The Case for Reforming Medicare with Premium Support

Published December 8, 2011


This article is published in the Brookings Institution's Premium Support: A Primer. The full report is available here.

In coming years, the United States must take steps to address the serious challenges of a large and growing fiscal gap as well as rapidly rising costs for both public and private purchasers of medical services. These problems are of course inter-related, as rapid cost growth in federal health entitlement programs is the most important reason that budget estimates show long-term deficits and debt soaring to levels that would be crippling for the American economy.

At the center of these twin challenges is the Medicare program. It is the largest federal health entitlement program, and Medicare spending is already putting tremendous pressure on federal finances due to many years of rapid cost growth. In the coming two decades, federal spending on Medicare is set to soar even more rapidly as the baby boom generation heads into its retirement years. Medicare is also the single largest insurance plan in the United States, and thus central to solving the problem of rapidly rising costs in the nation's broader health system.

While a political consensus has emerged that Medicare must be modified and reformed for both fiscal and health policy reasons, there is not yet a consensus around what are the key elements of an effective reform plan.

One prominent reform concept—so-called “premium support”—has been discussed for more than fifteen years as a possible organizing principle for modernizing Medicare. In previous debates, including one that occurred during deliberations of the 1998-99 National Bipartisan Commission on the Future of Medicare, premium support was advanced but ultimately not adopted by policymakers due to vigorous opposition from factions committed to preserving Medicare's current design.

And yet, despite the setbacks and continued opposition, premium support is the idea that just won't go away—and for good reason. That's because it's the most promising reform concept available, with the potential to bring about serious and continuous cost discipline without eroding the quality of care provided to Medicare's participants.

Medicare Fee-for-Service's Role in the Cost Problem

To see the value of premium support as a reform concept, it is necessary to understand how Medicare works today, and especially the role that Medicare plays in today's inefficient arrangements for delivering health care services.

Health care in the United States has many virtues. We have the world's most skilled physician workforce, as well as the world's most advanced hospitals and outpatient clinics. Most Americans have fairly ready access to the care that can be provided by the nation's sophisticated network of hospitals and physician offices through third-party insurance arrangements. U.S. health care also remains open to innovation in ways that other systems around the world are not.

But there's no question that U.S. health care also suffers from serious deficiencies. The primary problem is that health care in this country is highly fragmented and uncoordinated. In the main, physicians, hospitals, clinics, labs, and pharmacies are autonomous, financially independent units. They bill separately for the services they render to patients, with very little need to coordinate with anyone else in the system. The result is an incredible level of duplication and waste, overemphasis on procedure-based medicine, as well as burdensome paperwork, excessive bureaucracy, and a lack of accountability for the all-too-frequent cases of low quality care.

Why does health care delivery in this country suffer from these deficiencies? There are a number of reasons, but by far the most important one is the dominant role played by Medicare's traditional fee-for-service (FFS) insurance arrangements.

Medicare FFS is the largest and most influential payer in most markets. As the name implies, FFS pays any licensed health care provider when a Medicare patient uses services—no questions asked. Nearly 75 percent of Medicare's 49 million enrollees are in the FFS program (p. 173, Table IV.C1). Physicians, hospitals, clinics, and other care organizations most often set up their operations to maximize revenue from Medicare FFS payments.

For FFS insurance to make any economic sense at all, the patients need to pay some of the cost when they receive health care services. Otherwise, there is no financial check against the understandable inclination to agree to all of the tests, consultations, and procedures that could be possible, but not guaranteed, steps to better health.

But Medicare FFS does not have effective cost-sharing at the point of service. Yes, the program requires cost-sharing, including 20 percent coinsurance to see a physician, but more than 90 percent of FFS beneficiaries have additional insurance in the form of Medigap coverage, retiree wrap-around plans, or Medicaid that pays for nearly all costs not covered by FFS. Further, Medicare's rules require providers to accept Medicare's reimbursement rates as payment in full, effectively precluding any additional billing to the patient.

In the vast majority of cases, then, FFS enrollees incur no additional cost when they use more services, and health care providers earn more only when service use rises. It is therefore not at all surprising that Medicare's costs have risen rapidly over the years due a relentless rise in the volume of services used by FFS participants. For instance, the Congressional Budget Office (CBO) reports that the average beneficiary used 40 percent more physician services in 2005 than just eight years earlier (p. 15, Table 3). Spending for physician-administered imaging and other tests was up approximately 40 percent from 2002 to 2007 (p. 102).

Medicare's dominant FFS design also stifles much needed innovation in service delivery. As Mark McClellan, former Administrator of the Centers for Medicare and Medicaid Services (CMS), put it:

In traditional FFS Medicare, benefits are determined by statute and cannot easily include many innovative approaches to benefit design, provider payment, care coordination services, and personalized support for beneficiaries….When providers are paid more when patients have more duplicative tests and more preventable complications—as is the case in FFS payment systems—it is more challenging to take steps like adopting health IT [information technology] or reorganizing practices in other ways to deliver care more effectively.

Moreover, many of the payment regulations reward higher use of last year's services, offered by last year's list of qualified providers. New service delivery organizations, pricing approaches, and ways of caring for a patient—such as over the Internet and phone—are simply not accommodated by payment rules, many of w
hich were written decades ago. Even marginal changes can take years to implement, often after a multiyear test. Providers are thus understandably reluctant to invest in new approaches, no matter how promising, which will pay off only if Medicare accommodates the change. The result is today's fragmented and dysfunctional system is virtually frozen in place for all users of U.S. health care, not just Medicare beneficiaries.

Medicare's Administrators Can't Engineer Delivery System Reform

The antidote to a fragmented and uncoordinated delivery system is a high-value, low cost network of the best providers of medical care. The architects of the 2010 health care law recognized this need and set in motion a number of initiatives that they hoped would bring about this transformation under the heading of “delivery system reform.”

Unfortunately, these efforts are doomed to fall well short of the high expectations set for them. The reason is that the federal government has no capacity to build a higher value network of providers in the Medicare program. The private-sector delivery models that are so admired by federal Medicare officials—such as the Geisinger health plan, the Cleveland Clinic, and Intermountain Health Care—operate on a principle of provider exclusivity. They do not take just any licensed provider into their fold. They operate highly selective, data-driven networks. Low-quality performers are dropped or avoided altogether, and tight processes are established to streamline care and eliminate unnecessary steps.

The federal government has never shown any capacity to enforce rules on providers that are even remotely similar to those achieved by model programs such as Geisinger, the Cleveland Clinic, and Intermountain. Indeed, the whole point of the Medicare FFS model that Congress has protected so jealously over the years is that beneficiaries may see any licensed provider of their choosing, to whom Medicare pays a fixed reimbursement rate, irrespective of quality. Past attempts to steer patients toward preferred physicians or hospitals, such as the Centers of Excellence demonstration in the 1990's, have failed miserably because politicians and regulators find it impossible to make distinctions among hospitals and physician groups based on quality measures that are inevitably subject to dispute.

Congress and Medicare's regulators have found it much easier to cut costs with across-the-board payment rate reductions that apply to every licensed provider without regard to any measures of quality or efficient performance. Tellingly, the 2010 health law uses this approach to achieve most of its Medicare savings. The big reductions come from arbitrary cuts in payment updates for institutional providers of care. That pattern is unlikely to change so long as Medicare FFS remains the dominant option. To cut spending fast and with certainty, the preferred solution of the American political system will always be deeper reductions in payment rates.

The danger is that these cuts will erode the quality of medical care provided to the nation's seniors. Already, the Chief Actuary for the program is warning that the cuts imposed in the new health law will drive average payment rates for the Medicare program below that provided in Medicaid, and Medicaid is notorious for having such a constrained network of willing suppliers that enrollees have serious access to care problems.

The Premium Support Prototype: Medicare Part D

Premium support provides an alternative vision for how to bring about “delivery system reform.” Instead of relying on the government's capacity to re-engineer how doctors and hospitals are organized and provide care, premium support relies on a decentralized process of consumer choice and vigorous price and quality competition among the plans providing coverage as well as among those providing services directly to patients. The idea is to give the program's participants strong financial incentives to gravitate toward arrangements that can deliver high quality care at the lowest possible premium.

The drug benefit in Medicare provides a prototype of how premium support could work in the larger program. The key design feature of the drug benefit is that the government's contribution toward the coverage does not vary based on the plans selected by the beneficiaries. The participating private plans offering the insurance submit bids to the federal government based on the premium amounts they will charge for providing the drug benefit. The government then calculates what it will pay on a regional basis, based on a weighted average of the bids. The government's contribution toward drug coverage is the same for high cost and low cost plans. Beneficiaries selecting plans that cost more than the weighted average pay the additional premium entirely out of their own pockets. Conversely, beneficiaries choosing less expensive plans reduce their premium expenses commensurately.

At the time of enactment, this competitive design had many critics. Some argued that the program would not work because private plans would decline to participate without a guaranteed share of the market. Others said that beneficiaries would not sign up for the program because the competitive structure was too complex to navigate. Still others said that program costs would explode without government-regulated price controls.

All of these predictions proved to be wrong. Now in its sixth year of implementation, the program has exceeded all expectations. Some 90 percent of Medicare participants are in secure drug coverage of some sort, and public opinion surveys show that they are very satisfied with what they have. Most importantly, the program is coming in way under budget, with ten-year costs now expected to come in 42 percent below the estimates done at the time of enactment.

The Department of Health and Human Services recently announced that the average beneficiary's premium for the program will be about $30 in 2012, down from $30.76 in 2011. Remarkably, that is just $4 more per month than the average premium in 2006. Over the first six years of the program, the average premium increase has been just 2.5 percent per year—well below cost growth in the rest of Medicare.

The drug benefit is working because it engages the consumer in cost cutting. Seniors want the best value for their Part D premium, which means looking for plans that keep their branded drug prices low and offer favorable terms for using low-cost generics. The result has been a record of cost control that government micromanagement cannot match. Indeed, if the federal government had tried to mandate the kind of cost-cutting that the private part D plans are now enforcing, it almost certainly would have backfired. For instance, manufacturers and patient groups would have lobbied against blanket generic substitution requirements for a variety of reasons, thus slowing down the movement in that direction.

Broadening Support for the Concept

A number of objections have been raised about premium support over the years by opponents. These objections can be addressed without violating the fundamental design principles necessary to make the concept work.

The first objection is that some versions of premium support assume the only plans available to Medicare beneficiaries would be sponsored by private insurers, and that the traditional Medicare FFS program would be phased out with no new entrants beyond a certain cut-off year. It is certainly the case that the Medicare drug benefit has no “public option” competing with the private drug coverage plans, and the absence of a government-run competitor has made it easier to ensure a fair competition among the plans that are presented
to the beneficiaries. But because of Medicare's long history with a government-run FFS system, it is not unreasonable to consider retaining traditional FFS as one option from which seniors could elect to get their coverage in the future. That was a feature of the premium support proposal developed by the National Bipartisan Commission in 1998-99 (the Breaux-Thomas proposal), as well as the version advanced by the Bipartisan Policy Center in 2010.

The only condition that should be attached to continuing a FFS option is that the playing field for the competition must truly be level. Today, Medicare FFS essentially dictates payment rates to the provider community. That is not the case with private plans. They must negotiate contracts with networks of willing providers of services. In a premium support program with FFS retained as an option, FFS should be required to submit bids on a region-by-region basis consistent with the market area required to be covered by private plans, and the reimbursement rates paid by FFS to hospital, physician, and other providers of services and supplies in those markets must be reasonable by local standards.

A second objection is that the government's premium support payments should be set in a way that does not unduly push cost risk onto the beneficiaries. For instance, if premium support payments were scheduled to rise with inflation or even economic growth rather than health costs, then it is possible that the out-of-pocket costs seniors would face in a reformed Medicare program would rise much faster than their incomes.

But this objection can be addressed rather easily by setting the government's contribution for premium support payments using the same methodology employed in the drug benefit. There, the government's contribution is based on the enrollment-weighted average of the bids from the competing private plans. This ensures that the government's contribution never strays from the actual cost structure faced by the beneficiaries. The premium support plan advanced by a majority of the National Bipartisan Commission was based on a similar competitive bidding approach.

The downside of setting the government's contribution based on competitive bidding is that the official scorekeeper of Congressional legislation—the Congressional Budget Office—does not believe that competition of this sort will substantially “bend the cost curve” downward in future years. Thus, competitive bidding may not be “scored” as actually solving Medicare's long-term cost problem.

This should be not an insurmountable obstacle to advancing the premium support concept, however. One way around the problem would be to establish a back-up budgetary mechanism that kicks in depending on the robustness of the savings from competition in premium support. If it turns out that more savings is needed to hit budgetary targets beyond what is produced by premium support, then other adjustments could automatically kick in as necessary. However, if premium support works as well as the drug benefit has, with costs rising at a moderate and affordable pace, then no additional adjustments would be necessary to achieve the desired level of budgetary savings.


Medicare was designed in 1965 to be compatible with the prevailing Blue Cross-Blue Shield-type insurance that was prevalent in the marketplace at that time. Quite a lot has changed in last 46 years, so it should not be surprising that the program is due for an update.

Medicare is valuable to seniors because it provides secure access to needed medical care at the most vulnerable stage of life. That wouldn't change with premium support. What would change is that Medicare would benefit from the same competitive pressures that deliver continuous quality and productivity improvements in most sectors of the American economy.

James C. Capretta is a fellow at the Ethics and Public Policy Center and project director of e21's ObamaCare Watch. He was an associate director at the Office of Management and Budget from 2001 to 2004.

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