CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

CBO

P A P E R

JULY 2004

A Detailed 

Description of 

CBO’s Cost Estimate 

for the Medicare 

Prescription

Drug Benefit

The Congress of the United States O Congressional Budget Office

CBO

A Detailed Description

of CBO’s Cost Estimate for the

Medicare Prescription Drug Benefit

July 2004

A

PAPER
Note

Numbers in the text and tables of this report may not sum to totals because of rounding.
Preface

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 was 

signed into law by the President on December 8, 2003. The Congressional Budget Office 

(CBO) provided analysis to the Congress during its deliberations over the addition of an outpatient prescription drug benefit to Medicare and issued in July 2003 federal cost estimates 

for H.R. 1 and S.1 as passed by the House and Senate as well as an estimate of the conference 

agreement on H.R. 1 in November 2003.

This paper provides details of the reasoning behind CBO’s cost estimate of the prescription 

drug provisions contained in the Medicare Modernization Act. In accordance with CBO’s 

mandate to provide impartial analysis, this report makes no recommendations. Philip Ellis 

prepared the report in conjunction with Jeanne De Sa and Eric Rollins, with additional contributions from Niall Brennan, Robert Nguyen, Margaret Nowak, and Shinobu Suzuki. 

Arlene Holen, Allison Percy, and Tom Bradley, all of CBO, provided thoughtful comments on 

earlier drafts, as did Len Nichols of the Center for Studying Health System Change and 

Rachel Schmidt of the Medicare Payment Advisory Commission. (The assistance of external 

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

Over the past several years, numerous people at CBO have contributed to the agency’s analysis 

of the issues related to a Medicare drug benefit. Those analysts are Joseph Antos, David Auerbach, James Baumgardner, Shawn Bishop, Kate Bloniarz, Jennifer Bowman, Tom Bradley, 

Niall Brennan, Hayley Buchbinder, Kathleen Buto, Julia Christensen, Sandra Christensen, 

Anna Cook, Jeanne De Sa, Philip Ellis, Peter Fontaine, Carol Frost, Samuel Kina, Mara 

Krause, Steven Lieberman, Deborah Lucas, Mark Miller, Robert Nguyen, Margaret Nowak, 

Karuna Patel, Eric Rollins, Rachel Schmidt, Emily Shelton, Robert Sunshine, Shinobu 

Suzuki, Sarah Thomas, Bruce Vavrichek, Judith Wagner, and Daniel Wilmoth.

Christine Bogusz edited the paper, and Leah Mazade proofread it. Maureen Costantino prepared the report for publication as well as designed and took the photograph for the cover; 

Lenny Skutnik printed the copies of the report; and Annette Kalicki produced the electronic 

versions for CBO’s Web site (www.cbo.gov). 

Douglas Holtz-Eakin

Director

July 2004

Summary vii

Introduction 1

Factors in Estimating the Cost of the Basic Medicare 

Drug Benefit 3

Eligibility and Enrollment 3

Gross Costs of Providing the Basic Drug Benefit 5

Beneficiaries’ Premiums 18

The Employer Subsidy System 21

Summary of Basic Benefit Costs 25

Costs of the Low-Income Drug Subsidies and Effects 

on Medicaid and Other Direct Spending 26

Transitional Drug Assistance 26

Low-Income Drug Subsidies 27

Interactions with Medicaid 29

Other Effects on Direct Spending 32

Uncertainty and Conclusions 33

Appendix: The Drug Benefit’s Risk Corridor System 35

CONTENTS
vi A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Tables

S-1. CBO’s Estimate of the Total Cost of the Medicare Prescription 

Drug Benefit, Fiscal Years 2004 to 2013 viii

1. CBO’s Cost Estimate for the Medicare Prescription Drug Benefit,

Fiscal Years 2004 to 2013 2

2. Key Features of the Standard Drug Benefit Under the Medicare 

Modernization Act, Calendar Years 2006 to 2013 9

3. Key Factors Used in CBO’s Estimate of Gross Drug Costs per 

Drug Benefit Participant, Calendar Years 2006 and 2013 18

4. Estimated Costs for Drug Benefit Participants, Calendar Years 

2006 and 2013 19

5. Total Costs, Federal Subsidies, and Beneficiaries’ Premiums for

Calendar Year 2006 Under Three Illustrative Plans 20

6. Employers’ Options for Providing Drug Coverage Under the MMA 

and Resulting Net Medicare Subsidies per Enrollee, Calendar 

Years 2006 and 2013 23

7. Estimated Spending by and Costs for Drug Benefit Participants, 

Calendar Years 2006 and 2013 26

8. Number of Enrollees in Medicare Part B Who Are Eligible 

for Low-Income Drug Subsidies in Calendar Year 2006 28

9. Impact of the Medicare Prescription Drug Benefit on States’ 

Medicaid Outlays, Fiscal Years 2004 to 2013 31

A-1. Example of How the Drug Benefit’s Risk Corridors Would 

Operate in 2006 36
Summary

The recently enacted Medicare Prescription Drug, 

Improvement, and Modernization Act of 2003 (MMA) 

contains many provisions that affect the Medicare program specifically and the U.S. health sector more generally. This paper focuses on the provisions that establish a 

new outpatient prescription drug benefit under Medicare 

and explains the basis for and rationale behind the Congressional Budget Office’s (CBO’s) cost estimate of those 

provisions. CBO estimated that, on net, the Medicare 

drug benefit would increase mandatory outlays by $407 

billion for fiscal years 2004 to 2013 and would raise 

federal revenues by $7 billion over that period. Those 

estimates consist of many components and reflect the 

complex interactions of the law’s many provisions (see 

Summary Table 1). In describing how CBO derived its 

estimates, this paper also presents the agency’s analysis of 

how the drug benefit is anticipated to operate in practice. 

Taken as a whole, the MMA’s other provisions would reduce outlays by $13 billion and revenues by $7 billion, in 

CBO’s estimation, for a net savings of $6 billion. As a result, the MMA would increase deficits—or reduce surpluses—by $394 billion over the 2004-2013 period (reflecting an increase of $395 billion in federal outlays and 

an increase of $0.5 billion in federal revenues). 

Factors in Estimating the Cost 

of the Basic Medicare Drug Benefit

The MMA established a basic outpatient drug benefit as 

Part D of Medicare and made it available on a voluntary 

basis to all Medicare beneficiaries. Estimating the costs of 

providing that basic benefit involved three main steps: 

determining the number of beneficiaries who would 

decide to enroll in a Medicare drug plan; estimating the 

average and total costs of providing those enrollees with 

covered benefits; and using the resulting estimate of gross 

costs to calculate offsetting premium receipts on the basis 

of the law’s subsidy formulas. In addition, CBO had to 

calculate whether and to what extent employers that currently provide drug coverage to their retirees on Medicare 

would continue to do so once the new drug benefit was 

in place, and whether they would take advantage of an 

alternative mechanism in the MMA to receive direct payments from Medicare for continuing to provide qualified 

drug coverage to those retirees. 

Participation 

Overall, CBO estimated that 87 percent of Medicare 

beneficiaries would participate in the drug benefit once it 

became available in 2006, with average enrollment rising 

from 37 million in that calendar year to 43 million by 

2013. In large measure, CBO based those estimates on 

historical rates of participation in Medicare Part B—

which is similar to Part D in that it is a voluntary program, has a premium subsidy of about 75 percent, and 

imposes significant penalties for late enrollment. Although 94 percent of Medicare beneficiaries enroll in Part 

B, CBO assumed that participation in Part D would be 

somewhat lower because many active workers and federal 

retirees enrolled in Part B would decide not to sign up for 

the drug benefit. About 19 percent of Medicare beneficiaries would receive subsidized drug coverage through a 

former employer (and thus would technically not be enrolled in Part D), but the remaining 68 percent would be 

expected to receive their drug benefits from newly established prescription drug plans or through integrated private health plans that also provided Medicare’s other 

benefits. 

Costs for Medicare Drug Plans 

Under the MMA, Medicare will not pay directly for 

drugs provided to its enrollees. Instead, private entities 

are expected to deliver Part D benefits and will be paid 

partly on the basis of their expected costs (as expressed in 

bids) and partly on their actual costs. As a result, CBO’s 

estimate of federal costs took into account what types of 

entities would participate as drug plans and what sorts of 

costs they would incur. While those costs would depend
viii A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Summary Table 1.

CBO’s Estimate of the Total Cost of the Medicare Prescription Drug Benefit, 

Fiscal Years 2004 to 2013

(Billions of dollars)

-+

Source: Congressional Budget Office.

Note: MMA=Medicare Prescription Drug, Improvement, and Modernization Act of 2003.

a. Figures for the total impact on direct spending of the drug benefit provisions differ slightly from figures previously released by CBO 

because certain expenditures have been reclassified from Part D to other provisions of the MMA and vice versa. That difference does not 

affect CBO’s overall cost estimate, however. See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2005 to 

2014 (January 2004), pp. 12-13.

primarily on the share of beneficiaries’ drug spending that 

would be covered by the statutory benefit’s design, CBO’s 

estimate assumed that the new benefit would not only redistribute drug spending among the various payers but 

also change the level of total spending. 

The standard drug benefit specified by the MMA for calendar year 2006 will have a $250 annual deductible; pay 

75 percent of covered drug costs between $250 and 

$2,250 (the “initial coverage limit”); provide no further 

coverage until an enrollee has incurred $3,600 in out-ofpocket drug costs for the year (the end of the so-called 

doughnut hole); and pay about 95 percent of covered 

drug costs beyond that catastrophic threshold. Because 

the benefit’s parameters are indexed to per capita drug 

spending, the benefit will cover about the same share of 

total drug spending for enrollees each year. The catastrophic threshold is defined in terms of the “true out-ofpocket costs” that enrollees actually incur—meaning that 

enrollees who purchased additional private drug coverage 

would delay the point at which they reached that threshold and thus would receive less coverage through Medicare, an outcome that CBO assumed would discourage 

them from purchasing such additional coverage. 

To estimate the costs for drug plans of providing those 

covered benefits, CBO started with a projection of total 

outpatient drug spending by the Medicare population in 

the absence of a Medicare drug benefit. The agency then 

adjusted that total by several factors: 

Total Cost

of the Benefit

Changes to Direct Federal Spending

Payments to Medicare drug plans for basic benefits and administrative costs 507

Beneficiaries’ premiums -131

Subsidies for employer and union drug plans 71

Subsidies for low-income benefits 192

Federal Medicaid spending -142

Transfers from states’ Medicaid programs -88

Other effects on federal spending -2

Totala 407

Changes to Federal Revenues 7

Net Budgetary Impact of the Drug Benefit Provisions 400

Net Budgetary Impact of the MMA’s Other Provisions -6

Net Budgetary Impact of the MMA 394

Memorandum:

Net Change to Direct Federal Spending 395
SUMMARY ix

B A “price effect” to reflect the likelihood that average 

drug prices will be slightly higher because beneficiaries 

who currently lack drug coverage (about 25 percent of 

the Medicare population) will become partially insulated from those prices;

B A “use effect” to capture changes in demand for drugs 

resulting from changes in beneficiaries’ cost-sharing 

liabilities (to reflect the assumption that beneficiaries’ 

total drug use will increase somewhat if their own 

out-of-pocket costs fall);

B An adjustment to reflect the degree to which Medicare 

drug plans will manage the drug costs of their enrollees (discussed further below); and

B A slight decrease in spending because prices negotiated 

by Medicare drug plans will be exempt from Medicaid’s best-price provisions—an exemption that gives 

those plans more leeway to negotiate steeper price discounts from manufacturers since those manufacturers 

will not have to pass on the same discount to Medicaid. 

In estimating the degree of cost management that Medicare drug plans would achieve on average, CBO focused 

on two main considerations: the incentives that plans 

would have to control costs (based on the degree of financial risk they would bear and the type of competition they 

would face); and the tools that they could use to control 

spending (such as preferred drug lists and pharmacy networks). To summarize the effects of those factors on cost 

management, CBO estimated the degree to which spending would be reduced in comparison with an unmanaged 

benefit, such as a traditional indemnity insurance plan. 

The gross drug savings achieved by the Medicare plans 

would result from negotiating price discounts or rebates 

from drug manufacturers and pharmacies; controlling 

overall drug use; and changing the mix of drugs used. 

The savings are gross in that they do not reflect the administrative costs of the mechanisms used to achieve 

them (which were accounted for separately). 

Drug plans bearing the full level of financial risk specified 

by the MMA would achieve average gross drug savings of 

20 percent initially, CBO estimated, growing to 25 percent over the budget window. That initial level of savings 

reflected CBO’s assessment that the MMA would create a 

highly competitive environment for drug plans but 

would somewhat limit the financial risk they faced—in 

part because of relatively narrow initial “risk corridors”—

and also would place certain constraints on their use of 

cost-management tools. (Under the law’s risk corridor 

provisions, drug plans incurring costs that exceeded their 

expected levels by a sufficient degree would be partially 

compensated by additional federal payments, whereas 

drug plans with costs that fell far enough below their expectations would have to reimburse Medicare.) Over 

time, with the gradual widening of the MMA’s risk corridors, drug plans would be exposed to greater financial 

risk, so CBO’s estimate of gross drug savings rose accordingly. For beneficiaries whose current drug spending already reflected some degree of cost management, however, CBO adjusted that spending to capture only the 

incremental savings that would be achieved. CBO also 

assumed that there was some chance that beneficiaries 

would be enrolled in reduced-risk or “fallback” drug plans 

as specified by the law; in those cases, CBO estimated 

that gross savings would be about half as large owing both 

to the limited financial risk those plans would face and to 

the less competitive environment in which they would 

operate. 

To calculate the costs of providing covered benefits to 

Part D enrollees, CBO then applied the law’s drug benefit 

design and added an estimate of drug plans’ administrative costs (which also reflected the degree of financial risk 

they would face). In sum, CBO estimated that the average cost per enrollee for providing basic benefits would be 

$1,640 in calendar year 2006, rising to $2,713 in 2013. 

Multiplying the average costs for each year by the number 

of enrollees and then converting them to fiscal year outlays, CBO projected total payments to Medicare drug 

plans of $507 billion over the 2006-2013 period. 

Beneficiaries’ Premiums

A portion of the costs of providing the drug benefit will 

be financed by premiums paid by or on behalf of beneficiaries, which CBO estimated would total $131 billion 

through fiscal year 2013. Although the MMA’s subsidy 

formulas are complex—specifying both a “direct” subsidy 

that is fixed and a “reinsurance” subsidy that varies with 

the share of spending above the catastrophic threshold—

CBO estimated average premiums for beneficiaries by applying the law’s 74.5 percent average subsidy to average 

gross costs. Reflecting the agency’s estimate of average 

costs per enrollee, average premiums for beneficiaries 

would rise from $418 in calendar year 2006 (or about 
x A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

$35 per month) to $692 in 2013 (or about $58 per 

month), CBO projected. The premiums that beneficiaries paid would depend on which drug plan they joined, 

however, and would be higher if they joined a plan with 

above-average costs overall and lower if they joined a plan 

with below-average costs. As a result, drug plans will have 

strong incentives to keep their costs low to attract enrollees, and beneficiaries will be strongly encouraged to consider whether the extra premium of a more costly plan is 

worth paying—two factors that also affected CBO’s assumption about the gross savings that drug plans would 

achieve on average. 

Employers’ Subsidies

Former employers are an important source of drug coverage for Medicare beneficiaries, and CBO had projected 

that in the absence of a Medicare drug benefit, the share 

of beneficiaries with such coverage would remain roughly 

constant through 2013. Under the MMA, those employers would have three options for providing drug coverage. 

First, they could serve as the prescription drug plan for 

their retirees or could supplement the drug benefits offered by a generally available Medicare drug plan. If employers’ supplemental coverage was generous, though, 

even individuals with very high drug use might never 

reach the Medicare benefit’s catastrophic threshold because they would not incur sufficient out-of-pocket costs 

themselves. Medicare’s average subsidy payments would 

thus be lower under that option than if employers 

dropped their drug coverage—that is, stopped providing 

such coverage themselves to Medicare beneficiaries and 

did not supplement the drug benefit for Part D enrollees. 

A third option for employers would be to provide Medicare-eligible retirees with qualified drug coverage and receive a tax-free payment directly from Medicare equal to 

28 percent of their total drug costs in a specified dollar 

range. But CBO estimated that on average, those direct 

Medicare payments would also be much lower than the 

net Medicare subsidies for retirees whose employers had 

dropped drug coverage. At the same time, those direct 

payments would be accorded favorable tax treatment, 

making that option somewhat more attractive for employers. 

CBO concluded that the net difference in subsidies under 

the MMA would give employers a new financial incentive 

to drop prescription drug coverage for Medicare-eligible 

retirees and that some employers would respond to that 

incentive. In particular, CBO estimated that 2.7 million 

Medicare-eligible retirees who would have had more generous employer drug coverage in 2006 in the absence of a 

Medicare drug benefit would enroll in Part D but would 

see their former employer decide not to supplement its 

basic benefits (although they could have their premium 

paid or receive some other compensation instead). Of the 

remaining nonfederal retirees that were projected to have 

generous employer-sponsored drug coverage, CBO assumed that nearly all—about 8.2 million individuals in 

calendar year 2006, rising to 9.5 million in 2013—would 

see their employer take the 28 percent subsidy payment 

from Medicare, both because of its tax advantages and for 

reasons of administrative simplicity. CBO’s estimate of 

$71 billion in direct subsidy payments to qualified employer and union plans for fiscal years 2006 to 2013 reflected the share of drug spending by those retirees that 

was projected to fall in the covered range. The Medicare 

drug benefit’s provisions would increase revenues by 

about $7 billion over that period, CBO further estimated, as businesses reduced expenditures for the (nontaxable) drug benefits they had previously provided and 

increased them for other (taxable) forms of compensation. 

Costs of the Low-Income Drug

Subsidies and Effects on Medicaid

and Other Direct Spending

Low-Income Drug Subsidies and 

Transitional Assistance

The MMA established two levels of additional drug benefits for enrollees with relatively low income and countable 

assets: a substantially higher subsidy for beneficiaries who 

are either dually eligible for full Medicare and Medicaid 

benefits or have income below 135 percent of the federal 

poverty level and few assets; and a somewhat higher subsidy for those with income below 150 percent of the poverty level and assets below a slightly higher limit. Those 

subsidies would pay all or a portion of those beneficiaries’ 

Part D premiums and substantially reduce their costsharing liabilities (both by lowering their copayment rate 

and by extending that coverage to costs falling between 

the initial benefit limit and the catastrophic threshold). 

About 35 percent of beneficiaries enrolled in Part B of 

Medicare would be eligible for those low-income subsidy 

benefits, CBO estimated. 

In estimating enrollment in the low-income drug subsidy 

program, CBO assumed that all dual eligibles would re-
SUMMARY xi

ceive the subsidies but that a significant proportion of the 

remaining eligible population would not apply. That assumption primarily reflected the fact that participation is 

low in similar Medicaid programs that pay for premiums 

and cost sharing under Parts A and B of Medicare. 

(Those programs are for qualified Medicare beneficiaries 

[QMBs] and specified low-income Medicare beneficiaries 

[SLMBs], who have income below 120 percent of the 

poverty level and limited assets.) Ultimately, CBO assumed that almost 70 percent of eligible enrollees would 

receive low-income subsidies under the MMA. About 75 

percent of those eligible for the substantially higher subsidy (including all dual eligibles) would receive it, while 

about 35 percent of those eligible for the somewhat 

higher subsidy would receive that benefit. Take-up rates 

would be slightly lower in the initial years of the benefit. 

In estimating the costs of the low-income subsidy payments, CBO assumed that participants would generally 

have higher average drug costs than beneficiaries who 

were eligible for those subsidies but chose not to enroll. 

The total cost of $192 billion that CBO estimated for the 

low-income subsidies over 10 years also includes about $1 

billion for the costs of covering the enrollment fees and 

providing up to $600 of assistance for certain low-income 

beneficiaries in conjunction with the Medicare drug discount card. For that transitional assistance program, 

which is scheduled to operate from mid-2004 through 

December 2005, CBO assumed a relatively low take-up 

rate (nearly 1 million enrollees in 2005) because of the 

program’s limited benefits and temporary nature. 

Interactions with Medicaid

The MMA transfers responsibility for the prescription 

drug benefits of dual eligibles from Medicaid to Medicare. As a result, CBO estimated that federal spending on 

Medicaid would be reduced by $152 billion through fiscal year 2013 compared with projections of spending in 

the absence of a Medicare drug benefit. Those savings on 

drug costs would be partly offset by an additional $10 

billion in federal Medicaid outlays over that period stemming primarily from additional spending on other benefits for Medicare beneficiaries who would enroll in Medicaid or the QMB and SLMB programs as a result of 

applying for the low-income drug subsidy program. In 

the absence of other provisions, those federal Medicaid 

savings on drug costs would be accompanied by corresponding savings for the states. The MMA’s “clawback” 

provision, however, would recapture a substantial portion 

of the states’ estimated drug savings, which CBO projected would further reduce federal costs by $88 billion 

for fiscal years 2004 to 2013. 

Other Effects on Direct Spending

CBO estimated that some federal retirees would enroll in 

a Medicare drug plan; as a result, a portion of their prescription drug costs would be indirectly shifted to Medicare (the figures provided above reflect that estimate). On 

the basis of that impact, as well as small effects on other 

federal programs that pay for prescription drugs, CBO 

estimated that the Medicare law’s drug benefit provisions 

would reduce mandatory federal spending by about 

$3 billion through fiscal year 2013. At the same time, the 

MMA provided $1.5 billion in mandatory spending for 

the federal administrative costs of implementing the drug 

benefit in 2004 and 2005, so the estimated impact on 

other direct spending was a net reduction of about $2 billion over 10 years. CBO assumed that the drug benefit 

would not generally increase or decrease spending for 

hospitalizations, doctors’ visits, or other services paid for 

under Parts A and B of Medicare and that it would not 

substantially affect net enrollment in private health plans 

(Part C).

Uncertainty and Conclusions 

Anytime a complex and substantially new program is created, difficulties arise in predicting its outcome, particularly in the case of an entitlement program with a large 

number of potential enrollees. For many reasons, actual 

program costs could turn out to be higher or lower than 

CBO has estimated. Several key variables—including the 

number of participants in the basic drug benefit or in the 

low-income subsidy program, their level of drug spending 

in the absence of a Medicare drug benefit, and the adjustments made to that spending to determine average costs 

per participant—could deviate, in either direction, from 

CBO’s projections. Until such information becomes 

available, however, the cost estimate described here represents the agency’s best judgment about the net budgetary 

impact of the Medicare drug benefit that was established 

by the MMA.

A Detailed Description of CBO’s Cost Estimate

for the Medicare Prescription Drug Benefit

Introduction 

The Medicare Prescription Drug, Improvement, and 

Modernization Act of 2003 (MMA), Public Law 108-

173, was passed by the House of Representatives on November 22 and by the Senate on November 25 and was 

signed into law by the President on December 8, 2003. 

That legislation contains numerous provisions that modify Medicare’s payments to hospitals, doctors, and other 

health care providers, as well as provisions that affect 

other parts of the health sector (such as those establishing 

health savings accounts or changing the rules that govern 

the introduction of generic prescription drugs). This paper focuses on the provisions of the MMA that create an 

outpatient prescription drug benefit under Medicare, explaining how the Congressional Budget Office (CBO) 

generated its cost estimate for those provisions.1

The provisions of the MMA that established the Medicare drug benefit would increase outlays for direct federal 

spending by $407 billion for fiscal years 2004 to 2013, in 

CBO’s estimation.2

 That projection has several components (see Table 1). Under the law, drug benefits would 

be delivered by private-sector entities bearing some financial risk—generally through newly established prescription drug plans (PDPs) or through integrated private 

health plans that also provide Medicare’s other benefits to 

their enrollees. Those plans would incur costs of $507 

billion in providing the basic statutory drug benefit, 

CBO projected, which would be partially offset by $131 

billion in premium payments made by or on behalf of enrollees. The law provides a separate payment system for 

beneficiaries who instead receive qualified drug coverage 

through plans offered by employers or unions; CBO estimated that Medicare payments to those plans would 

amount to $71 billion. The impact of the drug benefit 

provisions on employers’ costs would indirectly raise federal revenues by $7 billion over the fiscal year 2004-2013 

period, in CBO’s estimation, modestly offsetting the impact of the increases in direct spending on future federal 

deficits or surpluses. 

In addition to offering a basic drug benefit to all Medicare beneficiaries, the MMA would subsidize more generous drug coverage for certain low-income enrollees, 

which CBO estimated would cost $192 billion through 

fiscal year 2013. Because the new benefit and low-income 

subsidies would replace the drug coverage that many 

Medicare beneficiaries receive through Medicaid, federal 

spending on drugs under Medicaid would decline by 

$152 billion compared with projected spending in the 

absence of a Medicare drug benefit. Those savings would 

be partly offset by an additional $10 billion in federal 

outlays for Medicaid resulting from the new law’s drug 

benefit provisions—largely owing to additional spending 

on other benefits for Medicare beneficiaries who enroll in 

Medicaid when they apply for the low-income drug subsidy program. Thus, the net federal Medicaid savings 

shown in Table 1 were estimated at $142 billion over 10

1. A section-by-section breakdown of CBO’s scoring for the entire 

MMA was provided in Congressional Budget Office, H.R. 1, 

Medicare Prescription Drug, Improvement, and Modernization Act 

of 2003 (November 2003), and additional details were provided in 

Congressional Budget Office, The Budget and Economic Outlook: 

Fiscal Years 2005 to 2014 (January 2004), pp. 12-13. CBO’s scoring of the MMA was also discussed by CBO Director Douglas 

Holtz-Eakin in his statement, Estimating the Cost of the Medicare 

Modernization Act, before the House Committee on Ways and 

Means, March 24, 2004. 

2. That figure differs slightly from the $409 billion total shown in 

recent CBO publications. The reason for the difference is a slight 

reclassification of certain expenditures from the drug benefit to 

other provisions of the MMA and vice versa, but the difference 

does not affect CBO’s overall cost estimate for the MMA. 
2 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Table 1.

CBO’s Cost Estimate for the Medicare Prescription Drug Benefit,

Fiscal Years 2004 to 2013

(Billions of dollars)

Source: Congressional Budget Office.

Notes: MMA=Medicare Prescription Drug, Improvement, and Modernization Act of 2003.

a. Includes $1.5 billion in mandatory spending for federal administrative costs of implementing the drug benefit. 

b. Figures for the total impact on direct spending of the drug benefit provisions differ slightly from figures previously released by CBO 

because certain expenditures have been reclassified from Part D to other provisions of the MMA and vice versa. That difference does not 

affect CBO’s overall cost estimate, however. See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2005 to 

2014 (January 2004), pp. 12-13. 

c. Includes the estimated effect on revenues of MMA provisions that would modify the Hatch-Waxman Act (an increase of $0.2 billion over 

the 2004-2013 period). 

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Total,

2004-

2008

Total,

2004-

2013

Changes to Direct Federal Spending

Payments to Medicare Drug Plans 

for Basic Benefits and 

Administrative Costs 0 0 33.3 49.9 55.9 60.5 66.3 72.1 80.1 89.3 139.0 507.2

Beneficiaries’ Premiums 0 0 - 9.1 - 12.8 - 14.3 - 15.5 - 17.0 - 18.5 - 20.6 - 22.9 - 36.2 - 130.6

Subsidies for Employer and Union 

Drug Plans 0 0 4.7 6.8 7.5 8.3 9.3 10.3 11.5 12.6 19.0 71.1

 Subtotal, Basic Drug Benefit 0 0 28.9 43.9 49.1 53.3 58.6 64.0 71.0 79.0 121.8 447.7

Subsidies for Low-Income Benefits 0.1 0.5 8.9 18.1 20.8 23.2 25.7 28.2 31.2 34.8 48.4 191.5

Federal Medicaid Spending 0 0 - 6.5 - 13.9 - 15.3 - 17.0 - 18.9 - 21.0 - 23.3 - 25.9 - 35.6 - 141.8

Transfers from States’ Medicaid 

Programs 0 0 - 5.7 - 9.1 - 10.0 - 10.8 - 11.7 - 12.6 - 13.7 - 14.9 - 24.8 - 88.5

Other Effects on Federal Spendinga 0.5 1.0 - 0.1 - 0.3 - 0.3 - 0.4 - 0.4 - 0.5 - 0.5 - 0.6 0.8 - 1.5

Totalb 0.6 1.5 25.5 38.7 44.3 48.3 53.3 58.1 64.7 72.5 110.7 407.5

Changes to Federal Revenues

Indirect Effects of Drug Benefit 

Provisionsc 0 0 0.4 0.7 0.8 0.8 0.9 1.0 1.2 1.3 1.9 7.2

Net Budgetary Impact

Medicare Drug Benefit

Provisions 0.6 1.5 25.0 38.0 43.5 47.5 52.3 57.1 63.5 71.1 108.8 400.3

Other MMA Provisions 3.4 4.9 2.6 2.1 0.4 - 1.1 - 2.7 - 4.3 - 5.2 - 6.0 13.3 - 6.0

Medicare Modernization Act 4.0 6.5 27.6 40.2 43.9 46.4 49.6 52.8 58.4 65.1 122.1 394.3

Memorandum:

Net Change to Direct Federal 

Spending 3.8 6.0 27.5 40.2 44.0 46.5 49.8 53.0 58.7 65.5 121.4 394.8
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 3

years.3 Another provision of the act would capture a substantial portion of states’ savings on Medicaid drug expenditures, reducing federal costs by an estimated $88 

billion. Finally, the Medicare drug benefit would on net 

reduce mandatory spending for the Federal Employees 

Health Benefits (FEHB) program and other federal programs that currently pay for prescription drugs, although 

the MMA also included mandatory spending for the federal administrative costs of implementing the drug benefit. Over 10 years, the net reduction in other direct 

spending would be about $2 billion. 

Taking into account all of the MMA’s provisions, including those unrelated to the drug benefit, CBO estimated 

that the law would yield a net increase in deficits or a 

reduction in surpluses of $394 billion over the fiscal year 

2004-2013 period.4

This paper aims to explain what each component of 

CBO’s cost estimate for the Medicare drug benefit represents and how those components were derived. In doing 

so, the paper also reviews how the agency addressed a 

number of difficult but fundamental questions raised by 

the prospect of such a new benefit. For example, would 

Medicare beneficiaries sign up for it—and in particular, 

would enrollment in the benefit be broad and representative, or would it be concentrated among the small share 

of beneficiaries with the highest drug costs? Would private-sector entities step forward to provide a stand-alone 

drug benefit to the Medicare population and accept the 

degree of financial risk specified by the MMA? If so, how 

well would they be able to control drug spending, what 

costs would they incur in doing so, and how would enrollees balance the costs and benefits of competing drug 

plans when deciding which one to select? If privatesector entities did not come forward, what would be the 

costs of providing benefits through reduced-risk or “fallback” drug plans, and how would the market for drug 

coverage evolve over time? How would the organizations 

currently providing drug coverage to many Medicare 

beneficiaries—such as their former employers—react to 

the new benefit’s provisions? And how would beneficiaries who were eligible for the low-income subsidies respond to their availability?5

The first section of this paper focuses on the drug benefit 

that will be made generally available to Medicare beneficiaries and discusses the factors affecting the number of 

participants in that program and the costs per participant, both in gross terms and net of beneficiaries’ premium payments. It includes a discussion of the related 

impact on employer-sponsored drug coverage for Medicare beneficiaries and of the payments Medicare will 

make to qualified employer and union plans for drug 

costs. The second section focuses primarily on the subsidies for providing more generous drug coverage to certain 

low-income beneficiaries—and the related provisions affecting federal Medicaid spending—but also covers several other effects on federal outlays. A concluding section 

notes the uncertainty inherent in estimating the costs of 

such an entitlement program, given that the federal government will be offering an entirely new type of benefit 

to a large number of individuals.

Factors in Estimating the Cost 

of the Basic Medicare Drug Benefit

Eligibility and Enrollment

A key determinant of total federal costs for providing a 

Medicare drug benefit is the number of beneficiaries who 

enroll. Under the MMA, benefits will be first available on 

January 1, 2006, and beneficiaries who are enrolled in either Part A or Part B of Medicare at that time (including 

those who get their Medicare benefits through a private 

health plan under Part C) will be eligible for the new prescription drug benefit, which will be established as Part D

3. In a comparable table that CBO released in November 2003, the 

additional federal Medicaid outlays were included with “other 

direct spending,” whereas Medicaid drug savings were added to 

the net savings on drug costs for other federal programs (yielding a 

10-year total of $155 billion). See Congressional Budget Office, 

Letter to the Honorable Don Nickles providing additional information about CBO’s cost estimate for the conference agreement on H.R. 1

(November 2003). 

4. Taken together, the MMA’s other provisions would reduce outlays 

by $13 billion, CBO estimated, so that the net increase in mandatory outlays for the MMA as a whole would round to $395 billion. The MMA’s other provisions would also reduce revenues—

by $7 billion, CBO projected—nearly offsetting the effect on revenues of the drug benefit provisions. 

5. For additional background information and a discussion of how 

CBO approached many of those questions, see Congressional 

Budget Office, Issues in Designing a Prescription Drug Benefit for 

Medicare (October 2002). 
4 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

of Medicare.6 Enrollment in Part D will be voluntary, 

however, so CBO modeled the decision to participate as a 

function of the “carrots and sticks” that potential enrollees would face—carrots in the form of federal subsidies to 

keep their premiums down and sticks in the form of lateenrollment penalties. In large measure, CBO based its approach for estimating participation in Part D on the experience of Part B, which is also voluntary, has similar 

premium subsidies and late-enrollment penalties, and enrolls nearly all beneficiaries who are eligible. 

Key Considerations. The federal subsidies that will be 

provided under Part D are a major incentive to enroll in 

the drug benefit. As discussed in more detail below, those 

subsidies mean that beneficiaries’ premiums will, on average, cover about 25 percent of the costs of providing the 

standard Part D benefit. Because of those subsidies, most 

Medicare beneficiaries by enrolling will receive more in 

benefits than they will pay in premiums. Even those enrollees who end up paying more in premiums than they 

save on their drug costs in a given year will derive the 

benefit of having had insurance protection against the 

risk of incurring higher out-of-pocket costs. Although 

beneficiaries generally will not be enrolled in Part D by 

default—unlike Part B—CBO assumed that the premium subsidy would be sufficient to overcome the hurdle 

of actively signing up.7 Eligible beneficiaries who currently have drug coverage will have a clear incentive to 

enroll in Part D—or the sponsors of their coverage will 

want them to enroll—in order to obtain those new federal subsidies, regardless of their current drug use. (CBO 

estimated that about 75 percent of Medicare beneficiaries 

have some form of drug coverage, though in many cases 

that coverage is rather limited.) For beneficiaries who 

have sufficiently low income and assets, the additional 

premium and cost-sharing subsidies they are offered will 

provide a further inducement to enroll in the basic drug 

benefit. 

Although enrollment in Part D is voluntary, beneficiaries 

who do not sign up when they are first eligible, and those 

who disenroll and subsequently reenroll, will be subject 

to a late-enrollment penalty (unless they maintain drug 

coverage from certain other sources in the meantime that 

is at least as generous as the Medicare benefit). For example, beneficiaries who went without drug coverage for 

two years before signing up would generally pay a surcharge of at least 24 percent of the average premium each 

year thereafter; as a result, they would very likely owe 

more in total premium payments over their lifetime than 

if they had signed up for the Medicare benefit when it 

was first available.8

 Even beneficiaries whose current drug 

use is relatively low will thus have strong financial incentives to enroll in Part D promptly to protect against the 

risk of having higher drug costs in the future. In essence, 

the late-enrollment penalty changes the decision about 

whether to enroll from one that compares next year’s premium with next year’s expected benefits—a choice that 

could lead beneficiaries to delay signing up until they had 

recurring, high drug costs—to one that compares lifetime 

premiums with expected benefits over the same period—

a choice that is likely to favor prompt enrollment because 

of the substantial premium subsidies and the probability 

of incurring significant drug costs sooner or later.

Estimated Participation. In light of those factors, CBO 

started with the assumption that the share of eligible 

Medicare beneficiaries who will participate in Part D will 

be no larger than the share who enroll in Part B—about 

94 percent. In other words, CBO assumed that because 

6 percent of all Medicare beneficiaries choose not to participate in Part B—with its 75 percent premium subsidy 

and substantial late-enrollment penalty—a comparable 

6. For calendar year 2006, CBO projects that the average number of share of beneficiaries would forgo a drug benefit with a 

beneficiaries enrolled in Medicare at any point will be 42.6 million. While most of them will be enrolled in both Part A (Hospital 

Insurance) and Part B (Supplementary Medical Insurance), CBO 

projects that 2.7 million will be enrolled only in Part A and 0.5 

million will be enrolled only in Part B. The corresponding projections for 2013 are 49.6 million total beneficiaries, with nearly 3.1 

million in Part A only and about 0.6 million in Part B only. The 

number of Part B enrollees (whether enrolled in Part A or not) will 

thus increase from 39.9 million in 2006 to 46.6 million in 2013.

7. Medicare beneficiaries who also receive full Medicaid benefits 

(commonly known as dual eligibles) will be enrolled in Part D by 

default.

8. Under the MMA, the late-enrollment penalty will be the greater 

of “an amount that the Secretary [of the Department of Health 

and Human Services, or HHS] determines is actuarially sound” or 

1 percent of the national average premium for each “uncovered 

month.” (See section 1860D–13(b)(3) of the Social Security Act, 

as amended.) In setting an actuarially sound penalty, HHS would 

have to take into account the expected program costs for individuals who chose to enroll late even in the face of the penalty, costs 

that would probably exceed average program costs for other enrollees. That penalty could therefore be greater than the 1-percent-per-month minimum.
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 5

similar structure. CBO then reduced the projected rate of 

participation in Part D below the rate for Part B, for two 

reasons. First, CBO assumed that Part B enrollees who 

are active workers and have drug coverage through their 

employer would keep that primary coverage rather than 

sign up for the Medicare benefit. Second, CBO assumed 

that Part B enrollees who are retired but also qualify for 

the FEHB program or the military’s TRICARE For Life 

(TFL) program would be less likely to participate in a 

new Medicare drug benefit. Because they already have 

fairly generous drug coverage, many of them would find 

that the premium for Part D was not worth the additional benefits. Those active workers and federal retirees 

together account for about 7 percent of Part B enrollees.9

In sum, CBO assumed that 87 percent of all Medicare 

beneficiaries would elect to participate in the prescription 

drug benefit. Thus, the average number of Part D participants would rise from 37.2 million in calendar year 2006 

to 43.4 million in calendar year 2013, CBO estimated. 

CBO further assumed that Part D participants would not 

have systematically higher drug costs than nonparticipants because the combination of premium subsidies and 

late-enrollment penalties would be sufficient to avoid the 

insurance-market phenomenon known as adverse selection, in which people who expect to have above-average 

costs disproportionately enroll.10 Those participation figures also include a substantial number of beneficiaries—

about 19 percent of all Medicare enrollees—who will 

continue to receive drug coverage through a plan from 

their former employer or union (which would be subsidized by Medicare through a separate mechanism but 

technically would not constitute enrollment in Part D). 

The reasons that CBO assumed that certain beneficiaries 

would receive coverage from those sources are discussed 

separately below. First, however, this paper examines the 

gross costs and premium payments that would be incurred by the remaining majority of Part D participants 

and the delivery system through which they would receive their drug benefits. 

Gross Costs of Providing the Basic Drug Benefit

Having concluded that enrollment in the Medicare drug 

benefit would be broadly representative, CBO estimated 

average and total costs for enrollees in a series of steps. 

CBO projected what drug spending would be in the absence of a Medicare drug benefit (that is, under prior 

law); adjusted individual spending levels to reflect provisions of the MMA that would either increase or decrease 

total drug spending; and then applied the MMA’s benefit 

design provisions to determine the gross costs of providing covered benefits. This section explains what each of 

those steps involved and specifically reviews the following 

factors:

B CBO’s baseline projections of drug spending under 

prior law; 

B The design of the MMA’s standard drug benefit and 

the provisions for varying, supplementing, and indexing that benefit design over time; 

B The delivery mechanisms specified by the law; 

B CBO’s estimate of the impact that different delivery 

mechanisms would have on covered drug spending;

B Other provisions of the MMA that CBO judged 

would affect drug prices or utilization; and

B CBO’s estimate of various administrative costs that 

would be incurred in providing the new drug benefit.

Baseline Drug Spending. Data on current drug spending 

are not available for all Medicare beneficiaries. CBO 

therefore chose to develop a microsimulation model for 

use in generating cost estimates that was designed to capture how a given proposal would affect a representative 

sample of those beneficiaries. The model contains detailed information about beneficiaries’ spending for prescription drugs and Medicare-covered services, their sup9. To some extent, those are simplifying assumptions. Some active 

workers might enroll in a Medicare drug benefit, but under Medicare’s secondary-payer rules, their employer’s plan would pay first 

and thus would probably offset most of Medicare’s costs. And if 

more FEHB annuitants or TFL beneficiaries enrolled in Part D 

than CBO assumed, Medicare spending would be greater, but 

there would be offsetting federal savings for those programs. In 

both cases, CBO also assumed that those beneficiaries would be 

exempt from any late-enrollment penalties if they later lost their 

drug coverage since that coverage would be at least equivalent to 

and probably better than the Medicare benefit. As a result, they 

would not have a strong incentive to enroll in Part D. It is also 

worth noting that some of the Medicare beneficiaries who do not 

enroll in Part B are active workers or federal retirees. 

10. For a more detailed discussion of issues related to adverse selection 

and their potential impact on a Medicare drug benefit, see Congressional Budget Office, Issues in Designing a Prescription Drug 

Benefit for Medicare, pp. 17-23. 
6 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

plemental insurance coverage (both public and private), 

their health status, and their income. The information 

used in the model is based on data from Medicare claims 

for 1999 and from the 1999 and 2000 Medicare Current 

Beneficiary Survey (MCBS), projected forward using 

CBO’s March 2003 economic and technical assumptions 

and baseline projections of Medicare spending. For drug 

spending, the MCBS data were adjusted to account for 

underreporting in survey responses and for missing data 

on nursing home residents. The assumptions used about 

subsequent growth rates for per capita drug spending 

were based on the most recent historical estimates and on 

projections for national health expenditures made by the 

Centers for Medicare and Medicaid Services (CMS).11

On the basis of that model, CBO projected the total outpatient drug costs that would be incurred by or on behalf 

of Medicare beneficiaries in the absence of a new Medicare benefit.12 For calendar years 2004 to 2013, CBO 

estimated that cumulative spending would total $1.84 

trillion. Reflecting the assumption that a two-year implementation period would be required before drug benefits 

could be delivered, however, the focus of CBO’s analysis 

was on spending from 2006 to 2013, which was projected to total $1.61 trillion. CBO then excluded drug 

spending covered by Veterans Health Administration 

(VHA) programs and spending by projected nonparticipants in Part D to generate a total baseline of $1.36 trillion for drug spending that could be covered by the 

Medicare benefit.13 Under that baseline, average spending for participants would rise from $3,096 in 2006 to 

$5,617 in 2013, while median spending would increase 

from $1,913 to $3,475. (Those figures include spending 

by participants who are projected to receive coverage 

through a qualified employer or union drug plan.) 

The primary factor that determines the gross federal costs 

of a drug benefit proposal is the share of enrollees’ current 

drug spending—how much of that $1.36 trillion—that 

the new benefit will cover, which is a function of the benefit’s design. But CBO’s estimates also assume that, rather 

than simply rearrange who pays for drug spending, the 

new benefit will change the level of total spending in various ways. Some enrollees will fill more prescriptions or 

use more brand-name drugs once they gain better insurance coverage, thus increasing overall drug spending. The 

new Medicare benefit will also give manufacturers somewhat greater leeway to raise prices on certain drugs (to the 

extent that enrollees become less sensitive to the underlying price of their prescriptions). Conversely, spending 

will be reduced to the extent that the entities administering the drug benefit make aggressive use of cost-management tools, which can result in substantial price discounts and changes in the mix of drugs prescribed or 

purchased. Because the provisions of the MMA that affect the drug benefit’s cost per enrollee are complicated, 

CBO’s modeling of those provisions was correspondingly 

complex. 

Benefit Design. In addition to specifying a standard benefit design for 2006, the MMA included various rules regarding ways in which the benefit design could be varied 

or supplemented and defined a mechanism for indexing 

the benefit’s parameters for future years. (It also included 

provisions that stipulated how the benefit should be provided, such as requirements for determining which drugs 

would be covered and which pharmacies could be used to 

fill prescriptions. A discussion of those provisions is presented later in this paper.) The standard drug benefit for 

calendar year 2006 will have these specifications: 

B A $250 annual deductible; 

B Coverage for 75 percent of drug costs (on average) between the deductible and an initial coverage limit of 

$2,250;

11. CMS projected that per capita drug spending would increase by 

98.6 percent between 2000 and 2006 (an average annual growth 

rate of 12.1 percent) and by 67.5 percent between 2006 and 2012 

(an average annual growth rate of 9.0 percent). See “National 

Health Care Expenditure Projections: 2002-2012,” available at 

the CMS Web site (www.cms.hhs.gov/statistics/nhe/projections2002/proj2002.pdf).

12. The calculation excluded spending for drugs already covered by 

Medicare, such as drugs used during an inpatient hospital admission, which are covered under Part A, and the limited number of 

drugs used on an outpatient basis that are already covered under 

Part B. 

13. Because the drug benefits provided by the VHA are relatively generous, CBO assumed that Medicare beneficiaries who had been 

filling prescriptions through that system would continue to do so. 

For purposes of estimating the effect of the Part D provisions on 

mandatory federal spending, CBO thus assumed that prescription 

drug spending by the VHA (which is discretionary) would not be 

shifted to Medicare—and thus would not differ substantially from 

the levels projected under prior law. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 7

B A “doughnut hole” beyond $2,250 in which no coverage is provided until an individual has incurred 

$3,600 in out-of-pocket drug costs for the year; and 

B Catastrophic coverage of about 95 percent of covered 

drug costs beyond that point.14

Subject to the approval of the Department of Health and 

Human Services (HHS), drug coverage can be offered 

that deviates from the standard design as long as four key 

conditions are met: the catastrophic coverage is the same 

as the standard benefit’s; the deductible is no higher than 

the standard benefit’s; the average value of the alternative 

coverage (based on the drug use of a representative sample of seniors) is the same as the standard benefit’s value; 

and payments by the plan for benefits at the initial coverage limit equal what the plan would have paid using the 

standard benefit design. Basic drug plans could thus be 

offered that had a lower deductible combined with 

slightly higher average coinsurance below the initial coverage limit, or that simply varied the coinsurance rate between the standard benefit’s deductible and initial coverage limit (so long as cost sharing in that range averaged 

25 percent).15 Because the cost of providing an alternative benefit design is supposed to be the same as the cost 

of providing the standard benefit (taking into account the 

effects of that design on drug use), CBO estimated the 

MMA’s costs as though the standard benefit were offered 

uniformly.

The fact that the catastrophic threshold was defined in 

terms of out-of-pocket costs rather than total drug spending would have been immaterial but for another feature 

of the MMA—one commonly referred to as the “true 

out-of-pocket” provision. Under that provision, out-ofpocket costs will generally count toward the catastrophic 

threshold only if they are incurred by an individual and 

are not reimbursed by third-party insurance coverage 

(such as supplemental drug coverage provided by a 

former employer). As a result, an enrollee with no supplemental drug coverage will reach the catastrophic threshold in 2006 when he or she had purchased $5,100 worth 

of covered drugs.16 Beneficiaries with supplemental coverage, however, would not reach the catastrophic threshold until they had incurred higher levels of total drug 

spending—and if their supplemental plan included a 

lower limit on out-of-pocket costs, they would never 

reach the Medicare benefit’s catastrophic threshold. At 

the same time, costs covered by Medicare’s low-income 

subsidies or by state pharmaceutical assistance programs 

would still be counted as true out-of-pocket expenses; 

that is, they would be treated as though the beneficiary 

had paid them. Beneficiaries with those forms of supplemental coverage could therefore reach the catastrophic 

threshold once they had purchased $5,100 worth of 

drugs in 2006 (and thus, as an accounting matter, most 

of their remaining drug spending would be covered by 

the standard Medicare benefit and not by those lowincome subsidies). 

Drug plans could also provide coverage that was more 

generous than the standard design, but the costs of any 

extra benefits would not be federally subsidized, so beneficiaries would have to pay an additional premium for 

those benefits. Such supplemental coverage would also 

delay the point at which the catastrophic threshold was 

reached and thus could reduce the cost of providing the 

standard drug benefit. Yet beneficiaries with very high 

drug spending would find it disadvantageous to purchase 

such coverage because in addition to paying their supplemental premium, they would still need to incur $3,600 

in out-of-pocket costs in 2006 before they reached the

14. For 2006, cost sharing above the catastrophic threshold will be the 

greater of 5 percent coinsurance or a copayment of $2 for all 

generic drugs and preferred brand-name drugs with generic competitors or $5 for other drugs including all brand-name drugs 

without generic competitors. After 2006, the $2 and $5 amounts 

will be indexed to per capita drug costs for the Medicare population. 

15. Coverage provided above the initial coverage limit (that is, in the 

doughnut hole) would not count toward meeting the fourth condition and thus would be treated as an extra benefit. According to 

the MMA, therefore, a drug plan could not offer a basic benefit 

with a higher initial coverage limit that was offset by a higher average coinsurance rate above the deductible, even if the overall 

expected value of that benefit design for a representative sample of 

seniors was equal to the standard benefit’s value. Although HHS 

could waive those restrictions in a budget-neutral way (that is, 

without increasing net federal spending), a drug plan might be 

reluctant to seek such a waiver since providing coverage in the 

doughnut hole would be most attractive to enrollees with high 

drug costs and thus could raise the issue of adverse selection for 

that plan. 

16. At that point, the beneficiary would have paid the $250 deductible; $500 in cost sharing to cover 25 percent of his or her drug 

costs between that deductible and the $2,250 initial coverage 

limit; and $2,850 in spending above that limit (which would be 

paid for entirely by the beneficiary), for a total of $3,600 in outof-pocket costs. 
8 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

catastrophic threshold.17 Consequently, CBO assumed 

that individuals would not purchase supplemental coverage in a way that substantially affected the cost of providing the standard drug benefit (but did assume that most 

employers now providing more generous drug coverage 

to Medicare-eligible retirees would continue to do so).18

The MMA also specifies that, after 2006, the standard 

benefit’s deductible, initial benefit cap, and catastrophic 

threshold will increase each year at the projected rate of 

growth in per capita drug expenditures for the Medicare 

population. As a result, the drug benefit will, on average, 

cover about the same share of enrollees’ drug costs each 

year. (See Table 2 for CBO’s projections of each of those 

benefit parameters through calendar year 2013 as well as 

the associated levels of beneficiaries’ cost-sharing liabilities and total drug spending.) CBO estimated that per 

capita drug spending for Medicare beneficiaries would 

increase at an average annual rate of nearly 9 percent 

between 2006 and 2013, by which time the deductible 

would be $445, the initial coverage limit would be 

$4,000, and the catastrophic threshold for out-of-pocket 

costs would be $6,400. 

Delivery Mechanism. Under the MMA, Medicare will 

not pay directly for drugs provided to its enrollees. Instead, private entities are expected to deliver Part D benefits and will be paid partly on the basis of their expected 

costs and partly on their actual costs for doing so. As a 

result, CBO’s estimate of federal costs considered what 

types of entities would participate as drug plans and what 

sorts of costs they would incur. In particular, CBO assumed that plans’ costs would be related to the degree of 

financial risk they would bear. Consequently, CBO 

sought to model the effects of the MMA’s provisions on 

the level of risk that the plans would generally be asked to 

assume; then, taking into account the provisions allowing 

drug plans to accept lesser degrees of risk under certain 

circumstances, CBO estimated the probability that beneficiaries would be enrolled in plans bearing those differing levels of risk, both initially and over time. 

Subject to the approval of HHS, various entities could 

provide Part D benefits. Beneficiaries who received their 

Part A and Part B benefits through a private health insurance plan, such as a health maintenance organization or 

preferred provider organization under the renamed Medicare Advantage program, generally would obtain their 

drug coverage through that plan. (Medicare Advantage 

will take the place of the existing Medicare+Choice program.) Those enrolled in the traditional fee-for-service 

Medicare program would generally obtain drug coverage 

through a prescription drug plan that provided only their 

Part D benefits. CBO assumed that such plans would 

probably combine the attributes of an insurance company and a pharmacy benefit manager (PBM), but a wide 

array of organizational arrangements could be allowed. 

Once enrolled in Part D, beneficiaries could also switch 

among plans annually, and those plans would be responsible for providing all covered benefits and tracking each 

enrollee’s total drug costs for the year. Although Medicare 

Advantage drug plans could have a service area as small as 

a county, prescription drug plans would have to serve an 

entire region. (The MMA encourages but does not require HHS to divide the country into at least 10 but no 

more than 50 regions.) 

Provisions for Full-Risk Plans. In general, prescription 

drug plans and Medicare Advantage drug plans would be 

expected to assume insurance risk in delivering Part D 

benefits. They would submit bids reflecting their expected costs of providing those benefits and would largely 

be paid on the basis of those bids (subject to review by 

HHS). Thus, they would stand to profit if their costs of 

17. For example, beneficiaries who expected to have $7,100 in drug 

spending in 2006 would incur $3,700 in out-of-pocket costs 

under the standard benefit ($3,600 for the first $5,100 in drug 

spending plus 5 percent of the remaining $2,000). If they purchased a supplemental policy that provided up to $1,000 worth of 

benefits in the doughnut hole, their out-of-pocket costs would fall 

only to $3,650 ($3,600 for the first $6,100 in drug spending, 

which is the point at which they would reach the catastrophic 

threshold, plus 5 percent of the remaining $1,000). In addition, 

they would have to pay a premium for that supplemental coverage. Given that enrollees with high drug costs would be most 

attracted to that package—and could decide each year whether to 

sign up for the additional protection—that premium would probably be a large share of the maximum $1,000 benefit. Even if 

enrollment in that supplemental coverage was broadly representative, its premium would undoubtedly exceed the $50 in savings on 

cost sharing that such enrollees would gain. 

18. Medigap policies that cover cost sharing for other Medicare benefits are prohibited from including supplemental drug coverage for 

Part D enrollees, so enrollees who desire such coverage will have to 

obtain it from another source (such as a former employer or their 

Medicare drug plan). CBO estimated that about 8 percent of Part 

B enrollees currently have an individual medigap policy that 

includes drug coverage. If they chose to sign up for Part D, those 

beneficiaries would be allowed to enroll in another medigap policy 

or in a modified version of their current policy that did not provide drug coverage. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 9

Table 2.

Key Features of the Standard Drug Benefit Under the

Medicare Modernization Act, Calendar Years 2006 to 2013

(Dollars)

Source: Congressional Budget Office.

Note: Benefit parameters shown here reflect the Medicare Modernization Act's rounding rules.

a. Represents total spending at the catastrophic threshold for individuals without other drug coverage.

b. For 2006, cost sharing will be the greater of 5 percent coinsurance or a copayment of $2 (for generic drugs and preferred brand-name 

drugs with generic competitors) or $5 (for other drugs, including all brand-name drugs without generic competitors). After 2006, the $2 

and $5 amounts will be indexed to per capita drug costs for the Medicare population.

providing benefits turned out to be lower than expected 

but would lose money if their costs exceeded expectations. Such a system could provide strong incentives for 

cost control. But if drug plans were paid only a single and 

fixed amount per enrollee that was set at the beginning of 

the year—and thus assumed all financial risk for providing covered benefits—they would also have very strong 

incentives to avoid enrollees with high drug spending 

(especially since the same enrollees might incur high drug 

costs year after year). At the same time, the range of drug 

plans’ potential profits or losses could be large given the 

uncertainty that surrounds predictions of their costs of 

providing this new benefit—particularly in the initial 

years of its operation—and companies might be either 

unwilling to accept that degree of financial risk or unable 

to insure against it (through private reinsurance or other 

mechanisms) at a reasonable cost. Policymakers might 

also be concerned about the potential for windfall profits 

if plans’ costs turned out to be substantially lower than 

had been projected. 

To mitigate those concerns, the MMA included two sets 

of provisions that limit the degree of insurance risk that 

plans would face and that reduce their incentives to avoid 

the highest-cost enrollees:

B Individual-Level Reinsurance. Federal reinsurance 

payments would cover 80 percent of total drug costs 

actually incurred once a beneficiary reached the catastrophic threshold on out-of-pocket costs. From that 

point on, drug plans would thus bear about 15 percent of those costs, while beneficiaries would be liable 

for about 5 percent.19

2006 2007 2008 2009 2010 2011 2012 2013

Annual Deductible 250 275 300 325 350 380 410 445

Average Coinsurance Between Deductible 

and Initial Coverage Limit (Percent) 25 25 25 25 25 25 25 25

Initial Coverage Limit

Program spending at limit 1,500 1,646 1,808 1,946 2,115 2,265 2,460 2,666

Beneficiary spending at limit 750 824 903 974 1,055 1,135 1,230 1,334

Total spending at limit 2,250 2,470 2,710 2,920 3,170 3,400 3,690 4,000

Coinsurance Between Initial Coverage Limit 

and Catastrophic Threshold (Percent) 100 100 100 100 100 100 100 100

Catastrophic Threshold

Out-of-pocket spending at threshold 3,600 3,950 4,350 4,650 5,050 5,450 5,900 6,400

Total spending at threshold a 5,100 5,596 6,158 6,596 7,165 7,715 8,360 9,066

Coinsurance above threshold (Percent)b 55555555

19. The portion of federal subsidy payments that were made to drug 

plans on a capitated basis would also be adjusted for risk to reflect 

the expected costs of enrollees based on their health status or other 

characteristics. However, the adjustment would be made in a 

manner that was budget neutral overall. Those capitated, or 

“direct,” subsidies are discussed further below.
10 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

B Aggregate “Risk Corridors.” After subtracting reinsurance payments, drug plans that experienced benefit 

costs that were somewhat higher than they had expected would see an increasing share of those costs 

covered by additional federal payments, whereas plans 

with benefit costs that were somewhat below expected 

levels would essentially have to reimburse Medicare 

for a corresponding share of the savings. The thresholds of the risk corridors would be relatively narrow in 

2006 and 2007 but would double beginning in 2008 

and could be increased further by HHS after 2011. 

(The mechanics of the risk corridor system, how it relates to the MMA’s other risk-abatement mechanisms, 

and the approach that CBO used in estimating its impact on program costs are discussed in the appendix.) 

The MMA set no limit on the number of drug plans that 

could participate if they were willing to accept the full 

statutory levels of financial risk that resulted from those 

reinsurance and risk corridor mechanisms. The law specified that at a minimum, though, all Medicare beneficiaries should have a choice of at least two drug plans—one 

of which could be part of an integrated health plan under 

the Medicare Advantage program. Thus, the minimum 

number of prescription drug plans that are supposed to 

be available to enrollees in the traditional fee-for-service 

Medicare program is one in areas where a drug plan is offered via Medicare Advantage and two otherwise. 

Provisions for Limited-Risk Plans. In case the number of 

PDPs that are willing to accept full risk in a given area is 

not sufficient, the MMA provides two mechanisms designed to ensure that beneficiaries have a plan available to 

them through which to get their drug coverage. 

B Reduced-Risk Plans. PDPs that were willing to accept 

some insurance risk could submit bids that provided 

for narrower risk corridors in order to reduce (but not 

eliminate) the risk they would face. Those reducedrisk bids would not be considered, however, unless the 

number of full-risk plans approved for an area was insufficient to meet the access requirements. If reducedrisk bids were considered, only one or two could be 

approved (depending on the number of other plans 

available in the area), with priority generally given to 

plans willing to accept the most risk. 

B Fallback Plans. In case there are not enough plans willing to bear insurance risk (either on a full-risk or reduced-risk basis) in an area, HHS would contract with 

another organization—designated as a fallback plan—

to offer the prescription drug benefit in that area on a 

“performance-risk” basis.20 One fallback plan would 

be chosen for each region of the country through a 

competitive bidding process; however, it would be 

allowed to enroll members only in the event that too 

few plans bearing insurance risk were available. At 

other times, the fallback plan would essentially be on 

call. 

Probability of Enrollment in Limited-Risk Plans. Because 

of those provisions, CBO assumed that all Medicare beneficiaries would have access to prescription drug coverage 

under the MMA. Nevertheless, CBO had to estimate the 

probability that beneficiaries would be enrolled in 

reduced-risk or fallback plans. That estimate sought to 

account for several competing considerations.

B Factors Increasing Enrollment Probability. In general, 

CBO assumed that the easier it was for drug plans to 

participate as reduced-risk or fallback plans, the 

greater the likelihood that such plans would be available and thus the higher the expected share of enrollees in those plans. For example, the greater the 

number of risk-bearing plans that the law requires, the 

greater the odds that an insufficient number of fullrisk bidders will step forward—thus triggering the reduced-risk and fallback provisions. Similarly, the more 

opportunities that plans have to enroll and retain 

members while operating on a limited-risk basis, the 

more attractive it will be to operate as such a plan. 

20. With performance risk, the organization would be reimbursed for 

all costs it incurred in providing benefits and thus would not bear 

insurance risk, but a portion of its administrative fee would be 

tied to certain performance requirements. The MMA specified 

that those requirements should include the following measures: 

containing costs to Medicare and enrollees “through mechanisms 

such as generic substitution and price discounts”; providing “quality programs that avoid adverse drug reactions and overutilization 

and reduce medical errors”; and providing “timely and accurate” 

customer service and “efficient and effective benefit administration and claims adjudication.” (See section 1860D–11(g)(5) of 

the Social Security Act, as amended.) 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 11

B Factors Reducing Enrollment Probability. Conversely, 

mechanisms that encouraged companies seeking to 

participate in Part D to bear the statutory level of 

risk—or that made it easier for such companies to 

displace reduced-risk and fallback plans—would tend 

to limit the availability of such plans and thus would 

reduce the expected share of enrollees in those plans, 

both initially and over time. For example, because 

reduced-risk plans could be displaced if enough fullrisk plans submitted acceptable bids, those reducedrisk plans would have a strong incentive to accept full 

risk as quickly as possible. Similarly, entities such as 

PBMs that served as fallback plans in one area could 

not participate as part of a risk-bearing PDP in another area of the country at the same time and could 

not participate as part of a risk-bearing PDP in the 

same area in the following year—factors that would 

make it less attractive to be a fallback plan. 

CBO also assumed that the probability of enrollment in 

reduced-risk and fallback plans would generally decline 

over time as uncertainty surrounding the cost of providing the benefit diminished. 

After analyzing the specific provisions of the MMA, CBO 

estimated that the expected share of Part D participants 

enrolled in reduced-risk plans or fallback plans would be 

about 18 percent in 2006, declining to about 5 percent 

by 2013. (In other words, about 82 percent of enrollees 

would be in full-risk plans in the first year of the benefit, 

increasing to about 95 percent by the end of the budget 

window.) The percentages represent the likelihood that 

all enrollees will be in full-risk drug plans and not the 

share of the population that will be covered by such 

plans. Although it is possible that full-risk plans will 

emerge in some regions and not others, CBO did not ascribe an important role for locality per se in the outcome 

(except insofar as the availability of a Medicare Advantage 

drug plan would affect the number of prescription drug 

plans needed in an area to avoid triggering the reducedrisk or fallback provisions). 

More generally, in considering whether and to what extent risk-bearing drug plans would participate, CBO assumed that the kind of local disparities that have historically been seen in the Medicare+Choice program would 

probably not be replicated—largely because the drug 

benefit program would differ from the Medicare+Choice 

system in two important respects. (Medicare+Choice 

plans are currently available to about 60 percent of beneficiaries, primarily those living in urban areas.) First, the 

only local network of providers that a drug plan would 

have to establish would be a network of retail pharmacies, 

which CBO understood was already in place nationwide. 

By contrast, the need to establish a network of doctors 

and hospitals could significantly constrain private health 

plans seeking to provide Medicare’s current benefits, at 

least in many areas of the country. Second, as discussed 

further below, the payment system for the drug benefit 

would base federal subsidies on the average costs of drug 

plans, not an external reference point. As a result, those 

subsidies would automatically adjust to reflect faster or 

slower growth in the average costs of providing the drug 

benefit, so that efficiently run plans could expect to cover 

their costs while still offering relatively attractive premiums to enrollees. By contrast, payment rates for Medicare+Choice plans are based on statutory formulas that 

have not kept up with plans’ rising costs (even though 

those payment rates have often exceeded the costs of providing services in the traditional fee-for-service program, 

with its administered pricing systems for providers). As a 

result, many private plans have withdrawn from the 

Medicare+Choice program in recent years.

Gross Drug Savings. The shares of beneficiaries expected 

to enroll in differing types of plans affected CBO’s cost 

estimate because the agency assumed that plans bearing 

more financial risk would have stronger incentives to 

control drug spending (but would also incur other administrative costs in doing so). Having established the 

probability that beneficiaries would enroll in different 

types of plans, CBO then analyzed the degree of financial 

risk and competition that those plans would face, took 

into account any constraints that the MMA placed on 

their efforts to control costs, and generated a summary 

statistic for the gross level of savings that the program 

would yield relative to current spending levels. That summary statistic was designed to encompass all of the dynamics that would occur as beneficiaries sorted themselves among the available drug plans and was applied in 

a manner that accounted for the degree of cost management already reflected in beneficiaries’ current spending 

levels.21

21. For additional discussion of the effects of different delivery mechanisms on cost containment, see Congressional Budget Office, 

Issues in Designing a Prescription Drug Benefit for Medicare, pp. 

22-29. 
12 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Incentives for Cost Management. To assess the relative risk 

that full-risk drug plans would face under the MMA, 

CBO analyzed the extent to which their actual costs 

might deviate from the levels they assumed when submitting their bids the previous year. Such deviations could 

arise from unanticipated changes in drug spending 

growth generally—such as faster or slower adoption of 

new brand-name drugs or generic competitors—or from 

unexpectedly favorable or adverse selection in specific 

drug plans. In the initial years of the drug benefit, there 

would be additional uncertainty about what level of 

spending to assume for an average enrollee. CBO’s modeling took into account the random fluctuations that 

could occur in each of those variables. The degree to 

which the resulting deviations between actual and expected costs would generate higher or lower reinsurance 

payments or would yield payments to or from drug plans 

via the risk corridor system was then factored into the 

analysis. CBO’s assessment of the incentives for cost management also took into account the extent to which beneficiaries would be exposed to the cost differences among 

drug plans—as expressed through premium levels and 

cost-sharing requirements. Those differences would affect 

the degree and nature of competition among plans and 

their resulting systemic incentives to control costs.22

Tools for Cost Management. How effectively PDPs could 

control Medicare drug costs would also depend on 

whether and to what extent they were allowed to use the 

various tools at their disposal, such as:

B Enforceable limits on the number and types of drugs 

included in their “formulary,” or list of covered drugs; 

B Variable, or tiered, cost sharing among the drugs included in the formulary, to encourage beneficiaries to 

use less expensive generic drugs or to switch to similar 

but lower-cost preferred drugs for which price discounts had been negotiated; and 

B Limits on the number and types of pharmacies 

through which coverage for prescriptions could be obtained. 

In general, drug plans can obtain the greatest price discounts for drugs that have close substitutes by giving one 

of them “preferred” status—thereby allowing that drug’s 

manufacturer to increase its sales volume (at the expense 

of its competitors) to offset a lower price per unit.23 Similarly, drug plans can obtain discounts from pharmacies 

included in their network by steering customers to those 

pharmacies. Another way they can often lower their costs 

and achieve greater compliance with their formulary is 

through the use of mail-order pharmacies. As a result, the 

prices of drugs used by individuals with drug coverage 

(combining what they pay out of pocket with the costs 

covered by their health plan) are usually less than the 

prices faced by comparable but uninsured individuals 

paying full retail prices. At the same time, a trade-off 

generally exists between the ease with which enrollees can 

obtain the drugs of their choice and a plan’s effectiveness 

in managing drug spending. 

The MMA included a number of rules about how drug 

benefits would be provided, several of which could restrict plans’ use of cost-management tools. One set of requirements would primarily affect whether and how beneficiaries could get coverage for specific drugs. 

B Plans would have to include in their formulary at least 

two drugs within each “therapeutic class” (set of medications) that could be substituted in the treatment of a 

condition or disease (but they would not have to cover 

all drugs in each class). 

B After an outside entity (U.S. Pharmacopeia) had established a standard set of therapeutic classes, drug 

plans could deviate from that system, but if they did, 

they would be more vulnerable to rejection by HHS 

on the grounds that they had designed their benefit to 

discourage sicker beneficiaries from enrolling. 22. For example, if beneficiaries had been given a choice of drug plans 

but their premiums did not reflect the overall costliness of the 

plan they joined and if they faced low coinsurance rates that 

largely insulated them from drug price levels, then competition 

among plans would probably focus on offering more generous 

benefits and would not encourage the use of cost-saving mechanisms. 

23. In dollar terms, discounts are often largest for brand-name drugs 

that have brand-name competitors. In percentage terms, discounts 

are often largest for generic drugs and brand-name drugs with 

generic competitors, but such drugs are generally less expensive 

and constitute a smaller share of total drug spending. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 13

B Subject to certain rules regarding their development, 

plans could establish formularies that not only limited 

coverage to certain drugs but also designated some 

drugs as preferred (and thus subject to lower cost sharing) or even instituted various tiers of coverage (subject to the overall constraints on beneficiary cost 

sharing for covered drugs).

B Before beneficiaries satisfied the deductible and while 

they were in the benefit’s doughnut hole, they would 

have to be able to buy their drugs at the same negotiated prices on which plan costs for providing covered 

benefits were based. 

B Beneficiaries could request coverage of a noncovered 

or nonpreferred drug on the terms applicable to a covered or preferred drug if their doctor determined that 

the covered or preferred drug would not be as effective 

or would have adverse side effects. If the use of such 

nonformulary drugs was not successfully appealed, 

however, spending on them would not count toward 

the benefit’s deductible, initial coverage limit, or catastrophic threshold.

A second set of MMA requirements regarding how benefits would be provided would primarily affect which 

pharmacies enrollees could use to get their prescriptions 

filled. 

B Drug plans could establish a network of preferred 

pharmacies and could use differential cost sharing to 

encourage beneficiaries to use those pharmacies, but 

that network would have to meet certain requirements 

regarding accessibility. (For example, 90 percent of 

urban Medicare beneficiaries would have to have a 

network pharmacy available within two miles of their 

home.) 

B At the same time, plans would have to allow “any willing pharmacy” to serve their enrollees (though not 

necessarily as a preferred or network pharmacy), so 

long as those pharmacies accepted the terms and conditions specified by the drug plan. 

B Beneficiaries would have to be allowed to fill prescriptions at a retail pharmacy instead of a mail-order pharmacy, but they could be charged more for doing so. 

Taken as a whole, the provisions of the MMA would 

place some limits on the ability of drug plans to use costmanagement tools, CBO concluded. For example, the requirement that cost sharing average about 25 percent for 

a substantial portion of the benefit would constrain to 

some extent the price differences that beneficiaries would 

be likely to see between preferred and nonpreferred 

drugs, which in turn would limit the ability of plans to 

steer usage toward lower-cost preferred drugs and to get 

commensurate discounts for those drugs. Furthermore, 

CBO judged that the external review process—under 

which requests to cover excluded drugs or to purchase 

nonpreferred drugs at the cost-sharing rate for preferred 

drugs would be automatically reviewed when denied—

would make it more costly for drug plans to enforce (and 

thus less likely to impose) a strict formulary. Plans would 

also have to cover at least two drugs in each class of similar therapies, but their ability to define those classes 

broadly (so as to limit coverage to selected drugs) would 

be circumscribed. 

At the same time, CBO assumed that the MMA’s pharmacy network provisions would not substantially impede 

plans’ efforts to control costs. Even though the MMA 

would require drug plans to allow any willing pharmacy 

to fill enrollees’ prescriptions, it would give drug plans 

broad authority to vary reimbursement rates and beneficiaries’ out-of-pocket payments between network and 

other participating pharmacies in order to discourage participation by and use of nonnetwork pharmacies.24 Similarly, the requirement that beneficiaries be allowed to use 

retail rather than mail-order pharmacies would also provide considerable latitude for plans to use differences in 

cost sharing to steer beneficiaries toward the distribution 

channel that was least costly for the plans.25

24. Specifically, paragraph (c)(1) of section 1860D–4 of the Social 

Security Act, as amended, specifies that nothing in that section 

“shall be construed as impairing a PDP sponsor from utilizing cost 

management tools (including differential payments) under all 

methods of operation.”

25. Paragraph (b)(1)(D) of section 1860D–4 allows beneficiaries to 

fill any prescription at a retail pharmacy rather than a mail-order 

pharmacy but also allows drug plans to impose “any differential in 

charge” in such cases. CBO interpreted that language to mean 

that drug plans could impose an additional charge for using a 

retail pharmacy that exceeded the strict difference in transaction 

costs between retail and mail-order pharmacy services in order to 

encourage beneficiaries to use mail-order pharmacies. 
14 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Overall Impact. To summarize the effects of incentives 

and tools on cost management, CBO sought to estimate 

the gross drug savings that would result on average.26

Those gross drug savings represent the degree to which 

costs would be reduced relative to an unmanaged benefit 

in which drugs were purchased at full retail price, such as 

a traditional indemnity insurance plan—a hypothetical 

but useful reference point. Those savings would result 

from three types of cost management: negotiating price 

discounts or rebates from drug manufacturers and pharmacies (net of pharmacy dispensing fees and other claims 

processing costs); controlling overall drug use; and changing the mix of drugs used.

Following its analysis of the available literature on costmanagement techniques as well as discussions with industry and other health care experts, CBO assumed that the 

maximum level of gross drug savings that could be 

achieved on average under any circumstances was 30 percent. Achieving that level of savings would require a 

highly competitive environment, meaningful risk bearing 

by plans, and substantial freedom to use cost-management techniques. Beyond that point, though, CBO concluded that an average beneficiary would probably not 

value the savings from joining a lower-cost plan enough 

to accept the restrictions it would have to impose, nor 

would additional increments of financial risk elicit further cost control efforts by drug plans. By comparison, 

CBO estimated that Medicare beneficiaries with employer-sponsored drug coverage experienced gross drug 

savings of 15 percent, on average, in the 1999-2000 period (the latest years for which detailed spending data on 

Medicare beneficiaries were available in 2003).27 While 

those employer plans ultimately bear substantial financial 

risk in providing drug benefits, they must also balance 

their interest in limiting costs with their need to provide 

competitive compensation and to maintain productive 

relationships with their employees (some of whom are 

union members covered by collective bargaining agreements). Furthermore, retirees generally are not offered a 

choice of a drug plan that is separate from their overall 

choice of a health plan, so the degree of price competition 

that occurs is limited. 

For the MMA, CBO estimated that the gross drug savings for plans that bore the statutory level of risk would 

rise gradually from an average of 20 percent in 2006 to an 

average of 25 percent by 2013, an increase that primarily 

reflected the evolution of the MMA’s risk-sharing arrangements over the budget window. CBO determined 

that the MMA’s risk corridor provisions for the initial 

years of the benefit would have a meaningful impact on 

plans’ incentives to control spending. By contrast, the ultimate risk corridors provided in the law would have only 

a negligible effect on cost-management efforts—so gross 

drug savings estimated for those years primarily reflected 

the effects of the limits that the MMA would place on the 

use of cost-management tools. Another key consideration 

was that, to the extent they arose, full-risk plans would 

face a highly competitive environment that encouraged 

beneficiaries to join the lowest-cost plan that met their 

needs (as discussed further in the section on beneficiaries’ 

premiums). It is important to note, however, that CBO’s 

estimate of gross savings represents savings from managing the drug benefit but not the costs of the mechanisms 

used to achieve them. It also does not capture the effect 

that the legislation will have on trends in drug prices, 

changes in drug use by beneficiaries as a result of changes 

in their own out-of-pocket costs under the program, or 

the impact of any exemption from Medicaid’s best-price 

provisions for prescription drugs—each of which was 

modeled separately. 

For many beneficiaries, the effect of cost management on 

their drug spending will be smaller than the 20 percent to 

25 percent savings assumed for individuals who now pay 

full retail prices and who will enroll in full-risk drug 

plans. For Part D enrollees whose current drug costs are 

being managed in some way—primarily those with employer-sponsored or Medicaid coverage—that spending 

already reflects some degree of gross savings. CBO’s estimates took that fact into account and also assumed that 

any incremental savings would be further attenuated to 

the extent that those enrollees retained relatively generous 

supplemental coverage (which would make their spending more difficult to manage). Furthermore, for beneficiaries enrolled in reduced-risk and fallback plans, CBO 

estimated gross savings averaging 12.5 percent throughout the budget window (somewhat smaller than the 15 

percent savings seen for current employer-sponsored drug 

coverage). In part that estimate reflected the reduced fi26. That summary statistic was often referred to as a cost-management factor, or CMF.

27. Any increases in the average level of gross drug savings since that 

time or in the future—to reflect additional efforts by employers to 

control growth in drug spending—would be reflected in the 

growth rates that CBO applied to drug spending in the 2004-

2013 base period. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 15

nancial incentives to control costs that such plans would 

have, and in part it reflected the less competitive environment in which they would operate.28 Finally, CBO assumed that the gross savings would be offset somewhat 

by difficulties in allocating and auditing drug discounts 

and other expenditures (for example, to determine which 

costs were subject to reinsurance payments or risk corridor transfers).

Other Effects on Drug Prices. CBO’s analysis also sought 

to account separately for various effects that the Medicare 

drug benefit’s provisions could have on drug prices, including responses of drug manufacturers, interactions 

with the Medicaid best-price provisions regarding prescription drugs, and restrictions on the role that HHS 

could play in setting drug prices or establishing a drug 

formulary.

First, CBO assumed that even the most aggressive use of 

cost-management tools by drug plans would be unlikely 

to keep prices for some drugs from rising as a result of a 

Medicare drug benefit. By reducing the cost to consumers 

of obtaining covered drugs, the new Medicare drug benefit would correspondingly make Medicare enrollees—

particularly those who currently do not have prescription 

drug coverage—less sensitive to drug prices. For instance, 

if a drug’s target population consisted mainly of Medicare 

beneficiaries and close substitutes for that drug did not 

exist, the manufacturer could raise the drug’s price—or, 

in the case of a new drug, could enter the market with a 

higher launch price. The loss in sales resulting from that 

price hike would not be large enough to reduce the manufacturer’s profit, however, because beneficiaries would 

pay only a portion of that higher price. Preventing such 

price hikes would be difficult without imposing direct 

price controls or threatening to deny or delay coverage of 

the drug. Most drugs, however, face competition from 

close substitutes, and the most likely effect of a Medicare 

drug benefit would be modest price increases for the subset of drugs that had patent protection or exclusive marketing rights. CBO modeled that “price effect” as a function of drug spending by enrollees who previously did 

not have prescription drug coverage, because those who 

already had generous coverage would have been insulated 

from full prices even in the absence of legislation. 

At the same time, CBO estimated that the cost-sharing 

requirements of the MMA would limit the extent of that 

price effect. Beneficiaries who did not receive the lowincome subsidies would still face the full negotiated price 

of the drugs they purchased before they reached their 

deductible and when their spending fell between their 

initial coverage limit and the catastrophic threshold. Even 

after they reached the catastrophic threshold, beneficiaries would generally face some coinsurance and thus 

would not be completely insulated from price increases. 

In light of those factors, CBO estimated that drug costs 

for Medicare beneficiaries would ultimately be 3.5 percent higher, on average, because of the price effect, with 

the impact phasing in over the first 10 years of the benefit. The extent to which the entities delivering the drug 

benefit would offset those price increases through negotiated discounts or would design cost-sharing requirements 

to encourage price sensitivity is already reflected in the estimated average level of gross drug savings. 

Second, CBO considered the fact that prices negotiated 

under the Medicare drug benefit would be exempt from 

Medicaid’s best-price provisions. Those provisions essentially require drug manufacturers to charge Medicaid the 

lowest price paid by any private purchaser for a brandname drug (after taking into account rebates, discounts, 

and other adjustments). As a CBO paper on that topic 

noted, “Medicaid constitutes between 10 and 15 percent 

of the market for outpatient prescription drugs, [so] 

pharmaceutical manufacturers are much less willing to 

give large private purchasers steep discounts off the 

wholesale price when they also have to give Medicaid access to the same low price.” That report and others have 

shown that private discounts declined after the Medicaid 

best-price provisions were implemented in the early 

1990s.29

On the basis of that evidence, CBO assumed that the 

price discounts that Medicare drug plans could negotiate 

would be greater if they were exempt from the best-price 

requirements. CBO further assumed that the extent of 

the additional savings would depend on the gross savings 

level that the drug plans achieved—because the greater 

the incentives and tools that a drug plan had to control 

28. Those plans would still have to compete to be selected by HHS as 

a reduced-risk or fallback plan.

29. See Congressional Budget Office, How the Medicaid Rebate on Prescription Drugs Affects Pricing in the Pharmaceutical Industry (January 1996); and General Accounting Office, Drug Prices: Effects of 

Opening Federal Supply Schedule for Pharmaceuticals Are Uncertain, 

GAO/HEHS-97-60 (June 1997). 
16 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

costs, the more constraining the best-price provisions 

would be. CBO also modeled the extent of the savings as 

a function of Medicaid’s remaining market share for prescription drugs (once the Medicare benefit was in place); 

in the absence of an exemption from the best-price provisions, that market share would also have affected the willingness of manufacturers to provide discounts to Medicare drug plans.30 For the MMA, CBO assumed that—

when averaged across all drugs—Medicare drug plans 

would be able to obtain an additional 1.6 percent price 

discount in the initial years of the benefit because of the 

best-price exemption, increasing to an ultimate level of 

2.5 percent. 

Third, the MMA also included a provision specifying 

that HHS “may not interfere with the negotiations between drug manufacturers and pharmacies” and prescription drug plans and “may not require a particular formulary or institute a price structure” for covered Part D 

drugs. For a variety of reasons, CBO assumed that including that “noninterference” provision would neither 

raise nor lower federal costs significantly. It is not clear 

that HHS would have taken such steps in the absence of 

those restrictions. And even if it had, it is not clear that 

those steps would have appreciably raised or lowered drug 

spending relative to the levels that prescription drug plans 

would secure. 

Underlying that uncertainty is CBO’s assumption that 

risk-bearing drug plans will obtain substantial savings on 

their own and in particular will probably do so by establishing relatively narrow lists of lower-cost preferred drugs 

and steering beneficiaries’ use toward those drugs.31 For 

HHS to use the greater market share of the entire Medicare population as a source of leverage to secure deeper 

price discounts and greater cost savings, it would probably have to threaten similar exclusions and limitations on 

coverage for that entire population—a threat that could 

be difficult to make credible given the potential impact 

on stakeholders. (Other policy objectives, such as encouraging the development of new drugs, also could be adversely affected as a result of securing deeper discounts.) 

Alternatively, HHS could encourage or require preferred 

status for a larger number of drugs than private drug 

plans would otherwise offer. Although that approach 

could help meet other objectives (such as enhancing beneficiaries’ access to those additional drugs), it would increase the cost of providing the drug benefit. On balance, 

then, CBO concluded that retaining the noninterference 

provision (or by the same token, striking it) would have a 

negligible effect on the expected level of federal spending.32

Other Effects on Drug Use. CBO also assumed that enrollees’ total spending on prescription drugs would 

change as a result of the insurance coverage provided by 

the new Medicare benefit, depending on the relative generosity of pre- and postpolicy drug coverage for each enrollee. In other words, enrollees’ overall drug use under 

the MMA would rise or fall along with changes in their 

out-of-pocket costs. That “use effect” took into account 

all of the factors discussed above that would affect enrollees’ out-of-pocket costs—those that changed enrollees’ 

total spending on drugs (such as the price effect or gross 

savings from cost management) and those that simply 

changed the share of that spending for which enrollees 

themselves paid (because of the benefit’s design or any 

supplemental coverage they had). 

Specifically, CBO assumed that enrollees’ spending for 

prescription drugs would rise by as much as 3 percent for 

every 10 percent drop in their out-of-pocket costs.33 The 

estimated change in enrollees’ out-of-pocket costs took 

into account their current coverage and whether they 

would enroll only in the basic Medicare benefit or would 

participate in the low-income subsidy program as well (as 

described below). Among enrollees in stand-alone prescription drug plans and Medicare Advantage drug plans, 

that assumption about the induced demand for drugs increased CBO’s estimate of drug spending by approximately 9 percent. That is, total drug consumption was 

30. Although Medicaid’s share of total U.S. drug spending will decline 

under the MMA because spending on dual eligibles will shift to 

Medicare, Medicaid will still purchase a significant amount of 

drugs on behalf of its other enrollees. 

31. In the process, drug plans could secure deeper price discounts for 

those preferred drugs in exchange for the increase in their sales 

volume. Even without such discounts, though, simply shifting use 

to lower-priced drugs—including generic drugs—would probably 

constitute an important source of savings.

32. For additional discussion of this issue, see Congressional Budget 

Office, Letter to the Honorable William H. Frist, M.D., regarding 

CBO’s estimate of the effect of striking the “noninterference” provision 

as added by P.L. 108-173, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (January 2004); and Congressional Budget Office, Letter to the Honorable Ron Wyden 

regarding the authority to negotiate prices for single-source drugs for 

Medicare beneficiaries (March 2004).
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 17

projected to be about 9 percent higher each year than it 

would have been in the absence of a demand response. 

Other Administrative Costs. CBO’s estimate of covered 

drug costs included certain costs that could be considered 

purely administrative (such as dispensing fees paid to 

pharmacies and other costs of processing claims), but the 

agency accounted separately for expenses that drug plans 

would incur for marketing, member acquisition, and 

member retention as well. In addition, CBO assumed 

that plans would incur costs as a result of having to bear 

financial risk—whether to offset the costs of purchasing 

private reinsurance policies or to build up their own reserves in case their costs exceeded expectations. Specifically, CBO estimated that plans bearing the statutory 

level of risk would require a premium in proportion to 

the degree of risk they faced; that premium would be 

higher in the initial years of the benefit (when there was 

greater uncertainty about its costs) than in later years. For 

reduced-risk and fallback plans, however, such costs 

would be cut or absent. Overall, CBO estimated that 

drug plans’ other administrative costs would add about 

11 percent to the costs of providing covered drug benefits 

in 2006, with that increment declining to about 6 percent in 2013.34 (Those percentages represent weighted 

averages of the administrative costs for full-risk drug 

plans and for reduced-risk and fallback drug plans.) 

Summary of Effects on Gross Benefit Costs. As discussed 

above, CBO applied several key factors to estimate gross 

benefit costs (see Table 3). The net effect of those assumptions can be seen in levels of average drug spending 

under the MMA as well as the average gross costs of providing the standard drug benefit (see Table 4). Overall, 

the various adjustments that CBO made to baseline drug 

spending reduced the amount of spending that would be 

subject to coverage by about 0.5 percent in 2006 and 

about 5 percent in 2013.35 Applying the MMA’s benefit 

design to that spending generated an average cost for covered benefits of $1,482 in 2006, rising to $2,568 in 

2013. Including administrative costs and multiplying by 

the number of participants in each year yielded estimates 

of total calendar year obligations that would be incurred. 

CBO then converted those estimates to outlays made 

during the fiscal year, projecting that payments to prescription drug plans and Medicare Advantage plans for 

providing the basic Medicare drug benefit would total 

$507 billion for the 2006-2013 period (see Table 1 on 

page 2). 

CBO’s estimates of average cost-sharing obligations and 

average out-of-pocket costs for Part D enrollees are also 

shown in Table 4. The estimate of average liability for 

cost sharing is simply the difference between average 

spending under the benefit ($2,878 in 2006) and average 

covered benefits ($1,482 in 2006). That liability figure 

does not take into account any supplemental coverage 

that enrollees might have (through the low-income subsidies or a former employer, for instance). Beneficiaries’ 

33. In economic terms, CBO started with the assumption that the arc 

elasticity of demand for prescription drugs was -0.3 (in which the 

denominator used to calculate the percentage change in drug 

spending and out-of-pocket costs was the average of the pre- and 

postpolicy levels). That elasticity estimate reflected a review of the 

available studies on drug spending as well as CBO’s own internal 

analysis using MCBS data on drug spending by Medicare beneficiaries. Although demand elasticities usually relate a percentage 

change in quantity to a percentage change in price, total spending 

and out-of-pocket costs were used instead, both to reflect the 

results of the literature and to comport more closely with CBO’s 

focus on spending (which could change if an individual switched 

to a more or less expensive medicine even though the quantity 

consumed was held constant). At the same time, estimates based 

on the responses of individuals with less generous drug coverage 

might not be applicable for beneficiaries with very generous drug 

coverage. CBO thus applied an adjustment factor based on the 

portion of an individual’s cost-sharing liabilities that was covered 

by third parties, which ranged from 1 (for beneficiaries with no 

additional drug coverage beyond the basic Medicare benefit) to 

zero (for beneficiaries who would face no cost sharing before or 

after the Medicare benefit was implemented). In other words, the 

effective arc elasticity used was -0.3 for otherwise uninsured 

enrollees and a smaller amount for those with some form of supplemental drug coverage. For a recent summary of elasticity estimates for drug spending, see Mark Pauly, “Medicare Drug 

Coverage and Moral Hazard,” Health Affairs, vol. 23, no. 1 (January/February 2004), p. 117.

34. Whether those costs offset administrative costs that would have 

been incurred in providing drug coverage in the absence of a 

Medicare benefit or instead represented added costs was not a significant consideration in the cost estimate but could affect estimates of total U.S. spending in the health or drug sectors. 

35. To generate a cost estimate, CBO focused on drug spending that 

would be covered under the Medicare benefit. To the extent that 

drug plans reduced costs by limiting coverage to preferred drugs 

but beneficiaries continued to purchase drugs that were not covered, average drug spending for participants would be greater than 

the amount shown here. 
18 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Table 3.

Key Factors Used in CBO’s Estimate of Gross Drug Costs per Drug Benefit 

Participant, Calendar Years 2006 and 2013

(Percent)

Source: Congressional Budget Office.

Note: See the text for an explanation of the terms used here.

average out-of-pocket costs—accounting for such other 

drug coverage but excluding their Part D premiums—are 

also relevant to the cost estimate because of the use effect 

described earlier. CBO estimated that for 2006, average 

out-of-pocket costs would fall from $1,257 in the absence of a Medicare drug benefit (43 percent of average 

drug spending) to $792 under the MMA (28 percent of 

average drug spending). 

Beneficiaries’ Premiums

The share of gross benefit costs that will be covered by 

beneficiaries’ premiums and the corresponding subsidies 

will have a large effect on the federal costs of providing a 

drug benefit under Medicare. Not only will the premium 

subsidies determine how gross costs are allocated between 

enrollees and the government, but they will also affect 

participation in such a voluntary program. This section 

examines how those premiums and the corresponding 

federal subsidies are established under the MMA and 

then shows how CBO estimated and accounted for total 

premium payments. 

Under the MMA, the premium that an individual beneficiary pays for Part D benefits is not set in law and will 

depend on which drug plan he or she joins. Drug plans 

will submit bids to reflect their expected costs per beneficiary of providing basic drug coverage, and HHS will calculate a national average of those bids. HHS will then set 

an av-erage beneficiary premium to cover 25.5 percent of 

expected average costs per enrollee. Plans with bids below 

the national average will see a corresponding reduction in 

their enrollees’ premiums, whereas plans bidding above 

the national average will see a commensurate increase. 

Under that mechanism, drug plans will have strong incentives to keep their bids low to attract enrollees, and 

beneficiaries will have to consider whether the extra premium of a more costly plan is worth paying—two factors 

that affected CBO’s assumption about the gross savings 

that drug plans would achieve on average. 

Once beneficiaries’ premiums for each drug plan are set, 

the remaining portion of a drug plan’s expected costs will 

be covered by federal subsidies, which will come in two 

forms. As discussed above, reinsurance payments will 

2006 2013

Factors Reducing Gross Costs

Gross Drug Savings Relative to Spending for an Unmanaged Drug Benefit

Average for full-risk drug plans 20.0 25.0

Average for reduced-risk or fallback drug plans 12.5 12.5

Average Reduction in Spending as a Result of Exemption from Medicaid’s Best-Price Provision 1.6 2.5

Factors Increasing Gross Costs

Average “Price Effect” 0.3 2.8

Average “Use Effect” 9.0 9.3

Administrative Costs as a Share of Benefit Costs 10.7 5.6

Memorandum:

Probability of Enrollment 

Full-risk drug plans 82 95

Reduced-risk or fallback drug plans 18 5
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 19

Table 4.

Estimated Costs for Drug Benefit Participants, Calendar Years 2006 

and 2013

(Dollars)

Source: Congressional Budget Office.

a. These figures differ from comparable figures that CBO released in November 2003 because of subsequent refinements in the calculation 

of spending and costs per participant that do not affect the cost estimate. See Congressional Budget Office, Letter to the Honorable Don 

Nickles providing additional information about CBO’s cost estimate for the conference agreement on H.R. 1 (November 2003).

cover 80 percent of drug spending incurred once an individual enrollee reaches the benefit’s catastrophic threshold. In total, those payments will cover about 27 percent 

of gross costs for benefits and administrative expenses in 

2006, CBO estimated. The remaining subsidy (referred 

to as the “direct” subsidy) will be set prospectively so that 

the two subsidies together cover 74.5 percent of the average expected costs for all enrollees in the basic Medicare 

benefit. In other words, the direct subsidy will cover 

about 47.5 percent of average costs in 2006, in CBO’s estimation—but if in the future the share of costs expected 

to be covered by reinsurance differs from 27 percent, 

HHS will be required to adjust the direct subsidy correspondingly to keep the sum of the two subsidies at 74.5 

percent. (That adjustment will be made on a purely prospective basis; the direct subsidy is a capitated payment 

that will not be changed midyear or retroactively if actual 

reinsurance payments differ from the projections.) The 

direct subsidy will also be essentially the same regardless

of which drug plan enrollees join, which is why their premium will vary with the total cost of each plan.36

Using CBO’s estimates for 2006, costs for an average plan 

of about $137 per month would translate into federal 

subsidies of about $102 per month and beneficiaries’ premiums of about $35 per month (see Table 5). To illustrate the impact on beneficiaries’ premiums, the table also 

presents hypothetical submissions by plans that have benefit costs per member per month that are $10 higher or 

lower. (CBO did not estimate the likely range of premiums that beneficiaries would actually face across drug 

plans.) Each plan’s expected level of reinsurance pay2006 2013

Average Drug Spending by Projected Participants

Without a Medicare drug benefit 2,894 5,268

Under the Medicare drug benefita 2,878 5,017

Average Gross Medicare Costs per Participant for Basic Drug Benefits

Excluding plans’ administrative costs 1,482 2,568

Including plans’ administrative costsa 1,640 2,713

Average Cost-Sharing Liability 1,396 2,448

Average Out-of-Pocket Costs

Without a Medicare drug benefit 1,257 2,312

Under the Medicare drug benefit 792 1,392

Memorandum:

Projected Number of Participants (Millions) 29.0 33.9

36. The direct subsidy will be adjusted for risk to reflect expected differences in drug costs stemming from differences in health status 

among enrollees in different plans; it could also be adjusted to 

account for differences in drug prices in different regions of the 

country (if HHS determined that such differences were more than 

minimal). For those reasons, the actual direct subsidy payment per 

enrollee could differ among drug plans and enrollees. 
20 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Table 5.

Total Costs, Federal Subsidies, and Beneficiaries’ Premiums for

Calendar Year 2006 Under Three Illustrative Plans

(Average amount in dollars per enrollee per month)

Source: Congressional Budget Office.

a. Figures shown here assume that reinsurance payments are a constant percentage of each plan’s total costs and represent an average 

monthly level of such payments (even if actual reinsurance payments are likely to be concentrated toward the end of the calendar year).

ments—here assumed to cover 27 percent of its average 

costs—would be subtracted from its expected total costs 

of providing the drug benefit to yield its bid.37 HHS 

would then calculate an average of those bids (weighted 

by enrollment) and would set the direct subsidy so that 

the total subsidies for the average plan covered 74.5 percent of its total costs. The same direct subsidy amount 

would be provided to the higher-cost and lower-cost 

plans. As a result, although a portion of the cost differences across plans would be absorbed by federal reinsurance payments, the bulk of the differences would be 

passed on to beneficiaries through higher or lower 

monthly premiums. The examples in the table also show 

that total payments to drug plans are expected to equal 

the amount that the plans specify in their submissions to 

HHS (although those amounts are subject to review by 

and negotiation with HHS). That is, the sum of the expected reinsurance payment, the direct subsidy, and the 

beneficiary premium for each plan equals its total expected costs.38

Although beneficiaries’ premiums will vary as a result of 

this subsidy system, CBO did not have to estimate the extent of that variation because, on average, the higher premium payments made by beneficiaries joining highercost plans would be offset exactly by reduced premium 

payments from beneficiaries who join lower-cost plans. 

Applying the 74.5 percent subsidy to the average costs of 

providing covered benefits of $1,640 thus yielded average 

annual premiums of $418 in 2006 (about $35 per 

month, as shown above); the net federal subsidy would 

thus average $1,221. By 2013, when the average cost of 

providing the basic drug benefit is projected to be 

$2,713, the average beneficiary’s premium would total 

$692 for the year (about $58 per month); the net federal 

subsidy would thus be $2,021 per enrollee. (Premiums 

grow somewhat more slowly than the benefit’s parameters—by about 7.5 percent per year, on average—because 

Lower-Cost Plan Average-Cost Plan Higher-Cost Plan

Expected Total Costs

(Benefits plus administrative costs) 127 137 147

Minus Expected Federal Reinsurance Paymentsa - 34 - 37 - 40

Plan’s Bid for Providing Coverage 93 100 107

Minus “Direct” Federal Subsidy - 65 - 65 - 65

Beneficiary’s Premium 28 35 42

Memorandum:

Premium as a Share of Total Costs (Percent) 22.0 25.5 28.5

37. Since a lower plan bid will translate into a lower beneficiary premium, this system could appear to provide an incentive for plans 

to overstate their expected reinsurance payments. If they did, however, their total payments for the year (including the reinsurance 

payments they actually received) would not cover their costs. Similarly, drug plans would not want to understate their expected 

reinsurance payments because (if total costs were held constant) 

the enrollee’s premium would be commensurately higher as well, 

which would discourage enrollment. Thus, plans will have strong 

incentives to estimate their expected reinsurance payments accurately. 

38. To the extent that plans’ actual costs diverged from expectations, 

that difference could yield higher or lower federal reinsurance payments and could trigger transfers under the risk corridor system.
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 21

they reflect administrative costs as well as benefit costs.) 

Multiplying those figures by the projected number of enrollees in prescription drug plans and Medicare Advantage plans, and then converting to fiscal year receipts, 

yielded the overall estimate of $131 billion for the 2006-

2013 period (see Table 1 on page 2). 

Two accounting matters are relevant to the calculation of 

CBO’s estimate for premium collections. First, the MMA 

will permit beneficiaries to pay the premium for the basic 

drug benefit either by having it withheld from their Social Security benefit (as is generally done for the Part B 

premium) or by arranging to pay their drug plan directly. 

The estimate for premium collections in Table 1, however, is presented as if all participants in the drug benefit 

chose to have premiums withheld from their Social Security benefits (in which case Medicare would transfer those 

payments to the drug plans). To the extent that beneficiaries chose to pay plans directly, federal spending for benefits and premium collections would be reduced dollar for 

dollar and there would be no change in the estimate of 

the net cost of the Medicare benefit. Second, the figures 

for premium collections also include the portion of premiums paid by Medicare on behalf of participants in the 

low-income subsidy system (with those payments also appearing below as a cost of providing the low-income subsidies). Displayed in that way, the difference shown in 

Table 1 between the payments to drug plans for benefits 

and administrative costs, on the one hand, and premium 

liabilities, on the other, represents the net cost for Part D 

enrollees of the federal subsidies for the basic Medicare 

benefit—a total of $377 billion through 2013. 

The Employer Subsidy System

Former employers are the single largest source of drug 

coverage for Medicare beneficiaries today. The extent to 

which those employers will supplement the Medicare 

benefit in the future can have important effects on federal 

costs because of the MMA’s true-out-of-pocket provision. 

(As discussed above, that provision lowers the federal cost 

of providing the basic drug benefit for enrollees with additional drug coverage because that supplemental coverage delays the point at which enrollees reach the catastrophic threshold for out-of-pocket costs.) Another 

potential factor that could affect federal costs is the number of employer and union plans that choose to provide 

Medicare-eligible retirees with qualified drug coverage 

and receive a subsidy directly from Medicare. In light of 

those considerations, CBO had to project the prevalence 

of coverage from employers in the absence of a Medicare 

drug benefit and then estimate both the degree to which 

that coverage would change as a result of the legislation 

and the mechanism through which it would be subsidized. CBO also had to account for any indirect impacts 

of the drug benefit on federal tax revenues. 

Background. About 30 percent of the enrollees in Medicare Part B are nonfederal retirees who currently receive 

prescription drug coverage through a former employer, 

CBO estimated. Their retiree health coverage generally 

supplements Medicare’s benefits for Parts A and B as well. 

Because Medicare covers a large share of acute medical 

costs but has not provided an outpatient drug benefit, a 

sizable share of the current cost of retiree health plans 

consists of prescription drug spending—as much as 40 

percent to 60 percent, by some estimates.39 Although 

employer-sponsored drug coverage is typically rather generous—providing relatively low cost sharing as well as 

limits on retirees’ out-of-pocket costs—recent growth in 

drug spending has led employers to take measures to control their health costs, such as raising cost-sharing obligations, requiring retirees to shoulder a larger share of supplemental premiums, or dropping coverage for future 

retirees. However, CBO did not see strong evidence that 

current beneficiaries or those who will soon enroll in 

Medicare have been losing retiree drug coverage in ways 

that would substantially affect the overall share of beneficiaries with such coverage in the near term.40 Thus, CBO 

39. See Hewitt Associates LLC, The Implications of Medicare Prescription Drug Proposals for Employers and Retirees (prepared for the 

Henry J. Kaiser Family Foundation, Washington, D.C., July 

2000), pp. 1 and 15. 

40. For example, one recent study found that the share of Medicare 

beneficiaries ages 65 to 69 with drug coverage through a former 

employer declined in the late 1990s. However, that share was still 

greater than or equal to the share of older Medicare beneficiaries 

with retiree drug coverage, so the total share of Medicare beneficiaries with such coverage—combining younger and older 

cohorts—remained virtually constant. See Bruce Stuart and others, “Employer-Sponsored Health Insurance and Prescription 

Drug Coverage for New Retirees: Dramatic Declines in Five 

Years,” Health Affairs Web Exclusive (July 23, 2003), available at 

http://content.healthaffairs.org/cgi/reprint/hlthaff.w3.334v1. A 

more recent study indicated that declines in the coverage offered 

to future retirees over the past few years have applied almost exclusively to newly hired employees and thus would not be likely to 

affect the share of Medicare beneficiaries with such coverage in the 

near term. See Henry J. Kaiser Family Foundation and Hewitt 

Associates, Retiree Health Benefits Now and in the Future: Findings 

from the Kaiser/Hewitt 2003 Survey on Retiree Health Benefits 

(Washington, D.C.: Kaiser Family Foundation, January 2004).
22 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

assumed that the share of beneficiaries with such retiree 

coverage would remain at about 30 percent through 2013 

in the absence of a Medicare drug benefit, but it also assumed that average cost-sharing liabilities for those beneficiaries would increase at nearly the same rate as overall 

drug spending. 

Options for Employers. Under the MMA, employers 

would have three broad options from which to choose in 

determining the extent of the drug coverage they would 

provide, the mechanism they would use to do so, and the 

subsidies that would be generated as a result. 

Option 1: Wrap Around a Medicare Drug Plan. An employer could have its retirees enroll in a prescription drug 

plan or Medicare Advantage plan to obtain the basic drug 

benefit and then contract with that plan to provide supplemental drug coverage to those retirees.41 If that supplemental coverage was generous, though, even individuals with very high drug costs might never reach the 

Medicare benefit’s catastrophic threshold because they 

would not incur sufficient out-of-pocket costs themselves. As a result, the costs of providing catastrophic drug 

coverage would have to be covered by the employer, at 

least initially (with some portion of those costs passed on 

to retirees through their premium payments). Even so, a 

portion of retirees’ drug costs would be shifted to Medicare under this option. 

Option 2: Provide Drug Coverage Directly and Receive a 

Subsidy from Medicare. An employer could continue to 

provide drug coverage itself (or through a health plan or 

other subcontractor of its own choosing). So long as that 

coverage was at least as valuable overall as the basic Medicare benefit, the employer could then receive a payment 

from Medicare to cover 28 percent of each retiree’s total 

drug spending in a specified range. (For 2006, that range 

would extend from $250 to $5,000; in future years, its 

endpoints would be indexed to per capita drug spending 

for Medicare beneficiaries.) In addition, that Medicare 

subsidy payment would receive preferential tax treatment, 

and such employer plans would be subject to less scrutiny 

and fewer regulatory requirements than Medicare drug 

plans would be.

Option 3: Drop Drug Coverage for Retirees. An employer 

could decide not to provide drug coverage for its Medicare-eligible retirees once the Medicare benefit became 

available (meaning that the employer would neither provide the benefit directly nor supplement the basic benefit 

offered by a Medicare drug plan).42 In that case, affected 

retirees would presumably enroll in a Medicare drug plan. 

Assuming that they did not purchase supplemental drug 

coverage on their own (for reasons discussed above), retirees with high drug spending would probably reach the 

benefit’s catastrophic threshold and thus would trigger 

federal subsidies to cover most of those catastrophic costs. 

Given that employers would reduce their drug costs the 

most under the third option, it might seem reasonable to 

conclude that all employers would drop drug coverage for 

their Medicare-eligible retirees once the Medicare benefit 

was in place. If employers were seeking only to minimize 

their drug costs, however, they would probably have 

dropped drug coverage already, even in the absence of a 

Medicare drug benefit. Presumably, then, firms that provide drug coverage for retirees today see reasons for doing 

so and may continue providing such coverage once the 

Part D benefit is in place. Some firms may have little 

choice but to continue providing coverage, either because 

they did not retain the right to modify the health benefits 

they provide to current retirees or because they must bargain with unions that have been loath to see those benefits reduced. Even without those constraints, employers 

operating in competitive labor markets must offer a total 

compensation package that is attractive to workers and 

may judge that covering health care costs for retirees allows them to reduce their wage bills. The fact that employers’ health spending already receives preferential tax 

treatment also favors that decision. 

41. That approach would be analogous to the way that employer coverage currently wraps around Medicare’s other benefits. Employers 

could even function as the prescription drug plan for their retirees 

(and could serve them exclusively) but they would have to be 

approved by HHS in the same manner as other PDPs were. 

42. A court decision in 2000 involving retired government workers in 

Erie County, Pennsylvania, had been interpreted as potentially 

preventing employers from varying the health coverage they 

offered to Medicare-eligible retirees and younger retirees. However, the Equal Employment Opportunity Commission has more 

recently issued draft regulations allowing employers to drop drug 

coverage only for Medicare-eligible retirees without violating age 

discrimination laws. (See Robert Pear, “Agency to Allow Insurance 

Cuts for the Retired,” New York Times, April 23, 2004.) Had 

employers been precluded from varying their benefits, that outcome could have discouraged some of them from dropping coverage for Medicare-eligible retirees and could have led others to drop 

drug coverage for all their retirees once the Medicare benefit was 

in place. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 23

Table 6.

Employers’ Options for Providing Drug Coverage Under the MMA

and Resulting Net Medicare Subsidies per Enrollee, Calendar Years

2006 and 2013

(Dollars)

Source: Congressional Budget Office.

Notes: The net Medicare subsidy reflects covered drug costs minus beneficiaries' premiums (if any) and excludes payments to drug plans for 

their administrative costs. Figures for Option 2 represent Medicare payments only and exclude the effective tax subsidy that applies to 

those payments. 

MMA = Medicare Prescription Drug, Improvement, and Modernization Act of 2003.

In general, then, CBO modeled employers’ behavior under a Medicare drug benefit as a function of the benefit’s 

overall generosity, any differential in subsidies between 

the available options (taking into account their effects on 

tax liabilities), and the degree of administrative complexity involved in each option. That analysis also accounted 

for the average effect of each option on premium liabilities and cost sharing for retirees. As an example of the role 

that the benefit’s generosity could play, CBO assumed 

that if the Medicare drug benefit was as generous as the 

coverage that employers offered to their retirees, then employers would be strongly inclined not to supplement 

that benefit (in part because dropping coverage in that 

case would not leave retirees worse off). Although dropping drug coverage might seem like an extreme response 

if the Medicare benefit was less generous, one recent survey indicated that nearly one-quarter of large employers 

would take that approach if Medicare offered drug coverage that included a deductible, coinsurance, and catastrophic protection above $4,000 in out-of-pocket spending—and that response did not factor in any penalty for 

supplemental coverage.43

Effects on Coverage and Outlays. After analyzing the 

three basic options available to employers under the 

MMA, CBO concluded that average Medicare subsidy 

payments on behalf of retirees would be greatest if employers dropped drug coverage (Option 3). For example, 

CBO estimated than in 2006, those retirees would receive 

an average of $1,619 in covered benefits if they enrolled 

in a Medicare drug plan and were provided the basic drug 

benefit with no supplemental coverage. (That estimate 

took into account the effect on their out-of-pocket costs.) 

Subtracting the average beneficiary’s premium of $418 

for that year would yield an estimated net subsidy from 

Medicare of $1,201 under Option 3 (see Table 6). By 

2013, the net Medicare subsidy would grow to an average 

of $2,320 for retirees whose former employers had 

dropped drug coverage.

If those retirees were instead provided generous wraparound coverage by their former employer (Option 1), 

Medicare’s average subsidy payment would fall. (In that 

case, enrollees would pay essentially the same premium 

but receive less coverage through Medicare.) Specifically, 

the net Medicare subsidy would average $692 in 2006 

under that option, CBO estimated, or about half of the 

subsidy that would be generated if employers dropped 

their drug coverage altogether. CBO further estimated 

that the 28 percent subsidy payments from Medicare 

(Option 2) would be comparable, on average, to the net

Average Net Medicare Subsidy per Enrollee

2006 2013

Option 1: Employer’s Coverage Wraps Around a Medicare Drug Plan 692 1,348

Option 2: Employer Provides Qualified Coverage Directly and Receives 

a 28 Percent Subsidy Payment from Medicare 766 1,369

Option 3: Employer Drops Drug Coverage 1,201 2,320

43. Henry J. Kaiser Family Foundation and Hewitt Associates, The 

Current State of Retiree Health Benefits: Findings from the Kaiser/

Hewitt 2002 Retiree Health Survey (Washington, D.C.: Kaiser 

Family Foundation, December 2002), pp. 51-53. 
24 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

subsidies that retirees would generate if they enrolled in a 

Medicare drug plan and retained a generous wraparound 

policy from their employer (Option 1).44 In other words, 

those Medicare payments to employer and union plans 

would also be substantially lower, on average, than the 

net subsidies for retirees whose employers dropped drug 

coverage (Option 3). Those payments to employer and 

union plans would be accorded favorable tax treatment, 

increasing the attractiveness of that option somewhat. 

Even so, the disparity in Medicare subsidies between 

Option 3 and the other two options would grow over 

time. 

On the basis of that analysis, CBO concluded that the 

difference in subsidies under the MMA would give employers a new financial incentive to drop prescription 

drug coverage for their Medicare-eligible retirees once the 

drug benefit became available. In essence, the MMA’s 

true out-of-pocket provision would reduce the extent to 

which federal spending substituted for, or “crowded out,” 

employers’ spending on drugs, but it also would penalize 

supplemental drug coverage sponsored by employers.45

CBO further assumed that some employers would respond to that incentive to drop coverage. As a result, 

CBO estimated that 2.7 million Medicare-eligible retirees 

who would have had relatively generous employer drug 

coverage in 2006 in the absence of a Medicare drug benefit would enroll in Part D but would see their former employer decide not to supplement its basic benefits. That 

figure represents about 23 percent of projected participants in the drug benefit who would have had such coverage from a nonfederal source, or about 17 percent of all 

Part B enrollees who CBO projected would have had 

some form of employer-sponsored drug coverage in the 

absence of a Medicare drug benefit.46 CBO assumed that 

the affected retirees would enroll in a Medicare drug plan, 

with their former employer potentially “cashing them 

out” or at least choosing to pay their Part D premium as a 

means of compensation. (Federal costs for those enrollees 

were included above in the estimate of payments to 

Medicare drug plans.) 

At the same time, CBO assumed that nearly all of the remaining retirees with relatively generous employer-sponsored drug coverage from a nonfederal source would see 

their employer take the 28 percent subsidy payment from 

Medicare, both because of its tax advantages and for reasons of administrative simplicity.47 The number of beneficiaries covered by the 28 percent subsidy would thus rise 

from 8.2 million in calendar year 2006 to 9.5 million by 

2013, CBO estimated. The estimate of $71 billion in 

subsidy payments to qualified employer and union drug 

plans over 10 years (see Table 1 on page 2) reflects both 

the number of participants and the share of those retirees’ 

drug spending that is projected to fall in the covered 

range.48

Effects on Revenues. Although employers can deduct as a 

business expense the costs that they incur in providing 

health benefits to their employees and retirees, those costs 

are not included in those individuals’ taxable income—

which results in a considerable “tax expenditure” for employer-sponsored health benefits. Any legislation that affects employers’ health costs thus has the potential to 

change federal revenue collections. In general, CBO as44. Because participants in the employer subsidy system would pay no 

premium to Medicare, the figures for the net Medicare subsidy 

under Option 2 also represent CBO’s estimate of the average payment to employer and union plans under that system.

45. For employers who chose to receive the 28 percent subsidy payment from Medicare, that payment system would not penalize 

additional drug coverage at the margin. However, the lower average subsidies in that system would still provide an incentive to 

forgo that option and drop drug coverage. 

46. For a further discussion of the denominators used to calculate 

those percentages, which differ primarily in their treatment of 

active workers and federal retirees enrolled in Part B, see Congressional Budget Office, Letter to the Honorable William “Bill” M. 

Thomas regarding Medicare beneficiaries who receive health insurance provided by employers (November 2003) and Letter to the Honorable Don Nickles. 

47. CBO assumed that a very small percentage of employers would 

find it advantageous to have some or all of their retirees enroll in a 

prescription drug plan or Medicare Advantage drug plan and wrap 

around the basic Medicare drug benefit that those plans would 

provide. CBO also assumed that beneficiaries with employer coverage who were eligible for the low-income subsidies and wanted 

to enroll in them would also choose to enroll in a prescription 

drug plan or Medicare Advantage drug plan to receive the lowincome subsidy benefits. The MMA does not include a provision 

allowing low-income subsidy payments to be made to employers 

that are receiving the 28 percent subsidy payments. 

48. Because the net costs to Medicare are similar whether employers 

receive the 28 percent subsidy payment or instead wrap around 

the basic drug benefit provided by a Medicare drug plan, net federal outlays (including payments to Medicare drug plans for their 

administrative costs) would be comparable if the majority of 

employers chose Option 1 instead of Option 2. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 25

sumed that savings to employer-sponsored plans on their 

health costs would raise federal revenues by shifting the 

composition of total compensation packages for employees and retirees toward taxable forms of income (wages 

and pensions) and away from nontaxable health benefits. 

That assumption again reflects the view that employers 

must provide compensation that is commensurate with 

workers’ output in order to attract and retain workers. 

Under the MMA, employers that dropped drug coverage 

would see their health costs decline substantially, whereas 

employers that received subsidy payments directly from 

Medicare or wrapped around a Medicare drug plan 

would see a partial reduction. By themselves, those effects 

would have led CBO to estimate an increase in federal 

revenues of about $25 billion over the 2004-2013 period. 

However, the MMA also excluded the payments under 

the 28 percent subsidy system from income taxation, 

while still allowing employers a tax deduction for the entire portion of retirees’ drug costs that they bear (an approach that is sometimes referred to as a “super-credit,”

in that it essentially provides both a partial tax credit and 

a deduction for the same expenditures). Accordingly, 

CBO estimated that those tax preferences would reduce 

revenue collections by about $18 billion over the same 

period. The $18 billion figure thus represents CBO’s estimate of the tax expenditure that would result from the 

MMA’s preferential tax treatment of those subsidy payments. On balance, then, CBO estimated that the 

MMA’s prescription drug provisions would result in an 

increase of $7 billion in federal revenues through 2013.49

There are two reasons why it would be inappropriate to 

add together the $18 billion tax expenditure and the $71 

billion in direct payments to generate a total figure of $89 

billion for subsidies to employers. First, the tax expenditure represents the extent to which that $71 billion in 

payments would ultimately have been recaptured through 

the tax system had it not been for the income-tax exclusion; the tax expenditure can thus be thought of as maintaining the value of those payments but not augmenting 

it. Second, that approach does not take into account the 

subsidy payments that would be made on behalf of retirees who would otherwise have had employer-sponsored 

drug coverage and who enrolled in a prescription drug 

plan or Medicare Advantage drug plan (whether as their 

only source of drug coverage, in conjunction with an employer wraparound policy, or to take advantage of the 

low-income subsidies). Those indirect subsidy payments 

also cover spending that employers would have borne in 

the absence of a Medicare drug benefit, and they are 

made in addition to the $71 billion in direct subsidy payments. 

Summary of Basic Benefit Costs 

CBO’s estimate of overall costs per participant for the basic Medicare drug benefit reflected both the number of 

participants and average cost per participant in the two 

subsidy systems contained in the MMA (see Table 7). 

Average drug spending for participants in qualified employer and union drug plans was projected to be substantially higher than average spending for Part D enrollees 

(primarily reflecting differences in their projected spending under prior law), but Medicare’s net payments were 

estimated to cover a smaller share of that spending. For all 

enrollees, the average net Medicare cost per participant is 

the weighted average of net costs for beneficiaries projected to receive coverage through a qualified employer or 

union plan and net costs for beneficiaries projected to enroll in Part D and receive coverage through a prescription 

drug plan or a Medicare Advantage drug plan.50 As Table 

7 indicates, the basic Medicare benefit is projected to pay 

for one-third of participants’ covered drug spending, on 

average (once beneficiaries’ premiums and plans’ administrative costs are netted out). Combined, net federal payments to all of those plans will total $448 billion over the 

fiscal year 2006-2013 period—which represents CBO’s 

estimate of the net federal outlays involved in providing 

the basic Medicare drug benefit. 

49. Increased Social Security payroll tax receipts, which are offbudget, would account for about $2 billion of that total. The figures shown in Table 1 also include the estimated effect on revenues (an increase of $0.2 billion over the 2004-2013 period) of 

the MMA’s provisions that would modify the Hatch-Waxman Act. 

Those provisions would modestly reduce employers’ drug costs, 

and CBO assumed that taxable compensation would increase 

slightly as a result.

50. With plans’ administrative costs included, the net cost per participant for enrollees in prescription drug plans and Medicare Advantage drug plans is simply the gross cost per participant from Table 

4 minus the average annual premium. When plans’ administrative 

costs are excluded, the calculation is somewhat more complicated; 

in that case, the amount that is subtracted from gross benefit costs 

is only the portion of the average beneficiary premium that is 

attributable to those benefit costs. The differences between the 

gross amounts shown in Table 4 and the net amounts shown in 

Table 7 are thus slightly smaller when plans’ administrative costs 

are excluded. 
26 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Table 7.

Estimated Spending by and Costs for Drug Benefit Participants,

Calendar Years 2006 and 2013

(Dollars)

Source: Congressional Budget Office.

Note: Average net subsidies reflect Medicare payments minus Part D premiums. Net figures that exclude plans’ administrative costs equal 

gross benefit costs minus the portion of beneficiaries’ premiums that is attributable to those benefit costs.

a. These figures differ from comparable figures that CBO released in November 2003 because of subsequent refinements in the calculation 

of spending and costs per participant that do not affect the cost estimate. See Congressional Budget Office, Letter to the Honorable Don 

Nickles providing additional information about CBO’s cost estimate for the conference agreement on H.R. 1 (November 2003).

Costs of the Low-Income Drug

Subsidies and Effects on Medicaid 

and Other Direct Spending 

The low-income drug subsidies provided under the 

MMA will total $192 billion for fiscal years 2004 to 

2013, CBO estimated. That figure includes spending under the transitional drug assistance program that will be 

in effect during fiscal years 2004 to 2006 as well as the 

costs of the additional low-income subsidies that will supplement the basic Medicare drug benefit starting on January 1, 2006. This section reviews the basis for those estimates and also examines offsetting savings and costs for 

other federal programs—primarily Medicaid—that CBO 

estimated would result from the implementation of the 

MMA’s drug benefit provisions. 

Transitional Drug Assistance 

Before the Medicare prescription drug program is implemented in 2006, a prescription drug discount card program will go into effect under the MMA. That program, 

which was designed to help participants obtain their prescriptions at reduced prices, will provide limited government subsidies to low-income beneficiaries. Specifically, 

2006 2013

Participants in Qualified Employer and Union Drug Plans

Number of participants (Millions) 8.2 9.5

Average drug spending by projected participants 3,815 6,689

Average Medicare costs per participant 766 1,369

Participants in Prescription Drug Plans and Medicare Advantage Drug Plans

Number of participants (Millions) 29.0 33.9

Average drug spending by projected participantsa 2,878 5,017

Average net Medicare costs per participant

Excluding plans’ administrative costs 1,104 1,913

Including plans’ administrative costsa 1,221 2,021

All Participants

Number of participants (Millions) 37.2 43.4

Average drug spending by projected participants 3,084 5,420

Average net Medicare costs per participant

Excluding plans’ administrative costs 1,029 1,795

Including plans’ administrative costs 1,121 1,879

Memorandum:

Medicare Enrollment (Millions) 42.6 49.6

Medicare Part B Enrollment (Millions) 39.9 46.6
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 27

it will pay the enrollment fee (which cannot exceed $30 

per year) and cover up to $600 in annual drug spending 

for Medicare beneficiaries with income below 135 percent of the federal poverty level who have no other form 

of drug coverage. Beneficiaries with income below the 

federal poverty level will be required to pay 5 percent of 

their drug costs; those with income between 100 percent 

and 135 percent of the federal poverty level will face a coinsurance rate of 10 percent.

About 15 percent of Medicare beneficiaries will be eligible for such transitional benefits under the MMA, CBO 

estimated, and about 20 percent of those eligible (or 

nearly 1 million individuals in 2005) will ultimately enroll. Participation was projected to be quite low because 

the discount card program will operate for only a short 

time (about 18 months) and will offer limited benefits.51

Combining the projected number of participants in the 

program and the cost per participant, CBO estimated 

that spending on transitional benefits would total about 

$0.8 billion over the fiscal year 2004-2006 period. The 

bulk of that spending would occur in 2005.

Low-Income Drug Subsidies 

In conjunction with the basic Medicare prescription drug 

benefit that begins in 2006, the MMA will cover some or 

all of the prescription drug premiums and required costsharing amounts for beneficiaries with low income and 

assets. Overall, the cost of providing those low-income 

subsidies would be $191 billion over the 2006-2013 period, in CBO’s estimation. That estimate was derived by 

projecting the number of beneficiaries who would be eligible for the subsidies, determining a participation rate 

for those beneficiaries, and multiplying the resulting 

number of participants by an estimate of their average 

subsidy costs. 

Eligibility. The MMA will provide subsidies to two 

groups of individuals who are enrolled in the Medicare 

drug benefit. The first group (which will be referred to 

here as eligible for “Subsidy A”) consists of individuals 

with income below 135 percent of the poverty level and 

assets below $6,000 for an individual or $9,000 for a couple. That group also includes Medicare beneficiaries who 

receive full Medicaid benefits regardless of their income 

or assets. The second group (eligible for “Subsidy B”) 

consists of all other individuals with income below 150 

percent of the poverty level and assets below $10,000 for 

an individual or $20,000 for a couple. (All of those limits 

on assets will be adjusted for general inflation in later 

years.) 

After analyzing data from Medicaid, the Medicare Current Beneficiary Survey, and the Census Bureau’s Survey 

of Income and Program Participation, CBO estimated 

that about 35 percent of the enrollees in Medicare Part 

B—or about 14 million people in 2006, rising to 16 million by 2013—would be eligible for low-income subsidy 

benefits under the MMA (see Table 8).52 About 30 percent of those Medicare beneficiaries would be eligible for 

Subsidy A, with the other 5 percent qualifying for Subsidy B. Of the beneficiaries who would otherwise qualify 

for one of the subsidies in 2006, CBO estimated that 

about 1.8 million would be deemed ineligible on the basis of their assets. 

Benefits. The MMA is slated to provide different benefits 

to the two groups of individuals described above.

Subsidy A. For individuals in this first group, the MMA 

will eliminate the basic drug benefit’s deductible and will 

reduce other cost sharing to nominal amounts that will 

depend on income and whether a person is a dual eligible. For all enrollees in this group, those nominal copayments will apply to all spending below the catastrophic 

threshold, thus filling in the doughnut hole in the standard Medicare drug benefit. Dual eligibles residing in 

nursing homes will not face any cost sharing, whereas 

other dual eligibles with income below the poverty level 

will pay $1 for a generic drug or preferred brand-name 

drug with a generic competitor and $3 for other covered 

drugs in 2006 (those amounts will be indexed to general 

inflation in later years). Other enrollees in Subsidy A will

51. CBO did not have to make an assumption about enrollment in 

the prescription drug discount card program as a whole because 

that factor did not affect the estimate of mandatory outlays. Even 

so, the experience of the drug discount card program to date may 

not be indicative of the full drug benefit’s likely prospects, for two 

reasons. First, although a large number of card sponsors are participating in the discount card program, that program does not require sponsors to bear much financial risk. Second, eligible beneficiaries may not be strongly motivated to enroll in the program 

because of its limited benefits and temporary nature. 

52. For reasons discussed above in the section on enrollment in the 

basic drug benefit, CBO based its estimates of participation on 

the number of Medicare beneficiaries who had chosen to enroll in 

Part B of Medicare. 
28 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Table 8.

Number of Enrollees in Medicare Part B Who Are Eligible

for Low-Income Drug Subsidies in Calendar Year 2006

(Millions of enrollees)

Source: Congressional Budget Office.

Notes: Some of the figures in this table differ slightly from comparable figures CBO released in November 2003 because of the correction of a 

calculation error not affecting the cost estimate. See Congressional Budget Office, Letter to the Honorable Don Nickles providing additional information about CBO’s cost estimate for the conference agreement on H.R. 1 (November 2003).

See the text for an explanation of Subsidies A and B.

pay either $2 or $5 per prescription in 2006, with those 

amounts increased each year at the projected rate of 

growth in per capita drug expenditures for the Medicare 

population. Once any of those beneficiaries reaches the 

Medicare benefit’s catastrophic threshold ($5,100 in total 

covered drug spending in 2006), they will be not liable 

for any further cost sharing. And depending on which 

drug plan they join, they will pay either no premium or a 

reduced premium.53

Subsidy B. For individuals in this second group, the subsidy will lower the basic benefit’s deductible (to $50 in 

2006) and will limit cost sharing to 15 percent for all 

other spending below the catastrophic threshold. Beneficiaries’ cost sharing for spending above that threshold will 

equal $2 or $5 in 2006 (depending on the type of drug 

purchased), and those amounts as well as the deductible 

will be indexed to growth in per capita drug expenditures 

for the Medicare population. Beneficiaries also will receive the same premium subsidy as the first group if their 

income is less than or equal to 135 percent of the poverty 

level, with the premium subsidy declining to zero for individuals with income equal to 150 percent of the poverty level. (Beneficiaries with income below 135 percent 

of the poverty level can be in this group if they are not 

dual eligibles and their assets are too high to qualify for 

the substantially higher subsidy.) 

Participation. CBO projected that all dual-eligible beneficiaries would participate in the low-income drug subsidy program but that a significant proportion of the remaining eligible population would not apply for those 

 Income as a Percentage of the Federal Poverty Level

Below 

100

100-

120

120-

135

135-

150

150-

175

175-

200

Above 

200 Total

Beneficiaries Eligible for Subsidy A

Dual eligibles 4.4 0.9 0.2 0.2 0.2 0.1 0.3 6.4

Other beneficiaries 2.8 2.1 1.1 0 0 0 0 5.9

Subtotal 7.1 3.0 1.4 0.2 0.2 0.1 0.3 12.3

Beneficiaries Eligible for Subsidy B 0.2 0.3 0.2 1.2 0 0 0 1.9

Total Eligible 

Beneficiaries 7.4 3.2 1.6 1.4 0.2 0.1 0.3 14.2

Beneficiaries Not Eligible for 

Subsidies 0.4 0.4 0.5 0.5 2.4 2.4 19.2 25.7

Total Medicare Part B Enrollment 7.8 3.7 2.1 1.8 2.6 2.5 19.5 39.9

53. For beneficiaries in this group, a full premium subsidy is provided 

up to the national average premium. Beneficiaries who join a 

more expensive drug plan will thus pay the difference between 

that plan’s premium and the national average. (If no plan is available in an area for a premium at or below the national average, the 

subsidy will fully cover the premium for the lowest-cost plan in 

that area, with beneficiaries paying the difference to join another 

plan.) In that system, subsidized beneficiaries would have an 

incentive to join plans with premiums close to the national average, but CBO assumed that some of them would join plans costing less than that average. As a result, the average payment for 

premium subsidies for this group was projected to be slightly 

below the national average premium amount. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 29

subsidies. For those beneficiaries, CBO’s estimate of the 

number of people who would enroll was based on several 

factors, including the value of the subsidies and historical 

participation in the qualified Medicare beneficiary 

(QMB) and specified low-income Medicare beneficiary 

(SLMB) programs. (Those programs pay some or all of 

the premiums and cost sharing under Parts A and B of 

Medicare for beneficiaries with income below 120 percent of the poverty level and limited assets.) In those programs, many beneficiaries who are eligible do not enroll. 

Specifically, about one-third of eligible beneficiaries are 

currently estimated to enroll in the QMB program, 

which covers Medicare’s premiums and all cost-sharing 

requirements (and thus is projected to have an average 

value of nearly $3,000 for participants in 2006). The 

take-up rate for the SLMB program, which covers the 

Part B premium and thus would be worth about $900 to 

each enrollee in 2006, is approximately 13 percent.54

CBO also estimated that the share of eligible beneficiaries 

receiving low-income subsidies would rise gradually after 

the implementation of the Medicare drug benefit. (Unlike the basic drug benefit, which penalizes individuals 

for late enrollment, the additional low-income subsidies 

are available to Part D enrollees at any time and with no 

penalty.) For 2006, CBO projected that there would be 

about 8.7 million recipients of the low-income subsidies, 

or about 60 percent of those eligible. Ultimately, CBO 

assumed, almost 70 percent of those eligible would 

receive low-income subsidies under the MMA, which 

translates into 11.2 million enrollees in 2013. About 75 

percent of those eligible for the substantially higher subsidy would ultimately receive it, while about 35 percent 

of those eligible for the somewhat higher subsidy would 

receive that benefit. Participation rates for the substantially higher subsidy program would be much greater because they would include all dual eligibles—about 6.4 

million individuals in 2006, rising to 7.4 million by 

2013. Excluding dual eligibles, about 45 percent of eligible beneficiaries would ultimately enroll in the lowincome subsidy program, CBO assumed. Although the 

average value of the low-income drug subsidy would be 

somewhat lower than the savings typically available 

through the QMB program, CBO assumed that participation in the low-income drug subsidy program would be 

somewhat greater than that for other welfare-related programs because individuals are allowed to enroll at offices 

of the Social Security Administration—which is easier for 

enrollees and carries less stigma. 

Costs per Participant. In estimating the costs of the subsidy payments per participant, CBO started with the average cost-sharing liabilities that those beneficiaries 

would incur under the standard Medicare benefit. (That 

calculation as well as the average cost of providing the 

standard benefit took into account any increase in drug 

use that would occur for beneficiaries newly receiving the 

relatively generous coverage provided by the low-income 

drug subsidies.) Those averages were then adjusted to 

reflect the assumption that Medicare beneficiaries who 

chose to enroll would generally have higher average drug 

costs than beneficiaries who were eligible for those subsidies but chose not to participate—that is, that some adverse selection would occur because those with the highest drug costs would gain the most by enrolling. In part as 

a result of that adverse selection, the difference between 

the average cost of providing the two types of benefits 

outlined above would be relatively small despite the differences in their overall generosity, CBO estimated. For 

2006, average payments for cost sharing were estimated 

to be about $1,400 for beneficiaries in the first group 

(Subsidy A), rising to about $2,500 in 2013; for the second group (Subsidy B), average payments for cost sharing 

would climb from roughly $1,300 in 2006 to about 

$2,300 in 2013. (Under the MMA, drug plans would be 

reimbursed for those expenses on a cost basis.) Average 

premium payments made on behalf of enrollees would 

also be somewhat greater for the first group owing to the 

substantially higher premium subsidy (with a maximum 

value of $418 in 2006 and $692 in 2013, according to 

CBO’s estimates of average premiums). 

Interactions with Medicaid

Because of the large number of low-income Medicare 

beneficiaries who are enrolled in or eligible for various 

benefits through the Medicaid program, the Medicare 

drug benefit and low-income drug subsidies also have 

substantial implications for Medicaid spending on behalf 

of those beneficiaries—including but not limited to drug 

spending. Those implications, along with an additional 

provision of the MMA, not only affect federal spending 

but also have important impacts on states’ Medicaid 

costs. 

54. Those participation rates exclude beneficiaries who are also eligible for full Medicaid benefits. Those beneficiaries receive more 

benefits and have higher take-up rates than beneficiaries not 

dually eligible and were assumed to enroll in the low-income drug 

subsidy program.
30 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Federal Drug Spending Under Medicaid. CBO estimated 

that under prior law, about 7.5 million Medicare beneficiaries would have had some type of drug coverage 

through Medicaid in 2006. (That figure is higher than 

the number of dual eligibles given above because it includes beneficiaries who would have received limited 

drug coverage through special Medicaid waiver programs.) Because the MMA will replace Medicaid’s coverage for prescription drugs for individuals who enroll in 

the Medicare drug benefit, it will lead to substantial savings in the Medicaid program. By formula, those savings 

will be split between the federal government and the 

states at the regular federal matching rate (57 percent, 

on average). 

CBO estimated that direct federal spending on prescription drugs by Medicaid would decline by $152 billion 

under the MMA over the 2006-2013 period. As part of 

its estimate, CBO assumed that states currently providing 

limited drug coverage to certain Medicare beneficiaries 

through special Medicaid waiver programs would discontinue those programs and instead provide coverage using 

state funds only. States will have a strong incentive to do 

so because spending by state pharmacy programs counts 

toward the catastrophic threshold in the Medicare drug 

benefit, whereas Medicaid spending does not (and, indeed, federal matching funds would not be allowed for 

purposes of supplementing the Part D benefit). CBO’s 

estimate of federal Medicaid spending under prior law 

included $18 billion in costs related to those special 

waiver programs for the 2006-2013 period. As a result of 

the MMA, CBO assumed that that spending would cease 

(with the resulting savings included in the $152 billion 

estimate). 

Other Federal Medicaid Costs. The prescription drug 

benefit and low-income subsidy programs would affect 

Medicaid spending in several other ways. In particular, 

CBO estimated that the MMA would cause an increase 

in Medicaid spending for individuals newly enrolled in 

the QMB and SLMB programs. Because that additional 

enrollment would be induced by the drug benefit’s new 

low-income subsidies, CBO attributed those costs to the 

MMA’s drug benefit provisions. 

By 2013, about 1.3 million beneficiaries enrolled in the 

low-income drug subsidy program would also become 

new enrollees in some form of Medicaid coverage, in 

CBO’s estimation. For all of those beneficiaries, Medicaid 

would pay their Medicare Part B premium. About half of 

those beneficiaries would also qualify for and enroll in 

Medicaid coverage of all cost-sharing obligations under 

Medicare (through the QMB program). That coverage 

would generate direct costs for Medicaid of about $900 

per enrollee.55 A small share of the new QMB participants (roughly 100,000 individuals) would also qualify 

for full Medicaid benefits, at an additional cost of about 

$900 per person in 2013. CBO assumed that coverage 

for those new dual eligibles would, on average, be much 

less costly than coverage for current dual eligibles—particularly for nursing home care, because beneficiaries who 

could have qualified for Medicaid coverage of their nursing home costs would almost certainly be enrolled in the 

program already. Of the total costs incurred by Medicaid, 

about 57 percent would represent federal spending. 

Medicaid would incur additional costs to provide prescription drug benefits to its non-Medicare populations, 

CBO estimated. Such costs would rise slightly over the 

budget window because the advent of Medicare prescription drug coverage would increase demand for prescription drugs and thus have a price effect, as discussed 

above. There would also be additional spending for the 

administrative costs to states’ Medicaid programs for the 

low-income subsidy program. (Medicaid’s administrative 

costs are counted as direct spending.) In total, those other 

effects would cost the federal government $10 billion 

through 2013, CBO estimated. Combined with the estimate of $152 billion in federal savings on Medicaid drug 

costs, that $10 billion in costs would yield a net estimate 

of $142 billion in federal Medicaid savings over that period (see Table 1 on page 2). 

Reduction in Federal Medicaid Payments. Under the 

MMA, the federal government would also recover some 

of the savings that states would otherwise realize in their 

Medicaid programs from having dual eligibles covered by 

the Medicare prescription drug benefit and low-income 

55. The costs of providing QMB benefits are somewhat lower than 

the savings that enrollees see because costs are based on Medicaid’s 

payment rates, which are often lower than Medicare’s payment 

rates. CBO also assumed that full coverage of Medicare’s costsharing liabilities would lead enrollees to use more Medicare services, increasing Medicare’s costs by about $1,000 for each of 

those beneficiaries in 2013. In the figures provided here, however, 

the effects of the interaction between Part D and Medicare spending for benefits under Parts A and B were included in the estimated cost for the MMA’s other provisions rather than in the 

estimated cost for the drug benefit provisions. 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 31

Table 9.

Impact of the Medicare Prescription Drug Benefit on States’ Medicaid

Outlays, Fiscal Years 2004 to 2013

(Billions of dollars)

Source: Congressional Budget Office.

Notes: Estimates do not include the effects of the Medicaid provisions in Title X of the Medicare Modernization Act or the effects of the prescription drug benefit on other state spending.

QMB=qualified Medicare beneficiary; SLMB =specified low-income Medicare beneficiary. 

drug subsidies. (That provision in the law is often referred to as the “clawback” mechanism.) Starting in January 2006, each state will make a monthly payment equal 

to one-twelfth of the product of the following factors:

B Average per capita spending by Medicaid on prescription drugs for dual eligibles in that state in 2003 (adjusted to the current year using a national average 

growth rate for drug spending);

B The state’s Medicaid matching rate;

B The number of dual eligibles in the state; and

B A percentage specified by the law that will equal 90 

percent in 2006, gradually decline to 75 percent by 

2015, and remain constant after that.

Those payments will total $88 billion over the 2006-

2013 period, CBO estimated. Under the MMA, the payments will be credited to the new Medicare prescription 

drug account in the Part B trust fund.

Impact on States’ Medicaid Costs. CBO estimated that, 

on net, states’ Medicaid programs as a group would save 

$17 billion through 2013 as a result of the MMA’s drug 

benefit provisions (see Table 9). Savings for individual 

states may not be proportional to the overall amount, but 

CBO did not estimate effects for individual states. States 

would save $115 billion in prescription drug costs 

through 2013, an amount that corresponds to the $152 

billion in federal savings on Medicaid drug costs discussed above. (That is, total savings to the Medicaid 

program were projected to be $267 billion, of which the 

states’ share would be 43 percent, or $115 billion.) Similarly, the spending for new enrollees and administrative 

costs shown in Table 9 represents states’ shares of payments that generated those $10 billion in federal costs. 

The figures in Table 9 are for Medicaid outlays only and 

do not include any estimate of the impact of the drug 

benefit on other state expenditures. (For example, a portion of the federal subsidies to former employers providing drug coverage to their retirees would go to the states 

that are a source of retiree drug coverage for Medicare 

beneficiaries today.) 

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Total,

2004-

2008

Total,

2004-

2013

Spending for Prescription 

Drugs 0 0 - 5.2 - 11.2 - 12.4 - 13.8 - 15.3 - 16.9 - 18.8 - 20.9 - 28.9 - 114.6

Spending for Newly Enrolled 

Dual Eligibles, QMBs, and 

SLMBs 0 0.1 0.2 0.5 0.6 0.7 0.8 0.9 0.9 1.0 1.5 5.8

Reduction in Federal 

Medicaid Payments 

(“Clawback” Mechanism) 0 0 5.7 9.1 10.0 10.8 11.7 12.6 13.7 14.9 24.8 88.5

Administrative Costs and 

Other Spending 0.1 0.1 0.3 0.3 0.3 0.3 0.4 0.4 0.4 0.5 1.1 3.1

Total 0.1 0.2 0.9 - 1.3 - 1.5 - 1.9 - 2.4 - 3.1 - 3.7 - 4.4 - 1.5 - 17.2
32 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Other Effects on Direct Spending 

Effects on Outlays for Federal Retirees. Some federal retirees would enroll in a Medicare drug plan, CBO estimated, in which case that plan would pay first for their 

drugs and then their current health plan would supplement that coverage. As a result, a portion of their prescription drug costs would be indirectly shifted to Medicare (that portion is included in the costs of providing the 

Medicare benefit). CBO’s estimate reflected that impact, 

as well as small effects on other federal programs that pay 

for prescription drugs, and showed the Medicare law’s 

drug benefit provisions as reducing mandatory federal 

spending by about $3 billion through 2013. However, 

the MMA also provided $1.5 billion in mandatory 

spending for the federal administrative costs of implementing the drug benefit in 2004 and 2005, so the net 

impact on other direct spending would be a reduction of 

$1.5 billion over 10 years. CBO did not estimate whether 

federal retirees would generate payments under the employer subsidy system because even if they did, those payments would be considered intragovernmental transfers 

and would not count as outlays. 

Other Effects on Medicare Outlays. Adding a prescription 

drug benefit to Medicare could also have ripple effects on 

the rest of the program, but little conclusive evidence 

exists as to the expected direction or magnitude of those 

effects. For some seniors, greater access to outpatient 

prescription drugs would improve their health, reducing 

their use of hospitals and other services that Medicare 

now covers under Parts A and B. For other seniors, however, use of health care would increase. For example, 

using a greater number of drugs raises the probability of 

adverse events—such as harmful drug interactions or side 

effects—that could lead to new or longer visits to hospitals, emergency rooms, and other health care providers. 

While such adverse reactions would probably be impossible to prevent altogether, Medicare spending could increase even without them as beneficiaries used more 

ancillary services (such as additional lab tests) in conjunction with their drug treatment regimens. As discussed 

above, however, the MMA’s net impact on drug use is 

likely to be modest; in part, that is because many beneficiaries already have some form of coverage for their drug 

costs, and in part because beneficiaries with no drug coverage nonetheless fill a substantial number of prescriptions. Overall, CBO assumed that costs for other Medicare services would not change significantly because of 

the drug benefit.56

Another aspect of Medicare that could be affected by the 

availability of a drug benefit is the rate of participation in 

integrated private health plans—which could in turn 

have an important impact on spending under Part C for 

Medicare’s other benefits. Those pressures would go in 

conflicting directions, however. On the one hand, the 

managed care plans that take part in Medicare have historically attracted beneficiaries by offering benefits beyond the basic Medicare package—the most desirable of 

which has been prescription drug coverage. Once drug 

coverage became available to beneficiaries in the traditional fee-for-service Medicare program, such plans 

might lose one of their principal competitive advantages. 

That effect would be muted, though, to the extent that 

the Medicare beneficiaries remaining in private health 

plans today did so for reasons other than drug coverage. 

Also, the scope of that drug coverage has declined substantially in recent years.57 Instead, those enrollees might 

be attracted by the coverage of Medicare’s cost sharing 

that private health plans typically provide or by other, extra benefits they offer (which would largely continue). 

On the other hand, integrated private plans that offered 

drug coverage would now be paid for the value of that 

coverage, rather than having to finance it from what they 

save in providing (relative to the statutory payment rate) 

Medicare’s other benefits. Private health plans would thus 

be able to use a portion of those savings to give beneficiaries partial rebates on their Part B or Part D premiums or 

to provide additional benefits. By offering a more integrated delivery system, such private plans might also be 

able to provide a slightly less restrictive benefit for the 

same cost as that offered by a stand-alone prescription 

drug plan (they could have fewer limits on the drugs included in their formulary, for instance) so as to attract enrollees. On balance, then, CBO assumed that adding a 

drug benefit under the MMA would neither increase nor 

decrease enrollment in Medicare’s private health plans. 

56. For a more detailed discussion of the potential effects of drug coverage on the use of other health services, see Congressional Budget 

Office, Issues in Designing a Prescription Drug Benefit for Medicare, 

pp. 31-34 and 49-52. 

57. See Lori Achman and Marsha Gold, Trends in Medicare+Choice 

Benefits and Premiums, 1999-2002 (report prepared by Mathematica Policy Research for the Commonwealth Fund, November 

2002). 
A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT 33

Uncertainty and Conclusions 

It is always difficult to predict the outcome when a complex and substantially new program is created, particularly in the case of an entitlement program with a large 

number of potential enrollees. Actual program costs for 

the Medicare drug benefit could differ from CBO’s projections, for several reasons. 

B Current drug spending by the Medicare population 

and its future rate of increase could be higher or lower 

than CBO estimated; 

B The take-up rate among eligible beneficiaries for the 

basic drug benefit could be higher or lower than CBO 

projected (with the impact on costs depending significantly on whether those who declined coverage were 

representative of the Medicare population); 

B Risk-bearing private drug plans could have more difficulty forming than CBO assumed, or, alternatively, 

they could succeed in limiting drug costs to a greater 

extent; 

B The rate at which employers dropped retiree drug coverage could differ from CBO’s projections; 

B Beneficiaries’ enrollment in the low-income subsidy 

program or the costs of those subsidies per enrollee 

could exceed or fall short of CBO’s estimates; 

B The impact on federal Medicaid spending (relative to 

the amounts that would have been spent without the 

MMA) could be larger or smaller than CBO anticipated; and 

B CMS, in promulgating regulations to implement the 

program, could interpret the law in ways that differ 

from the assumptions used by CBO in estimating its 

costs. 

As a result of such differences, the actual number of participants and the average cost per participant could 

vary—in either direction—from CBO’s projections.58

Until such information becomes available, the cost estimate presented here represents the agency’s best judgment about the net budgetary impact of the Medicare 

drug benefit that was established by the MMA.

58. For a discussion and explanation of the main differences between 

CBO’s cost estimate for the MMA and the estimate developed by 

CMS, see the statement of Douglas Holtz-Eakin, March 24, 

2004. 

The Drug Benefit’s Risk Corridor System

The Medicare Prescription Drug, Improvement, and 

Modernization Act of 2003 (MMA) established a system 

of “risk corridors” for prescription drug plans and Medicare Advantage drug plans. That system would limit to 

some extent the profits or losses those plans would incur 

if their costs of providing the basic Medicare drug benefit 

turned out to be lower or higher than they had estimated 

in their bid submission. The system would work in the 

following way. At the end of the calendar year, the Department of Health and Human Services (HHS) would 

compare each plan’s expected and actual benefit costs (excluding federal reinsurance payments and administrative 

costs). Drug plans incurring benefit costs that exceeded 

their expected levels by a sufficient degree would then be 

partially compensated by additional federal payments, 

whereas drug plans with benefit costs that fell far enough 

below their expectations would generally have to reimburse Medicare at the same rate. (Because plans’ expected 

costs would determine the total amount they were paid 

up front, the risk corridor system also would help keep 

payments in line with actual costs while giving plans a residual incentive to control those costs.) 

The thresholds for triggering risk corridor payments and 

the share of the difference between actual and expected 

costs that those payments covered would vary under the 

statute. 

B For 2006 and 2007, drug plans would bear all gains 

and losses that fell within 2.5 percent of their expected 

costs. If costs differed from expectations by more than 

2.5 percent but less than 5 percent, the risk corridor 

payment would cover 75 percent of the amount in 

that range. If actual and expected costs differed by 

more than 5 percent, the risk corridor payment would 

cover 75 percent of the amount between 2.5 percent 

and 5 percent, and 80 percent of the amount in excess 

of 5 percent. In addition, if a sufficient number of 

plans serving a substantial majority of enrollees received risk corridor payments for the year, then the 

MMA would increase the share of costs covered in the 

initial range from 75 percent to 90 percent for that 

year. 

B For the 2008-2011 period, plans would face more risk 

as the risk corridor thresholds doubled—from 2.5 percent to 5 percent and from 5 percent to 10 percent, respectively— and the share of costs covered by the risk 

corridor payment in the initial range dropped from 75 

percent to 50 percent (with no provision for a higher 

rate if most plans missed their targets). Above the second threshold (that is, for deviations exceeding 10 

percent), the payment rate would remain at 80 percent. 

B After 2011, HHS could increase the first threshold 

above 5 percent and the second threshold above 10 

percent. 

The corridors would be structured symmetrically. Thus, 

a plan whose costs exceeded the expected level by 10 percent would receive a risk corridor payment from Medicare, but that plan would have to pay the same amount 

to the government if its costs fell below expectations by 

10 percent. 

How the Risk Corridor System Would 

Work: An Illustrative Example

The effects of the MMA’s risk corridor system can be 

illustrated using three hypothetical drug plans in 2006 

with the same expected benefit costs but differing actual 

benefit costs in 2006 (see Table A-1). To keep the example relatively simple, costs and payments are expressed as 

per-enrollee averages, and the reinsurance payments are 

assumed to cover exactly one-third of total benefit costs 

in all three plans (both in expectation and in actuality). In 

the example, the costs for covered benefits in Plan 1 fall 

below the expected level by $75 per enrollee. By assumpAPPENDIX
36 A DETAILED DESCRIPTION OF CBO’S COST ESTIMATE FOR THE MEDICARE PRESCRIPTION DRUG BENEFIT

Table A-1.

Example of How the Drug Benefit’s Risk Corridors Would Operate in 2006

(Average amount in dollars per enrollee per year)

Source: Congressional Budget Office.

Note: The examples used here assume that the test for triggering a higher payment rate in the initial range (between 2.5 percent and 5 percent) is not met. They also ignore any effects of risk adjustment.

tion, one-third of that difference is effectively recouped 

via a lower-than-anticipated reinsurance payment from 

the government. In the absence of any risk corridor provisions, Plan 1 would have seen a gain of $50 per enrollee 

(beyond any normal profits it had built into its bid submission). But because that gain constitutes more than 

2.5 percent of its expected benefit costs (net of individual 

reinsurance), it must make a risk corridor payment to 

Medicare of $18.75 per enrollee (75 percent of the 

amount by which its gain exceeds $25). Its final gain is 

thus reduced to $31.25 per person. 

Plan 2 also experiences a small gain in this example, but 

because that gain represents only 1 percent of its expected 

net costs, it does not have to make a risk corridor payment. By contrast, Plan 3 incurs total benefit costs of 

$150 per enrollee more than it had anticipated; although 

a portion of that excess is covered by greater-thanexpected federal reinsurance payments, that plan would 

(but for the risk corridors) face a loss of $100 per person. 

The risk corridor payment from Medicare covers nearly 

60 percent of Plan 3’s remaining losses, though, reducing 

its actual net loss to $41.25 per enrollee.

Risk Corridors and the MMA’s Other 

Risk-Mitigation Measures 

The MMA incorporates three methods of risk mitigation: 

risk corridor payments, federal reinsurance payments, 

and a risk adjustment. Although they have some similarities, each method would address somewhat different risks 

in somewhat different ways.

Risk adjustment would account for differences in beneficiaries’ expected drug spending based on their health 

status or other individual factors. HHS would thus pay 

more to plans with sicker enrollees (who would be expected to incur higher drug costs) and less to plans with 

healthier enrollees. Those payment adjustments would be 

made prospectively. If designed well, the risk-adjustment 

Plan 1 Plan 2 Plan 3

Expected Benefit Costs 1,500 1,500 1,500

Expected Federal Reinsurance Payments 500 500 500

Net Expected Benefit Costs 1,000 1,000 1,000

Actual Benefit Costs 1,425 1,485 1,650

Actual Federal Reinsurance Payments 475 495 550

Net Actual Benefit Costs 950 990 1,100

Initial Gain (+) or Loss (–) 50 10 -100

Risk Corridor Payment to Plan (+) or from Plan (–)

For costs between 2.5 percent and 5 percent -18.75 0 18.75

For costs above 5 percent 0 0 40.00

Total -18.75 0 58.75

Final Gain or Loss 31.25 10.00 -41.25

Memorandum:

Percentage Difference Between Expected Benefit Costs 

and Actual Benefit Costs 5 1 -10
APPENDIX 37

system would vary payments to take into account factors 

that predictably affected an individual’s future drug use 

but that were beyond the control of a drug plan. Therefore, it would be targeted primarily at plans’ risk of experiencing adverse selection and would not address other 

sources of financial risk. For example, if drug costs generally turned out to be higher in a given year than had been 

expected, risk adjustment of Medicare’s payments would 

not offset the resulting higher costs. By the same token, if 

a risk-adjustment system was truly prospective over time 

—and the adjustment made for an individual did not depend on steps taken by his or her plan, such as the number or type of prescriptions that the plan had approved—

it could keep payments in line with costs without distorting plans’ incentives to control those costs. (By adjusting 

federal subsidies, it would also help keep beneficiaries 

from paying higher premiums simply because they joined 

a plan with sicker enrollees.) Even so, trade-offs could 

arise between assuring payment accuracy in the short run 

and encouraging cost control in the longer term. 

Federal reinsurance payments would be made retrospectively on the basis of actual drug spending for individuals 

who reached the drug benefit’s catastrophic threshold. 

Those payments would limit the risk that plans faced in 

attracting the highest-cost enrollees but would not address the financial risks involved in providing the frontend portion of the benefit. Reinsurance payments would 

also provide some protection against general uncertainty 

about future drug costs—because if average drug prices or 

utilization was higher or lower than expected, the costs of 

providing benefits above the catastrophic threshold 

would probably vary in a corresponding manner. If overall drug costs proved to be lower than projected, the 

reinsurance payment system would also allow the government to share in the savings. 

Risk corridor payments would also be made retrospectively 

(and would be applied after risk adjustment and federal 

reinsurance payments), but they would limit more directly the overall level of profits or losses that a drug plan 

experienced. As structured in the MMA, the risk corridors would provide plans with strong incentives to control costs below the first risk corridor threshold but then 

generally would share more risk the greater the deviation 

between actual and expected costs—perhaps reflecting 

the assumption that deviations of such magnitude would 

have to result from forces beyond the plan’s control. 

Thus, the risk corridors would primarily protect against 

large shocks in drug spending growth rates and against 

misestimates of average drug costs per enrollee (particularly in the initial years of the benefit, when uncertainty 

about that average would be greatest and when the risk 

corridors were narrower). Risk corridor payments would 

address the risks of favorable or adverse selection only in 

the event that risk adjustment of payments did not account well for the variation in plans’ costs for providing 

the front-end portion of the benefit—and even then the 

residual deviation between actual and expected costs 

would have to be rather large before risk corridor payments kicked in. 

The Impact of Risk Corridors on 

Program Costs

In principle, the expected value of risk corridor payments 

would be zero. As discussed in the body of this report, 

drug plans would have strong incentives to submit accurate bids (in part because they would be reviewed by 

HHS). On average, cost overruns by some plans or in 

some years would thus offset lower-than-expected costs 

by other plans or in other years. In practice, however, the 

Congressional Budget Office (CBO) assumed that plans 

would be slightly more likely to reveal losses than gains 

under the risk corridor system and that HHS would not 

be able to audit costs perfectly (given the potential for 

reasonable differences in interpretation about which benefit costs were allowable and which were administrative).1

The risk corridor system mainly affected CBO’s estimate 

of program costs through its impact on plans’ incentives 

to control costs. Precisely because plans would be partially insulated from any resulting losses and would reap 

only a portion of any resulting gains, CBO assumed that 

they would be somewhat less aggressive in managing drug 

costs. To quantify that effect, CBO modeled the impact 

of the risk corridor system on the variability of plans’ net 

costs. Among other factors, that modeling took into account the number of regions that might be established for 

drug plans to serve, because variability in costs is a function of plan size and average plan size depends in turn on 

the number of regions. Overall, CBO concluded that the 

risk corridor provisions specified in the MMA would 

yield a modest increase in the costs of providing the 

Medicare drug benefit (but primarily in the initial years 

of the benefit, when the corridors were relatively narrow). 

1. CBO also assumed that drug plans bearing less risk would have 

lower administrative costs, so the MMA’s risk corridor system 

somewhat reduced the agency’s estimate of those costs.