United States General Accounting Office

GAO Report to the Ranking Minority Member,

Subcommittee on Health and the

Environment, Committee on Commerce,

House of Representatives

April 1995 MEDICAID MANAGED

CARE

More Competition and

Oversight Would

Improve California’s

Expansion Plan

GAO/HEHS-95-87

GAO United States

General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-257569 

April 28, 1995

The Honorable Henry A. Waxman

Ranking Minority Member, Subcommittee

 on Health and the Environment

Committee on Commerce

House of Representatives

Dear Mr. Waxman:

The Medicaid program was established to make health care services more

accessible to the poor. However, in many communities throughout the

nation, Medicaid beneficiaries’ access to quality care is far from assured.

Too few physicians and other health care providers choose to participate

in the Medicaid program because of low payment rates and administrative

burdens. In an attempt to address the access problem, as well as rising

costs and enrollment in its $15 billion Medi-Cal program which serves

about 5.4 million beneficiaries, California intends to increase its reliance

on managed care delivery systems.

California, with about two decades of Medicaid managed care experience,

has approximately 890,000 Medicaid beneficiaries in managed care plans.

This number would almost quadruple to 3.4 million as California expands

the managed care program, beginning in December 1995. According to

state officials, the purpose of California’s managed care expansion is to

improve access and the quality of health care. The state expects that, in

the long run, managed care will also contain Medicaid costs by reducing

unnecessary services and delivering care more efficiently. A number of

observers and participants, however, believe that the state’s expansion

plan will not achieve its goals of improved access or reduced costs.

Recognizing the significance of California’s planned expansion and the

value the state’s experience may have for other states’ Medicaid managed

care programs, you requested that we review California’s current and

planned Medicaid managed care programs. Our objectives were to

(1) describe California’s current Medicaid managed care program,

(2) review the state’s oversight of managed care contractors with a focus

on financial incentive arrangements and the provision of preventive care

for children, (3) describe the state’s plans for expansion, and (4) identify

key issues the state will face as it implements the expanded program.

Page 1 GAO/HEHS-95-87 California Medicaid Managed Care
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In doing this work, we interviewed California and federal Medicaid

officials, managed care contractors, and advocacy group representatives.

We also reviewed documents related to managed care, including

California’s laws, regulations, policies, and procedures; California’s

strategic plan for expanding managed care; and general literature on

financial incentives for providers of managed care. More detailed

information on our scope and methodology is in appendix I.

Results in Brief California plans a major expansion of its Medi-Cal managed care program

in selected counties. By the end of 1996, over 3.4 million enrollees will

receive health care through managed care plans—almost four times the

number now enrolled. In selected areas, enrollment will be mandatory for

women and children, who will choose to receive care from one of two

plans. This is a significant change from the predominantly voluntary

program the state currently administers that allows beneficiaries to

choose between fee-for-service and managed care.

Problems identified to date in a primarily voluntary enrollment program

could be significantly magnified in a much larger program with mandatory

enrollment. We are concerned about whether the state will monitor

managed care plans effectively enough to minimize any adverse effects on

the availability and quality of health care provided to Medicaid enrollees

placed in mandatory managed care. A vital factor in the success of the

program will be the capabilities of the state’s contract management staff.

The state has said it intends to improve its monitoring and strengthen its

staff capabilities through enhanced contract requirements and the hiring

of more staff. We are also concerned that the state does not give enough

attention to the extent that providers have financial incentives to limit

needed care and that the state has difficulty verifying whether services it

pays for are actually provided, including preventive care for children.

The state believes its expansion plan will improve Medicaid beneficiaries’

access to care and is a major improvement over the current fee-for-service

environment. However, we believe that any benefits of competitive

managed care will be lessened by the state’s decision to limit beneficiaries

in selected areas to choosing between two health plans. Several areas of

the state could support more than two health plans, giving beneficiaries

more choices and the state more latitude in dealing with plans that do not

meet their commitments.

Page 2 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

Background Enacted in 1965 as title XIX of the Social Security Act, Medicaid is a

federally aided, state-administered medical assistance program. At the

federal level, the program is administered by the Health Care Financing

Administration (HCFA), an agency within the Department of Health and

Human Services. Within broad federal guidelines, each state designs and

administers its own Medicaid program, which HCFA must approve for

compliance with current law and regulations. HCFA is also responsible for

providing program guidance and oversight to the state programs.

Nationwide, Medicaid served approximately 34 million low-income people

in fiscal year 1994, with combined federal and state expenditures of

$143 billion.

California established its Medicaid program, named Medi-Cal, in 1965. The

cost of the Medi-Cal program was estimated to be about $15 billion in

federal and state funds in fiscal year 1994, serving about 5.4 million people.

The California Department of Health Services (DHS) is the agency

responsible for administering the Medi-Cal program. It determines policy,

establishes fiscal and management controls, contracts with managed care

health plans, and reviews program activities.

California has over 20 years of experience with Medi-Cal managed care

programs. DHS began contracting with Prepaid Health Plan (PHP) pilot

projects in 1968. Abuses and scandals plagued the early years of PHP

contracting, resulting in beneficiaries being denied access to care. This led

the California legislature to pass the Waxman-Duffy Prepaid Health Plan

Act in 1972, which established standards for California Medicaid PHP

contracts and for program administration. Controls have been continually

strengthened over the years through amendments to the Waxman-Duffy

Act. The Knox-Keene Health Care Service Plan Act of 1975 gave the

California Department of Corporations authority to license and regulate

fully capitated PHPs in the state. One Waxman-Duffy amendment made

Knox-Keene licensure a prerequisite to obtaining a Medi-Cal PHP contract.

With the advent of the Waxman-Duffy and Knox-Keene acts, the majority

of then-contracting PHPs had to leave the Medi-Cal program because they

failed to meet the new standards.

Beginning in the 1980s, the state enacted several pieces of legislation

authorizing the development and testing of alternative ways to deliver

managed health care services to Medi-Cal beneficiaries. The first

legislation, in 1981, authorized the development of pilot Primary Care Case

Page 3 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

Management (PCCM) programs.1 Subsequent legislation, in 1982, authorized

County Organized Health Systems (COHS) and a Geographic Managed Care

(GMC) program, and also permitted routine PCCM contracting.

California’s Current

Medicaid Managed

Care Program

Medi-Cal managed care is currently built on a foundation of PHPs and

PCCMs. Contractors are all paid on a capitated basis for the services they

provide; that is, the state pays the managed care plan a monthly fee for

each enrollee, and the plan assumes responsibility for the full cost of the

services it has contracted to provide.2 PHPs are capitated to provide all

basic benefits covered by Medi-Cal, excluding a few selected services such

as organ transplants, chronic renal dialysis, long-term care, and dental

care. The capitation fee is intended to equal DHS’ cost of providing the

same services on a fee-for-service basis to an actuarially equivalent

population.

PCCMs are operated by physicians and other primary care providers who

are capitated to provide all outpatient physician services and to manage all

of the services provided to their enrollees. They may elect to provide

certain additional services for an increased capitation fee. The capitation

fee for PCCMs is set at 95 percent of the fee-for-service equivalent. All

services not capitated are available to the PCCM enrollee on a

fee-for-service basis.

DHS rewards PCCMs for effective case management by paying them a

percentage of the amount by which the state’s costs for the noncapitated

services fall below the projected costs for an equivalent non-case-managed

population.

California also uses other managed care delivery systems. COHSs deliver

health care to Medicaid beneficiaries in three counties—San Mateo, Santa

Barbara, and Solano. A COHS is a local agency that contracts with the state

Medicaid program to administer a capitated, comprehensive,

case-managed health care delivery system. The COHS is responsible for

administering claims, controlling utilization, and providing services to all

Medicaid beneficiaries residing in the county. Beneficiaries in the COHS

area must enroll in the COHS. They have a wide choice of managed care

providers but cannot obtain services under the traditional fee-for-service

1

PCCMs are entities that contract with the state to provide enrolled beneficiaries with physician and

outpatient services on a capitated basis.

2

DHS’ excess risk limitation arrangements can provide partial indemnification to plans for any

individual’s health care costs in excess of a specified risk limit per contract year. Contractors may also

purchase commercial insurance for some of their risk.

Page 4 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

system unless authorized by the COHS. All Medi-Cal services are arranged

for by COHSs through subcontracts with providers. The state plans to have

COHSs in two more counties—Orange and Santa Cruz—in 1995.

California began a GMC pilot in Sacramento County in 1994. Under this

project, the state contracts with several managed care plans to serve that

county’s recipients of Aid to Families With Dependent Children (AFDC)

population on a mandatory basis and other Medicaid beneficiaries on an

optional basis. The state is planning an additional GMC project in San Diego

County.

Presently, approximately 890,000 Medicaid beneficiaries are enrolled in

managed care plans in 20 of the state’s 58 counties. Table 1 shows

enrollment by type of plan.

Table 1: Statewide Medi-Cal Managed

Care Enrollment by Type of Plan

(Dec. 1994) 

Type of plan Enrollment

Prepaid Health Plans 476,041

Primary Care Case Management programs 147,835

County Organized Health Systems 136,086

Geographic Managed Care programs 130,423

Total 890,385

Most of the managed care enrollments are voluntary; that is, each

beneficiary may choose to receive care through either a managed care

plan or the traditional fee-for-service system. In addition, in some

counties, Medicaid beneficiaries have a choice of managed care plans.

Monitoring and Oversight DHS monitoring and evaluation of Medi-Cal contractors consist of annual

medical and periodic financial audits of all Medi-Cal managed care plans.

DHS also performs periodic monitoring and oversight, including quarterly

site visits to managed care plans by DHS contract management staff.

Managed care plans are reviewed for compliance with federal and state

regulations, with plan contract requirements, and with plans’ own

procedures.

The DHS Audits and Investigations Division conducts the annual medical

quality assurance audits and the periodic financial audits (approximately

every 2 years) of all Medi-Cal managed care plans. The medical audit

focuses on plan performance in areas such as accessibility, continuity of

Page 5 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

care, quality assurance, personnel licensure, preventive services,

grievances, and facilities and equipment.

DHS contract management staff’s monitoring of managed care plan

performance in terms of access and quality of care includes

(1) investigation of complaints from beneficiaries, county welfare

departments, beneficiary advocate groups, and providers; (2) review of

disenrollments from plans; (3) review of emergency room visits by plan

members; (4) follow-up of contractor corrective action plans for

deficiencies identified in medical and financial audits; and (5) reviews of

plan capacity and access. At the time of our review, DHS employed 17

contract managers. Each contract manager was responsible for one to

three health plans.

In addition to DHS’ periodic financial and medical audits, health plans

involved in Medi-Cal managed care must undergo several other types of

audits on a regular basis. These include the state Department of

Corporations’ medical and financial audits of all health maintenance

organizations (HMO); annual certified public accountant audits of health

plans; and HCFA-sponsored biennial independent cost, access, and quality

assessments of PCCMs and COHSs.

Monitoring and

Oversight Could Be

Strengthened

Effective monitoring and oversight activities are critical to the success of

any state Medicaid managed care program to ensure that beneficiaries

have access to quality health care.3

 However, a 1992 HCFA review found

that DHS was not always able to manage and monitor its managed care

program well enough to ensure that the health plans it contracted with

were meeting all their responsibilities or that beneficiaries were receiving

needed services in a timely fashion.4

Our review found three areas for continued concern. First, although DHS

monitors managed care plans for compliance with their Medicaid

contracts, it provides little guidance and training to those responsible for

this important task. Second, the state does minimal review of plans’

provider financial incentives to ensure that they do not encourage

inappropriately withholding health care services. Third, the state does

3

See Medicaid Managed Care: Healthy Moms, Healthy Kids—A New Program for Chicago

(GAO/HRD-93-121, Sept. 7, 1993); Medicaid: States Turn to Managed Care to Improve Access and

Control Costs (GAO/HRD-93-46, Mar. 17, 1993); and Medicaid: Oregon’s Managed Care Program and

Implications for Expansion (GAO/HRD-92-89, June 19, 1992).

4

HCFA Region IX, Review of California’s Administration of Its Managed Care Program (1993).

Page 6 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

little monitoring to ensure that services are actually provided through the

Early and Periodic Screening, Diagnostic, and Treatment (EPSDT) program,

which focuses on preventive services for children.

DHS Contract Managers

Lack Specific Guidance

and Training

After its 1992 review, HCFA criticized DHS’ monitoring of managed care

plans. Representatives of advocacy groups we interviewed also criticized

DHS’ contract management capabilities and lack of enforcement activity.

Although DHS often cites managed care plans for noncompliance with

contractual obligations, advocacy groups said effective enforcement is not

undertaken.

A December 1994 study by the Center for Health Care Rights in Los

Angeles concluded that Medi-Cal health plans with a history of poor care

had not been penalized or forced to make improvements.5

 The Center

reviewed a sample of health plans’ medical audits over time and DHS

activities after deficiencies were discovered. In its report, the Center

expressed concern with the inconsistent application of deficiency ratings

and the lack of DHS and health plan follow-up for serious quality of care

problems found during an audit.

Contract managers we interviewed expressed concerns of their own,

including their inability to monitor managed care health plans on a

proactive basis. They said that they dealt with problems brought to their

attention but did not have time to anticipate, identify, and resolve

emerging problems. Heavy workloads are one reason for this problem.

After its 1992 review of DHS, HCFA cited the agency’s lack of staff as one

reason for DHS’ inadequate monitoring, and an advocacy group we spoke

with also said contract managers’ heavy workloads had an adverse effect

on Medicaid beneficiaries’ access to quality health care. Although the state

has added staff, a HCFA official told us that DHS has just enough people to

keep current programs running and that heavy workloads remain a HCFA

concern.

Another factor involved in DHS’ inadequate monitoring that HCFA found in

its 1992 review was a generally low level of contract manager experience

and technical expertise. Our review also indicated that DHS could improve

its monitoring and management of health plans by giving contract

managers more training and guidance. In our discussions with DHS officials

and contract managers, we found that only on-the-job training and ad hoc

5

Center for Health Care Rights, State Oversight of Medi-Cal Managed Care Plans: How Well Does

California Protect Poor Families? (Los Angeles: Dec. 1994).

Page 7 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

workshops were provided. Only one of the five contract managers we

interviewed said enough training was provided.6

 Other contract managers

wanted additional training on topics such as how to interpret a contract,

how to review plans’ cost and utilization reports, and what to look for

during site visits.

We also found that DHS had not provided contract managers with written

policies and procedures on how to perform their duties. For instance,

contract managers said they did not have adequate guidance regarding

what they should do when contractors fail to comply with state

requirements. They believed that DHS policy on the use of sanctions for

noncompliance was vague and, therefore, not easily implemented. DHS

agreed contract managers could use more guidance and training.

DHS Does Minimal

Monitoring of Financial

Incentive Arrangements

Managed care plans that are paid on a capitated basis, such as PHPs and

PCCMs, often give incentives to their providers to encourage them to

control costs. If the costs of the services these plans provide are higher

than the capitation payments they receive, the plans must make up the

difference.7

 As a result, primary care physicians in managed care plans

typically serve as “gatekeepers” who must preapprove certain services for

their patients. Financial incentive arrangements adjust the compensation

paid to primary care physicians to discourage them from providing health

services such as inpatient hospital care, referrals to specialists, and certain

diagnostic tests when the services are unneeded. While there are no

reliable current data on the extent to which managed care plans use

financial incentives, evidence suggests that most HMOs use some

incentives.

All three Medi-Cal PHPs we spoke to regarding their financial arrangements

do use incentives. One plan, which has salaried primary care physicians,

pays them a bonus of up to 20 percent of salary partly on the basis of the

cost of individual physician referrals for specialty and hospital care. A

second plan pays a medical group on a capitated basis to provide virtually

all medical services in-house except inpatient care. Any surplus or deficit

up to a specified limit in the inpatient hospital budget is shared equally

6

We interviewed 5 of the 17 contract managers, which represents a judgmental sample of those who

work with different types of plans and report to different unit supervisors.

7

Financial incentives are only one of a number of methods capitated managed care plans may use to

limit service provision. Others include requiring physicians to obtain the plan’s preapproval when

ordering expensive procedures, educating physicians regarding cost control, reprimanding and

possibly terminating the contracts of physicians who exceed utilization guidelines, and screening out

physician applicants who do not share the plan’s cost-control goals.

Page 8 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

with physicians. The third plan, which passes along almost all the financial

risk, compensates each of its medical groups on a capitated basis for

nearly all medical services, including services for which patients must be

referred outside the group. It also uses bonus incentives for low hospital

utilization. Appendix II contains a more detailed discussion on the use of

financial incentives.

Ideally, financial incentives operate to reduce unnecessary medical

procedures, but they also have the potential to deny patients beneficial

and necessary services. Although there are few data on whether financial

incentives actually reduce the quality of medical care, the American

Medical Association, the Department of Health and Human Services,

advocacy groups, academic experts, and our past reports have commented

on the potential of incentives to impair quality. Among the factors cited as

influencing how much of a hazard incentives may pose are (1) the extent

to which a physician’s compensation is placed at risk for services

approved by, but not directly provided by, the physician; (2) whether the

incentives are based on the service utilization patterns of individual

physicians or of a group of physicians in the aggregate; (3) whether a

physician’s risk is spread over a large patient pool and the duration of the

period used for computing a bonus or deficit; (4) whether the managed

care plan provides stop-loss insurance to limit a physician’s risk; and

(5) whether the plan has an effective quality assurance program that

attempts to counteract any adverse effect the incentive may have on

patient care.

Although DHS reviews financial incentive arrangements, officials told us

they have no criteria or guidelines regarding the types of financial

incentives that are acceptable. Their auditors, who review the Medicaid

managed care plans’ financial statements, use their individual professional

judgment when analyzing financial arrangements between the plans and

their subcontractors. The auditors focus primarily on whether the

compensation a plan pays to a subcontractor is adequate to protect the

financial viability of the subcontractor, not on whether the compensation

arrangements threaten quality of care.

DHS relies primarily on the Department of Corporations’ licensing process

to uncover unsatisfactory financial incentive arrangements. A Department

of Corporations official told us that the only general rule applied when

reviewing financial incentive arrangements is that a provider or provider

group that does not provide hospital or other institutional care may not be

Page 9 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

capitated for such care.8 Apart from applying this rule, the Department of

Corporations reviews financial incentive arrangements on a case-by-case

basis. In general, though, it does not examine the arrangements closely

because the managed care plan is responsible for ensuring that its

subcontracting arrangements meet the state’s quality assurance

requirements.

Pursuant to the Omnibus Budget and Reconciliation Act of 1990 (P.L.

101-508), HCFA is currently developing standards for imposing restrictions

on the financial incentive arrangements that managed care plans

contracting under Medicare and Medicaid can enter into with their

physicians. The final regulation is undergoing internal review and is

scheduled to be published in 1995.

Assurance Needed That

EPSDT Services Are

Provided in a Capitated

System

EPSDT strives to improve low-income children’s health by providing a

framework for the timely detection and treatment of health problems.

However, research shows that the percentage of eligible children

participating is low,9

 indicating that the program has not been entirely

successful. Under managed care, the success of an EPSDT program depends

largely on the capitated providers who are generally responsible for

furnishing most primary and preventive health services.

Though DHS contracts with managed care plans to provide EPSDT services

to Medi-Cal enrollees, DHS does not know to what extent the services are

provided because of inadequate data and monitoring. In addition, in

violation of federal and state requirements, the state does not require that

all eligible children be periodically notified of available services.

HCFA requires states to ensure that Medicaid-eligible children, from birth

through age 20, are provided preventive health services under the EPSDT

program. EPSDT services consist of screening services;10 vision, dental, and

hearing tests; diagnostic services; and other medical services needed to

correct conditions discovered during screenings. Problems with

8

The Department of Corporations established this rule because it believed that capitating a group or

provider group for hospital or institutional care gave the group too great an incentive to deny patients

this care. The Department believes this rule may be out of date and is considering rescinding it

because the arrangements it prohibits are becoming increasingly widespread in the industry.

9

U.S. Department of Health and Human Services Office of Inspector General, Final Report: Early and

Periodic Screening, Diagnosis, and Treatment (EPSDT)—Performance Measurement, OEI-07-90-00131

(Aug. 1992).

10Screenings, also called health assessments in California, consist of a comprehensive health and

developmental history, a comprehensive unclothed physical examination, appropriate immunizations,

laboratory tests, and health education and guidance.

Page 10 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

California’s EPSDT data and monitoring were noted by HCFA in its 1992

review. HCFA reported that plans kept poor medical records that made it

impossible to determine whether children received appropriate services.

HCFA recommended that the state adopt procedures to track Medicaid

providers’ activities and to validate that children received necessary

diagnostic and treatment services in accordance with EPSDT requirements.

We found continuing problems in the current program. Specifically, DHS

(1) allowed plans to submit aggregate data regarding their provision of

EPSDT services that allow for little or no analysis or verification; (2) did not

comply with federal and state requirements by periodically notifying, or

ensuring PHPs periodically notify, all eligible children of available services;

and (3) could not ensure that all children referred for diagnosis and

treatment actually received it.

PHPs may report EPSDT services to the state on an encounter level (Form

PM-160) or monthly aggregate basis. According to DHS officials, most

report aggregate data. From these aggregate data, it cannot be determined

how many children actually received at least one screening, whether

eligible children were receiving all required screenings, or whether

children referred for diagnosis and treatment because of screening results

actually received treatment. Aggregate data are also difficult to verify,

making validation of reported services impossible.

HCFA’s policy had been that PHPs can be “deemed” to have met EPSDT

requirements because they are assumed to emphasize preventive care.

According to a DHS official, this policy gives DHS no incentive, for HCFA

reporting purposes, to track or verify whether plans actually provided

EPSDT services. HCFA recently revised its reporting requirements and no

longer allows “deeming.” As a result, in September 1994, California

changed its reporting requirements and now requires PHPs to submit

encounter-level reports (Form PM-160). The state, however, admits that

implementation will be slow and incremental.

Federal and state requirements say DHS must notify EPSDT-eligible children

through age 20 of upcoming screenings and of the availability of assistance

with transportation and scheduling appointments, and must record the

response to this notification. DHS issues notices for children under age 3

except for those enrolled in PHPs that submit aggregate data to the state.

However, the state does not determine whether PHPs issue notices except

through annual audits, in which issuance of screening notices may not be

Page 11 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

reviewed. Furthermore, DHS neither issues notices nor requires PHPs to

issue notices to children aged 3 and older.

Federal law requires the state to provide diagnostic and treatment services

for children with conditions discovered during screenings. To determine

whether children referred for diagnosis and treatment actually received it,

follow-up is needed. DHS conducts follow-up for children enrolled in PCCMs

through county Child Health Disability Prevention offices. However, it

does not do follow-up for children in PHPs because the task is considered

to be case management, a role PHPs are required to perform. The state does

not verify whether PHPs perform follow-up as required.

DHS’ Medical Review Branch does annual medical quality assurance audits

of managed care plans to determine if the plans comply with federal and

state regulations, contract requirements, and the plans’ own procedures. If

any problems or deficiencies related to EPSDT happened to be noted in the

annual health plan audits, contract managers should determine if managed

care plans corrected them. However, the DHS audits are designed to assess

the quality of services rendered to beneficiaries in general. They are not

designed to assess or estimate the number of children who received

screenings or to determine the rate at which health plans provided

diagnosis and treatment to children who needed it based on screening. In

addition, unless children had at least three visits to a provider during the

year, their records are not audited.

California’s Expansion

Will Significantly

Change Program

Movement toward the expansion of managed care in the Medi-Cal program

began in 1991 with the passage of state legislation that emphasized

managed care as a means for delivering health care services. After

considering different models of managed care, including using a single

plan organized by a local agency with broad representation in each county,

the state decided to use two plans per county. A draft plan was released in

January 1993. Public hearings followed and, based on the testimony of

interested parties, the state revised its plan for expansion. It was published

in final form in March 1993.

By December 1996, California intends to have approximately 3.4 million

Medicaid beneficiaries enrolled in managed care—a majority of the

estimated 6 million Medi-Cal beneficiaries. Most of these beneficiaries will

be enrolled as part of the state’s 12-county expansion plan. Figure 1 shows

the counties with Medi-Cal managed care programs by type of enrollment

after the expansion has occurred.

Page 12 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

Figure 1: Type of Enrollment in

Medi-Cal Managed Care Counties After

Expansion

Mandatory Enrollment

Voluntary Enrollment

No Managed Care

Page 13 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

California sees managed care as the solution to many of the access and

quality problems of its current, largely fee-for-service program. These

problems include difficulties in finding physicians who accept Medicaid

patients and the lack of a quality assurance system for Medicaid

beneficiaries in the fee-for-service program. State officials believe the

expanded managed care program will bring a greater number of providers

into the program and give beneficiaries greater continuity of care. In

addition, they believe that managed care offers better opportunities for

controlling costs than a fee-for-service environment.

The state intends to contract with two health plans in each of 12

counties—one would be a “local initiative” and the other would be a

“mainstream” plan. The local initiative could take different forms. County

governments were given the first opportunity to establish local initiatives.

If a county government chose not to, a local initiative could have been

formed by a consortium of local stakeholders.11 However, all 12 counties

submitted a formal letter of intent to establish local initiatives. The

mainstream plan will be a single private plan selected through a bidding

process; joint ventures will be considered. All health plans within the new

program will have to meet federal and state requirements for access and

quality for managed care plans.

Under the state’s proposal, only AFDC and AFDC-related Medicaid

beneficiaries (who together make up approximately 67 percent of the

Medicaid beneficiaries statewide) will be required to enroll.12 Other

categories of eligibles such as Supplemental Security Income (SSI) and

SSI-related Medicaid beneficiaries will not be required to enroll in managed

care plans, but they may do so if the plans in their areas have the capacity

to serve these groups and their coverage is provided for in the plans’

Medicaid contracts.13

DHS set the minimum enrollment level at 22,500 for each plan. DHS believes

this number will ensure the viability of the mainstream plan and the

safety-net providers participating in the local initiative. Safety-net

11DHS did not specifically define the term “stakeholders” in its plan. It appears to refer to any

interested parties that will be affected by the Medicaid program in a county—including providers and

beneficiaries.

12AFDC includes families receiving cash assistance. AFDC-related women and children are those who

are not receiving cash assistance but are eligible for Medicaid based on family income relative to the

federal poverty level.

13SSI beneficiaries are people who are aged, blind, or disabled and receive cash assistance. SSI-related

beneficiaries include people who meet SSI requirements but have too much income to qualify for SSI

supplemental payments but not enough income to cover their health care costs.

Page 14 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

providers include community health centers and hospitals that provide

charity care and serve relatively high numbers of Medicaid beneficiaries.

Maximum enrollment levels, still to be determined, will be established to

moderate the effect the enrollment of beneficiaries in the mainstream plan

will have on disproportionate-share payments to safety-net hospitals,

which have partially compensated them for their volume of charity care

and Medicaid services. The state expects to set a maximum enrollment for

the mainstream plan at approximately 30 to 40 percent of the total

Medicaid managed care enrollees in most counties.

To implement several provisions of the program, the state will have to

seek a waiver of certain federal requirements that set minimum standards

for state Medicaid programs. For example, to require a beneficiary to join

a managed care plan, the state must obtain a waiver of federal Medicaid

requirements that allow beneficiaries a choice of providers.14

Improvements Proposed

for Expanded Program

In an effort to improve program operations and oversight, DHS has

proposed several enhancements to the Medi-Cal managed care program.

These changes are described in the state’s September 1994 “Request for

Application” that solicited health plan applications for the mainstream

plan contracts in the 12 counties. The request for application also forms

the basis for agreements with the local initiatives. These initiatives are

based on input received from interested parties throughout the state.

Proposed changes include the following:

• Increasing access to, and coordination of, care through promoting the

integration of public health and specialty services within managed

care—The expansion will include traditional and safety-net providers,

including community clinics and family planning in managed care

networks. Health plans will be expected to enter into memorandums of

understanding with local health departments for the provision of specified

public health services, for example, immunization, family planning, and

detection and treatment of sexually transmitted diseases.

• Improving the health status of the Medi-Cal population through

strengthening and standardizing the definition of preventive health care

services—Contracting plans will notify members of the availability of an

14In June 1994, the state announced a delay in its implementation schedule of up to a year;

implementation is now not anticipated until December 1995. The primary reasons for the delay are to

(1) consider comments raised on the state’s draft request for application and its decisions on

recommendations made by the Medi-Cal managed care Expansion Work Group, (2) ensure sufficient

time for the counties involved to develop information systems, and (3) allow enough time for local

initiatives to plan.

Page 15 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

initial health assessment and will be required to complete the assessment

within 120 days of enrollment. The plans will be required to meet other

requirements consistent with the EPSDT periodicity schedule.

• Strengthening quality assurance efforts through expanding monitoring and

data reporting capabilities—Contracting plans will report encounter-level

data to DHS that will allow the state to identify all of the diagnoses and

procedures performed by the health care provider during an interaction

with a patient.

• Removing barriers to accessing care through the development of

standards for cultural and linguistic services.

In addition, once the request for application procurement process is

completed, request for application requirements will be developed into a

standardized program manual for training and use by DHS staff.

Better Monitoring and

Oversight Are Needed in

Expanded Program

On the basis of our review of the current program operations, we believe

the state must improve its monitoring and oversight activities to avoid

problems in the expanded program. Although the proposed changes in

contract requirements with health plans may improve the program, these

provisions must be implemented, monitored, and enforced. As was

described before, under the current program, the state’s monitoring of

managed care plans has not been sufficient to determine whether

beneficiaries received EPSDT services that plans had contracted to provide.

Problems identified to date in a primarily voluntary enrollment program

could be significantly magnified in a much larger program with mandatory

enrollment.

In addition, the state needs to provide better guidance and training to its

contract managers and to expand oversight to include reviews of financial

arrangements and EPSDT programs. In recognition of these needs, DHS has

requested an additional 102 positions for the managed care program.

Expansion Raises

Some Important

Questions

While the state seeks to benefit from competition, we believe that by

allowing only two plans to serve an area, California is limiting

beneficiaries’ choices and may be reducing its ability to deal with plans

that do not fulfill their contractual requirements. Limiting mandatory

enrollment to AFDC and AFDC-related beneficiaries seems reasonable as the

program is first implemented, but the state should reconsider including the

SSI population once the expanded program is running smoothly. How the

traditional and safety-net providers fare under the expansion plan remains

Page 16 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

to be seen, but the state’s plan attempts to strike a reasonable balance

between protecting traditional and safety-net providers15 and moving them

toward a competitive managed care system.

The Two-Plan Model

Raises Questions About

Competition

Representatives of private managed care health plans that currently have

Medi-Cal contracts have voiced concerns over the two-plan model. They

believe that the limit on private contractors is unnecessary and that it

eliminates meaningful choice for beneficiaries. In addition, they have

challenged the state’s contention that the two-plan model will create a

competitive environment. For example, private plans that are normally

competitors may need to work together in the larger counties under the

two-plan model to form large enough entities to handle the enrollment

requirements. This would put them in the awkward position of sharing

confidential information with their competitors.

The California Association of Health Maintenance Organizations believes

that without competition, Medi-Cal contractors will not be responsive to

market demands for increased quality of care. According to an analysis

done by the California Legislative Analyst’s Office, having two plans in a

county—a local initiative plan that does not have to compete and a

mainstream plan—does not represent a competitive market. The analysis

said that once the mainstream plan has been selected, the state will feel

compelled to continue existing contracts regardless of how poorly plans

may perform because of the major disruption that would occur if enrollees

were forced to change plans.

DHS officials stated that the primary reason for the two-plan model is that

the state lacks the resources to administer and oversee more plans. They

said another major reason is that having multiple plans would force the

state to lower the minimum enrollment levels set for each plan (now set at

22,500 enrollees).

DHS officials believe that the initial bidding process for the mainstream

plan and subsequent rebidding will provide adequate competition among

private sector plans. With regard to choice, DHS officials pointed out that

15The state defines traditional providers and safety-net providers in general terms. A traditional

provider is one that has historically delivered services to Medicaid beneficiaries. The term includes

medical and hospital providers that provide services to relatively high numbers of Medicaid

beneficiaries. Safety-net providers are clinical providers that provide comprehensive primary care and

hospitals that provide acute inpatient services to the medically indigent and special needs segment of

the state’s population. They are providers of charity care. Most safety-net providers also provide

services to Medicaid beneficiaries. Examples of safety-net providers include community health

centers, hospitals that receive so-called disproportionate-share payments from Medicaid, and public

and university hospitals.

Page 17 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

each of the contracting plans will contain large networks of providers,

giving beneficiaries a choice of providers within each plan. Finally, state

officials said that they will act aggressively against plans when problems

with access and quality are identified—even if that means terminating a

contract.

We believe that California’s two-plan model will restrict competition and

beneficiary choice. For example, competition will be restricted in Los

Angeles County where several health plans appeared ready to compete for

the mainstream contract.16 While beneficiaries may have a choice of many

providers, the plans’ policies and practices are a controlling factor in the

care that providers give. Selecting a different provider will not solve a

problem that arises because of plan decisions, such as to restrict the

availability of high-cost specialized services.

Relying on only two plans could also reduce the state’s willingness to

cancel a contract and thus weaken its ability to make plans comply with

contract provisions. Each plan will have a large number of enrollees,

making canceling a plan extremely disruptive to many people. This will be

especially true in large metropolitan areas. In addition, because DHS has

already had difficulty ensuring access, quickly finding alternative sources

of care for large numbers of enrollees could be very difficult.

While the state’s ability to administer and oversee the program is

important, administrative limits are not a persuasive argument for

restricting the number of plans to two. The number of plans may not have

as much effect on DHS’ administrative workload as the total number of

providers or number of enrollees in the managed care program.

DHS officials were also concerned that having multiple plans would force

the state to lower enrollment levels. However, DHS could keep the

minimum and maximum enrollment levels that it established for both the

local and mainstream plans, but use the maximum enrollment number for

the mainstream plan in each county as a “global cap” for multiple

participating plans.

Optional Enrollment of SSI

Population Appears

Reasonable

As in other states, California’s decision not to require the aged and

disabled of the SSI and SSI-related population to enroll was the culmination

of weighing the potential benefits of including the entire Medicaid

16Six health plans in Los Angeles have announced their intention to form a joint venture to compete for

the mainstream contract.

Page 18 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

population in the managed care program versus the uncertainties of how

to implement and manage such a program. There have been diverse views

from several parties in assessing the decision by California.

In our March 1993 report on state managed care efforts, we noted that

although some states had included other population groups in their

managed care programs, most states targeted their Medicaid managed care

programs to AFDC and AFDC-related beneficiaries. They did this because

AFDC and AFDC-related populations (1) most closely resemble patients in

existing primary care practices and generally do not require the same

specialized health care services as the SSI population, (2) are more likely to

benefit from the types of preventive services that are the hallmark of a

managed care delivery strategy, and (3) have the greatest problems getting

access to care.

Officials in two California counties operating COHSs have stated that the

way to achieve the maximum benefits from managed care is to have the

entire Medicaid population, including the SSI recipients, enrolled. They

attributed some of the financial savings of their programs to the

mandatory enrollment of the SSI population in their counties. They said

that including SSI beneficiaries increases the COHSs ability to spread risk

and to achieve savings.

In contrast, after its 1992 review, HCFA officials recommended that instead

of including more beneficiaries as the COHS officials suggest, California

limit the size of its program by targeting its managed care effort to specific

high-risk/high-cost beneficiary groups, rather than enroll the entire AFDC

and AFDC-related population in so many counties. Given the state’s limited

administrative resources, the expansion effort could be improved by

targeting managed care on groups that would benefit the most from case

management while, at the same time, controlling costs, HCFA officials

believe. Administering a managed care program of over 3 million AFDC and

AFDC-related beneficiaries will create an even greater administrative strain

on the state than it is now experiencing, HCFA officials said.

However, DHS officials point out that the primary goal of the new program

is to improve Medicaid beneficiaries’ access to health care services while

controlling costs. They believe that enrolling the entire AFDC and

AFDC-related population in the designated regions is the best way to

increase access for the largest number of people at this time. DHS officials

also point out that the state is dealing with problems associated with

high-risk/high-cost beneficiaries through the design and implementation of

Page 19 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

special projects. The state is expanding its Programs of All-Inclusive Care

for the Elderly that provide a continuum of care from primary and acute

care to long-term care. In addition, the state has begun a medical case

management program for high-risk/high-cost beneficiaries.

We believe that excluding the SSI population from the expanded program

may limit the potential for cost savings. However, at the same time, leaving

out the SSI population during the implementation of the program may be a

prudent decision with such a large expansion. Administering this program

is going to be a major challenge for the state. The state can reconsider the

desirability of enrolling the SSI population once the expanded program is

running smoothly.

Impact on Safety-Net

Providers Could Affect

Access

Counties in California are financially responsible for providing health care

to those who are medically indigent but do not qualify for Medi-Cal. To do

so, some counties administer and partially fund their own health care

systems that include hospitals and clinics. These county systems, which

also provide care to Medi-Cal beneficiaries, are recognized as traditional

and safety-net providers. Critics, including Los Angeles County officials

and some advocacy groups, believe that the two-plan model may harm the

financial viability of safety-net and traditional providers, diminishing their

ability to provide care for the medically indigent and for undocumented

aliens.

With few exceptions, counties have little or no experience in running

managed care systems. County hospitals and clinics receive their revenues

from a variety of sources, including county appropriations and third party

payers such as private insurance, Medicare, and Medicaid. These third

party payers primarily reimburse on a fee-for-service basis. Although

Medicaid does not reimburse for all the health care expenses a county

incurs, it has been a reliable source of substantial revenue.

Medicaid disproportionate-share payments—supplemental payments to

hospitals that serve large numbers of Medicaid and other low-income

patients—also have become an important revenue source for California’s

county hospitals, particularly to subsidize the care of the uninsured. If

county hospitals lose Medicaid patients to other managed care providers,

county revenues to fund health care will be affected in two ways:

(1) direct Medicaid reimbursement for services provided will be lost and

(2) disproportionate-share payments will decline as the number of

Medicaid beneficiaries they serve drops.

Page 20 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

The state’s managed care expansion model extends participation to

safety-net and traditional providers to ensure that the hard-to-serve

populations will have access to health care. The local initiative must

include all safety-net providers that agree to the terms and conditions

required of similar providers affiliating with the initiative. The local

initiative will also be required to submit standards for including traditional

providers. Furthermore, DHS will encourage mainstream plans to include

safety-net and traditional providers in their networks by assigning

favorable weighting to mainstream plan proposals that provide for the

inclusion of traditional and safety-net providers.

Most of the counties involved in the expansion program have asked to be

allowed to set up COHSs with no competition from mainstream plans.

County officials believe that these arrangements are the best way to

provide for the Medicaid population as well as the indigent and the

undocumented alien populations. COHSs would eliminate the competition

of the private plan and, therefore, minimize the potential financial losses

and risk safety-net providers face.

However, Los Angeles County health care officials believe that even if

plans contract with safety-net providers, the state’s plan for expanding

managed care will lead to a loss of essential revenues for their health care

system because many Medicaid beneficiaries who now obtain care in

county facilities will enroll in mainstream plans. They fear this will destroy

the viability of some safety-net providers, resulting in reduced access to

care for the remaining Medicaid beneficiaries and the indigent uninsured.

County officials are also concerned that the mainstream plans will enroll

the healthier beneficiaries, leaving the sicker and more costly beneficiaries

in the county system. In addition, according to the California Association

of Public Hospitals, because traditional and safety-net providers lack

experience running managed care plans, they may be at a disadvantage

competing with experienced private plans.

State officials told us that there are no plans to establish COHSs beyond the

ones already operating or scheduled to start in 1995. The officials believe

that assurances have been built into the strategic plan so that counties will

receive adequate revenues to ensure the financial viability of safety-net

providers. Specifically, the state has put in place safeguards to reduce bias

selection between health plans. For example, beneficiaries who do not

choose plans will be equitably distributed between plans. Furthermore, the

expansion plan protects disproportionate-share payments in three ways:

Page 21 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

• The enrollment floor for the local initiative is based on total

disproportionate-share hospital days in the county and is designed to

protect disproportionate-share hospital payments flowing to that county.

• A 2-year implementation period and a 2-year data lag17 will allow

disproportionate-share hospitals time to make the transition to the new

managed care environment.

• Safety-net providers will play a significant role in the local initiative and

therefore will be able to arrange admissions to hospitals in a way that

protects their disproportionate-share supplemental payments.

Despite these efforts to protect some of the revenue sources for counties,

however, state officials believe that county facilities could operate more

efficiently. They believe more efficient operations by the county, and by

safety-net providers in general, will lead to better care for Medicaid

beneficiaries because care will be provided in more appropriate settings,

such as physicians’ offices rather than hospital emergency rooms.

We believe the state’s plan attempts to reasonably balance the need to

protect traditional and safety-net providers, while moving them toward a

competitive system. To insulate them completely from competition would

preclude gaining any of the benefits of competition.

Observations California has devoted considerable effort to its proposed expansion of

Medi-Cal managed care. It has involved the public in its planning process,

modified its plan based on the comments of interested parties, and

adjusted its schedule for implementation when problems have been

encountered. The expanded program will attempt to improve Medicaid

beneficiaries’ access to care and control costs. However, given incentives

to control costs by limiting services, the state will need to provide

effective oversight to ensure that managed care plans provide

beneficiaries with high-quality comprehensive care. This is especially

important for EPSDT and other preventive services where outreach efforts

are often required.

The state’s decision to exclude the SSI population from mandatory

enrollment is consistent with the practices of other states and seems

reasonable at this time. However, we believe that California may want to

consider mandatory enrollment of the high-cost SSI population once the

expanded program is running smoothly.

17Statistics used to calculate disproportionate-share payments are 2 years behind the year in which

such payments are received.

Page 22 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

Insulating county health systems and other traditional and safety-net

providers from competition to avoid any risk would eliminate the benefits

of competition. The state’s plan to protect these providers attempts to

strike a reasonable balance between protecting their viability and fostering

competition.

The success of California’s planned expansion is largely dependent on its

ability to increase access by creating competition and choice. We believe

that the two-plan model will unnecessarily restrict both competition and

beneficiary choice. In addition, it may limit the state’s ability to take action

against plans that do not comply with contract provisions.

Agency Comments We obtained official comments on this report from HCFA and DHS. We have

incorporated their views where appropriate. Specifically, HCFA agreed with

our conclusion that more competition is desirable in the proposed

expansion.

In its comments, DHS (1) emphasized the improvements that the new

Medi-Cal managed care contracting program will bring under the

expanded program; (2) provided additional information and top

management’s perspective on DHS monitoring and oversight activities; and

(3) acknowledged that while competition will be limited under the

expansion plan, DHS believes that the expanded access and choice for

beneficiaries are major improvements over the current fee-for-service

environment.

As arranged with your office, unless you publicly announce the contents of

this report earlier, we plan no further distribution until 14 days from its

issue date. At that time, we will send copies to the Secretary of Health and

Human Services, the Administrator of HCFA, the Director of the Office of

Management and Budget, the Director of DHS, and other interested parties.

We also will make copies available to others upon request.

Page 23 GAO/HEHS-95-87 California Medicaid Managed Care
B-257569 

Please call me on (202) 512-4561 if you or your staff have any questions

about this report.

Sincerely yours,

William J. Scanlon

Associate Director,

 Health Financing Issues

Page 24 GAO/HEHS-95-87 California Medicaid Managed Care
Page 25 GAO/HEHS-95-87 California Medicaid Managed Care
Contents

Letter 1

Appendix I 

Scope and

Methodology

28

Appendix II 

Financial Incentive

Arrangements

Between Health

Maintenance

Organizations and

Their Physicians

29

Methods of Compensating Primary Care Physicians 30

Prevalence of Financial Incentive Arrangements 33

Factors Affecting the Power of Incentives 34

Financial Incentives Used by Three Southern California PHPs

That Are Medi-Cal Contractors

37

Effect of Financial Incentives on the Quality of Care 37

Appendix III 

Major Contributors to

This Report

39

Table Table 1: Statewide Medi-Cal Managed Care Enrollment by Type

of Plan

5

Figure Figure 1: Type of Enrollment in Medi-Cal Managed Care Counties

After Expansion

13

Abbreviations

AFDC Aid to Families With Dependent Children

COHS County Organized Health System

DHS Department of Health Services

EPSDT Early and Periodic Screening, Diagnostic, and Treatment

GMC Geographic Managed Care

HCFA Health Care Financing Administration

HMO health maintenance organization

PCCM Primary Care Case Management

PHP Prepaid Health Plan

SSI Supplemental Security Income

Page 26 GAO/HEHS-95-87 California Medicaid Managed Care
Page 27 GAO/HEHS-95-87 California Medicaid Managed Care
Appendix I 

Scope and Methodology

To obtain general information on California’s Medi-Cal managed care

program and plans for expansion, we interviewed state officials from DHS;

the Departments of Finance, Corporations, and Personnel; and the

California Medical Assistance Commission. We also interviewed federal

officials from HCFA’s headquarters and Region IX office, contractors,

advocacy groups, and associations. We reviewed documents related to the

Medi-Cal managed care program and plans for expansion, including the

following:

• federal and state program laws, regulations, policies, and procedures;

• HCFA Region IX’s Review of California’s Administration of Its Managed

Care Program for fiscal year 1993; and

• California’s strategic plan for expanding the Medi-Cal managed care

program.

To obtain specific information on contract administration, we interviewed

DHS Medi-Cal Managed Care Division officials, including contract managers

and supervisors, as well as contractors and advocates. We also reviewed

documents related to contract management, including contract manager

duty statements, state contract administration job series requirements, and

managed care contracts.

To better understand the financial incentive arrangements between

managed care plans and their physicians, we interviewed officials from

HCFA, the state Department of Corporations, the American Medical

Association, Group Health Association of America, experts, advocates, and

contractors. We also reviewed documents regarding physician incentive

arrangements, including a 1990 Department of Health and Human Services

report, legislative provisions, proposed HCFA regulations, our previous

reports, and journal articles.

To assess how adequately managed care plans provide EPSDT services to

children, we interviewed officials from DHS’ Children’s Medical Services

Branch, its Medi-Cal Managed Care Division, its Audits and Investigations

Division, policy consultants, and contractors. We also reviewed

documents related to the federal EPSDT program and the state Child Health

Disability Prevention Program.

Our work was performed between May 1993 and December 1994 in

accordance with generally accepted government auditing standards.

Page 28 GAO/HEHS-95-87 California Medicaid Managed Care
Appendix II 

Financial Incentive Arrangements Between

Health Maintenance Organizations and Their

Physicians

Financial incentive arrangements may be loosely defined as compensation

arrangements between a health maintenance organization (HMO) and its

physicians that are intended to encourage physicians to control the

services provided to plan enrollees. HMOs often assume responsibility for

providing services to their enrollees for a fixed, predetermined capitation

fee. Thus, they are at risk for the difference between the capitation fee and

the cost of the care they provide.18 Although precise figures are

unavailable, it is believed that most HMOs use financial incentives in their

compensation arrangements with physicians.

While financial incentives may operate to reduce unnecessary or

inappropriate services, many analysts believe they also have the potential

to reduce the quality of medical care by denying patients beneficial

treatments. As a result, in our prior reports, we, like others, have called for

increased oversight and quality assurance monitoring.19 Pursuant to a

congressional mandate in the Omnibus Budget and Reconciliation Act of

1990 (P.L. 101-508), HCFA is developing regulations to restrict the financial

incentive arrangements which HMOs that are Medicare or Medicaid

contractors can use.20

Financial incentives are only one of several means an HMO may use to

control the amount of care its physicians provide. Other methods include

requiring physicians to obtain the HMO’s preapproval when ordering

expensive procedures, educating physicians regarding cost control,

reprimanding and possibly terminating the contracts of physicians who

exceed utilization guidelines, and screening out physician applicants who

do not seem to share the plan’s cost-control goals.

A number of factors counteract the tendency of financial incentives to

impair the quality of care. These include the professional ethics of the

medical profession, concern about malpractice liability, the desire of HMOs

to attract and retain patients, HMOs’ quality assurance programs, and

18As we stated in an earlier report, all other things being equal, the fewer services a capitated HMO

provides, the more money from the fixed fee it retains as earnings. Medicare: Physician Incentive

Payments by Prepaid Health Plans Could Lower Quality of Care (GAO/HRD-89-29, Dec. 12, 1988), p. 8.

19Medicaid: Oversight of Health Maintenance Organizations in the Chicago Area (GAO/HRD-90-81,

Aug. 17, 1990), pp. 32-33; and Medicare: Physician Incentive Payments by Prepaid Health Plans Could

Lower Quality of Care (GAO/HRD-89-29, Dec. 12, 1988), pp. 29-30.

20The Congress first enacted legislation aimed at regulating the financial incentives used by HMOs that

are Medicare or Medicaid contractors in 1986. However, because of subsequent congressional

revisions and postponements of the effective date, no regulatory action was taken before the

enactment of the Omnibus Budget and Reconciliation Act of 1990.

Page 29 GAO/HEHS-95-87 California Medicaid Managed Care
Appendix II 

Financial Incentive Arrangements Between

Health Maintenance Organizations and Their

Physicians

quality assurance reviews by external entities, such as government

regulatory agencies.

In addition, the structure of a managed care plan may affect the financial

incentive arrangement it uses. In two-tier HMOs, the plan contracts directly

with individual physicians. Examples of two-tier plans are (1) staff model

plans, which provide care through physicians they employ, and

(2) independent practice association plans, which contract with physicians

to provide care through their independent practices. In three-tier HMOs, the

plan contracts with one or more medical groups or associations, which in

turn contract with individual physicians. Thus, in a three-tier HMO, the

contract between the plan and the group and the contract between the

group and its physicians may each contain financial incentive

arrangements—and the arrangements may differ significantly.

Methods of

Compensating

Primary Care

Physicians

The manner in which HMOs compensate primary care physicians and

physician groups for the services they provide is the starting point for an

analysis of financial incentive arrangements. Financial incentives

commonly take the form of adjustments to primary care physicians’

compensation. In addition, the method of compensation employed can

itself have incentive effects. HMOs generally pay primary care physicians in

one of the following three ways:

• Fee-for-service: It has been estimated that about 40 percent of HMOs pay

primary care physicians by the traditional fee-for-service method,

compensating them for each unit of service they provide. The

fee-for-service rate is usually lower than the fees the physicians would

charge nonplan patients.

• Capitation: About half of individual primary care physicians also are paid

in this manner. Most three-tier HMOs pay the middle-tier medical group or

association on a capitated basis, whereby a fixed monthly fee per enrollee

is deemed payment in full for all services provided to that enrollee.

• Salary: About 15 percent of HMO primary care physicians are paid a salary

for their primary care services. But an estimated 80 percent of staff model

HMOs pay their primary care physicians in this manner. Salaried physicians

cannot increase their income either by providing additional services, as

physicians paid on a fee-for-service basis can, or by providing fewer

services in order to increase the number of patients assigned to them as

capitated physicians can. As a result, salary is widely regarded as having

the most “neutral” incentive effects of any of the three modes of

compensation.

Page 30 GAO/HEHS-95-87 California Medicaid Managed Care
Appendix II 

Financial Incentive Arrangements Between

Health Maintenance Organizations and Their

Physicians

Types of Financial

Incentive Arrangements

Financial incentive arrangements take many forms. Typically, however,

they consist of mechanisms for adjusting the compensation of primary

care physicians or groups to encourage them to limit service utilization.

Although the incentives may be designed to limit the services provided by

the primary care physicians themselves (“direct services”), it is believed

that they more commonly target services preapproved by the primary care

physicians but provided by others (“referral services”). Primary care

physicians in HMOs usually serve as “gatekeepers” who must authorize all

or most nonprimary care, including inpatient hospital care, visits to

specialists, and diagnostic tests and other forms of ancillary care. The

following are four commonly used financial incentive arrangements.

Shared Deficit In a shared deficit arrangement, the HMO may establish separate budgets

for primary care, inpatient hospital, specialty, and ancillary services. If

there is a deficit in any of the referral funds, primary care physicians are

required to absorb a portion of it. Those physicians with the highest

referral costs are sometimes required to contribute the most. Primary care

physicians who are compensated on a fee-for-service basis may also be

required to absorb a portion of any deficit in the primary care fund to

discourage them from providing too many services themselves. Often a

portion of the physician’s compensation, usually not exceeding 20 percent,

is withheld to be applied against a possible deficit. Some HMOs limit the

physician’s liability to the amount withheld. Others require the physician

to make up deficits beyond that amount through direct repayment,

deductions from future compensation, or increased withholding rates.

The following describes a typical shared deficit arrangement: A primary

care physician is paid $20 per patient per month for providing direct

services (and for providing administrative services, such as serving as a

gatekeeper for nonprimary care). Of the $20, $4 is withheld to cover a

possible deficit in the inpatient hospital care fund. If there is a deficit in

that fund, some or all of the $4 will not be returned to the physician,

depending on the physician’s hospital referral rate. In addition, the

physician may be liable for additional amounts beyond the $4.

Shared Surplus Shared surplus arrangements operate much like shared deficit

arrangements, except instead of being penalized if there is a fund deficit,

physicians are given a bonus if there is a surplus. Bonuses are widely used

in staff model HMOs, to reward salaried primary care physicians for holding

down referral costs.

Page 31 GAO/HEHS-95-87 California Medicaid Managed Care
Appendix II 

Financial Incentive Arrangements Between

Health Maintenance Organizations and Their

Physicians

The following is an example of a shared surplus arrangement: A primary

care physician is paid $16 per patient per month for direct services. If

there is a surplus in the specialty care fund, the physician can receive an

additional amount based on the physician’s specialist referral rate. Often,

the additional amount is limited to a percentage of the physician’s

compensation. Thus, in this case, the maximum bonus might be $4 per

patient.

Shared Surplus and Deficit In a shared surplus and deficit arrangement, if there is a deficit in a fund,

primary care physicians are required to contribute toward it. Conversely, if

there is a surplus, they receive a bonus. If money was withheld from the

physicians and there is a surplus, they receive the amount withheld plus a

bonus.

The following illustrates how a shared surplus and deficit arrangement

might work: A physician is paid $20 per patient per month for direct

services. Of the $20, $4 is withheld to cover a possible deficit in the

ancillary services fund. If there is a deficit in that fund, the physician may

forfeit the $4 and possibly be liable for additional contributions as well. If

there is a surplus in the fund, the physician may receive the $4 withheld

plus a bonus.

Capitation for Referral

Services

When physicians are capitated to provide not only primary care but also

referral services, the physicians’ compensation for the services they render

directly can be reduced by 100 percent of the cost of the referral services.

This is a more potent incentive to deny patients referral services than the

deficit/surplus arrangements under which the physicians bear only a

portion of the cost. It is also an arrangement that can impose a

considerable financial risk on the physicians, depending on the scope of

the referral services for which they are capitated. The risk can range from

being responsible only for the costs associated with processing in-office

tests performed by the primary care physician to being responsible for the

cost of all patient care—including inpatient hospitalization.

The following example illustrates how a capitation-for-referral-services

arrangement might work: A physician group is paid $100 per patient per

month to provide all primary care, specialty, and ancillary services. The

group consists exclusively of primary care physicians and must contract

with others for specialty services. Since the group must absorb the entire

cost of specialty care, it could potentially pay out a significant share or

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Appendix II 

Financial Incentive Arrangements Between

Health Maintenance Organizations and Their

Physicians

even more than the entire compensation it receives for treating its

patients.

Prevalence of

Financial Incentive

Arrangements

There are no reliable current data regarding the extent to which HMOs use

financial incentive arrangements or the prevalence of the different types of

arrangements. The best available data are derived from surveys conducted

in the late 1980s by the Group Health Association of America, an HMO trade

association; by a consulting firm under contract to HCFA, and by Alan

Hillman, a leading academic expert on financial incentives.21

According to the Group Health Association of America’s 1987 survey,

85 percent of HMOs used financial incentive arrangements. The study by

HCFA’s consulting firm, conducted in 1988, found that incentives were used

in 95 percent of HMOs. In a 1990 journal article, Hillman stated that the

great majority of HMOs use incentives.22 Although the data are not

conclusive, there is evidence that HMOs are increasingly using financial

incentive arrangements that shift more risk to providers.

There is also evidence that it has become increasingly common for HMOs to

capitate physicians, or (more typically) physician groups, for all medical

services—including inpatient hospital care. This type of arrangement

obviously places the physician or group at unlimited financial risk, unless,

as is often the case, the plan provides stop-loss insurance.

It is not a new development for primary care physicians to be capitated for

some referral services. A 1987 study by Alan Hillman found that primary

care physicians were capitated for the cost of outpatient lab tests

40 percent of the time.23 The Group Health Association of America’s 1987

study found that capitation fees paid to primary care physicians usually

covered not only primary care services, but also referrals to specialists and

ancillary services. However, they rarely covered inpatient hospital care.

Officials at both HCFA and California’s Department of Corporations told us

21The Physician Payment Review Commission reported to the Congress in March 1995 on the results of

a survey on HMO physician payment arrangements that it conducted in 1994.

22Mark V. Pauly, Alan L. Hillman, and Joseph Kerstein, “Managing Physician Incentives in Managed

Care,” Medical Care, Vol. 28, No. 11 (Nov. 1990).

23Alan L. Hillman, “Financial Incentives for Physicians in HMOs—Is There a Conflict of Interest?” The

New England Journal of Medicine, Vol. 317, No. 27 (Dec. 31, 1987).

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they believe this is changing and that the capitation of medical groups for

all medical services, including inpatient care, is becoming widespread.24

Factors Affecting the

Power of Incentives

Many factors can affect the likelihood that a financial incentive will

influence a physician’s practice decisions.

Extent of the Risk The extent of a physician’s risk is the physician’s maximum possible

financial gain or liability under an incentive arrangement. In the case of a

deficit or a capitation-for-referral-services arrangement, the physician’s

liability is potentially unlimited. In the case of a surplus arrangement, the

physician’s potential gain is limited because the amount by which costs

can be constrained below the HMO’s budget is finite.

HMOs may limit the extent of a physician’s potential liability or gain to a

percentage of the compensation the physician is paid for direct services.25

For this reason, extent of risk is sometimes defined as the maximum

possible percentage increase or decrease in a physician’s compensation

for direct services that an incentive can produce.26 Obviously, the more a

physician is placed at risk for a type of service, the greater the incentive

for the physician to limit the use of that service.

24Under the arrangement, termed “full integration” by a Department of Corporations official, the

medical groups enter into contracts with hospitals to provide inpatient care. The hospitals may be paid

on a fee-for-service, capitation, or other basis. Even if it is capitated, however, the medical group has

an incentive to hold down referrals to keep down the capitation fee it pays the hospital in the next

period.

25For example, as previously explained, many plans that use deficit arrangements limit the physician’s

liability to the amount of the physician’s compensation that is withheld, which generally is no more

than 20 percent of the physician’s compensation for direct services.

26The extent of risk has also been defined as the breadth of the services for which the physician is at

risk. For example, the physician may be subject to a deficit arrangement that covers specialty referrals

but not hospital referrals. Obviously, an incentive that does not place a physician at risk for a

particular type of service is unlikely to affect the physician’s utilization of that service.

Extent of risk might also be defined as the portion the physician bears of the cost of the services the

incentive is intended to limit. For example, if a physician is capitated for specialty services, the

physician is liable for 100 percent of the cost of such services. If a physician is subject to a deficit

arrangement with respect to specialty services, then (oversimplifying somewhat) the physician is liable

for an agreed-upon percentage of the amount by which the cost of such services exceeds the budgeted

amount. Even if a physician’s maximum total liability under an incentive plan is limited to a specified

percentage of the physician’s direct compensation, the physician might be more reluctant to arrange

for specialty care if he or she is capitated for it than if he or she is subject to a deficit arrangement

under which the physician might bear perhaps 50 percent of the cost.

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Stop-Loss Insurance In a deficit or a capitation-for-referral-services arrangement, the HMO may

sometimes provide its physicians or physician groups with stop-loss

insurance to limit their potential risk. Stop-loss insurance is typically

provided on a per patient basis and is designed to protect physicians

whose patients suffer catastrophic illnesses. Coverage usually begins at

between $1,000 and $9,000 per patient per year for outpatient referral

services and between $10,000 and $100,000 per patient per year for

inpatient hospital services. If stop-loss insurance is not combined with a

limitation on the physician’s overall risk to a specified percentage of his or

her direct compensation, and if the physician happens to have an

unusually sick group of patients, then the insurance may not prevent the

physician from having to pay out more than his or her entire direct

compensation.

Distribution of Risk Deficits and surpluses can be distributed on the basis of the cost

performance of either an individual physician or a group of physicians.

Numerous researchers, including the American Medical Association,

independent analysts, advocacy groups, and HMO industry representatives

have stated that incentives based on group performance are less likely to

influence a physician’s behavior. When a physician’s cost performance is

aggregated with that of other physicians, the effect on the physician’s

income of each decision he or she makes regarding patient services is

reduced. In addition, a physician with unusually sick patients would be

less likely to reduce care provided to patients needing expensive

treatments because the physician’s performance would be aggregated with

that of physicians with healthier patients. Some researchers have

suggested, however, that peer pressure might actually make group

performance incentives more potent than individual performance

incentives.

Number of Physicians

Sharing the Risk

In instances where the distribution of a surplus or deficit is based on the

performance of a group of physicians, it is generally believed that as the

size of the group increases, the effect of the incentive on physician

behavior may diminish. The greater the number of physicians, the smaller

the impact of each physician’s decisions on the physician’s incentive

payment.

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Financial Incentive Arrangements Between

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Number of Patients in a

Physician’s Patient Panel

Numerous analysts have maintained that the more patients assigned to a

physician, the less effect financial incentives are likely to have on the

physician’s behavior.27 Having more patients increases the probability that

a physician can recoup the cost of treating the sickest patients from the

savings generated by healthier ones. As a result, the physician would be

less inclined to withhold an expensive treatment from a sick patient.

Duration of the Risk

Assessment Period

According to many analysts, the shorter the period over which a

physician’s cost performance is assessed, the greater the impact the

incentive is likely to have on the physician’s behavior. A shorter period

allows a physician less opportunity to recoup the cost of treating a very

sick patient from healthy patients. Risk assessment periods generally

range from 1 month to 1 year. According to the Group Health Association

of America, at least one-third of HMOs assess financial incentive payments

more frequently than annually.

Generosity of the

Physician’s Compensation

for Direct Services

The less the physician is compensated for primary care services, the more

sensitive the physician will be to an incentive that would increase or

decrease the physician’s income on the basis of his or her referral service

utilization rate.

Portion of the Physician’s

Income Derived From the

HMO

The greater the proportion of a physician’s total income that comes from

an HMO, the greater the likely effect of that HMO’s financial incentives on

the physician’s practice pattern.

Generosity of Service

Utilization Budgets

In general, the lower the cost target a physician must achieve to obtain a

bonus or avoid contributing towards a deficit, the more powerful the

incentive to withhold services. An approach used by some HMOs that puts

physicians under particular pressure is one that requires individual

physicians to meet or beat a group average. This places the physicians in

competition with each other.28

27In the case of distribution based on group performance, the relevant variable is the number of

patients assigned to all of the physicians in the group.

28In general, according to one expert, HMOs base their service utilization budgets on prior years’ usage

and anticipated changes. A spokesperson for one Southern California HMO told us that if the bonuses

awarded to its member physicians for controlling hospital costs seem excessive, the HMO may reduce

the hospital utilization budget in the next contract period.

Page 36 GAO/HEHS-95-87 California Medicaid Managed Care
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Financial Incentive Arrangements Between

Health Maintenance Organizations and Their

Physicians

Financial Incentives

Used by Three

Southern California

PHPs That Are

Medi-Cal Contractors

Three Southern California PHPs that are Medi-Cal contractors use the

following financial incentive arrangements: One plan, which is a staff

model, uses a bonus arrangement. The plan compensates primary care

physicians at its 30 medical centers on a salaried basis. It seeks to control

referral costs by providing a bonus to the physicians that is based in part

on the extent to which they hold down specialty and inpatient hospital

referrals. The bonus is linked to the referral rates of individual physicians

and cannot exceed 20 percent of a physician’s salary.

Another plan, which is a group model, uses a combination deficit and

surplus arrangement. The plan pays its medical group a capitation fee as

compensation for providing all medical services except inpatient hospital

care. Since the group is staffed to provide virtually all of the services it is

capitated for, the arrangement does not fall into the

capitation-for-referral-services incentive category. To control hospital

referrals, the plan establishes a budget for hospitalization and shares any

surplus or deficit with the group. The amount that can be shared with the

group is subject to a relatively modest cap. The group in turn divides its

share of any surplus or deficit among its physicians equally, rather than on

the basis of their individual referral rates.

A third plan, which is a network/independent practice association model,

uses capitation for some referral services plus a bonus arrangement for

others. The plan pays the medical groups and independent practice

associations it contracts with a capitation fee that covers virtually all

medical services except inpatient hospital care. Because the groups and

associations contract out some specialty and surgical care, this

arrangement amounts to a capitation-for-referral-services type of

incentive. In addition, the plan uses a bonus incentive to reward groups

and associations that keep hospital referral rates low. The plan believes

that most of its groups and associations adjust the compensation of their

primary care physicians to encourage them to control specialty and

hospital referral costs.

Effect of Financial

Incentives on the

Quality of Care

Few data exist on the extent to which financial incentives affect

physicians’ service utilization patterns. A number of studies have shown

that HMOs in general hospitalize patients at a significantly lower rate than

traditional fee-for-service practices.29 However, these studies did not

assess whether the HMOs’ lower rate was attributable to their use of

financial incentives or to other differences between HMOs and

29These studies have not found any consistent differences in the use of ambulatory services.

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Financial Incentive Arrangements Between

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fee-for-service providers. There have been at least two studies of the

utilization effects of different forms of compensation within the HMO

setting. But in the course of our work, we were unable to find any

systematic analyses of the effects of specific types of incentives on the

utilization of the services the incentives are intended to reduce, such as

the effect of a bonus for controlling specialty referrals on such referrals.

Even if the effects of financial incentives on service utilization were

known, their impact on quality of care would not be readily ascertainable

because there is currently no consensus about how quality of care should

be defined and measured. If a financial incentive induced a physician to

withhold a service that a patient did not need, then quality of care would

not be impaired. The difficulty lies in determining which services are

“needed.” Although the effect on patient outcomes is one measure of

quality, efforts to measure the impact of care or outcomes are still in their

infancy.

Page 38 GAO/HEHS-95-87 California Medicaid Managed Care
Appendix III 

Major Contributors to This Report

Robert Hughes, Assistant Director

Aleta Lee Hancock, Evaluator-in-Charge, (213) 346-8069

Richard N. Jensen, (202) 512-7146

Carla D. Brown

Jay Goldberg

(101312) Page 39 GAO/HEHS-95-87 California Medicaid Managed Care
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