United States General Accounting Office

GAO Testimony

Before the Special Committee on Aging, U.S. Senate

For Release on Delivery

Expected at 2:00 p.m.

Monday, May 19, 1997

MEDICARE MANAGED

CARE

HMO Rates, Other Factors

Create Uneven Availability

of Benefits

Statement of William J. Scanlon, Director

Health Financing and Systems Issues

Health, Education, and Human Services Division

GAO/T-HEHS-97-133

Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

Benefits

Mr. Chairman and Members of the Committee:

We are pleased to be here today as you discuss aspects of Medicare

managed care, including greater choice and equity across the program. In

fiscal year 1997, federal expenditures for Medicare benefits are expected

to reach nearly $209 billion. The Congressional Budget Office estimates

that costs will rise an average of 8.4 percent a year during fiscal years 1998

through 2002. As the Congress seeks ways to slow this growth rate, several

proposals have been made that would encourage beneficiaries to join risk

contract health maintenance organizations (HMO). Risk contract HMOs have

the potential to be advantageous for two reasons. First, the payment of a

capitated rate for all services needed by each enrolled beneficiary gives

these plans a financial incentive to hold down costs.1

 In addition, risk

contract HMOs often provide Medicare enrollees additional benefits at

lower out-of-pocket costs than Medicare fee-for-service coverage.

As you know, Medicare risk HMO plans are not available nationwide, and

differences in premiums charged and benefits offered across the country

produce inequities for Medicare program beneficiaries. In addition, as we

recently reported,2

 the risk contract program has not realized the savings

that were anticipated from enrolling beneficiaries in capitated managed

care plans. Concerned about program inequities and the lack of savings

from risk HMOs, you asked us to discuss the mechanics of the current risk

HMO payment system and its shortcomings—including why the system

produces differences in HMO availability and benefit packages for

beneficiaries and fails to produce expected savings for taxpayers. I will

focus on (1) the link between counties’ capitation rates and Medicare’s

spending on fee-for-service care; (2) factors affecting the availability of

plans in a given area, the level of premiums charged, and the benefit

packages offered; and (3) modifications to Medicare’s current payment

methodology that could reduce HMO overpayments.

My remarks today are based primarily on analyses done for our recently

issued work on HMO rate setting and the enrollment of HMOs in Medicare’s

risk contract program. (A list of related GAO products appears at the end of

this statement.)

1

Other Medicare managed care plans include cost contract HMOs and health care prepayment plans,

which together enroll fewer than 2 percent of the total Medicare population. Because Medicare pays

these plans using methods other than capitation rates, they are not the subject of this statement.

2

Medicare HMOs: HCFA Can Promptly Eliminate Hundreds of Millions in Excess Payments

(GAO/HEHS-97-16, Apr. 25, 1997).

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Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

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In summary, Medicare’s risk HMO payment system, which is built largely on

fee-for-service costs, accounts for some, but not all, of the unevenness in

Medicare’s risk contract program. Differences in local medical prices and

service utilization explain much of the variation in HMO capitation rates

across counties. In turn, the variation in capitation rates explains some of

the differences across locations in availability of risk contract HMOs, level

of HMO premiums charged, and richness of benefits offered. However,

other factors also play an important role.

Reducing the uneveness in, and realizing the savings potential of, the risk

contract program involves reforming its payment system. As a start to that

process, we have proposed correcting a flaw in Medicare’s rate-setting

method that currently contributes to excess payments to HMOs. Our

proposed modification could also help smooth the unevenness in counties’

HMO capitation rates.

Background Medicare provides health care insurance for nearly all elderly Americans

(those aged 65 and older) and certain of the nation’s disabled. It is

administered by the Health Care Financing Administration (HCFA), an

agency of the Department of Health and Human Services (HHS). Although

most Medicare services are provided through the fee-for-service sector, in

recent years, greater numbers of Medicare beneficiaries have enrolled in

HMOs to receive covered services.

Medicare risk HMOs must cover all Medicare part A and part B services.

However, many risk HMOs also cover part A and part B copayments and

deductibles and additional services that are not covered under traditional

Medicare—such as a portion of the costs of outpatient prescription drugs,

routine physical exams, hearing aids, and eyeglasses. HMOs are allowed,

subject to certain Medicare restrictions, to charge beneficiaries a monthly

premium for cost-sharing and services not otherwise covered by Medicare.

However, nearly two thirds of HMOs do not charge beneficiaries a monthly

premium.3

Congressional interest in risk-bearing HMOs dates from the Social Security

Act Amendments of 1972 (P.L. 92-603). Under the 1972 law, if an HMO’s

costs were less than its capitation payments, it was required to share these

profits with Medicare. In addition, an HMO’s profits were capped at

10 percent of its total payment from the government. However, if an HMO’s

costs exceeded its payments from Medicare, the HMO had to absorb the

3

All beneficiaries enrolled in HMOs must, however, continue to pay their part B premium to Medicare.

Page 2 GAO/T-HEHS-97-133
Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

Benefits

loss or carry it over to offset future profits from its Medicare business.

Few HMOs contracted with Medicare under this arrangement.

In 1982, the Congress modified Medicare’s rate-setting method, creating

the risk contract program that exists today.4

 One significant change was

that the Congress eliminated the 1972 law’s requirement that an HMO’s

Medicare profits be completely shared with Medicare. Instead, HMOs are

permitted to retain all profits up to the levels they earn on their

non-Medicare business.

As of May 1, 1997, 280 HMOs5

 participated in Medicare’s risk contract

program. Recent growth in enrollment of plans in the risk contract

program has been rapid but uneven across the country. When we reported

on 1994 enrollment trends, for example, 15 states had experienced

double-digit growth increases, whereas the other states had experienced

little or no growth.6

 At the end of 1996, California, Florida, New York,

Texas, and Washington had the largest number of risk contract HMOs,

whereas 37 states had five or fewer of these plans. Medicare’s enrollment

of beneficiaries in risk HMOs is currently growing by about 85,000

beneficiaries per month. As of May 1, 1997, 4.6 million, or nearly 12

percent, of the approximately 39 million Medicare beneficiaries were

enrolled in risk HMOs.

Diversity in Capitation

Rates Across Counties

Is Driven by Variation

in Local Medicare

Fee-for-Service

Spending

Medicare law ties HMO capitation rates to spending in the traditional

fee-for-service program. Every year, HCFA calculates per-beneficiary

spending in each county’s fee-for-service sector and, using projections of

spending growth, determines capitation rates for each county in the

following year. Fee-for-service costs vary widely among counties because

of differences in medical prices paid and in beneficiaries’ use of services.

Therefore, HMO capitation rates, directly based on fee-for-service spending,

can vary considerably from one county to another.

4

The legislation creating this program is contained in section 114 of the Tax Equity and Fiscal

Responsibility Act (P.L. 97-248).

5

Competitive medical plans, which also enter into risk contracts with Medicare to serve beneficiaries,

are included in this figure.

6

Medicare Managed Care: Growing Enrollment Adds Urgency to Fixing HMO Payment Problem

(GAO/HEHS-96-21, Nov. 8, 1995).

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Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

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HCFA’s Process for

Determining an HMO’s

Payment Rate Is Tied

Directly to Medicare’s

Fee-for-Service Spending

Medicare law stipulates that the capitation rate be set at 95 percent of the

costs Medicare would have incurred for HMO enrollees if they had

remained in fee-for-service.7

 Under Medicare’s current rate-setting

method, HCFA each year uses the Medicare costs incurred by a county’s

fee-for-service beneficiaries to develop an estimate of each county’s

average fee-for-service spending in the following year.8

 The result,

multiplied by 0.95, produces a county rate known as the adjusted average

per capita cost (AAPCC).9

 In projecting spending growth, HCFA’s calculations

take into account national trends in inflation and utilization patterns as

well as changes in Medicare program provisions.

To arrive at the capitation rate paid for each HMO enrollee, HCFA applies a

risk-adjustment factor to the AAPCC that is intended to align the rate with

how much an enrollee’s expected costs differ from the average

beneficiary’s cost. Our work has shown that, even after HCFA’s risk

adjustments, the capitation rate is only weakly related to a beneficiary’s

expected fee-for-service costs.

Variation in Fee-for-Service

Spending Produces

Diversity in Counties’

AAPCC Rates

In 1997, the average AAPCC was $395 per month.10 However, AAPCC rates

vary dramatically from place to place—from a low of $221 in Arthur

County, Nebraska, to $767 in Richmond County (Staten Island), New York

(see fig. 1). Even among counties in the same geographic area, substantial

rate variation can exist. For example, in the Philadelphia metropolitan

area, Philadelphia County’s AAPCC is $704, but in neighboring Montgomery

County, Pennsylvania, the AAPCC is $516. Because capitation rates are

based on a beneficiary’s county of residence, a Philadelphia-area HMO

would receive $188 more for serving a Philadelphia county resident than it

would for serving a Montgomery County resident with identical

demographic characteristics. The payment differential remains, even if the

two beneficiaries see the same physician and use the same medical

facilities.

7

Section 1876(a)(4) of the Social Security Act (42 U.S.C 1395mm(a)(4) (1994)).

8

Through this process, HCFA determines county-specific Medicare expenditures for part A and part B

for the elderly and the disabled.

9

HCFA calculates separate cost figures for Medicare part A and part B services for the aged, the

disabled, and people with end-stage renal disease.

10The average county rate weighted by the number of beneficiaries living in each county is $468.

AAPCC rates discussed in this statement exclude rates for the U.S. territories.

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Medicare Managed Care: HMO Rates, Other

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Figure 1: Distribution of Counties by

1997 AAPCC Rates Number of Counties

0

100

200

300

400

500

600

700

800

900

1000

<$251

$251-300

$301-350

$351-400

$401-450

$451-500

$501-550

$551-600

$601-650

>$650

1997 AAPCC Rates

The wide variation in HMO payment rates is a consequence of the variation

in local Medicare fee-for-service expenditures which, in turn, is caused by

local differences in both the prices of medical services and the quantities

of medical services consumed. To illustrate that price differences alone

cannot fully explain the variation in AAPCC rates, figure 2 shows an

estimate of the AAPCC rate that would exist in Arthur County, Nebraska,

and Richmond County, New York, if the cost of medical services in both

counties were equal to the national average. Although an adjustment for

differences in medical prices reduces the original $546 AAPCC rate

differential by 39 percent, a gap of $332 nevertheless remains.

Page 5 GAO/T-HEHS-97-133
Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

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Figure 2: 1997 AAPCC Rates and

AAPCC Rates Adjusted for Local

Medical Costs in Arthur County,

Nebraska, and Richmond County, New

York

Dollars

0

200

400

600

800

1997 AAPCC

Rates

1997

Price-Adjusted

AAPCC Rates

221

767

275

597

Arthur County, Nebraska

Richmond County, New York

Differences in the quantity of medical services beneficiaries receive

account for the variation in AAPCC rates not attributable to differences in

local prices. HMO capitation rates are higher in counties where

beneficiaries use more services (or a more expensive mix of services)

compared with counties where beneficiaries use fewer services. An

example of variation in service utilization is Medicare beneficiaries’ use of

short-stay hospitals. In 1994, Utah beneficiaries averaged 1,270 days of

hospital care per 1,000 beneficiaries, whereas New York beneficiaries

averaged 3,738 days of hospital care per 1,000 beneficiaries.

Some of the variation in the use of medical services may reflect

inappropriate levels of care. For example, low utilization could be caused

by access-to-care barriers, such as inadequate transportation or a lack of

providers in rural areas. Similarly, some high utilization could represent

excessive use of medical services. Nonetheless, current fee-for-service

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Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

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medical utilization rates—whether appropriate or not—are an important

factor in determining HMO capitation payment rates.

HMO enrollment patterns may also contribute to the county variation in the

use of fee-for-service medical services. It is widely acknowledged that HMO

enrollees tend to be healthier than beneficiaries who remain in

fee-for-service—a phenomenon known as favorable selection. As we

recently reported, the growing enrollment of a county’s generally healthier

Medicare beneficiaries in risk HMOs drives up the medical service use rates

for the generally sicker beneficiaries remaining in fee-for-service.11

Capitation Rates

Alone Do Not

Determine HMO

Availability, Premiums

Charged, or Benefits

Offered

There is a significant correlation between Medicare’s capitation rates and

the availability of Medicare HMOs in different areas, the premiums these

plans charge, and the benefits they offer. However, a number of

exceptions suggests that other factors, such as the concentration of

Medicare beneficiaries and the availability of HMOs to the non-Medicare

population, play an important role.

Population Size and Rate

Volatility Also Likely

Influence Plan

Participation in a Given

Area

Medicare HMOs are not available everywhere. Nationally, 63 percent of

beneficiaries have at least one plan available to them; 25 percent have five

or more plans available. Many HMOs are concentrated in urban areas, while

rural areas have few or no HMOs. Because capitation rates are typically

higher in urban areas than in rural areas, Medicare payment rates to HMOs

are often considered to be an important influence on Medicare HMO

availability. However, other factors—such as county size and the stability

of the capitation rate from year to year—also play a key role.

Many counties with low AAPCCs are sparsely populated. Such counties

simply may not have enough potential enrollees to make an HMO financially

viable. As we recently reported, HMO officials have stated that plans need

to enroll at least 10,000 Medicare beneficiaries within a few years to

spread both financial risk and their fixed costs.12 In addition, many rural

counties are not served by commercial HMOs. This precludes the formation

of Medicare HMOs, because Medicare requires that HMOs serving rural areas

11GAO/HEHS-97-16, Apr. 25, 1997.

12Medicare HMO Enrollment: Area Differences Affected by Factors Other Than Payment Rates

(GAO/HEHS-97-37, May 2, 1997).

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have at least 1,500 commercial members (5,000 for nonrural HMOs) and

that at least 50 percent of their enrollees be commercial members.

Instability of capitation rates from year to year may also discourage some

HMOs from locating in areas with few beneficiaries. Between 1996 and

1997, the average AAPCC rate increased by about $23, or just over 6 percent.

However, some counties’ rates increased much more than the average

while others decreased substantially.13 In counties with a small number of

beneficiaries, a relatively few expensive medical cases in 1 year can drive

up Medicare fee-for-service expenditures (and therefore HMO rates), while

an especially “healthy” year can reduce expenditures. HMO officials have

stated that such rate instability impairs long-term planning efforts—for

example, by complicating decisions about investing in new clinics and

expanding physician networks. By using a 5-year average of fee-for-service

data to determine a county’s AAPCC rate, HCFA dampens—but does not

eliminate—the effect of fluctuating fee-for-service costs on HMO payment

rates.

HMO Profit Restrictions,

Competition Also

Influence Premium Rates

and Benefit Packages

Beneficiaries’ out-of-pocket costs and the benefits they receive depend on

where they live as well as on which HMO they join. For example,

beneficiaries living in southern California who enroll in PacifiCare pay no

monthly premium and may receive an unlimited annual prescription drug

benefit. In contrast, beneficiaries who enroll in PacifiCare in Portland,

Oregon, pay a $37 monthly premium and receive no prescription drug

benefit.

Geographic differences in capitation rates (PacifiCare of southern

California receives an average monthly capitation rate of $497, while

PacifiCare of Oregon receives $338) explain part of the premium and

benefit variation, but not all. Restrictions on HMO profits and the amount of

local competition among HMOs also influence the out-of-pocket costs

beneficiaries must pay and the benefits they receive.

Medicare’s HMO Profit

Restrictions

Medicare’s restrictions on HMOs’ profit-making partly explain the link

between capitation payments to HMOs and their benefit packages. Medicare

does not permit HMOs to earn profits on their risk contracts that are higher

than on their commercial business. If HCFA estimates that the capitation

payments would result in an HMO earning excess profits, the plan must

reduce premiums (or other beneficiary out-of-pocket expenses), offer

13For example, the AAPCC rate in Loving County, Texas, fell 40 percent (from $881 to $527), while the

rate in Culberson County, Texas, rose 37 percent ($355 to $487).

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Medicare Managed Care: HMO Rates, Other

Factors Create Uneven Availability of

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additional benefits, or return money to the program. Virtually all HMOs in

this situation decide to reduce premiums or offer additional benefits.

HCFA attempts to enforce Medicare’s restrictions on HMOs’ profits through

what is known as the “adjusted community rate” (ACR) process. Before

each contract year, every HMO submits to HCFA a proposal—called the ACR

proposal—that describes the HMO’s planned package of benefits (which

may go beyond those covered by fee-for-service Medicare) and monthly

premiums and other charges to beneficiaries. The ACR also includes an

estimate of the amount the HMO would have charged commercial enrollees

for a similar benefit package. Although this estimate may initially be based

on HMOs’ actual charges, numerous adjustments must be made to account

for the generally higher utilization of services by Medicare beneficiaries

compared with commercial enrollees and any differences in benefit

coverage between the two groups. HCFA reviews the ACR proposal to

determine whether the plan must offer additional benefits to enrollees and

the maximum premium the plan will be permitted to charge. The net result

is that the more an HMO will profit from its Medicare business, the more

additional benefits Medicare enrollees receive.

Competition for Market Share The amount of local competition among HMOs for market share can also

influence the level of HMO premiums and benefits. Through the ACR

process, HCFA approves the maximum premium (and other beneficiary

out-of-pocket costs) an HMO may charge for its proposed benefit package.

HMOs may, however, charge a premium lower than the one approved by

HCFA or offer benefits beyond those included in the plan’s ACR proposal.

Many HMOs seeking greater market share take advantage of this option. For

example, Health Options, Inc., operating in the competitive south Florida

market, is permitted to charge a monthly premium of $94 for the package

of benefits contained in its ACR proposal. However, Health Options has

waived this premium—beneficiaries pay no monthly fee. PacifiCare, in the

competitive Los Angeles market, is allowed to charge a $12 monthly

premium for its package of benefits, which includes a prescription drug

benefit with a $2,500 annual limit. As with Health Options, however,

market forces induced PacifiCare to go beyond the ACR requirements.

PacifiCare enrollees in the Los Angeles area pay no monthly premium, and

some receive an unlimited annual drug benefit.

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Medicare Managed Care: HMO Rates, Other

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Correcting

Rate-Setting Flaws

Addresses HMO

Overpayment

Problem, May Reduce

Risk Contract

Program Unevenness

The variation in the risk contract program that produces inequities across

the country in Medicare beneficiaries’ costs and benefits is a manifestation

of rate-setting flaws that produce HMO overpayments. As mentioned

earlier, favorable selection—the tendency of HMOs to attract healthier than

average beneficiaries—produces AAPCC rates that are higher than

warranted in some counties. Favorable selection can result in

overpayments to HMOs in two ways.

First, as discussed earlier, estimating a county’s average cost of serving

Medicare beneficiaries under fee-for-service is central to the current

method for setting HMO rates. The problem is that HCFA’s method excludes

HMO enrollees’ costs from estimates of the per-beneficiary average cost and

bases the AAPCC only on the cost of the county’s fee-for-service

beneficiaries. Thus, the rates generated reflect the costs of only a portion

of the county’s Medicare beneficiaries—a portion which, according to the

preponderance of research on this subject, is generally more costly than

the portion of beneficiaries enrolled in HMOs. In this way, the current

method generates rates that result in overpayments to HMOs in counties

where the Medicare HMO population is, on average, healthier than the

Medicare fee-for-service population.

A difficulty in correcting the problem is that HCFA cannot directly observe

the costs HMO enrollees would have incurred if they had remained in the

fee-for-service sector. We have proposed a modification that addresses

this problem. We developed a way to estimate HMO enrollees’ expected

fee-for-service costs using information available to HCFA, thus generating

an AAPCC that represents the costs of all Medicare beneficiaries in the

county.

On the basis of our work examining the AAPCC rates of California’s 58

counties,14 we found that in 1995 our method would have reduced excess

payments to HMOs by $276 million, or about 25 percent of total excess

payments. Thus, if HCFA adopted our modification, Medicare could save

hundreds of millions of dollars in HMO overpayments.

HCFA recognizes the effect of favorable selection on AAPCC rates. The

administration’s current budget proposal calls for an across-the-board

reduction in Medicare’s HMO payments that would lower the payments

from 95 percent to 90 percent of estimated fee-for-service costs. Our

14We selected California because, at the time of our review, it covered 36 percent of all Medicare

enrollees and includes counties that in 1995 had the nation’s highest HMO penetration rates. Our

estimates pertain to a large portion of the risk contract program; we did not develop a national

estimate.

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modification to calculating AAPCC rates takes a more targeted approach.

Under our method, HMOs in counties with higher excess payments would

receive greater payment reductions than HMOs in counties with lower

excess payments. The modification could be applied to HCFA’s current

payment method or other methods that rely on fee-for-service costs to set

or update HMO rates. (See the appendix for a more detailed discussion of

our work.)

Second, favorable selection results in overpayments to HMOs because of

HCFA’s method of risk adjustment. Medicare’s risk adjusters explain only

about 3 percent of the variation in individual-level health care costs and

are thus not adequate to account for the cost differences among

beneficiaries. The difficulty is that the risk adjusters are not precise

enough to distinguish between two beneficiaries who may be

demographically identical but who may have significant health differences.

For example, of two beneficiaries alike in age, sex, and the other

demographic traits considered by HCFA’s risk adjusters, one may

experience occasional minor ailments, while the other may suffer from a

serious chronic condition. Because such dramatic differences in health

status are not captured in risk adjustment, some HMOs receive payments

that are higher than justified by the expected costs of their enrollees.

HCFA announced in January 1997 that it was about to launch a

demonstration project on two risk-adjustment systems that seek to

differentiate more and less costly patients on the basis of diagnostic

information from inpatient, outpatient, and physician encounters. HCFA has

not announced a schedule for implementing a better risk adjuster

programwide.

Conclusions The AAPCC system, with its linkage to fee-for-service expenditures, is an

imperfect mechanism for setting capitation rates. It incorporates some

local factors—such as service utilization differences—that may be

inappropriate without adequate adjustments. As a result, the system

assigns some counties AAPCC rates that are too low and other counties

rates that are too high. Coupled with such factors as market competition

and Medicare’s complex ACR process, Medicare’s payment system results

in dramatic contrasts in HMO plan availability, out-of-pocket beneficiary

costs, and benefit packages. Addressing the flaws in setting capitation

rates is essential if the risk contract program is to realize the potential of

program savings, enhanced benefits, and beneficiary equity.

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Mr. Chairman, this concludes my prepared statement. I will be pleased to

answer any questions.

Contributors For more information on this testimony, please call Jonathan Ratner,

Associate Director, on (202) 512-7107 or James C. Cosgrove, Assistant

Director, on (202) 512-7029. Other contributors to this product include

Richard M. Lipinski and Hannah F. Fein.

Page 12 GAO/T-HEHS-97-133
Page 13 GAO/T-HEHS-97-133
Appendix I 

Including HMO Enrollees’ Costs in County

Average Calculation Improves Accuracy of

AAPCC

Modifying the method for calculating adjusted average per capita cost

(AAPCC) rates would help reduce Medicare’s excess health maintenance

organization (HMO) payments in counties with healthier-than-average

Medicare HMO enrollees. In setting AAPCC rates, the Health Care Financing

Administration (HCFA) currently estimates the average Medicare costs of a

county’s beneficiaries using the costs of only those beneficiaries in

Medicare’s fee-for-service sector. This method would be appropriate if the

average health cost of fee-for-service beneficiaries were the same as that

of demographically comparable HMO enrollees. However, in counties

where there are cost differences between Medicare’s fee-for-service and

HMO enrollee populations, this method can either overstate the average

costs of Medicare beneficiaries and lead to overpayment or understate

average costs and lead to underpayment. Correcting this problem is

difficult because it is impossible to observe the costs HMO enrollees would

have incurred if they had remained in the fee-for-service sector. Therefore,

we developed a method to estimate HMO enrollees’ expected fee-for-service

costs using information available to HCFA. Our method consists of two

main steps:

• First, we compute the average cost of demographically similar new HMO

enrollees during the year before they enrolled—that is, while they were

still in fee-for-service Medicare. These fee-for-service costs are available

through HCFA’s claims data.

• Next, we adjust this amount to reflect the expectation that a new

enrollee’s use of health services will, over time, rise.15

Having completed these steps, we combine the result with an estimate of

the average cost of fee-for-service beneficiaries. This new average

produces an AAPCC rate that reflects the costs of all Medicare beneficiaries.

Selected 1995 AAPCC

Rates Produced

Substantial Excess

Payments

To illustrate the effect of our approach, we analyzed data for counties with

different shares of beneficiaries enrolled in HMOs. We chose counties

within a single state to eliminate variations attributable to state

differences. We selected California because, at the time of our review, it

covered 36 percent of all Medicare HMO enrollees and includes counties

that in 1995 had the nation’s highest HMO penetration rates. We found that

our method could have reduced excess payments by more than 25 percent.

15Our analysis adjusts for (1) the tendency for enrollees’ costs to become more like—or “regress”

toward—the fee-for-service cost mean after joining an HMO and (2) the costs incurred by HMO

enrollees who die while enrolled, because last-year-of-life costs are typically high relative to those

incurred in preceding years. How our method accounts for these costs is discussed more thoroughly in

GAO/HEHS-97-16.

Page 14 GAO/T-HEHS-97-133
Appendix I 

Including HMO Enrollees’ Costs in County

Average Calculation Improves Accuracy of

AAPCC

Although better risk adjusters could further reduce the large remainder of

excess payments, improving risk adjustment is a complex effort that may

take years to implement full-scale.

The following key points also emerged from our analysis:

• First, for the counties that we analyzed, we estimated that total excess

payments in 1995 amounted to about $1 billion (of about $6 billion in total

Medicare payments to risk HMOs in the state). Applying our method for

setting AAPCC rates would have reduced the $1 billion in excess payments

by about $276 million.

• Second, the excess payments attributable to inflated AAPCC rates were

concentrated in 12 counties with large HMO enrollment and ranged from

less than 1 percent to 6.6 percent of the counties’ total HMO payments,

representing between $200,000 and $135.3 million.16 Despite the size of

these amounts, the application of our method would have produced

relatively small changes in the monthly, per-beneficiary capitation

payments, ranging from $3 to $38.

• Third, our analysis did not support the hypothesis, put forward by the HMO

industry and others, that the excess payment problem will be mitigated as

more beneficiaries enroll in Medicare managed care and HMOs

progressively enroll a more expensive mix of beneficiaries. Our

analysis—which includes data from counties with up to a 39-percent HMO

penetration in 1995—indicated that the difference between Medicare rates

and our rates is larger in counties with higher Medicare penetration. For

example, the four counties with the highest rates of excess payment,

ranging from 5.1 to 6.6 percent, were also among the counties with the

highest HMO enrollment percentages in 1995.

Data Are Available to

Enable HCFA to Promptly

Adjust AAPCC Rates

Because the data we used to estimate HMO enrollees’ costs come from data

that HCFA compiles to update HMO rates each year, our method has two

important advantages. First, HCFA’s implementation of our proposal could

be achieved in a relatively short time. The time element is important,

because the prompt implementation of our method would avoid locking

the current methodological flaw into any adopted changes to Medicare’s

HMO payment method that continued to use current AAPCC rates as a

baseline or fee-for-service costs to set future rates. Second, the availability

of the data would also make our proposal economical: the savings to be

16For the state’s remaining 46 counties, excess payments attributable to inflated county rates

amounted to less than 3 percent of the 58-county total.

Page 15 GAO/T-HEHS-97-133
Appendix I 

Including HMO Enrollees’ Costs in County

Average Calculation Improves Accuracy of

AAPCC

achieved from reducing AAPCC excess payments would be much greater

than the administrative costs of implementing the process.

Page 16 GAO/T-HEHS-97-133
Appendix I 

Including HMO Enrollees’ Costs in County

Average Calculation Improves Accuracy of

AAPCC

Page 17 GAO/T-HEHS-97-133
Appendix I 

Including HMO Enrollees’ Costs in County

Average Calculation Improves Accuracy of

AAPCC

Page 18 GAO/T-HEHS-97-133
Appendix I 

Including HMO Enrollees’ Costs in County

Average Calculation Improves Accuracy of

AAPCC

Page 19 GAO/T-HEHS-97-133
Related GAO Products

Medicare HMO Enrollment: Area Differences Affected by Factors Other

Than Payment Rates (GAO/HEHS-97-37, May 2, 1997).

Medicare HMOs: HCFA Can Promptly Eliminate Hundreds of Millions in

Excess Payments (GAO/HEHS-97-16, Apr. 25, 1997).

Medicare HMOs: HCFA Could Promptly Reduce Excess Payments by

Improving Accuracy of County Payment Rates (GAO/T-HEHS-97-78, Feb. 25,

1997).

Medicare HMOs: Rapid Enrollment Growth Concentrated in Selected States

(GAO/HEHS-96-63, Jan. 18, 1996).

Medicare Managed Care: Growing Enrollment Adds Urgency to Fixing HMO

Payment Problem (GAO/HEHS-96-21, Nov. 8, 1995).

Medicare: Changes to HMO Rate Setting Method Are Needed to Reduce

Program Costs (GAO/HEHS-94-119, Sept. 2, 1994).

(101566) Page 20 GAO/T-HEHS-97-133
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