CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

STUDY

DECEMBER 2006

Designing a

Premium Support

System for

Medicare

CBO
Pub. No. 2596
The Congress of the United States O Congressional Budget Office

CBO

Designing a Premium

Support System for Medicare

December 2006

A

STUDY
Notes

All years referred to in this study are calendar years.

All dollar amounts are expressed in current dollars.
Preface

Driven by rising health care costs and an aging population, federal spending on the 

Medicare program will exert substantial pressures on the federal budget over the coming 

decades. Policymakers have considered a number of strategies for restraining Medicare spending. One approach would restructure the competition between private health plans and the 

traditional Medicare program by converting Medicare to a “premium support” system. Under 

such a system, the federal government would contribute an amount that beneficiaries could 

use to purchase Medicare coverage by enrolling in the traditional program or in a private plan.

This Congressional Budget Office (CBO) study—prepared at the request of William M. 

Thomas, chairman of the House Ways and Means Committee—examines the key decisions to 

be confronted in designing a premium support system for Medicare and the implications

of alternative design choices for federal spending and beneficiaries’ premiums. In accordance 

with CBO’s mandate to provide objective, impartial analysis, the study makes no recommendations.

Lyle Nelson prepared the study, with contributions from David Auerbach, under the supervision of Bruce Vavrichek and James Baumgardner. Carol Frost provided assistance with data 

and tabulations. Tom Bradley, Philip Ellis, Timothy Gronniger, Arlene Holen, and Allison 

Percy, also of CBO, provided comments on drafts, as did Bryan Dowd of the University of 

Minnesota and Robert Reischauer of the Urban Institute. (The assistance of external reviewers 

implies no responsibility for the final product, which rests solely with CBO.)

Christine Bogusz edited the study, and Kate Kelly proofread it. Maureen Costantino prepared 

the study for publication and designed the cover. Lenny Skutnik printed the initial copies, and 

Simone Thomas produced the electronic version for CBO’s Web site (www.cbo.gov).

Donald B. Marron

Acting Director

December 2006

Contents

1 Summary and Introduction 1

Background on Medicare 2

Issues in Designing a Premium Support System for Medicare 3

Potential Effects of Premium Support 5

2 Traditional Medicare and Private Health Plans 7

The Fee-for-Service Program 7

Private Health Plans 8

3 Issues in Designing a Premium Support System for Medicare 15

The Government’s Contribution 15

The Benefit Package 21

Other Design Issues 26

4 Health Care Systems That Are Similar to Premium Support 31

Managed Competition 31

The Federal Employees Health Benefits Program 35

Implications for Medicare 36

5 Potential Effects of Selected Approaches to Premium Support 37

CBO’s Key Assumptions 37

The Analysis of Different Approaches to Determining the 

Government’s Contribution 40
VI DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

A Technical Aspects of the Analysis 49

B Supplementary Tables 53
CONTENTS VII

Tables

1-1. The Bidding Mechanism in the Medicare Advantage Program 3

2-1. Private Plans’ Per Capita Costs of Providing Medicare Benefits Relative to

Those of the FFS Program, 2005 11

5-1. Projected Benchmarks If Benchmarks Were Set Equal to the Minimum

Bid in Each County in 2006 and Plans’ Bids Were Standardized Using

2004 Risk-Adjustment Data 41

5-2. Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Minimum Bid in Each County in 2006 and Plans’ 

Bids Were Standardized Using 2004 Risk-Adjustment Data 42

5-3. Projected Benchmarks If Benchmarks Were Set Equal to the EnrollmentWeighted Average Bid in Each County in 2006 and Plans’ Bids Were 

Standardized Using 2004 Risk-Adjustment Data 44

5-4. Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Enrollment-Weighted Average Bid in Each County in 

2006 and Plans’ Bids Were Standardized Using 2004 Risk-Adjustment Data 45

5-5. Projected Benchmarks If Benchmarks Were Set Equal to the National Average

Bid in 2006, Adjusted to Account for Geographic Variation in Input 

Prices, and Plans’ Bids Were Standardized Using 2004 Risk-Adjustment Data 46

5-6. Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the National Average Bid in 2006, Adjusted for 

Geographic Variation in Input Prices, and Plans’ Bids Were Standardized 

Using 2004 Risk-Adjustment Data 48

A-1. Private Plans’ Per Capita Costs of Providing Medicare Benefits Relative to 

Those of the FFS Program, Based on Plan-Level Estimates, 2005 50

B-1. Projected Benchmarks If Benchmarks Were Set Equal to the Minimum 

Bid in Each County in 2006 and Plans’ Bids Were Standardized Using 

2003 Risk-Adjustment Data 53

B-2. Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Minimum Bid in Each County in 2006 and Plans’ 

Bids Were Standardized Using 2003 Risk-Adjustment Data 54

B-3. Projected Benchmarks If Benchmarks Were Set Equal to the EnrollmentWeighted Average Bid in Each County in 2006 and Plans’ Bids Were 

Standardized Using 2003 Risk-Adjustment Data 54

B-4. Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Enrollment-Weighted Average Bid in Each County in 

2006 and Plans’ Bids Were Standardized Using 2003 Risk-Adjustment Data 55

B-5. Projected Benchmarks If Benchmarks Were Set Equal to the National Average 

Bid in 2006, Adjusted to Account for Geographic Variation in Input 

Prices, and Plans’ Bids Were Standardized Using 2003 Risk-Adjustment Data 55
VIII DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

B-6. Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the National Average Bid in 2006, Adjusted for 

Geographic Variation in Input Prices, and Plans’ Bids Were Standardized 

Using 2003 Risk-Adjustment Data 56

Boxes

3-1. Legislative Context for a Premium Support System 18

3-2. Illustration of Plans’ Incentives to Inflate Their Medicare Bids 24

Tables (Continued)
CHAPTER

1

Summary and Introduction

Under current policies, federal spending on 

Medicare will increase substantially in the coming 

decades, exerting significant strains on the federal budget.1

 The growth in Medicare spending will come from 

two sources: an increase in the number of elderly and disabled people and growth in costs per beneficiary. If past 

trends continue, the growth in costs per beneficiary will 

be a more important driver of future growth in Medicare 

spending, causing that spending to increase much more 

rapidly than enrollment.

Policymakers and analysts have offered various proposals 

aimed at limiting the growth of Medicare spending and 

making the program more efficient. One approach that 

has received attention in the Congress and the policy 

community would convert Medicare into a “premium 

support” system. Under such a system, the federal government would contribute an amount that beneficiaries 

could use to purchase Medicare coverage either by enrolling in the traditional fee-for-service (FFS) part of the program or in a private plan. The government’s contribution 

would be based on the bids of competing plans or set at a 

predetermined amount. Beneficiaries who enrolled in 

plans whose premiums exceeded the government’s contribution would be responsible for paying the difference 

between the two, while those who enrolled in lower-cost 

plans would receive additional benefits or a rebate. An 

important feature of this system is that Medicare’s fee-forservice part of the program would compete for enrollees 

on the same terms—its bid, as well as the quality of services it provides—as private plans. The Medicare Prescription Drug, Improvement, and Modernization Act of 

2003 mandated that the government conduct a six-year 

demonstration of premium support in up to six metropolitan areas beginning in 2010.

Proponents of premium support proposals point to several advantages. Depending on how the government’s 

contribution was determined, such a system could 

restrain federal spending on Medicare (that is, spending 

after subtracting the premiums that beneficiaries pay to 

the government). Moreover, proponents assert, premium 

support could reduce total systemwide spending on 

Medicare benefits (including beneficiaries’ premiums and 

cost sharing) by stimulating greater price competition 

among plans and making beneficiaries more costconscious in their choice of plans. In that way, proponents maintain, premium support could lead to a more 

efficient Medicare program, one in which the government and beneficiaries received more for the money that 

is spent on Medicare, whatever that level of spending 

might be, than they do today.

Opponents of premium support proposals have voiced 

several concerns, however. One is that some beneficiaries 

who stayed in the traditional FFS program could see their 

premiums increase sharply, even if they do not have a private plan available in their area or do not consider it a 

desirable option for receiving their medical care. Another 

concern is that the traditional program might attract the 

sickest enrollees, which could raise the average beneficiary’s premium for that program because methods of 

adjusting the government’s contribution to account for 

differences in beneficiaries’ health status are inadequate. 

Opponents also maintain that much of the federal savings 

from premium support would come from increases in 

the premiums paid by beneficiaries, not from increases 

in the efficiency of health care delivery.

This Congressional Budget Office study examines the key 

decisions that policymakers would confront in designing 

a premium support system for Medicare and the implications of alternative design choices for government spending and beneficiaries’ premiums. In the following chapters, this study describes the current Medicare program 

1. Congressional Budget Office, The Long-Term Budget Outlook

(December 2005).
2 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

and the payment system now used to pay private plans; 

explains how premium support would differ from payment structures under current law; reviews the available 

evidence on the experiences of other payers, such as university systems, that have adopted comparable payment 

systems for health care services; and concludes with a 

simulation analysis that examines the potential effects of 

selected design options on Medicare spending and beneficiaries’ premiums. The rest of this chapter summarizes 

some of that information.

Background on Medicare

Medicare provides federal health insurance for 42 million 

elderly and disabled people. The funding for the program 

comes primarily from a payroll tax, general revenues, and 

premiums paid by beneficiaries.

Most Medicare beneficiaries receive their care through 

the fee-for-service program, which pays providers for each 

service (or bundle of services) they provide. About 17 

percent of beneficiaries are enrolled in private health 

plans (termed Medicare Advantage plans) that assume 

financial risk and responsibility for providing Medicare 

benefits.

Private plans that want to participate in Medicare submit 

bids indicating the per capita payment for which they are 

willing to provide the package of benefits that Medicare 

covers.2

 The government’s maximum payment for an 

enrollee in a private plan—which is called the “benchmark” and varies geographically—is established by statutory rules and made public each year before the plans 

submit their bids. Plans whose bids exceed the government’s maximum (benchmark) payment receive a payment from the government equal to the benchmark and 

must charge enrollees the additional cost (as an add-on to 

their regular monthly Medicare premium). Plans whose 

bids are less than the benchmark are paid the amount of 

their bid, plus 75 percent of the difference between that 

bid and the benchmark, for each person they enroll (see 

Table 1-1). Those plans are required to return the extra 

75 percent to beneficiaries in the form of additional 

benefits or as a rebate on their Medicare premium. (The 

government retains the other 25 percent.)

The additional benefits and premium rebates offered by 

most private plans provide a major incentive to beneficiaries to enroll in those plans: for each $1 per month that a 

plan’s bid is less than the federal benchmark in its area, 

enrollees in the plan receive 75 cents in additional benefits or lower premiums (or some combination of the two). 

That structure gives private plans an incentive to provide 

Medicare benefits efficiently, because the lower their bid 

is relative to the benchmark in their area, the greater the 

additional benefits and premium rebates they can offer to 

their enrollees.

The maximum government payment per enrollee in a 

private plan is set at the county level each year by statutory rules that are based in part on a payment mechanism 

that was established in 1997 and subsequently modified. 

Under those rules, the benchmark in each county must 

be at least as high as average per capita FFS spending 

there. In many counties, the benchmark is higher than 

per capita FFS spending, in some cases substantially so. 

For 2006, the benchmark is about 11 percent higher, on 

average, than is per capita FFS spending nationwide.

Although the current payment system for Medicare 

Advantage plans has some elements of a premium support system, it diverges from such a system by treating 

private plans differently from the FFS program. Currently, beneficiaries who receive their care in the FFS 

program pay a monthly premium for that coverage equal 

to a percentage of national per capita Medicare spending 

that is specified in law. Beneficiaries who enroll in private 

plans receive a rebate or pay a surcharge, depending on 

whether their plan’s bid is below or above a benchmark 

that is constrained to be at least as high as local per capita 

FFS spending. Under a premium support system, in 

contrast, the FFS program would be treated on the same 

basis as private plans. The government’s contribution 

would either be determined from plans’ bids—with the 

“bid” of the FFS program treated in the same manner as 

the bids of private plans—or set at a predetermined level. 

Consequently, enrollees in the FFS program could be 

required to pay higher or lower premiums than they 

would face under current law, depending on the bid of 

the FFS program. By incorporating those differences, and 

allowing a potentially more flexible benefit package (as 

discussed below), premium support proponents have 

attempted to construct a system to expand the role 

of competition in the operation of the entire Medicare 

program.

2. This discussion focuses on the bids that plans submit for providing all Medicare services except the new prescription drug benefit. 

(Plans submit separate bids for the drug benefit.)
CHAPTER ONE SUMMARY AND INTRODUCTION 3

Table 1-1.

The Bidding Mechanism in the Medicare Advantage Program

Source: Congressional Budget Office.

Note: The benchmark is the government's maximum payment for an enrollee in a private plan. The benchmark for each plan is a weighted 

average of the benchmarks for the counties in its service area, with each county weighted by the proportion of the plan's enrollees 

who live there. Benchmarks are determined by statutory rules that guarantee that they will be at least as high as per capita

fee-for-service spending in every county. In some counties, benchmarks are substantially higher than fee-for-service spending. 

Issues in Designing a Premium 

Support System for Medicare

Instituting a premium support system for Medicare 

would affect the amount of money the federal government spent on the program and the level of premiums 

charged to beneficiaries. Key design choices include the 

mechanism for setting the government’s contribution and 

the requirements the government would impose for the 

benefit package. 

The Government’s Contribution

The government’s contribution toward beneficiaries’ 

purchase of Medicare coverage under a premium support 

system could follow two general approaches: it could be 

determined from the bids of competing health plans or 

set at a predetermined amount. 

The competitive-bidding approach could be adopted by 

modifying the current Medicare Advantage program in 

two ways. First, the benchmarks could be determined 

from the bids of participating plans instead of from the 

current statutory rules. Second, to apply the influences of 

competition more broadly in the program, the fee-forservice part of the program could be designated as one of 

the bidding plans, with projected per capita FFS spending in each county used as that plan’s bid. The premium 

for beneficiaries who enrolled in a plan whose bid was 

equal to the benchmark could remain the same as the 

current Medicare premium, or it could be set at a specified percentage of the benchmark. 

As in the current Medicare Advantage program, beneficiaries who enrolled in a plan whose bid was above the 

benchmark would pay the regular Medicare premium 

plus an additional premium equal to the difference 

between the bid and the benchmark, whereas those who 

enrolled in a plan whose bid was below the benchmark 

could receive some or all of the difference as a premium 

rebate or in additional benefits. A key difference between 

the competitive-bidding approach and the current program is that beneficiaries who enrolled in the FFS 

program would have to pay the regular Medicare premium plus a premium surcharge if they lived in an area 

where the bid of that program (the average projected FFS 

spending per beneficiary) was above the benchmark, and 

they would pay a lower premium if the bid of the FFS 

program was below the benchmark.

The effects of a competitive-bidding approach to premium support would depend to a great extent on how 

the benchmarks were determined from the bids. Many 

options are possible, such as setting benchmarks equal to 

the minimum bid in each market area, the average or 

median bid in each market area, or the national average 

bid. (Setting the benchmark equal to the minimum bid 

Returned to Enrollees as

Plan's Bid Relative to the Additional Benefits or Additional Premium

Retained by the Plan Premium Rebates Paid by Enrollees

Bid Equals

Bid Zero Zero

Bid Is Less Than 75 Percent of the Difference

Bid Between Bid and Benchmark Zero

Bid Is Greater Than Difference Between 

Benchmark Zero Bid and Benchmark

Medicare Program's Payment

Benchmark

Benchmark

Benchmark

Benchmark
4 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

in each market area is analogous to the managed 

competition purchasing strategy that some employers 

have adopted.)3

In the second general approach to premium support, the 

federal government would decide in advance how much 

to spend on the Medicare program each year and set its 

contribution at a level that would meet that target. The 

main advantage of this approach is that it would give the 

federal government direct control over the amount that it 

spent on Medicare. However, because the federal contribution would be determined on the basis of budgetary 

criteria rather than the bids of competing health plans, it 

may not grow at the same rate as plans’ costs of providing 

Medicare benefits under the same standards of medical 

care that are typical in the privately insured population.

If the government’s contribution was determined from 

the national average bid of competing plans or set at a 

predetermined amount, a key design choice would be the 

extent to which it would be adjusted to account for geographic variation in per capita Medicare spending, which 

is substantial. In 2005, 10 percent of beneficiaries lived in 

counties in which average spending in the FFS program 

was over $700 per month, while another 10 percent lived 

in counties in which average FFS spending was less than 

$500 per month. The main source of that variation in 

spending is geographic variation in the level and intensity 

of service utilization.4 Other contributing factors are geographic variation in the health status and other characteristics of beneficiaries and variation in Medicare’s payment 

rates. The government adjusts Medicare’s FFS payment 

rates to account for geographic differences in the prices of 

inputs that are used to provide Medicare services (such as 

wages and office rents) and also adjusts payments for certain types of providers (such as teaching hospitals and 

those that serve a high proportion of low-income people).

The government’s contribution could be adjusted to 

account for some or all of the sources of geographic variation in Medicare spending. For example, adjustments 

could account only for differences in beneficiaries’ health 

status and input prices across areas or, alternatively, could 

also account for geographic differences in beneficiaries’ 

utilization of services. One rationale for excluding 

geographic differences in service utilization from the 

adjustment is that the higher rates of utilization in highspending areas do not appear to improve the quality of 

care that beneficiaries receive or their health outcomes.5

The Benefit Package

Another key design choice under premium support 

would be whether the government would define a standard Medicare benefit package that all participating plans 

would be required to offer or whether plans would be 

allowed to vary their benefit packages and, if so, by how 

much. A standard benefit package offers three advantages: 

first, in a system in which benchmarks were determined 

from plans’ bids, it would help assure the fairness of the 

bidding process because all plans would bid on the same 

product; second, it would make it easier for beneficiaries 

to compare their premiums across plans and for the government to educate them about their options; and third, 

it would prevent plans from designing their benefit packages to discourage enrollment by beneficiaries with medical conditions that are costly to treat. (Another way to 

reduce plans’ incentive to design their benefit packages to 

limit the enrollment of beneficiaries who have costly 

medical conditions would be for the government to 

adjust its contribution for the health status of a plan’s 

enrollees.)

Standardization of benefits would have two important 

disadvantages, however. It would prevent plans from 

developing innovative benefit designs that might lead to 

more efficient delivery of care, and it would prevent plans 

from offering benefit packages that some beneficiaries 

might prefer to a standard package specified by the government. Indeed, allowing plans to offer varying benefit 

designs is one of the sources of increased efficiency that 

some proponents envision under a system of premium 

support.

Several alternatives to benefit standardization are possible. For example, under the competitive-bidding 

approach, plans could be allowed to vary their benefit 

package as long as it was actuarially equivalent to a specified package. That alternative would help ensure the fairness of the bidding process while avoiding some of the 

disadvantages of benefit standardization. Under a system 

in which the government’s contribution was set at a pre3. Alain C. Enthoven, “The History and Principles of Managed 

Competition,” Health Affairs, supplement (1993), pp. 24–48.

4. John E. Wennberg, Elliott S. Fisher, and Jonathan S. Skinner, 

“Geography and the Debate Over Medicare Reform,” Health 

Affairs, Web exclusive (February 13, 2002). 5. Ibid.
CHAPTER ONE SUMMARY AND INTRODUCTION 5

determined amount, plans could be given even greater 

flexibility in the design of their benefit package, because 

the absence of a formal bidding mechanism would lessen 

the need for actuarial equivalence. An important design 

choice in that case would be what minimum coverage 

requirements the federal government would specify.

Potential Effects of Premium Support

The effects of premium support on Medicare spending 

and beneficiaries’ premiums are highly uncertain, primarily because of uncertainty about how health plans and 

beneficiaries would respond to the new incentives. 

Although information is available on the bids that private 

plans submit under the Medicare Advantage program, the 

incentives created by premium support might induce 

some plans to submit lower bids than they do currently. 

There is little basis for predicting the magnitude of any 

such effect, however. Moreover, the limited evidence that 

is available on the responsiveness of Medicare beneficiaries to changes in premiums pertains primarily to relatively small changes, which may not provide a reliable 

guide for predicting beneficiaries’ responses to the larger 

changes that might occur under some approaches to premium support.

Despite the uncertainty about the effects of premium 

support, several general conclusions can be drawn.6

Among the approaches to premium support that are 

based on competitive bidding, setting benchmarks equal 

to the minimum bid in each market area would generate 

the greatest federal savings and the highest increase in 

premiums in certain areas for beneficiaries who wanted to 

remain in the FFS program. The main source of federal 

savings would be lower federal contributions on behalf of 

enrollees in the FFS program. Most beneficiaries are currently enrolled in that program, and many live in areas 

where the benchmarks set under the minimum-bid 

approach would be lower than per capita FFS spending. 

In addition, the federal contributions on behalf of enrollees in private plans would fall because benchmarks under 

the minimum-bid approach would be lower than the 

benchmarks currently established for the Medicare 

Advantage program. The effects of such a system on total 

spending for Medicare benefits (including the premiums 

paid by beneficiaries) would depend on the extent to 

which beneficiaries switched to less expensive plans, but 

the extent of that response is highly uncertain.

Under the minimum-bid approach to setting benchmarks, the greatest reduction in federal spending would 

occur in areas where per capita FFS spending is high, and 

beneficiaries who live in those areas would probably face 

substantially higher premiums if they remained in the 

FFS program. Private plans are more likely to submit bids 

that are lower than per capita FFS spending in areas 

where such spending is high because those areas tend to 

have high rates of service utilization in the FFS program, 

and reductions in service utilization are a key mechanism 

through which private plans seek to achieve savings. 

In contrast, the FFS program is likely to be the lowestbidding plan in areas where FFS spending is low, so 

beneficiaries in those areas would not be required to pay 

higher premiums if they wanted to remain in the traditional program. In all areas, the additional benefits and 

premium rebates that are available to enrollees in private 

plans would be eliminated because, by definition, no 

plan’s bid would be lower than the benchmark.

Setting benchmarks equal to the average bid in each market area (with each plan’s bid weighted by its enrollment 

in the previous year) would yield much smaller federal 

savings than would the minimum-bid approach. The 

sources of federal savings would be the same—namely, 

lower federal contributions for enrollees in the FFS program and for enrollees in private plans—but the benchmarks would be much higher than under the minimumbid approach. Consequently, setting benchmarks equal to 

the average bid in each area would result in much smaller 

increases in premiums for beneficiaries who wanted to 

remain in the FFS program and smaller reductions in the 

additional benefits and premium rebates that would be 

available to enrollees in private plans.

The effect of setting benchmarks equal to the national 

average bid would depend on the extent to which benchmarks were adjusted to account for geographic variation 

in per capita Medicare spending. Some policymakers and 

analysts have recommended that the benchmarks in such 

a system be adjusted to account for geographic variation 

in input prices and beneficiaries’ health status but not for 

6. Those conclusions are based on the results of a simulation analysis 

presented in Chapter 5 of this study, which examines the potential 

effects of premium support under a range of assumptions about 

the responses of plans and beneficiaries.
6 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

geographic variation in service utilization.7 That 

approach would result in benchmarks that are considerably lower than per capita FFS spending in areas where 

such spending is high and considerably higher than per 

capita FFS spending in areas where such spending is low. 

Consequently, the premiums for beneficiaries who 

remained in the FFS program would increase substantially in the highest-spending areas and decline significantly in the lowest-spending areas. Benchmarks under 

such a system would be lower than the benchmarks established under the Medicare Advantage program, so the 

additional benefits and premium rebates available to 

enrollees in private plans would decline.

7. That approach to geographic adjustment was contained in the 

premium support proposal that was included in the Medicare 

Preservation and Improvement Act of 2001 (S. 357). 
CHAPTER

2

Traditional Medicare and Private Health Plans

Medicare provides federal health insurance for

42 million people who are aged or disabled or who have 

end-stage renal disease. Part A of Medicare (Hospital 

Insurance) covers inpatient services provided by hospitals 

as well as skilled nursing and hospice care. Part B of 

Medicare (Supplementary Medical Insurance) covers services provided by physicians and other practitioners, hospitals’ outpatient departments, and suppliers of medical 

equipment. Home health care may be covered by either 

Part A or Part B. The Medicare Prescription Drug, 

Improvement, and Modernization Act of 2003 (MMA) 

added a voluntary prescription drug benefit beginning in 

2006 under Part D.

Part A benefits are financed primarily from a payroll tax. 

Premiums paid by beneficiaries currently cover about 

25 percent of the costs of the Part B program, and the rest 

comes from general revenues.1

 Those Part B premiums 

are currently about 11 percent of the total combined cost 

of the Part A and Part B programs. Enrollees’ premiums 

under Part D are set at a level to cover about one-quarter 

of the cost of the basic prescription drug benefit, but 

receipts from premiums will cover less than one-quarter 

of the total cost of the Part D program because some of 

the costs of that program (such as subsidies for lowincome beneficiaries and for employers that maintain 

drug coverage for their retirees) are not included in the 

calculation of premiums.

The majority of Medicare beneficiaries receive services 

through the traditional fee-for-service part of the program. The rest (about one-sixth) are enrolled in private 

health plans. This chapter briefly discusses traditional 

Medicare and examines private plans in more detail, 

describing the payment system for private plans, the costs 

of those plans relative to the costs of traditional Medicare, 

and the sources of geographic variation in plans’ costs.

The Fee-for-Service Program

Most Medicare beneficiaries receive their care in the feefor-service program, which pays providers for each covered service (or bundle of services) they provide. The FFS 

program is popular with beneficiaries because, unlike 

many private insurance plans, it does not restrict their 

choice of providers and does not require prior authorization for any covered service. 

The FFS program has several inefficiencies, however. To 

begin with, it is likely that beneficiaries who are enrolled 

in the program receive services whose costs exceed their 

benefits, for two reasons: the program gives providers 

incentives to increase the volume of services they deliver, 

and the out-of-pocket costs beneficiaries face are typically 

much lower than the total costs of providing the services. 

In addition, the FFS program does not give providers 

incentives to coordinate the care of beneficiaries who 

obtain services from multiple providers. Consequently, 

many beneficiaries—especially those with multiple 

chronic conditions—may receive care that is fragmented 

and inefficient.

The government has implemented changes to improve 

the efficiency of care delivery in the FFS program. 

For example, in 1983, Medicare replaced its cost-based 

reimbursement mechanism for inpatient hospital care 

with a prospective payment system in which the payment 

for each hospital stay is based on a patient’s diagnosis 

(and, in some cases, on whether certain procedures are 

performed). That system is designed to encourage hospitals to provide care during each inpatient stay as efficiently as possible. Medicare subsequently implemented 

1. Premiums will cover a somewhat higher proportion of Part B costs 

in the future because premiums for high-income beneficiaries will 

be increased beginning in 2007. Higher premiums will be 

required of single beneficiaries with annual income over $80,000 

and couples with annual income over $160,000 in 2007. Those 

income thresholds will be indexed to inflation in future years. 
8 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

prospective payment systems for hospital outpatient 

departments, home health agencies, and skilled nursing 

facilities. Although those systems encourage providers to 

use resources efficiently for each bundle of services for 

which payment is made (such as a hospital stay), they do 

not limit providers’ incentives to increase the number of 

“service bundles” they provide. Moreover, they do not 

address inefficiencies associated with the lack of coordination of care across providers.

Beneficiaries must pay a portion of the costs of their care 

through deductibles and coinsurance. Cost-sharing liabilities can be substantial for some beneficiaries, in part 

because Medicare does not include an annual cap on beneficiaries’ cost sharing, as many private plans do. Nearly 

90 percent of beneficiaries who receive care in the FFS 

program have supplemental insurance that covers many 

or all of Medicare’s cost-sharing requirements. The most 

common sources of supplemental coverage are retiree 

plans offered by former employers (held by 38 percent of 

beneficiaries in the FFS program), individually purchased 

Medigap policies (34 percent), and Medicaid (16 percent).2 Supplemental insurance substantially reduces 

beneficiaries’ exposure to financial risk. By largely 

insulating beneficiaries from the financial consequences 

of their treatment decisions, however, such coverage leads 

to greater utilization of services and higher Medicare 

spending.

Private Health Plans

In nearly all areas of the country, Medicare beneficiaries 

have the option of enrolling in Medicare Advantage—

the program through which private plans participate in 

Medicare—rather than receiving their care through the 

fee-for-service program.3

 As of October 2006, about 

17 percent of beneficiaries were enrolled in private health 

plans, which accept responsibility and financial risk for 

providing Medicare benefits.4

 Although the payment system for private plans has been modified several times during the more than 20 years that they have participated in 

Medicare, a key feature of the system has remained intact: 

plans that can provide Medicare benefits at a cost below 

their payment from the government are required to give 

enrollees additional benefits or, in an option that became 

available recently, rebates on their Part B or Part D premiums.5

 The additional benefits and rebates are a major 

incentive for beneficiaries to enroll in Medicare Advantage plans.

About 75 percent of the Medicare beneficiaries enrolled 

in private plans are in health maintenance organizations 

(HMOs). The other main types of available plans are 

local preferred provider organizations (PPOs), regional 

PPOs, and private fee-for-service (PFFS) plans. Both 

HMOs and PPOs have comprehensive networks of providers. Some HMOs offer coverage for services received 

outside their network (and thus resemble PPOs, which 

allow beneficiaries to obtain care outside the network if 

they pay a higher amount), while others require that their 

enrollees receive all of their nonemergency care within 

the network. Regional PPOs, an option that became 

available in 2006, are required to serve broad regions of 

the country rather than define their service areas on a 

county-by-county basis, as local PPOs do. PFFS plans 

allow their enrollees to obtain care from any provider 

who will furnish it.

As of 2006, 80 percent of beneficiaries live in a county 

served by an HMO or a local PPO, up from 67 percent 

in 2005.6 Nearly all beneficiaries who do not have access 

to an HMO or local PPO have access to a PFFS plan or a 

regional PPO.

The number of private plans that participate in Medicare 

varies across geographic areas. In 2005, HMOs participated in Medicare in about one-quarter of U.S. counties, 

although those counties account for about two-thirds of 

the national Medicare population. About 14 percent of 

counties had one HMO that participated in Medicare in 

2005, 10 percent had two or three HMOs, 3 percent had 

four or five HMOs, and less than 1 percent had more 

than five HMOs.

2. Medicare Payment Advisory Commission, A Data Book: Healthcare Spending and the Medicare Program (June 2006). 

3. The program through which private plans participate in Medicare 

is also called Part C. Previously, the program had been called 

Medicare+Choice.

4. Another 1 percent of beneficiaries were enrolled in private plans 

that are paid on a cost-reimbursement basis. Those plans are not 

included in this study.

5. Plans have had the option of giving their enrollees a rebate on 

their Part B premium since 2003. Beginning in 2006, plans can 

also offer a rebate on the Part D premium.

6. Medicare Payment Advisory Commission, Report to the Congress: 

Increasing the Value of Medicare (June 2006), p. 206.
CHAPTER TWO TRADITIONAL MEDICARE AND PRIVATE HEALTH PLANS 9

The Payment System for Private Health Plans 

The latest changes to the payment system for private 

health plans were mandated by the Medicare Modernization Act. The modified payment system is largely similar 

to the previous system, as are the incentives facing plans 

and beneficiaries.

Beginning in 2006, private plans that want to participate 

in Medicare must submit bids indicating the per capita 

payment for which they are willing to provide Medicare’s 

Part A and Part B benefits.7 The government compares 

those bids with county-level benchmarks that are determined in advance through statutory rules. The benchmarks are the maximum payment that the government 

will make for enrollees in private plans. (The benchmark 

for a plan that serves more than one county is an 

enrollment-weighted average of the county-level benchmarks in its service area.) Plans are paid their bids (up to 

the benchmark) plus 75 percent of the amount by which 

the benchmark exceeds their bid. Plans must return that 

75 percent to beneficiaries as additional benefits or as a 

rebate on their Part B or Part D premium. Plans whose 

bids are above the benchmark are required to charge 

enrollees the full difference between the bid and benchmark as an additional premium for the Medicare benefit 

package.8

Under current law, benchmarks are required to be at least 

as great as per capita FFS expenditures in every county 

and are higher than FFS expenditures in many counties. 

For 2006, benchmarks are 11 percent higher, on average, 

than projected per capita FFS expenditures nationwide. 

Benchmarks are updated each year by either the amount 

of growth in national per capita Medicare spending or 

2 percent, whichever is greater.9

The benchmarks for 2006 were derived from the payment rates for private plans that were established by the 

Balanced Budget Act of 1997 (BBA) and modified 

through subsequent legislation. Under the BBA, the payment rate in each county was the greatest of three 

amounts: a minimum or “floor” rate, a blend of a local 

rate and the national average rate, and a minimum 

increase from the previous year’s rate (which was equal to 

2 percent in most years).10 The BBA rules resulted in 

rates in some counties that were higher—in some cases, 

by a substantial amount—than local per capita spending 

in the FFS program. In other counties, however, the 

update mechanism resulted in payment rates that were 

lower than local per capita FFS spending. (In counties 

where payment rates were below FFS spending, the 

benchmarks were raised to meet the MMA’s requirement 

that the benchmark in each county be at least as great as 

local per capita FFS spending.)

Despite some differences in terminology, the bidding 

mechanism established by the MMA is analogous to the 

payment system that was already in place. Under the previous system, private plans that participated in Medicare 

were required to submit a projection of their per capita 

revenue requirement for delivering Medicare’s covered 

benefits, which was called the adjusted community rate 

(ACR). If a plan’s ACR was less than its projected per 

capita payment from Medicare, it was required to return 

the difference to enrollees in the form of additional benefits or as a rebate on their Part B premium. If the difference was returned in the form of additional benefits, the 

cost of those benefits to the plan had to be equal to the 

entire difference between the plan’s ACR and its payments from Medicare. If the difference was returned in 

the form of a rebate on the Part B premium, the Medicare 

program retained 20 cents for every dollar the plan used 

to provide the rebate, and enrollees received the other 

80 cents. In contrast, under the payment mechanism that 

went into effect in 2006, beneficiaries receive 75 cents for 

7. Plans must also submit bids for the voluntary prescription drug 

benefit and their premiums for any supplemental benefits they 

intend to offer.

8. The description of the MMA payment mechanism in this section 

pertains to plans that participate in Medicare on a county-bycounty basis (or “local” plans). The payment mechanism for 

regional PPOs is analogous to the mechanism described here for 

local plans but uses a modified approach to compute benchmarks. 

See Medicare Payment Advisory Commission, Report to the 

Congress: Issues in a Modernized Medicare Program (June 2005), 

pp. 59-81.

9. The MMA also requires that the government “rebase,” or reestimate, per capita FFS expenditures in each county at least once 

every three years using the most current data available. In those 

years in which rebasing occurs, the benchmark for each county 

will be the greater of the rebased per capita FFS expenditure or the 

update from the previous year’s rate.

10. Prior to enactment of the BBA, county-level payment rates for 

private plans had been set equal to 95 percent of projected average 

per capita spending in the FFS program. For a description of that 

payment mechanism and the modifications that were mandated 

by the BBA, see Sandra Christensen, “Medicare+Choice Provisions in the Balanced Budget Act of 1997,” Health Affairs, vol. 17, 

no. 4 (July/August 1998), pp. 224-231.
10 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

every dollar of difference between the plan’s bid and the 

benchmark, regardless of whether it is given in the form 

of additional benefits or premium rebates, and the government retains the other 25 cents.

The Costs of Private Health Plans and

Traditional Medicare 

The Congressional Budget Office (CBO) analyzed how 

private health plans’ costs of delivering Medicare benefits 

under the incentives created by the Medicare Advantage 

program compare with the costs of the traditional FFS 

program. CBO compared plans’ projected per capita 

costs of providing Medicare benefits as reported in their 

2005 ACR submissions (including administrative costs 

and normal profits) with average per capita FFS expenditures in their service areas.11 Because differences between 

private plans and the FFS program in the costs of delivering Medicare benefits may partially reflect differences in 

their enrollees’ health status, CBO adjusted plans’ costs—

by using risk scores from the Hierarchical Condition 

Codes (HCC) model—to try to remove those differences.

Adjusting Costs for Differences in Health Status. The 

HCC model uses diagnoses and demographic characteristics in a given year to assign each beneficiary a risk score 

that measures his or her predicted expenditure in the following year relative to the national average. The higher 

the risk score, the higher the beneficiary’s predicted 

expenditure in the following year. (A beneficiary whose 

predicted spending is equal to the national average has a 

risk score of 1.0.) CBO used those estimated risk scores 

for enrollees in private plans to adjust plans’ reported 

costs to reflect the costs that they would have incurred for 

a “standard beneficiary”—that is, a beneficiary whose predicted expenditures are equal to the national average. The 

county-level estimates of per capita spending in the FFS 

program obtained from the Centers for Medicare and 

Medicaid Services (CMS) also reflect the projected 

spending for a standard beneficiary.

Although HCC risk scores were the best method available 

for this study to measure beneficiaries’ relative health status, there is uncertainty about how well they do so. The 

Medicare program began phasing in the HCC model for 

adjusting payments to private plans in 2004, so experience with the new system has been limited.12 Moreover, 

in the two most recent years for which data are available 

(2003 and 2004), the average risk score for enrollees in 

private plans increased significantly relative to the average 

risk score for beneficiaries in the FFS program, even 

though there was little change during that period in the 

composition of the private plans that participate in Medicare or in their enrollment. Risk scores for private-plan 

enrollees estimated from 2003 data were about 12 percent lower than risk scores for enrollees in the FFS program, on average. That difference narrowed to about 

6 percent when risk scores were computed using 2004 

data.13

It is not known why risk scores for enrollees in private 

plans increased during that two-year period. Private plans 

may have become better at collecting and reporting diagnostic information on their enrollees, which they have a 

strong incentive to do because they receive higher payments for enrollees with greater expected costs. (In the 

FFS program, by contrast, physicians have a limited 

incentive to ensure that all diagnoses are fully reported on 

their claims because the extent to which diagnoses are 

reported does not influence their payment.) If private 

plans and FFS providers differ systematically in how 

completely they report their diagnostic information, risk 

scores computed from that information could give a 

biased measure of the relative health status of enrollees in 

11. CBO received data on the bids that plans submitted for 2006 after 

it had completed the analysis. The ratios of the 2006 bids to local 

spending in the FFS program are very similar to the corresponding ratios estimated from plans’ costs reported in the 2005 ACR 

submissions, so using the bid data would not have affected the 

basic conclusions of the analysis.

12. In 2004, payments computed using the HCC risk adjuster 

accounted for 30 percent of plans’ total payments, with the 

remaining 70 percent determined by a risk-adjustment formula 

that relies on enrollees’ demographic characteristics. The share of 

plans’ total payments that is determined by the HCC risk adjuster 

increased to 50 percent in 2005 and 75 percent in 2006, and it is 

scheduled to reach 100 percent in 2007 and later years. However, 

through 2006, CMS applied a “budget-neutrality” adjustment to 

HCC-based payments to ensure that, in the aggregate, plans 

received the same payments that they would have received if CMS 

had paid them using the adjuster that considers only demographic 

characteristics. Thus, aggregate payments to plans were not 

affected by the phased implementation of the HCC risk adjuster, 

although payments to individual plans were affected. The Deficit 

Reduction Act of 2005 requires that the budget-neutrality adjustment be phased out beginning in 2007.

13. CBO obtained risk scores based on 2003 data from plans’ ACR 

submissions for 2005 (which were submitted in mid-2004). 

Average county-level risk scores based on 2004 data for privateplan enrollees were provided by CMS.
CHAPTER TWO TRADITIONAL MEDICARE AND PRIVATE HEALTH PLANS 11

Table 2-1.

Private Plans’ Per Capita Costs of Providing Medicare Benefits Relative to

Those of the FFS Program, 2005

Source: Congressional Budget Office based on data submitted by private plans to the Medicare program for 2005. 

Notes: FFS = fee for service; n.a. = not applicable. 

The estimates measure plans' projected costs of providing Medicare benefits, including administrative costs and profits. Plans' costs 

and FFS expenditures were standardized using risk scores from the Hierarchical Condition Codes model, which measures differences 

in beneficiaries' health status and characteristics. Estimates are presented under two different assumptions about the risk scores of 

private-plan enrollees, based on estimates generated from 2003 data and 2004 data. For each U.S. county, the average 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 2005 were 

included in the analysis. Each county was weighted by the number of private-plan enrollees who live there. 

private plans and those in the FFS program. The Deficit 

Reduction Act of 2005 requires that CMS compare the 

diagnostic coding patterns of private plans and FFS providers and, if important differences are found, appropriately adjust the payments to private plans.

Because of uncertainty about how well the available estimates of risk scores measure the relative health status of 

enrollees in private plans and those in the FFS program, 

CBO conducted the analysis of plans’ costs under two 

different assumptions, corresponding to the 2004 riskadjustment data and the 2003 data. The analysis focused 

on HMOs, which have lower costs relative to spending in 

the FFS program than the other types of Medicare 

Advantage plans.

Private Plans’ Adjusted Costs per Enrollee. Using 2004 

risk-adjustment data, CBO estimates that private plans’ 

adjusted costs per enrollee of delivering Medicare benefits 

in 2005 were an average of 3 percent higher than those of 

the FFS program (see Table 2-1). The costs of private 

plans relative to those of the FFS program varied greatly 

across geographic areas, though. For example, private 

plans’ costs were lower relative to FFS expenditures in 

areas where FFS spending is high. On a per capita basis, 

private plans’ adjusted costs averaged 8 percent lower 

than FFS expenditures in the highest-spending counties 

(those with per capita FFS spending of at least $700 per 

month) but 21 percent higher than FFS expenditures in 

the lowest-spending counties (those with per capita FFS 

spending of less than $550 per month).14

Using 2003 risk-adjustment data, CBO estimates that 

private plans’ adjusted costs per enrollee of delivering 

Medicare benefits in 2005 were an average of 11 percent 

higher than those of the FFS program (see Table 2-1).15

Private plans’ adjusted costs per enrollee averaged 2 percent higher than per capita FFS expenditures in the 

highest-spending counties and 29 percent higher than per 

capita FFS expenditures in the lowest-spending counties. 

Average Per Capita

FFS Expenditure

Per Month in County

(Dollars)

Less Than 550 14.2 1.21 1.29

550 to 599 20.1 1.08 1.16

600 to 649 23.4 1.00 1.08

650 to 699 15.3 1.01 1.09

700 and Higher 27.0 0.92 1.02

National Average n.a. 1.03 1.11

Percentage of

Private-Plan Enrollees

Average Ratio of Plans' Costs to

Per Capita FFS Expenditures

Using 2004 Risk-Adjustment Data Using 2003 Risk-Adjustment Data

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

by county. CBO’s approach to estimating plans’ costs at the 

county level is described in Appendix A. 

15. Plans’ adjusted costs per enrollee are higher when 2003 riskadjustment data are used because estimates from the 2003 data, 

relative to estimates from the 2004 data, imply that enrollees in 

private plans are healthier. Consequently, removing the influence 

of differences in health status from the comparison between plans’ 

costs and costs of the FFS program has a bigger effect when the 

2003 risk-adjustment data are used.
12 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Private plans are able to participate in Medicare even if 

their costs are greater than those of the FFS program 

because their payment rates are higher than per capita 

FFS expenditures. Among the areas that were served by 

private plans in 2005, those payment rates were 26 percent higher than per capita FFS expenditures in the 

lowest-spending counties, on average, and 4 percent 

higher than per capita FFS expenditures in the highestspending counties.16 Roughly 14 percent of Medicare 

Advantage enrollees live in the lowest-spending counties, 

while 27 percent live in the highest-spending counties.

Sources of Geographic Variation in Costs 

Private plans’ costs relative to FFS expenditures vary 

greatly across geographic areas. That variation generally 

depends on the net effect of three factors:

B The administrative costs of private plans relative to 

those of FFS Medicare;

B The level and intensity of beneficiaries’ use of services 

in private plans relative to their use of services in the 

FFS sector; and

B The payment rates that providers receive from private 

plans relative to the rates they receive from FFS 

Medicare.

Administrative Costs. Private health plans that participate 

in Medicare have higher administrative costs per enrollee 

than the traditional Medicare program because of their 

smaller scale of operations and their costs associated with 

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

costs and return on investment account for about 11 percent of private plans’ costs of delivering Medicare benefits, whereas the administrative costs of the fee-for-service 

Medicare program (as reported by CMS) account for less 

than 2 percent of its expenditures.17 There is some disagreement among analysts about the size of that difference in costs, however. Some analysts contend that the 

latter estimate understates the administrative costs of the 

Medicare program because it excludes some costs that 

should be allocated to Medicare, such as portions of the 

salaries of legislators, legislative staff, and CMS administrators; depreciation on certain federal office buildings; 

and the costs of collecting Medicare premiums and payroll taxes.18 Following that reasoning, however, a portion 

of those additional costs should also be allocated to the 

Medicare Advantage program. 

The higher administrative costs of private plans do not 

imply that those plans are less efficient than the traditional FFS program. Some of the plans’ administrative 

expenses are for functions, such as utilization management and quality improvement, that are designed to 

increase the efficiency of care delivery. The main point 

for this analysis is that, because of their higher administrative costs, private plans can provide Medicare services 

at a lower cost than the FFS program only if they can 

achieve savings through lower service utilization or reductions in provider payment rates that more than offset 

their higher administrative costs. The ability of plans to 

achieve such savings varies greatly across geographic areas. 

Service Utilization. Prior research on the effects of private 

plans on service utilization has focused primarily on comparing HMOs with other types of plans (mainly indemnity plans and PPOs). That research suggests that, in general, HMOs keep their medical costs down by reducing 

the level and intensity of service utilization, particularly 

by limiting their enrollees’ use of services such as visits to 

specialists, inpatient hospital care, costly tests and procedures, and services in intensive care units.19 HMOs use 

various approaches to reduce the costs of health care in 

general, such as contracting with low-cost providers, giving primary care physicians responsibility for coordinating care, requiring prior authorization for certain services, 

giving providers financial incentives that discourage 

excessive use of services, and educating providers on prac- 16. In addition, the budget-neutrality adjustment described previously results in higher payments to plans than would have been 

the case if those payments had been adjusted to account for differences in beneficiaries’ health status.

17. CBO computed the average administrative cost of Medicare 

Advantage plans from 2005 ACR data. Information on Medicare’s 

administrative costs is available from the 2006 Annual Report of 

the Boards of Trustees of the Federal Hospital Insurance and Federal 

Supplementary Medical Insurance Trust Funds (May 1, 2006), p. 5.

18. See Merrill Matthews, Medicare’s Hidden Administrative Costs: 

A Comparison of Medicare and the Private Sector (Alexandria, Va.: 

Council for Affordable Health Insurance, January 10, 2006), 

available at www.cahi.org. 

19. 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), pp. 63-86.
CHAPTER TWO TRADITIONAL MEDICARE AND PRIVATE HEALTH PLANS 13

tice guidelines and offering feedback on their practice 

patterns.20

On balance, the evidence suggests that the quality of care 

in HMOs is similar to that in other types of plans.21 The 

best information available, although limited, suggests that 

HMOs provide care to Medicare enrollees that is similar 

in quality to that provided to nonelderly enrollees who 

have employment-based coverage.22 Moreover, Medicare 

beneficiaries who are enrolled in HMOs report similar 

levels of satisfaction with their care as do beneficiaries 

who are enrolled in the FFS program. More research is 

needed, however, to draw more-definitive conclusions 

about how the quality of care received by Medicare beneficiaries in HMOs compares with that received by beneficiaries in the FFS program. 

Private plans that participate in Medicare have much 

greater potential to achieve savings relative to the FFS 

program 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. 

Private plans have much less opportunity to achieve such 

savings in areas 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 2-1 showing that 

plans’ costs are higher relative to FFS spending in areas 

where FFS spending levels are relatively low.

Providers’ Payment Rates. Private health plans seek to 

reduce medical spending by contracting with providers 

who are willing to accept discounted payment rates in 

exchange for a greater number of patients. Even those discounted rates generally exceed the rates that FFS Medicare pays to providers, however. An analysis of claims data 

conducted for the Medicare Payment Advisory Commission found that, on average, private plans paid physicians 

about 20 percent higher rates than FFS Medicare paid in 

2001.23 In general, the fees that private plans 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.

Differences between the rates paid to physicians by private plans and those paid by FFS Medicare also vary geographically. In the FFS program, payment rates for physicians vary to account for differences in providers’ costs of 

inputs. Relative to FFS rates, the rates paid by private 

plans are higher in rural 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 FFS rates in small 

metropolitan areas and rural areas, 10 percent higher in 

medium-sized metropolitan areas, and 1 percent higher 

in large metropolitan areas.24

Less information is available on how the hospital payment rates of private plans compare with those of FFS 

Medicare. 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.25 The stronger negotiating positions of hospitals are the result of various factors, including hospital 

consolidations, strong consumer preferences that hospitals not be excluded from plans’ networks, and high 

demand for hospital services relative to the available supply in some markets, which reduces hospitals’ incentive to 

accept discounts.

20. In the late 1990s, some HMOs eliminated or scaled back their 

utilization management procedures in response to widespread 

dissatisfaction among consumers and providers. More recently, 

however, many of those plans have reintroduced such procedures 

and begun experimenting with new cost-containment strategies. 

See Glen P. Mays, Gary Claxton, and Justin White, “Managed 

Care Rebound? Recent Changes in Health Plans’ Cost Containment Strategies,” Health Affairs, Web exclusive (August 11, 2004).

21. Miller and Luft, “HMO Plan Performance Update.”

22. Medicare Payment Advisory Commission, Report to the Congress: 

Medicare Payment Policy (March 2004), pp. 31-50.

23. 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).

24. 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 of between 1 million and 3 million, and 

large metropolitan areas are those with a population of more than 

3 million.

25. Justin S. White, Robert E. Hurley, and Bradley C. Strunk, Getting 

Along or Going Along? Health Plan-Provider Contract Showdowns 

Subside, Issue Brief No. 74 (Washington, D.C.: Center for Studying Health System Change, January 2004).
14 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

The payments that rural hospitals receive from private 

health plans exceed their associated costs by a much 

greater percentage than is true for urban hospitals.26 In 

contrast, the payments that rural hospitals receive from 

FFS Medicare are lower relative to the hospitals’ costs of 

providing the services than is true for urban hospitals.

Those findings are supported by industry sources who 

have reported that private plans typically must pay rates 

to hospitals and physicians in rural areas that far exceed 

Medicare’s FFS 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. 26. Medicare Payment Advisory Commission, Medicare in Rural 

America (report to the Congress, June 2001).
CHAPTER

3

Issues in Designing a

Premium Support System for Medicare

Concern about the projected growth of Medicare 

expenditures and the fiscal strains those expenditures will 

create under current policies has prompted some policymakers and analysts to propose that Medicare be converted to a premium support system. Under such a system, the federal government would contribute an amount 

that beneficiaries could use toward the purchase of Medicare coverage, which they could obtain by enrolling in the 

fee-for-service program or a private health plan. The FFS 

program would compete on the same terms as private 

plans, and the projected average per capita cost of that 

program would be regarded as its premium. Beneficiaries 

who enrolled in plans whose premiums were higher than 

the government’s contribution would be responsible for 

paying the difference between the two, whereas beneficiaries who enrolled in plans whose premiums were lower 

than the government’s contribution could receive premium rebates or additional benefits.

Proponents maintain that, depending on how the 

government’s contribution was determined, premium 

support could reduce net federal spending on Medicare.1

Moreover, proponents say, such a system could reduce 

total spending on Medicare benefits (including beneficiaries’ premiums and cost sharing) by stimulating greater 

price competition among plans and making beneficiaries 

more cost-conscious in their choice of plans. 

This chapter examines the key issues that would have to 

be addressed in designing a premium support system for 

Medicare, including the mechanism for setting the government’s contribution and the requirements for the benefit package. Decisions about those issues would have 

important implications for the effects of premium support on federal spending and beneficiaries’ premiums. 

The Government’s Contribution

Under premium support, the government’s contribution 

toward the cost of Medicare coverage could be determined from the bids of competing health plans or could 

be set equal to a predetermined amount. Those two 

approaches could have very different implications for federal spending on Medicare.

Determining the Government’s Contribution from 

Plans’ Bids

In a premium support system based on competitive bidding, plans would submit bids indicating the per capita 

payment for which they were willing to provide Medicare 

benefits. The government would compute benchmarks 

based on those bids and would pay plans their bids, up to 

the benchmark. Beneficiaries who enrolled in plans 

whose bids were equal to the benchmark would be 

required to pay a premium for their Medicare coverage 

(as they do now), which could be determined in various 

ways (see below). Beneficiaries who enrolled in plans 

whose bids were above the benchmark would be required 

to pay that premium plus an additional premium equal to 

the difference between their plan’s bid and the benchmark. Beneficiaries who enrolled in plans whose bids 

were below the benchmark could receive some or all of 

the difference between their plan’s bid and the benchmark as a premium rebate or additional benefits. Such a 

system would be similar to the current payment mechanism for the Medicare Advantage program, although it 

would differ in two important ways: the benchmarks 

would be determined from plans’ bids (rather than set by 

statutory rules), and the FFS program would be one of 

the bidding plans.2

1. Net federal spending on Medicare is the amount that the federal 

government spends on the program after subtracting the premiums it collects from beneficiaries. 

2. The projected per capita spending in the FFS program would be 

regarded as that program’s bid.
16 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

One key choice in designing a premium support system 

based on competitive bidding is the mechanism for setting the benchmarks. The benchmarks could be set in 

many ways. For example, they could be set equal to the 

minimum bid in each market area, the average or median 

bid in each market area, or the national average bid.3 Setting benchmarks equal to the minimum bid in each area 

would ensure that beneficiaries had access to a plan that 

met certain basic standards, without requiring the government to subsidize the choice of a more expensive plan. 

Setting benchmarks equal to the average bid in each area 

(with plans’ bids weighted by their enrollments in the 

previous year) would allow the choices of enrollees to 

influence the government’s subsidy. Determining benchmarks from the national average bid would have the 

added effect of altering the cross-subsidies that now exist 

within Medicare, whereby beneficiaries who live in areas 

with lower spending levels pay a larger share of such 

spending (through their Part B premiums) than beneficiaries who live in areas with higher spending levels. The 

effects on those cross-subsidies, like the other effects from 

setting benchmarks equal to the national average bid, 

would depend on the extent to which benchmarks were 

adjusted to account for geographic variation in per capita 

Medicare spending.

Another key choice in designing a premium support system based on competitive bidding is the premium that 

would be required of beneficiaries who enrolled in plans 

whose bids were equal to the benchmark. That premium 

could be determined in various ways. One approach 

would be to require such beneficiaries to pay the national 

Part B premium, just as they do in the Medicare Advantage program. (That approach will be used in the premium support demonstration that was mandated by the 

Medicare Modernization Act; see Box 3-1.) Another 

approach would be to set the premium equal to a fixed 

percentage of the benchmark. Under that approach, net 

federal spending and beneficiaries’ premiums would 

depend greatly on the level at which the percentage

was set.

Setting Benchmarks Equal to the Minimum Bid in Each 

Market Area. Setting benchmarks equal to the minimum 

bid in each market area is analogous to the managed 

competition purchasing strategy that some employers 

have adopted.4

 Two advantages of this approach are that 

it would lead to lower federal spending than would setting benchmarks equal to the average or median bid in 

each market area, and it would give beneficiaries stronger 

incentives to be cost-conscious in their choice of plans. 

According to projections presented in Chapter 5 of this 

study, benchmarks under this approach could be substantially lower than average FFS expenditures in market 

areas where those expenditures are high, so the premium 

paid by beneficiaries for the FFS program in those areas 

could be substantially greater than it would be under

current law. In many other market areas, however,

benchmarks would probably be equal to average FFS 

expenditures.

There are three potential problems with the minimumbid approach to setting benchmarks. First, the substantial 

increases in beneficiaries’ premiums for the FFS program 

in some market areas could generate protests by beneficiaries and lead to confusion. To the extent that 

beneficiaries did not understand the new rules in the first 

year, they could experience a large unexpected increase in 

their premium, which could cause financial hardships. 

Those problems could be partially addressed by gradually 

phasing in the new system. For example, the increases in 

premiums for the FFS program could be constrained not 

to exceed certain amounts that would slowly rise over a 

suitable phase-in period, giving beneficiaries time to learn 

about and adjust to the new rules.5 Another option is to 

implement a premium support system that would initially produce smaller changes in beneficiaries’ premiums 

(such as by setting benchmarks equal to the average bid in 

each market area) and then switch to the minimum-bid 

system on a phased-in basis.

A second potential problem with setting benchmarks 

equal to the minimum bid in each market area is that the 

lowest-bidding plans in some areas might achieve their 

savings by providing either low-quality care or poor customer service, or both. The government’s contribution in 

3. Market areas could be defined as counties or as larger geographic 

units, such as metropolitan areas.

4. The minimum-bid approach to setting benchmarks was proposed 

by Bryan E. Dowd, Roger Feldman, and Jon Christianson in 

Competitive Pricing for Medicare (Washington, D.C.: AEI Press, 

1996). The managed competition purchasing strategy is discussed 

in Chapter 4 of this study.

5. A government campaign to educate beneficiaries about their 

choices would be an important element of a premium support

system.
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 17

those market areas would be lower than it would have 

been if the government had recognized the problems with 

the lowest-bidding plans and excluded them from the 

program. Because plans that provide low-quality care or 

poor customer service would probably have trouble 

attracting large numbers of enrollees, however, they 

would have less of an incentive to engage in such behavior. The government already has numerous mechanisms 

in place in the Medicare Advantage program to ensure 

that plans meet certain standards regarding quality of 

care, and those mechanisms could be continued under a 

premium support system.6

 Even so, monitoring the quality of care provided by health plans is difficult, and it is 

possible for problems to go undetected.

A third potential problem with the minimum-bid 

approach to setting benchmarks is that the lowestbidding plan might not have the capacity to accept all

of the beneficiaries who might want to enroll. In principle, that problem could be addressed by requiring plans 

to state their enrollment capacity when they submit their 

bids. The government could then rank the bids in each 

area from lowest to highest and set the benchmark at the 

level at which the combined enrollment capacity of the 

plans whose bids are at or below that amount meets a 

specified threshold. Plans might overstate their enrollment capacity, however, and it would be difficult for the 

government to detect such behavior during the bid evaluation process.7

 One way in which the government could 

deter plans from overstating their enrollment capacity 

would be by imposing strong sanctions on plans that 

were later found to have done so. 

Several alternatives related to the minimum-bid approach 

would at least partly address some of those potential 

problems, although they would most likely result in 

smaller federal savings. For example, benchmarks could 

be set equal to the second-lowest bid in each market area 

or to a specified percentage above the lowest bid. Alternatively, benchmarks could be set equal to the average of the 

lowest three bids in each market area (or the average of 

the lowest two bids in areas with fewer than three bidders). With each of those approaches, plans’ incentives to 

submit low bids would be strongest if plans whose bids 

were below the benchmark were allowed to offer rebates.

Setting Benchmarks Equal to the Average Bid or the

Median Bid in Each Market Area. A second option would 

be to set benchmarks equal to the average bid or the 

median bid in each market area.8 In either case, bids 

could be weighted according to plans’ enrollments in the 

previous year, which would take into account the preferences and perceptions of beneficiaries in the local market 

area regarding the relative quality of care and other 

attributes of the available plans. Under that approach, 

however, the geographic variation in benchmarks might 

partly reflect differences in beneficiaries’ demand for 

higher-cost plans, resulting in a higher federal subsidy in 

market areas where beneficiaries have greater preferences 

for higher-cost plans or a greater ability to pay for them. 

In the premium support demonstration that was mandated by the MMA, benchmarks will be set equal to the 

average bid in each county (see Box 3-1).

Setting benchmarks equal to the average or median bid in 

each market area would at least partially address some of 

the problems with the minimum-bid approach. For 

example, plans that achieved savings by providing lowquality care or poor customer service would have less 

potential for influencing the government’s contribution 

than if benchmarks were set equal to the minimum bid. 

Moreover, benchmarks set equal to the average or median 

bid would be higher than those set equal to the minimum 

bid, so beneficiaries who live in areas where per capita 

FFS spending is high and who wanted to remain in 

the FFS program would face smaller increases in their 

premiums.

A recommendation that benchmarks be set equal to the 

enrollment-weighted average bid or the median bid came 

from a panel of experts that was convened to advise the 

6. For example, plans must meet certain standards regarding the size 

and geographic coverage of their provider networks, they must 

have an ongoing quality improvement program, and they 

must collect and report data on health outcomes and measures of 

quality to the federal government. The data on health outcomes 

and quality are made available to beneficiaries to assist them in 

selecting a plan.

7. For example, information on the number and geographic distribution of providers in a plan’s network does not, by itself, indicate a 

plan’s enrollment capacity, because some of those providers may 

have limited capacity (or willingness) to accept new Medicare 

patients.

8. The average bid is defined as the sum of the bids divided by the 

number of plans. The median bid is defined as the middle of the 

distribution of bids: half the bids are above the median and half 

are below it.
18 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

federal government on a demonstration of competitive 

bidding for private health plans under Medicare.9

 That 

demonstration, which was mandated by the Balanced 

Budget Act of 1997 but was never implemented, would 

have had some of the elements of a premium support system. However, the FFS program would not have been 

included as a bidding plan, and the Part B premiums of 

enrollees in that program would not have been affected 

by the demonstration. The advisory panel considered recommending that benchmarks be set equal to the minimum bid in the demonstration sites, but it rejected that 

approach because of a desire to limit the increases in premiums that enrollees in some plans would have faced in 

those sites.

Setting Benchmarks Equal to the National Average Bid.

As an alternative to setting the benchmark in each market 

area on the basis of the bids in that area, benchmarks 

could be determined from the national average bid. A key 

design choice for such a system is the extent to which 

benchmarks would be adjusted to account for geographic 

variation in per capita Medicare expenditures, which is

Box 3-1.

Legislative Context for a Premium Support System

Numerous policy analysts have proposed changing 

the Medicare program by adopting the principles of 

premium support.1

 The proposals vary in specificity 

and design, but all envision a system in which private 

plans would compete on the same terms as the feefor-service (FFS) program and beneficiaries would 

face incentives to choose plans on the basis of their 

relative premiums and the quality of care they provide. A demonstration that is scheduled to begin in 

2010 and a bill that was introduced in the Congress 

in 2001 illustrate alternative design options for premium support that have been debated by lawmakers 

in recent years.

Demonstration Program

The Medicare Prescription Drug, Improvement, and 

Modernization Act of 2003 (MMA), Public Law 

108-173, requires that the federal government conduct a six-year demonstration of premium support in 

up to six metropolitan areas beginning in 2010. (The 

legislation uses the term “comparative cost adjustment program” rather than premium support.) The 

demonstration is a compromise that was achieved as 

part of the conference agreement. The original bill 

that passed the House (H.R. 1) called for the nationwide implementation of premium support beginning 

in 2010 in all areas that are served by at least two private plans, whereas the Senate bill (S. 1) did not 

include a provision for premium support.

Under the demonstration, the benchmark—the government’s maximum payment for an enrollee in a private plan—in each county will be a weighted average 

of the bids of private plans and local per capita FFS 

expenditures.2 The rules for local Medicare Advantage plans will remain in place in the demonstration 

sites, but they will be subject to the demonstration 

benchmarks. The fee-for-service program in the 

1. For example, see Henry J. Aaron and Robert D. Reischauer, 

“The Medicare Reform Debate: What Is the Next Step?” 

Health Affairs, vol. 14, no. 4 (Winter 1995), pp. 8–30; Bryan 

E. Dowd, Roger Feldman, and Jon Christianson, Competitive 

Pricing for Medicare (Washington, D.C.: AEI Press, 1996); 

and Stuart M. Butler and Robert E. Moffit, “The FEHBP 

as a Model for a New Medicare Program,” Health Affairs, 

vol. 14, no. 4 (Winter 1995), pp. 47–61. 

2. The bid of the FFS program will be weighted by either the 

percentage of beneficiaries in the county who are in the FFS 

program or the percentage of beneficiaries nationally who are 

in the FFS program, whichever is greater. The average bid of 

private plans in the county will be computed by weighting 

each plan’s bid by its share of local private-plan enrollees, and 

that average bid of private plans will be weighted by 1 minus 

the weight of the FFS bid.

9. Bryan Dowd, Robert Coulam, and Roger Feldman, “A Tale of 

Four Cities: Medicare Reform and Competitive Pricing,” Health 

Affairs, vol. 19, no. 5 (September/October 2000), pp. 9–29. 
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 19

substantial.10 That variation in expenditures results primarily from geographic differences in the level and intensity of service utilization.11 Other contributing factors are 

geographic differences in the health status and other characteristics of beneficiaries and geographic differences in 

Medicare’s payment rates. Currently, the payment rates in 

the FFS program are adjusted to account for geographic 

differences in the prices of inputs that are used to provide 

medical care and differences in the characteristics of providers (for example, payments are higher for teaching 

hospitals and hospitals that serve a large proportion of 

low-income people).

There are many possible approaches to adjusting the 

national average bid to account for geographic variation 

in spending. One general approach is to adjust for all 

sources of geographic variation. If that approach was 

implemented by using plans’ bids to measure geographic 

differences in spending, the outcome would be the same 

Box 3-1.

Continued

demonstration sites will be subject to rules that are 

analogous to those in place for private plans. However, the increase or decrease in the Part B premium 

for beneficiaries in the FFS program in any year will 

be constrained to not exceed 5 percent of the national 

Part B premium. In addition, low-income beneficiaries in the FFS program will not be subject to any 

change in their Part B premium.

Breaux-Thomas and Breaux-Frist I

In 1999, the National Bipartisan Commission on the 

Future of Medicare, chaired by Senator John Breaux 

and Representative Bill Thomas, developed a Medicare proposal based on premium support. Although 

the majority of the commission’s members voted in 

favor of the proposal (named Breaux-Thomas after 

the chairmen of the commission), it did not receive 

enough votes to be presented as a formal recommendation to the President and the Congress. Subsequently, some members of the commission introduced a bill, the Medicare Preservation and 

Improvement Act of 2001 (S. 357), based on the 

commission’s proposal. That bill became known in 

the policy community as Breaux-Frist I.

Under Breaux-Frist I, benchmarks would have been 

set equal to the national average bid, weighted by 

plans’ enrollments in the previous year. Benchmarks 

would have been adjusted to account for geographic 

differences in the prices of inputs that are used to 

provide Medicare services but not for geographic differences in the level and intensity of beneficiaries’ use 

of services. (Payments to plans would have also been 

adjusted to account for differences in beneficiaries’ 

health status.) Beneficiaries who enrolled in plans 

whose bids were equal to the benchmark would have 

been required to pay a Medicare premium that would 

have been analogous to the Part B premium required 

under current law.3 Those who enrolled in plans 

whose bids were below the benchmark would have 

received 80 percent of the difference between the bid 

and benchmark as a reduction in their premium, 

whereas those who enrolled in plans with bids above 

the benchmark would have been required to pay an 

additional premium equal to the amount by which 

their plan’s bid exceeded the benchmark.

3. Breaux-Frist I also would have combined Medicare Parts A 

 and B, established a unified Medicare trust fund, and 

 replaced the Part B premium with a Medicare premium.

10. In 2005, 10 percent of Medicare beneficiaries lived in counties 

where average spending in the FFS program was at least $730 per 

month, while another 10 percent of beneficiaries lived in counties 

where average FFS spending was no more than $500 per month.

11. John E. Wennberg, Elliott S. Fisher, and Jonathan S. Skinner, 

“Geography and the Debate Over Medicare Reform,” Health 

Affairs, Web exclusive (February 13, 2002); and Marsha Gold, 

“Geographic Variation in Medicare Per Capita Spending: Should 

Policymakers Be Concerned?” Research Synthesis Report No. 6 

(Princeton, N.J.: Robert Wood Johnson Foundation, July 2004).
20 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

as if benchmarks were set equal to the average bid in each 

county.

Another general approach is to adjust the national average bid to account for part of the geographic variation in 

spending. That approach was contained in the premium 

support proposal included in the Medicare Preservation 

and Improvement Act of 2001 (S. 357), which would 

have adjusted the national average bid to account for geographic variation in the prices of inputs that are used to 

produce Medicare services (see Box 3-1).12 (That bill also 

would have adjusted payments to plans to account for 

differences in the health status and other characteristics of 

beneficiaries, as is currently done for Medicare Advantage 

plans.) No geographic adjustment would have been made 

to account for differences in the level and intensity of service utilization. The rationale for that approach is that 

the higher rates of service utilization in high-spending 

areas do not appear to improve the quality of care that 

beneficiaries receive or their health outcomes.13 Not 

adjusting benchmarks on the basis of service utilization 

means that the benchmarks in high-spending areas would 

be lower than they would have been if they had been 

adjusted to account for the higher service utilization in 

those areas. Conversely, the benchmarks in low-spending 

areas would be higher than they would have been if they 

had been adjusted to account for the lower service utilization in those areas.

Adjusting benchmarks to account for geographic variation in the prices of inputs that are used to deliver Medicare services would require an index measuring that variation. The Medicare program has several indexes that 

measure geographic variation in the prices of inputs faced 

by providers in the FFS program, which it uses to adjust 

payment rates in that program. However, those indexes 

may not accurately reflect the geographic variation in 

input prices faced by private plans, which must negotiate 

rates with providers. The rates that private plans pay to 

providers in local markets depend greatly on the amount 

of competition those providers face. As noted previously, 

private plans must typically pay providers in nonmetropolitan areas rates that far exceed Medicare’s FFS 

rates because of the lack of competition among providers 

in those areas.

Setting the Government’s Contribution Equal to a 

Predetermined Amount

A second general approach to premium support is to set 

the federal government’s contribution at an amount that 

is designed to meet a specified trajectory of spending. For 

example, that trajectory could be specified to ensure that 

federal spending on Medicare did not exceed a targeted 

percentage of the nation’s economy. The contribution 

could be based initially on current spending levels (net of 

premium collections) and then updated by a certain 

amount to ensure that Medicare spending followed the 

specified trajectory.

The effects of such an approach would depend in large 

part on the level at which the government’s contribution 

was set. If the contribution was set at a level that was 

below the average spending that the federal government 

would have otherwise incurred, then beneficiaries and 

health plans would have stronger incentives to seek lowercost modes of care. Depending on the responses of beneficiaries, plans, and providers, such an approach could 

increase the amount of costs borne by beneficiaries. In 

addition, if the government’s contribution grew at a rate 

that was substantially lower than the rate of growth of 

total health care spending in the nation, beneficiaries 

could be faced with higher costs, lower-quality care, or 

reduced access to care. Alternatively, some beneficiaries 

could enroll in health plans that are more efficient and 

better at coordinating care than the plans that they would 

have otherwise been enrolled in.

How the government’s contribution would be adjusted to 

account for geographic differences in per capita Medicare 

spending would also be an important design choice in 

this type of premium support system. The government’s 

contribution could be adjusted to account for some or all 

of the geographic differences in per capita spending using 

the approaches described above for adjusting the national 

average bid.

Finally, in a premium support system in which the government’s contribution was set at an amount to achieve a 

budgetary target, special consideration could be given to 

geographic areas that lack private plans and where the 

premium of the FFS program substantially exceeds the 

12. The Medicare Preservation and Improvement Act of 2001 was 

based on a premium support proposal that was developed in 1999 

by the National Bipartisan Commission on the Future of Medicare. Although a majority of the commission’s members voted for 

the proposal, it did not receive enough votes to be presented as a 

formal recommendation to the President and the Congress. 

13. Wennberg, Fisher, and Skinner, “Geography and the Debate Over 

Medicare Reform.” 
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 21

government’s contribution. For example, rules could be 

specified to limit the increase in premiums for beneficiaries in those areas.

The Benefit Package

A system of premium support would have to include 

rules concerning the design of the Medicare benefit package and any supplemental coverage that was offered.

The Medicare Benefit Package 

A premium support system could be designed so that all 

plans would be required to offer a standard package of 

Medicare benefits. Alternatively, plans could be allowed 

to vary their benefit packages. Standardizing the benefit 

package would offer three advantages.14 First, if the government’s contribution is determined through competitive bidding, benefit standardization would help assure 

plans and beneficiaries of the fairness of the bidding process, because all plans would bid on the same product and 

the government could evaluate bids in a straightforward 

manner. Second, regardless of how the government’s contribution is determined, a standard benefit package 

would facilitate beneficiaries’ comparisons of premiums 

and simplify the task of informing beneficiaries about 

their options. For example, beneficiaries would be assured 

that lower-priced plans did not achieve their savings 

through benefit exclusions that might be difficult for 

them to detect prior to enrollment. Third, standardization would prevent plans from structuring their benefit 

packages to achieve favorable risk selection. Although a 

premium support system should adjust payments to plans 

to account for differences in their enrollees’ health status, 

such adjustments are imperfect. Plans could therefore 

have an incentive to design their benefit packages to 

attract beneficiaries who are in good health and discourage enrollment by those with chronic conditions that are 

costly to treat.

A standard benefit package would specify detailed 

requirements regarding the scope and limits of covered 

benefits and cost-sharing requirements. Health benefits 

have many dimensions, however, and even under standardization, some variation would probably persist 

regarding what benefits were covered under what circumstances. For example, plans’ utilization management protocols determine the circumstances under which visits to 

specialists and other services are covered.

A standard benefit package would not have to be identical to the current Medicare benefit package. That package 

has several important limitations, including the absence 

of an annual cap on beneficiaries’ out-of-pocket costs and 

a complex set of cost-sharing requirements that does not 

give beneficiaries accurate signals regarding the costs of 

different types of care. A thorough evaluation and possible modification of the current Medicare benefit package 

would be an important element in the design of a premium support system. 

Standardization of benefits would have two major disadvantages. First, requiring all plans to offer the same benefit package would prevent them from implementing 

innovative benefit designs that might lead to more efficient delivery of care. For example, plans would be prevented from implementing alternative cost-sharing 

arrangements or more flexible benefits for managing 

patients’ care. Second, standardization would keep plans 

from offering benefit packages that some beneficiaries 

might prefer to a standard package specified by the federal government.

An alternative to benefit standardization is to give plans 

flexibility in their benefit design but require that their 

benefit packages be actuarially equivalent to a specified 

package.15 In a premium support system in which the 

government’s contribution is determined through competitive bidding, this alternative would help preserve the 

fairness of the bidding process. The requirement for actuarial equivalence could be specified in either of two general ways. The first approach would require that all private plans offer the same benefits as the FFS program, but 

plans could vary their cost-sharing requirements as long 

as they were actuarially equivalent to those of the FFS 

program. (The Medicare program has traditionally given 

private plans the flexibility to vary their cost-sharing 

requirements in this manner.) The second approach is to 

let plans vary their cost-sharing requirements and the 

scope and limits of covered benefits, as long as the actuar- 14. See Report to Congress by the Competitive Pricing Advisory Committee of the U.S. Department of Health and Human Services (January 

19, 2001). The advisory committee recommended a standard 

benefit package for the Medicare competitive-pricing demonstration for private health plans that was mandated by the BBA but 

never implemented. 

15. The federal government could be given the discretion to reject 

benefit designs that appeared likely to result in favorable risk 

selection.
22 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

ial value of their benefit package equaled that of the FFS 

program. The federal government could specify a set of 

services that plans were required to cover—and could 

perhaps specify minimum coverage requirements for 

those services—but the details would be left to the plans. 

Thus, plans could be given greater opportunity for innovation than if they were allowed to vary only their costsharing requirements.

Under the two approaches to determining actuarial 

equivalence, plans would be required to certify, and the 

federal government verify, that their benefit packages satisfied the necessary requirements. Actuarial projections 

pose a number of analytical challenges, however, and they 

are subject to error. In the proposed rule for the Medicare 

Advantage program, for instance, the Centers for Medicare and Medicaid Services presented three different 

methods for determining cost-sharing levels in private 

plans that are actuarially equivalent to those in the FFS 

program and acknowledged important limitations in the 

method that the agency had used previously.16 Furthermore, the potential for plans to manipulate their actuarial 

projections could raise questions about the fairness of the 

bidding process, because some plans might try to reduce 

their bids by offering benefit packages whose true actuarial values were less than the required level.

In a premium support system in which the government’s 

contribution is set at a predetermined amount, plans 

could be given even greater flexibility in their benefit 

designs. (Because the government’s contribution would 

not be determined through a formal bidding mechanism, 

one of the reasons for requiring actuarial equivalence 

would be eliminated.) The federal government would 

specify minimum coverage requirements, which would 

enable policymakers to ensure that all benefit packages 

met certain minimum standards. In principle, those standards could specify certain services that all plans were 

required to cover or could specify more-detailed coverage 

requirements by type of service (such as requirements 

concerning the number of inpatient hospital days that 

would be covered, along with any limitations on beneficiaries’ cost sharing). Decisions about minimum coverage 

requirements would depend in part on decisions about 

the federal government’s contribution amount, because 

beneficiaries’ access to coverage would depend on plans’ 

ability to offer benefit packages whose premiums did not 

greatly exceed the federal contribution. 

Supplemental Benefits

An important set of choices in designing a premium support system concerns the supplemental benefits that plans 

would offer to beneficiaries. The great majority of Medicare beneficiaries currently have supplemental coverage, 

which typically reduces their cost sharing on Medicare 

services and, in some cases, pays for some services that are 

not covered by Medicare. 

This section first examines how supplemental benefits 

might be offered under premium support and then looks 

at whether those benefits should be standardized, how 

outcomes under premium support could depend on the 

decisions of employers that offer supplemental coverage 

to their retirees, and how supplemental coverage could 

affect plans’ incentives to compete aggressively on their 

bids to provide Medicare benefits.

Supplemental Benefits Under Premium Support. Currently, the vast majority of enrollees in the fee-for-service 

program have supplemental insurance that covers much 

or all of Medicare’s cost-sharing requirements. Continuing supplemental coverage in its current form could put 

the FFS program at a competitive disadvantage relative to 

private plans, however, under a system of premium support. Generous or complete coverage of Medicare’s cost 

sharing increases spending in the FFS program because it 

largely negates one purpose of cost sharing, which is to 

give beneficiaries financial incentives to be judicious in 

their use of care. Thus, the FFS program’s bids under premium support would be higher than if beneficiaries faced 

greater cost sharing. The FFS program would be more 

competitive, and federal spending would be reduced, if 

restrictions were placed on the amount of Medicare’s cost 

sharing that could be covered by Medigap insurers and 

retiree plans.17

Private plans could be permitted to offer supplemental 

benefits under premium support in much the same manner as they do under current law. If a plan’s bid on the 

Medicare benefit package was below the benchmark, it 

16. Department of Health and Human Services, “Medicare Program; 

Establishment of the Medicare Advantage Program; Proposed 

Rule,” Federal Register, vol. 69, no. 148 (August 3, 2004),

pp. 46865–46914.

17. For an estimate of the federal savings that could be achieved 

by restricting Medigap coverage of Medicare’s cost sharing, see 

Congressional Budget Office, Budget Options (February 2005),

pp. 210–211.
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 23

could use some or all of the difference (depending on the 

program’s design) to reduce its enrollees’ premiums for 

Part B, Part D, or supplemental coverage. Under current 

law, private plans can prohibit their enrollees from 

obtaining supplemental coverage from another source. 

The advantage of maintaining that restriction under premium support is that plans could continue to use cost 

sharing as a means of reducing enrollees’ use of services 

that have low value relative to their cost. Allowing enrollees in private plans to obtain supplemental coverage from 

a third party would increase the plans’ costs of providing 

the basic Medicare benefit package. Unless plans were 

able to recover those costs from their enrollees through 

higher premiums on the basic Medicare package, the 

increased costs would result in higher bids and lower federal savings.

Standardization of Supplemental Benefits. Standardization of supplemental benefits would be appropriate under 

a premium support system only if the Medicare benefit 

package was standardized. A standard package of supplemental benefits could include a schedule of cost-sharing 

requirements that are lower than those in the standard 

Medicare package and a cap on cost sharing (if such a cap 

was not included in the Medicare package).

The advantages and disadvantages of standardizing supplemental benefits are analogous to those discussed above 

for the Medicare benefit package. Standardizing supplemental benefits would reinforce some of the advantages 

of standardizing the Medicare benefit package. Conversely, not standardizing supplemental benefits would 

lessen some of the advantages of standardizing the Medicare benefit package. For example, allowing plans to vary 

their supplemental packages could result in widely varying cost-sharing requirements for Medicare benefits even 

though those requirements were standardized in the 

underlying Medicare benefit package.

Coverage for Retirees. The effects of premium support 

would depend in part on the response of employers that 

provide health care coverage to their retirees. Most 

employers that provide such coverage offer their retirees 

a limited choice of plans. According to one recent study, 

46 percent of large private employers that provide coverage to their Medicare-eligible retirees offer only one plan, 

and 23 percent offer a choice of only two plans.18 The 

most commonly offered types of plans are those that supplement benefits in the FFS program, although an estimated 43 percent of large employers offer one or more 

Medicare Advantage plans. If employers offered a limited 

set of plan options under premium support, their 

employees would be constrained in their ability to 

respond to incentives created by the new program.

Implications for Plans’ Bidding Incentives. In a premium 

support system based on competitive bidding, plans 

should be given an incentive to submit bids that reflect 

their costs of efficiently providing Medicare benefits. 

That incentive could be reduced, however, if plans competed on the basis of their total premium for a combined 

package of Medicare benefits and supplemental benefits. 

Under some program designs, plans could have an incentive to inflate their Medicare bids and reduce their premiums for supplemental benefits by an equivalent amount, 

thereby shifting some of the costs for supplemental benefits from beneficiaries to the government.19 For example, 

plans would have such an incentive in a program in 

which enrollees in plans whose bids are below the benchmark receive a rebate that is only a portion of the difference between the bid and the benchmark. Under that 

type of program, a plan that raised its bid for Medicare 

benefits by $1 would reduce its enrollees’ rebate by less 

than $1, while the full amount of the $1 reduction in its 

premium for supplemental benefits would be passed on 

to enrollees as savings (see Box 3-2).

That concern about plans’ inflating their Medicare bids 

could be addressed in several ways. One approach would 

be to set the rebate equal to the entire difference between 

the benchmark and the bid, or to a relatively high percentage of that difference, which would reduce the incentive for plans to inflate their Medicare bids. A second 

approach would be for the federal government to review 

plans’ bids and their supplemental premiums for actuarial 

soundness, as it does under the Medicare Advantage 

program. Although it is likely that such reviews would 

identify plans that inflated their Medicare bids by 

large amounts, plans that inflated their bids by smaller 

amounts could go undetected because of the uncertainty 

surrounding actuarial projections.

18. Kaiser Family Foundation, Current Trends and Future Outlook 

for Retiree Health Benefits: Findings from the Kaiser/Hewitt 2004 

Survey on Retiree Health Benefits (December 2004).

19. Plans would have this incentive only if the vast majority of beneficiaries continued to want supplemental coverage under premium 

support, which would be likely unless the basic Medicare benefit 

package was expanded to reduce beneficiaries’ cost sharing (for 

example, by including a cap on beneficiaries’ annual out-of-pocket 

costs).
24 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Box 3-2.

Illustration of Plans’ Incentives to Inflate Their Medicare Bids

In a premium support system based on competitive 

bidding, plans could have incentives to inflate their 

Medicare bids. As an example, consider a hypothetical county in which one private plan would compete 

with the fee-for-service (FFS) program. Assume that 

the plan would submit a bid of $700 per month to 

provide the Medicare benefit package if it was competing for enrollees strictly on the basis of the cost of 

that package and that the average FFS expenditure in 

the county would be $800. Also assume that the 

benchmark would be set equal to the median of the 

two bids ($750). Beneficiaries in the FFS program 

would pay an additional premium for their Medicare 

coverage equal to the difference between the FFS bid 

and the benchmark, or $50 per month, which would 

increase their monthly Medicare premium from 

$88.50 (the national Part B premium in 2006) to 

$138.50. Assume that the rebate for enrollees in the 

private plan would be 75 percent of the difference 

between the plan’s bid and the benchmark, or 

$37.50, which would reduce their Medicare premium to $51, or $87.50 less than the premium paid 

by enrollees in the FFS program (see the first column 

of the table at right).

Next, assume that the private plan would offer 

supplemental benefits for which it would charge a 

monthly premium of $100. It would offer Medicare 

benefits and supplemental benefits as a unified package for which the net cost to beneficiaries would be 

$151 per month.1

 Beneficiaries in the FFS program 

who bought supplemental insurance for a monthly 

premium of $100 would face a total cost of $238.50 

per month.2 Thus, the total premium for Medicare 

benefits and supplemental benefits would be $87.50 

less in the private plan than in the FFS program.

If the private plan inflated its Medicare bid by $20 

and reduced its premium for supplemental benefits 

by $20 (without changing its benefit package), its 

monthly premium for Medicare and supplemental 

benefits would be $90 less than the cost of such coverage in the FFS program—rather than the $87.50 

difference that would prevail otherwise (see the first 

column of the table at right). Thus, the plan’s total 

premium for Medicare and supplemental benefits relative to that of the FFS program would be reduced by 

$2.50.3 That outcome stems from the fact that only 

part of the $20 increase in the plan’s Medicare bid 

would be translated into an increase in its Medicare 

premium relative to that of the FFS program, because 

the forgone rebate would be 75 percent (rather than 

100 percent) of the reduction in the difference 

between the plan’s bid and the benchmark. Conversely, the entire $20 reduction in the premium for 

supplemental benefits would be passed on to beneficiaries. The plan could realize an even greater reduction in its total premium relative to that of the FFS 

program by inflating its Medicare bid and reducing 

its premium for supplemental benefits by higher 

amounts.

In general, the greater the percentage of the difference 

between the bid and the benchmark that is given to 

beneficiaries as a rebate, the lower the incentive for 

plans to inflate their Medicare bids. In the previous 

example, if the rebate was set equal to the entire difference between the benchmark and the bid, the private plan’s total premium for Medicare benefits and 

supplemental benefits would be $100 less than the 

total premium for such coverage in the FFS program, 

regardless of whether the plan inflated its Medicare 

bid (see the second column of the table at right). 

1. The total premium of $151 is equal to the $88.50 national 

Part B premium plus the $100 premium for the supplemental benefits minus the $37.50 rebate.

2. The assumption that enrollees in private plans and those in 

the FFS program both demand $100 of supplemental benefits was made to simplify the comparisons. It does not affect 

the basic conclusions of this example.

3. Moreover, the total premium for Medicare and supplemental 

benefits in the plan relative to the premium that a beneficiary 

would face in the FFS program without supplemental benefits would also be reduced by $2.50. Thus, the plan would 

become more attractive to beneficiaries who otherwise would 

have remained in the FFS program without supplemental 

insurance.
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 25

Box 3-2.

Continued

An Example of the Incentive for Plans to Inflate Their Bids

Source: Congressional Budget Office.

Notes: FFS = fee for service; n.a. = not applicable.

This hypothetical example focuses on a county in which one private plan is assumed to participate in Medicare. The benchmark is computed as the median of the bids of the private plan and the FFS program.

The estimates in the column labeled "75 Percent Rebate" were calculated under the assumption that the rebate for enrollees 

in the private plan is 75 percent of the difference between the plan's bid and the benchmark. The estimates in the column 

labeled “100 Percent Rebate” were calculated under the assumption that the rebate for enrollees in the private plan is equal 

to the entire difference between the plan's bid and the benchmark.

From that perspective, plans would be indifferent to 

inflating their Medicare bid or submitting a true bid. 

However, by inflating their Medicare bid, plans could 

reduce the total dollar cost of Medicare benefits and 

supplemental benefits for their enrollees (from 

$138.50 to $128.50 in the example), although the 

total dollar cost of such benefits in the FFS program 

would be reduced by the same amount (from 

$238.50 to $228.50). Plans might pursue a strategy 

of inflating their bid if they considered it advantageous to market their combined package of Medicare 

and supplemental benefits as being available for less 

than a certain dollar amount.

Medicare Benefits

Bid 700.00 700.00 800.00

Benchmark 750.00 750.00 750.00

National Part B premium 88.50 88.50 88.50

Premium adjustment (rebate or

surcharge) -37.50 -50.00 50.00

Premium for Supplemental

Benefits 100.00 100.00 100.00

Premium for Medicare and 

Supplemental Benefits 151.00 138.50 238.50

Premium for Private Plan 

Relative to FFS Program -87.50 -100.00 n.a.

Medicare Benefits

Bid 720.00 720.00 800.00

Benchmark 760.00 760.00 760.00

National Part B premium 88.50 88.50 88.50

Premium adjustment (rebate or

surcharge) -30.00 -40.00 40.00

Premium for Supplemental

Benefits 80.00 80.00 100.00

Premium for Medicare and 

Supplemental Benefits 138.50 128.50 228.50

Premium for Private Plan

Relative to FFS Program -90.00 -100.00 n.a.

Private Plan's Bid, Inflated

75 Percent Rebate 100 Percent Rebate FFS Program

Bids Based on Plan's Best Estimate of Costs

(Dollars)

Private Plan, Under Alternative

Assumptions About Size of Rebate
26 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Another possible approach would be to penalize plans 

with high bids on the Medicare benefit package. For 

example, in market areas with a large number of plans, 

the government could select only the lowest bidders for 

participation in the program and exclude the others. Such 

a policy would not only focus the competition on plans’ 

Medicare bids but would also add another layer of competition that could cause plans to lower their bids. Two 

drawbacks to this approach are that it would only be feasible in market areas with multiple bidders and that it 

would limit beneficiaries’ choice of plans.

A fourth possible approach would be to prohibit plans 

from offering supplemental benefits, which would focus 

the competition strictly on the Medicare benefit package. 

The elimination of supplemental benefits would increase 

the financial risk facing Medicare beneficiaries, however. 

That risk could be substantially reduced by restructuring 

Medicare’s cost-sharing requirements to include a cap on 

beneficiaries’ annual out-of-pocket expenses.

Other Design Issues

Other issues that would have to be addressed in designing 

a premium support system for Medicare include the 

structure of the incentives that beneficiaries would face, 

the adjustment of payments to plans to account for differences in their enrollees’ health status, the dissemination of information to beneficiaries, the geographic 

definition of bidding areas, and possible subsidies for 

low-income beneficiaries.

Beneficiaries’ Incentives

In a premium support system based on competitive bidding, beneficiaries who enroll in plans whose bids are 

above the benchmark would be required to pay the entire 

difference between the bid and benchmark as an additional premium for their Medicare coverage. Beneficiaries 

who enroll in plans whose bids are below the benchmark 

could be given a rebate equal to a certain percentage of 

the difference between the bid and the benchmark. That 

enrollee rebate percentage could range from zero to 

100 percent. In the premium support demonstration that 

was mandated by the MMA, the rebate will be 75 percent 

of the amount by which the benchmark exceeds the plan’s 

bid.

It is unclear what enrollee rebate percentage would minimize federal spending. On the one hand, increasing the 

percentage of the rebate kept by enrollees would 

strengthen the incentive for beneficiaries to enroll in lowbidding plans and thus strengthen the incentive for plans 

to submit low bids. Those factors could reduce the 

benchmarks and thus reduce federal spending. On the 

other hand, decreasing the percentage of the rebate kept 

by enrollees would allow the federal government to capture more of the savings when beneficiaries switched to 

lower-cost plans. The effect of different rebate percentages on federal spending would depend on the responses 

of health plans and beneficiaries to the change in incentives, and there is little experience from which to predict 

those responses.

Risk Adjustment

A mechanism for adjusting payments to plans to account 

for differences in the health status of their enrollees 

would be an important element of a premium support 

system. If payments to plans were not adequately 

adjusted to account for differences in the expected costs 

of their enrollees, plans would have a strong incentive to 

discourage enrollment by beneficiaries with costly 

chronic conditions. Plans could design their benefit packages to discourage such beneficiaries from enrolling (if 

benefits were not standardized) or could exclude from 

their networks providers who are highly regarded for 

treating certain high-cost conditions. Plans could also 

impose stringent utilization controls to limit access to 

certain specialists, which would in all likelihood encourage their costliest enrollees to switch to other plans at the 

next open enrollment period.

Inadequate risk adjustment could also distort the competition between private plans and the traditional fee-forservice Medicare program. Medicare spending is highly 

concentrated in a relatively small proportion of the beneficiary population.20 If the FFS program attracted enrollees who were sicker and had higher health care costs than 

average—and such differences were not adequately 

accounted for in determining payments to plans—then 

beneficiaries’ premiums for the FFS program would be 

higher as a result. Those higher premiums could discourage beneficiaries from enrolling in the FFS program, even 

if that program was able to provide Medicare benefits at 

the same cost as private plans for the same set of enrollees. 

20. In 2001, the costliest 5 percent of beneficiaries enrolled in the FFS 

program accounted for 43 percent of total spending, and the costliest 25 percent accounted for 85 percent of total spending. See 

Congressional Budget Office, High-Cost Medicare Beneficiaries

(May 2005).
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 27

One way to determine payments to plans under premium 

support would be to use the risk-adjustment mechanism 

that the federal government has developed for the Medicare Advantage program, which is based on the Hierarchical Condition Codes model. As in the Medicare 

Advantage program, plans could be asked to submit bids 

for a standard beneficiary. The government would compare those bids with the standardized benchmark to 

determine whether the plan would be allowed to offer a 

rebate or whether it would be required to charge beneficiaries an additional premium for their Medicare coverage. In determining the government’s payment to each 

plan, each plan’s standardized bid would be multiplied by 

its risk score to compensate for differences across plans in 

the health status and other characteristics of their enrollees. As noted in Chapter 2, it would be important for the 

government to determine whether risk scores are biased 

because of differences between private plans and FFS providers in their diagnostic coding practices and to make 

appropriate adjustments if such biases are found.

Even after adjusting for differences in coding practices, 

however, existing risk-adjustment mechanisms are imperfect, and the implications for a premium support system 

would need to be considered carefully. Current riskadjustment systems tend to overpredict the costs of beneficiaries who end up with low health care spending and to 

underpredict the costs of those who end up with high 

spending.21 If those differences are systematic, they could 

cause premiums for enrollees in plans that attract highercost beneficiaries to rise substantially over time.22

Dissemination of Information

Educating beneficiaries about their choices under a premium support system would be challenging, in part 

because the Medicare population has a higher prevalence 

of frailty and cognitive limitations than the general population. The government faces a similar challenge in educating beneficiaries and their caregivers about their 

options under the current Medicare Advantage program 

and the new prescription drug benefit.

The federal government could educate beneficiaries 

about their choices under premium support using the 

methods it has traditionally used for the Medicare Advantage program as well as the additional methods it developed for the prescription drug benefit. In the past, the 

government has informed beneficiaries about their 

options under the Medicare Advantage program using a 

federally funded toll-free telephone information service; 

marketing information disseminated by plans (which 

must be approved in advance by the government); the 

State Health Insurance Assistance Program, which provides in-person counseling and other assistance to Medicare beneficiaries and their caregivers through funds provided by federal, state, and local governments; and a 

government Web site that compares the premiums and 

benefits of competing plans. Moreover, the government 

collects and disseminates information on the quality of 

care provided by participating plans to assist beneficiaries 

in selecting a plan.

To inform beneficiaries of their options under the prescription drug benefit that went into effect in 2006, the 

government supplemented the approaches it has traditionally used for the Medicare Advantage program with 

more personalized approaches. Those approaches were 

designed to reach a wider audience and to target certain 

populations, such as low-income beneficiaries, the homebound, those who live in rural areas, and those with limited English language skills.23 For example, the Medicare 

program developed partnerships with senior citizens’ 

organizations, community centers, churches, civic and 

social organizations, and state and local governments to 

develop a network of trained volunteers to educate beneficiaries about the new drug benefit and help them enroll. 

The Medicare program also held numerous outreach 

events throughout the country to inform beneficiaries 

about the new benefit.

The government could build on the approaches it developed for the Medicare Advantage program and the prescription drug benefit to inform beneficiaries about their 

options under a premium support program. Even so, 

many beneficiaries and their caregivers may have limited 

21. See Medicare Payment Advisory Commission, Report to the

Congress: Issues in a Modernized Medicare Program (June 2005),

pp. 52–53.

22. For an illustration of how inadequate risk adjustment could lead 

to higher premiums for beneficiaries in the FFS program under 

premium support, see Thomas Rice and Katherine A. Desmond, 

“The Distributional Consequences of a Medicare Premium Support Proposal,” Journal of Health Politics, Policy, and Law, vol. 29, 

no. 6 (December 2004), pp. 1187–1226.

23. Statement of Mark B. McClellan, Administrator, Centers for 

Medicare and Medicaid Services, before the House Committee on 

Ways and Means (June 14, 2006). 
28 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

understanding of the consequences of their enrollment 

decisions under such a program, particularly in the initial 

years of the program. Confusion and lack of knowledge 

could lead some beneficiaries to enroll in plans whose 

premiums are much higher than they anticipated. That 

risk could be lessened through a phased implementation 

of premium support, which would give beneficiaries and 

their caregivers time to adjust to the new system. For 

example, in a premium support system based on competitive bidding, benchmarks in the first year could be constrained not to fall below average FFS expenditures by 

more than a specified percentage, and benchmarks in 

subsequent years could be similarly constrained (with the 

constraints gradually phased out). Plans whose bids were 

below the constrained benchmark could be permitted to 

offer premium rebates or additional benefits, which 

would preserve their incentive to submit low bids. 

Defining Market Areas Under Premium Support

Another design choice for a premium support system is 

whether benchmarks would be set at the county level, as 

they are in the Medicare Advantage program, or whether 

they would be set for broader geographic areas. The 

Medicare Payment Advisory Commission (MedPAC) has 

recommended that the government establish payment 

areas for the Medicare Advantage program that are larger 

than counties.24 In particular, MedPAC recommended 

that payment areas for the Medicare Advantage program 

be collections of counties that are in the same state and 

the same metropolitan statistical area. For counties that 

are outside metropolitan areas, MedPAC recommended 

that payment areas be collections of counties in the same 

state that are accurate reflections of health care market 

areas.

In making those recommendations, MedPAC pointed to 

two limitations of counties as payment areas for the 

Medicare Advantage program. First, in counties with 

small Medicare populations, the government’s projection 

of per capita spending in the FFS program (which is used 

in constructing benchmarks) can vary dramatically from 

year to year.25 Second, projected per capita FFS spending 

often differs greatly among adjacent counties within a 

metropolitan area, leading plans to avoid serving some of 

those counties or offering lower benefits in them.

In principle, the bidding areas in a premium support 

system (which would also be the areas for which benchmarks would be established) could be defined as counties 

or as collections of counties, such as those recommended 

by MedPAC for the Medicare Advantage program. If bidding areas were defined as collections of counties, they 

should closely match the service areas of private plans. 

Even so, policymakers would have to decide whether to 

allow plans to participate in Medicare if they were capable of serving only a portion of a defined bidding area. 

Not allowing such plans to participate could limit beneficiaries’ choice of plans and limit the competitiveness of 

the market. But allowing plans to participate in only 

some counties within a bidding area would raise questions about how to adjust for the fact that average Medicare spending in those counties may differ substantially 

from average spending in the entire bidding area. Such 

differences should be taken into account when using 

plans’ bids to compute benchmarks. Adjustments would 

also be needed when comparing such a plan’s bid to the 

benchmark to determine the amount of any premium 

rebate or surcharge for its enrollees.

Subsidies for Low-Income Beneficiaries

In a premium support system in which beneficiaries’ premiums could increase substantially in certain geographic 

areas, the government may need to provide subsidies to 

low-income beneficiaries. Currently, certain Medicare 

beneficiaries who are very poor or who spend a substantial portion of their income on medical care qualify for 

full Medicaid coverage, which not only pays their Medicare premiums and cost-sharing amounts but also covers 

certain services that are not covered by Medicare, such as 

long-term care. Other poor Medicare beneficiaries with 

somewhat higher income have more limited Medicaid 

benefits, consisting of payments to cover Medicare’s premiums and cost sharing or the premiums only.

Subsidies for low-income beneficiaries in a premium support system could be specified in various ways that would 

depend in part on how the government’s contribution 

was determined. For example, in a system in which the 

24. Medicare Payment Advisory Commission, Report to the Congress: 

Issues in a Modernized Medicare Program, pp. 41–52.

25. Large year-to-year variation in those projections can occur 

in counties with relatively few beneficiaries, even though the 

projections are based on a five-year moving average of per capita 

spending at the county level. In counties with small Medicare 

populations, modest changes in the number of beneficiaries who 

have very high expenses can result in substantial changes in the 

estimated average spending in the county.
CHAPTER THREE ISSUES IN DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE 29

benchmark in each market area was determined from the 

average or median bid in the area, one approach would be 

for Medicaid to pay the Medicare premiums of beneficiaries who would have qualified for such assistance under 

current law, as long as they enrolled in a plan whose bid 

was equal to or below the benchmark. Depending on the 

program’s design, such beneficiaries could receive a rebate 

if they enrolled in a plan whose bid was below the benchmark, but they would have to pay a premium surcharge 

(just like all other beneficiaries) if they enrolled in a plan 

whose bid was above the benchmark. That approach 

could also be applied in a program in which benchmarks 

were set equal to the minimum bid in each market area. 

In areas where spending in the FFS program is high, such 

a program would provide strong incentives for lowincome beneficiaries to enroll in the lowest-cost private 

plan. As discussed previously, close federal monitoring of 

such plans would be needed to ensure that they provided 

care of acceptable quality.

In a premium support system in which benchmarks are 

determined from the national average bid, or in a system 

in which the government’s contribution is set at a predetermined amount, the only plans available in some 

market areas might require higher premiums from beneficiaries than would have been required for the traditional 

program under current law. Careful consideration would 

have to be given to the design of low-income subsidies in 

such market areas. For example, one approach would be 

for Medicaid to pay an estimate of the Part B premium 

that would have prevailed under current law for beneficiaries who would have qualified for such assistance. The 

federal government could provide additional assistance to 

ensure that low-income beneficiaries had at least one plan 

available at no out-of-pocket premium. The federal costs 

of providing such assistance would depend on how the 

program was structured.

Under any type of premium support system, coordination of low-income subsidies for Parts A and B of Medicare with low-income subsidies under the prescription 

drug benefit (Part D) would require attention. Because 

plans would submit separate bids for the basic Medicare 

benefit package and for the prescription drug benefit, 

rules would have to be developed for determining the 

subsidies that would be available to low-income beneficiaries in plans whose bids were low enough for their 

enrollees to qualify for low-income subsidies for the basic 

benefit package or the drug benefit, but not both.

CHAPTER

4

Health Care Systems That Are

Similar to Premium Support

Premium support would establish the government’s 

contribution toward the cost of Medicare coverage using 

methods that are similar to those used by the health benefits programs of some large employers. Although Medicare differs from employment-based insurance in some 

important ways, the experiences of those employers provide lessons for designing a premium support system for 

Medicare and for assessing the potential effects of such a 

system. This chapter examines evidence from the research 

literature on two types of employment-based systems that 

are similar to premium support: the “managed competition” purchasing strategy and the Federal Employees 

Health Benefits program.

Managed Competition

Managed competition is a purchasing strategy that creates 

incentives for consumers to be cost-conscious in their 

choice of health plans and for plans to compete on the 

basis of premiums and quality of care. Alain Enthoven 

and others have developed a managed competition purchasing model that includes a detailed set of recommendations.1 Two key recommendations are that employers 

should offer a choice of health plans and that they should 

make a fixed-dollar contribution toward all employees’ 

premiums that is no greater than the premium of the 

lowest-priced plan offered. Employees, therefore, would 

bear the full cost of any difference in premiums across 

plans.

Employers that use this general approach vary in the 

extent to which they have adopted the other features of 

the model. Those other features call for employers to 

measure the quality of care provided by plans and disseminate that information to employees, define a standard 

benefit package that all plans must offer, and adjust premium payments to plans to account for differences in the 

health status of their enrollees. Standardization of the 

benefit package is intended to facilitate premium comparisons by employees and to prevent plans from structuring their benefits to achieve favorable risk selection.

Most employers do not currently use the principles of 

managed competition to purchase health insurance benefits for their employees. According to one recent study, 

only about one-quarter of Fortune 500 companies make 

fixed-dollar contributions to their employees’ insurance 

premiums.2 Instead, most companies seek to contain 

health care costs primarily through competition at the 

stage at which plans vie to be selected by the employer 

rather than the stage at which employees select plans.

Mechanisms to Potentially Reduce 

Health Care Spending 

The effect of managed competition on health care spending depends in large part on the alternative system with 

which it is compared. Many employers contribute a larger 

dollar amount when their employees choose a plan with

a higher premium—for example, by paying the entire 

premium or paying a fixed percentage of the premium. 

Replacing that type of system with managed competition 

could reduce total spending on health care through two 

mechanisms: encouraging employees to switch from 

higher-cost plans to lower-cost plans and inducing plans 

1. See Alain C. Enthoven, “The History and Principles of Managed 

Competition,” Health Affairs, supplement (1993), pp. 24–48. To 

simplify the discussion, this study refers to the entity that sponsors 

managed competition as an employer. Other entities, such as purchasing alliances, can also act as sponsors.

2. See James Maxwell and Peter Temin, “Managed Competition Versus Industrial Purchasing of Health Care Among the Fortune 

500,” Journal of Health Politics, Policy, and Law, vol. 27, no. 1 

(2002), pp. 5–30.
32 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

to reduce their premiums through greater price

competition.3

A simple example is useful for illustrating the incentives 

that managed competition creates for employees and 

plans. Assume that prior to implementing managed competition, an employer paid 80 percent of the total premium for each employee (the so-called 80 percent contribution rule), regardless of the plan chosen. An employee 

who chose a plan with a total premium of $4,000 would 

pay $800 (or 20 percent of $4,000), while an employee 

who chose a plan with a total premium of $5,000 would 

pay $1,000. Although the total premium of the more 

expensive plan is $1,000 more than that of the less expensive plan, the price difference facing the employee is only 

$200. In contrast, under managed competition, an 

employee would face the full $1,000 price difference 

between the two plans and would therefore have a much 

stronger incentive to choose the lower-cost plan. Making 

employees face the full difference in premiums could also 

give plans a greater incentive to contain costs. Under the 

80 percent contribution rule, if a plan implemented costsaving mechanisms that enabled it to lower its premium 

by $100, the price to employees for the plan would fall by 

only $20. Under managed competition, however, the 

price to employees would fall by the full $100, which 

could give the plan a greater expected increase in enrollment in return for its cost-saving initiative.

The effect of managed competition on an employer’s 

health care costs depends in part on the level at which it 

sets the fixed-dollar contribution and how that compares 

with its previous contribution formula. An employer can 

reduce its health care costs by setting its premium contribution sufficiently low. If total health care costs are not 

reduced, however, such a policy would simply shift costs 

from the employer to its employees.

Evidence on the Effects of Managed Competition 

Evidence on the effects of managed competition on 

health care costs is limited. A few studies have conducted 

in-depth analyses of particular employers that implemented managed competition. Other studies have compared employers that make fixed-dollar contributions to 

their employees’ insurance premiums with employers that 

use other contribution formulas. Both types of studies 

have estimated the effect of managed competition on 

total health care spending, not merely its effect on 

employers’ spending.

Several conclusions can be drawn from the available 

research on managed competition. First, managed competition reduces total spending on health care, when 

compared with systems in which employers subsidize the 

purchase of more expensive plans. Second, the introduction of managed competition often leads large numbers 

of employees to switch to lower-cost plans, which is an 

important source of the cost reductions. Little information is available on whether managed competition leads 

plans to reduce their premiums. Third, there is insufficient evidence to conclude that managed competition can 

reduce the growth of health care costs. Fourth, for the 

most expensive plans, managed competition can trigger 

“adverse selection spirals” in which successive waves of 

relatively healthy employees “disenroll,” leaving only the 

sickest employees enrolled. In some cases, employers have 

dropped such plans because their premiums skyrocketed 

and their enrollments plummeted. (Those employers did 

not adjust premium payments to plans to account for differences in enrollees’ health status; still, it is not known 

whether the more expensive plans would have survived 

even if the premium payments had been adjusted for 

risk.)

Distinguishing between the effects on levels of health care 

costs and the effects on the long-term growth of those 

costs is important when evaluating managed competition 

or other policies designed to contain costs.4

 Managed 

competition could reduce the level of costs through the 

mechanisms noted above. Reducing the long-term 

growth of costs is more difficult. Studies have concluded 

that the major factor contributing to the growth of health 

care costs is the development and use of new medical 

technology, which has been fueled in part by the prevalence of health insurance that gives patients and providers

3. Total spending on health insurance premiums includes both the 

employer’s portion and the employee’s portion.

4. Some policies may reduce the level of costs but may not affect the 

long-term growth of costs (even though it may appear so in the 

first few years of implementation, as spending adjusts to the new, 

lower level). Such policies would yield a permanent reduction in 

the level of costs, but after adjusting to the lower level, costs would 

continue growing at the same rate as before. Policies that reduce 

both the level of costs and their rate of growth offer the greatest 

potential to contain costs over the long term.
CHAPTER FOUR HEALTH CARE SYSTEMS THAT ARE SIMILAR TO PREMIUM SUPPORT 33

little incentive to contain costs.5 That evidence suggests 

that if managed competition was to reduce the long-term 

growth of health care costs to an appreciable extent, it 

would have to alter the incentives facing individuals, 

health plans, and providers in such a way as to reduce the 

growth in the development and use of new medical technology. The evidence presented below, although limited, 

suggests that the adoption of managed competition by a 

minority of employers has not had that effect. Some analysts maintain that managed competition could reduce 

the long-term growth of health care costs if it was 

adopted by a sufficiently large number of employers, but 

there is currently no evidence to support that contention.6

Studies of Particular Employers. Some of the best evidence on managed competition comes from in-depth 

studies of particular employers. Although those studies 

are informative, they do not provide sufficient evidence 

to quantify the effects of implementing managed competition on a broader scale. In studies that focus on a single 

employer, the results depend heavily on circumstances 

that are unique to that employer, such as the nature of the 

contribution formula that was used before managed competition was implemented, the level at which the fixeddollar contribution is set, the number and types of health 

plans that are offered, the characteristics of the local 

health care market, and the characteristics of the employees (in particular, their responsiveness to differences in 

premiums when choosing among health plans). To date, 

employer-specific studies of managed competition have 

focused on a limited range of employers (universities 

and state governments) that are not representative of all 

employers nationally. Moreover, studies that focus on a 

single employer face a difficult challenge in estimating the 

total health care spending that would have prevailed at 

that employer in the absence of the change in policy. 

Some studies have used spending per employee at other 

local employers or national average spending for that purpose, but there is a risk that the observed differences in 

spending may at least partly reflect underlying differences 

between employers and their workforces.

The State of Wisconsin. One study examined the experiences of the state of Wisconsin when it implemented a 

managed competition system for its employees in 1984.7

In the first year under the new policy, the change in relative premiums facing employees prompted a dramatic 

shift in enrollment from indemnity plans to health maintenance organizations, increasing the share of employees 

who were enrolled in HMOs from 21 percent to 

85 percent. The study compared premium trends for 

state employees with national premium trends for 

employment-based insurance during the two years before 

the policy change and the next nine years, using statistical 

methods to adjust for differences in demographic characteristics and benefits. The study concluded that, largely 

because of the shift in enrollment to lower-cost plans, 

total health care spending per employee fell in the first 

two years under the new system. After falling to a lower 

level, health care spending for state employees continued 

growing at a rate similar to national trends.

The state of Wisconsin set its premium contribution 

equal to 105 percent of the premium of the lowest-priced 

plan. Thus, plans whose premiums did not exceed the 

premium of the lowest-priced plan by more than 5 percent were available at no cost to employees. In general, 

that approach is expected to yield a smaller reduction in 

health care spending than would be achieved if the 

employer’s contribution was set at or below the premium 

of the lowest-priced plan, because it gives weaker incentives for employees to select the lowest-priced plan and 

for plans to compete to be the lowest-priced plan. In the 

other employer-specific studies discussed next, the 

employers set their contributions at or below the premium of the lowest-priced plan.

Various Universities. Several studies have examined the 

experiences of universities that implemented managed 

competition systems for their employees. In each case, a 

substantial number of employees switched to lower-cost 

plans under managed competition. At the University of 

California, about half of the employees who had been 

enrolled in indemnity plans switched to a lower-cost plan 

in the first year under the new system (1994), when the 

employee premiums for the indemnity plans increased

5. Michael E. Chernew and others, “Managed Care, Medical 

Technology, and Health Care Cost Growth: A Review of the 

Evidence,” Medical Care Research and Review, vol. 55, no. 3 

(September 1998), pp. 259–288.

6. For example, see Alain C. Enthoven and Brian Talbott, “Stanford 

University’s Experience with Managed Competition,” Health 

Affairs, vol. 23, no. 6 (November/December 2004), pp. 136–140. 

7. See Steven C. Hill and Barbara L. Wolfe, “Testing the HMO 

Competitive Strategy: An Analysis of its Impact on Medical

Care Resources,” Journal of Health Economics, vol. 16, no. 3 

(June 1997), pp. 261–286.
34 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

substantially.8 Many employees also switched from 

higher-cost HMOs to lower-cost HMOs. After factoring 

out the effects of general inflation, the study found that 

such switching caused total health care spending per 

employee to fall by about 6 percent in the first year under 

the new policy and by an additional 1 percent in the second year.9 The study was not able to determine whether 

managed competition led to additional savings by inducing plans to reduce their premiums. The university 

implemented managed competition at a time of intense 

competition among health plans in California, which led 

to declining premiums statewide.

A study of Harvard University’s implementation of managed competition in 1995 concluded that increased price 

competition led plans to reduce their premiums. The 

study estimated that those premium reductions lowered 

health care spending per employee by about 5 percent to 

8 percent in the first year, and spending remained at that 

lower level in the following two years.10 That estimate 

does not include spending reductions that were generated 

as a result of employees’ switching to lower-cost plans and 

therefore does not measure the total reduction in health 

care spending at Harvard.11 The study estimated the 

effects of increased competition by comparing the growth 

of premiums per employee at Harvard with the growth of 

premiums at other local employers during the four years 

prior to the policy change and the following three 

years (and excluding changes in spending that resulted 

from plan switching). Because premiums were analyzed 

for a relatively short period following the policy changes 

at Harvard and the University of California, the longterm effects of those changes are not known.

Stanford University implemented a managed competition 

system for its employees in 1992. A recent study found 

that from 1999 to 2004, the premiums of the plans 

offered by Stanford grew at approximately the same rate 

as the premiums charged to other employers in the 

region.12 That evidence suggests that managed competition has not reduced the long-term growth of health care 

spending at Stanford.

At both the University of California and Harvard University, the adoption of managed competition triggered an 

adverse selection spiral for the most expensive plans 

offered (an indemnity plan at California and a preferred 

provider organization at Harvard). In each case, the university dropped the plan from its menu. Like many 

employers that use managed competition, the two universities did not adjust their payments to plans to account 

for differences in the health status or other characteristics 

of enrollees. In principle, a well-designed risk adjuster 

could minimize or even eliminate adverse selection spirals.13 Risk adjustment to account for differences in 

enrollees’ health status is imprecise, however. The Medicare program has been in the forefront of the development of risk-adjustment methods and, as noted previously, has developed a risk adjuster for the Medicare 

Advantage program that uses beneficiaries’ diagnoses and 

demographic characteristics to adjust payments to private 

plans. 

Other Studies. A few other studies have estimated the 

effects of managed competition by comparing health care 

spending at employers that make a fixed-dollar contribution toward their employees’ insurance premiums with 

employers that subsidize their employees’ purchase of 

more-expensive plans. Those studies use statistical methods to control for differences in the characteristics of 

employers that use different contribution methods, in an 

effort to remove the influence of those factors from the 

comparison of health care spending. Such studies have 

concluded that a fixed-dollar contribution reduces total 

health care spending per employee. For example, one 

8. Thomas C. Buchmueller and Paul J. Feldstein, “The Effect of 

Price on Switching Among Health Plans,” Journal of Health 

Economics, vol. 16, no. 2 (April 1997), pp. 231–247.

9. Thomas C. Buchmueller, “Does a Fixed-Dollar Premium 

Contribution Lower Spending?” Health Affairs, vol. 17, no. 6 

(November/December 1998), pp. 228–235. 

10. David M. Cutler and Sarah J. Reber, “Paying for Health Insurance: The Trade-Off Between Competition and Adverse Selection,” Quarterly Journal of Economics, vol. 113, no. 2 (May 1998), 

pp. 433-466.

11. The authors of the study removed the estimated spending reduction that resulted from employees’ switching plans (which they 

did not report separately) to estimate the effect of the policy 

change on the premiums that health plans charged.

12. Enthoven and Talbott, “Stanford University’s Experience with 

Managed Competition.”

13. There is no guarantee that even accurate risk adjustment would 

have prevented the loss of the higher-cost plans from the Harvard 

and University of California systems, however. To the extent that 

the higher-cost plans encouraged excessive utilization of services, 

the risk-adjusted premiums may have been so high that few, if any, 

employees would have enrolled. 
CHAPTER FOUR HEALTH CARE SYSTEMS THAT ARE SIMILAR TO PREMIUM SUPPORT 35

study estimated that city and county governments that 

make a fixed-dollar contribution toward their employees’ 

health insurance premiums reduce their total health care 

spending by about 6 percent to 7 percent.14 That study 

did not determine how much of the savings were from 

employees’ switching to lower-cost plans and how much 

were from plans’ reducing their premiums as a result of 

increased competition. An inherent limitation of such 

studies is the possibility that the estimates may partly 

reflect differences in the characteristics of employers, 

their employees, and their local health care markets—and 

thus may not isolate the effect of managed competition 

on total health care spending.

The Federal Employees 

Health Benefits Program

Some analysts regard the Federal Employees Health Benefits (FEHB) program as a model for changing Medicare.15 The FEHB program offers federal employees, 

retirees, and their dependents a wide choice of health 

plans. In 2006, there are 13 national plan options available in the program, and most participants have access to 

numerous local plans (which are mostly HMOs).16 Plans 

are allowed to vary their benefits and cost-sharing 

requirements.

National plans determine their premiums on the basis of 

their prior claims experience with the FEHB program. 

They are not permitted to vary their premiums geographically. The premiums of local plans are not allowed to 

exceed the average premiums they charge their two largest 

commercial accounts in the local market area (although 

plans are allowed to adjust for differences between the 

FEHB program and the commercial clients with respect 

to benefit design and demographic characteristics). 

National insurers that offer local FEHB program plans in 

different market areas may vary their premiums across 

those areas.

The government contributes 75 percent toward the premium of the insurance plan selected by the employee, up 

to a maximum dollar amount that is equal to 72 percent 

of the weighted average premium of all participating 

plans. The government’s maximum contribution is determined separately for single and family coverage, but it 

does not vary geographically. In 2006, the government’s 

maximum contribution for single coverage is $3,619, so 

the government pays 75 percent toward the cost of any 

single-coverage plan whose total annual premium does 

not exceed $4,825.17 Employees who enroll in a moreexpensive plan have to pay the full amount by which the 

plan’s premium exceeds $4,825. Thus, among plans 

whose premiums are greater than that amount, employees 

and plans face incentives that are similar to those under 

managed competition. Among lower-cost plans, however, 

employees have a much weaker incentive to be costconscious in their choice of plans because they pay only 

25 cents for each $1 increase in the total premium. 

Consequently, those health plans face weaker incentives 

to compete on price than they would under managed 

competition. 

Some analysts have suggested that the Medicare program 

could be made more efficient by incorporating key features from the FEHB program, and a few studies have 

compared the growth of costs for the two programs. 

Drawing inferences from such comparisons is difficult, 

however, because differences between the programs in 

benefit design and population characteristics could influence the growth of their costs. For example, outpatient 

prescription drugs have historically been covered by plans 

in the FEHB program and most other private health 

insurance plans but not by Medicare (until 2006). That is 

an important difference because spending on prescription 

drugs has grown faster than spending on most other types 

of medical care. Partly because of that difference, the 

average annual growth in Medicare expenditures per beneficiary from 1969 to 2002 (9.3 percent) is lower than 

the growth of average premiums per enrollee in the 

FEHB program over that period (10.6 percent) or the 

14. Bryan Dowd and Roger D. Feldman, “Employer Premium Contributions and Health Insurance Costs,” in Michael A. Morrisey, 

ed., Managed Care and Changing Health Care Markets (Washington, D.C.: AEI Press, 1998).

15. For example, see Stuart M. Butler and Robert E. Moffit, “The 

FEHBP as a Model for a New Medicare Program,” Health Affairs, 

vol. 14, no. 4 (Winter 1995), pp. 47–61. 

16. That figure does not include four additional national plan options 

that are available only to employees or retirees of certain small federal agencies. Some insurers offer multiple plan options under the 

FEHB program, which are counted separately here. 

17. A premium of $4,825 is the amount for which the government’s 

maximum contribution for single coverage is reached, since 

$3,619 is 75 percent of $4,825.
36 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

growth of average premiums per enrollee for private 

health insurance generally (11.1 percent).18

Those differences are narrowed, but not eliminated, 

when the influence of prescription drugs on spending 

growth is removed. One study found that, for benefits 

that are commonly covered by Medicare as well as by 

plans in the FEHB program, Medicare expenditures per 

beneficiary grew at an average annual rate of 9.1 percent 

from 1969 to 2002, compared with average annual rates 

of growth of 9.6 percent for premiums in the FEHB program and 10.1 percent for private health insurance 

spending generally.19 That study did not control for 

other differences between the two programs that could 

influence the growth of their costs—such as the characteristics of the covered populations or changes in benefit 

design—and therefore does not provide definitive evidence on whether the FEHB program can control costs 

better than the Medicare program. 

Implications for Medicare

Studies of managed competition have found that health 

care spending in employment-based settings can be 

reduced by giving consumers incentives to be more conscious of costs when choosing a health plan. Although 

those findings suggest that premium support could 

reduce Medicare’s costs, the effects on those costs would 

depend to a large extent on how the program was 

designed. Some of the design options for premium support differ from managed competition because they 

would set benchmarks at a level other than the minimum 

bid. However, even a premium support system in which 

benchmarks are set equal to the minimum bid could have 

a different effect on Medicare’s costs from the effects that 

have been reported for employers.

The Medicare program—which is national in scope—

differs from the employment-based settings in which 

managed competition has been implemented in some 

important ways that could influence the effects of premium support. To begin with, studies of managed competition have focused primarily on urban areas, where 

such changes are likely to have greater effects (because of 

the greater competition among health plans and providers) than they would in rural areas. Moreover, the vast 

majority of Medicare beneficiaries are currently enrolled 

in the traditional fee-for-service program, and the unique 

features of that program could heavily influence the outcomes under premium support. For example, as discussed 

in Chapter 2, Medicare is able to set payment rates for 

providers that are substantially below the rates that private health plans pay. In addition, there is evidence that 

Medicare beneficiaries are less responsive to differences in 

premiums when choosing a health plan than the privately 

insured population is, so plans may have less incentive to 

compete on the basis of premiums in the Medicare market than in the privately insured market.20 Because of 

those factors, premium support could yield less savings 

for Medicare than a comparable policy change by an 

employer. 

Because of other factors, however, premium support 

could produce greater savings for Medicare. Because 

Medicare is such a large program (often constituting a 

major share of a given provider’s revenue), changes to the 

program could introduce greater incentives for health 

plans and providers to modify their behavior than comparable changes enacted by individual employers, who 

may constitute only a tiny fraction of a provider’s revenue 

base. 

18. Katherine Levit and others, “Health Spending Rebound Continues in 2002,” Health Affairs, vol. 23, no. 1 (January/February 

2004), pp. 147–159. 

19. Ibid.

20. Thomas C. Buchmueller, “The Health Plan Choice of Retirees 

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

no. 5 (December 2000), pp. 949–976.
CHAPTER

5

Potential Effects of Selected

Approaches to Premium Support

The effects of premium support on federal spending 

and beneficiaries’ premiums would depend on how the 

program was designed and on how health plans and beneficiaries responded to the change in incentives. To illustrate the potential range of effects, this chapter presents 

estimates of different approaches to premium support 

under a set of plausible assumptions about how market 

participants would respond. Although those assumed 

responses are based on the best evidence available, that 

evidence is limited in many ways. Consequently, the 

effects of premium support are uncertain and could differ 

markedly from the estimates presented here. 

The analysis in this chapter focuses on premium support 

systems in which the government’s contribution is determined from plans’ bids. It examines the effects of alternative methods for setting benchmarks (other features of 

the premium support system are left unchanged). The 

premium support prototypes that the Congressional 

Budget Office analyzed do not directly correspond to 

any specific legislative proposals.

Although the estimates in this chapter are subject to considerable uncertainty, several general conclusions can be 

drawn from the findings. First, different approaches to 

determining benchmarks are likely to have substantially 

different effects on federal spending. Among the options 

analyzed here, setting benchmarks equal to the minimum 

bid in each county would generate the greatest federal 

savings and lead to the highest increase in premiums in 

certain geographic areas for beneficiaries who wanted to 

remain in the fee-for-service program. Second, under 

each approach that CBO examined, benchmarks would 

be lower than per capita FFS expenditures in geographic 

areas where those expenditures are high, which would 

increase beneficiaries’ premiums for the FFS program in 

those areas. Third, benchmarks would be lower than the 

statutory benchmarks for the Medicare Advantage program, which would reduce the Medicare program’s per 

capita payments for enrollees in private plans. Consequently, the premium rebates and additional benefits that 

are currently offered by private plans would probably be 

reduced and, in some cases, replaced by premium surcharges. In any given area, the change in beneficiaries’ 

incentives regarding plan choice would depend on the 

amount of any changes in the premium for the FFS program and any changes in the premium rebates and additional benefits offered by private plans. 

CBO’s Key Assumptions

CBO projected benchmarks at the county level by projecting the bids of private plans and using county-level 

data on per capita spending in the fee-for-service program 

(available from the Centers for Medicare and Medicaid 

Services). The estimates in this chapter are intended to 

measure the potential effects of different approaches 

to setting benchmarks after the system fully adjusts to the 

change in policy. 

Projections of Plans’ Bids

CBO projected the bids of private plans under premium 

support from cost data in the Adjusted Community Rate 

submissions of plans that participated in the Medicare 

Advantage program in 2005.1 The Medicare Advantage 

payment system gives plans an incentive to provide Medicare benefits efficiently because the lower a plan’s costs of 

providing those benefits relative to the benchmark, the 

1. After completing the analysis, CBO received data on the bids that 

plans submitted for 2006. The ratios of those bids to per capita 

FFS spending are very similar to the ratios predicted from the 

2005 ACR data, so using the 2006 data would not change 

the basic conclusions of this study. 
38 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

greater the additional benefits or premium rebates it can 

offer to its enrollees. 

Projections of plans’ bids under premium support are 

subject to considerable uncertainty from several sources. 

One source of uncertainty is whether premium support 

would give plans a greater incentive to limit their costs of 

providing Medicare benefits than they face under the 

Medicare Advantage program. If so, plans’ bids under 

premium support could be lower than their costs under 

Medicare Advantage. Currently, many beneficiaries who 

live in the service areas of private plans do not seriously 

consider enrolling in those plans and have little or no 

information on the additional benefits or premium 

rebates that are available.2

 That situation would probably 

change under premium support, however, particularly in 

market areas where the premium for enrollees in the FFS 

program increased substantially. Raising beneficiaries’ 

awareness of the differences in premiums across plans 

could stimulate greater price competition among those 

plans because it would increase the number of beneficiaries who might switch to a plan in response to a given 

decrease in its bid.

There is little experience from which to predict whether 

and to what extent plans’ bids under premium support 

would be lower than their costs under the Medicare 

Advantage program (or how such differences might vary 

with the mechanism for setting benchmarks or vary geographically). Because of that uncertainty, this study presents estimates under two alternative assumptions about 

plans’ bids—first, that plans’ bids under premium support would be the same as their projected costs in the 

Medicare Advantage program; and, second, that premium support would induce all plans to reduce their bids 

below their costs in the Medicare Advantage program by 

5 percent.3

 A comparison of the two sets of estimates provides information on the sensitivity of the projected outcomes to those different assumptions about plans’ bids.

A second source of uncertainty in projections of plans’ 

bids is how much of the difference between the costs of 

Medicare Advantage plans and the costs of the FFS program stems from differences in beneficiaries’ health status. CBO used risk scores from the Hierarchical Condition Codes model to remove the influence of those 

differences in health status to project plans’ bids for a 

standard beneficiary. As noted in Chapter 2, however, 

average risk scores computed from the two most recent 

years of available data differ significantly, and it is not 

known which of those two sets of risk scores more accurately measures differences in health status. As a result, 

CBO projected standardized bids using risk scores 

derived from the 2004 data as well as scores derived from 

the 2003 data.4

A third source of uncertainty in projections of plans’ bids 

is whether, under any of the approaches to setting benchmarks analyzed in this study, premium support would 

reduce the long-term rate of growth of Medicare expenditures. At this time, CBO has insufficient evidence to conclude that premium support would have such an effect. 

As noted previously, the limited evidence that is available 

suggests that employers that have adopted managed competition have not seen a decline in the rate of growth of 

their health care costs. Moreover, the available evidence, 

although limited, is that both health care costs and the 

use of new technologies grow at about the same rate in 

health maintenance organizations as in other types of 

health plans.5 Consequently, the estimates in this chapter 

measure the effects of alternative approaches to setting 

benchmarks on the levels of federal spending and beneficiaries’ premiums. CBO made no assumption about 

2. Marsha Gold and Natalie Justh, “How Salient Is Choice to 

Medicare Beneficiaries?” (report prepared for the Robert Wood 

Johnson Foundation by Mathematica Policy Research under the 

Monitoring Medicare+Choice Project, January 2001). 

3. The assumption of a 5 percent reduction in plans’ bids is within 

the range of estimated premium reductions among health plans 

that contracted with Harvard University during the period of the 

university’s implementation of managed competition in 1995. See 

David M. Cutler and Sarah J. Reber, “Paying for Health Insurance: The Trade-Off Between Competition and Adverse Selection,” Quarterly Journal of Economics (May 1998), pp. 433–466. 

As noted in Chapter 4, however, the experiences of a single 

employer cannot be generalized to the Medicare program because 

those experiences are likely to depend on circumstances that are 

unique to that employer.

4. On average, risk scores estimated from the 2004 data for enrollees 

in private plans were about 6 percent lower than risk scores for the 

FFS population; using the 2003 data, the difference in the two 

sets of risk scores was about 12 percent. 

5. For example, see Joseph P. Newhouse and others, “Are Fee-forService Costs Increasing Faster Than HMO Costs?” Medical Care, 

vol. 23, no. 8 (August 1985), pp. 960–966; and Michael 

Chernew, A. Mark Fendrick, and Richard A. Hirth, “Managed 

Care and Medical Technology: Implications for Cost Growth,” 

Health Affairs, vol. 16, no. 2 (March/April 1997), pp. 196–206. 
CHAPTER FIVE POTENTIAL EFFECTS OF SELECTED APPROACHES TO PREMIUM SUPPORT 39

effects on the long-term rate of growth of those 

outcomes.6

In projecting plans’ bids under premium support, CBO 

used data on the costs of plans that Medicare classifies as 

“coordinated care plans,” most of which are HMOs. 

CBO did not include private fee-for-service plans, plans 

that operate under demonstrations, or those that are paid 

by Medicare on a cost basis. CBO excluded PFFS plans 

because they are not likely to be competitive with the FFS 

program under premium support.7

In its analysis, CBO assumed that private plans could 

designate their service areas on a county-by-county basis 

and would not enter any counties that they did not serve 

in early 2005.8

 The Medicare Advantage payment rates 

in counties that were not served by private plans in early 

2005 were 13 percent higher than per capita FFS expenditures, on average. The absence of private plans in those 

areas suggests that they would not have been able to 

provide Medicare benefits at a lower cost than the 

FFS program.

Additional information on CBO’s approach to the analysis is provided in Appendix A.

Assumptions About Key Features of the 

Premium Support System

Under each approach to setting benchmarks, CBO 

assumed that other features of the premium support system would remain the same as they are under current law. 

In particular, CBO assumed that plans would bid on the 

current Medicare benefit package but could vary their 

cost-sharing requirements as long as they were actuarially 

equivalent to those of the current package. Moreover, 

CBO assumed that beneficiaries who enrolled in plans 

whose bids were above the benchmark would pay the 

regular Medicare premium plus an additional premium 

equal to the entire difference between the bid and the 

benchmark, while those who enrolled in plans whose bids 

were below the benchmark would receive 75 percent of 

the difference as a premium rebate or additional benefits. 

Beneficiaries who enrolled in plans whose bids were equal 

to the benchmark would be required to pay a national 

Part B premium that would be determined in the same 

manner as under current law, CBO assumed.

CBO assumed that payments to plans under premium 

support would be adjusted, using the HCC risk adjuster, 

to account for differences in beneficiaries’ health status. 

For this analysis, CBO assumed that the HCC risk 

adjuster would fully control for differences in health status between enrollees in private plans and those in the 

FFS program. CBO further assumed that the HCC risk 

adjuster would be fully implemented in the Medicare 

Advantage program prior to the introduction of premium 

support. Thus, CBO first projected the effects of fully 

implementing the HCC risk adjuster in the Medicare 

Advantage program9

 and then used the resulting estimates as the starting point from which to examine the 

implications of alternative approaches to setting benchmarks under premium support.

Assumptions About Beneficiaries’ Response to

Premium Support

With some approaches to setting benchmarks, beneficiaries’ decisions to switch plans in one year can influence 

benchmarks in the following year.10 Consequently, CBO 

developed a multiperiod simulation model to project the 

benchmarks that would prevail after those enrollment 

shifts had had their full effect. The analysis used estimates 

from the research literature on the responsiveness of the 

elderly population to changes in health insurance premiums to project the shifts in enrollment between the FFS 

program and private plans that would occur in response

6. However, even if premium support reduced the level of federal 

spending but not its long-term growth, the savings would continue indefinitely because spending would grow from a lower base.

7. PFFS plans are not required to have provider networks, their 

enrollees may obtain care from any provider who will furnish it, 

and they are permitted to use Medicare FFS rates to pay providers. 

Thus, under current law, their greatest potential for success is in 

areas where Medicare Advantage benchmarks are much higher 

than per capita FFS expenditures.

8. The ACR data used in the analysis were submitted by plans that 

participated in Medicare in early 2005. The data do not include 

plans that entered Medicare later in the year. 

9. CBO projects that fully implementing the HCC risk adjuster 

would reduce per capita payments to private plans and reduce 

enrollment in those plans. 

10. For example, if the benchmark was set equal to the enrollmentweighted average bid in each county, enrollment shifts in the first 

year of the program would alter the weights that were used to 

compute benchmarks in the second year.
40 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

to the changes in financial incentives that beneficiaries 

would face under premium support.11

To model changes in enrollment under premium support, CBO first estimated the average premium rebate or 

surcharge of private plans in each county in the period 

before premium support would be implemented.12 That 

estimate provided a measure of the initial average “relative 

premium” of private plans, which reflects beneficiaries’ 

incentive to enroll in those plans. (For example, an average rebate of $50 in private plans implies that the average 

premium of those plans is $50 less than that of the FFS 

program.) CBO then modeled the implementation of 

premium support and estimated the new average relative 

premium of private plans in each county, which depends 

on the average rebate or surcharge of private plans as well 

as that of the FFS program. CBO then modeled the shift 

in enrollment between private plans and the FFS program on the basis of the change in the average relative 

premium of private plans.13

As noted previously, many enrollees in the FFS program 

have limited information on the additional benefits or 

premium rebates that private plans offer. Under premium 

support, increases in premiums for the FFS program are 

likely to be more noticeable—and thus could have a 

greater effect on beneficiaries’ behavior—than changes in 

the additional benefits or premiums of private plans. 

Given the uncertainty regarding that issue, CBO conducted its analysis under two alternative assumptions 

about beneficiaries’ responsiveness to changes in premiums. Under the first assumption, beneficiaries’ responsiveness to increases in the premium of the FFS program 

is assumed to be 50 percent greater than their responsiveness to changes in the additional benefits or premiums of 

private plans or to decreases in the premium of the FFS 

program.14 Under the second assumption, beneficiaries’ 

responsiveness to changes in the premium of the FFS 

program is assumed to be the same as their responsiveness 

to changes in the additional benefits or premiums of 

private plans. Projected enrollment in private plans is 

greater under the first assumption than under the second, 

but the two assumptions yield similar projections of 

benchmarks and federal savings.15

The Analysis of Different Approaches 

to Determining the Government’s

Contribution

In the rest of this chapter, CBO analyzes three approaches 

to determining benchmarks in a premium support system 

based on competitive bidding: setting benchmarks equal 

to the minimum bid in each county, to the average bid in 

each county, and to the national average bid.

Setting Benchmarks Equal to the 

Minimum Bid in Each County 

The effects of setting benchmarks equal to the minimum 

bid in each county are highly uncertain because of CBO’s 

uncertainty in predicting plans’ minimum bids.16 Nevertheless, under the methods and assumptions used in this 

analysis, CBO estimates that this approach to setting 

benchmarks would reduce net federal spending on Medicare by about 8 percent to 11 percent if plans’ bids were 

standardized using the 2004 risk-adjustment data.17 Net 

federal spending would fall by about 4 percent to 6 percent if plans’ bids were standardized using the 2003 riskadjustment data.

There are two sources of federal savings under the 

11. For example, see Thomas C. Buchmueller, “Price and the Health minimum-bid approach to setting benchmarks. First, in 

Plan Choices of Retirees,” Journal of Health Economics, vol. 25, 

no. 1 (January 2006), pp. 81–101; and Adam Atherly, Bryan E. 

Dowd, and Roger Feldman, “The Effects of Benefits, Premiums, 

and Health Risk on Health Plan Choice in the Medicare Program,” Health Services Research, vol. 39, no. 4, Part I (August 

2004), pp. 847–864.

12. CBO defined a rebate to include either a premium rebate or 

additional benefits and did not distinguish between the two. 

13. CBO’s model assumes that beneficiaries may enroll either in the 

FFS program or in a private plan whose bid is equal to the average 

bid of all private plans in the county. CBO did not project the 

bids of individual plans in counties that have multiple private 

plans or model changes in enrollment among those plans.

14. Thus, under the first assumption, an increase in the premium for 

the FFS program has a 50 percent greater weight than other 

changes in premiums or additional benefits.

15. The estimates of benchmarks, federal savings, and beneficiaries’ 

premiums presented in the next section were obtained under the 

first assumption.

16. CBO’s approach to projecting minimum bids at the county level 

is described in Appendix A. 

17. Because the effect of premium support on federal Medicare spending is subject to great uncertainty, all such estimates in this study 

are rounded to the nearest percent.
CHAPTER FIVE POTENTIAL EFFECTS OF SELECTED APPROACHES TO PREMIUM SUPPORT 41

Table 5-1.

Projected Benchmarks If Benchmarks Were Set Equal to the Minimum

Bid in Each County in 2006 and Plans’ Bids Were Standardized Using

2004 Risk-Adjustment Data 

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

Note: FFS = fee for service; n.a. = not applicable. 

counties where the benchmark is lower than per capita 

FFS expenditures, net federal spending on enrollees in 

the FFS program would be reduced by an amount equal 

to the difference between the benchmark and per capita 

FFS expenditures. (That difference would be paid by 

beneficiaries who enrolled in the FFS program, as an 

additional premium.) Thus, on a per capita basis, federal 

savings on beneficiaries who enrolled in the FFS program—and on those who would have enrolled in that 

program if premium support had not been introduced—

would be greatest in areas where benchmarks are lowest 

relative to per capita FFS expenditures. The second 

source of federal savings is lower per capita payments to 

private plans. In all counties, benchmarks set equal to 

the minimum bid would be lower than benchmarks 

in the Medicare Advantage program. Moreover, the 

government-funded additional benefits and premium 

rebates that many private-plan enrollees currently receive 

would be eliminated because, by definition, no plan’s 

bid would be below the benchmark.

Under this approach to setting benchmarks, the federal 

savings do not depend on the number of beneficiaries 

who switch plans. In each county, the federal government’s spending on Medicare would be determined by 

the benchmark. All beneficiaries would be required to 

pay the national Part B premium, and those who enrolled 

in a plan whose bid exceeded the benchmark would be 

required to pay the difference between the bid and the 

benchmark as an additional premium. In contrast, the 

effects of the program on total systemwide costs (including the premiums paid by beneficiaries) would depend on 

the extent to which beneficiaries switched to lower-cost 

plans. Predicting such behavior is subject to considerable 

uncertainty, however, so CBO did not estimate the effects 

on total systemwide costs in this study.18

Standardizing Plans’ Bids Using 2004 Data. If plans’ 

bids were standardized using the 2004 risk-adjustment 

data, benchmarks set equal to the minimum bid in each 

county would be an average of 6 percent to 8 percent 

below per capita FFS expenditures nationally (see 

Table 5-1). Benchmarks would be lowest relative to per 

capita FFS expenditures in areas where those expenditures are high, because private plans have the greatest 

potential to achieve savings relative to the FFS program 

in those areas. The projected benchmarks in the highestspending counties (those in which projected per capita 

FFS spending in 2006 is at least $700 per month) are 

14 percent to 17 percent lower than per capita FFS 

expenditures, on average. Consequently, beneficiaries’ 

premiums for the FFS program in those counties would 

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 15.0 1.00 0.99 0.79 0.79

550 to 599 20.1 0.98 0.98 0.86 0.85

600 to 649 23.5 0.94 0.93 0.87 0.85

650 to 699 15.2 0.92 0.89 0.88 0.85

700 and Higher 26.3 0.86 0.83 0.83 0.80

National Average n.a. 0.94 0.92 0.85 0.83

Average Ratio of Projected Benchmarks to

Per Capita FFS Expenditures

Average Ratio of Projected Benchmarks to

Medicare Advantage Benchmarks

Percentage of

Medicare 

Beneficiaries

If Plans' Bids Were the

Same as Under

Medicare Advantage

If Plans Reduced

Their Bids

by 5 Percent

If Plans Reduced

Their Bids

by 5 Percent

If Plans' Bids Were the

Same as Under

Medicare Advantage

18. In counties with multiple private plans, the effects on total 

systemwide costs would depend on the bid of each private plan 

and on the amount that each plan’s enrollment changed under 

premium support. As noted previously, CBO did not model such 

outcomes. 
42 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table 5-2.

Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Minimum Bid in Each County in 2006 and Plans’ Bids Were 

Standardized Using 2004 Risk-Adjustment Data

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

Notes: FFS = fee for service.

The percentage change in the Part B premium is computed relative to the estimated value of that premium after the Hierarchical 

Condition Codes (HCC) risk adjuster was fully implemented in the Medicare Advantage program. Fully implementing that risk adjuster 

would reduce federal Medicare spending and therefore reduce the Part B premium below what it otherwise would be. Throughout this 

analysis, CBO assumed that the HCC risk adjuster would be fully implemented before premium support was introduced. 

rise substantially under this system of premium support 

(see below).

On average, projected benchmarks are higher relative to 

FFS expenditures in counties where those expenditures 

are low. Private plans are less likely to deliver Medicare 

benefits at a lower cost than the FFS program in those 

areas, and CBO projects that the FFS program would be 

the lowest bidding plan in many such areas. The projected benchmarks in the lowest-spending counties (those 

in which per capita FFS spending is less than $550 per 

month) are approximately equal to per capita FFS expenditures, on average (see Table 5-1).

Projected benchmarks nationally are an average of 15 percent to 17 percent lower than benchmarks for the Medicare Advantage program (see Table 5-1). On average, 

projected benchmarks are about 21 percent lower than 

Medicare Advantage benchmarks in the lowest-spending 

counties and 17 percent to 20 percent lower than Medicare Advantage benchmarks in the highest-spending 

counties. Thus, the Medicare program’s per capita 

payments for enrollees in private plans would decline 

substantially under this system of premium support.

If plans’ bids were standardized using the 2004 riskadjustment data, setting benchmarks equal to the minimum bid in each county would increase beneficiaries’ 

premiums for the FFS program nationwide by an average 

of 49 percent to 64 percent (see Table 5-2). Those premiums would vary greatly across geographic areas, however, 

and beneficiaries who live in the highest-spending counties would face the greatest increase in premiums. In the 

highest-spending counties, the monthly premium for 

beneficiaries who wanted to enroll in the FFS program 

would more than double, increasing to an average of 

$200 to $228.19 Beneficiaries’ premiums for the FFS program would increase by smaller amounts, on average, in 

counties with moderate levels of per capita FFS expendiAverage 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 82 82 -7 -7 16 16

550 to 599 90 93 2 6 16 16

600 to 649 116 126 32 43 19 20

650 to 699 135 154 53 75 20 23

700 and Higher 200 228 127 159 26 29

National Average 131 144 49 64 20 21

Same as Under

Projected

Bids Were the

Same as Under

Bids Were the

Same as Under

Medicare Advantage

Average Monthly Premium

for FFS Program (Dollars)

If Plans

Their Bids by

5 Percent

Reduced

If Plans'

Medicare Advantage

Average Percentage Change in

Part B Premium

If Plans

Their Bids by

5 Percent

Reduced

If Plans'

Medicare Advantage

Average Premium for FFS

Program as a Percentage of 

Per Capita FFS Expenditures

If Plans

Their Bids by

5 Percent

Reduced

If Plans'

Bids Were the

19. Those estimates measure the premiums that would prevail in 

2006 if premium support had been fully implemented in that 

year and if the system had fully adjusted to the change in policy. 

In computing the average beneficiary’s premium for the FFS program, CBO weighted the premium in each county by the number 

of beneficiaries in that county. The percentage change in premiums was computed relative to the premium that would prevail 

after the HCC risk adjuster was fully implemented. That premium is projected to be somewhat lower than the current Part B 

premium ($88.50 per month in 2006).
CHAPTER FIVE POTENTIAL EFFECTS OF SELECTED APPROACHES TO PREMIUM SUPPORT 43

tures. In the lowest-spending counties, those premiums 

would decline by an average of about 7 percent because 

the FFS program would be the lowest-bidding plan in 

virtually all of those counties (and thus enrollees in that 

program would not face a premium surcharge), and the 

national Part B premium would fall as a result of the 

reduction in gross Medicare spending. 

Those changes in premiums would substantially alter the 

geographic cross-subsidies in the Medicare FFS program. 

Currently, because the Part B premium is uniform 

nationally, beneficiaries in the lowest-spending counties 

pay a higher share of their spending through Part B premiums than beneficiaries in the highest-spending counties do. Specifically, among enrollees in the FFS program, 

Part B premiums are currently 17 percent of FFS spending in the lowest-spending counties, on average, but 

only about 12 percent of FFS spending in the highestspending counties. If benchmarks were set equal to the 

minimum bid in each county, however, beneficiaries’ 

premiums for the FFS program in the highest-spending 

counties would increase to an average of 26 percent to 

29 percent of FFS spending, while such premiums in 

the lowest-spending counties would fall to an average of 

16 percent of FFS spending (see Table 5-2). 

Those estimates assume that per capita spending levels in 

the fee-for-service program would not be affected by the 

implementation of premium support. In principle, if premium support was accompanied by federal policies that 

reduced FFS expenditures in areas where those expenditures are high, the increases in premiums for the FFS program could be reduced. However, although analysts and 

policymakers have proposed various approaches for 

reducing spending in the FFS program, they remain 

untested on a broad scale and their effect on spending is 

uncertain.20

Standardizing Plans’ Bids Using 2003 Data. The projected benchmarks are higher if plans’ bids are standardized using the 2003 risk-adjustment data rather than the 

2004 data, and the projected increases in beneficiaries’ 

premiums for the FFS program are therefore lower.21

Using the 2003 risk-adjustment data yields projected 

benchmarks that are an average of 3 percent to 5 percent 

lower than per capita FFS expenditures nationally (see 

Table B-1 in Appendix B).

In the highest-spending counties, the projected benchmarks are 8 percent to 11 percent lower than per capita 

FFS expenditures when the 2003 risk-adjustment data 

are used to standardize plans’ bids. The monthly premium for beneficiaries in those counties who wanted to 

enroll in the FFS program would increase to an average 

of $148 to $174, an increase of 70 percent to 100 percent 

(see Table B-2). Although those increases in premiums 

are substantial, they are much lower than the increases 

that are projected using the 2004 risk-adjustment data.

Setting Benchmarks Equal to the 

Average Bid in Each County 

Based on the methods and assumptions used in this analysis, CBO projects that setting benchmarks equal to the 

average bid in each county (with each plan’s bid weighted 

by its enrollment in the previous year) would reduce net 

federal spending on Medicare by about 1 percent to 

2 percent if plans’ bids were standardized using the 2004 

risk-adjustment data. Net federal spending would fall by 

less than 1 percent if those bids were standardized using 

the 2003 risk-adjustment data.

The sources of federal savings under this approach to 

setting benchmarks are the same as those under the 

minimum-bid approach—namely, lower federal contributions for enrollees in the FFS program and for enrollees in private plans. The benchmarks would be substantially higher under the average-bid approach than under 

the minimum-bid approach, however, so the federal savings would be much smaller. With benchmarks set equal 

to the enrollment-weighted average bid in each county, 

the bid of the FFS program would initially have a dominant effect on the benchmark in most counties, because 

the great majority of beneficiaries are enrolled in that pro20. Approaches that have been proposed for reducing spending in the 

FFS program include establishing payment rates through competitive bidding, requiring prior authorization to reduce inappropriate use of services, covering case management services for people 

with multiple chronic conditions, and giving beneficiaries financial or other incentives to obtain care from the most efficient 

providers.

21. Plans’ standardized bids are higher when the 2003 risk-adjustment 

data are used because those data imply that enrollees in private 

plans are healthier than the 2004 data do (and both sets of data 

imply that enrollees in private plans are healthier than those in the 

FFS program). Therefore, standardizing plans’ bids to remove the 

influence of health status requires a greater upward adjustment 

when the 2003 data are used. 
44 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table 5-3.

Projected Benchmarks If Benchmarks Were Set Equal to the EnrollmentWeighted Average Bid in Each County in 2006 and Plans’ Bids Were 

Standardized Using 2004 Risk-Adjustment Data

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

Note: FFS = fee for service; n.a. = not applicable.

gram. To the extent that beneficiaries switched to lowercost plans, future benchmarks would be reduced, because 

such switching would increase the weight that was 

applied to the bids of lower-cost plans. Moreover, under 

the program design that CBO assumed for this analysis, 

the federal government would capture part of the savings 

when beneficiaries switched to plans whose bids are 

below the benchmark, because the rebate for such beneficiaries would be 75 percent of the difference between the 

bid and the benchmark (with the government retaining 

the other 25 percent).

Standardizing Bids Using 2004 Data. When plans’ bids 

are standardized using the 2004 risk-adjustment data, 

projected benchmarks nationally are approximately equal 

to, or 1 percent lower than, per capita FFS expenditures, 

on average (see Table 5-3). In the highest-spending counties, where private plans’ bids are lowest relative to FFS 

expenditures, projected benchmarks are an average of 

1 percent to 2 percent lower than per capita FFS expenditures. That relatively small difference implies that beneficiaries in the highest-spending counties who wanted to 

enroll in the FFS program would face much smaller 

increases in their premiums than if benchmarks were set 

equal to the minimum bid in each county (see below). In 

all of the other counties, benchmarks are approximately 

equal to per capita FFS spending, on average. In many of 

those counties, the projected average bid of private plans 

is higher than per capita FFS expenditures. For that reason, CBO projects that many private-plan enrollees in 

those counties would switch to the FFS program under 

this system of premium support.

Nationally, the projected benchmarks are an average of 

about 10 percent lower than the Medicare Advantage 

benchmarks (see Table 5-3). Projected benchmarks are 

about 5 percent lower than the Medicare Advantage 

benchmarks in the highest-spending counties, on average, 

and about 20 percent lower than those benchmarks in the 

lowest-spending counties. Those lower benchmarks 

would substantially reduce—and, in many cases, eliminate—the premium rebates and additional benefits that 

would be available to enrollees in private plans.

Setting benchmarks equal to the enrollment-weighted 

average bid in each county would result in much smaller 

changes in beneficiaries’ premiums for the FFS program 

than setting benchmarks equal to the minimum bid in 

each county would, CBO projects. When plans’ bids are 

standardized using the 2004 risk-adjustment data, the 

projected premiums for the FFS program increase by 

2 percent to 5 percent nationally (see Table 5-4). The 

greatest increases in beneficiaries’ premiums for the FFS 

program would be in the highest-spending counties, 

where such premiums are projected to increase by an 

average of 9 percent to 17 percent. In the two lowestspending categories of counties (those in which per capita 

spending in 2006 is less than $600 per month), beneficiaAverage 

Per Capita FFS

Expenditure in

County in 2006

(Dollars)

Less Than 550 15.0 1.00 1.00 0.79 0.80

550 to 599 20.1 1.00 1.00 0.87 0.87

600 to 649 23.5 1.00 1.00 0.92 0.91

650 to 699 15.2 1.00 0.99 0.95 0.94

700 and Higher 26.3 0.99 0.98 0.95 0.95

National Average n.a. 1.00 0.99 0.90 0.90

by 5 Percent by 5 Percent

Average Ratio of Projected Benchmarks to

Per Capita FFS Expenditures

If Plans' Bids Were the

Same as Under

Beneficiaries Medicare Advantage

If Plans' Bids Were the

Same as Under

Medicare Advantage

Average Ratio of Projected Benchmarks to

Medicare Advantage Benchmarks

Percentage of

Medicare 

If Plans Reduced

Their Bids

If Plans Reduced

Their Bids
CHAPTER FIVE POTENTIAL EFFECTS OF SELECTED APPROACHES TO PREMIUM SUPPORT 45

Table 5-4.

Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Enrollment-Weighted Average Bid in Each County in 

2006 and Plans’ Bids Were Standardized Using 2004 Risk-Adjustment Data

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

Notes: FFS = fee for service. 

The percentage change in the Part B premium is computed relative to the estimated value of that premium after the Hierarchical 

Condition Codes (HCC) risk adjuster was fully implemented in the Medicare Advantage program. Fully implementing that risk adjuster 

would reduce federal Medicare spending and therefore reduce the Part B premium below what it otherwise would be. Throughout this 

analysis, CBO assumed that the HCC risk adjuster would be fully implemented before premium support was introduced. 

ries’ premiums for the FFS program would fall by an 

average of 1 percent to 2 percent.

Those changes in premiums would have little effect on 

the geographic cross-subsidies in the Medicare FFS program. The premiums of FFS enrollees in the lowestspending counties would remain at about 17 percent of 

average spending in those areas, while the premiums 

of FFS enrollees in the highest-spending counties would 

increase slightly to 12 percent to 13 percent of average 

spending (see Table 5-4).

Standardizing Plans’ Bids Using 2003 Data. When plans’ 

bids are standardized using the 2003 risk-adjustment 

data, projected benchmarks nationally are approximately 

equal to per capita FFS expenditures, on average (see 

Table B-3). Even in the highest-spending counties, projected benchmarks are equal to per capita FFS expenditures. Consequently, using the 2003 risk-adjustment 

data, CBO estimates that beneficiaries’ premiums for the 

FFS program would remain approximately the same as 

under current law, on average (see Table B-4).

Projected benchmarks nationally are about 9 percent 

lower than the Medicare Advantage benchmarks, on 

average (see Table B-3). Those lower benchmarks would 

reduce Medicare’s payments for enrollees in private plans, 

which would be the principal source of federal savings 

under this system of premium support.

Setting Benchmarks Equal to the 

Median Bid in Each County 

In general, setting benchmarks equal to the median bid in 

each county would reduce net federal Medicare spending 

by more than would setting benchmarks equal to the 

enrollment-weighted average bid but by less than would 

setting benchmarks equal to the minimum bid. Likewise, 

beneficiaries’ premiums for the FFS program would be 

somewhere between the projected premiums that would 

be required under those other two methods of setting

benchmarks. 

CBO did not quantify the precise effects of setting 

benchmarks equal to the median bid for this study 

because of the uncertainty associated with projecting 

median bids at the county level. Projecting how median 

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 87 86 -1 -2 17 17

550 to 599 87 86 -1 -2 15 15

600 to 649 87 88 -1 0 14 14

650 to 699 89 93 1 6 13 14

700 and Higher 96 103 9 17 12 13

National Average 90 92 2 5 14 14

Projected

If Plans'

Same as Under

If Plans

Their Bids by

Average Monthly Premium for 

FFS Program (Dollars)

Average Percentage Change in

Part B Premium

Medicare Advantage

Average Premium for FFS

Program as a Percentage of 

Per Capita FFS Expenditures

If Plans

Their Bids by

5 Percent

Bids Were the Reduced

5 Percent

If Plans'

Same as Under

Medicare Advantage

Bids Were the Reduced Bids Were the Reduced

If Plans

Their Bids by

5 Percent

If Plans'

Same as Under

Medicare Advantage
46 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table 5-5.

Projected Benchmarks If Benchmarks Were Set Equal to the National Average

Bid in 2006, Adjusted to Account for Geographic Variation in Input Prices, and 

Plans’ Bids Were Standardized Using 2004 Risk-Adjustment Data

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

Note: FFS = fee for service; n.a. = not applicable. 

bids might change over time as some private plans enter 

or exit the program would be subject to much greater 

uncertainty than projecting how enrollment-weighted 

average bids might change. For example, decisions by 

plans with small enrollments to enter or exit the program 

could have a much greater effect on the median bid in a 

given county than on the enrollment-weighted average 

bid.

Setting Benchmarks Equal to the 

National Average Bid

The effects of setting benchmarks equal to the national 

average bid, with each plan’s bid weighted by its enrollment in the previous year, would depend on the extent 

to which benchmarks were adjusted to account for geographic variation in per capita Medicare spending. For 

this analysis, CBO assumed that benchmarks would be 

adjusted to account for geographic variation in the prices 

of inputs that are used to provide Medicare services but 

not for geographic variation in beneficiaries’ use of services. That approach was contained in the premium support proposal in the Medicare Preservation and Improvement Act of 2001 (S. 357).

To measure geographic variation in input prices, CBO 

used a weighted average of two price indexes that are used 

by CMS to adjust payment rates in the fee-for-service 

program. The first is the hospital wage index, which 

measures geographic variation in the wages of hospital 

employees and is used by the Medicare program to adjust 

payments to hospitals. The second is the geographic 

adjustment factor (GAF), which is a weighted average of 

three indexes that measure geographic variation in different inputs for physicians’ services, which are used by the 

Medicare program to adjust payment rates to physicians.22 In constructing an average of those indexes, 

CBO weighted the hospital wage index by the proportion 

of Medicare expenditures nationally that is covered under 

Part A and the GAF by the proportion of Medicare 

expenditures nationally that is covered under Part B.

Standardizing Plans’ Bids Using 2004 Data. If plans’ bids 

were standardized using the 2004 risk-adjustment data, 

benchmarks would be approximately equal to per capita 

FFS expenditures nationally. Projected benchmarks are an 

average of 8 percent to 9 percent lower than per capita 

FFS expenditures in the highest-spending counties and 

an average of 16 percent higher than per capita FFS 

expenditures in the lowest-spending counties (see 

Table 5-5). Consequently, enrollees in the FFS program 

who live in the highest-spending counties would be 

required to pay premium surcharges, on average, while 

Average 

Per Capita FFS

Expenditure in

County in 2006

(Dollars)

Less Than 550 15.0 1.16 1.16 0.92 0.92

550 to 599 20.1 1.05 1.05 0.91 0.91

600 to 649 23.5 1.01 1.01 0.92 0.92

650 to 699 15.2 0.96 0.95 0.91 0.91

700 and Higher 26.3 0.92 0.91 0.89 0.88

National Average n.a. 1.01 1.00 0.91 0.91

Their Bids by

5 Percent

Medicare Advantage Benchmarks

Their Bids by

5 Percent

If Plans' Bids Were the

Same as Under

Medicare Advantage

Medicare 

Beneficiaries

If Plans' Bids Were the

Same as Under

Medicare Advantage

Average Ratio of Projected Benchmarks to

Per Capita FFS Expenditures

Average Ratio of Projected Benchmarks to

Percentage of If Plans Reduced If Plans Reduced

22. The three indexes measure geographic variation in three components of physicians’ input costs: physicians’ work (measured by the 

hourly earnings of workers in selected professions), practice 

expense (which includes employees’ wages, office rents, and other 

expenses), and malpractice insurance costs.
CHAPTER FIVE POTENTIAL EFFECTS OF SELECTED APPROACHES TO PREMIUM SUPPORT 47

those who live in the lowest-spending counties would 

receive rebates.

Under this approach to setting benchmarks, the geographic variation in the ratio of benchmarks to per capita 

FFS expenditures depends on the geographic adjustment 

that is applied to the national average bid. Because the 

national average bid is adjusted to account for geographic 

differences in input prices but not for differences in the 

level and intensity of service utilization, benchmarks are 

lower than per capita FFS expenditures in the highestspending counties and higher than per capita FFS expenditures in the lowest-spending counties. 

The effects of this approach to setting benchmarks on 

federal spending and on beneficiaries’ premiums for the 

FFS program would depend on another feature of the 

program’s design—namely, the rules for determining 

the premiums of beneficiaries who live in areas that are 

not served by private plans. For this analysis, CBO 

assumed that no restrictions would be placed on the 

premiums of such beneficiaries. Thus, the premiums of 

beneficiaries who live in areas that are not served by private plans would be determined in the same manner as 

the premiums of enrollees in the FFS program who live 

in areas that are served by private plans.23

Based on the methods and assumptions used in this 

paper, CBO estimates that a premium support program 

designed in that manner would reduce net federal spending on Medicare by about 2 percent if plans’ bids were 

standardized using the 2004 risk-adjustment data. 

Beneficiaries’ premiums for the FFS program would 

increase by 7 percent to 9 percent nationally (see 

Table 5-6).24 The changes to those premiums would vary 

greatly across geographic areas, however. In the highestspending counties, beneficiaries’ premiums for the FFS 

program would rise by more than 75 percent, to an average of $155 to $158. In the lowest-spending counties, in 

contrast, beneficiaries’ premiums for the FFS program 

would fall by at least 70 percent, to an average of $24 

to $26. 

In the lowest-spending counties, the premiums of 

enrollees in the FFS program would fall from 17 percent 

of spending to 5 percent, on average (see Table 5-6). In 

the highest-spending counties, the premiums of enrollees 

in the FFS program would increase from an average of 

about 12 percent of spending to an average of about 20 

percent.

Other design choices are possible for determining the 

premiums of beneficiaries who live in areas that are not 

served by private plans. One approach is to constrain the 

premiums of such beneficiaries to not exceed the national 

Part B premium. Under that approach, beneficiaries who 

live in areas that are not served by private plans would not 

be required to pay a premium surcharge if the average 

FFS expenditure in their county exceeded the benchmark, but they would be eligible to receive a premium 

rebate if the opposite was true. That approach is analogous to a provision in the proposal in the Medicare Preservation and Improvement Act of 2001.25

That alternative approach to determining beneficiaries’ 

premiums in counties that are not served by private plans 

would result in higher net federal spending than the 

approach described above in which no constraints are 

placed on the premiums of such beneficiaries. In fact, a 

premium support system with such a design could result 

in little or no federal savings—and perhaps even an 

increase in federal spending. In counties that are not 

served by private plans and in which per capita FFS 

spending exceeds the benchmark, federal spending under 

the alternative approach would be determined by per capita spending in the FFS program, not by the (lower) 

benchmark. The effect of that approach to determining 

beneficiaries’ premiums on federal spending is highly 

uncertain because it depends greatly on the number of 

counties that would be served by private plans, and

23. Specifically, if the average FFS expenditure in the county was 

above the benchmark, beneficiaries would have to pay a premium 

surcharge equal to the difference between the two. Conversely, 

if the average FFS expenditure in the county was below the benchmark, beneficiaries would receive a premium rebate equal to 

75 percent of the difference between the two.

24. Although benchmarks nationally are approximately equal to per 

capita FFS spending, on average, beneficiaries’ premiums for the 

FFS program would increase by an average of 7 percent to 9 percent nationally because of how CBO assumed that premium surcharges and rebates would be determined. In particular, CBO 

assumed that the premium surcharge for a plan whose bid exceeds 

the benchmark would equal the full difference between the two, 

whereas the premium rebate for a plan whose bid is less than the 

benchmark would equal 75 percent of the difference between 

the two (with the government retaining the other 25 percent).

25. As noted in Box 3-1, the Senate bill would have combined the 

Part A and Part B Medicare trust funds and replaced the Part B 

premium with a Medicare premium. 
48 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table 5-6.

Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the National Average Bid in 2006, Adjusted for Geographic 

Variation in Input Prices, and Plans’ Bids Were Standardized Using 2004

Risk-Adjustment Data

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

Notes: FFS = fee for service. 

Estimates in this table were calculated under the assumption that there would be no restrictions on the premiums of beneficiaries who 

live in areas not served by private plans. 

The percentage change in the Part B premium is computed relative to the estimated value of that premium after the Hierarchical 

Condition Codes (HCC) risk adjuster was fully implemented in the Medicare Advantage program. Fully implementing that risk adjuster 

would reduce federal Medicare spending and therefore reduce the Part B premium below what it otherwise would be. Throughout this 

analysis, CBO assumed that the HCC risk adjuster would be fully implemented before premium support was introduced. 

projections of plan participation at the county level are 

highly uncertain.26 Therefore, the effects of such a program design are not quantified in this analysis.

Standardizing Plans’ Bids Using 2003 Data. If plans’ bids 

were standardized using the 2003 risk-adjustment data, 

net federal spending on Medicare would fall by about 

1 percent (under the assumption that the program used 

the main approach to determining beneficiaries’ premiums described above). The 2003 risk-adjustment data 

result in higher standardized bids than the 2004 data; 

those higher bids would in turn result in slightly higher 

benchmarks and slightly lower beneficiaries’ premiums 

for the FFS program (see Tables B-5 and B-6).

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 24 26 -73 -70 5 5

550 to 599 63 65 -28 -26 11 11

600 to 649 83 85 -6 -3 13 14

650 to 699 117 119 33 35 17 18

700 and Higher 155 158 76 80 20 20

National Average 94 96 7 9 14 14

Projected

Average Percentage Change in

Part B Premium

Average Premium for FFS

Program as a Percentage of 

Per Capita FFS Expenditures

Average Monthly Premium for 

FFS Program (Dollars)

If Plans

Reduced

Their Bids by

5 Percent

If Plans'

Same as Under

Medicare Advantage

Bids Were the

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent

26. The simulation model used in this study predicts enrollment in 

private plans under premium support. For computing benchmarks under this system of premium support, the results do not 

change very much under differing assumptions about whether 

some counties would have small enrollments in private plans or 

whether such enrollment would fall to zero. Predicting whether 

private plans would remain in such counties under a particular 

premium support design is subject to considerable uncertainty, 

however. 
APPENDIX

A

Technical Aspects of the Analysis

This appendix describes the Congressional Budget 

Office’s (CBO’s) approach to two components of its analysis of alternative methods of setting benchmarks under 

premium support. The first section describes CBO’s 

approach to estimating private plans’ costs of delivering 

Medicare benefits at the county level. The Adjusted 

Community Rate (ACR) reports contain plans’ projections of their cost per enrollee of delivering Medicare 

benefits in their service area. Many plans include more 

than one county in their service area, however, and plans 

are not required to report costs by county. For this study, 

therefore, CBO developed an approach to estimating 

each plan’s cost per enrollee at the county level from the 

costs each plan projected for its entire service area. The 

second section describes CBO’s approach to projecting 

plans’ bids under premium support from the estimates 

of plans’ costs.

How CBO Estimated County-Level

Costs from Plan-Level Data

The objective of the analysis described in this appendix is 

to develop county-level estimates of each plan’s cost per 

enrollee of delivering Medicare benefits, using data on 

each plan’s projected costs for its entire service area. To 

estimate how costs vary across counties for a given plan, 

CBO first examined how costs vary across plans that 

serve different geographic areas. The relationships 

revealed through that analysis were then used to estimate 

county-level costs for each plan.

For the initial analysis of plan-level data, plans were classified 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, and the weights were based on the 

distribution of the plan’s enrollees across counties. 

CBO used data on plans’ projected costs (including 

administrative costs and normal profits) that were contained in the plans’ ACR reports for 2005. CBO standardized plans’ costs using risk scores based on the Hierarchical Condition Codes model that were included in 

those ACR reports. (For most plans, those risk scores 

were probably based on 2003 risk-adjustment data, since 

the 2005 ACR reports were due to the government by 

September 2004). The county-level estimates of per capita FFS expenditures in 2005 were standardized by the 

Centers for Medicare and Medicaid Services (CMS).

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

plans’ costs per enrollee were 11 percent higher than per 

capita FFS expenditures in the plans’ service areas (see 

Table A-1). Plans that served areas where FFS spending is 

low had much higher relative costs than plans that served 

areas where FFS spending is high.1 On a per capita basis, 

private plans’ costs were an average of 34 percent higher 

than FFS expenditures in service areas with a per capita 

FFS expenditure of less than $500 and equal to FFS 

expenditures in service areas with a per capita FFS expenditure of at least $750. 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.

To estimate county-level costs for individual plans, CBO 

assumed that the factors that contribute to variation in 

costs across counties served by a particular plan are the 

same factors that contribute to the variation in costs 

across plans that serve different geographic areas. Therefore, CBO used the plan-level relative cost ratios in 

Table A-1 to allocate costs across counties for each plan.

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

capita FFS expenditures.
50 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table A-1.

Private Plans’ Per Capita Costs of Providing Medicare Benefits Relative to 

Those of the FFS Program, Based on Plan-Level Estimates, 2005

Source: Congressional Budget Office based on data submitted by private plans to the Medicare program for 2005. 

Note: Plans' costs and average fee-for-service (FFS) expenditures in plans’ service areas were standardized using risk scores from the 

Hierarchical Condition Codes model. Estimates for private-plan enrollees are based on risk scores derived from 2003 risk-adjustment 

data. 

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

Fi

 = per capita FFS expenditures in county i

The total cost per enrollee for the plan is a weighted 

average of its county-level costs:

(1) P1*C1 + P2*C2 + P3*C3 = C

Assume that the per capita FFS expenditures in counties 

1, 2, and 3 are $525, $675, and $800, respectively. Then, 

using the estimates in Table A-1:

(2) C1/F1 = (1.25/1.08) * C2/F2

(3) C1/F1 = (1.25/1.00) * C3/F3

The values 1.25 and 1.08 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 ($525 and $675, respectively). The values 1.25 and 1.00 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

Once those equations are rearranged, the cost per enrollee 

in each county can be computed. 

That approach yields county-level estimates of relative 

costs that exhibit the same pattern with respect to FFS 

expenditures that the corresponding plan-level estimates 

do—that is, the county-level relative cost ratios in Table 

2-1 (based on 2003 risk-adjustment data) are very similar 

to the plan-level estimates in Table A-1.

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 

Average Per Capita

FFS Expenditure in Plan's

Service Area (Dollars)

Less Than 500 4.3 1.34

500 to 549 8.7 1.25

550 to 599 19.6 1.14

600 to 649 26.3 1.10

650 to 699 13.7 1.08

700 to 749 11.9 1.09

750 and Higher 15.6 1.00

National Average n.a. 1.11

Percentage of 

Private-Plan

Enrollees

Average Ratio of Plans' Costs to

Per Capita FFS Expenditures 

2. The approach is valid for a plan that serves any number of 

counties.

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 A TECHNICAL ASPECTS OF THE ANALYSIS 51

assumption is not appropriate because the service areas of 

some 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.

After CBO had allocated plans’ costs by county, CMS 

announced that risk scores for private-plan enrollees computed from 2004 risk-adjustment data were significantly 

higher relative to those of the FFS population than the 

risk scores computed from 2003 data, which CBO had 

used. Because such differences in risk scores could significantly affect the findings of the analysis, CBO developed 

an alternative set of estimates based on the more recent 

risk scores. To do so, CBO obtained from CMS countylevel estimates of the average risk scores for private-plan 

enrollees based on 2004 data. (Plan-level estimates of risk 

scores based on those data were not available.) CBO 

adjusted the county-level estimates of plans’ standardized 

costs (which it had computed using risk scores from 2003 

data) by multiplying the estimate for each county by the 

ratio of the average risk score for private-plan enrollees in 

that county estimated from 2003 data to the corresponding estimate from 2004 data. The result was a set of 

county-level estimates of plans’ standardized costs based 

on risk scores from the 2004 data.

How CBO Projected Plans’ Bids Under 

Premium Support

CBO used the county-level estimates of private plans’ 

costs of delivering Medicare benefits in 2005 to project 

plans’ bids under premium support. CBO computed the 

average bid of private plans in each county, with each 

plan’s bid weighted by its enrollment in the previous year, 

and used those average bids to analyze premium support 

proposals in which benchmarks were set equal to the 

average bid in each county or the national average bid.

To analyze a premium support system in which benchmarks are set equal to the minimum bid in each county, 

CBO projected minimum bids at the county level. Projecting minimum bids is subject to greater uncertainty 

than projecting average bids because the minimum plan 

cost estimated for some counties could reflect errors in 

the data. For example, if costs or risk scores are misreported on some plans’ ACR submissions, those plans’ 

estimated costs could be lower or higher than their actual 

costs. In some counties, the estimated costs of the 

minimum-cost plans were so much lower than the costs 

of other local plans as to raise suspicions about the data. 

Consequently, CBO “trimmed” the data to remove the 

influence of extreme values.

To trim the data, CBO used the plan/county estimates of 

per capita costs—that is, the estimates of each plan’s cost 

in each county in its service area. Each plan/county 

observation was assigned to a category of counties on the 

basis of per capita FFS spending in the county.4 For each 

plan/county observation, CBO computed the ratio of the 

plan’s cost in that county to the per capita FFS expenditure in the county. Next, CBO examined the distribution 

of that cost ratio for each category of counties. Those distributions were close to the normal distribution. Within 

each category of counties, plan/county observations in 

which the cost ratio was more than 2.5 standard deviations from the mean were identified. For observations in 

which the cost ratio was below the mean by more than 

2.5 standard deviations, CBO “recoded” the cost ratio for 

that observation to equal the mean minus 2.5 standard 

deviations. Similarly, for observations in which the cost 

ratio was above the mean by more than 2.5 standard deviations, CBO recoded the cost ratio for that observation 

to equal the mean plus 2.5 standard deviations. Overall, 

about 2 percent of plan/county observations were 

recoded. Changing the cutoff point to 3 standard deviations from the mean reduced the number of observations 

that were recoded but did not affect the results presented 

in the study. 

4. For this analysis, CBO defined the same categories that were used 

in Table A-1.

APPENDIX

B

Supplementary Tables

This appendix contains tables illustrating the potential effects of different approaches to setting benchmarks 

under premium support. The tables reflect the assumption that plans’ bids are standardized using the 2003 riskadjustment data. (For estimates made using the 2004 risk-adjustment data, see Chapter 5.)

Table B-1.

Projected Benchmarks If Benchmarks Were Set Equal to the Minimum 

Bid in Each County in 2006 and Plans’ Bids Were Standardized Using 

2003 Risk-Adjustment Data

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

Note: FFS = fee for service; n.a. = not applicable.

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 15.0 1.00 1.00 0.79 0.79

550 to 599 20.1 0.99 0.99 0.87 0.86

600 to 649 23.5 0.97 0.96 0.89 0.88

650 to 699 15.2 0.96 0.94 0.92 0.89

700 and Higher 26.3 0.92 0.89 0.89 0.86

National Average n.a. 0.97 0.95 0.88 0.86

If Plans Reduced

Their Bids by

5 Percent

Average Ratio of Projected Benchmarks to

Per Capita FFS Expenditures

Average Ratio of Projected Benchmarks to

Medicare Advantage Benchmarks

If Plans Reduced

Their Bids by

 5 Percent

If Plans' Bids Were the

Same as Under

Medicare Advantage

Percentage of

Medicare 

Beneficiaries

If Plans' Bids Were the

Same as Under

Medicare Advantage
54 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table B-2.

Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Minimum Bid in Each County in 2006 and Plans’ Bids Were 

Standardized Using 2003 Risk-Adjustment Data 

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

Notes: FFS = fee for service.

The percentage change in the Part B premium is computed relative to the estimated value of that premium after the Hierarchical 

Condition Codes (HCC) risk adjuster was fully implemented in the Medicare Advantage program. Fully implementing that risk adjuster 

would reduce federal Medicare spending and therefore reduce the Part B premium below what it otherwise would be. Throughout this 

analysis, CBO assumed that the HCC risk adjuster would be fully implemented before premium support was introduced. 

Table B-3.

Projected Benchmarks If Benchmarks Were Set Equal to the EnrollmentWeighted Average Bid in Each County in 2006 and Plans’ Bids Were 

Standardized Using 2003 Risk-Adjustment Data

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

Note: FFS = fee for service; n.a. = not applicable.

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 83 83 -5 -5 16 16

550 to 599 87 89 0 2 15 15

600 to 649 100 108 15 24 16 17

650 to 699 108 124 24 43 16 18

700 and Higher 148 174 70 100 19 22

National Average 109 120 25 38 17 18

Average Premium for FFS

Program as a Percentage of 

Per Capita FFS Expenditures

Projected

Average Monthly Premium for 

FFS Program (Dollars)

Average Percentage Change in

Part B Premium

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Their Bids by

5 Percent

If Plans'

Bids Were the

Same as Under

Medicare Advantage

Reduced

If Plans

Reduced

Their Bids by

5 Percent

Bids Were the

If Plans'

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 15.0 1.00 1.00 0.80 0.80

550 to 599 20.1 1.00 1.00 0.87 0.87

600 to 649 23.5 1.00 1.00 0.92 0.92

650 to 699 15.2 1.00 1.00 0.95 0.95

700 and higher 26.3 1.00 1.00 0.96 0.96

National Average n.a. 1.00 1.00 0.91 0.91

Percentage of

Medicare 

Beneficiaries

If Plans' Bids Were the

Same as Under

Medicare Advantage

Their Bids by

5 Percent

Medicare Advantage Benchmarks

If Plans Reduced

Their Bids by

 5 Percent

If Plans' Bids Were the

Same as Under

Medicare Advantage

Average Ratio of Projected Benchmarks to Average Ratio of Projected Benchmarks to

Per Capita FFS Expenditures

If Plans Reduced
APPENDIX B SUPPLEMENTARY TABLES 55

Table B-4.

Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the Enrollment-Weighted Average Bid in Each County in 

2006 and Plans’ Bids Were Standardized Using 2003 Risk-Adjustment Data 

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

Note: FFS = fee for service.

The percentage change in the Part B premium is computed relative to the estimated value of that premium after the Hierarchical 

Condition Codes (HCC) risk adjuster was fully implemented in the Medicare Advantage program. Fully implementing that risk adjuster 

would reduce federal Medicare spending and therefore reduce the Part B premium below what it otherwise would be. Throughout this 

analysis, CBO assumed that the HCC risk adjuster would be fully implemented before premium support was introduced. 

Table B-5.

Projected Benchmarks If Benchmarks Were Set Equal to the National Average 

Bid in 2006, Adjusted to Account for Geographic Variation in Input Prices, and 

Plans’ Bids Were Standardized Using 2003 Risk-Adjustment Data

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

Note: FFS = fee for service; n.a. = not applicable.

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 86 86 -1 -1 17 17

550 to 599 86 86 -1 -1 15 15

600 to 649 86 86 -1 -1 14 14

650 to 699 86 87 -1 0 13 13

700 and Higher 86 88 -1 1 11 11

National Average 86 87 -1 0 14 14

Projected Average Premium for FFS

Average Monthly Premium for Program as a Percentage of 

FFS Program (Dollars)

Average Percentage Change in

Part B Premium

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent 5 Percent

Per Capita FFS Expenditures

If Plans

Reduced

Their Bids by

If Plans'

Bids Were the

Same as Under

Medicare Advantage

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than 550 15.0 1.16 1.16 0.92 0.92

550 to 599 20.1 1.05 1.05 0.92 0.92

600 to 649 23.5 1.02 1.01 0.93 0.93

650 to 699 15.2 0.96 0.96 0.91 0.91

700 and Higher 26.3 0.92 0.92 0.89 0.89

National Average n.a. 1.01 1.01 0.91 0.91

Average Ratio of Projected Benchmarks to

Per Capita FFS Expenditures Medicare Advantage Benchmarks

Percentage of

Medicare 

Beneficiaries

If Plans' Bids Were the

Same as Under

Medicare Advantage

If Plans Reduced

Their Bids by

5 Percent

If Plans' Bids Were the

Same as Under

Medicare Advantage

If Plans Reduced

Their Bids by

5 Percent

Average Ratio of Projected Benchmarks to
56 DESIGNING A PREMIUM SUPPORT SYSTEM FOR MEDICARE

Table B-6.

Projected Monthly Beneficiaries’ Premiums for the FFS Program If Benchmarks 

Were Set Equal to the National Average Bid in 2006, Adjusted for Geographic 

Variation in Input Prices, and Plans’ Bids Were Standardized Using 2003 

Risk-Adjustment Data

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

Notes: FFS = fee for service. 

Estimates in this table were calculated under the assumption that there would be no restrictions on the premiums of beneficiaries who 

live in areas not served by private plans. 

The percentage change in the Part B premium is computed relative to the estimated value of that premium after the Hierarchical 

Condition Codes (HCC) risk adjuster was fully implemented in the Medicare Advantage program. Fully implementing that risk adjuster 

would reduce federal Medicare spending and therefore reduce the Part B premium below what it otherwise would be. Throughout this 

analysis, CBO assumed that the HCC risk adjuster would be fully implemented before premium support was introduced.

Average 

Per Capita FFS

Expenditure in 

County in 2006

(Dollars)

Less Than $550 23 23 -74 -74 4 4

550 to 599 61 61 -30 -30 11 11

600 to 649 80 81 -8 -7 13 13

650 to 699 114 114 31 31 17 17

700 and Higher 150 150 73 73 19 19

National Average 91 92 5 6 13 13

Average Premium for FFS

Program as a Percentage of 

Projected

Average Monthly Premium for 

FFS Program (Dollars)

Average Percentage Change in

Part B Premium

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent

Per Capita FFS Expenditures

If Plans'

Bids Were the

Same as Under

Medicare Advantage

If Plans

Reduced

Their Bids by

5 Percent