Better prices--through competitive bidding--can help solve Medicare's fiscal crisis

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Article Highlights

  • #Medicare simply tells private health plans what they'll be paid - ignoring the plans' true costs #expensive

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  • Both private plans and FFS medicare should submit the lowest bids possible for a standard entitlement #competition

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  • Competitive pricing could save 8% of Medicaid costs without sudden disruption of beneficiaries #transition

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Medicare faces a severe fiscal crisis and one reason is that it pays too much for the Medicare entitlement benefit. There is a way to fix the Medicare program without raising taxes: use market-like arrangements to set prices for both the traditional fee-for-service (FFS) program and for private Medicare Advantage (MA) plans. A fully implemented competitive pricing system for Medicare would save $550 billion over 10 years (almost 8 percent of total program costs) or $460 billion if it were phased in gradually. At the same time, this reform would:

  • Preserve full government funding for basic Medicare benefits-elders would not be exposed to the risk of higher health costs, as in approaches that would set fixed voucher payments toward the purchase of medical insurance.
  • Preserve the traditional FFS Medicare program as an option-FFS would continue to be offered, although without any special advantages in competing with private plans.


The core of this approach is payment reform. At present, Medicare is dominated by the traditional FFS plan, under which patients can see any doctor of their choice for any covered service with only minor limits. Medicare pays a fee for each service. Not surprisingly, doctors and other health providers have an incentive to provide more services. That increases costs. Medicare also offers private "Medicare Advantage" plans that are paid a fixed amount each month to care for seniors who enroll. Medicare Advantage plans have an incentive to work with doctors and hospitals to reduce the use of ineffective and costly services. In some parts of the country, MA plans are cheaper than FFS Medicare and the quality of care is as good.

...those who fear that the quality of care will suffer as a result of competitive pricing are overstating the quality assurances that exist under the current program and current pricing arrangements.

For decades, Medicare has based its contributions to private health plans' premiums on the cost of FFS Medicare in the same market area. Medicare simply tells private health plans what they will be paid, regardless of the plans' true costs of caring for Medicare beneficiaries. Competitive pricing reverses this misdirected flow of information. Here is how competitive pricing would work. Both private plans and FFS Medicare would submit bids in each market area for a standard set of covered benefits (the entitlement). The government then would set its payment equal to the lowest bid in each area, adjusted for the health risk of the each plan's enrollees. In some market areas the low bidder will be a private plan, while in other areas it will be FFS Medicare. All seniors would have guaranteed access to at least one health plan that offered the standard set of benefits at no more than the Part B premium, which is what seniors currently pay. Seniors who wanted a more expensive plan would pay the additional premium out of their own pockets.

The penalty for bidding high would be predictable-beneficiaries would have to pay out-of-pocket premiums-thereby providing an incentive for plans to offer their best price. The reward for low bidders would be increased enrollment. For competitive pricing to work, it must encompass all Medicare plans, including FFS.

A competitive pricing system that used the lowest bid from any qualified plan to set the government contribution to all plans would save almost $550 billion over ten years, or 7.7 percent of Medicare costs. By contrast, a voucher plan-paying a fixed dollar amount toward the purchase of medical insurance--might save more or less than competitive pricing, depending on the level at which the voucher is set in relation to the cost of producing the entitlement benefit. However, vouchers would be set by a political process that would not reveal the underlying costs of producing the entitlement benefit-and thus could not guarantee to seniors that their medical costs would be covered as fully as they are now. Only a bidding system can do that.

Some seniors may like the free choice of physicians in FFS Medicare. Moreover, the FFS plan is a check on the market power of sometimes concentrated local providers-FFS Medicare does not have to negotiate prices, as it has enough market share to set them. The FFS option would continue to be available under this competitive pricing proposal. Seniors who preferred that option could choose it, as long as they were willing to pay the additional cost in areas where FFS Medicare was not the low bidder. Meanwhile, MA plans would stop offering supplementary benefits in areas where these plans are overpaid.

These changes would result in disruption for some beneficiaries and some health plans. This is an appropriate concern. However, these beneficiaries and health plans can be identified in advance, and there are innumerable ways to create a slow transition to full competitive pricing so health plans and beneficiaries are not abruptly disrupted. For example, Congress could pick a future year for full implementation and then blend new and old methods in a gradual transition to the new. A five-year phase in of the program would yield ten-year savings of $460 billion.

Some critics have expressed the fear that competitive prices will lead to lower quality. There are three reasons that this worry is overstated. First, there is no evidence that higher prices are associated with higher quality. Second, those who fear that the quality of care will suffer as a result of competitive pricing are overstating the quality assurances that exist under the current program and current pricing arrangements. Finally, rather than harming beneficiaries, competitive bidding arrangements provide a natural administrative platform for maintaining and enhancing competition and quality-e.g., through additional qualification requirements for bidders (such as enhanced accreditation as a condition of bidding) and additional data requirements (such as enhanced monitoring of quality and access).

Competitive bidding is hardly a radical proposal. Lowest-bid systems have been used for decades by employers, with good results. Variations on this approach are commonplace in state Medicaid programs and the Defense Department's health care programs. This approach would work for Medicare.

Everyone agrees that Medicare must do something to control costs, and competitive pricing is a step in the right direction. Of all the payment reform proposals, competitive pricing is the only one that will save a significant amount of money based on paying the actual costs of health care, and in so doing preserve the existing FFS program and the entitlement benefit. It will not solve all of Medicare's financial problems, but it is an essential step in the right direction.

For further discussion and information, see BRING MARKET PRICES TO MEDICARE! Essential Reform at a Time of Fiscal Crisis (Washington, DC: American Enterprise Institute, 2009), by Robert Coulam, Roger Feldman, and Bryan Dowd.

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About the Author


  • American Enterprise Institute (AEI) adjunct scholar Roger Feldman is the Blue Cross Professor of Health Insurance and Professor of Economics at the University of Minnesota, where he specializes in applying economic theory to health services research. He is currently a member of the Congressional Budget Office’s Panel of Health Advisers and consults for various federal and state agencies on health care–related matters.

    Previously, he served on the senior staff of the President’s Council of Economic Advisers. From 1988 to 1992, he directed one of the four national research centers sponsored by the Centers for Medicare and Medicaid Services (CMS) and has advised CMS on the design of a demonstration of competitive bidding for Medicare health plans. At AEI, Feldman’s research focuses on Medicare reform, competition in health care, and health insurance markets.

    Feldman holds a Ph.D. in economics from the University of Rochester. He obtained an M.S. in economics at the London School of Economics, where he was a Marshall Scholar, and a B.S. from the University of Wisconsin-Madison.

  • Phone: (612) 624-5669


Bryan E.
  • American Enterprise Institute (AEI) adjunct scholar Bryan Dowd is the Mayo Professor of Public Health and the director of graduate programs in health services research and policy at the School of Public Health at the University of Minnesota. His work at AEI focuses on the economics of health care policy, Medicare reform, and health insurance markets.

    A health economist with a Ph.D. in public policy analysis from the University of Pennsylvania, Dowd also has an M.S. in urban administration from Georgia State and a B.A. in architecture from the Georgia Institute of Technology.

  • Phone: (612) 624-5468

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