Medicare: Financial Challenges and Considerations for Reform

Published by the Government Accountability Office on 2003-04-10.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                           United States General Accounting Office

GAO                        Testimony
                           Before the Joint Economic Committee

For Release on Delivery
Expected at 10:00 a.m.
Thursday, April 10, 2003   MEDICARE
                           Financial Challenges and
                           Considerations for Reform
                           Statement of David M. Walker
                           Comptroller General of the United States

    Mr. Chairman and Members of the Committee:

    I am pleased to be here today as you examine Medicare’s financial health
    and consider the budgetary and economic challenges presented by an
    aging society. I have been particularly attentive to the sustainability
    challenges faced by the nation’s two largest entitlement programs—
    Medicare and Social Security—for more than a decade since I served as a
    public trustee for these programs in the early 1990s. The recent
    publication of the 2003 Trustees’ annual report reminds us, once again,
    that the status quo is not an option for Medicare. If the program stays on
    its present course, in 10 years Hospital Insurance (HI) Trust Fund outlays
    will begin to exceed tax receipts, and by 2026 the HI trust fund will be
    exhausted. It is important to note that trust fund insolvency does not mean
    the program will cease to exist; program tax revenues will continue to
    cover a portion of projected expenditures.1 However, Medicare is only part
    of the broader health care financing problem that confronts both public
    programs and private payers. The unrelenting growth in health care
    spending is producing a health care sector that continues to claim an
    increasing share of our gross domestic product (GDP).

    Despite the grim outlook for Medicare’s financial future, fiscal discipline
    imposed on Medicare through the Balanced Budget Act of 1997 (BBA)
    continues to be challenged, and interest in modernizing the program’s
    benefit package to include prescription drug coverage and catastrophic
    protection continues to grow. Such unabated pressures highlight the
    urgency for meaningful reform. As we deliberate on the situation, we must
    be mindful of several key points:

•   The traditional measure of HI Trust Fund solvency is a misleading gauge of
    Medicare’s financial health. Long before the HI Trust Fund is projected to
    be insolvent, pressures on the rest of the federal budget will grow as HI’s
    projected cash inflows turn negative and grow as the years pass.
    Moreover, a focus on the financial status of HI ignores the increasing
    burden Supplemental Medical Insurance (SMI)—Medicare part B—will
    place on taxpayers and beneficiaries.

     Under the Trustees 2003 intermediate assumptions, revenues from the HI payroll tax and
    taxation of certain Social Security benefits are initially projected to cover about three-
    fourths of projected expenditures once the trust fund is exhausted. This ratio, however, is
    projected to decline rapidly.

    Page 1                                                                        GAO-03-577T
•   GAO’s most recent long-term budget simulations continue to show that
    demographic trends and rising health care spending will drive escalating
    federal deficits and debt, absent meaningful entitlement reforms or other
    significant tax or spending actions. To obtain budget balance, massive
    spending cuts, tax increases, or some combination of the two would be
    necessary. Neither slowing the growth of discretionary spending nor
    allowing the tax reductions to sunset will eliminate the imbalance. In
    addition, while additional economic growth will help ease our burden, the
    potential fiscal gap is too great to grow our way out of the problem.

•   Since the cost of a drug benefit would boost spending projections even
    further, adding drug coverage when Medicare’s financial future is already
    bleak will require difficult policy choices that will mean trade-offs for both
    beneficiaries and providers. Just as physicians take the Hippocratic oath
    to “do no harm,” policymakers should avoid adopting reforms that will
    worsen Medicare’s long-term financial health.

•   Our experience with Medicare—both the traditional program and its
    private health plan alternative—provides valuable lessons that can guide
    consideration of reforms. For example, we know that proposals to enroll
    beneficiaries in private health plans must be designed to encourage
    beneficiaries to join efficient plans and ensure that Medicare shares in any
    efficiency gains. We also recognize that improvements to traditional
    Medicare are essential, as this program will likely remain significant for
    some time to come.

    Ultimately, we will need to look at broader health care reforms, as
    spending growth problems are not exclusive to Medicare. For both public
    and private payers, containing growth in health expenditures will be an
    abiding 21st century challenge. In today’s health care sector, there are few
    incentives for providers and consumers to be prudent in their ordering and
    use of health care services, too little transparency with regard to the value
    and costs of care, and inadequate accountability to ensure that health care
    plans and providers meet standards for appropriate use and quality.

    These problems cannot be solved overnight. It will require committed,
    long-term resolve and sustained attention to help policymakers and the
    public understand the need to move beyond the status quo. The magnitude
    of the challenge suggests that reforms will need to be phased in over time
    to minimize any temporary disruptions that may result. However,
    incremental reforms should build upon each other and continue to bring
    us closer to our desired goals. This argues for having a systematic process
    for setting common goals and assessing the potential for any proposed
    reforms to meet these goals. At GAO, we are developing a framework—

    Page 2                                                            GAO-03-577T
                        that is, a comprehensive set of criteria—for consideration by the Congress,
                        to help policymakers evaluate proposed health care reforms.

                        Now I would like to discuss overall trends in health care spending, the
                        financial challenges Medicare faces, and considerations for health care
                        reform efforts.

                        To best understand Medicare’s fiscal plight, we should also understand the
Trends in Health Care   broader health care context in which it operates. Total health care
Spending Systemwide     spending from all sources—public and private—continues to increase at a
                        breathtaking pace. From 1990 through 2000, spending nearly doubled from
Pose Significant        about $696 billion to about $1.3 trillion (see fig. 1). From 2000 through
Challenges for 21st     2010, the rate of spending growth is expected to accelerate somewhat,
                        resulting in an estimated $2.7 trillion in total annual health care spending
Century                 by the end of the period. Increases in medical prices account for a little
                        more than half of the 20-year spending increase, while increases in the use
                        of services—owing to population growth and rise in the number of
                        services used per person—and more expensive services account for the

                        Figure 1: Total National Health Care Spending, 1990–2010
                        Dollars in billions






                                   1990                2000                    2010
                        Source: Centers for Medicare & Medicaid Services (CMS), Office of the Actuary,
                        National Health Statistics Group.

                        Note: The figure for 2010 is projected. All dollars are nominal.

                        Page 3                                                                           GAO-03-577T
The rapid growth in health care spending means that an increasing share
of the nation’s output, as measured by GDP, will be devoted to the
production of health care services and goods. In 1970, spending on health
care represented about 7 percent of GDP (see fig. 2). By 2010, health care
spending’s share of GDP is expected to rise to about 17 percent.

Figure 2: Total National Health Care Spending as a Percentage of GDP, 1970–2010

National health expenditures as a percentage of GDP









     1970          1980          1990           2000              2010
 Sources: CMS, Office of the Actuary, National Health Statistics Group and
 U.S. Department of Commerce, Bureau of Economic Analysis.

Note: The figure for 2010 is projected.

At the same time that health care spending has increased, consumers have
become more insulated from these costs. In 1962, nearly half—46
percent—of health care spending was financed by individuals out of their
own pockets (see fig. 3). The remaining 54 percent was financed by a
combination of private health insurance and public programs. By 2002, the
amount of health care spending financed by individuals out of their own
pockets was estimated to have dropped to 14 percent.

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Figure 3: Sources of Health Care Financing, 1962–2002

                             1962                                                          1982                          2002

                          6%                                                           6%                                5%
                                                                                                       22%       12%
                                                                        10%                                  16%
                  23%                                                         16%                                  16%


                                                                            Private health insurance



                                                                            Other public

                                                                            Other private

Source: CMS, Office of the Actuary, National Health Statistics Group.

                                                                   Note: The figure for 2002 is estimated.

                                                                   Tax considerations encourage employers to offer health insurance to their
                                                                   employees, as the value of the premium is excluded from the calculation
                                                                   of employees’ taxable earnings. Moreover, the value of the insurance
                                                                   coverage does not figure into the calculation of payroll taxes. These tax
                                                                   exclusions represent a significant source of foregone federal revenue,
                                                                   currently amounting to about 1 percent of GDP.

                                                                   Today the Medicare program faces a long-range and fundamental financing
Outlook Worsening                                                  problem driven by known demographic trends and projected escalation of
for Medicare’s Long-                                               health care spending beyond general inflation. The lack of an immediate
                                                                   crisis in Medicare financing affects the nature of the challenge, but it does
Term Sustainability                                                not eliminate the need for change. Within the next 10 years, the first baby
                                                                   boomers will begin to retire, putting increasing pressure on the federal
                                                                   budget. From the perspectives of the program, the federal budget, and the
                                                                   economy, Medicare in its present form is not sustainable. Acting sooner

                                                                   Page 5                                                             GAO-03-577T
                          rather than later would allow changes to be phased in so that the
                          individuals who are most likely to be affected, namely younger and future
                          workers, will have time to adjust their retirement planning while helping
                          to avoid related “expectation gaps.” Since there is considerable confusion
                          about Medicare’s current financing arrangements, I would like to begin by
                          describing the nature, timing, and extent of the financing problem.

Demographic Trends And    As you know, Medicare consists of two parts—HI and SMI. HI, which pays
Expected Rise in Health   for inpatient hospital stays, skilled nursing care, hospice, and certain home
Care Costs Drive          health services, is financed by a payroll tax. Like Social Security, HI has
                          always been largely a pay-as-you-go system. SMI, which pays for physician
Medicare’s Long-Term      and outpatient hospital services, diagnostic tests, and certain other
Financing Problem         medical services, is financed by a combination of general revenues and
                          beneficiary premiums. Beneficiary premiums pay for about one-fourth of
                          SMI benefits, with the remainder financed by general revenues. These
                          complex financing arrangements mean that current workers’ taxes
                          primarily pay for current retirees’ benefits except for those financed by
                          SMI premiums.2

                          As a result, the relative numbers of workers and beneficiaries have a major
                          impact on Medicare’s financing. The ratio, however, is changing. In the
                          future, relatively fewer workers will be available to shoulder Medicare’s
                          financial burden. In 2002 there were 4.9 working-age persons (18 to 64
                          years) per elderly person, but by 2030, this ratio is projected to decline to
                          2.8. For the HI portion of Medicare, in 2002 there were nearly 4 covered
                          workers per HI beneficiary. Under the Trustees’ intermediate 2003
                          estimates, the Medicare Trustees project that by 2030 there will be only 2.4
                          covered workers per HI beneficiary. (See fig. 4.)

                           Another small source of funding derives from the tax treatment of Social Security benefits.
                          Under certain circumstances, up to 85 percent of an individual’s or couple’s Social Security
                          benefits are subject to income taxes. Under present law, the Old-Age and Survivors
                          Insurance (OASI) and Disability Insurance (DI) Trust Funds are credited with the income
                          taxes attributable to the taxation of the first 50 percent of OASDI benefit payments. The
                          remainder of the income taxes attributable to the taxation of up to 85 percent of OASDI
                          benefit payments is credited to the HI Trust Fund. Any other income taxes paid by retirees
                          would also help finance the general revenue contribution to SMI.

                          Page 6                                                                       GAO-03-577T
Figure 4: Ratio of HI-Covered Workers to Beneficiaries

 Workers per HI beneficiary

                       4.1             4.1

 3                                                                 2.9

                                                                                          2.3        2.2         2.1


       1970           1980             1990   2000     2010       2020       2030       2040        2050        2060       2070
 Source: CMS, Office of the Actuary.

                                                     Note: Projections based on the intermediate assumptions of The 2003 Annual Report of the Boards of
                                                     Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust

                                                     The demographic challenge facing the system has several causes. People
                                                     are retiring early and living longer. As the baby boom generation ages, the
                                                     share of the population age 65 and over will escalate rapidly. A falling
                                                     fertility rate is the other principal factor underlying the growth in the
                                                     elderly’s share of the population. In the 1960s, the fertility rate was an
                                                     average of 3 children per woman. Today it is a little over 2, and by 2030 it
                                                     is expected to fall to 1.95—a rate that is below replacement. The
                                                     combination of the aging of the baby boom generation, increased
                                                     longevity, and a lower fertility rate will drive the elderly as a share of total
                                                     population from today’s 12 percent to almost 20 percent in 2030.

                                                     Taken together, these trends threaten both the financial solvency and
                                                     sustainability of this important program. Labor force growth will continue
                                                     to decline and by 2025 is expected to be less than a third of what it is
                                                     today. (See fig. 5.) Relatively fewer workers will be available to produce
                                                     the goods and services that all will consume. Without a major increase in
                                                     productivity, low labor force growth will lead to slower growth in the
                                                     economy and slower growth of federal revenues. This in turn will only
                                                     accentuate the overall pressure on the federal budget. This slowing labor
                                                     force growth is not always recognized as part of the Medicare debate, but

                                                     Page 7                                                                            GAO-03-577T
                              it is expected to affect the ability of the federal budget and the economy to
                              sustain Medicare’s projected spending in the coming years.

                              Figure 5: Labor Force Growth

                              Percentage change (5-yr moving average)



                                  1970     1980       1990       2000        2010       2020       2030       2040   2050   2060   2070   2080
                              Source: Social Security Administration, Office of the Chief Actuary, and GAO.

                              Note: GAO analysis based on the intermediate assumptions of The 2003 Annual Report of the Board
                              of Trustees of the Federal Old-Age and Survivors Insurance and the Federal Disability Insurance
                              Trust Funds. Percentage change is calculated as a centered 5-year moving average.

                              The demographic trends I have described will affect both Medicare and
                              Social Security, but Medicare presents a much greater, more complex, and
                              more urgent challenge. Unlike Social Security, Medicare spending growth
                              rates reflect not only a burgeoning beneficiary population, but also the
                              escalation of health care costs at rates well exceeding general rates of
                              inflation. The growth of medical technology has contributed to increases
                              in the number and quality of health care services. Moreover, the actual
                              costs of health care consumption are not transparent. Third-party payers
                              largely insulate covered consumers from the cost of health care decisions.
                              These factors and others contribute to making Medicare a greater and
                              more complex fiscal challenge than even Social Security.

HI’s Trust Fund Faces         Current projections of future HI income and outlays illustrate the timing
Cash Flow Problems Long       and severity of Medicare’s fiscal challenge. Today, the HI Trust Fund takes
before the HI Trust Fund Is   in more in taxes than it spends. Largely because of the known
                              demographic trends I have described, this situation will change. Under the
Projected to Be Insolvent     Trustees’ 2003 intermediate assumptions, program outlays are expected to

                              Page 8                                                                                               GAO-03-577T
                                                         begin to exceed program tax revenues in 2013 (see fig. 6). To finance these
                                                         cash deficits, HI will need to draw on the special-issue Treasury securities
                                                         acquired during the years of cash surpluses. For HI to “redeem” its
                                                         securities, the government will need to obtain cash through some
                                                         combination of increased taxes, spending cuts, and/or increased
                                                         borrowing from the public (or, if the unified budget is in surplus, less debt
                                                         reduction than would otherwise have been the case). Neither the decline
                                                         in the cash surpluses nor the cash deficits will affect the payment of
                                                         benefits, but the negative cash flow will place increased pressure on the
                                                         federal budget to raise the resources necessary to meet the program’s
                                                         ongoing costs. This pressure will only increase when Social Security also
                                                         experiences negative cash flow and joins HI as a net claimant on the rest
                                                         of the budget.3

Figure 6: Medicare’s HI Trust Fund Faces Cash Deficits as Baby Boomers Retire

Billions of 2003 dollars



                                               Medicare HI
                                               cash deficit



        2000              2005                 2010           2015               2020           2025             2030             2035             2040

                                                                  Cash surplus

                                                                  Cash deficit

Source: CMS, Office of the Actuary, and GAO.

                                                         Note: GAO analysis based on the intermediate assumptions of The 2003 Annual Report of the
                                                         Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance
                                                         Trust Funds.

                                                          Under the Trustees’ intermediate 2003 projections, this will occur for Social Security
                                                         (OASDI) in 2018.

                                                         Page 9                                                                           GAO-03-577T
The gap between HI income and costs shows the severity of HI’s financing
problem over the longer term. This gap can also be expressed relative to
taxable payroll (the HI Trust Fund’s funding base) over a 75-year period.
This year, under the Trustees 2003 intermediate estimates, the 75-year
actuarial deficit is projected to be 2.40 percent of taxable payroll—a
significant increase from last year’s projected deficit of 2.02 percent. This
means that to bring the HI Trust Fund into balance over the 75-year
period, either program outlays would have to be immediately reduced by
42 percent or program income immediately increased by 71 percent, or
some combination of the two. These estimates of what it would take to
achieve 75-year trust fund solvency understate the extent of the problem
because the program’s financial imbalance gets worse in the 76th and
subsequent years. Every year that passes we drop a positive year and add a
much bigger deficit year.

The projected exhaustion date of the HI Trust Fund is a commonly used
indicator of HI’s financial condition. Under the Trustees 2003 intermediate
estimates, the HI Trust Fund is projected to exhaust its assets in 2026. This
solvency indicator provides information about HI’s financial condition, but
it is not an adequate measure of Medicare’s sustainability for several
reasons. HI Trust Fund balances do not provide meaningful information on
the government’s fiscal capacity to pay benefits when program cash
inflows fall below program outlays. As I have described, the government
would need to come up with cash from other sources to pay for benefits
once outlays exceeded program tax income.

In addition, the HI Trust Fund measure provides no information on SMI.
SMI’s expenditures, which account for about 43 percent of total Medicare
spending, are projected to grow even faster than those of HI in the near
future. Moreover, Medicare’s complex structure and financing
arrangements mean that a shift of expenditures from HI to SMI can extend
the solvency of the HI Trust Fund, creating the appearance of an
improvement in program’s financial condition. For example, the Balanced
Budget Act of 1997 modified the home health benefit, which resulted in
shifting a portion of home health spending from the HI Trust Fund to SMI.
Although this shift extended HI Trust Fund solvency, it increased the draw
on general revenues and beneficiary SMI premiums while generating little
net savings.

Ultimately, the critical question is not how much a trust fund has in assets,
but whether the government as a whole and the economy can afford the
promised benefits now and in the future and at what cost to other claims
on scarce resources. To better monitor and communicate changes in

Page 10                                                          GAO-03-577T
                             future total program spending, new measures of Medicare’s sustainability
                             are needed. As program changes are made, a continued need will exist for
                             measures of program sustainability that can signal potential future fiscal
                             imbalance. Such measures might include the percentage of program
                             funding provided by general revenues, the percentage of total federal
                             revenues or gross domestic product devoted to Medicare, or program
                             spending per enrollee. As such measures are developed, questions would
                             need to be asked about actions to be taken if projections showed that
                             program expenditures would exceed the chosen level.

Absent Reform of             Taken together, Medicare’s HI and SMI expenditures are expected to
Medicare and Other           increase dramatically, rising from about 12 percent of federal revenues in
Entitlements for the         2002 to more than one-quarter by midcentury. The budgetary challenge
                             posed by the growth in Medicare becomes even more significant in
Elderly, Budgetary           combination with the expected growth in Medicaid and Social Security
Flexibility Will Disappear   spending. This growth in spending on federal entitlements for retirees will
                             become increasingly unsustainable over the longer term, compounding an
                             ongoing decline in budgetary flexibility. Over the past few decades,
                             spending on mandatory programs has consumed an ever-increasing share
                             of the federal budget. 4 In 1962, prior to the creation of the Medicare and
                             Medicaid programs, spending for mandatory programs plus net interest
                             accounted for about 32 percent of total federal spending. By 2002, this
                             share had almost doubled to approximately 63 percent of the budget. (See
                             fig. 7.)

                              “Mandatory spending” refers to outlays for entitlement programs such as Food Stamps,
                             Medicare, veterans’ pensions, payment of interest on the public debt, and nonentitlements
                             such as payments to states from Forest Service receipts. In 2002 Social Security, Medicare,
                             and Medicaid accounted for over 71 percent of mandatory spending.

                             Page 11                                                                      GAO-03-577T
Figure 7: Federal Spending for Mandatory and Discretionary Programs, Fiscal Years 1962, 1982, and 2002

                      1962                                                  1982                            2002

                                                                   11%                                     9%

          26%                                                                                                      37%

                                68%                          45%



                                                             Net interest
Source: Budget of the United States Government: Fiscal Year 2004, Office of Management and Budget.

                                                     In much of the past decade, reductions in defense spending helped
                                                     accommodate the growth in these entitlement programs. Even before the
                                                     events of September 11, 2001, however, this ceased to be a viable option.
                                                     Indeed, spending on defense and homeland security will grow as we seek
                                                     to combat new threats to our nation’s security.

                                                     GAO prepares long-term budget simulations that seek to illustrate the
                                                     likely fiscal consequences of the coming demographic tidal wave and
                                                     rising health care costs. These simulations continue to show that to move
                                                     into the future with no changes in federal retirement and health programs
                                                     is to envision a very different role for the federal government. Assuming,
                                                     for example, that the tax reductions enacted in 2001 do not sunset and
                                                     discretionary spending keeps pace with the economy, by midcentury
                                                     federal revenues may be inadequate to pay Social Security and interest on
                                                     the federal debt. Spending for the current Medicare program—without any
                                                     additional new benefits—is projected to account for more than one-
                                                     quarter of all federal revenues. To obtain budget balance, massive
                                                     spending cuts, tax increases, or some combination of the two would be
                                                     necessary. (See fig.8). Neither slowing the growth of discretionary
                                                     spending nor allowing the tax reductions to sunset eliminates the

                                                     Page 12                                                         GAO-03-577T
imbalance. In addition, while additional economic growth would help ease
our burden, the projected fiscal gap is too great for us to grow our way out
of the problem.

Figure 8: Composition of Spending as a Share of GDP Assuming Discretionary
Spending Grows with GDP after 2003 and the 2001 Tax Cuts Do Not Sunset

 Percentage of GDP





              2000                   2015                    2030                      2050
      Fiscal year
              All other spending

             Medicare and Medicaid

             Social Security

             Net interest
Source: GAO’s March 2003 analysis.

Note: Assumes currently scheduled Social Security benefits are paid in full throughout the simulation
period. Social Security and Medicare projections are based on the Trustees’ 2003 intermediate

Indeed, long-term budgetary flexibility is about more than Social Security
and Medicare. While these programs dominate the long-term outlook, they
are not the only federal programs or activities that bind the future. The
federal government undertakes a wide range of programs, responsibilities,
and activities that obligate it to future spending or create an expectation
for spending. Our recent report describes the range and measurement of
such fiscal exposures—from explicit liabilities such as environmental
cleanup requirements to the more implicit obligations presented by life-

Page 13                                                                               GAO-03-577T
                        cycle costs of capital acquisition or disaster assistance.5 Making
                        government fit the challenges of the future will require not only dealing
                        with the drivers—entitlements for the elderly—but also looking at the
                        range of other federal activities. A fundamental review of what the federal
                        government does and how it does it will be needed.

                        At the same time, it is important to look beyond the federal budget to the
Medicare Is Projected   economy as a whole. Figure 9 shows the total future draw on the economy
to Absorb Ever-         represented by Medicare, Medicaid, and Social Security. Under the 2003
                        Trustees’ intermediate estimates and the Congressional Budget Office’s
Increasing Shares of    (CBO) most recent long-term Medicaid estimates, spending for these
the Economy             entitlement programs combined will grow to 14 percent of GDP in 2030
                        from today’s 8.4 percent. Taken together, Social Security, Medicare, and
                        Medicaid represent an unsustainable burden on future generations.

                        Figure 9: Social Security, Medicare, and Medicaid Spending as a Percentage of GDP

                        Percentage of GDP


                        15                                                                                 Medicaid


                                                                                                           Social Security

                            2000             2010            2020            2030            2040            2050            2060     2070
                            Source: CMS, Office of the Actuary, SSA, Office of the Actuary, CBO and GAO.

                        Note: Projections based on the intermediate assumptions of the 2003 Trustees’ Reports, CBO’s
                        March 2003 short-term Medicaid estimates, and CBO’s June 2002 Medicaid long-term projections
                        under midrange assumptions.

                         U.S. General Accounting Office, Fiscal Exposures: Improving the Budgetary Focus on
                        Long-Term Costs and Uncertainties, GAO-03-213 (Washington, D.C.: Jan. 24, 2003).

                        Page 14                                                                                                     GAO-03-577T
Although real incomes are projected to continue to rise, they are expected
to grow more slowly than has historically been the case. At the same time,
the demographic trends and projected rates of growth in health care
spending I have described will mean rapid growth in entitlement spending.
Taken together, these projections raise serious questions about the
capacity of the relatively smaller number of future workers to absorb the
rapidly escalating costs of these programs.

As HI trust fund assets are redeemed to pay Medicare benefits and SMI
expenditures continue to grow, the program will constitute a claim on real
resources in the future. As a result, taking action now to increase the
future pool of resources is important. To echo Federal Reserve Chairman
Alan Greenspan, the crucial issue of saving in our economy relates to our
ability to build an adequate capital stock to produce enough goods and
services in the future to accommodate both retirees and workers in the
future.6 The most direct way the federal government can raise national
saving is by increasing government saving, that is, as the economy returns
to a higher growth path, a balanced fiscal policy that recognizes our long-
term challenges can help provide a strong foundation for economic growth
and can enhance our future budgetary flexibility. It is my hope that we will
think about the unprecedented challenge facing future generations in our
aging society. Putting Medicare on a sustainable path for the future would
help fulfill this generation’s stewardship responsibility to succeeding
generations. It would also help to preserve some capacity for future
generations to make their own choices for what role they want the federal
government to play.

As with Social Security, both sustainability and solvency considerations
drive us to address Medicare’s fiscal challenges sooner rather than later.
HI Trust Fund exhaustion may be more than 20 years away, but the
squeeze on the federal budget will begin as the baby boom generation
begins to retire. This will begin as early as 2008, when the leading edge of
the baby boom generation becomes eligible for early retirement.7 CBO’s
current 10-year budget and economic outlook reflects this. CBO projects
that economic growth will slow from an average of 3.2 percent a year from
2005 through 2008 to 2.7 percent from 2009 through 2013 reflecting slower

 Testimony before the Senate Committee on Banking, Housing, and Urban Affairs, July 24,
 In 2008 the first baby boomers will reach age 62 and become eligible for Social Security
benefits; in 2011, they will reach age 65 and become eligible for Medicare benefits.

Page 15                                                                       GAO-03-577T
                      labor force growth. At the same time, annual rates of growth in entitlement
                      spending will begin to rise. Annual growth in Social Security outlays is
                      projected to accelerate from 5.2 percent in 2007 to 6.6 percent in 2013.
                      Annual growth in Medicare enrollees is expected to accelerate from 1.1
                      percent today to 2.9 percent in 2013. Acting sooner rather than later is
                      essential to ease future fiscal pressures and also provide a more
                      reasonable planning horizon for future retirees. We are now at a critical
                      juncture. In less than a decade, the profound demographic shift that is a
                      certainty will have begun.

                      Despite a common awareness of Medicare’s current and future fiscal
Pressure to Address   plight, pressure has been building to address recognized gaps in Medicare
Medicare Coverage     coverage, especially the lack of a prescription drug benefit and protection
                      against financially devastating medical costs. Filling these gaps could add
Gaps Must Be          massive expenses to an already fiscally overburdened program. Under the
Balanced against      Trustees 2003 intermediate assumptions, the present value of HI’s
                      actuarial deficit is $6.2 trillion.8 This difficult situation argues for tackling
Program               the greatest needs first and for making any benefit additions part of a
Sustainability        larger structural reform effort.
Concerns              The Medicare benefit package, largely designed in 1965, provides virtually
                      no outpatient drug coverage. Beneficiaries may fill this coverage gap in
                      various ways. All beneficiaries have the option to purchase supplemental
                      policies—Medigap—when they first become eligible for Medicare at age
                      65. Those policies that include drug coverage tend to be expensive and
                      provide only limited benefits. Some beneficiaries have access to coverage
                      through employer-sponsored policies or private health plans that contract
                      to serve Medicare beneficiaries. In recent years, coverage through these
                      sources has become more expensive and less widely available.
                      Beneficiaries whose income falls below certain thresholds may qualify for
                      Medicaid or other public programs. According to one survey, in the fall of

                       This estimate represents the present value of HI’s future expenditures less future tax
                      income, taking into account the amount of HI trust fund assets at hand at the beginning of
                      the projection period and adjusting for the ending target trust fund balance. Excluding the
                      ending target trust fund balance, HI’s unfunded obligation is estimated to be $5.9 trillion
                      over the 75-year period under the Trustees 2003 intermediate assumptions.

                      Page 16                                                                       GAO-03-577T
1999, more than one-third of beneficiaries reported that they lacked drug
coverage altogether.9

Medicare also does not limit beneficiaries’ cost-sharing liability. The
average beneficiary who obtained services had a total liability for
Medicare-covered services of $1,700, consisting of $1,154 in Medicare
copayments and deductibles in addition to the $546 in annual part B
premiums in 1999, the most recent year for which data are available on the
distribution of these costs. The burden can, however, be much higher for
beneficiaries with extensive health care needs. In 1999, about 1 million
beneficiaries were liable for more than $5,000, and about 260,000 were
liable for more than $10,000 for covered services. In contrast, employer-
sponsored health plans for active workers typically limited maximum
annual out-of-pocket costs for covered services to less than $2,000 per
year for single coverage.10

Modernizing Medicare’s benefit package will require balancing competing
concerns about program sustainability, federal obligations, and the
hardship faced by some beneficiaries. In particular, the addition of a
benefit that has the potential to be extremely expensive—such as
prescription drug coverage—should be focused on meeting the needs
deemed to be of the highest priority. This would entail targeting financial
help to beneficiaries most in need—those with catastrophic drug costs or
low incomes—and, to the extent possible, avoiding the substitution of
public for private insurance coverage. As I continue to maintain, acting
prudently means making any benefit expansions in the context of overall
program reforms that are designed to make the program more sustainable
over the long term instead of worsening the program’s financial future.

One reform to help improve Medicare’s financial future would be to
modify Medicare’s cost-sharing rules and provide beneficiaries with better
incentives to use care appropriately. Health insurers today commonly
design cost-sharing requirements—in the form of deductibles,
coinsurance, and copayments—to ensure that enrollees are aware that

 Mary A. Laschober and others, “Trends in Medicare Supplemental Insurance and
Prescription Drug Coverage, 1996 to 1999,” Health Affairs Web Exclusive (Bethesda, Md:
Project Hope, Feb. 27, 2002).
v21n2/s4.pdf (downloaded Mar. 19, 2003).
 The Kaiser Family Foundation and Health Research and Education Trust, Employer
Health Benefits: 2000 Annual Survey (Menlo Park, Calif. and Chicago: 2000).

Page 17                                                                    GAO-03-577T
                          there is a cost associated with the provision of services and to use them
                          prudently. Ideally, cost-sharing should encourage beneficiaries to evaluate
                          the need for discretionary care but not discourage necessary care.
                          Coinsurance or copayments would be required generally for services
                          considered to be discretionary and potentially overused and would aim to
                          steer patients to lower cost or better treatment options. Care must be
                          taken, however, to avoid setting cost-sharing requirements so high as to
                          create financial barriers to care.

                          Medicare fee-for-service cost-sharing rules diverge from these common
                          insurance industry practices in important ways. For example, Medicare
                          imposes a relatively high deductible of $840 for hospital admissions, which
                          are rarely optional. In contrast, Medicare has not increased the part B
                          deductible since 1991. For the last 12 years, the deductible has remained
                          constant at $100 and has thus steadily declined as a proportion of
                          beneficiaries’ real incomes. Adjusted for inflation, the deductible has fallen
                          to $74.39 in 1991 dollars.

                          In recent years, leading proposals have been made to restructure Medicare
Medicare Reforms          that have included greater reliance on private health plans and reforms to
Should Realign            the traditional fee-for-service program. The weaknesses identified in these
                          two components of the current program suggest several lessons regarding
Incentives, Improve       such restructuring. Experience with Medicare’s private health plan
Transparency, and         alternative, called Medicare+Choice, suggests that details matter if
                          competition is to produce enhanced benefits for enrollees and savings for
Strengthen                the program. In addition, the traditional program must not be left
Accountability            unattended because it will be an important part of Medicare for years to
                          come. The strategies needed to address either structural component must
                          incorporate sufficient incentives to achieve efficiency, adequate
                          transparency to reveal the cost of health care, and appropriate
                          accountability mechanisms to ensure that the promised care and level of
                          quality are actually delivered.

Reforms That Include      If the inclusion of private health plans is to produce savings for Medicare,
Private Plans Should      private incentives and public goals must be properly aligned. This means
Incorporate Incentives    designing a program that will encourage beneficiaries to select health plan
                          options most likely to generate program savings. This is not the case in the
Sufficient to Result in   current Medicare+Choice program. For example, incentives for health
Program Savings           plan efficiency exist, but any efficiency gains achieved do not produce
                          Medicare savings. Payments to private health plans that participate in
                          Medicare+Choice are not set through a competitive process. Instead, plans

                          Page 18                                                          GAO-03-577T
receive a fixed payment from Medicare as prescribed by statute and in
return must provide all Medicare-covered services with the exception of
hospice. Efficient health plans are better able to afford to provide extra
benefits, such as outpatient prescription drug benefits; charge a lower
monthly premium; or both and may do so to attract beneficiaries and
increase market share. Until recently, however, these efficiency and
market share gains were advantageous to beneficiaries and health plans
but generated no savings for Medicare. Even today, the opportunity for the
program to realize savings from competition among Medicare+Choice
health plans remains extremely limited.11 This experience has shown that
savings are not automatic from simply enrolling beneficiaries in private
health plans.

The Medicare+Choice experience offers another lesson about private
plans and program savings. That is, as we recommended in 1998, payments
to health plans must be adequately risk-adjusted for the expected health
care costs of the beneficiaries they enroll. Otherwise, the government can
inadequately compensate health plans that enroll less healthy beneficiaries
with higher expected health care costs or will overpay health plans that
enroll relatively healthy beneficiaries with low expected health care costs.
Moreover, health plans will have an incentive to avoid enrolling less
healthy beneficiaries with higher expected health care costs. In 2000, we
reported that the failure to adequately adjust Medicare’s payments to
private health plans for beneficiaries’ expected health care costs
unnecessarily increased Medicare spending by $3.2 billion in 1998.12

A third lesson is that the use of private plans to serve Medicare
beneficiaries may not be feasible in all locations nationwide. In
Medicare+Choice, it has been difficult and expensive to encourage private

  Beginning in 2003, Medicare health plans may, in effect, rebate to beneficiaries some, or
all, of Medicare’s $58.70 monthly part B premium. Both beneficiaries and the government
benefit if health plans use this option to compete because, for every $1 reduction in health
care premiums, the health plans must return $0.25 to the government. If a health plan
rebates the entire part B premium, the government saves $14.68 per beneficiary per month.
Currently, five Medicare+Choice health plans in eight counties rebate at least a portion of
the part B premium. In 2003, Medicare began pilot testing an arrangement for sharing
financial risk with preferred provider organizations that enroll program beneficiaries. As of
March 2003, there were 56,677 enrollees in these preferred provider organizations.
  See U.S. General Accounting Office, Medicare+Choice: Payments Exceed Cost of Fee-for-
Service Benefits, Adding Billions to Spending, GAO/HEHS-00-161 (Washington, D.C: Aug.
23, 2000). CMS has since begun to phase in a payment adjustment system that is designed
to help prevent some of these excess payments.

Page 19                                                                       GAO-03-577T
                              health plans to serve rural areas. Payment rates have been substantially
                              raised in rural areas since 1997, yet by 2003 nearly 40 percent of
                              beneficiaries living in rural areas lack access to a private health plan; in
                              contrast, 15 percent of beneficiaries in urban areas lack access to a plan.
                              Finally, the Medicare+Choice experience underscores the importance of
                              beneficiaries having user-friendly, accurate information to compare their
                              health plan options and of holding private health plans appropriately
                              accountable for the services they have promised to deliver.

Fixing Flaws In Traditional   Leading Medicare reform proposals have included traditional Medicare as
Medicare Essential to Alter   a component in their design. Traditional Medicare is likely to have a
Program’s Fiscal Course       significant role for years to come, as any fundamental structural reforms
                              would take considerable time before plan and beneficiary participation
                              becomes extensive. Therefore, addressing flaws in the traditional program
                              should be part of any plan to steer Medicare away from insolvency and
                              improve its sustainability for future generations. The experience of other
                              health insurers’ use of cost-containment strategies, including some
                              incentives for beneficiaries to make value-based choices, suggests a
                              strategy for modernizing the program’s design. In the current program, the
                              lack of insurance-type protections and difficulty in setting payment rates
                              keep Medicare from achieving greater efficiencies and thus from
                              improving its balance sheet.

Supplemental Coverage         Coverage through Medigap—policies that meet federally established
Reduces Beneficiary Cost      standards and are sold by private insurers—helps to fill in some of
Sensitivity                   Medicare’s gaps, but Medigap plans also have shortcomings. As required
                              by law, Medigap plans must conform to 1 of 10 standard benefit packages,
                              which vary in levels of coverage. Medigap offers beneficiaries stop-loss
                              protections that are lacking in traditional Medicare, but these policies
                              diminish important program protections by covering required deductibles
                              and coinsurance. The most popular Medigap plans are fundamentally
                              different from employer-sponsored health insurance policies for retirees in
                              that they do not require individuals to pay deductibles, coinsurance, and
                              copayments. Such cost-sharing requirements are intended to make
                              beneficiaries aware of the costs associated with the use of services and
                              encourage them to use these services prudently. In contrast, Medigap’s
                              first-dollar coverage—the elimination of deductibles or coinsurance
                              associated with the use of covered services—undermines this objective.
                              Although such coverage reduces financial barriers to health care, it
                              diminishes beneficiaries’ sensitivity to costs and likely increases
                              beneficiaries’ use of services, adding to total Medicare spending.

                              Page 20                                                          GAO-03-577T
                                  Traditional Medicare needs the tools that other insurers use to achieve
                                  better value for the protection provided. Instead of working at cross-
                                  purposes to the traditional program, Medigap should be better coordinated
                                  with it. Insurance-type reforms to Medicare and Medigap—namely, the
                                  preservation of cost-sharing requirements in conjunction with stop-loss
                                  provisions—could help improve beneficiaries’ sensitivity to the cost of
                                  care while better protecting them against financially devastating medical

Difficulties in Setting Payment   Medicare too often pays overly generous rates for certain services and
Rates                             products, preventing the program from achieving a desirable degree of
                                  efficiency. For example, for certain services, our work has shown
                                  substantially higher Medicare payments relative to providers’ costs—35
                                  percent higher for home health care in the first six months of 2001 and 19
                                  percent higher for skilled nursing facility care in 2000.13 Similarly,
                                  Medicare has overpaid for various medical products. Last year, we
                                  reported that, in 2000, Medicare paid over $1 billion more than other
                                  purchasers for certain outpatient drugs that the program covers. Earlier
                                  findings that have since been addressed by the Congress following our
                                  recommendations showed Medicare paying over $500 million more than
                                  another public payer for home oxygen equipment. Excessive payments
                                  hurt not only the taxpayers but also the program’s beneficiaries or their
                                  supplemental insurers, as beneficiaries are liable for copayments equal to
                                  20 percent of Medicare’s approved fee. For certain outpatient drugs,
                                  Medicare’s payments to providers were so high that the beneficiaries’
                                  copayments exceeded the price at which providers could buy the drugs. In
                                  2001, we recommended that, for covered outpatient prescription drugs,
                                  Medicare establish payment levels more closely related to actual market
                                  transaction costs, using information available to other public programs
                                  that pay at lower rates.

                                  Over the past two decades, at the Congress’ direction, Medicare has
                                  implemented a series of payment reforms designed to promote the
                                  efficient delivery of services and control program spending. Some reforms
                                  required establishing set fees for individual services; others required
                                  paying a fixed amount for a bundle of services. The payment methods

                                   See U.S. General Accounting Office, Medicare Home Health Care: Payments to Home
                                  Health Agencies Are Considerably Higher than Costs, GAO-02-663 (Washington, D.C: May
                                  6, 2002) and U.S. General Accounting Office, Skilled Nursing Facilities: Medicare
                                  Payments Exceed Costs for Most but Not All Facilities, GAO-03-183 (Washington, D.C:
                                  Dec. 31, 2002).

                                  Page 21                                                                GAO-03-577T
introduced during this time were designed to include—in addition to
incentives for efficiencies—a means to calibrate payments to ensure
beneficiary access and fairness to providers.

A major challenge in administering these methods—whether based on fee
schedules or prospective payment systems using bundled payments—
involves adjusting the payments to better account for differences in
patients’ needs and providers’ local markets to ensure that the program is
paying appropriately and adequately. Payment rates that are too low can
impair beneficiary access to services and products, while rates that are too
high add unnecessary financial burdens to the program. As a practical
matter, Medicare is often precluded from using market forces—that is,
competition—to determine appropriate rates. In many cases, Medicare’s
size and potential to distort market prices makes it necessary to use means
other than competition to set a price on services and products.

Most of Medicare’s rate-setting methods are based on formulas that use
historical data on providers’ costs and charges. Too often, these data are
not recent or comprehensive enough to measure the costs incurred by
efficient providers. At the same time, data reflecting beneficiaries’ access
to services are also lacking. When providers contend that payments are
not adequate, typically information is not readily available to provide the
analytical support needed to determine whether these claims are valid. I
have noted in the past the essential need to monitor the impact of program
policy changes so that distinguishing between desirable and undesirable
consequences can be done systematically and in a timely manner. To that
end, I have also noted the importance of investing adequate resources in
the agency that runs Medicare to ensure that the capacity exists to carry
out these policy-monitoring activities.

Under some circumstances, competition may be feasible and practical for
setting more appropriate rates. Medicare has pilot tested “competitive
bidding” in a few small markets. According to program officials, these test
projects have shown that, for selected medical products, Medicare has
saved money on items priced competitively. As part of these competitive
bidding tests, steps were taken to monitor beneficiary access and product
quality. To use competitive bidding on a broader scale, Medicare would
require not only new authority but would need to make substantial
administrative preparations, as competing with a larger number of
products nationally would entail bidding in multiple markets and
monitoring access and quality once prices had been set.

Page 22                                                         GAO-03-577T
               Medicare’s financial challenge is very real. The 21st century has arrived
Concluding     and the demographic tidal wave is on the horizon. Within 5 years,
Observations   individuals in the vanguard of the baby boom generation will be eligible
               for Social Security and 3 years after that they will be eligible for Medicare.
               The future costs of serving the baby boomers are already becoming a
               factor in CBO’s short-term cost projections.

               Clearly the issue before us is not whether to reform Medicare but how. I
               feel the greatest risk lies in doing nothing to improve Medicare’s long-term
               sustainability. It is my hope that we will think about the unprecedented
               challenge of facing future generations in our aging society. Engaging in a
               comprehensive effort to reform the program and put it on a sustainable
               path for the future would help fulfill this generation’s stewardship
               responsibility to succeeding generations.

               Medicare reform would be done best with considerable lead time to phase
               in changes and before the changes that are needed become dramatic and
               disruptive. Given the size of Medicare’s financial challenge, it is only
               realistic to expect that reforms intended to bring down future costs will
               have to proceed incrementally. We should begin this now, when retirees
               are still a far smaller proportion of the population than they will be in the
               future. The sooner we get started, the less difficult the task will be.

               As we contemplate the forecast for Medicare’s fiscal condition and its
               implications, we must also remember that the sources of some of its
               problems—and its solutions—are outside the program and are universal to
               all health care payers. Some tax preferences mask the full cost of
               providing health benefits and can work at cross-purposes to the goal of
               moderating health care spending. Therefore, it may be important to
               reexamine the incentives contained in current tax policy and consider
               potential reforms. Advances in medical technology are also likely to keep
               raising the price tag of providing care, regardless of the payer. Although
               technological advances unquestionably provide medical benefits, judging
               the value of those benefits—and weighing them against the additional
               costs—is more difficult. Consumers are not as informed about the cost of
               health care and its quality as they may be about other goods and services.
               Thus, while the greater use of market forces may help to control cost
               growth, it will undoubtedly be necessary to employ other cost control
               methods as well.

               We must also be mindful that health care costs compete with other
               legitimate priorities in the federal budget, and their projected growth
               threatens to crowd out future generations’ flexibility to decide which

               Page 23                                                           GAO-03-577T
competing priorities will be met. In making important fiscal decisions for
our nation, policymakers need to consider the fundamental differences
between wants, needs, and what both individuals and our nation can
afford. This concept applies to all major aspects of government, from
major weapons system acquisitions to issues affecting domestic programs.
It also points to the fiduciary and stewardship responsibility that we all
share to ensure the sustainability of Medicare for current and future
generations within a broader context of providing for other important
national needs and economic growth.

A major challenge policymakers face in considering health care reforms is
the dearth of timely, accurate information with which to make decisions.
Medicare’s size and impact on the nation’s health care economy means
that its payment methods and rate adjustments, no matter how reasonable,
often produce opposition. Recent experience with the payment reforms
established in the BBA illustrates this point. In essence, these reforms
changed Medicare’s payment methods to establish incentives for providers
to deliver care efficiently. BBA’s changes were enacted in response to
continuing rapid growth in Medicare spending that was neither sustainable
nor readily linked to demonstrated changes in beneficiary needs.
Nonetheless, affected provider groups conducted a swift, intense
campaign to roll back the BBA changes. In the absence of solid, data-
driven analyses, affected providers’ anecdotes were used to support
contentions that Medicare payment changes were extreme and threatened
their financial viability. This and similar reactions to mandated Medicare
payment reforms underscore how difficult it is, without prompt and
credible data, to defend against claims that payments changes have
resulted in insufficient compensation that could lead to access problems.

The public sector can play an important role in educating the nation about
the limits of public support. Currently, there is a wide gap between what
patients and providers expect and what public programs are able to
deliver. Moreover, there is insufficient understanding about the terms and
conditions under which health care coverage is actually provided by the
nation’s public and private payers. In this regard, GAO is preparing a
health care framework that includes a set of principles to help
policymakers in their efforts to assess various health financing reform
options. This framework will examine health care issues systemwide and
identify the interconnections between public programs that finance health
care and the private insurance market. The framework can serve as a tool
for defining policy goals and ensuring the use of consistent criteria for
evaluating changes. By facilitating debate, the framework can encourage
acceptance of changes necessary to put us on a path to fiscal

Page 24                                                       GAO-03-577T
                  sustainability. I fear that if we do not make such changes and adopt
                  meaningful reforms, future generations will enjoy little flexibility to fund
                  discretionary programs or make other valuable policy choices.

                  Mr. Chairman, this concludes my prepared statement. I will be happy to
                  answer any questions you or other committee members may have.

                  For future contacts regarding this testimony, please call William J.
Contacts and      Scanlon, Director, Health Care Issues, at (202) 512-7114. Other individuals
Acknowledgments   who made key contributions include Linda Baker, James Cosgrove, Jessica
                  Farb, Hannah Fein, James McTigue, Yorick F. Uzes, and Melissa Wolf.

                  Page 25                                                           GAO-03-577T
Related GAO Products

             Major Management Challenges and Program Risks: Department of
             Health and Human Services. GAO-03-101. Washington D.C.: January 2003.

             Fiscal Exposures: Improving the Budgetary Focus on Long-Term Costs
             and Uncertainties. GAO-03-213. Washington, D.C.: January 24, 2003.

             Skilled Nursing Facilities: Medicare Payments Exceed Costs for Most but
             Not All Facilities. GAO-03-183. Washington, D.C.: December 31, 2002.

             Medicare Home Health Care: Payments to Home Health Agencies Are
             Considerably Higher than Costs. GAO-02-663. Washington, D.C.: May 6,

             Medicare: Financial Outlook Poses Challenges for Sustaining Program
             and Adding Drug Coverage. GAO-02-643T. Washington, D.C.: April 17,

             Medigap: Current Policies Contain Coverage Gaps, Undermine Cost
             Control Incentives. GAO-02-533T. Washington, D.C.: March 14, 2002.

             Medicare: New Spending Estimates Underscore Need for Reform. GAO-
             01-1010T. Washington, D.C.: July 25, 2001.

             Medicare: Cost-Sharing Policies Problematic for Beneficiaries and
             Program. GAO-01-713T. Washington, D.C.: May 9, 2001.

             Medicare: Higher Expected Spending and Call for New Benefit
             Underscore Need for Meaningful Reform. GAO-01-539T, Washington, D.C.:
             March 22, 2001.

             Medicare+Choice: Plan Withdrawals Indicate Difficulty of Providing
             Choice While Achieving Savings. GAO/HEHS-00-183. Washington, D.C.:
             September 7, 2000.

             Medicare+Choice: Payments Exceed Cost of Fee-for-Service Benefits,
             Adding Billions to Spending. GAO/HEHS-00-161. Washington, D.C.:
             August 23, 2000.

             Page 26                                                     GAO-03-577T