CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

CBO

PAPER

OCTOBER 2004

CBO’s Analysis of 

Regional Preferred

Provider

Organizations

Under the Medicare

Modernization Act

© Royalty-free/BXP35466/Brand X Pictures

The Congress of the United States O Congressional Budget Office

CBO

CBO’s Analysis of Regional Preferred 

Provider Organizations Under the 

Medicare Modernization Act

October 2004

A

PAPER

Preface

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) 

made many changes to the Medicare program, including changes that increased the incentives 

for preferred provider organizations (PPOs) to serve broad regions of the country. About 13 

percent of Medicare’s 42 million beneficiaries currently are enrolled in private health plans; 

nearly all of those beneficiaries are in health maintenance organizations that primarily serve 

metropolitan areas. The service areas of regional PPOs generally would be larger than those of 

private plans that currently participate in Medicare and would include many areas that are not 

served by those plans.

This paper describes how the Congressional Budget Office (CBO) analyzed the likely effects 

of the MMA’s provisions for regional PPOs. In accordance with CBO’s mandate to provide 

objective, impartial analysis, this paper makes no recommendations. 

Lyle Nelson of CBO’s Health and Human Resources Division prepared the paper, with contributions from Shawn Bishop, under the general supervision of Steve Lieberman (formerly of 

CBO). Todd Anderson provided assistance with data and tabulations, and Meenakshi 

Fernandes fact-checked the paper. James Baumgardner, Tom Bradley, Philip Ellis, Arlene 

Holen, David Moore, Sven Sinclair, and Bruce Vavrichek, all of CBO, provided thoughtful 

comments on drafts, as did Joseph Antos of the American Enterprise Institute and William 

Scanlon, an independent consultant. (The assistance of external reviewers implies no responsibility for the final product, which rests solely with CBO.)

Christine Bogusz edited the paper, and John Skeen and Loretta Lettner proofread it. Maureen 

Costantino prepared the paper for publication and designed the cover. Lenny Skutnik produced the printed copies of the report, and Annette Kalicki produced the electronic versions 

for CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin

Director

October 2004

Summary and Introduction 1

Medicare’s Experience with Private Health Plans 1

Provisions of the MMA Affecting Private

Health Plans 2

CBO’s Analysis of the Regional PPO Program 2

Medicare’s Experience with Private Health Plans 4

The Medicare Risk Program 4

The Medicare+Choice Program 5

The MMA’s Regional PPO Program 7

Analyzing the Regional PPO Program 9

The Costs of Medicare+Choice Plans 10

Variation in M+C Plans’ Costs 12

Estimating the Costs of Medicare PPOs 13

Projecting the Bids of Regional PPOs 18

Appendix: Technical Aspects of the Analysis 21

CONTENTS
vi CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

Tables

1. Changes in the Percentage of Medicare Beneficiaries Enrolled in

Private Plans and Increases in Payment Rates, 1997 to 2003 7

2. Costs per Enrollee of Medicare+Choice Plans Based on

County-Level Estimates, 2002 11

3. Estimated Costs That PPOs Would Have Incurred if They

Had Entered the Medicare+Choice Program, 2002 15

4. Comparison of the Characteristics of Counties With and Without

Medicare+Choice Plans, 2002 16

5. Projected Bids of Regional PPOs Relative to per Capita 

Fee-for-Service Expenditures and Benchmarks Under

Alternative Approaches to Defining Regions, 2006 19

A-1. Costs per Enrollee of Medicare+Choice Plans Based on Plan-Level

Estimates, 2002 22

A-2. Estimated Parameters of Sample Selection Model of

Medicare+Choice Plans’ Costs 24

Figure

1. Enrollment in Medicare Risk/Medicare+Choice Plans, 1985 to 2003 4

Box

1. The Medicare PPO Demonstration 10
CBO’s Analysis of Regional Preferred Provider 

Organizations Under the Medicare Modernization Act

Summary and Introduction

The recently enacted Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) 

made many changes to the Medicare program, including 

changes in the way that private health plans are paid to 

provide Medicare benefits.1 This paper focuses on a subset of those changes that affected a particular form of private health plan—preferred provider organizations, or 

PPOs—and PPOs’ incentives to participate in Medicare 

and serve broad regions of the country. Although PPOs 

are widely used by privately insured Americans, few such 

plans have participated in the Medicare program. 

PPOs are health plans that have networks of independent 

providers who have agreed to accept lower fees negotiated 

with the plan in exchange for access to a greater number 

of patients. Although PPOs will pay for covered services 

received outside their network, enrollees pay a smaller 

share of the costs when they use “in-network” providers. 

Compared with health maintenance organizations 

(HMOs), PPOs typically offer their enrollees a greater 

choice of providers and make fewer efforts to manage 

their enrollees’ care.

Medicare’s Experience with Private Health Plans

Private health plans have a long history of participating in 

Medicare. The Medicare risk program, implemented in 

1985, permitted HMOs to participate in Medicare on a 

county-by-county basis and receive a fixed monthly payment for each beneficiary they enrolled. The participating health plans were known as risk plans because they 

were at financial risk if the costs of caring for enrollees exceeded their payments from Medicare. The payment rates 

were set at 95 percent of projected average per capita 

spending in the traditional fee-for-service (FFS) Medicare 

program at the county level. Plans that could deliver 

Medicare benefits at a cost below that payment rate were 

required to use the difference to provide additional benefits, such as prescription drugs and reduced cost-sharing 

on Medicare services, which provided a major incentive 

for beneficiaries to enroll. By 1997, 70 percent of Medicare beneficiaries lived in areas served by a risk plan, and 

5.2 million beneficiaries (or 13.5 percent of the entire 

Medicare population) were enrolled in those plans. 

The Balanced Budget Act of 1997 (BBA) replaced the 

Medicare risk program with the Medicare+Choice 

(M+C) program. The BBA and subsequent legislation 

substantially increased the payment rates offered to private health plans in some geographic areas—generally, 

those where plans either did not participate in Medicare 

or had small market shares—in an attempt to improve 

beneficiaries’ access to plans. But the BBA also established a process whereby payment rates grew more slowly 

than private plans’ costs in other geographic areas, particularly urban areas with substantial enrollment. The slow 

growth of payment rates in those areas contributed to a 

significant decline in the plans’ availability and enrollment. The percentage of beneficiaries with access to a private plan fell from its peak of 74 percent in 1998 to 59 

percent in 2003.2

 During that time, enrollment in private 

plans declined from 6.1 million to 4.6 million. 1. The Congressional Budget Office provided a detailed breakdown 

of its scoring of the entire MMA in its cost estimate titled H.R. 1, 

Medicare Prescription Drug, Improvement, and Modernization Act 

of 2003 (November 2003). CBO’s scoring of the MMA was also 

discussed by CBO Director Douglas Holtz-Eakin in his statement 

Estimating the Cost of the Medicare Modernization Act, before the 

House Committee on Ways and Means, March 24, 2004.

2. The statistics on plans’ availability and enrollment in this section 

do not include private fee-for-service (PFFS) plans (which are discussed later in this paper) or plans that are paid by Medicare on a 

cost-reimbursement basis.
2 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

Provisions of the MMA 

Affecting Private Health Plans

The MMA made several changes to the payment system 

for private health plans and included incentives for plans 

to offer a PPO option to Medicare beneficiaries on a 

regionwide basis beginning in 2006. (Private health plans 

are now part of the newly named Medicare Advantage 

program, which replaced Medicare+Choice.) 

Under the MMA, the existing payment system for “local” 

(county-based) plans was largely retained for 2004 and 

2005, but the payment rates were increased. A modified 

payment system will be implemented in 2006 for both 

local plans and regional plans. The payment rates will become “benchmarks,” and plans will submit bids reflecting 

the payment per enrollee for which they are willing to 

provide Medicare’s covered benefits.3 Plans will be paid 

their bids (up to the benchmarks) plus 75 percent of the 

amount by which the benchmarks exceed their bids. 

Plans must return that 75 percent to beneficiaries as additional benefits or as a rebate on their Part B or Part D premium.4 Additional benefits and premium rebates will be 

the primary incentives for beneficiaries to enroll. Plans 

whose bids are above the benchmarks are required to 

charge enrollees the full difference as an additional premium for the Medicare benefit package.

Despite some differences in terminology, the bidding 

mechanism is analogous to current requirements, and the 

competitive pressures facing private plans will be similar. 

Currently, private plans that participate in Medicare submit a projection of the revenue per enrollee that they require to deliver Medicare’s covered benefits, which is 

called the adjusted community rate (ACR). If a plan’s 

ACR is less than its projected payment per enrollee from 

Medicare, it must return the difference to enrollees in the 

form of additional benefits or as a rebate of their Part B 

premium. Thus, the ACRs that plans submit under current law are analogous to the bids that plans will submit 

beginning in 2006. 

The main distinction between the ACRs and the bids is 

in the amount that plans share with Medicare. Currently, 

plans can use 100 percent of the difference between their 

ACRs and their projected payments from Medicare to 

provide additional benefits. But for every dollar that they 

use to provide rebates on premiums, the Medicare program retains 20 cents and enrollees receive the other 80 

cents. Under the MMA, plans must use 75 percent of the 

difference between their bids and the benchmarks for additional benefits or premium rebates, with Medicare always retaining the remaining 25 percent.

For the regional PPO program, the MMA requires the establishment of at least 10, but not more than 50, regions. 

PPOs that participate in Medicare in December 2005 

will be allowed to continue to operate as local plans or to 

become regional plans. PPOs that enter Medicare in 

2006 or 2007 will be required to operate as regional plans 

during that period; however, they may operate either as 

local plans or as regional plans after 2007. PPOs that enter Medicare after 2007 can operate as either local or regional plans. 

Another aspect of the incentives for PPOs to participate 

on a regional basis is that the MMA established a “stabilization fund” that the Centers for Medicare and Medicaid 

Services (CMS) may draw from to increase regional 

benchmarks or to make bonus payments to plans during 

the 2007-2013 period. That fund will have an initial balance of $10 billion.

CBO’s Analysis of the Regional PPO Program

All of the provisions in title II of the Medicare Modernization Act, which altered the payment system for private 

plans and established the regional PPO program, will increase federal spending by $14 billion over the 2004-

2013 period, the Congressional Budget Office (CBO) estimates. Spending from the stabilization fund for the regional PPO program accounts for $10 billion of the total. 

(CBO assumed that the entire amount of the stabilization 

fund would be spent.) The provisions that raised payment rates for local plans (including local PPOs) account 

for the remaining $4 billion. CBO estimates that, other 

than the $10 billion in spending from the stabilization 

fund, the regional PPO program will have a negligible ef3. The benchmark for a local plan will be a weighted average of the 

county-level benchmarks in the plan’s service area. The benchmark for a regional plan will be a blend of two components: a 

weighted average of the county-level benchmarks in the region 

and a weighted average of the bids in the region. The blend percentage applied to the bids will be the percentage of Medicare 

beneficiaries nationally who are enrolled in local or regional plans.

4. The premium paid by beneficiaries who are enrolled in Medicare 

Part B, which covers physicians’ services, outpatient hospital services, certain home health services, and other services and medical 

supplies, is $66.60 per month in 2004. The Part D premium 

is the premium that beneficiaries who enroll in the voluntary outpatient prescription drug benefit (offered as Part D of Medicare 

beginning in 2006) will pay for that coverage.
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 3

fect on federal outlays. This paper describes the analyses 

that formed the basis for that estimate regarding regional 

PPOs.

To analyze the regional PPO program, CBO projected 

the bids that regional plans would submit by analyzing 

cost data from private plans that participate in Medicare. 

(Discussions with industry representatives also contributed to the analysis.) CBO then compared those bids 

with the benchmarks the plans would face. The difference provides a measure of the incentives for beneficiaries 

to enroll. 

In projecting the bids of regional PPOs, CBO accounted 

for the fact that the service areas of such plans would include places where private plans are not currently available to Medicare beneficiaries. About 40 percent of beneficiaries live in such areas. CBO expects that the perenrollee costs of PPOs in those areas will be higher—in 

some cases, substantially so—than local per capita FFS 

expenditures.5

Areas in which Medicare beneficiaries do not have access 

to private plans differ from other areas in various ways 

that influence health plans’ costs. In particular, those areas are more likely to be rural and to have relatively low 

per capita expenditures in the Medicare FFS program. 

Because of their limited number, rural health care providers typically have significant negotiating leverage with 

private health plans. Consequently, the rates that private 

plans must pay rural providers are often substantially 

higher than Medicare’s FFS rates. In addition, such areas 

tend to have low utilization of expensive services, so private plans have little or no opportunity to achieve savings 

relative to the Medicare FFS program through utilization 

management.

Apart from temporary increases in enrollment attributable to the stabilization fund, CBO expects that the establishment of the regional PPO program will not significantly increase the percentage of Medicare beneficiaries 

who are enrolled in private plans. CBO estimated that, in 

most regions, the bids of regional PPOs would either be 

above the benchmarks (in which case the PPOs would be 

required to charge enrollees an additional premium for 

Medicare benefits) or below the benchmarks by such a 

small amount that the PPOs would not be able to offer a 

sufficiently generous package of additional benefits or 

premium rebates to attract significant enrollments.6

Even in those regions where it appears that PPOs could 

submit bids significantly lower than the benchmarks, 

CBO expects that they probably will participate either as 

local plans (for example, by entering the program after 

the two-year moratorium on new local PPOs expires) or 

as regional plans but draw their enrollments almost entirely from areas that are served by local plans (for example, by concentrating their marketing in such areas). 

Those situations were a component of CBO’s cost estimate of the provisions of the MMA that increased payment rates for local plans.

In general, CBO expects that PPOs will tend to enroll 

beneficiaries only in areas where their costs per enrollee of 

providing Medicare’s covered benefits are substantially 

lower than the county-level benchmarks (which CBO estimates will be true only in certain areas that are currently 

served by local plans). Enrolling a substantial number of 

beneficiaries in areas where a plan’s costs per enrollee were 

greater than, or only slightly lower than, the county-level 

benchmark would reduce the gap between the regional 

benchmark and the plan’s bid. As a result, the amount of 

additional benefits or premium rebates that the plan 

could offer to attract enrollees would diminish, placing 

the plan at a competitive disadvantage relative to plans 

that operated only in areas where their local costs were 

substantially below the county-level benchmarks.7

In the great majority of regions, the benchmarks and the 

projected bids of regional PPOs are higher than per capita 

FFS expenditures. Therefore, if PPOs participated in 

those regions, Medicare outlays would increase.

The remainder of this paper discusses the basis for CBO’s 

conclusions regarding regional PPOs by describing the 

following factors in detail:

5. CBO projects that the per-enrollee costs of PPOs also will be 

higher than local per capita FFS expenditures in many areas where 

private plans currently participate in Medicare.

6. CBO conducted the analysis using various approaches to defining 

regions that are consistent with the specifications in the MMA.

7. The MMA includes a provision to adjust the payments to both 

local plans and regional plans to account for geographic variation 

in county-level benchmarks. CBO assumed that this provision 

would be applied in an identical manner for regional and local 

plans, in each case adjusting the payment for a particular enrollee 

to reflect the benchmark in the county where that person lives.
4 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

B Medicare’s experience with private health plans;

B The provisions of the MMA that establish a program 

for regional PPOs; and

B CBO’s analysis of the costs of regional PPOs in the 

Medicare program, including a comparison of the bids 

that such plans would submit to provide Medicare’s 

covered benefits and the benchmarks those plans 

would face.

Medicare’s Experience 

with Private Health Plans

Since the Medicare program’s inception in 1965, the vast 

majority of beneficiaries have received their care through 

a fee-for-service system in which Medicare pays providers 

on a piecemeal basis for each service they deliver. Over 

the past 20 years, efforts have been made to expand the 

delivery system to include private health plans that receive a fixed payment per enrollee and thus have incentives to seek efficiencies in delivering care. 

The Medicare Risk Program

The Medicare risk program, which was in force from 

1985 to 1997, permitted HMOs to enroll Medicare beneficiaries and receive fixed monthly payments in return 

for providing all Medicare-covered services. Reflecting 

the expectation that HMOs would provide Medicare services more efficiently than the fee-for-service sector, payment rates were set at 95 percent of projected average per 

capita FFS expenditures at the county level. Payments 

were adjusted to account for differences between HMO 

enrollees and FFS beneficiaries with respect to selected 

demographic characteristics, such as age and sex. However, there is considerable evidence that Medicare HMO 

enrollees were healthier than FFS beneficiaries and that 

those differences were not fully accounted for by the demographic adjusters included in the payment formula.8

That evidence suggests that the risk program did not save 

Medicare the intended 5 percent and may have led to 

even higher total spending on the program.

Figure 1.

Enrollment in Medicare Risk/

Medicare+Choice Plans, 1985 to 2003

(Millions)

Source: Marsha Gold and others, Monitoring Medicare+Choice: 

What Have We Learned? Findings and Operational Lessons for Medicare Advantage (report submitted by Mathematica Policy Research, Inc., to the Robert Wood Johnson 

Foundation, August 2004).

Note: The Balanced Budget Act of 1997 created the Medicare+

Choice program to replace the Medicare risk program.

The payment system included an additional feature designed to prevent HMOs from earning a higher return on 

their Medicare business than on their commercial business. Each year, HMOs were required to submit an actuarial projection of the rate they would charge commercial 

enrollees for the Medicare benefit package, after accounting for differences between commercial enrollees and 

Medicare enrollees in the level and intensity of their use 

of services. If that projected rate, called the adjusted community rate, was less than the average payment a plan expected to receive from Medicare, the plan was required to 

provide the difference to enrollees in the form of additional benefits. Those additional benefits could include 

services not covered by Medicare, such as prescription 

drugs, and reductions in cost-sharing for Medicare services. Those richer benefit packages were a major incentive for beneficiaries to enroll in HMOs, and plans generally competed for enrollees on that basis.

Enrollment in Medicare HMOs grew slowly at first and 

then accelerated in the mid-1990s, reaching 5.2 million 

8. Michelle M. Mello and others, “Understanding Biased Selection 

in Medicare HMOs,” Health Services Research, vol. 38, no. 3 (June 

2003), pp. 961-992.

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

0

1

2

3

4

5

6

7
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 5

(or 13.5 percent of the Medicare population) by 1997 

(see Figure 1). Enrollment rates were highest in U.S. 

counties with higher payment rates, reflecting the fact 

that HMOs were more likely to serve such areas and were 

able to offer more-generous benefit packages there.9

Medicare HMOs were heavily concentrated in urban areas. In 1996, 82 percent of beneficiaries in metropolitan 

areas lived in the service area of at least one Medicare 

HMO, compared with only 19 percent of beneficiaries in 

nonmetropolitan areas.10 The proportion of Medicare 

beneficiaries enrolled in HMOs also varied greatly by 

state. In 1997, more than 35 percent of Medicare beneficiaries in Arizona and California were enrolled in HMOs, 

but there were 25 states in which fewer than 5 percent of 

Medicare beneficiaries were enrolled in HMOs.

The Medicare+Choice Program

The Balanced Budget Act of 1997 created the Medicare+Choice program to replace the Medicare risk program as the vehicle by which private health plans could 

participate in Medicare.

Key Provisions. Lawmakers established the M+C program to give Medicare beneficiaries access to an array of 

health plans comparable to those that were available to 

people with employment-based coverage. The BBA expanded the types of health plans eligible to participate in 

Medicare to include PPOs, provider-sponsored organizations, and private fee-for-service plans. The BBA also 

changed the method of setting payment rates for private 

health plans. Among the many competing objectives of 

the BBA, the new M+C payment method gave plans 

greater incentives to participate in areas with low per capita FFS spending levels (many of which are rural areas).11

Under the Medicare+Choice program, the payment rate 

for each county was the greatest of three amounts:

B A minimum increase from the previous year’s rate;

B A minimum (floor) rate; and

B A blend of a local (county-level) rate and the national 

rate.

The minimum increase was 2 percent in every year except 

2001, when it was 3 percent. The BBA set the floor rate 

at $367 per month in 1998 and required the Centers for 

Medicare and Medicaid Services to update the floor rate 

and the local and national components of the blended 

rate each year by the projected change in national per 

capita Medicare expenditures, minus a specified reduction.12 In 2001, lawmakers established separate floor 

rates of $525 and $475 for counties in a metropolitan 

area with a population of more than 250,000 and for all 

other counties, respectively.

The BBA specified that the local component of the 

blended rate was to be updated from the 1997 countylevel rates under the Medicare risk program (thus reflecting local average costs in the FFS program); the national 

rate was the national average of the local rates. In computing the blended rate for a particular county, the BBA 

required that the national rate be adjusted to account for 

geographic variation in the prices of the “inputs” that private plans used to deliver Medicare’s services.13 The BBA 

established a budget-neutrality adjustment for the 

blended rates, which sought to ensure that total projected 

M+C payments each year were equal to the payments 

that would have been made if all plans had been paid the 

local rates. Because of that provision, 2000 is the only 

year in which the rates for any counties were based on the 

blend. In all other years, every county received either the 

minimum update or the floor rate.14

Experience Under Medicare+Choice. Under the M+C 

program, a substantial number of plans withdrew from 

Medicare or reduced their service area, and many plans 

significantly lessened the generosity of their benefits.15

9. Timothy D. McBride, “Disparities in Access to Medicare Managed Care Plans and Their Benefits,” Health Affairs, vol. 17, no. 6 

(November/December 1998), pp. 170-180.

10. Ibid.

11. The BBA also required Medicare to develop and implement a new 

method of risk adjustment to account for differences in beneficiaries’ health status as well as differences in their demographic characteristics in setting payments. 

12. The reduction applied to the update was at its highest in 1998 (at 

0.8 percentage points) and declined to zero in 2003.

13. CMS implemented that requirement by adjusting the national 

rate to account for geographic variation in the wages of hospital 

employees and the costs of the inputs used by physicians to deliver 

Medicare’s services.

14. The budget-neutrality adjustment was applied only to the blended 

rates, because the BBA did not allow rates to be reduced below the 

floors or minimum update amounts. Consequently, it was not 

possible to achieve overall budget neutrality every year.

15. Marsha Gold, “Medicare+Choice: An Interim Report Card,” 

Health Affairs, vol. 20, no. 4 (July/August 2001), pp. 120-138.
6 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

By 2003, the fraction of beneficiaries who had access to a 

private plan had fallen to 59 percent, from a high of 74 

percent in 1998, and the enrollment in private plans had 

fallen to 4.6 million, from a high of 6.3 million in 1999 

(see Figure 1).16 Few of the new types of plans authorized 

by the BBA entered the program.17

M+C payment rates grew more slowly than private plans’ 

costs in some areas of the country, particularly urban areas that previously had substantial enrollment. Some of 

those areas received the minimum payment update in 

most (or all) years. Other areas, particularly those where 

plans did not operate or those with small Medicare market shares, saw significant increases in the payment rates 

that were offered. Nationally, M+C payment rates 

(weighted by M+C enrollment) increased by about 2 percent in both 1998 and 1999 and grew at an average annual rate of 3.2 percent from 1997 to 2003. The slow 

growth in payment rates in areas where private plan enrollees were concentrated contributed to the decline in 

plans’ availability and enrollment.18

By design, the statutory payment floors caused M+C payment rates to grow more rapidly in counties where FFS 

spending was low. In the lowest-spending counties (those 

with 2003 per capita FFS expenditures of less than $400 

per month), payment rates increased by an average of 

67 percent from 1997 to 2003 (see Table 1).19 In the 

highest-spending counties (those with 2003 per capita 

FFS expenditures of at least $650 per month), payment 

rates increased by only 14 percent.

The large increases in payment rates in areas where FFS 

spending was low, however, did not result in significantly 

larger M+C enrollments in those areas. In the lowestspending counties, where M+C payment rates had grown 

to an average of 36 percent higher than per capita FFS expenditures by 2003, the percentage of Medicare beneficiaries who were enrolled in private plans increased but 

remained low, rising from 0.5 percent in 1997 to 1.8 percent in 2003 (see Table 1). In counties in the next-lowest 

spending category (where per capita FFS expenditures in 

2003 were greater than $400 but less than $450), the percentage of Medicare beneficiaries who were enrolled in 

private plans remained stable at about 6 percent, despite 

the fact that M+C payment rates in those areas had 

grown to an average of 23 percent higher than per capita 

FFS expenditures by 2003. That limited M+C enrollment—even with payment rates that were substantially 

higher than per capita FFS expenditures—indicates that 

there are factors that hinder plans’ ability to operate in 

such areas, including high costs relative to payment rates, 

providers’ resistance to contracting with private plans, or 

beneficiaries’ reluctance to enroll in private plans.

Private fee-for-service plans, which were not included in 

the estimates of private plan participation and enrollment 

presented above, serve many areas that are not covered by 

Medicare+Choice HMOs. PFFS plans are not required to 

have provider networks, they do not attempt to coordinate care, and their enrollees are allowed to obtain care 

from any provider who will furnish it. Only three PFFS 

plans participated in Medicare in 2003, but they each 

had large multistate service areas. In all, although more 

than 15 million beneficiaries (or about 38 percent of the 

Medicare population) lived in areas served by a PFFS 

plan in 2003, fewer than 25,000 beneficiaries were enrolled in such plans. About half of the beneficiaries who 

had access to PFFS plans in 2003 did not have access to a 

Medicare HMO, and about a third lived in nonmetropolitan areas. 

PFFS plans are permitted to use Medicare fee-for-service 

rates to reimburse providers. Thus, their greatest potential for success would appear to be in areas where M+C 

payment rates are much higher than per capita FFS expenditures (which tend to be rural areas and other areas 

with low FFS spending levels), where the potential gap 

between their costs of providing Medicare benefits and 

their payments from Medicare is greatest. The small 

number of PFFS plans that have participated in Medicare, along with the limited enrollment in such plans, 

is further evidence of the challenges facing private 

16. The estimates of plans’ availability and enrollment do not include 

PFFS plans, which are discussed later in this section.

17. Additional PPOs entered the Medicare PPO Demonstration in 

2003, which offered more favorable terms than the M+C program.

18. Robert E. Hurley, Joy M. Grossman, and Bradley C. Strunk, 

“Medicare Contracting Risk/Medicare Risk Contracting: A Life 

Cycle View from Twelve Markets,” Health Services Research, vol. 

38, no. 1, part II (February 2003), pp. 395-417.

19. All counties in the United States were included in this analysis, 

and payment rates were weighted by the number of beneficiaries 

in each county.
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 7

Table 1.

Changes in the Percentage of Medicare Beneficiaries Enrolled in Private Plans 

and Increases in Payment Rates, 1997 to 2003

Source: Congressional Budget Office based on data from the Centers for Medicare and Medicaid Services.

Notes: CBO weighted the payment rates and per capita FFS expenditures by the number of beneficiaries in each U.S. county and used those 

weighted averages to calculate the changes in payment rates and the ratio of M+C payment rates to per capita FFS expenditures.

FFS = fee for service; M+C = Medicare+Choice.

a. In 1997, private plan enrollees were beneficiaries enrolled in Medicare risk plans. In 2003, they were beneficiaries enrolled in M+C plans.

plans in rural areas and other areas where per capita FFS 

spending is low.

The MMA’s Regional PPO Program

Preferred provider organizations have become the most 

popular form of health insurance among privately insured 

people, selected by 55 percent of the workers enrolled in 

employment-based health plans in 2004.20 The key component of a PPO is a network of providers who agree to 

accept discounted payment rates in exchange for access to 

a larger volume of patients. A PPO will pay for covered 

services furnished by a nonnetwork provider, but enrollees have financial incentives (in the form of lower fees 

and lower copayments) to obtain their care in the PPO 

network. Compared with HMOs, PPOs offer enrollees a 

greater choice of providers and employ less utilization 

management. In particular, PPOs typically do not require 

enrollees to select a primary care physician who is responsible for coordinating their care.21

The Medicare Modernization Act included provisions 

that affected the incentives for private health plans to offer a PPO option to Medicare beneficiaries on a regionwide basis beginning in 2006. The law requires that CMS 

establish at least 10 regions but no more than 50 and that 

they be defined to maximize the availability of regional 

plans. Plans may offer PPOs in as many regions as they 

wish. PPOs that participate in Medicare in December 

2005 will be allowed to continue on a county-by-county 

basis (or as local plans in the terminology of the MMA) 

or they can convert to the regional program. New PPOs 

that enter Medicare in 2006 or 2007 will be required to 

be regional plans. After 2007, PPOs may participate on 

either a local or a regional level.

The MMA retained the basic structure of the M+C payment method for 2004 and 2005 but modified it to inPercentage Increase in Payment Rate

Average per Capita FFS Payment Rates, to per Capita FFS

Expenditure per Month in 2003 1997 to 2003 Expenditures, 2003

Less Than $400 2.9 66.8 1.36 0.5 1.8

$400 to $449 9.2 49.7 1.23 5.9 6.2

$450 to $499 16.5 40.1 1.14 6.1 6.2

$500 to $549 19.4 26.8 1.05 11.4 9.7

$550 to $599 14.7 20.9 0.98 12.6 9.4

$600 to $649 12.6 17.2 0.94 18.4 12.9

$650 and Higher 24.8 14.2 0.96 22.4 19.1 ____

Total 100.0 24.7 1.04 13.5 11.3

Percentage of

Beneficiaries 2003

Ratio of M+C

1997

Percentage of 

Medicare Beneficiaries

Enrolled in Private Plansa

20. Kaiser Family Foundation and Health Research and Educational 

Trust, Employer Health Benefits 2004 Annual Survey, available at 

www.kff.org. 

21. Many large health plans offer both HMO products and PPO 

products in their commercial business. The term PPO is used in 

this paper to refer to the PPO product and, in cases in which the 

meaning is clear, the health plan offering the PPO product.
8 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

crease the rates.22 Beginning in 2006, the payment rates 

will be called benchmarks, and a new payment system 

will be implemented for both local plans and regional 

plans. Both types of plans will submit bids reflecting the 

per capita payment for which they are willing to provide 

Medicare (nondrug) benefits for a “standard beneficiary.”23 Plans’ bids will be compared to the benchmark 

amounts. Medicare will pay plans their bids (up to the 

benchmarks), plus 75 percent of the amount by which 

the benchmarks exceed the bids. Plans must then return 

that 75 percent to enrollees in the form of extra benefits 

or as rebates on their Part B or Part D premium. Plans 

with bids above the benchmarks must charge beneficiaries the full difference as an additional premium for the 

Medicare benefit package. Thus, beneficiaries will face financial incentives to enroll in plans with low bids.

For a local plan, the benchmark will be a weighted average of the statutorily determined county-level benchmarks in the plan’s service area. For a regional plan, the 

benchmark will be a blend of the county-level benchmarks within the region and the regional bids. The blend 

percentage applied to the bids in the region will be the 

national percentage of beneficiaries who are enrolled in a 

local or regional private plan. The MMA includes a provision to adjust the payments to both local plans and regional plans to account for variations in county-level 

benchmarks. CBO assumed that this provision would be 

implemented in an identical manner for regional and local plans, in each case adjusting the payment for a particular enrollee to reflect the local benchmark in the county 

where that person lives.

The bidding mechanism that takes effect in 2006 will be 

similar to current requirements. The bids to be submitted 

are analogous to the ACRs that plans currently submit; 

both reflect plans’ projections of the revenue per enrollee 

that they require to provide Medicare’s covered benefits. 

The bidding mechanism will preserve a central feature of 

the current payment system—plans will compete for enrollees by offering additional benefits or rebates of premiums. Currently, the amount of additional benefits or premium rebates that plans must offer is determined 

through a comparison of their ACRs with their projected 

per capita payments from Medicare. In the bidding 

mechanism to be implemented in 2006, the amount of 

additional benefits or rebates to be offered will be determined through a comparison of the plans’ bids with their 

benchmarks. 

The main distinction between the two payment systems 

is in the portion that plans share with Medicare. Through 

2005, plans can use 100 percent of the difference between their ACRs and their projected payments from 

Medicare to provide additional benefits. But for every 

dollar that plans use to provide premium rebates, the 

Medicare program retains 20 cents and beneficiaries receive the other 80 cents. Under the MMA, plans must 

use 75 percent of the difference between their bids and 

benchmarks for either extra benefits or premium rebates, 

with Medicare always retaining the remaining 25 percent.

The MMA includes several incentives for private health 

plans to participate as regional PPOs. First, the Medicare 

program will share the risk for medical expenses with all 

regional plans for the first two years (2006 and 2007). 

Symmetric risk corridors will be established so that regional plans will share some of their losses or profits (depending on whether their costs of providing Medicare 

benefits turn out to be higher or lower than they estimated in their bids) with the Medicare program.24 Second, the Secretary of the Department of Health and Human Services may draw from a stabilization fund to 

increase regional benchmarks or make bonus payments to 

plans that participate on a regional or national basis. The 

stabilization fund, which will be capitalized with $10 billion, will be available from 2007 through 2013. Third, 

Medicare will provide up to $25 million in 2006 to subsidize services furnished by certain “essential” hospitals to 

enrollees in regional plans. That amount will be updated 

in subsequent years according to the increase in the hos22. The minimum increase is now the greater of 2 percent or the projected growth in per capita Medicare spending. Among the other 

changes the law requires, the payment formula (described on page 

5) in 2004 includes a fourth option, which is the level of per capita FFS expenditures in the county. After 2004, each county’s rate 

will be updated from the previous year’s rate according to the new 

formula specifying a minimum increase. 

23. A standard beneficiary is an individual with characteristics that, 

based on the risk-adjustment mechanism in the payment formula, 

is expected to have average Medicare expenditures (at the national 

level). Plans must also submit separate bids for Part D (prescription drug) benefits and for any supplemental benefits they offer, 

such as reductions in cost-sharing for Medicare services or additional benefits not covered by Medicare.

24. Regional plans will be at full risk for medical expenses that are 

within 3 percent of a target amount and will share the risk with 

Medicare for expenses outside that range.
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 9

pital market basket index, which measures the increase in 

the prices of inputs used by hospitals.

Analyzing the Regional PPO Program

In analyzing the regional PPO program, CBO estimated 

the bids that plans would submit under the program and 

compared those bids with the regional benchmarks. In 

general, the lower the bids relative to the benchmarks, 

the greater the anticipated enrollment in regional PPOs, 

because lower bids would allow PPOs to offer moregenerous benefit packages or larger premium rebates. 

CBO assumed that PPOs would be unlikely to enter the 

program unless they could attract significant enrollment—which, in turn, would require that their bids be 

substantially below the benchmarks. CBO further assumed that if any plans participated but had bids that 

were either above the benchmarks or only slightly below 

the benchmarks, they would have very small enrollment. 

CBO estimated the effects of the regional PPO program 

on Medicare outlays by comparing the amount per enrollee that Medicare would pay the plans with per capita 

FFS expenditures in each region. Inducing beneficiaries 

to switch from the FFS sector to regional PPOs would reduce total Medicare outlays only if Medicare’s payments 

for PPO enrollees were less than what it would have cost 

the program to cover those beneficiaries in the FFS sector.

In developing its estimate of the costs of the regional 

PPO program, CBO assumed that the entire amount of 

the stabilization fund would be spent. The analyses in 

this paper formed the basis for CBO’s estimate of the 

costs of the regional PPO program other than those costs 

attributable to the stabilization fund.

CBO projected the bids of regional PPOs by estimating 

the per capita costs that PPOs would face at the county 

level and then totaling those costs for regions.25 CBO assumed that plans’ bids would reflect their costs of providing Medicare’s required benefits at the statutory costsharing level or at an actuarially equivalent level, as required by the MMA. To put costs and benchmarks on a 

comparable basis, CBO assumed that the distribution of 

PPO enrollees across counties within each region would 

equal the corresponding distribution of the Medicare 

population.26 PPOs’ costs were estimated from the costs 

of M+C plans, virtually all of which are HMOs. CBO 

used information from industry sources and prior research to predict how the costs of PPOs would differ 

from those of HMOs. In addition, because regional 

PPOs would be required to serve geographic areas that 

are not served by M+C plans, CBO used multivariate regression analysis to predict PPOs’ costs in those areas. 

That component was a critical part of CBO’s approach, 

because geographic areas that are not served by M+C 

plans differ greatly from other areas in a number of ways 

that are expected to influence private health plans’ costs. 

In projecting the costs of regional PPOs, CBO assumed 

that plans would be required to meet the same network 

adequacy standards that they were required to meet under 

the M+C program.

CBO also examined cost projections submitted by plans 

that are participating in the Medicare PPO Demonstration that began in 2003 (see Box 1). The PPOs in the 

demonstration were permitted to select particular counties to serve; nearly all of them serve metropolitan counties that are also covered by Medicare HMOs. CBO used 

the cost projections of the demonstration PPOs as an additional source of data on cost differences between PPOs 

and HMOs. Information from the Medicare PPO Demonstration had a limited role in CBO’s analysis, however, 

because the demonstration covers selected geographic areas that are not representative of the nation as a whole, 

and the participating plans may not be representative of 

those that might participate more broadly in the regional 

PPO program.

The next section of this paper presents CBO’s analysis of 

the costs of M+C plans. That is followed by a discussion 

of why costs for M+C plans vary geographically and differ from costs in the Medicare FFS program, which

25. In this paper, a health plan’s costs refer to its required revenues for 

providing Medicare-covered benefits, including administrative 

costs and an allowance for normal profits.

26. The basic conclusions of the analysis are not sensitive to that 

assumption. To the extent that enrollment would be concentrated 

in counties with local plans, the effects were captured in CBO’s 

analysis of the MMA’s provisions affecting local plans. To the 

extent that enrollment would be concentrated in counties without 

local plans, regional PPOs would be even less viable than this 

analysis concludes.
10 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

provides a basis for understanding projected costs for 

PPOs. The following section describes how CBO estimated PPOs’ costs for areas that are served by countybased plans and those that are not. The final section compares the estimated bids of regional plans with the benchmarks and uses those comparisons to draw conclusions 

regarding the likely enrollment in regional PPOs.

The Costs of Medicare+Choice Plans 

In their annual ACR submissions, M+C plans project 

their costs of providing Medicare benefits (including administrative costs and normal profits) given the expected 

characteristics of their enrollees. CBO standardized those 

projected costs to reflect the costs that would be expected 

for a standard beneficiary in each county. The per capita 

FFS expenditures were similarly standardized (by CMS) 

to make them comparable.27 CBO’s estimates are based 

on ACR data submitted for 2002, the most recent data 

available when CBO conducted its analysis for its cost esBox 1.

The Medicare PPO Demonstration

In contrast with their widespread availability and enrollment in the privately insured health care market, 

preferred provider organizations (PPOs) have a limited history in Medicare. Although the Balanced 

Budget Act of 1997 allowed health plans to offer 

PPOs to Medicare beneficiaries beginning in 1999, 

few did so until the Medicare PPO Demonstration 

began in January 2003. The demonstration was designed to attract private plans by offering three features:1

B Payment rates in each county were equal to the 

greater of 99 percent of average fee-for-service expenditures or the Medicare+Choice payment rate;

B PPOs were allowed to enter into risk-sharing arrangements with the Centers for Medicare and 

Medicaid Services; and

B Requirements for quality assurance monitoring 

and reporting were lessened for demonstration 

PPOs to reduce their administrative burden.

Those features persuaded some 17 health plans to 

participate in the demonstration, which ends in December 2005.2

 The demonstration PPOs primarily 

serve metropolitan counties that are also served by 

Medicare’s health maintenance organizations 

(HMOs). Some 94 percent of beneficiaries with access to a demonstration PPO live in metropolitan 

counties, and 92 percent have access to a Medicare 

HMO. In contrast, only 69 percent of beneficiaries 

who do not have access to a demonstration PPO live 

in metropolitan counties, and only 46 percent have 

access to a Medicare HMO.

Just over 10 million beneficiaries, or about one-quarter of the entire Medicare population, live in the service area of a demonstration PPO. Yet only about 

100,000 beneficiaries had enrolled in a demonstration PPO as of September 2004. Nearly half of the 

demonstration enrollees are in a single plan that replaced one of its Medicare HMO products with the 

PPO demonstration product. On the basis of enrollment trends, it appears that most of the enrollees in 

that PPO switched from the plan’s HMO product. 

1. Marsha Gold, Lori Achman, and Jim Verdier, The Medicare 

Preferred Provider Organization Demonstration: Overview of 

Design, Characteristics, and Outstanding Issues of Interest 

(report prepared by Mathematica Policy Research, Inc., for 

AARP, June 2003), available at www.aarp.org/ppi.

2. The 17 health plans have 35 contracts with Medicare that 

cover different geographic areas.

27. The standardization was based on the demographic factors 

included in the payment mechanism. A standard beneficiary has a 

nationally average demographic profile—that is, at the national 

level, he or she is expected to have average Medicare expenditures.
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 11

Table 2.

Costs per Enrollee of Medicare+Choice Plans 

Based on County-Level Estimates, 2002

Source: Congressional Budget Office based on data (adjusted community rates) submitted by M+C plans for 2002. Costs in this analysis are 

the plans' projected costs of providing the standard Medicare benefit package, including administrative costs and profits.

Notes: For each U.S. county, the mean plan cost is the enrollment-weighted average of the county-level cost of the plans that serve the 

county. Only counties that had plans in 2002 were included in the analysis.

FFS = fee for service; M+C = Medicare+Choice.

timates of the MMA.28 Subsequently, CBO replicated its 

analysis using 2003 ACR data and obtained similar results.

In the past, analysts have expressed concerns about the reliability of the data in plans’ ACR submissions. To address those concerns, CMS began using a completely revised ACR reporting form in 2000 and began subjecting 

plans to more extensive auditing. Although there may be 

inaccuracies in the ACR submissions, they are still an appropriate data source for this analysis because plans 

present through their ACRs the same information that 

they will reveal through their bids—namely, the revenue 

per enrollee that they need to receive to provide Medicare’s covered benefits.

In 2002, M+C plans operated in less than 20 percent of 

U.S. counties, but those counties contained about 61 percent of the Medicare population. In those areas, M+C 

plans delivered Medicare services at a cost per enrollee 

that was, on average, 7 percent lower than per capita FFS 

expenditures (see Table 2).29 Private plans’ costs relative 

to per capita FFS expenditures vary greatly among counties, however. For example, private plans’ costs were much 

higher relative to FFS expenditures in counties where FFS 

spending was low. On a per capita basis, private plans’ 

costs averaged 24 percent higher than FFS expenditures 

in the lowest-spending counties (those with per capita 

FFS spending of less than $400 in 2002) but 14 percent 

lower than FFS expenditures in the highest-spending 

counties (those with per capita FFS spending of at least 

$650 in 2002).30

On average, private plans’ costs per enrollee were higher 

than per capita FFS expenditures in counties where per 

capita FFS spending was less than $500 per month (see 

Table 2). Private plans can operate in those areas because 

Ratio of Plan Costs to

per Enrollee

Less Than $400 1.3

$400 to $449 6.7

$450 to $499 9.2 491 1.03

$500 to $549 19.0 500 0.96

$550 to $599 16.5 524 0.91

$600 to $649 18.3 531 0.85

$650 and Higher 29.0 594 0.86 ____

 Total 100.0 531 0.93

FFS Expenditures

Payment Rate

Ratio of M+C

to per Capita 

Mean per Capita 

per Month in County

FFS Expenditure

Mean Plan Cost

M+C Enrollees

464 1.24 1.41

474

0.87

0.88

0.88

0.88

0.90

Payment Rate

M+C

1.11

Percentage of

(Dollars) Expenditures

Per Capita FFS

0.90

1.26

1.16

1.05

1.07

1.02

0.96

1.00

0.88

0.90

28. To compare plans’ costs with FFS spending, CBO used 2003 

county-level per capita FFS expenditure data from CMS and 

deflated those estimates to 2002 (county-level estimates were not 

available for 2002). After CBO released its estimate of the effects 

of the MMA on federal costs, CMS revised its estimates of 

national FFS expenditures in 2002 and 2003. The estimates in 

this paper incorporate those revised estimates of FFS spending. 

That change had a relatively minor effect on the estimated relationship between plans’ costs and FFS spending. 

29. Estimated FFS expenditures include the administrative costs of 

processing Medicare FFS claims, which in 2002 were 0.2 percent 

of benefit payments for Part A services and 1.5 percent of benefit 

payments for Part B services.

30. ACR filings contain data at the plan level and are not broken out 

by county. CBO used a procedure described in the appendix to 

estimate plans’ costs at the county level.
12 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

Medicare’s payment rates are higher than per capita FFS 

expenditures—in some cases, substantially higher. For example, in counties that were served by M+C plans in 

2002 and where per capita FFS spending was less than 

$400, payment rates were 41 percent higher than per capita FFS spending.

M+C plans’ per capita costs in 2002 were, on average, 12 

percent lower than the payments they received from 

Medicare. That difference translated into an average of 

$72 per month that plans offered as additional benefits to 

their enrollees. Despite the offer of those additional benefits, only 20 percent of beneficiaries who lived in the service area of an M+C plan in 2002 were enrolled in such a 

plan. That evidence indicates that, in general, plans must 

offer a substantial amount of additional benefits to induce beneficiaries to enroll in managed care plans and accept the utilization controls and restrictions on choosing 

a health care provider that distinguish such plans from 

coverage in the FFS sector. 

The packages of additional benefits that plans offered in 

2002 were less generous than what plans had offered at 

the beginning of the M+C program, because payment 

rates in the areas where enrollment was concentrated 

grew more slowly than plans’ costs.31 By 2002, a substantial number of M+C plans had withdrawn from the program or reduced their service area, and M+C enrollment 

had fallen significantly. Therefore, the 12 percent difference between plans’ costs and payment rates measured in 

2002 may not be sufficient for plans to enter new areas 

and attract substantial numbers of new enrollees. 

Variation in M+C Plans’ Costs

Why do private plans’ costs relative to fee-for-service expenditures vary so much among geographic areas? And 

why are those ratios higher in geographic areas where FFS 

spending is low? In general, the costs of private plans relative to FFS expenditures depend on the net effect of three 

factors:

B The level and intensity of beneficiaries’ use of services 

in private plans relative to their use of services in the 

FFS sector; 

B The payment rates that providers receive from private 

plans relative to the rates they receive from FFS Medicare; and

B The administrative costs of private plans relative to 

those of FFS Medicare.

In all geographic areas, private plans have higher administrative costs per enrollee than FFS Medicare because of 

their smaller scale of operations and their costs associated 

with marketing, utilization management, network development and retention, and reinsurance. Administrative 

costs and profits account for about 11 percent of M+C 

plans’ costs of delivering Medicare benefits, whereas the 

administrative costs of the Medicare program account for 

less than 2 percent of benefit payments.32 Thus, private 

plans can provide Medicare services at a lower cost than 

the FFS sector only if they can achieve savings through 

utilization management or reductions in providers’ payment rates that more than offset their higher administrative costs. The ability of plans to achieve such savings varies greatly among geographic areas. 

Savings Through Utilization Management. The available 

evidence suggests that, in general, HMOs constrain medical costs by reducing the level and intensity of service 

utilization, particularly by limiting visits to specialists, inpatient hospital care, costly tests and procedures, and 

services in intensive care units.33 HMOs use various approaches to reduce the use of those services, including selective contracting with low-cost providers, coordination 

of care by primary care physicians, requirements for prior 

authorization, financial incentives to providers to discourage excessive use of services, and programs to educate 

providers and offer feedback on their patterns of practice. 

Private plans have much greater potential to achieve savings through utilization management in geographic areas 

where FFS practice involves relatively high utilization of 

costly services—which also tend to be areas with high per 

capita FFS expenditures. Plans have little or no opportunity to achieve savings through those approaches in areas 

31. Lori Achman and Marsha Gold, Trends in Medicare+Choice Benefits and Premiums, 1999-2002 (report prepared by Mathematica 

Policy Research, Inc., for the Commonwealth Fund, November 

2002).

32. CBO computed the average administrative cost of M+C plans 

from 2002 ACR data. Information on Medicare’s administrative 

costs is available from CMS at www.cms.hhs.gov/charts/

default.asp.

33. Robert H. Miller and Harold S. Luft, “HMO Plan Performance 

Update: An Analysis of the Literature, 1997-2001,” Health Affairs, 

vol. 21, no. 4 (July/August 2002).
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 13

where utilization rates for expensive services in the FFS 

sector are already relatively low. Those areas tend to have 

low per capita FFS expenditures, which explains the findings presented in Table 2 showing that plans’ costs are 

higher relative to FFS spending in areas where FFS 

spending is low.

Savings Through Reductions in Providers’ Payment 

Rates. One of the approaches that health plans use to reduce spending for the privately insured is to contract with 

providers who are willing to accept discounted payment 

rates in exchange for a greater number of patients. Those 

discounted rates generally exceed the rates that Medicare 

pays to providers. An analysis of claims data conducted 

for the Medicare Payment Advisory Commission (MedPAC) found that, on average, private insurers paid physicians about 20 percent higher rates than Medicare paid in 

2001.34 In general, the fees that private insurers pay physicians are slightly higher than Medicare’s fees for office 

visits and other medical services but are substantially 

higher for major procedures, tests, and diagnostic imaging.

Less information is available on how the hospital payment rates of private plans compare with those of Medicare.35 In recent years, the rates that private plans pay 

hospitals have grown substantially, as hospitals have 

achieved much stronger bargaining positions relative to 

health plans.36 The stronger negotiating positions of hospitals are the result of various factors, including hospital 

consolidations, strong consumer preferences that hospitals not be excluded from the networks of private plans, 

and high demand for hospital services relative to the 

available supply in some markets, which reduces hospitals’ incentive to accept discounts.

Differences between the rates paid to physicians by private insurers and those paid by Medicare also vary geographically. In the Medicare FFS program, payment rates 

for physicians vary to account for differences in providers’ 

input costs. Relative to Medicare FFS rates, the rates paid 

by private insurers are higher in rural areas and small metropolitan areas than in large metropolitan areas. According to one study, the rates paid to physicians by private 

plans are an average of 30 percent higher than Medicare’s 

rates in small metropolitan areas and rural areas, 10 percent higher in medium-sized metropolitan areas, and 1 

percent higher in large metropolitan areas.37 In addition, 

although rural hospitals have lower margins on their 

Medicare business than urban hospitals, rural hospitals 

have greater total margins because the payments they receive from private health plans exceed their associated 

costs by a much greater percentage than is true for urban 

hospitals.38 Those findings are supported by industry 

sources who have reported that private plans typically 

must pay rates in rural areas that far exceed Medicare’s 

rates because of the lack of competition among providers 

in such areas. That factor contributes to the higher relative costs reported for plans in counties where FFS expenditures are low, since those areas are more likely to be rural.

Estimating the Costs of Medicare PPOs

Although the preceding analysis explains why private 

plans’ costs might diverge from per capita FFS spending, 

CBO’s quantitative analysis was based primarily on cost 

information provided by Medicare plans themselves and 

not on specific assumptions about payment rates, service 

utilization rates, or administrative costs. Specifically, 

CBO estimated the costs that PPOs would incur to provide Medicare services using 2002 data on the costs of 

M+C plans. Because virtually all M+C plans are HMOs, 

CBO assumed an overall average difference in costs between HMOs and PPOs that captured the net effect of 

differences in payment rates, service utilization rates, and 

34. Direct Research, LLC, Medicare Physician Payment Rates Compared to Rates Paid by the Average Private Insurer, 1991-2001 

(report prepared for the Medicare Payment Advisory Commission, August 2003).

35. Comparisons of payment-to-cost ratios for Medicare and private 

payers reported by MedPAC suggest that private plans’ payment 

rates for hospital services are higher than Medicare’s rates. Because 

of data limitations, however, it is not possible to quantify the difference.

36. Justin S. White, Robert E. Hurley, and Bradley C. Strunk, “Getting Along or Going Along? Health Plan-Provider Contract Showdowns Subside,” Center for Studying Health System Change, 

Issue Brief No. 74 (January 2004).

37. Dyckman & Associates, Survey of Health Plans Concerning Physician Fees and Payment Methodology (report prepared for the Medicare Payment Advisory Commission, August 2003). In the 

analysis cited, small metropolitan areas are those with a population of less than 1 million, medium-sized metropolitan areas are 

those with a population between 1 million and 3 million, and 

large metropolitan areas are those with a population of over 3 million.

38. Medicare Payment Advisory Commission, Medicare in Rural 

America (report to the Congress, June 2001).
14 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

administrative costs. The analysis was conducted separately for counties where M+C plans operate and counties 

where they do not, because the two sets of counties differ 

greatly in terms of the characteristics that influence private plans’ costs.

Counties Where M+C Plans Operate. In counties with 

M+C plans, CBO used the costs of those plans to estimate the costs that PPOs would face. To estimate those 

costs, however, CBO needed information on how PPOs 

differ from HMOs in their ability to control costs. Previous studies of the effects of private health plans on health 

care spending and service utilization have focused primarily on HMOs. There is little empirical evidence on the 

effects of PPOs. However, based on published descriptions of how PPOs and HMOs differ and on information 

obtained from industry sources, CBO expects that PPOs 

will have higher costs per enrollee than HMOs for a given 

benefit package.39

Differences Between PPOs and HMOs in Their Ability to 

Control Costs. PPOs are less likely than HMOs to manage 

service utilization because they offer enrollees a greater 

choice of providers and employ less utilization management. Because many PPOs have broader provider networks than HMOs do, they have less success in directing 

enrollees to the lowest-cost providers in a community. Industry sources also report that PPOs typically pay providers higher rates than those paid by HMOs, which are able 

to negotiate lower rates from providers in exchange for a 

higher anticipated number of patients. PPOs have less 

ability than HMOs to steer enrollees to particular providers—and thus less leverage for negotiating lower rates—

because of their broader networks of providers and the 

ability of enrollees to obtain care outside the network. At 

the same time, PPOs have lower administrative costs than 

HMOs, in part because they engage in less care management. Those lower administrative costs offset some of the 

higher costs that PPOs incur as a result of greater utilization rates and higher payment rates to providers.

Based on information obtained from industry sources, including insurers that offer both PPO and HMO products, CBO assumed that PPOs would deliver Medicare 

services at an overall cost per enrollee that was 10 percent 

higher than that of HMOs. That 10 percent cost difference is consistent with cost projections submitted by 

PPOs for the first year of the Medicare PPO Demonstration. According to an analysis of financial projections 

submitted by the demonstration PPOs, the PPOs’ projected costs per enrollee were, on average, about 3 percent 

higher than per capita FFS expenditures in their service 

areas and about 10 percent higher than the projected average cost per enrollee of Medicare+Choice HMOs operating in those areas.

Estimated Costs for PPOs. Based on the assumed 10 percent difference between the costs of PPOs and HMOs, 

CBO estimated that the average cost per enrollee in 

PPOs in areas that were served by M+C plans would be 

about 2 percent higher than per capita FFS expenditures 

(see the top panel of Table 3). Estimated costs for PPOs 

would be much higher relative to per capita FFS expenditures in areas where FFS spending was low, which is consistent with the pattern observed for M+C plans. On average, estimated costs for PPOs on a per capita basis are 

37 percent higher than FFS expenditures in the lowestspending counties (those with per capita FFS spending of 

less than $400) and 5 percent lower than per capita FFS 

expenditures in the highest-spending counties (those with 

per capita FFS spending of at least $650). The much 

higher relative costs in the lowest-spending counties are 

consistent with the expectation that PPOs in those areas 

would achieve little or no savings (relative to FFS costs) 

through utilization management, would pay providers 

significantly higher rates than Medicare, and would have 

higher administrative costs than FFS Medicare.

On average, the estimated costs that PPOs would have 

faced in 2002 in areas that were served by M+C plans 

were 3 percent lower than M+C payment rates. That difference translates into about $18 per month in additional

39. Simple comparisons of commercial HMOs’ premiums and PPOs’ 

premiums do not provide the required information on relative 

costs because such comparisons do not control for differences in 

the value of the benefit package or differences in the characteristics 

of enrollees.
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 15

Table 3.

Estimated Costs That PPOs Would Have Incurred if They Had Entered the

Medicare+Choice Program, 2002

Source: Congressional Budget Office.

Note: PPOs = preferred provider organizations; FFS = fee for service; M+C = Medicare+Choice.

benefits that PPOs would have been able to offer (see Table 3).40 As noted earlier, HMOs’ per capita costs were 

about 12 percent lower than M+C payment rates, which 

enabled them to offer an average of $72 per month in additional benefits. In general, CBO would expect PPOs to 

be more attractive to beneficiaries than HMOs for reasons previously stated: they have broader networks of 

providers, offer coverage for services received outside the 

network, and employ less utilization management. 

Therefore, to achieve a given level of enrollment, PPOs 

should be able to offer less generous additional benefits 

than HMOs. The fact that few PPOs participated in the 

M+C program suggests that PPOs generally believed that 

the amount of additional benefits they would have been 

Mean FFS Expenditure Mean PPO Cost Per Capita FFS

per Month Beneficiaries (Dollars) Expenditures

Less Than $400 1.0 510 1.37

$400 to $449 4.4 521 1.22

$450 to $499 7.1 540 1.14

$500 to $549 11.5 550 1.05

$550 to $599 10.4 576 1.00

$600 to $649 10.0 584 0.93

$650 and Higher 16.2 653 0.95 ___

60.5 584 1.02

Less Than $400 4.0 521 1.40

$400 to $449 9.9 541 1.27

$450 to $499 10.5 554 1.17

$500 to $549 8.7 568 1.08

$550 to $599 4.0 590 1.03

$600 to $649 1.5 604 0.97

$650 and Higher 1.1 642 0.94 ___

39.5 558 1.17

Less Than $400 5.0 519 1.39

$400 to $449 14.3 535 1.25

$450 to $499 17.6 548 1.16

$500 to $549 20.2 558 1.07

$550 to $599 14.4 580 1.01

$600 to $649 11.5 586 0.94

$650 and Higher 17.3 652 0.95 ____

100.0 574 1.08

Ratio of PPO Cost to Payment Rate

Ratio of M+C 

Counties With M+C Plans

Percentage of M+C

Payment Rate

to per Capita 

FFS Expenditures

1.41

1.26

1.02

0.96

1.16

1.07

1.36

1.00

1.05

0.89

0.87

1.35

1.20

1.10

1.01

0.94

1.03

0.99

0.95

0.99

1.07

 Total

 Total

 Total

1.10

0.97

1.04

1.05

1.07

1.07

1.03

0.97

0.97

0.99

0.99

0.96

0.99

0.97

0.95

1.10

1.10

1.09

1.07

1.01

All Counties

Counties Without M+C Plans

1.03

1.02

1.02

0.99

1.22

1.12

1.04

40. The average Medicare+Choice payment rate in those areas in 

2002 was $602, 3 percent of which is $18. 
16 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

Table 4.

Comparison of the Characteristics of Counties With and Without

Medicare+Choice Plans, 2002

Source: Congressional Budget Office.

Notes: In 2002, the average per capita FFS expenditure was $578 in counties with M+C plans and $484 in counties without M+C plans.

M+C = Medicare+Choice; FFS = fee for service.

able to offer (estimated in this analysis at 3 percent of 

M+C payment rates, on average) was not sufficient for 

them to attract significant enrollment.

Counties Where M+C Plans Do Not Operate. About 40 

percent of Medicare beneficiaries live in geographic areas 

that are not served by M+C plans. Those areas differ from 

other areas in a variety of ways that are important to this 

analysis. In particular, areas that are not served by M+C 

plans are more likely than other areas to be rural and to 

have relatively low per capita expenditures in the FFS 

program. Although PPOs could have lower absolute costs 

by operating in areas that are not served by M+C plans, 

the key to determining whether they would participate is 

their costs relative to the benchmark. To estimate the 

costs per enrollee that PPOs would face in counties that 

have no M+C plans, CBO started with the cost data from 

M+C plans but adjusted the data to account for differences in counties’ characteristics.

Characteristics of Counties That Are Not Served by M+C 

Plans. Areas that are not served by M+C plans are much 

more likely than other areas to be nonmetropolitan. In 

2002, more than half of the beneficiaries who did not 

have access to an M+C plan lived in a nonmetropolitan 

area, compared with only 5 percent of beneficiaries with 

access to an M+C plan (see the bottom row of Table 4). 

Because nonmetropolitan areas tend to have sparsely distributed providers, plans would have to contract with a 

very large proportion of those providers to establish networks. Private health plans generally must pay providers 

in rural areas rates that far exceed Medicare’s FFS rates, 

according to industry sources, because of the market 

power of those providers. 

Areas that are not served by M+C plans also have much 

lower per capita FFS expenditures than other areas ($484 

versus $578 in 2002). More than 60 percent of the beneficiaries who did not have access to an M+C plan in 2002 

lived in counties where the per capita FFS expenditure 

was less than $500, while only 20 percent of all other 

beneficiaries lived in counties where the per capita FFS 

expenditure was that low (see Table 4). As noted previously, areas with low per capita FFS expenditures tend to 

have low utilization of expensive services, so private plans 

have little or no opportunity to reduce costs through utilization management.

At the same time, M+C payment rates are relatively high 

in areas that are not served by private plans, at least compared with local per capita FFS costs. On average, payment rates in areas that were not served by M+C plans in 

2002 were 10 percent higher than per capita FFS expenditures, whereas payment rates in other areas were 5 perPercentage of 

Ratio of M+C Beneficiaries Ratio of M+C 

Payment Rate to Who Live in Payment Rate to 

per Capita FFS Nonmetropolitan per Capita FFS 

Expenditures Areas Expenditures

1.7 39.1 1.41 9.8 83.3 1.35

7.2 18.6 1.26 24.8 58.9 1.20

11.5 9.0 1.16 26.6 53.3 1.10

19.1 4.8 1.07 21.9 41.4 1.01

17.2 3.7 1.02 10.3 43.1 0.94

16.5 1.7 0.96 3.9 50.1 0.89

26.8 0.8 1.00 2.7 39.8 0.87 ____ ____

 Total 100.0 5.1 1.05 100.0 53.5 1.10

Counties With M+C Plans Counties Without M+C Plans

Mean FFS Expenditure

Beneficiaries

Who Live in 

Nonmetropolitan 

Percentage of 

Percentage of Percentage of

Less Than $400

$400 to $449

per Month Beneficiaries Areas Beneficiaries

$550 to $599

$600 to $649

$650 and Higher

$450 to $499

$500 to $549
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 17

cent higher. The rates in areas without M+C plans are 

higher because beneficiaries in those areas are more likely 

to be concentrated in areas with low per capita FFS expenditures (where M+C payment rates are substantially 

higher than per capita FFS expenditures). The absence of 

plans suggests that plans’ costs in those areas range from 

close to, to substantially higher than, M+C payment 

rates.

Among counties with similar per capita FFS expenditures, those that are not served by M+C plans have lower

payment rates than other counties. That outcome is to be 

expected because, all other things being equal, plans are 

more likely to participate in counties with higher payment rates. For example, among counties with per capita 

FFS expenditures of at least $650 in 2002, payment rates 

in the counties that were not served by M+C plans were 

13 percent lower than per capita FFS expenditures, on average, while payment rates in the counties that were 

served by M+C plans were equal to per capita FFS expenditures (see Table 4). That result is consistent with the 

findings of a multivariate analysis conducted for this 

study that found that, after controlling for other factors, 

plans are more likely to serve counties with higher payment rates (see the appendix).

Estimated Costs for PPOs. CBO used cost data from M+C 

plans and a regression model that controls for differences 

between counties that are served by M+C plans and those 

that are not to predict the costs that private plans would 

face if they entered areas without M+C plans.41 Since virtually all M+C plans are HMOs, the predictions from the 

model reflect the costs that HMOs would face if they entered areas that were not served by M+C plans. For the 

reasons described previously, CBO assumed that the costs 

per enrollee of PPOs in those areas would be 10 percent 

higher than the projected costs of HMOs. As discussed 

below, however, the basic conclusions of the analysis are 

not sensitive to that assumption.

In areas without M+C plans, the PPOs’ costs per enrollee 

would be 17 percent higher, on average, than per capita 

FFS expenditures, CBO estimates (see the middle panel 

of Table 3). In contrast, their estimated costs per enrollee 

would average only 2 percent higher than per capita FFS 

expenditures in areas with M+C plans. The higher estimated costs in counties that are not served by M+C plans 

result primarily from the fact that beneficiaries in those 

counties are heavily concentrated in areas with low per 

capita FFS expenditures, where plan costs are expected to 

be high relative to FFS expenditures. Among most groups 

of counties that have similar per capita FFS expenditures, 

the estimated average cost for PPOs in counties that are 

not served by M+C plans is only slightly higher than the 

corresponding average cost in counties that are served by 

M+C plans (compare the top and middle panels of Table 

3).42 The direction of those differences is consistent with 

expectations because, even among counties with similar 

per capita FFS expenditures, those that are not served by 

M+C plans are more likely to be rural (see Table 4). As already noted, health plans typically must pay providers 

higher rates (relative to Medicare’s FFS rates) in rural areas than in urban areas.

In areas without M+C plans, the estimated costs for 

PPOs were, on average, 7 percent higher than the M+C 

payment rate (see the middle panel of Table 3). Although 

some PPOs might have costs that are lower than the 

county-level averages estimated in this analysis, the fact 

that no plans participated in those areas suggests that the 

costs of those more efficient plans were either above the 

M+C payment rates or below the payment rates by too 

small a margin to permit the plans to offer enough additional benefits to attract significant enrollments.

The projected costs per enrollee that HMOs would face 

in areas without M+C plans are not presented here but 

can be readily derived from the projected costs for PPOs 

in Table 3, because, as previously noted, CBO assumed 

that PPOs’ costs per enrollee would be 10 percent higher 

than HMOs’ costs. Thus, while PPOs’ projected costs per 

enrollee in areas that are not served by M+C plans are an 

average of 7 percent higher than the M+C payment rate, 

HMOs’ projected costs per enrollee in those areas are an 41. The estimation of the model is described in the appendix. CBO 

used a sample selection model to control for possible differences 

between the two groups of counties on important unobserved 

characteristics as well as observed characteristics. For a discussion 

of such models, see Francis Vella, “Estimating Models with Sample Selection Bias: A Survey,” Journal of Human Resources, vol. 33, 

no. 1 (Winter 1998).

42. For example, in counties where the average FFS expenditure was 

between $400 and $450 in 2002, the estimated average PPO cost 

was 27 percent higher than per capita FFS expenditures in areas 

without M+C plans and 22 percent higher in areas with M+C 

plans.
18 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

average of 3 percent lower than the payment rate.43

Those estimates indicate that if HMOs had entered such 

areas in 2002, they would have been able to offer an average of only $16 per month in additional benefits.44 The 

absence of HMOs in those areas suggests that they did 

not believe they would have been able to attract significant enrollment with such limited additional benefits. 

In contrast, in areas where M+C plans operated in 2002, 

their costs were an average of 12 percent lower than the 

M+C payment rate (see Table 2), which allowed them to 

offer an average of $72 per month in additional benefits. 

Moreover, there may be factors other than those fully accounted for in this analysis of plans’ cost data that influenced plans’ decisions not to enter certain geographic areas. For example, the difficulty that plans would face in 

developing networks of providers to meet Medicare’s network adequacy requirements in rural areas may not have 

been fully captured in this analysis. Furthermore, plans 

may believe that beneficiaries in rural areas would be 

more resistant to enrolling in managed care plans than 

beneficiaries in urban areas because of their more limited 

experience with such plans.

Finally, the basic conclusions of this analysis are not sensitive to the assumption that PPOs’ costs are 10 percent 

higher than HMOs’ costs in areas without M+C plans.45

Even if CBO had assumed that there was no difference 

between PPOs’ costs and HMOs’ costs in such areas, the 

estimated cost of private plans in those areas would be 3 

percent lower than the M+C payment rate, on average. 

That amount is identical (in percentage terms) to the estimated difference between PPOs’ costs and M+C payment 

rates in areas where M+C plans operate (see the top panel 

of Table 3). The fact that few PPOs have participated in 

the Medicare+Choice program suggests that a larger gap 

between PPOs’ costs and payment rates would be necessary to attract significant numbers of PPOs to the Medicare program.

Projecting the Bids of Regional PPOs

CBO used the county-level estimates of PPOs’ costs in 

2002 to project the bids of regional PPOs beginning in 

2006.46 CBO projected the bids under a variety of assumptions about how regions would be defined, such as 

defining regions as states or as the 10 regions that CMS 

uses to manage the Medicare program. (The MMA does 

not specify precisely how regions are to be defined but requires that there be no fewer than 10 and no more than 

50.) CBO assumed that PPOs’ costs would grow at the 

same rate as per capita national health care expenditures 

for hospital and physicians’ services (for all payers) from 

2002 to 2006 and at the rate of increase in Medicare’s per 

capita FFS expenditures in subsequent years. 

To assess the regional PPO program, CBO compared the

projected bids of the plans with the regional benchmarks. 

Whether regions are defined either as the 10 CMS management regions or as states, the majority of beneficiaries 

live in regions where PPOs’ projected average bids in 

2006 exceed the benchmarks (see the bottom panel of Table 5). CBO assumed that PPOs would not participate in 

those regions or that few beneficiaries would join such 

plans if they were available. In most other regions, the 

projected average bids are only slightly below the benchmarks. If regions are defined as the 10 CMS regions, 34 

percent of beneficiaries live in regions where the bids are 

below the benchmarks. However, on average, the bids are 

only 3 percent lower than the benchmarks in those regions. And, under the provisions of the MMA, only 75 

percent of that difference would be available for additional benefits or premium rebates; the government 

would keep the remainder. Although some PPOs would 

have lower-than-average costs and thus submit bids that 

were below the projected averages, CBO concluded that 

43. The average ratio of estimated costs for PPOs to M+C payment 

rates in areas that are not served by M+C plans is 1.07 (see the 

middle panel of Table 3). Therefore, because CBO assumed that 

PPOs’ costs are 10 percent higher than HMOs’ costs in such areas, 

the average ratio of estimated costs for HMOs to M+C payment 

rates in those areas is 0.97 (1.07 divided by 1.1).

44. The average M+C payment rate in 2002 in areas without M+C 

plans was $524 per month, 3 percent of which is $16.

45. The difference between PPOs’ costs and HMOs’ costs may be 

smaller in the mostly rural areas that are not served by M+C plans 

than in the mostly urban areas that are served by such plans. 

HMOs in rural areas have less ability to achieve cost savings relative to Medicare’s FFS program than their urban counterparts—

and therefore may be more similar to PPOs—for the reasons discussed previously. As noted, however, the assumed 10 percent cost 

difference between PPOs and HMOs in areas that are not served 

by M+C plans yielded estimated costs for PPOs relative to per 

capita FFS expenditures in those areas that are consistent with the 

estimated costs for PPOs in areas that are served by M+C plans.

46. For each year, the regional bid was computed as the weighted average of the projected costs for PPOs for counties in the region, with 

the weights equal to the proportion of beneficiaries in the region 

who live in each county.
CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT 19

Table 5.

Projected Bids of Regional PPOs Relative to per Capita 

Fee-for-Service Expenditures and Benchmarks 

Under Alternative Approaches to Defining Regions, 2006

Source: Congressional Budget Office.

Note: PPOs = preferred provider organizations; CMS = Centers for Medicare and Medicaid Services; n.a. = not applicable.

the difference between those bids and the benchmarks 

would not be enough to attract substantial enrollment.47

CBO therefore inferred that regional plans would attract 

relatively few enrollees. That conclusion is based in part 

on evidence that the elderly are much less likely than the 

nonelderly to switch health plans in response to financial 

incentives.48 CBO conducted simulations using a range 

of sensitivities to such incentives consistent with the findings of prior research on the elderly and concluded that 

the amount of additional benefits and premium reductions that regional PPOs could offer would attract only a 

small number of beneficiaries. That conclusion is also 

consistent with the experience of the Medicare PPO 

Demonstration.

Even if PPOs could submit bids significantly lower than 

the benchmarks in some regions, such plans probably 

would participate either as local plans (for example, by 

entering the program after the two-year moratorium on 

new local PPOs expires) or as regional plans but draw 

their enrollment almost entirely from areas that are served 

by local plans. Both cases were included in CBO’s estimate of the costs of the MMA provisions that increased 

payment rates for local plans. If a regional PPO developed in a state, it would probably concentrate its marketing efforts in counties where its local costs were substanMean Ratio

Ratio of PPOs' Bids to

 Less than 0.95 0 n.a. 2.2 0.89

 0.95 to 0.99 10.2 0.99 16.5 0.98

 1.00 to 1.049 24.0 1.04 16.1 1.01

 1.05 to 1.099 37.1 1.09 21.6 1.08

 1.10 or higher 28.7 1.15 43.6 1.20

Ratio of PPOs' Bids to

Benchmarks

 Less than 0.95 0 n.a. 0.7 0.85

 0.95 to 0.99 34.2 0.97 43.2 0.97

 1.00 to 1.049 48.1 1.02 33.8 1.02

 1.05 to 1.099 17.7 1.05 21.9 1.07

 1.10 or higher 0 n.a. 0.5 1.11

Distribution of

Mean Ratio

Beneficiaries

Regions Defined as States

per Capita FFS Expenditures

(Percent)

Distribution of

Beneficiaries

Regions Defined as 10 CMS Regions

(Percent)

47. CBO computed the regional benchmarks as a blend of the 

county-level benchmarks in the region and the bids in the region, 

as required by the MMA. Including the bids in the formula for the 

regional benchmarks did not change the conclusions of the analysis. In regions where the average bid was projected to be above the 

statutory component of the regional benchmark, incorporating 

bids in the calculation of benchmarks increased the benchmarks 

modestly, but not by enough to change CBO’s conclusions about 

the incentives for plans to participate or for beneficiaries to enroll. 

In regions where the average bid was projected to be below the 

statutory component of the benchmark, incorporating bids in the 

calculation of benchmarks reduced the benchmarks, thus decreasing the amount of additional benefits or premium rebates that 

plans could offer.

48. Thomas C. Buchmueller, “The Health Plan Choices of Retirees 

Under Managed Competition,” Health Services Research, vol. 35, 

no. 5 (December 2000), pp. 949-976.
20 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

tially below the county-level benchmark. Otherwise, by 

enrolling beneficiaries in counties where its local costs exceeded the local benchmark or were only slightly below 

the benchmark, the plan would narrow the gap between 

its overall bid for the region and the overall regional 

benchmark (and thus reduce the amount of additional 

benefits it could offer to attract enrollees). In effect, enrollees in areas where the PPO’s local costs were substantially below the local benchmark would be subsidizing extra benefits for enrollees in other areas served by the 

plan—putting the plan at a competitive disadvantage relative to other plans that operated only in areas where 

their local costs were substantially below the local benchmark.

Because the projected bids of regional PPOs are higher 

than per capita FFS expenditures in most regions, the 

participation of regional plans would be likely to increase 

outlays for Medicare. If regions are defined either as the 

10 CMS management regions or as states, nearly twothirds of beneficiaries live in regions where the projected 

bids are at least 5 percent higher than per capita FFS expenditures (see the top panel of Table 5).
Technical Aspects of the Analysis

This appendix describes the Congressional Budget Office’s (CBO’s) approach to two components of its analysis of regional preferred provider organizations (PPOs) 

under the Medicare Modernization Act: the estimation of 

county-level costs from plan-level data for areas that are 

served by Medicare+Choice (M+C) plans, and the multivariate analysis used to predict plans’ costs in geographic 

areas that are not served by M+C plans.

Estimation of County-Level Costs 

from Plan-Level Data

For areas that are served by M+C plans, the adjusted 

community rate reports contain plans’ estimates of their 

average costs of delivering Medicare benefits in their service areas. Those service areas could cover several counties, however, and plans are not required to report costs 

by county. To account for geographic variation in plans’ 

costs, CBO first disaggregated plan-level costs into 

county-level costs for each plan using the approach described here. In counties with more than one plan, CBO 

then computed a weighted average plan cost for each 

county, using the plans’ enrollments in the county as 

weights.

To estimate the variation in costs across counties for a 

given plan, CBO first examined the variation in costs 

across plans. For that analysis, CBO classified plans by 

the per capita fee-for-service (FFS) expenditure in their 

service area. For plans that serve more than one county 

(which is true of most plans), the per capita FFS expenditure for the plan was computed as a weighted average of 

per capita FFS expenditures in the counties in the plan’s 

service area, where the weights are based on the distribution of the plan’s enrollees across counties.

The analysis of plan-level data found that, on average, 

plans’ costs per enrollee were 6 percent lower than per 

capita FFS expenditures in the plans’ service areas (see Table A-1). Plans that serve areas where FFS spending is low 

have much higher relative costs than plans that serve areas 

where FFS spending is high.1 On a per capita basis, private plans’ costs are 26 percent higher than FFS expenditures in the lowest-spending service areas (those where 

the per capita FFS expenditure is less than $400) and 12 

percent lower than FFS expenditures in the highestspending service areas (those where the per capita FFS expenditure is at least $650). Private plans have greater potential to achieve savings in areas with high FFS spending 

levels because expensive services that plans seek to limit 

are used at a higher rate in those areas. In addition, areas 

with high FFS spending are more likely to be metropolitan, and plans are generally able to negotiate more favorable payment rates in those areas because of greater competition among providers.

The factors that contribute to the variation in costs across 

plans are also expected to contribute to variation in costs 

across counties served by a particular plan. Therefore, 

CBO used the plan-level relative cost ratios in Table A-1 

to allocate costs across counties for each plan. To illustrate the approach, consider a plan that serves three counties.2 Let:

C = the cost per enrollee reported by the plan for its 

service area,

Ci

 = the (unobserved) cost per enrollee for the plan in 

county i,

Pi

 = the proportion of the plan’s enrollees who live in 

county i, and

Fi

 = per capita FFS expenditures in county i.

APPENDIX

1. The relative cost refers to the plan’s cost per enrollee relative to per 

capita FFS expenditures.

2. The approach is valid for a plan that serves any number of counties.
22 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

Table A-1.

Costs per Enrollee of Medicare+Choice Plans 

Based on Plan-Level Estimates, 2002

Source: Congressional Budget Office based on data (adjusted community rates) submitted by M+C plans for 2002.

Note: M+C = Medicare+Choice; FFS = fee for service.

The total cost per enrollee for the plan is a weighted average of its county-level costs:

B P1*C1 + P2*C2 + P3*C3 = C.

Assume that the per capita FFS expenditures in counties 

1, 2, and 3 are $425, $540, and $630, respectively. Then, 

using the estimates in Table A-1:

B C1/F1 = (1.12/0.96) * C2/F2 and

B C1/F1 = (1.12/0.88) * C3/F3.

The values 1.12 and 0.96 appear in equation (2) because 

they are the relative cost ratios in Table A-1 that correspond to the assumed per capita FFS expenditures in 

counties 1 and 2 ($425 and $540, respectively). The values 1.12 and 0.88 appear in equation (3) for analogous 

reasons. 

Equations (1), (2), and (3) have three unknowns—the 

three county-level costs per enrollee (C1, C2,and C3).3

After rearranging those equations, CBO can compute the 

cost per enrollee in each county. 

That approach yields county-level estimates of relative 

costs that exhibit the same pattern with respect to FFS expenditures as the corresponding plan-level estimates do 

(that is, the county-level relative cost ratios in Table 2 are 

very similar to the plan-level estimates in Table A-1). The 

key assumption in that approach is that relative cost ratios vary across counties within a plan’s service area in the 

same proportion as they vary across plans. 

CBO considered and rejected two alternative assumptions before using the more complex approach described 

above. The first alternative that was rejected is that a 

plan’s costs per enrollee do not vary across counties. That 

assumption is clearly not appropriate, since the service areas of many plans include counties that vary greatly with 

respect to per capita FFS expenditures and other local 

market characteristics that influence plans’ costs. The second alternative that was rejected is that a plan’s costs vary 

across counties in the same proportion as the variation in 

per capita FFS expenditures. That assumption was rejected because the plan-level estimates indicate that plans’ 

costs exhibit less variation across geographic areas than 

per capita FFS expenditures do.

Multivariate Analysis

To predict private plans’ costs in counties where M+C 

plans do not operate, CBO estimated a regression model 

in which costs are a function of counties’ characteristics. 

Counties without M+C plans differ from other counties 

in a variety of ways that are associated with higher plan 

Mean FFS Expenditure

per Month in Plan's Per Capita FFS M+C

Service Area Expenditures Payment Rate

Less Than $400 3.4 1.26 0.86

$400 to $449 12.3 1.12 0.87

$450 to $499 17.9 1.02 0.89

$500 to $549 16.5 0.96 0.88

$550 to $599 13.3 0.89 0.88

$600 to $649 17.9 0.88 0.87

$650 and Higher 18.7 0.88 0.84 ____

Total 100.0 0.94 0.87

Ratio of Plan Costs to

Percentage

of Plans

3. Another equation could be written expressing the relationship 

between the relative cost ratios in counties 2 and 3, but that would 

not be an independent equation because it could be derived 

directly from equations (2) and (3).
APPENDIX TECHNICAL ASPECTS OF THE ANALYSIS 23

costs relative to per capita FFS expenditures. For example, they have lower per capita FFS expenditures and 

higher M+C payment rates relative to FFS expenditures 

and are more likely to be nonmetropolitan. It is likely 

that the two groups of counties also differ with respect to 

important unobserved characteristics that influence 

plans’ costs. Plans only enter counties where they expect 

to be successful—that is, where their costs are far enough 

below the payment rate to allow them to offer an attractive benefit package—and they may have more detailed 

information on local health care markets than is captured 

in available data sources.

CBO estimated a sample selection model designed to 

control for both observed and unobserved differences between counties where M+C plans operate and counties 

where they do not. The model consists of two equations.4

The first is a probit model in which a binary (0/1) measure of whether or not the county is served by any M+C 

plans is specified as a function of the county’s characteristics. The second is a linear regression model in which the 

average cost per enrollee in the county is specified as a 

function of the county’s characteristics. The costs per enrollee in the second equation are only observed in counties where M+C plans operate.

The estimated parameters of the first equation indicate 

that, all other things held constant, counties with higher 

payment rates are more likely to be served by M+C plans 

(see the middle column of Table A-2).5 Counties with 

large numbers of beneficiaries and those in which a high 

proportion of the non-Medicare population is enrolled in 

a health maintenance organization (HMO) are more 

likely to have M+C plans, all other factors held constant. 

In contrast, areas with high hospital input prices (as measured by the Centers for Medicare and Medicaid Services’ 

hospital wage index), those with high poverty rates, and 

nonmetropolitan areas that are not adjacent to a metropolitan area are less likely to have M+C plans. 

Counties with a high geographic adjustment factor 

(GAF), which measures geographic variation in physicians’ input prices, are more likely to have M+C plans. 

One possible explanation for that finding comes from a 

recent study that showed that the higher the GAF, the 

lower the private health plans’ payment rates to physicians relative to Medicare’s FFS rates.6

 Thus, private 

plans appear to negotiate lower payment rates to physicians relative to Medicare’s rates in areas with high GAFs, 

which would explain why counties with high GAFs are 

more likely to have M+C plans.

The estimated parameters of the second equation show 

that higher per capita FFS expenditures and a higher hospital wage index are associated with higher health plan 

costs (see the right-hand column of Table A-2). The 

model includes an interaction term that allows the marginal effect of per capita FFS expenditures on plans’ costs 

to differ for per capita FFS expenditures below $550 and 

those above $550. CBO included the interaction term—

and set the threshold at $550—because that approach 

was consistent with the relationships observed in the 

data. The coefficient on the “lambda” term is negative 

and statistically significant, indicating that unobserved 

factors that increase the likelihood that a county has an 

M+C plan are associated with lower plan costs, which 

was expected.7

To permit identification of the model, two variables that 

were included in the first equation were excluded from 

the second equation: the M+C payment rate, and the ratio of that rate to per capita FFS expenditures. CBO assumed that those variables influence the decision of plans 

to enter counties but have no independent effect on 

plans’ costs. (That assumption could hold even if plans’ 

costs were correlated with M+C payment rates.) M+C 

payment rates clearly affect plans’ decisions about which 

counties to enter, but they are not expected to affect 

plans’ costs. That is because those rates are established 

through a statutory formula in which key parameters 

(such as the floors and the minimum updates) are set legislatively and are not directly linked to costs in local markets. 4. James J. Heckman, “Sample Selection Bias as a Specification 

Error,” Econometrica, vol. 47, no. 1 (January 1979), pp. 153-161. 

5. The estimates are from a probit model. As such, they do not provide a direct estimate of the marginal effect of the independent 

variables on the probability that a county has an M+C plan. However, they indicate the sign and statistical significance of those 

effects.

6. Dyckman & Associates, Survey of Health Plans Concerning Physician Fees and Payment Methodology (report prepared for the Medicare Payment Advisory Commission, August 2003). 

7. For a description of the lambda term, see Heckman, “Sample 

Selection Bias as a Specification Error.”
24 CBO’S ANALYSIS OF REGIONAL PREFERRED PROVIDER ORGANIZATIONS UNDER THE MEDICARE MODERNIZATION ACT

Table A-2.

Estimated Parameters of Sample Selection Model 

of Medicare+Choice Plans’ Costs

Source: Congressional Budget Office.

Notes: Both equations also included regional dummy variables.

The spline variable involving per capita FFS expenditures is equal to zero for counties with per capita FFS expenditures of $550 or less 

and equal to per capita FFS expenditures minus $550 for counties with higher spending levels. It was included to allow the partial 

derivative of plan costs with respect to FFS expenditures to differ for FFS values above $550 per month and for values below $550 per 

month, which is consistent with the patterns in the data.

M+C = Medicare+Choice; FFS = fee for service; **= significant at the 0.01 level; *= significant at the 0.05 level; HMO = health

maintenance organization; n.a.=not applicable.

CBO used the estimated parameters of the second equation in the sample selection model to predict the cost per 

enrollee that private plans would face if they entered 

counties that had no M+C plans. A predicted cost was 

then generated for each county by inserting the values of 

the county’s characteristics into the equation. In addition, because there were no M+C plans in those counties, 

the equation to predict private plans’ costs included the 

expected value of the error term in the second equation of 

the sample selection model, conditional on no M+C 

plans’ being present.8

Because virtually all M+C plans are HMOs, the sample 

selection model yielded predictions of the costs that 

HMOs would face in counties that were not served by 

M+C plans. CBO assumed that PPOs’ average costs per 

enrollee would be 10 percent higher than the predicted 

Independent Variable

Constant -9.94 ** 294.87 **

M+C Payment Rate 0.011 ** n.a.

Ratio of M+C Payment Rate to per

Capita FFS Expenditure 0.816 ** n.a.

Per Capita FFS Expenditure n.a. 0.237 **

Per Capita FFS Expenditure

"spline" variable n.a. 0.314 **

Hospital Wage Index -2.47 ** 111.5 **

Geographic Adjustment Factor 5.45 ** -58.3

Number of Medicare Beneficiaries

(Thousands) 0.013 ** 0

Population per Square Mile 0 0.001

Poverty Rate -0.032 ** 0.588

Non-Medicare HMO Penetration Rate 1.52 ** 2.30

Number of Hospital Beds per Capita 0 -1.12

Number of Physicians per Capita -0.20 0.73

Metropolitan Area, Not Central City -0.314 -0.72

Nonmetropolitan Area, Adjacent to

Metropolitan Area -0.282 -5.63

Nonmetropolitan Area, Not Adjacent to

Metropolitan Area -0.684 ** 1.78

Lambda n.a. -18.29 *

Probability That an

M+C Plan Is Present

Cost per Enrollee

Average Plan

in a County

8. Including the conditional expectation of the error term yielded a 

better prediction of plans’ costs because it made use of important 

information about the counties for which predictions were being 

made (that is, those counties had no M+C plans). For a discussion 

of this approach, see Francis Vella, “Estimating Models with Sample Selection Bias: A Survey,” Journal of Human Resources, vol. 33, 

no. 1 (Winter 1998), pp. 145-146.
APPENDIX TECHNICAL ASPECTS OF THE ANALYSIS 25

costs for HMOs in those counties—the same assumption 

that was used in counties that are served by M+C plans.9

That assumption was based on information obtained 

from industry sources, including insurers that offer both 

HMO and PPO products, and is consistent with cost 

projections submitted by PPOs for the first year of the 

Medicare PPO Demonstration. PPOs are expected to 

have higher costs per enrollee than HMOs because they 

employ less utilization management and they typically 

pay providers higher rates (PPOs have less negotiating 

power with providers because of their lesser ability to 

steer enrollees to particular providers). At the same time, 

PPOs have lower administrative costs than HMOs, in 

part because of their more limited utilization management. The assumed 10 percent higher costs for PPOs 

than for HMOs reflects the net effect of those factors.

9. As noted, however, the basic conclusions of the analysis would not 

have changed if CBO had assumed that the costs of PPOs and 

HMOs were equal in the areas without M+C plans.