United States General Accounting Office

GAO Testimony

Before the Subcommittee on Health, Committee on Ways

and Means, House of Representatives

For Release on Delivery

Expected at 9:00 a.m.

Tuesday, February 25, 1997

MEDICARE HMOs

HCFA Could Promptly

Reduce Excess Payments

by Improving Accuracy of

County Payment Rates

Statement of William J. Scanlon, Director

Health Financing and Systems

Health, Education, and Human Services Division

GAO/T-HEHS-97-78

Medicare HMOs: HCFA Could Promptly

Reduce Excess Payments by Improving

Accuracy of County Payment Rates

Mr. Chairman and Members of the Subcommittee:

We are pleased to be here today to discuss the rates Medicare pays health

maintenance organizations (HMO) in its risk contract program, Medicare’s

principal managed care option.1

 As you know, Medicare’s method for

paying risk contract HMOs was designed to save the program 5 percent of

the costs for beneficiaries who enroll in HMOs. However, 10 years of

research on Medicare’s costs under HMOs has found that the program’s

rate-setting method results in excess payments to HMOs because HMO

enrollees would have cost Medicare less if they had stayed in the

fee-for-service sector.2

 Recently, the Physician Payment Review

Commission (PPRC) estimated that annual excess payments to HMOs

nationwide could total $2 billion.3

A number of proposals have been made recently to help alleviate

Medicare’s HMO payment problems. For example, the proposed Balanced

Budget Act of 1995 called for, among other things, mechanisms to lessen

rate disparities across geographic areas and to decouple annual HMO rate

increases from annual fee-for-service spending increases. The

administration’s current budget proposal adopts several provisions from

the proposed Balanced Budget Act but also adds new twists—such as 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. Under the auspices of the Health Care Financing Administration

(HCFA), which administers the Medicare program, several demonstration

projects are planned or under way, including efforts to improve risk

adjustment and using a process of competitive bidding to set rates.

At the request of the Subcommittee’s Chairman, we reviewed HCFA’s

method for setting HMO rates to identify feasible options for promptly

reducing the amount of excess payments. A comprehensive discussion of

our work is included in a forthcoming report. In conducting our study, we

reviewed previous research on Medicare’s HMO rate-setting method;

analyzed available HCFA data; and had our findings reviewed by experts on

HMO payment issues, including staff at PPRC and HCFA.

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

See the attached list of related GAO products.

3

This estimate was contained in material presented to the Commissioners for their December 12-13,

1996, meeting.

Page 1 GAO/T-HEHS-97-78
Medicare HMOs: HCFA Could Promptly

Reduce Excess Payments by Improving

Accuracy of County Payment Rates

Today, I would like to focus my comments on our proposed modification

to HCFA’s HMO rate-setting method. We believe this modification could help

reduce excess HMO payments under Medicare’s current payment method,

the administration’s method, or other methods that rely on fee-for-service

costs to set initial HMO rates or update those rates. Central to the current

method and proposals for setting HMO rates is an estimate of the average

cost of serving Medicare beneficiaries under fee-for-service in defined

geographic areas (currently, counties). The actual rates paid HMOs for an

enrollee are set by adjusting these averages up or down on the basis of the

enrollee’s “risk” of incurring higher or lower costs. Considerable attention

has focused on the failure of current risk adjustment methodology to

adequately account for favorable selection, the term used to describe the

tendency of HMOs to attract a population of Medicare seniors whose health

costs are generally lower than those of the average beneficiary. Our work

centers on the estimate of average cost of serving a county’s beneficiaries:

the county rate.

In summary, we found that HCFA’s current method of determining the

county rate produces excess payments. Because HCFA’s method excludes

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

bases county payment rates on the average per-beneficiary cost of only

those beneficiaries that remain in the fee-for-service sector and ignores the

costs HMO enrollees would have incurred if they had remained in

fee-for-service. Research has shown the costs of those remaining in

fee-for-service to be higher on average than the likely costs of HMO

enrollees. 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. Our proposed modification is

designed to fix that problem. We developed a way to estimate HMO

enrollees’ expected fee-for-service costs using information available to

HCFA. Our approach produces a county rate that represents the costs of all

Medicare beneficiaries and could result in hundreds of millions of dollars

in savings to Medicare.

How Medicare

Determines an HMO’s

Payment Rate

Essentially, HCFA’s calculation of its per-enrollee (capitation) rate can be

expressed as follows:

Capitation rate = average per-beneficiary cost x .95 x

 risk adjustment factor

Page 2 GAO/T-HEHS-97-78
Medicare HMOs: HCFA Could Promptly

Reduce Excess Payments by Improving

Accuracy of County Payment Rates

Medicare pays risk HMOs a fixed amount per enrollee—a capitation

rate—regardless of what each enrollee’s care actually costs. 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.4

 In implementing the law’s rate-setting provisions, HCFA

estimates a county’s average per-beneficiary cost and multiplies the result

by 0.95.5

 The product is the county adjusted average per capita cost rate.6

HCFA then applies a risk-adjustment factor to the county rate. Under HCFA’s

risk-adjustment system, beneficiaries are sorted into groups according to

their demographic traits (age; sex; and Medicaid, institutional, and

working status). HCFA calculates a risk factor for each group—the group’s

average cost in relation to the cost of all beneficiaries nationwide. For

example, in 1995 the risk factor for younger seniors (65- to 70-year-old

males) was .85, whereas for older seniors (85-year-old or older males) it

was 1.3. HCFA uses the risk factor to adjust the county rate, thereby raising

or lowering Medicare’s per capita payment for each HMO enrollee,

depending on the individual’s demographic characteristics.

Medicare’s HMO

Rate-Setting Method

Has Led to Excess

Payments

One reason the HMO rate-setting method overstates the expected

fee-for-service costs of HMO enrollees is that it uses only the cost

experience of fee-for-service beneficiaries. If the health status of the mix

of beneficiaries enrolled by HMOs were the same as the health status of

those in fee-for-service, using fee-for-service beneficiaries to estimate the

expected fee-for-service costs of HMO enrollees would be an appropriate

method. However, because research has shown that HMOs have in general

enrolled healthier-than-average beneficiaries, the beneficiaries remaining

in fee-for-service represent a sicker-than-average population.7

 This, in turn,

means that using data on fee-for-service beneficiaries exclusively produces

HMO payment rates higher than envisioned when the current rate setting

provisions were enacted.

4

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

5

A 5-percent discount is taken on the premise that, compared with fee-for-service care, managed care

plans achieve certain efficiencies. For example, HMOs can negotiate with hospitals, physicians, and

other providers to obtain discounts on services and supplies.

6

Medicare determines four capitation rates for each county, one each for part A aged, part B aged, part

A disabled, and part B disabled.

7

HCFA’s Health Care Financing Review, a 1996 study using postdisenrollment data, estimated that

HMO enrollees’ costs were 12 percent lower than average, while a 1996 PPRC study using

preenrollment data estimated that enrollees’ costs were 37 percent lower than for comparable

fee-for-service beneficiaries.

Page 3 GAO/T-HEHS-97-78
Medicare HMOs: HCFA Could Promptly

Reduce Excess Payments by Improving

Accuracy of County Payment Rates

Medicare’s risk adjustors explain 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, within the

same demographic group, HMO enrollees are healthier than fee-for-service

beneficiaries; for example, 70-year-old males in HMOs are, on average,

healthier than 70-year-old males in fee-for-service. Medicare’s risk adjustor

is said to be inadequate because, while it makes broad distinctions among

beneficiaries of different age, sex, and other demographic characteristics,

it does not account for the significant health differences among

demographically identical beneficiaries. The cost implications of health

status differences can be dramatic—for two demographically alike

beneficiaries, one may experience occasional minor ailments while the

other may suffer from a serious chronic condition.

Including HMO

Enrollees’ Costs in

County Average

Improves Accuracy of

County Rates

Independent of improved risk adjustment, modifying the method for

calculating the county rate would help reduce Medicare’s excess HMO

payments. In setting county rates, 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 disparities between Medicare’s

fee-for-service and HMO enrollee populations, this method can either

overstate the average costs of all 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.8

8

Our 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. How our method accounts for these costs is discussed more

thoroughly in our report.

Page 4 GAO/T-HEHS-97-78
Medicare HMOs: HCFA Could Promptly

Reduce Excess Payments by Improving

Accuracy of County Payment Rates

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

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

produces a county rate that reflects the costs of all Medicare beneficiaries.

Selected 1995 County

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 it covers 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. Although better risk

adjustors could further reduce the large remainder of excess payments,

improvements to risk adjustment require developing direct measures of

health status, which is a complex effort that may take years.

The following key points also emerged from our analysis:

• First, for the counties that we analyzed, we estimate 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 county rates would have reduced the excess by about $276 million.

• Second, the excess payments attributable to inflated county 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.9

 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

data—which include counties with up to a 39-percent HMO penetration in

1995—indicated that the disparity 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 enrollment

rates in 1995.

9

For 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 5 GAO/T-HEHS-97-78
Medicare HMOs: HCFA Could Promptly

Reduce Excess Payments by Improving

Accuracy of County Payment Rates

Data Are Available to

Enable HCFA to Promptly

Adjust County 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 in

a current methodological flaw that would persist in any adopted changes

to Medicare’s HMO payment method that continued to use current county

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: we

believe that the savings to be achieved from reducing county-rate excess

payments would be much greater than the administrative costs of

implementing the process.

Conclusions Medicare’s HMO rate-setting problems have prevented it from realizing the

savings that were anticipated from enrolling beneficiaries in capitated

managed care plans. In fact, enrolling more beneficiaries in managed care

could increase rather than lower Medicare spending—unless Medicare’s

method of setting HMO rates is revised. Our method of calculating the

county rate would have the effect of reducing payments more for HMOs in

counties with higher excess payments and less for HMOs in counties with

lower excess payments. In this way, our method represents a targeted

approach to reducing excess payments and could lower Medicare

expenditures by at least several hundred million dollars each year.

Furthermore, our approach is useful under several possible scenarios,

including whether (1) the Congress adopts any proposal that uses current

county rates as a baseline, (2) HCFA develops and adopts improved risk

adjustors, or (3) the Congress takes no action and preserves Medicare’s

current rate-setting process.

Mr. Chairman, this concludes my prepared statement. I would 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. The analysis was conducted by Scott L. Smith,

Project Director, and Richard M. Lipinski, Project Manager. Other major

contributors to this statement included Thomas Dowdal and Hannah F.

Fein.

Page 6 GAO/T-HEHS-97-78
Page 7 GAO/T-HEHS-97-78
Related GAO Products

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).

(101541) Page 8 GAO/T-HEHS-97-78
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