Medicare Reform After the Election

Published December 13, 2012


In the “fiscal cliff” talks, Republicans are demanding serious entitlement reforms in exchange for an agreement to raise revenues. But in the aftermath of the November election, what kinds of reforms should be on the table, especially in the Medicare program? President Obama made clear during the campaign his opposition to the one idea that could really make a difference—premium support of the kind developed and championed by the Republican vice presidential candidate, Paul Ryan. That’s the most direct route to injecting the kind of market discipline that Medicare and the rest of the health system desperately need.

But if premium support can’t be secured in this round of negotiation because of Democratic opposition, are there other reforms that are still worth fighting for?

The answer is yes, but to determine what they are requires a proper understanding of what is driving the cost problem in Medicare in the first place.

The most pressing problem in Medicare is the dominant and poorly designed fee-for-service (FFS) insurance model. Seventy-five percent of the beneficiaries are enrolled in FFS, with the other 25 percent enrolled in private plans (called Medicare Advantage). The FFS program is essentially a claims-paying machine. If a licensed provider renders a medical service to a beneficiary, the Medicare FFS program generally pays for the service, no questions asked. In that sense, it’s an FFS program modeled on the private insurance plans prevalent in 1965, when Medicare was created.

The problem is that FFS insurance requires effective cost-sharing on the part of the enrollees to provide some check on use of services. Otherwise, FFS insurance costs will soar as there is no other control mechanism overseeing appropriate care.

Unfortunately, Medicare FFS does not have an effective cost-sharing structure. The law certainly requires cost-sharing on the part of the beneficiaries (irrationally designed, but cost-sharing nonetheless). But the vast majority of FFS enrollees—90 percent, according to data from the Medicare Payment Advisory Commission—have secondary insurance that pays for the all of the costs that Medicare doesn’t cover. This secondary insurance comes in the form of Medigap plans, employer-sponsored wraparound coverage, or Medicaid. For beneficiaries with these kinds of secondary insurance coverage, Medicare’s cost-sharing is useless because the insurance pays it for them. Thus, there is very little reason for these beneficiaries to steer away from extra procedures and tests because they don’t pay any of the added cost that arises from the additional use of services.

The predictable result of these incentives is a steady and unrelenting rise in the volume and intensity of services provided to Medicare FFS enrollees. The Congressional Budget Office (CBO) has estimated that between 1997 and 2005, the real price per capita paid for physician services declined by about 5 percent, but overall spending per FFS enrollee rose nearly 40 percent because of an explosion in the use of services.

Any serious reform of Medicare must tackle this problem of a dysfunctional cost-sharing system.

The Obama administration’s solution is to try to enroll FFS beneficiaries into a new version of “managed care”—without really ever telling the beneficiaries what’s going on. The health law encourages doctors and hospitals to form Accountable Care Organizations (ACOs)—essentially HMOs without the insurance component. The idea is that these organizations will work against the fragmentation and lack of coordination in Medicare FFS and begin to reduce costs.

But the ACO model as currently constituted is flawed. The Medicare beneficiaries have no role whatsoever in selecting an ACO to get their care. The government is assigning the beneficiaries to ACOs based on who their primary physician is. If their doctor is part of an ACO, so are they. With this kind of “passive enrollment” system, the ACOs are destined to disappoint. They either won’t deliver much in terms of cost-cutting, or, if they do, the beneficiaries will revolt because they never really agreed to be a part of a more controlled “managed care” program.

Medicare reform could be jumpstarted with a far-reaching reform of both the secondary insurance system and the ACO concept. There are three parts to a sensible approach. First, in general, Medigap plans and employer-sponsored retiree coverage should not be allowed to fill in entirely Medicare’s cost-sharing. In an FFS insurance model, that’s commonsense. In addition to regular Medigap insurance, this rule would apply to the health program for retired federal employees as well as the military health system, both of which serve as secondary insurance for millions of former government workers and military personnel.

Second, the ACO “shared savings” program should be explicitly expanded to foster competition among ACOs through beneficiary choice. Instead of the automatic enrollment system now in place, beneficiaries should be given the option to enroll in an ACO of their choosing. And, as an incentive to do so, they should be allowed to share in the savings from ACO cost-cutting. The amount of savings they would get (in the form of reduced Medicare premiums) should be directly proportional to how much ACOs can bring down overall costs below what would otherwise occur in unmanaged FFS. Thus, ACOs that are particularly effective at cutting costs would attract market share and enrollment because beneficiaries would experience reduced premiums if they signed up with them.

Third, to provide even more incentive for enrollment in cost-effective care, the reform should allow secondary insurance to provide more favorable cost-sharing for beneficiaries who get their care from an approved integrated system (that could be an ACO model or perhaps even more aggressively managed models). This would give the beneficiaries even stronger financial incentives to forgo unmanaged FFS and would create within Medicare something like an “in-network” and “out-of-network” structure, much like what many private employers have in place today.

These three reforms would dramatically change the cost dynamic in the program. Even so, other reforms would still be necessary. The Medicare system of co-insurance and deductibles is completely out-of-date and needs to be modernized. The age of eligibility for Medicare needs to be updated to reflect the nearly five-year improvement in longevity that has occurred since 1965. And the move toward greater means testing should accelerate. All of these reforms would complement a thoroughgoing reform of the secondary insurance system and ACOs.

Of course, even with these reforms, Medicare will still need the full benefit that would come from opening up the program to stiff competition between private plans and FFS in a premium support reform plan. The potential for cost-cutting innovation with such a reform far exceeds what can be done within the FFS framework.

But until that model can be adopted in full, it’s important to start injecting into the program more rational consumer incentives to begin correcting the flaws that are now driving up costs so rapidly.

James C. Capretta is a fellow at the Ethics and Public Policy Center, a visiting fellow at the American Enterprise Institute, and project director of

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