The 5.1 percent reduction in Medicare payments scheduled to
begin in January 2007 could lead many physicians to stop accepting
new Medicare patients, to defer investments in new equipment and
technology, or both. These problems are merely symptoms of a
deeper pathology within Medicare and highlight the need for
Congress to adopt comprehensive Medicare reform. Without
congressional action to reform this profoundly flawed system,
America's seniors could face a decline in access to high-quality
Before Medicare was enacted in 1965, it was vigorously
opposed by the American Medical Association (AMA).  Given the political
realities, the final compromise on the Medicare law concerning
physician payment was designed to ensure that a maximum number of
physicians would participate in the program and that America's
seniors would have access to the highest-quality medical care.
These goals are now being undone. Following several
unsuccessful attempts to reform Medicare's physician payment
methodology over the past four decades, access to quality health
care for America's seniors is once again threatened. The current
system of administrative pricing and price controls is
antiquated and irrational. Congress should replace it with a
system that allows physicians and their patients to decide on
proper treatment options based on the free-market principles of
value, choice, and competition.
A New Policy
Congress should start reforming Medicare by replacing the
existing system of central planning and price controls that governs
physician payments and almost every other provider reimbursement in
the program. Specifically, Congress should:
- Promote value in the delivery of medical services by
introducing free-market forces. Congress should improve
quality of care by promoting transparency of price and
outcomes, allowing the market to function and thus rewarding
superior physician performance and superior results in the
treatment of disease. A number of positive policy changes to
accomplish this objective are embodied in the Medicare
Physician Payment Reform and Quality Improvement Act of 2006
(H.R. 5866), sponsored by Representative Michael C. Burgess
- Reject bureaucratic schemes that increase Medicare's
regulatory burden on doctors. Specifically, Congress should
reject pay-for-performance proposals that would force
physicians to comply with government guidelines in the
practice of medicine. The medical profession, not government
officials, should set standards for medical practice.
- Start moving Medicare to a defined-contribution
system. Instead of trying to determine the "right prices" for
thousands of medical treatments and procedures and enforcing
them with thousands of pages of rules and regulations, Congress
should start to move new retirees to an entirely new system based
on defined contributions and powered by the free-market
principles of choice, competition, price transparency, and
information that would drive improvements in quality. At the very
least, Congress should start a new system of defined contributions
for new retirees, allowing them to take the health plan of choice
with them into retirement.
Evolution of the Medicare Physician
The initial Medicare physician payment structure--known as
the customary, prevailing, and reasonable (CPR) payment
system--was implemented in 1966 without the threatened backlash
from the medical profession. However, the system not only was
complicated, but also contained serious weaknesses that
soon became evident. Because it was based initially on charges
rather than on the value of the medical services, procedural
services tended to be reimbursed at much higher levels than
"evaluation and management" services. In addition, prevailing
charges led to wide variations in reimbursement rates for the
same services from region to region. Critics often cited the CPR
payment system as the major reason for the rapid rise in the
cost of Medicare services because it created incentives for
physicians to raise their prices.
By the mid-1970s, rising costs and the irrationality of the
original Medicare physician payment system prompted
congressional action. In an attempt to limit costs, prevailing fees
were linked to the Medicare Economic Index (MEI), a measure that
was supposed to reflect changes in the medical marketplace,
including practice costs.
Not surprisingly, the resulting system did nothing to curb
the increasing cost of medical services. The MEI methodology,
implemented in 1975, limited charge inflation but placed no
control on the volume of services that physicians deliver. As
Medicare Part B expenditures continued to grow,
physicians were once again blamed, this time for increasing
the volume and intensity of services--an entirely predictable
outcome given the incentives built into the payment system.
The 1989 Physician Payment Reform. Faced with the evident
failings of Medicare's physician payment system, Congress embarked
on a new version of administered pricing that was far more
complex and cumbersome than anything previously prescribed. In
the Omnibus Budget Reconciliation Act (OBRA) of 1989, the
House Committee on Ways and Means and the Senate Committee on
Finance created a new system based on an even more rigorous model
of central planning, resulting in the adoption of the
resource-based relative value scale (RBRVS) for Medicare physician
payments. In a dramatic reversal of the Reagan Administration's
position on the proposed Medicare fee schedule, the George H. W.
Bush Administration supported the change, along with limits on the
right of physicians to balance-bill.
The RBRVS, a complicated formula developed by Harvard economist
William Hsiao, based Medicare payments on a social science
measurement of the time, energy, and effort involved in the work
done by the physician and the associated practice and malpractice
costs. It attempted to link physician payment to the
resources, or "inputs," that were used in providing medical
services. However, the formula did not adequately account for input
in terms of physician skill or expertise.
"Outputs," or results, were another matter. The fee schedule
also failed to assess either the value of a medical service or its
benefit to Medicare patients. Moreover, the methodology of
computing the value of work units used in the formula has been
subject to serious question.
Characteristically, complex systems based on central planning
tend to resolve one problem in a fashion that invariably generates
new ones. The RBRVS system was a way to ratchet down fees for
individual medical services, but it left in place the powerful
incentives for physicians to increase their volume of services and
drive the aggregate level of Medicare Part B spending even higher.
Congress anticipated this development and included yet another
administrative "fix" by limiting the volume of Medicare services
under Part B.
In an attempt to control total spending for physicians'
services driven by volume increases, OBRA also tied the annual
update of the fee schedule to the trend in total spending for
physicians' services relative to a target that was based on
historical trends in volume. This method, effective in 1992, became
known as the Medicare Volume Performance Standard (VPS). If
overall volume went up, physician reimbursement was adjusted
Of course, the obvious problem with this scheme was that
aggregate volume increases do not give physicians an incentive to
curb their own appetite to increase the volume of their individual
practices. Not surprisingly, adoption of this administrative fix
led to unstable and unpredictable physician payment updates.
Congress responded with the Balanced Budget Act of 1997, which
replaced VPS with the sustainable growth rate (SGR) mechanism that
governs physician payment updates today.
From VPS to SGR. Unlike the VPS, the SGR target is
tied to growth in the nation's gross domestic product per capita
and adjusts physician payments by a factor that reflects cumulative
spending relative to the target. The fundamental problem with
this method is that the vagaries of the general economy may
have no relation whatsoever to the cost of providing services to
Medicare beneficiaries. The SGR has done little to reduce
volatility in the system, does not control costs, and--if left
unfixed--promises to jeopardize Medicare beneficiaries' access
to care by discouraging physicians from accepting new Medicare
patients and by driving physicians out of the program
How Administrative Pricing Affects
Doctors and Patients
Physicians face a 5.1 percent cut in Medicare payments beginning
in January 2007, with cumulative cuts projected to reach 34
percent by 2015. Practice expenses are expected to increase by 15
percent to 20 percent during the same period. (See Chart 1.)
The real effect of Medicare fee cuts on physicians needs to
be understood in terms of the overall medical practice
environment. In addition to the cuts in Medicare payments,
physicians face declining reimbursements from all payers, public
and private alike. For example, the fee schedule for TRICARE--the
health care system for military personnel, retirees, and their
families--is linked directly to the Medicare fee schedule, and many
private payers follow Medicare's lead in setting their fees. In
addition, the growing number of uninsured puts a disproportionate
burden on physicians, who provide at least 18 percent of
uncompensated care to the uninsured and, unlike hospitals and
community health centers, are not compensated for their
contribution to the health care safety net.
The net effect of these economic forces has been a significant
decline in physician income. According to a recent study by the
Center for Studying Health System Change, the average
physician's real (inflation-adjusted) net income from practicing
medicine declined 7 percent between 1995 and 2003. This was in
contrast to income trends for other professionals, who experienced
an increase of about 7 percent during the same period. The
constraints on physicians' time have also affected their ability to
respond to increases in patient demand, and the need to comply with
thousands of pages of Medicare regulations under threat of criminal
prosecution only adds to the problem.
Patient Access to Care. Although Medicare beneficiaries
are not currently reporting major problems finding a doctor, a
closer look at the data suggests that access to health care for
America's seniors is unstable and that projections for the
future are even more ominous. From 1996-1997 to 2004-2005, the
percentage of physicians accepting all Medicare patients
declined only slightly, from 74.6 percent to 72.9 percent, but the
percentage of surgical specialists accepting all Medicare patients
dropped significantly, from 81.5 percent to 73.1 percent.
Interestingly, physicians with the lowest incomes actually
increased their acceptance of Medicare patients from 65.2 percent
in 2000-2001 to 72.2 percent in 2004-2005. Some analysts suggest that
this was to offset stagnant revenues from private payers.
A recent AMA physician survey reported that 45 percent of
physicians will either decrease or stop seeing new Medicare
patients if the projected 5.1 percent cuts go into effect in
January 2007. Faced with the projected 34 percent cuts by 2015, 82
percent of physicians say that they will need to make
significant changes in their practices that will affect access to
care. More than half of physicians also say that they will forgo
investments in their practices, including deferring purchase of new
medical equipment and information technology (IT).
This finding is troubling, particularly since officials in
Congress and the Administration are advocating increased use
of information technology, such as electronic medical records, as a
way to improve patient safety and quality of care. However,
adopting, installing, and using health IT systems could cost
as much as $44,000 per provider initially and $8,500 per provider
per year, an investment that many physicians are unwilling to make
given the uncertainty about future income.
In addition to complaints from the medical profession, the
Medicare Payment Advisory Commission in its 2006 report to
Congress called the SGR formula a "flawed, inequitable system for
volume control" and expressed its concern that "such
consecutive annual cuts would threaten access to
physician services over time, particularly primary care
services." In other words, the emerging situation
would be disastrous for Medicare patients.
Serious Medicare Reform
Physicians, like every other class of professionals,
respond to incentives. Reversing four decades of misguided
administration of the Medicare payment system will not happen
overnight. Physicians practicing medicine today should not be held
accountable for congressional mismanagement and micromanagement of
Medicare. Physicians are also not responsible for the financial
problems that Congress has imposed on Medicare, including the
massive entitlement expansion created by the prescription drug
benefit, adding an estimated $8 trillion of unfunded
liabilities in the form of benefits promised but not financed in
Nor should physicians be held responsible for Medicare spending
that is beyond their control. Medicare is providing seniors with
modern health care services, and much of the increase in spending
attributed to physician services is the result of the development
of better and more expensive technology and imaging
procedures. (See Chart 2.)
Much recent legislative action regarding Medicare physician
payment has taken the form of averting impending fee cuts. However,
in July 2006, Representative Burgess introduced the Medicare
Physician Payment Reform and Quality Improvement Act of 2006 (H.R.
5866). This bill goes beyond a mere moratorium on the scheduled fee
cuts and recommends terminating the SGR and replacing it with a
single conversion factor: the MEI minus 1 percent. In addition, it
proposes putting in place by 2009 a system of evidenced-based
quality measures developed by the physician specialty
organizations. Under this legislation, physicians would be allowed
to balance-bill certain patients above normal charges as limited by
current law as long as the physician participates in the quality
The bill takes the right approach in authorizing balance billing
because it allows market forces to operate in a way that gives
physicians an incentive to provide medical services that are of the
highest value. It would also motivate patients to demand
transparency about price and quality. The legislation
correctly specifies that quality measures should be developed by
the individual specialty groups. Basing payment on measures imposed
by an administrative agency is unlikely to produce any meaningful
gain in quality for the money spent.
Although the MEI is theoretically more sensitive to the medical
marketplace, its role as an indicator of the true cost of services
is questionable. Continuing to link the Medicare fee schedule
to the MEI would not address the basic financing structure
that has plagued Medicare since its inception. Without additional
major structural reforms, these limited modifications would likely
result in another round of increased spending followed by a call
for further cuts.
Congress cannot make up for its previous miscalculations or
policy decisions by simply cutting Medicare payments to physicians.
Avoiding cuts in the short run is not a substitute for real
Medicare reform, and this dalliance will only exacerbate the
problem. Medicare can no longer function with a payment system
that is linked to external measures that bear little or no relation
to the true cost or effectiveness of providing medical care.
Physician payment needs to be based on free-market competition that
provides the proper incentives for quality, efficiency, and
Step 1: Congress should start moving
Medicare to a defined-contribution system.
The present payment structure, which defines benefits, provides
no financial incentives for patients to learn more about the value
of their health care and no incentives for physicians to be
transparent or to compete on price and quality.
Government should define the contributions to be used for health
care and let patients and health care professionals decide on the
benefits, treatments, and medical procedures. If Congress is
unwilling or unable to overhaul the entire Medicare program,
it can at least start giving new retirees a defined contribution to
the health plan of their choice, enabling them to take their
private health plans into retirement with them.
Congressional concern about Medicare spending in the aggregate
is understandable, but the decisions that actually affect the
cost and quality of services are made during individual
encounters between patients and their doctors in which
discussions of macroeconomics have no place. Given the proper
incentives and ownership of their health care resources, patients
will become knowledgeable about the value of their care.
Millions of Americans, including seniors, make informed
decisions every day about goods and services in the economy, from
financial planners and lawyers to computers and cars. They can do
the same with medical services. By avoiding physicians who are
not transparent about quality and cost, they will drive
providers to make such information available.
Step 2: Physicians should be paid for
the real value of their services, not for bureaucratically defined
Physicians should be paid for the value of their services, not
for their ability to perform processes that may be unrelated to
patient outcomes. Current pay-for-performance (P4P) proposals and
programs have significant flaws and should not be considered a
substitute for real quality improvement of the health care
P4P advocates do not even agree on whether or not to pay for a
certain level of performance or improvement above a baseline level.
For example, under a quality measure such as screening women for
cervical cancer, should initially poor performers that raise their
screening rate from 40 percent to 80 percent be paid more than a
provider that improves from 80 percent to 85 percent? Furthermore,
does the increase from 40 percent to 80 percent represent
better medicine or better documentation by the provider? Finally,
should quality measures be enforced by withholding payments from
poor performers or by increasing payments to good
performers, or both?
A recent review of the early experience with pay for performance
reported several interesting findings: Most P4P programs
currently under way suffer from significant design flaws, some
measures are more difficult to affect than others, and
choosing only a subset of measures is an inadequate
evaluation strategy. Another recent study found that paying
clinicians to reach a common, fixed performance target may
produce little gain in quality for the money spent and will largely
reward those clinicians who show the greatest improvement in
reported performance, which raises the issue of whether better
medicine or simply better documentation is being rewarded.
A good example of an effective quality improvement
initiative is the National Surgical Quality Improvement Program
(NSQIP) developed within another government program. During the
mid-to-late 1980s, the Department of Veterans Affairs (VA) came
under a great deal of public scrutiny over the quality of surgical
care in the 133 VA hospitals. At issue were the operative mortality
rates in the VA hospitals and the perception in Congress that these
rates were significantly above the national (private-sector)
To address the gap, Congress mandated that the VA report its
surgical outcomes annually. In the process, the VA developed a
database of preoperative risk factors and postoperative
outcomes, allowing meaningful measurement of the quality of
surgical care. From 1991 to 2001, through feedback to
participating hospitals and providers, the VA hospitals saw a 27
percent decline in post-operative mortality and a 45 percent
drop in post-operative morbidity. Median post-operative length
of stay fell from nine days to four days, and patient satisfaction
improved. This program was then rolled out to non-federal
institutions and continues to grow in membership and
Significantly, this program was not a quick fix. Surgical
specialists took more than a decade to develop it.
Step 3: Congress should junk
Medicare's excessive regulation.
Physicians face not only cuts in fees, but also a number of
other burdensome Medicare regulations. Physicians should be given
the choice to set their own prices, including the ability to
balance-bill patients for charges not covered by Medicare, and let
market forces decide whether the price is correct.
Competition based on value will set prices much more rationally
than pricing systems administered by the government. Competition
will also be a more realistic and meaningful driver of long-term
quality improvement initiatives than the proposed
pay-for-performance schemes. Once patients control their own
medical care, they will insist on transparency in price and
quality, and physicians will have the proper incentives to improve
the effectiveness and efficiency of their care. Physicians will
also be more likely to invest in information technology and other
improvements in patient care if they are not restrained by the
threat of future income reductions.
Just as regulation has failed to control spending, it is
unlikely to improve quality. Physicians have always had incentives
through a number of mechanisms to provide quality care to
patients. Most important is their personal and professional duty to
alleviate suffering. In addition, physicians need to maintain their
reputations, both among peers and in their communities. Even though
the medical tort system is flawed in many states, the threat of
malpractice litigation provides an additional incentive to
The problem with these mechanisms is that they are difficult to
measure and do not provide the transparency needed in the current
system. As information collection methods improve, meaningful
data will become widely available, and lasting quality improvement
will be incorporated into the system. Regulation in the form of
price controls or piecemeal quality mandates will only impede this
Congress should move quickly to reform the Medicare physician
payment system. Simply avoiding impending cuts or tweaking the
current administrative payment system is insufficient. Because
physician payment is inseparable from the problems of Medicare
itself, the reform of physician payment should be accompanied by
policy changes that start to restructure Medicare.
Specifically, Congress should move toward a defined-contribution
system in Medicare, at least for new retirees, allowing them to
take private plans or health options with them into retirement.
Over time, this change would take Medicare completely out of
the business of fixing prices. Second, Congress should reject any
regulatory scheme that increases the already heavy regulatory
burdens on physicians, including pay-for-performance schemes that
would likely be counterproductive. Finally, Congress should promote
value through price transparency, information, and intensified
competition among doctors and other medical professionals.
John S. O'Shea, M.D., is Health
Policy Fellow in the Center for Health Policy Studies at The
the AMA national convention in 1965, nine state delegations
introduced proposals to boycott the new system.
the CPR system, physicians were paid the lowest of three possible
fees: the actual charge submitted, the fee customarily charged by a
particular physician, or the prevailing fee charged by physicians
in a given locality.
Balance billing allows physicians to charge
patients directly for the portion of the bill not covered by
an overview of the policy and politics surrounding the adoption of
the RBRVS, see Robert Emmet Moffit, "Back to the Future: Medicare's
Resurrection of the Labor Theory of Value," Regulation, Vol.
15, No. 4 (Fall 1992), pp. 54-63, at www.cato.org/pubs/regulation/reg15n4f.html
(November 20, 2006), and Physician Payment Review Commission,
1991 Annual Report to Congress.
a general description of the SGR formula and the congressional
debate over the pending 5.4 percent Medicare payment cut, see
Robert E. Moffit, Ph.D., "Why Doctors Are Abandoning Medicare and
What Should Be Done About It," Heritage Foundation
Backgrounder No. 1539, April 22, 2002, at www.heritage.org/Research/HealthCare/bg1539.cfm
(November 20, 2006).
Hadley, Ph.D., and John Holahan, Ph.D., "The Cost of Care for the
Uninsured: What Do We Spend, Who Pays, and What Would Full Coverage
Add to Medical Spending?" Kaiser Commission on Medicaid and the
Uninsured Issue Update, May 10, 2004, p. 3, at /static/reportimages/86CACE57D9FCE86AC2A4809BA9997426.pdf
(November 20, 2006).
T. Tu and Paul B. Ginsburg, "Losing Ground: Physician Income,
1995-2003," Center for Studying Health System Change Tracking
Report No. 15, June 2006, at www.hschange.org/CONTENT/851 (November 20,
Peter J. Cunningham, Andrea Staiti, and Paul B.
Ginsburg, "Physician Acceptance of New Medicare Patients Stabilizes
in 2004-05," Center for Studying Health System Change Tracking
Report No. 12, January 2006, at www.hschange.org/ CONTENT/811/811.pdf
(November 20, 2006).
For a broad discussion of the Medicare "pay
for performance" proposals, see Richard Dolinar, M.D., and S. Luke
Leininger, "Pay for Performance or Compliance? A Second Opinion on
Medicare Reimbursement," Heritage Foundation Backgrounder
No. 1882, October 5, 2005, at www.heritage.org/Research/HealthCare/bg1882.cfm.
Meredith B. Rosenthal, Richard G. Frank,
Zhonge Li, and Arnold M. Epstein, "Early Experience with
Pay-for-Performance: From Concept to Practice," JAMA, Vol.
294, No. 14 (October 12, 2005), pp. 1788-1793.