Medicare’s Structure and Payment Systems Part I: Traditional Medicare

This post originally appeared on The Finance Buff.

It makes sense to know at least a little bit about Medicare. For one, you pay for it through payroll and income taxes. Moreover, if you’re not on Medicare now someday you will be, provided you live long enough. Also, some issues and options under debate for national health reform have analogs in Medicare.

Part of my job is to study Medicare so I speak with some authority in saying that the program is a confusing mess. In this and two subsequent posts (one on Medicare Advantage and one on prescription drug plans) I will review the essential facts about the program, its payment systems, and the mechanisms and prospects for controlling its cost.

The Basics

Medicare is a federal health insurance program for the elderly (at least 65 years old), disabled, and a few other categories of individuals with specific diseases. Established in 1965, the program’s initial intent was to increase the welfare of the elderly, half of whom had no health insurance at that time. Today the program covers 45 million individuals (called “Medicare beneficiaries”), 84% elderly. Accounting for 13 percent of the federal budget and 19 percent of total national health expenditures (2009), in dollar terms Medicare is the largest federal health program. Medicare is financed by a 2.9% payroll tax, general revenue, state payments, taxation of Social Security benefits, and beneficiary premiums.

Medicare is an insurance program, not a health delivery system. That is, it pays for the cost of care but does not directly employ the providers of that care. (By way of contrast, the Veterans Health Administration and the Military Health System are financing and health care systems: the systems employ their own doctors.)

Some confuse Medicare with Medicaid, probably because of similarities in spelling. Medicaid is a joint federal-state program for low-income individuals who fall into certain eligibility categories (like aged, blind, disabled, and others). One way to remember which is which is as follows: Medicare is principally for retirees. The word “Medicare” ends in and the word “retirees” starts with “re”. Though not quite true, for mnemonic purposes one can think of Medicaid as a program for the disabled: “Medicaid” ends in and “disabled” starts with “di” (or “id”).

Traditional Medicare: The Essence of Simplicity

Originally, the only form of Medicare was fee-for-service indemnity insurance. A beneficiary saw a provider for a service, and the provider billed Medicare a fee for that service. This is called traditional Medicare or fee-for-service (FFS) Medicare. FFS Medicare still exists today and is the most popular form of Medicare. About 80% of Medicare beneficiaries are enrolled in FFS Medicare.

There are two parts to FFS Medicare: A and B. Together they account for 69% of Medicare spending (the remaining 31% of Medicare spending is not under FFS and will be discussed in subsequent posts). Part A is hospital insurance, which accounts for 41% of Medicare spending. It has no premium but has an over $1,000 deductible. Daily co-payments for hospital visits are $267 per day after 60 days and $534 per day after 90 days of care. To care for a patient, a hospital is paid by Medicare prospectively according to a schedule of payments tied to the expected resources required. If the hospital can care for a patient for less than the payment it keeps the difference. If the care costs more, the hospital, not Medicare, is at risk for the additional cost.

Part B is outpatient insurance, which accounts for 28% of Medicare spending. It has a nearly $100 per month premium and a $135 annual deductible. The doctor visit and medical equipment co-insurance is 20%. (All above figures are for 2009 and are summarized in this AARP document.)

Alone, FFS Medicare does not cover outpatient prescription drugs. It covers very little of what would be considered long-term care.

Controlling Spending under FFS Medicare

Since Congress sets the payment rates and fees for FFS Medicare they can be political footballs. For example, updates to the doctor fee schedule are usually accompanied by big fights in Congress. These fights are almost guaranteed by the way planned fee schedule updates are set to bring Medicare spending in line with a projected budget. The complicated update mechanism sometimes calls for a decrease in payments to physicians over time. Unless such updates are overridden by an act of Congress, fees would trend downward. You can imagine that doctors will not sit idly by and accept a lower payment from one year to the next. Beneficiaries and beneficiary advocacy groups would not react favorably if doctors refused to accept Medicare patients due to low reimbursement rates. Instead, these groups lobby Congress and get fee increases passed.

Price setting through legislation, such as the Medicare physician fee schedule, is known as “administrative” pricing (a misnomer, I know). The only way to control spending under an administrative pricing regime is for Congress to restrain payment increases, which is politically challenging, as evidenced by the fact that they override low or negative Medicare physician fee schedule updates regularly.

Administrative pricing is to be contrasted with “competitive pricing,” which relies on market signals to adjust prices. Competitive pricing can take some (but not all) of the politics out of the problem of restraining the growth of Medicare spending.

If I were describing Medicare in its first decade then I would be done. FFS Medicare was it back then. Today Medicare is much more complex. Completing the overview will require two more posts. In my next post on Medicare I will review some of the other components of the Medicare program that involve competitive pricing or have other “free market” characteristics.

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