Restructuring Medicare for the Next Century

Testimony Medicare

Restructuring Medicare for the Next Century

May 27, 1999 21 min read
Stuart Butler

Testimony before The Senate Finance Committee, United States Senate 

Mr. Chairman, my name is Stuart Butler. I am Vice President for Domestic and Economic Policy Studies at The Heritage Foundation. The views I express in this testimony are my own, and should not be construed as representing any official position of The Heritage Foundation.

I am pleased to be invited to testify on the issue of Medicare reform. I believe the majority of members of the recent bipartisan commission laid out a good framework for modernizing and strengthening the program. As the commission recognized, reform involves not only addressing the financing of Medicare, but also critical governance issues. Today I would like to focus primarily on these governance issues because many of the pressing concerns facing Congress, such as how to provide a drug benefit, are in fact symptoms of flaws in the organizational design of Medicare.


Let me summarize the main points I make in the body of my testimony:

  1. The Medicare Commission's premium support proposal would be the best way of guaranteeing a Medicare entitlement while introducing incentives for beneficiaries to make cost-conscious decisions.

Premium support can be:

  • Indexed to adjust for changes in medical costs.

  • Adjusted by income.

  • Adjusted for high-cost medical conditions.

  • Designed as a base amount plus a percentage of premium (a version of the Federal Employees Health Benefits Program [FEHBP] formula).

  1. Congress should create a Benefits Board to depoliticize changes in Medicare benefits and to facilitate the gradual evolution of Medicare benefits.
  • Board proposals should be subject to an up-or-down vote without amendment, much like the procedure used in the Base Closing Commission.

  • Only broad benefits categories should be set by Congress (like the FEHBP).

  • Medicare should be reconfigured as a leaner core set of benefits and a range of supplementary options.

  • The Benefits Board approach should be used immediately to determine how to create a drug benefit in the fee-for-service program for a given budget.

  1. Congress should create a Medicare Board to manage the market for competing plans, taking this role a way from the Health Care Financing Administration (HCFA). The Board should be allowed to negotiate services and prices with plans.
  • HCFA cannot and should not combine the role of managing a market of competing plans with the role of developing and marketing the fee-for-service plan -- one of the competing plans.

  • HCFA evidently cannot carry out its consumer information functions. It is significant that while HCFA spent $95 million in a futile attempt to produce a consumers' handbook for Medicare, Washington Consumers Checkbookcompleted the same task for the FEHBP, with complicated differences in benefits to explain, through the efforts of just one analyst working for two months with clerical assistance.

  • The Medicare Board, separate from HCFA, would carry out functions similar to those of the Office of Personnel Management (OPM) within the FEHBP.

  • Using the OPM/FEHBP model, the Board should negotiate benefits, service areas, and prices with plans, instead of the current approach of regulation and price formulas.

  1. Congress should empower the traditional fee-for-service program to compete.
  • Give HCFA greater freedom to introduce innovation into the fee-for-service program. Give the agency the power to create the equivalent of charter schools in Medicare.


Congress must move swiftly to reform Medicare before the aging Baby Boom generation makes reform increasingly difficult. Several steps should be incorporated into a reform measure.

  1. The Medicare Commission's premium support proposal would be the most effective way of combining the objectives of (a) guaranteeing seniors an entitlement to an affordable core set of benefits, while (b) giving seniors the incentive to seek the most cost-effective way of obtaining Medicare services.

For some time, the Medicare debate has been portrayed as a clash between two irreconcilable approaches to providing financial support to the elderly to pay for health care. One approach -- known as "defined benefits" -- guarantees those eligible for the program a comprehensive set of specific benefits without regard to the cost to Medicare of those services. While this approach protects beneficiaries from future rises in the costs of those service, the approach has been criticized as placing a huge financial risk onto the shoulders of taxpayers. The other approach -- known as "defined contribution" -- would provide seniors with a specific amount of financial help to pay for benefits. While this approach limits the risk for taxpayers and creates incentives for seniors to seek cost-effective plans, it has been criticized as shifting all the future financial risk to beneficiaries.

A sensible compromise between these two approaches is implicit in the "premium support" approach favored by the majority of members of the Medicare Commission. Under this arrangement, Medicare beneficiaries would receive financial assistance in the form of a blend of the two approaches. While several variants are possible, under a premium support system seniors could receive a contribution to the costs of a plan, but this contribution could be adjusted each year -- or indexed -- to cover the market price of plans providing a core set of benefits. In that way the elderly would continue to have an entitlement and know that the costs of standard coverage would be assured, but the premium support approach means they would also have a strong incentive to choose a cost-effective plan.

Congress should recognize that the premium support approach does not mean that the elderly and disabled are simply given an "arbitrary" voucher and are at risk for unbudgeted changes in the cost of their health coverage. In fact, the basic idea of a premium support can be modified in several ways to address variety of policy goals and to protect enrollees. For example:

  • The base amount of premium support could be adjusted by income, so the low-income senior would have a larger amount of assistance.

  • The base amount could be adjusted (i.e., indexed) to account for the higher costs of certain medical conditions.

  • A variant would be to combine an indexed, fixed amount of support with a percentage of the cost of a chosen plan above the standard amount up to a certain dollar limit. In this way, seniors who felt it necessary to choose more expensive plans, because of their medical condition or personal preference, would pay only part of the extra cost. Such a percentage support system is used in the FEHBP.

While these varied forms of the premium support approach would address the concerns of lawmakers who prefer a defined benefits system, covering only an indexed base premium, or a percentage of a higher premium, also would achieve in large part the incentives of a defined contribution. Just as federal workers in the FEHBP well know, the premium support approach would create incentives for beneficiaries to seek the best value for money in a plan, because they would gain financially by choosing a more economical plan.

  1. To enable the benefits package to be revised and improved steadily over time, the current politicized process for changing benefits should be replaced with a Benefits Board and other steps.

The current discussion about the need to add an outpatient drug benefit to Medicare simply underscores two related failings in the design of the program. The first is that ever since its inception, the Medicare benefits package has slipped further and further behind what would be acceptable in typical plans for the working population. The second is that the program will be constantly out of date so long as it takes an act of Congress to accomplish benefits changes in Medicare that in the private sector would be made in a few routine management meetings.

When Medicare was created in 1965, its benefit package was based on the prevailing Blue Cross/Blue Shield package for working Americans in large firms. As such, it was "state-of-the-art" coverage. But since then, the benefits package has gradually slipped further behind the benefits routinely available to working Americans. For example, Medicare provides no outpatient drug benefit. Yet it would be virtually unthinkable for a plan to be offered to workers in large corporations today that did not have at least some coverage for outpatient pharmaceuticals and protection against catastrophic medical costs.

The main reason that the benefits package is out-of-date despite general acceptance -- it needs to include such items as a drug benefit -- is that all major changes in benefits require an act of Congress. Consequently, discussions about changing benefits (and especially introducing new benefits by reducing coverage for less important ones) are necessarily entangled in the political process. Providers included fight hard and usually effectively to block attempts to scale back outdated coverage for their specialty. Meanwhile, talk of upgrading the Medicare benefits package unleashes an intense lobbying battle among other specialties seeking to be included in Medicare benefits. Invariably, the final result depends as much -- if not more -- on shrewd lobbying than on good medical practice. The understandable reluctance of most lawmakers to subject themselves to this pressure slows down the process of modernizing benefits.

Just as problematic is HCFA's complex administrative process of modifying benefits and determining whether certain medical treatments or procedures are to be covered under the Medicare benefits package and under what conditions or circumstances they are to be reimbursed. This Byzantine process is marked by intense pleading by medical specialty societies, occasionally accompanied by congressional intervention.

A long-term reform of Medicare must end the structurally inefficient and politicized system of changing or modifying benefits over time. The best way to do this involves three steps:

  • Set only broad benefit categories in Congress.. Rather than set specific benefits in legislation, Congress could confine itself to describing the broad categories of benefits that private plans competing in Medicare should provide (such as emergency care, drug benefits, etc.). This is the approach Congress has taken with the FEHBP.

  • Create a Medicare Benefits Board. Instead of Congress or the Administration's specifying detailed benefits, Congress could create a Benefits Board to propose specific incremental changes in the core benefits for Medicare. Such an independent board would have members selected for specific terms by the Administration and Congress. The recommendations of the board package would be subject to an up-or-down vote by Congress. This would reduce political pressures on benefit decisions and take lawmakers out of the process of making detailed medical decisions; yet it would give Congress the final say in any benefits changes. Essentially, the practical logic for establishing a board to function in this way is the same as the logic for creating the Base Closing Commission in the 1980s.

  • Establish Medicare as a combination of core and optional benefits. The broad categories for core benefits determined by Congress or a board could be confined to the "must-have" basic benefits expected of Medicare rather than the comprehensive benefits most seniors would actually obtain. In other words, the Medicare coverage for a senior (that is, someone eligible for premium support) would consist of a base set of benefits in every plan or in the traditional fee-for-service coverage plus a variety of negotiated supplemental benefits according to the needs and desires of each senior. Over time, it could be expected that the typical supplementary coverage would adapt to changing needs, desires, and medical practice. This two-tier benefits package thus would allow gradual adjustments in benefits according to the desires of individual seniors and would not require legislation by Congress to permit changes over time. This is essentially the process used in the FEHBP. In the FEHBP, broad categories of coverage are required, but the specific levels of benefits, including the kinds of medical treatments and procedures, offered by typical plans change with the times. Plans know they must keep up with medical developments yet remain cost-effective if they are to be selected by beneficiaries and thereby stay in business.

Had Medicare been able to evolve gradually, like the FEHBP, through these ways of significantly depoliticizing changes in benefits, Medicare no doubt today would have a modern and efficient system of benefits, more like the FEHBP and like Medicare at its inception.

Creating a drug benefit in the fee-for-service program. The first task for the proposed Benefits Board should be to determine the best way to introduce a drug benefit into the traditional fee-for-service segment of Medicare. With a board in place, Congress could instruct it to develop a modified benefits package, including drug coverage, within a specified budget. To work within the budget constraints, the board might develop a plan to make small changes in a number of features of the benefits package to achieve a well-balanced package that achieved Congress' objectives. The plan would be sent to Congress for an up-or-down vote without amendment. Should it fail to win approval, the board would develop a modified version until agreement could be reached.

  1. Remove from HCFA the function of managing a market of competing plans and place this function under a new Medicare Board with powers to negotiate prices and services with plans.

HCFA currently is responsible for operating the traditional fee-for-service program. But is also responsible for establishing and managing the market for the increasing range of plans that are offered to seniors at a monthly premium. This combination of tasks is inherently unsound and explains many of the problems and shortcomings at HCFA.

Basic Conflict. It is a very basic principle of economic organization in a market that those responsible for setting the rules of competition, and providing consumers with information on rival products, should have neither an interest in promoting any particular product nor even a close relationship with one of the competitors. That is why the Securities and Exchange Commission maintains a wall of separation between itself and individual companies. It is why Consumers' Reports accepts no advertising from products it evaluates. And it is why umpires in baseball do not own baseball teams. It is also the reason why state and local governments (and the federal government under the A-76 program) have a different agency evaluating competitive bids for government services from the agencies providing those services in-house. Entangling the running of a market with the management of any of the competing providers is a recipe for problems. It is interesting to note that in the federal health program that operates a market of dozens of competing plans made available to federal workers (the FEHBP), the agency responsible for running that market and providing information to beneficiaries (the OPM) does not run a plan itself.

This separation is not only necessary to avoid a conflict of interest, it is also necessary because the managerial cultures are very different for staff engaged in these two very different functions. Managers charged with dispassionately operating a market must display evenhandedness and pay close attention to the information that consumers need to make wise decisions. On the other hand, those managers engaged in marketing a particular plan, including a government-sponsored plan, must be highly competitive and concerned with the long-term viability of their particular product and the continued satisfaction of their customers. The cultural difference is much like that separating a judge from a trial attorney.

The simple fact is that HCFA cannot and should not carry on both these tasks. The main reason it cannot is that the agency has, over the years, developed a culture and expertise that focuses on regulating prices and services and identifying fraud and abuse. The training and skills of the staff reflect this general function. By contrast, HCFA has a shortage of the experience and skills needed to establish ground rules for a competitive market, develop businesslike relationships with competing private health plans, and provide consumers with the information they need to get the best value in such a market. For example, HCFA's efforts to create a handbook of information for beneficiaries that they could actually understand turned out to be a $95 million fiasco. Significantly, such a handbook has been available for many years for enrollees in the FEHBP. Besides a brief booklet from the OPM, a private consumers' organization, Washington Consumers Checkbook, produces a comprehensive guide, including patient rating surveys of plans, which is assembled by one analyst working for two months and backed-up by a few clerical staff.

It is not that HCFA staff is inherently incompetent, but that they have little training and expertise in these functions. It is a little like expecting experienced divorce lawyers suddenly to become good marriage counselors. Staff members at the OPM who operate the FEHBP, by contrast, have very different skills and backgrounds, and the agency has a different culture -- which is why OPM is successful at running an nationwide program with many competing plans in each area.

But HCFA should not carry out those functions even if it had the skills to do so, because it is extremely unwise to permit an organization to be responsible for setting the rules of a competitive market when it also has a direct interest in the success of one of the competitors. So long as HCFA runs the fee-for-service program of Medicare, it hardly can be expected to benignly create a market in which other plans compete directly with the traditional fee-for-service program.

Congress must, however, accept much of the blame for the agency's problems. HCFA's current structure and statutory obligations do not allow it to maintain a proper separation between these functions and are a impediment to the agency's ability to carry out either function very effectively. This stems from the fact that HCFA historically has acted as a bill-payer and regulator, rather than a referee in a market and a consumer information agency. As the Institute of Medicine (IOM) notes in its 1996 analysis of the Medicare market, "In the past HCFA has made little effort to inform Medicare enrollees of their choices regarding health care providers, treatment options, or competing private plans."1 And as the General Accounting Office notes in a 1995 study, HCFA amasses vast amounts of information but has a poor track record in providing information to beneficiaries that is useable.

To be sure, HCFA has been taking steps to provide better information to beneficiaries, including data on high-mortality hospitals and better benefits information. However, this falls far short of what is needed to enable elderly Americans to make sensible choices when there is an increasing number of options available. Moreover, even with the recent reorganization, the conflicting functions of dispassionate market management and plan operation are still hopelessly entwined.

Comparison with the OPM. It is interesting to contrast the way in which HCFA functions as a manager of a market with the manner in which the OPM functions within the FEHBP. According to James Morrison, the career civil servant who ran the FEHBP during the Reagan Administration, the contrast stems not from any inherent deficiency of HCFA staff as civil servants, but from differences in the structure imposed on the agencies running the two programs. This suggests that Congress must modify the program design if it is to achieve a change in the way HCFA functions. As Morrison explains to me in a note (which he has permitted me to make available to the Committee):

There is a profound difference in the way the Health Care Finance Administration (HCFA) deals with the private sector intermediary in the Medicare program and the way in which the Office of Personnel Management (OPM) deals with the private sector plans in the Federal Employees Health Benefits Program (FEHBP). This difference derives, in large measure, from the statutory difference between the two programs.

Medicare is a highly prescribed, statutorily defined program with benefit levels and payment rates essentially fixed in law. The FEHBP, on the other hand, has very few statutory prescriptions. Beyond the bare outlines of a core benefits package, specifics of the plan's offering and its price must be negotiated between the government and the private sector carrier. These fundamental differences shape the values, roles, responsibilities, and indeed the operating culture, of the administering agencies. Thus, HCFA employs legions of regulators bent on prescribing every detail of the Medicare program, and scores of health policy "experts" to determine the needs of beneficiaries. OPM employs a small number of contract specialists who can assess the price and value of a plan offering while leaving the determination of customer needs to individual consumers. HCFA places a premium on employees with advanced degrees in health policy; OPM values private sector health plan experience.

Create a Medicare Board. The Medicare Commission recognized this inherent problem when a majority of its members voted to establish a board to take over many of the marketing functions, and the management of private plans, now undertaken by HCFA. To establish such a board, Congress should create within the Medicare program a body that is the functional equivalent of the OPM within the FEHBP. The function of this body, and the focus of the staff within it, should be to structure and operate a market of competing plans, including the traditional fee-for-service plan, and to provide Medicare beneficiaries with the information they need to make the wisest choice possible.

This Medicare Commission proposal is very similar to a recommendation of the IOM's Committee on Choice and Managed Care in 1996. In making its recommendation, the IOM committee emphasized that HCFA currently tries to undertake two very different functions that demand very different approaches and skills. The IOM committee noted, among other things:

  • "The administration of the multiple choice program and the management of the traditional Medicare program involves very different mission and orientations."

  • "The two functions require different types of management, staff expertise, backgrounds, and knowledge. The committee is concerned that staff and senior managers with extensive experience in managing various aspects of multiple choice in the private sector be recruited and employed for this effort."

  • "The functions call for different organizational and corporate cultures, one operating a stable traditional public indemnity insurance program and the other a purchaser- and customer-oriented program that is required to be responsive to a diverse group of private programs in a rapidly changing and dynamic market place."2

The creation of a Medicare Board would permit the function of managing a market of competing plans to be separated from the operation of the traditional fee-for-service program as one of those competing plans. This would accomplish the economic and managerial objectives set out at the beginning of my testimony.

The new board could answer directly to the Secretary of Health and Human Services (HHS), and would have similar functions to those of the OPM within the FEHBP. Among the board's functions:

  • Setting standards for all plans being offered to Medicare beneficiaries, and certifying that all plans meet those standards. The standard setting should apply to the traditional fee-for-service program as well as the new choice programs created by Congress.

  • Negotiating with competing plans regarding benefits and prices. Just as the OPM negotiates with individual plans before they are offered to federal employees during open season, so, too, should the board use Medicare's purchasing power to push plans into providing the best options for seniors. One of the main reasons for doing this is to ensure that plans compete for business by offering good value rather than by introducing dubious marketing techniques (such as artificial boundaries for marketing areas, or benefits designed only to attract low-risk customers). CalPERS carries out a similar function for California state employees, as do many large corporate purchasers of health care.

  • Organizing payments to chosen plans. The board should evaluate and propose refinements of the payment system to plans, including the traditional fee-for-service plan, and recommend these to the Secretary of HHS and Congress.

  • Providing data and information to consumers. The board would take on the function of providing consumer and benefits information to seniors and guidance on how to make wise choices. This function would include examining techniques to measure quality and incorporating prudent techniques into the information made available to beneficiaries.

In order to carry out its mission effectively, the board itself should contain certain elements. One of these should be an Advisory Council, mainly representing consumers but also organizations with a general interest in creating a market for high-quality health care. However, the board, and the Advisory Council, should receive policy and technical advice on issues affecting the market for Medicare plans from an outside advisory body with experience of other health care markets. I would suggest that the Medicare Payment Advisory Commission (MedPAC), with an expanded staff, could play this role.

In addition, the board would need a full staff to undertake its broad functions. Some of these staff could be recruited from among current HCFA personnel. But for the reasons mentioned earlier, and emphasized by the IOM committee, it would be wise to recruit some staff from outside the Department of HHS in order to introduce new skills and experience. Some individuals might be recruited from the OPM, and others still from the private sector.

A Drug Benefit for Plans. In the FEHBP, there is no statutory requirement on plans to include an outpatient drug benefit. But the plans do include such a benefit. The benefit simply emerged as plans came to realize they could not compete without a drug benefit in a market where federal employees had a wide range of choices each open season. Like most benefits in the FEHBP, in other words, plans gradually included the benefit to reflect prevailing customer demand. On some occasions, the OPM actively encourages the inclusion of particular benefits by including them in its annual call letter to plans. Not all plans respond by proposing to include the OPM-suggested benefit; but, typically, leading plans that seek to market themselves as the most comprehensive available will do so. In the other cases, the OPM actively negotiates with plans on ways they might include the benefit, and the result is that it may be offered in vary different ways by different plans, reflecting local conditions and market factors.

The proposed Benefit Board could encourage the inclusion of a drug benefit in the

Medicare private plans in the same way. It could request plans to include outpatient drugs, and it could negotiate with plans for ways to do this in the least costly way.

  1. Empower the traditional fee-for-service program to compete

Because of the statutory basis of the fee-for-service benefits package and the many requirements Congress places on HCFA, it is currently very difficult for the agency to make improvements in the fee-for-service program so that it becomes more competitive and modern. Thus, the fee-for-service is inherently at a disadvantage when competing with the more flexible private plans now being made available to seniors.

The Medicare Commission discussed giving HCFA more flexibility to enable the fee-for-service program to compete more effectively. This makes sense -- though, for the reasons discuses earlier, only if the agency is relieved of the power to set the rules for competition.

If Congress were to do this, it would give HCFA the same ability to compete as states and local governments routinely give "in-house" public agencies when they are subject to competitive bids from the private sector. There is no reason why public enterprises cannot be competitive and entrepreneurial. In virtually every state of the union, we see such innovation, from the delivery of municipal services to the management of public education. Congress should give HCFA the same kind of flexibility and entrepreneurial opportunities that school districts are giving teachers and principals to create charter schools.

Specifically, Congress should refrain from locking HCFA into a statutory straightjacket, where its primary function is the rigid and increasingly onerous and ineffective micro-management of the financing and delivery of health care services for senior citizens under fee-for-service. Instead, Congress should give HCFA greater flexibility to run the traditional fee-for-service program in ways that would make it an aggressive competitor to managed care plans and other emerging private-sector health care options in the next century. Whenever a competitive market is introduced, the government-provided service must be given every opportunity to redesign itself to compete effectively. This should be so in Medicare. Thus, HCFA should be permitted to introduce innovations into the management of traditional fee-for-service Medicare. It should be allowed, for instance, to make extensive use of preferred provider organizations of those physicians and hospitals giving the best value for money. It should also be allowed to contract out the management of the traditional program in areas where that might improve Medicare.

The Heritage Foundation is a public policy, research, and educational organization recognized as exempt under section 501(c)(3) of the Internal Revenue Code. It is privately supported and receives no funds from any government at any level, nor does it perform any government or other contract work.

The Heritage Foundation is the most broadly supported think tank in the United States. During 2013, it had nearly 600,000 individual, foundation, and corporate supporters representing every state in the U.S. Its 2013 income came from the following sources:

Individuals 80%

Foundations 17%

Corporations 3%

The top five corporate givers provided The Heritage Foundation with 2% of its 2013 income. The Heritage Foundation’s books are audited annually by the national accounting firm of McGladrey, LLP.

Members of The Heritage Foundation staff testify as individuals discussing their own independent research. The views expressed are their own and do not reflect an institutional position for The Heritage Foundation or its board of trustees.



1. Stanley B. Jones and Marion Ein Lewin (Edit.), Improving the Medicare Market (Washington, D.C.: National Academy Press), p. 72.

2Ibid., pp. 107-108.


Stuart Butler