The Heritage Foundation

Backgrounder #1112 on Health Care

April 30, 1997

April 30, 1997 | Backgrounder on Health Care

Time is Running Out For Medicare Reform

INTRODUCTION

The recently released 1997 report of the Medicare Board of Trustees underscores yet again the need for decisive action to deal with the program's chronic financial problems. The six trustees, who include four top Clinton Administration officials, stress in their report that "[f]urther delay in implementing changes makes the problem harder to solve."

This year's report, like last year's, estimates that the Hospital Insurance (HI) Trust Fund, also known as Part A, literally will run out of money within about 48 months, early in 2001. This means that in 2001, under current law, the program will not be able to pay for all promised hospital benefits. After that year, the problem will become progressively worse for the foreseeable future. To put this in perspective, for families that buy a new car today, Medicare's hospital fund will run out of cash before the typical car loan is paid off; or if a son is going to college this fall, Medicare will be bankrupt before he graduates. Moreover, although the last Congress passed reforms to restructure the program for the long term, President Clinton vetoed that legislation and Democrats denounced it in last year's elections. Valuable time already has been lost.

The costs of doing nothing are enormous:

  • The trustees' report indicates that, if no action is taken to reform Medicare, the cost of bailing out the HI trust fund will be a staggering $472 billion by 2006. In that year alone, outlays will outstrip revenues by over $120 billion, leaving the fund unable to pay about $4,000 per enrollee in hospital costs. And the shortfall will accelerate in each subsequent year.
  • For the shortfall to be covered by new taxes, the average household would have to pay almost $5,000 in additional taxes between now and 2006.

But that is only one part of Medicare. There also is Part B, which pays for physician and other services. Part B is financed only partly by premiums, which covered just 27 percent of the actual cost in 1996. The rest of the program is subsidized by the taxpayers, and the level of subsidy received by a beneficiary is not related to the enrollee's income; elderly millionaires receive the same degree of subsidy as the elderly poor. The costs of Part B are rising rapidly, at a rate the public (non-Administration) trustees call "unsustainable." In just the past five years, total Part B outlays have risen by 45 percent. Under current law, the taxpayers' share of Part B's costs will rise from 73 percent last year to 84 percent by 2006, and to progressively higher levels thereafter. In dollar terms, the annual taxpayer share will rise from $62 billion in 1996 to an estimated $152 billion in 2006.

  • The report indicates that, if no action is taken, the cumulative cost to taxpayers of maintaining Medicare Part B will be $960 billion between now and 2006--roughly $10,000 in taxes for the average household.
  • Taking Part A and Part B together, in the absence of fundamental reform, each household--including elderly households--will have to pay an average of $15,000 in taxes over the next 10 years to keep Medicare afloat.

THREE PHONY SOLUTIONS

The Clinton Administration, among others, has proposed partial "solutions" to these stark numbers that would do nothing to solve the underlying problem. One such partial solution is to shift money for home health care from Part A to Part B, thereby giving a few more years' life to the HI trust fund. But this does nothing to deal with the underlying financial problem and has no effect on the total cost to the taxpayer: It is like using a check drawn on an already overdrawn checking account to pay off one's overdue credit card balance. Worse still, this accounting maneuver would reduce the pressure on Congress to take firm action now.

The second partial solution is to call for a commission to figure out how to address the structural problems of the Medicare system. The problem, however, is not any lack of knowledge about the options, which already are well known in Washington; the problem is an inability (or unwillingness) to make choices. Waiting for a commission to report what already is known simply allows lawmakers to avoid addressing the problem while time runs out. Moreover, this proposal overlooks the fact that the Bipartisan Commission on Entitlements and Tax Reform (the Kerrey-Danforth Commission) itself laid out the policy options two years ago, in 1995, only to have its report ignored. Like the Kerrey-Danforth Commission, a new Medicare commission is unlikely to achieve consensus; therefore, the most likely end result will be that the same difficult decisions still will have to be made later, when Medicare is even closer to the brink.

The third proposed solution is to pay doctors and hospitals less in real terms to provide the same services, thereby allowing lawmakers to say they are saving money but not cutting benefits. This "solution" has two flaws: (1) Price controls rarely work as advertised because doctors and hospitals typically find ways around them, such as reclassifying treatments to gain better payments or shifting costs to less tightly controlled procedures; and (2) even if they do work, the evidence from here and abroad is that the quality of services declines as doctors and hospitals reduce their own costs.

A BETTER APPROACH

Medicare is both costly and inefficient because of two fundamental design problems. Unless these design problems are addressed quickly, no amount of creative accounting or squeezing of providers, enrollees, or taxpayers can do more than delay for a brief time the imposition of staggering new taxes or draconian benefit cuts.

The first design problem is that Medicare operates on the principles of central planning. This means that the entire system is micromanaged from Washington. Intricate fee schedules are developed for specific benefits, and thousands of pages of regulations are drawn up to detail exactly what services should be provided, as well as how and to whom they should be provided. In short, a vast bureaucracy attempts to run Medicare in a manner that has been rejected for every other part of the economy. The result is enormous waste and inefficiency.

The second, related design problem is that Medicare is a defined benefits program. This means that Congress, through statute, promises specific medical services without regard to cost, leaving the taxpayer exposed to whatever proportion of the resulting costs of these services Congress feels it cannot impose on enrollees. Furthermore, the taxpayer subsidy for enrollees is unrelated to enrollee income. Because the program is one of defined benefits, an enormous provider-driven lobbying industry has developed in Washington to press for more benefits and to block the elimination of any benefits, no matter how out of date or costly they may be.

To deal with these problems, Congress needs to replace this central planning/defined benefit system with one shaped by choice, competition, and subsidies that are based more on need. Specifically, Congress should begin now to create a Medicare program more like the Federal Employees Health Benefits Program (FEHBP), the health care system serving federal workers and retirees. This means allowing the elderly to choose from a range of competing plans, including traditional fee-for-service plans, and giving the elderly a financial contribution, adjusted according to income, to help pay for the plans they choose. In this way, competition and the desire to satisfy the customer would replace bureaucracy and the perceived need to satisfy Washington, and would drive the system toward efficiency.

THE IMMEDIATE STEPS

Congress should lose no time in beginning long-term reform. It can and should act now to relieve the immediate pressure on Medicare and to move toward an FEHBP-style restructuring of the program. The following are among the steps Congress and the Administration should agree to take this year:

(1) Separate the management of the overall Medicare program from management of traditional fee-for-service Medicare, and create a semi-independent board for the latter.

The traditional program's benefits package today is politicized by lobbying, and its day-to-day operations are managed by an insensitive bureaucracy within the Department of Health and Human Services (HHS). Congress can address this now by vesting management of the traditional program in a board that is independent of the HHS, chosen by and answerable to Congress, and that is given limited powers to adjust benefits and payments. The board would focus on how to make the traditional program better serve the elderly and disabled--in other words, on improving customer service. It should include representatives of the elderly and should be tasked not only with overseeing the operations of traditional Medicare, but also with refining, adjusting, and improving the benefits package. This would allow benefits to be modernized without the intense lobbying and politicization that accompanies benefit changes considered by Congress. The board's proposals to change benefits would go into effect unless voted down, in an up-or-down vote without amendment, by Congress.

The HHS then would focus on the overall functioning of Medicare and its finances, and on steps to improve all services from any provider--such as developing usable quality measures and better customer information systems--rather than on running the traditional program and dealing directly with doctors and hospitals. And it would begin to determine how to create a framework within which a range of plans could be offered to enrollees. This would be roughly similar to the role the Office of Personnel Management plays with respect to the FEHBP.

(2) Introduce several limited new choices, especially from affinity organizations, into the Medicare program.

Under current law, few alternatives to fee-for-service are available to Medicare beneficiaries; the principal vehicle available is the health maintenance organization (HMO). The Clinton Administration, however, is launching demonstrations of alternative types of plans. To test other ways of providing care, Congress should launch demonstration plans in conjunction with organizations trusted by many of the elderly, such as selected unions, the American Association of Retired Persons (AARP), and certain churches. The aim should be to establish plans assembled not just by insurance or managed care companies, but by intermediary organizations with some direct affiliation with the elderly, so that both insurance coverage and providers are selected with a view to serving members of the organization efficiently. In this way, Congress could introduce new and powerful intermediaries between beneficiaries and providers--intermediaries acting on behalf of patients while also being motivated to assure that health care is delivered effectively and efficiently.

(3) Change the statutory standards for Medigap policies.

 The combination of an unduly small Part B deductible and Medigap requirements that virtually require first dollar coverage drives up the cost of Medicare and the price of Medigap plans. Congress should maintain the idea of categories of Medigap plans, to reduce both confusion among the elderly and exploitation by insurers, but should change the rules applying to those categories. Among the most important changes, no plans should be required to cover the Part B copayment or deductible, or the Part A deductible.

(4) Stop basing HMO payments on local fee-for-service costs. Instead, base the capitation payment on the local managed care market.

 Medicare is discovering today what private corporations discovered and corrected almost 20 years ago: Setting capitation payments to HMOs at 95 percent of average fee-for service costs typically means spending money rather than saving it. Private corporations abandoned formula payments of this kind and instead now shop around in the managed care market, agreeing to market-price contracts to save money. By contrast, the strict formula in Medicare not only invites cherry-picking by HMOs, but it also means that HMOs are universally overpaid in some markets and underpaid in others (meaning that quality suffers or modest potential savings from managed care are not obtained).

Simply reducing the capitation rate to 90 percent, as the Administration proposes, is a crude reform that--even though it would cut losses in some markets--would reduce the potential for long-run savings from adjusting Medicare payments to actual market conditions. Moreover, cutting all payments to HMOs invites the opposition of all HMOs. Adjusting more closely to local HMO markets would avoid united opposition. Although it would save money by allowing capitation rates to be reduced below 95 percent in some markets, it also would permit savings by adjusting payments upward in others (particularly in markets in which HMO penetration is low and raising capitation amounts would stimulate money-saving switching to HMOs).

Congress should amend the payment system immediately to pay HMOs according to the local health care market, not according to the fee-for-service segment of that market. This could be done in a number of ways. The HHS could negotiate prices, as many private corporations and the FEHBP do. Or it could determine payments according to the weighted average of competing bids, as the Physician Payment Review Commission recently has suggested.

(5) Raise the Part B deductible, using some of the savings to reduce the Part B premium for lower-income beneficiaries.

The low $100 deductible for Part B increases the incentive to overutilize services. It also requires Medicare to maintain higher-than-necessary premiums. In addition, rich and poor alike receive the same amount of taxpayer subsidy toward the cost of Part B coverage. This is indefensible, as well as costly, because Part B is not a social insurance program; it is a subsidized, voluntary insurance program unconnected to the payroll tax.

 A reasonable increase in the Part B deductible not only would save money, but also would be one of the first steps needed toward the restructuring of Part B. Raising the deductible to around $300 would bring Medicare in line with private plans, save money, and still allow premiums for lower income beneficiaries to be reduced.

(6) Repeal the law that would delink Part B premiums from the cost of the program after 1998.

 Under current law, Part B premium increases after 1998 will be based on the cost-of-living adjustment in Social Security payments. Thus, unless the annual cost increases of Part B services fall below increases in the general cost of living and the per capita volume of services does not rise, taxpayers will pay an ever-larger share of Part B costs--rising to 84 percent of costs by 2005 and a higher percentage thereafter--without regard to the beneficiary's income.

The original Medicare program split the cost of Part B equally between the beneficiary and the taxpayer. The current arrangement means not only that taxpayers must suffer unlimited financial exposure, but also that there is no incentive for beneficiaries to accept any limits on their benefits--and every incentive for them to push for even higher benefits--because program costs will have no effect on premiums. If Part B costs are to be constrained in the near term, and if the program is to be reformed over the long term, this premium formula must be altered immediately. The longer this formula is left in place, the greater the likelihood that beneficiaries will oppose reform.

CONCLUSION

This year's Medicare Trustees' report contains the same message that these annual reports delivered in 1995 and 1996: Medicare is nearing financial collapse and needs urgent action. Efforts to restructure the program during the 104th Congress were thwarted by presidential veto. Now is the time for the White House to show leadership by working with Congress to introduce long-term structural changes, not accounting tricks. The longer structural reform is delayed, the more painful it will be.

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