Medicare, the government program that pays for medical care for the aged and the disabled, is the principal health insurance for more than 40 million Americans.  It also provides a substantial part of the income for most health care professionals.  But the program is being criticized by both experts and beneficiaries for its inability to keep pace with medical technology and modern health coverage, and for its impending financial shortfalls. 

Origin and Development of the Program.[1]  President Lyndon Johnson signed Medicare into law in July 1965 after more than two decades of intense political debate.  The political compromises that enabled its passage also prevented Medicare from adapting to changing medical and market conditions, making it costly, inefficient and outdated.  Congress has exacerbated Medicare’s problems by making major changes to the program, and more are under consideration.

• Congress approved the largest addition to the covered population in 1973, when it added coverage for the disabled under age 65 and those with end stage renal disease.
  
• In 1983, hospital reimbursements changed from payments based on each hospital’s costs to a prospective payment system (PPS), in which Medicare provides a fixed payment for each hospital stay based on the average cost of treating a specific medical condition, or Diagnostic Related Group (DRG). A form of price control, this change substantially reduced the average length of a hospital stay, but it increased the amount of care provided in rehabilitation and skilled nursing facilities, outpatient clinics and homes.  Thus it shifted those needing extended care to other parts of the Medicare program.
  
• Then in 1991 Congress created a price control system for reimbursing physicians in the form of a national fee schedule.

By 1997, Medicare costs were growing so fast that Congress made substantial cuts in the rates paid to hospitals and physicians, intensifying the political fight over Medicare payment policies for providers. Congress later rescinded much of that legislation.

The Structure of Medicare. The Medicare program is divided into three parts, each covering a separate segment of benefits and each with its own method of financing.  Parts A and B were established in the original legislation. Medicare+Choice, sometimes referred to as Part C, was added in 1997. 

Medicare Part A.[2]  Part A is the hospital insurance (HI) program.  It “helps pay for hospital, home health, skilled nursing facility, and hospice care for the aged and disabled.”  All people eligible for Social Security are automatically enrolled, and Part A is financed by a 2.9 percent payroll tax paid into the HI trust fund by all working Americans. 

Each beneficiary admitted to a hospital is subject to a first-day deductible ($840 in 2003) and some cost sharing for hospital stays over 60 days, which are rare.

Medicare Part B.[3]  Part B, supplementary medical insurance (SMI), “pays for physician, outpatient hospital, home health, and other services for the aged and disabled,” and is the fastest growing part of the Medicare program.  Enrollment in Part B is voluntary, but almost all of the eligible elderly, about 38.1 million people, sign up for the program. 

Part B is financed by premiums and revenue from the federal government’s general fund.  Part B monthly premiums ($58.70 in 2003) are set each year to cover 25 percent of expected program expenditures.  Since these premiums are deducted from Social Security monthly payments, many seniors do not realize they are paying a premium for their Medicare coverage. 

With the exception of a small amount of interest income, the remaining cost of Part B is covered out of general revenues.  This obligation by the federal government to cover the remaining cost of Part B (about 74 percent of the yearly cost) is a major source of the unfunded liabilities of the U.S. government in future years.

Medicare Part C.[4]  Medicare+Choice is the managed care part of Medicare.  For beneficiaries who elect to be covered by a managed care plan, typically a health maintenance organization (HMO), Medicare pays a fixed, or “capitated,” amount per person, and the plan covers each enrollee’s medical needs. 

The Balanced Budget Act of 1997 that created Medicare+Choice also invited other forms of managed care such as preferred provider plans (PPOs), physician service organizations (PSOs), and medical savings accounts (MSAs) to participate in Medicare.  In 2003, 54 such demonstration projects enrolled 218,000 beneficiaries.

Some enrollees have chosen HMO plans because they offer benefits unavailable in fee-for-service Medicare, such as prescription drug coverage.  But low Medicare payments and high operational costs have made these plans unprofitable.  As a result, the number of participating plans has declined from a high of 346 in 1998 to only 154 in 2003, with a reduction in enrollment from 6.9 million in 1999 to 5.5 million today.[5]

Seniors and Medicare Coverage. Medicare is the most important source of health insurance coverage for Americans age 65 and over, but the program has gaps.  It does not cover prescription drugs or long-term care, and it has both front-end deductibles and limits on expensive hospital care.  As a result:

• Approximately 87 percent of eligible seniors have supplemental coverage.
  
• More than half of the elderly get supplemental coverage, either through a former employer (33 percent) or by purchasing a private Medigap policy (24 percent).
  
• 17 percent of the eligible elderly get extended coverage through Medicare managed care plans.
  
• 11 percent are poor and so are covered by both Medicare and Medicaid; these are the so-called dual eligibles.[6]

How Medicare Is Funded.[7]  Most people believe that Medicare is financed out of payroll taxes because they see the deduction on their pay stubs each payday.  This is only half true. 

In 2002, Medicare had revenue of $285 billion, with 54 percent coming from payroll taxes, 9 percent coming from Part B premiums deducted from beneficiaries’ Social Security checks and 28 percent, or approximately $78 billion, from the federal government’s general budget.  This expenditure does not go through the appropriations process, yet it is one of the largest unfunded liabilities imposed on future taxpayers.

How the Money Is Spent.[8]  In 2002, Medicare covered 34.6 million people age 65 and over and an additional 6 million disabled people.  Medicare spent $251 billion, about $34 billion less than it received in taxes.  The difference is said to accumulate in the Part A trust fund to help pay for the cost of Medicare in future years.  But the truth is that the government spends that money on other things, so there is no real money in the trust fund, only IOUs.

Medicare Expenditures, 1980-2010.[9]  Total expenditures in the Medicare program increased from $35 billion to $257 billion between 1980 and 2002.  Program expenditures grew at about 7.5 percent in the 1980s, leveled off in the mid-1990s and now are increasing again.  The program’s trustees project that Medicare expenditures will increase at a rate of 7 to 8 percent per year, reaching $420 billion by 2010--even without prescription drugs, additional payments to rural hospitals and physicians, or coverage for new medical technologies.

Major Medicare Issues: Current and Future. The Medicare program is understandably popular with beneficiaries but also is rigid and technologically backward.  The four major issues facing the program are:

Prescription Drug Coverage. Drugs are now increasing the length and the quality of life of a growing number of Americans.  Medicare must find an affordable, efficient way to cover this care. 

Provider Reimbursement. Medicare must find a way to create strong incentives for efficient medical decisions.  A regulatory approach that simply cuts payments to save program money turns providers away and reduces both access and quality.

Medicare Reform. Virtually all health policy analysts know that Medicare must be reformed.  The debate is over whether to expand government control or encourage market competition. 

Future Funding Shortfalls.[10] By the year 2025, the Medicare program under current law will have to increase its draw on federal revenues from the current 5 percent to 21 percent.  Adding any new program, such as a prescription drug benefit, will exacerbate the funding shortfall. 

If Medicare is not changed, these entitlement obligations will leave substantially less for all other federal activities.  Modernizing Medicare to address the problems will not be easy, either politically or economically, but it must be done.

Notes

[1] Robert Helms, “The Origins of Medicare,” The World & I, Vol. 14, No. 3, March 1999, pp. 40-45.

[2] 2003 Annual Report of the Boards of Trustees of Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, p. 1, p. 3.

[3] 2003 Trustees Report, p. 1, p. 3.

[4] 2003 Trustees Report, Table III.B6, p. 112.

[5] Medicare Managed Care Contract Monthly Summary Reports, August 1, 2003.

[6] Kaiser Family Foundation, Medicare Chart Book, second edition, Fall 2001, Figure 30.

[7] 2003 Trustees Report, Table I.C.1, p. 3.

[8] 2003 Trustees Report, Table I.C.1, p. 3.

[9] 2003 Trustees Report, Table II.A1, p. 21.

[10] Calculations by A. Rettenmaier, Private Enterprise Research Center, Texas A&M University, based on 2002 Medicare Trustees Report, CBO Testimony March 22, 2001 and March 7, 2002.

For Further Reading:

Sue. A Blevins, Medicare’s Midlife Crisis, Washington, DC, Cato Institute, 2001.

Michael J. O’Grady, “Health Insurance Spending Growth--How Does Medicare Compare?” Joint Economic Committee, June 10, 2003.

“Medicare Beneficiaries’ Links to Drug Coverage,” Joint Economic Committee, April 10, 2003.

Robert B. Helms is a resident scholar at AEI.