Medicare reform and fiscal reality

Demographic, economic, and political forces have placed unprecedented demands on Medicare that cannot be met without major program reform. The oldest baby boomers have just turned 65, heralding the start of a 70 percent expansion in the Medicare population over the next two decades (Boards of Trustees, Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, 2010, Table II.A3). Continued improvement in our ability to diagnose and treat disease has meant greater longevity and better quality of life, but will drive Medicare costs more sharply upward in the years to come (Congressional Budget Office [CBO], 2010a, Box 1-2). These factors will drive up demand for Medicare-covered services while the country's worsening fiscal crisis increases the pressure to reduce the growth of Medicare spending.

It is only natural in politics and human nature to want more while spending less. If the discrepancy between desires and willingness to pay is not too great, we could get along as we have in Medicare for the past several decades--trimming provider payment rates, rooting out fraud and abuse, and occasionally risking a more significant change in Medicare policy (such as hospital prospective payment or competitive bidding for durable medical equipment). But we face a much larger problem that is not likely to resolve on its own. Policies are needed to change the fundamental incentives that drive provider and patient behavior in Medicare--and ultimately the entire health sector.


The U.S. is in a serious fiscal crisis. The recession that ended in 2009 was the longest downturn since the Great Depression. The ensuing recovery has been anemic, with unemployment hovering around 9 percent. According to President Obama's National Commission on Fiscal Responsibility and Reform, the nation is on an unsustainable fiscal path, with spending well above tax revenue (National Commission on Fiscal Responsibility and Reform, 2010). Federal debt is likely to increase dramatically, rising from 62 percent of GDP in 2010 to 87 percent in 2020 under realistic assumptions (CBO, 2010a, Figure A-2).1

There is widespread agreement that the growth of federal health spending is our largest fiscal challenge (see Bipartisan Policy Center, 2010; Galston & MacGuineas,2010). The technical challenge is identifying policies that can successfully harness Medicare's spending growth with the least impact on access to services and quality of care. The political challenge is mustering the will and bipartisanship necessary to take difficult policy actions in a program that will serve a rapidly growing number of voters.

Demographics may not be destiny, but they are highly predictable in Medicare. The entry of the baby boom generation into the program follows several decades of slow but steady enrollment growth. Their impact on program spending will not be felt for some years, however, because younger Medicare beneficiaries are healthier on average and use fewer services.

"Policies are needed to change the fundamental incentives that drive provider and patient behavior in Medicare--and ultimately the entire health sector."--Joseph Antos

According to the Medicare Trustees, program spending (as a share of GDP) will decline over the next few years before it accelerates with an aging baby boom generation.2 Between 2010 and 2020, Medicare spending in real terms is projected to grow by 9 percent even though enrollment will increase by 34 percent. Between 2020 and 2030, the trends are more similar, with 30 percent real spending growth and 27 percent enrollment growth. This pattern could buy policymakers a little more time to settle their differences and address Medicare's spending problem in a serious way.

Those estimates may be overly optimistic. They are based on the assumption that the reductions in Medicare provider payment rates enacted in the Patient Protection and Affordable Care Act (PPACA), as well as previously legislated cuts in physician payment, will be implemented in full. Medicare's chief actuary has characterized those cuts as "unsustainable," driving Medicare payment rates below those of Medicaid by 2019, which would cause substantial reductions in the number of providers able to serve the Medicare population (Foster, 2010).

If future Congresses fail to implement PPACA's Medicare cuts, program spending would grow significantly faster than currently expected. Assuming that reductions in Medicare physician payments are abolished (which is the de facto policy) and other provider cuts are phased out after 2019, Medicare spending (as a share of GDP) will grow 68 percent between 2010 and 2030 rather than the 42 percent assumed by the Trustees (Shatto & Clemens, 2010).

It is clear from these studies that there is considerable uncertainty about PPACA's ability to stabilize Medicare's financing. Even if the new law's provisions to reduce Medicare spending are implemented,3 there is no reason to think that those policies will remain in place permanently, particularly in the face of mounting pressure from providers whose incomes are adversely affected. This political challenge is faced by any strategy intended to make Medicare financially sustainable over the long term.


The 2010 health reform legislation was an exercise in fiscal musical chairs. New subsidies for health insurance in the exchanges and expanded Medicaid eligibility were funded by new taxes and cuts in payments to Medicare providers. Health care providers hope that most of the revenue they lose through reductions in Medicare payments will be made up through increased payments from the formerly uninsured. At least initially, there are no significant changes in the way Medicare operates, and no significant changes in the way health care is delivered to seniors.

The bulk of Medicare budget savings comes from across-the-board reductions in provider payment rates. Euphemistically labeled "productivity adjustments" lower the market basket updates for hospitals and other institutional providers, generating $156 billion in savings through 2019 (CBO, 2010b). Those reductions will be taken whether or not providers are able to increase their productivity and reduce their operating costs. Another $40 billion is saved by cutting payment rates for home health care.

Focusing on payment rates is business as usual in Medicare. But program costs are driven more by growth in the volume and complexity of services than by prices, so business as usual is not fiscally sustainable.

PPACA also targeted Medicare Advantage (MA) plans for $135 billion in payment reductions. MA plans will now be paid at or very close to the equivalent rates in fee-for-service Medicare, reducing many plans' ability to offer additional benefits and reducing their attractiveness to beneficiaries. This is a false economy since traditional Medicare's costs are above the bids of MA plans in many local markets. Even greater savings are possible by creating head-to-head competition between MA plans and traditional Medicare, and paying the lowest bid that clears the market (Coulam, Feldman, & Dowd, 2009).


If there is a virtue in traditional price-setting policies in Medicare, it is that the Congressional Budget Office (CBO) will usually score them as budget savers. However, policymakers recognized that price controls are not sufficient to sustain the massive expansion of federal health subsidies in PPACA. Other, more speculative, policies were advanced that intend to change the practice of medicine and the delivery of care.


Perhaps the most widely touted initiative is the creation of accountable care organizations (ACOs). ACOs are supposed to offer the care management and cost containment possible under managed care, but in a fee-for-service context (Daly & Zigmond, 2011). Rather than formally enrolling in an ACO, beneficiaries in traditional Medicare would be assigned to one based on their use of providers and health services. This kinder and gentler version of an HMO would not restrict the beneficiary's choice of providers but would hold the ACO accountable for the total use of Medicare-covered services, including services rendered by non-ACO providers.

The logic behind this initiative is elusive, to put it mildly. Because patients will suffer no consequences if they seek care outside the ACO network, ACO providers will have very little ability to prevent the potentially wasteful treatment that characterizes fee-for-service Medicare--but they will be penalized for it. Moreover, the clear political need to micromanage these new plans--amply demonstrated in the 429-page proposed regulation (U.S. Department of Health and Human Services, 2009)--in an attempt to anticipate and prevent everything that could go wrong will stifle the private-sector innovation that policymakers say they want to encourage.4 It is no surprise that the high-profile health care centers (including the Mayo Clinic, the Cleveland Clinic, Intermountain Healthcare, and Geisinger Health System) that are claimed to be the models for ACOs are unlikely to participate (Adams, 2011).5

This does not mean that we should not seek new ways of organizing the business of health care. It does mean that detailed government direction of such an effort is unlikely to produce workable models. Policymakers cannot readily accept political risks and failed initiatives, but innovation is unavoidably a risky process that builds on failure and learns from mistakes. This is inevitably a process driven from below--in the market--not directed from above.

Comparative Effectiveness

One of the ongoing concerns about our health system that drives up costs unnecessarily is the lack of solid evidence on what works for which patient. PPACA established the Patient Centered Outcomes Research Institute as an independent nonprofit organization that sponsors comparative clinical effectiveness research (CER) intended to better inform treatment decisions. In addition, the American Recovery and Reinvestment Act of 2009 provided $1.1 billion to the U.S. Department of Health and Human Services (HHS) for CER.

Although government and private organizations (including health insurers and academic researchers) have been conducting CER for some time, the research and its potential use to influence clinical care is controversial.6 There are many technical concerns, including how the research should be conducted (clinical trials, analysis of claims data, systematic reviews of existing clinical research), what constitutes sufficient evidence to drive clinical decisions, how to stay abreast of the plethora of treatment innovations that are developed every year, and how to be sure that CER-based recommendations take appropriate account of variation in patient response to treatment.

Even if those thorny problems are resolved eventually, it is not clear how CER results will be used. CER raises the prospect that insurers or the government could formally ration medical care without direct input from the patient or physician. That concern is heightened by the prospect that the results of CER studies are likely to change as more evidence is gathered. HHS Secretary Kathleen Sebelius was caught up in the kind of controversy that CER could spawn on the sensitive topic of mammography guidelines. She essentially overruled the recommendations of the U.S. Preventive Services Task Force regarding routine mammograms for women under age 50, stating that this is "an area where the recommendations have gone back and forth for years" (Condon, 2009).

There is no question that patients and their physicians need better information regarding clinical choices, and there is no avoiding the fact that insurers will continue to make coverage decisions using the information that is available. Medicare has tested ways of bringing more evidence to bear on coverage determinations (notably through "coverage with evidence development"; Tunis & Pearson, 2006), but it seems likely that the program will not take the lead given the sensitivity of such issues.

Moreover, traditional Medicare provides no incentives to patients or providers to make cost-effective decisions. Most patients have no financial incentive to refuse high-cost, low-value services because they have supplemental insurance (through Medigap, retiree plans, or Medicaid) that covers the cost-sharing requirements they would otherwise pay out of pocket. Fee-for-service providers similarly have no financial reason to refrain from prescribing a service or a clinical test that might have some value to the patient, even though the odds are low. Such incentives are likely to overwhelm all but the clearest recommendations arising from CER.

New Payment Methods

The just-described perverse incentives of fee-for-service payment are well known. The search for new payment methods that retain the character of fee-for-service but can promote more efficient delivery of services has been ongoing for decades. New payment approaches involve variants of bundling (making one payment for a series of related services) and pay-for-performance (making higher payments for better results).

The best-known refinement of fee-for-service payment is the hospital prospective payment system (PPS), which provides a single payment for all hospital services provided during a patient's inpatient stay. Medicare's adoption of PPS in 1983 revolutionized hospital care in the U.S. as other insurers also converted from cost-based reimbursement to the new system. Hospital stays shortened, as an additional day no longer added to the hospital's payment, but also sparked the growth of post-acute care services needed by many elderly patients who no longer need the more intensive care. The portion of patient care covered by the fixed prospective payment has become more efficient, but the incentive to push services that may previously have been provided by the hospital into the hands of a different fee-for-service provider is clear.7

New fee-for-service payment methods build on the PPS concept, expanding the range of services covered by the payment. A bundled payment is likely to include inpatient services, some pre-admission services, and post-discharge services for 30 days or some other relatively brief period. Other new payment approaches offer rewards, in the form of quality bonuses or shared savings, for more effective clinical and financial performance.

These methods remain developmental, however. The PPS example illustrates the fact that there are unforeseen problems with any payment system as providers respond to the new incentives and restructure the way they provide services. More importantly, such methods generally rely on centralized price setting rather than the interplay of market forces. That means payments will adapt less rapidly and less completely to changes in the way medicine is practiced, and payment policies will remain as much political as they are financial. At best, the new payment approaches will prop up Medicare's fee-for-service system based primarily on supply-side concerns, without fully engaging the power of competitive markets to drive health system improvement.


As we have seen, there are many interesting ideas that might eventually yield practical policies to rein in the growth of Medicare spending. But that is far from certain. If we want to ensure Medicare's fiscal stability, we must put the program on a budget. If we are fortunate, that budget does not need to be a binding constraint if developments in the health sector yield efficiencies without the threat of limiting payments. That happy circumstance does not appear likely to this observer.

Placing a responsible limit on Medicare's spending trend can spur transformation in the delivery of health care that could benefit everyone. The way that is done will determine how well our health dollars are spent and whether we find a satisfactory balance between health spending and other national priorities.

Two basic approaches have emerged from the political debate. President Barack Obama has proposed using the Independent Payment Advisory Board (IPAB) to limit the growth in Medicare spending through reductions in provider payment and other policies that focus primarily on the supply side of the health market (White House, 2011). Rep. Paul Ryan (R-WI) has proposed a premium support system for Medicare, which offers beneficiaries a choice of health plans but limits the growth in government subsidies for that coverage (House Committee on the Budget, 2011; CBO, 2011).

One is a top-down approach, relying on the regulatory power and financial leverage of the federal government. The other is a bottom-up approach, relying on health plans to tailor their offerings and trim their costs to attract market share. Despite their major philosophical differences, either approach could be strong medicine for the Medicare program.8

The IPAB was created to circumvent Congress's endemic failure to take the difficult actions needed to ensure Medicare's financial stability. Attempts to limit Medicare spending are pilloried by politicians as depriving seniors of "necessary" care, no matter how dubious that may be. Regrettably, this is one of the few points of bipartisanship in the current health policy debate.

Instead of leaving Medicare policy solely to elected officials, PPACA established an independent board charged with holding Medicare spending growth to no more than the rate of growth in the economy plus 1 percentage point.9 (The president's framework toughened the standard to economic growth plus 0.5 percentage point.) The board would make policy recommendations to Congress, which the latter could replace with actions of its own but only if the new policies resulted in an equal or greater reduction in Medicare spending.

Absent congressional action, IPAB recommendations would have the force of law. Moreover, PPACA specifies that IPAB actions are not subject to judicial review. These procedures raise constitutional questions, including whether Congress has the right to delegate its legislative responsibilities to an unelected board.

The board is prohibited from recommending policies that ration health care, raise revenue or beneficiary premiums, increase cost-sharing, or otherwise restrict benefits or modify eligibility criteria. In other words, no actions that would directly affect potential voters are permitted.

Instead, IPAB will rely heavily on cuts in provider payment rates, changes in conditions of provider participation, and potentially new payment models. Although nothing precludes IPAB's adoption of competitive bidding methods and other market-based payment arrangements, an Obama-appointed board would likely favor more centralized pricing approaches. With the likely decline in Medicare Advantage due to payment reductions and other restrictions imposed by PPACA, beneficiaries will have few alternatives to the tightly constrained fee-for-service Medicare program.

In contrast, premium support promises to expand plan choices, allowing beneficiaries to express their preferences about how they want to receive their care in a world of restricted budgets. Instead of focusing on the supply side of the market, premium support limits the subsidy provided to Medicare plans. Within limits, competing health plans could adjust their benefits, provider networks, cost-sharing requirements, and premiums to attract enrollees. Beneficiaries choosing more expensive plans would pay higher premiums.

A prototype of premium support already operates as Medicare's Part D program. Beneficiaries wishing to purchase prescription drug coverage through Medicare have a range of plan choices that offer varying combinations of local pharmacy networks, mail order pharmacy, preferred drug lists, cost-sharing requirements, and premiums. Part D plans must meet Medicare's standards, and HHS provides standardized information that helps beneficiaries compare their plan alternatives. Competition is robust, resulting in lower costs for both the government and the beneficiary than anticipated when the program was enacted.

The key difference between the IPAB model and premium support is the degree of consumer involvement and plan innovation that is permitted. Premium support assumes that seniors have varying preferences with regard to the details of their health plans and that enough of them would act on those preferences if given the chance. That would motivate health plans to refine their offerings to increase market share, and would make the plans sensitive to the changing demands of consumers.

Since seniors live on limited incomes, plans will be motivated to find more efficient ways to deliver services that cut cost without unduly burdening patients. They cannot simply order more tests or procedures to increase their profits, as is the case in a fee-for-service world, because the total payment for an enrollee is limited. That provides a strong incentive to seek ways to deliver care that are both more efficient and attractive to consumers.


Incentives drive behavior, in life and in the health sector. Medicare's uncapped entitlement and fee-for-service incentives have driven a steady but unsustainable rise in program spending. The baby boom generation, which financed much of that expansion during their working years, is beginning to retire and enroll in Medicare. That means even greater financial burdens on younger generations--and on younger baby boomers.

It is not surprising that policymakers from across the political spectrum are proposing to put Medicare on a budget. How they do that matters a great deal.

A top-down regulatory approach is akin to trying to hold back the tide. Eventually the tide rolls in, in this case because regulators can never anticipate the imaginative ways people have of evading the rules if that is in their best interest. Instead, policymakers should take full advantage of economic incentives by not stifling that ingenuity under a blanket of excessive rules.

Premium support accepts the fact that resources available to Medicare are not limitless, and it provides beneficiaries with realistic health plan options. It also is a wake-up call to the health industry to provide more efficient and effective care if plans expect to operate successfully in a world of resource constraints. If the industry responds in that way, unnecessary costs will be trimmed by the providers themselves. But the industry might seek political relief instead, which would mean higher taxes rather than increased efficiency. Our health care and our fiscal future depend on Congress just saying no, and meaning it.

Joseph Antos is the Wilson H. Taylor Scholar in Health Care and Retirement Reform at AEI.


1. Estimates based on CBO's alternative fiscal scenario. That scenario assumes an extension of the 2001/2003 tax cuts (effectively what was passed in December 2010, after the CBO report was issued). It also assumes other tax changes that reduce revenue, permanent deferral of reductions in Medicare physician payments, and more rapid spending growth for health and discretionary spending than under its "extended baseline" scenario.

2. Despite the growth in enrollment, Medicare spending declines 2.8 percent in real terms between 2010 and 2013 before returning to its previous level by 2017. Author's calculations; Boards of Trustees, Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds (2010, Tables III.A2 and III.A3).

3. It has been argued that most provisions enacted in the past 20 years to produce Medicare savings were successfully implemented, but that analysis ignores subsequent legislation that undermined those savings. See Van de Water and Horney (2010).

4. Experts who support the ACO concept also have concerns about its feasibility in light of the new regulation. See, for example, Lieberman (2011).

5. Marshfield Clinic, the biggest financial winner in the Medicare physician group practice demonstration that is the precursor the ACOs, likely will not initially participate in the ACO project because of its restrictions. See Wilkerson (2011).

6. The challenges of CER are reviewed in Congressional Budget Office (2007) and Harrington (2011).

7. A host of other issues have been identified with PPS, including the risk that hospitals may be less careful to prevent complications after admission because more complex cases are paid at higher rates and the disincentives to adopt new technology because payment may not reflect the additional cost. See Averill et al. (2006) and Medicare Payment Advisory Commission (2010).

8. The Obama "framework" establishes a spending target that is tighter than prescribed in PPACA for IPAB, whose policies would begin to take effect as early as 2015. The Ryan proposal establishes the premium support program in 2022, but its deficit reduction goal is more ambitious than the president's. Obviously, either target can be ratcheted up or down. A comparison of the fiscal effects of the proposals is available; see Committee for a Responsible Federal Budget (2011).

9. Specifically, the rate of growth in Medicare spending per beneficiary may be no greater than the rate of growth of GDP per capita plus 1 percentage point.


Adams, R. (2011, May 6). Health centers skeptical of proposed rule. CQ Healthbeat News. Retrieved May 29, 2011, from

Averill, R. F. Vertrees, J. C., McCullough, E. C., Hughes, J. S., & Goldfield, N. I. (2006). Redesigning Medicare inpatient PPS to adjust payment for post-admission complications. Health Care Financing Review, 27, 83-93.

Bipartisan Policy Center. (2010, November). Restoring America's future. Washington, DC.

Boards of Trustees, Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds. (2010, August). 2010 annual report of the boards of trustees of the federal hospital insurance and federal supplementary medical insurance trust funds. Washington, DC.

Committee for a Responsible Federal Budget. (2011, April). Analyzing the president's new budget framework. Washington, DC.

Condon, S. (2009, November 18). Sebelius: Mammogram recommendations won't set policy (Television broadcast). New York: CBS News.

Congressional Budget Office. (2007, December). Research on the comparative effectiveness of medical treatment. Washington, DC.

Congressional Budget Office. (2010a, June). The long-term budget outlook. Washington, DC.

Congressional Budget Office. (2010b, August). Cost estimate for H.R. 4872. Letter to Hon. Nancy Pelosi. Washington, DC.

Congressional Budget Office. (2011, April). Long-term analysis of the Medicare and Medicaid proposals. Letter to Rep. Paul Ryan. Washington, DC.

Coulam, R. F., Feldman, R., & Dowd, B. E. (2009). Bring market prices to Medicare: Essential reform at a time of fiscal crisis. Washington, DC: American Enterprise Institute.

Daly, R., & Zigmond, J. (2011, March 31). CMS issues proposed ACO regulation. Modern Healthcare. Retrieved May 28, 2011, from

Foster, R. S. (2010, April). Estimated financial effects of the "Patient Protection and Affordable Care Act," as amended. Baltimore, MD: Centers for Medicare and Medicaid Services.

Galston, W. A., & MacGuineas, M. (2010, September). The future is now: A balanced plan to stabilize public debt and promote economic growth. Washington, DC: Brookings Institution.

Harrington, S. E. (2011). Incentivizing comparative effectiveness research. Unpublished manuscript, University of Pennsylvania.

House Committee on the Budget. (2011, April). The path to prosperity: Restoring America's promise. FY 2012 Budget Resolution. Washington, DC.

Lieberman, S. (2011, April). Proposed CMS regulation kills ACOs softly. Health Affairs Blog. Retrieved May 26, 2011, from

Medicare Payment Advisory Commission. (2003). Payment for new technologies in Medicare's prospective payment systems. In G. M.Hackbarth (Ed.), Report to the Congress: Medicare payment policy (pp. 175-190). Washington, DC.

National Commission on Fiscal Responsibility and Reform. (2010, December). The moment of truth. Washington, DC.

Shatto, J. D., & Clemens, M. K. (2010, August). Projected Medicare expenditures under an illustrative scenario with alternative payment updates to Medicare providers. Baltimore, MD: Centers for Medicare and Medicaid Services.

Tunis, S. R., & Pearson, S. D. (2006). Coverage options for promising technologies: Medicare's "Coverage with evidence development." Health Affairs, 25,1218-1230.

U. S. Department of Health and Human Services. (2009, March). Medicare shared savings program: Accountable care organizations. Retrieved May 26, 2011, from∼/media/Files/2011/ACO%20Proposed%20Rule.pdf.

Van de Water, P. N., & Horney, J. R. (2010, March). Health reform will reduce the deficit: Charges of budgetary gimmickry are unfounded. Washington, DC: Center for Budget and Policy Priorities.

White House. (2011, April 13). Fact sheet: The president's framework for shared prosperity and shared fiscal responsibility. Washington, DC.

Wilkerson, J. (2011, May 3). Marshfield clinic leaning toward not initially participating in ACO program. Inside Health Policy. Retrieved May 29, 2011, from

"Medicare reform and fiscal reality," Joseph Antos, Journal of Policy Analysis and Management, published online ahead of print, June 24, 2011. Copyright © 2011 Wiley Periodicals, Inc.

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