premium Trends for Federal Employees Health Benefits Program to
Private Sector Premium Trends and other Market Indicators (Fairfax,
Va.: Lewin-ICF, 1992).
(39) Office of Personnel Management, Office of Actuaries, Table
entitled "Federal Employees Health Benefit Program, 1992