Medicare: Observations on Program Sustainability and Strategies to Control Spending on Any Proposed Drug Benefit
Published: 2003-04-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The House Committee on Ways and Means is holding a hearing on modernizing Medicare and integrating prescription drugs into the program. There are growing concerns about gaps in the Medicare program, most notably the lack of outpatient prescription drug coverage, which may leave Medicare's most vulnerable beneficiaries with high out-of-pocket costs. At the same time, Medicare already faces a huge projected financial imbalance that has worsened significantly in the past year. This statement discusses the challenges of adding a drug benefit to Medicare in the context of the program's current and projected financial condition. It also examines program design issues to be considered with respect to administering any proposed drug benefit. Specifically, it discusses how private sector health plans have used entities called pharmacy benefit managers (PBM) to control drug benefit expenditures.
section_title: What GAO Found
paragraphs: The recent publication of the 2003 Medicare Trustees' annual report reminds us that Medicare in its current condition--without a prescription drug benefit--is not sustainable. At the same time there are growing concerns about gaps in the Medicare program, most notably the lack of outpatient prescription drug coverage, that may leave Medicare's most vulnerable beneficiaries with high out-of-pocket costs. The Hospital Insurance (HI) portion of Medicare faces a huge projected financial imbalance that has worsened significantly in the past year. Under the Trustees' 2003 intermediate estimates, the present value of HI's actuarial deficit is $6.2 trillion--a 20 percent increase over the prior year. Beginning in 2013, HI's program outlays are expected to begin to exceed program tax revenues, putting increased pressure on the federal budget to raise the resources necessary to meet program costs. In addition, Supplementary Medical Insurance is projected to place an increasing burden on taxpayers and beneficiaries. GAO's long-term budget simulations show that, absent meaningful entitlement reforms, demographic trends and rising health care spending will drive escalating federal deficits and debt. Neither slowing the growth of discretionary spending nor allowing the 2001 tax reductions to sunset will eliminate the imbalance. While additional economic growth will help ease our burden, the potential fiscal gap is too great to grow our way out of the problem. The application of basic health insurance principles to any proposed benefit could help moderate the cost for both beneficiaries and taxpayers. These include beneficiary protections against the risk of catastrophic medical expenses and premium contributions and cost-sharing arrangements that encourage beneficiaries to be cost conscious. The private sector's use of PBMs to control drug expenditures may be instructive for Medicare, but the program's unique role and nature may moderate how such entities would be used and the potential efficiency gains afforded in attempting to transfer PBM-like strategies to Medicare.

section_title: Letter
paragraphs: I am pleased to be here today as you discuss issues related to an  outpatient prescription drug benefit for Medicare beneficiaries. There are  growing concerns about gaps in the Medicare program, most notably the  lack of outpatient prescription drug coverage, which may leave Medicare’s  most vulnerable beneficiaries with high out-of-pocket costs. Recent  estimates suggest that, at any point in time, about a third of Medicare  beneficiaries lack prescription drug coverage. The rest have at least some  drug coverage through various sources—most commonly employer- sponsored health plans—although recent evidence indicates that this  coverage is beginning to erode.
At the same time, however, the recent publication of the 2003 Trustees’  annual report reminds us that Medicare in its current condition—with no  prescription drug benefit—already faces a huge projected financial  imbalance that has worsened significantly in the past year. Furthermore,  as the Medicare Trustees made clear over 10 years ago, the current  Medicare program is not fiscally sustainable in its present form.
In 10 years, Hospital Insurance (HI) Trust Fund outlays will begin to  exceed tax receipts, and by 2026 the HI trust fund will be exhausted.  However, trust fund insolvency does not mean the program will cease to  exist; program tax revenues will continue to cover a portion of projected  annual expenditures.
The huge fiscal pressures created by the retirement of the baby boom  generation and rising health care costs are on our 10-year budget horizon.  Between now and 2035, the number of people age 65 and older will double.  Federal health and retirement spending are expected to surge as people  live longer and spend more time in retirement. In addition, advances in  medical technology are likely to keep pushing up the cost of providing  health care. Moreover, the baby boomers will have fewer workers to  support them in retirement.
We must also remember that Medicare has grown substantially as a  percent of the federal budget since its enactment in 1965. In addition, it is  expected to represent an increasing percentage of the federal budget in  the years ahead. After a brief slowdown in the late 1990s, Medicare  spending growth has recently accelerated. In fiscal year 2001, growth in  program spending reached nearly 9 percent, with spending on certain  services increasing much more rapidly. For example, spending for home  health services grew about 30 percent and spending for skilled nursing  facility care grew slightly over 20 percent. For the first 5 months of fiscal  year 2003, Medicare spending has been growing at 7.6 percent.
A significant problem that hobbles Medicare’s ability to achieve a  desirable degree of efficiency is that the program too often pays overly  generous rates for certain services and products. For example, for certain  services, our recent work has shown substantially higher Medicare  payments relative to providers’ costs—as much as 35 percent higher for  home health care and 19 percent higher for skilled nursing facility care.  Similarly, Medicare has overpaid for various medical products. In 2001, we  reported that Medicare paid over $1 billion more than other purchasers in  2000 for certain outpatient drugs that the program covers. Excessive  payments hurt not only the taxpayers but also the program’s beneficiaries  or their supplemental insurers, as beneficiaries are generally liable for  copayments equal to 20 percent of Medicare’s approved fee. For certain  outpatient drugs, Medicare’s payments to providers were so high that the  beneficiaries’ copayments exceeded the price at which providers could  buy the drugs. The Centers for Medicare & Medicaid Services (CMS) has  not acted on our recommendation that Medicare establish payment levels  for drugs more closely related to actual market transaction costs, using  information available to other public programs that pay at lower rates.
In the face of these short-term and long-term cost pressures, I continue to  maintain that substantive financing and programmatic reforms are  necessary to put Medicare on a sustainable footing for the future. These  fundamental reforms are vital to reducing the program’s growth, which  threatens to absorb ever-increasing shares of the nation’s budgetary and  economic resources. Thus, any proposals to help seniors with the costs of  prescription drugs would need to be carefully crafted to avoid further  erosion of the projected financial condition of the Medicare program.  Stated differently, it will be prudent to adopt a modified Hippocratic oath  for Medicare reform—namely, any such reform proposals should “do no  further harm” to Medicare’s already serious long-range financial  imbalance.
As you deliberate on ways to modernize Medicare’s benefit package while  striving for program sustainability, I would like to highlight several key  considerations:    The traditional measure of HI Trust Fund solvency is a misleading gauge of  Medicare’s financial health. Long before the HI Trust Fund is projected to  be insolvent, pressures on the rest of the federal budget will grow as HI’s  projected cash flow turns negative and the gap between program tax  revenues and expenditures escalates. Moreover, a focus on the financial  status of HI ignores the increasing burden Supplemental Medical  Insurance (SMI)—Medicare part B—will place on taxpayers and  beneficiaries.
GAO’s most recent long-term budget simulations continue to show that,  absent meaningful entitlement reforms, demographic trends and rising  health care spending will drive escalating federal deficits and debt. To  obtain budget balance, massive spending cuts, tax increases, or some  combination of the two would be necessary. Neither slowing the growth of  discretionary spending nor allowing the 2001 tax reductions to sunset will  eliminate the imbalance. In addition, while additional economic growth  will help ease our burden, the potential fiscal gap is too great to grow our  way out of the problem.
Under the huge budgetary pressures that we are sure to face in the coming  years, we must set priorities so that any benefit expansions are in line with  available resources. In this regard, the application of basic health  insurance principles to any proposed benefit could help moderate the cost  for both beneficiaries and taxpayers. Under these principles, beneficiaries  receive protections against the risk of catastrophic medical expenses  while remaining conscious of the cost of care through their premium  contributions and cost-sharing arrangements. Given our already huge  Medicare financial imbalance, it is also important that benefit expansion  proposals include targeting mechanisms to ensure that federal support is  directed at the beneficiaries with the greatest financial risk.
The private sector’s use of entities called pharmacy benefit managers for  controlling drug expenditures may be instructive for Medicare, but the  program’s unique role and nature may moderate how these strategies will  be used and the potential efficiency gains afforded in attempting to  transfer these strategies to Medicare.
subsections: section_title: Outlook Worsening for Medicare’s Long- Term Sustainability
paragraphs: Today the Medicare program faces a long-range and fundamental financing  problem driven by known demographic trends and projected escalation of  health care spending beyond general inflation. The lack of an immediate  crisis in Medicare financing affects the nature of the challenge, but it does  not eliminate the need for change. Within the next 10 years, the first baby  boomers will begin to retire, putting increasing pressure on the federal  budget. From the perspectives of the program, the federal budget, and the  economy, Medicare in its present form is not sustainable. Acting sooner  rather than later would allow changes to be phased in so that the  individuals who are most likely to be affected, namely younger and future  workers, will have time to adjust their retirement planning while helping  to avoid related “expectation gaps.” Since there is considerable confusion  about Medicare’s current financing arrangements, I would like to begin by  describing the nature, timing, and extent of the financing problem.
subsections: section_title: Demographic Trends and Expected Rise in Health Care Costs Drive Medicare’s Long-Term Financing Problem
paragraphs: As you know, Medicare consists of two parts—HI and SMI. HI, which pays  for inpatient hospital stays, skilled nursing care, hospice, and certain home  health services, is financed by a payroll tax. Like Social Security, HI has  always been largely a pay-as-you-go system. SMI, which pays for physician  and outpatient hospital services, diagnostic tests, and certain other  medical services, is financed by a combination of general revenues and  beneficiary premiums. Beneficiary premiums pay for about one-fourth of  SMI benefits, with the remainder financed by general revenues. These  complex financing arrangements mean that current workers’ taxes  primarily pay for current retirees’ benefits except for those financed by  SMI premiums.
As a result, the relative numbers of workers and beneficiaries have a major  impact on Medicare’s financing. The ratio, however, is changing. In the  future, relatively fewer workers will be available to shoulder Medicare’s  financial burden. In 2002 there were 4.9 working-age persons (18 to 64  years) per elderly person, but by 2030, this ratio is projected to decline to  2.8. For the HI portion of Medicare, in 2002 there were nearly 4 covered  workers per HI beneficiary. Under their intermediate 2003 estimates, the  Medicare Trustees project that by 2030 there will be only 2.4 covered  workers per HI beneficiary. (See fig. 1.)
The demographic challenge facing the system has several causes. People  are retiring early and living longer. As the baby boom generation ages, the  share of the population age 65 and over will escalate rapidly. A falling  fertility rate is the other principal factor underlying the growth in the  elderly’s share of the population. In the 1960s, the fertility rate was an  average of 3 children per woman. Today it is a little over 2, and by 2030 it  is expected to fall to 1.95—a rate that is below replacement. The  combination of the aging of the baby boom generation, increased  longevity, and a lower fertility rate will drive the elderly as a share of total  population from today’s 12 percent to almost 20 percent in 2030.
Taken together, these trends threaten both the financial solvency and  fiscal sustainability of this important program. Labor force growth will  continue to decline and by 2025 is expected to be less than a third of what  it is today. (See fig. 2.) Relatively fewer workers will be available to  produce the goods and services that all will consume. Without a major  increase in productivity, low labor force growth will lead to slower growth  in the economy and slower growth of federal revenues. This in turn will  only accentuate the overall pressure on the federal budget. This slowing  labor force growth is not always recognized as part of the Medicare  debate, but it is expected to affect the ability of the federal budget and the  economy to sustain Medicare’s projected spending in the coming years.
The demographic trends I have described will affect both Medicare and  Social Security, but Medicare presents a much greater, more complex, and  more urgent challenge. Unlike Social Security, Medicare spending growth  rates reflect not only a burgeoning beneficiary population, but also the  escalation of health care costs at rates well exceeding general rates of  inflation. The growth of medical technology has contributed to increases  in the number and quality of health care services. Moreover, the actual  costs of health care consumption are not transparent. Third-party payers  largely insulate covered consumers from the cost of health care decisions.  These factors and others contribute to making Medicare a greater and  more complex fiscal challenge than Social Security.
section_title: HI’s Trust Fund Faces Cash Flow Problems Long before the HI Trust Fund Is Projected to Be Insolvent
paragraphs: Current projections of future HI income and outlays illustrate the timing  and severity of Medicare’s fiscal challenge. Today, the HI Trust Fund takes  in more in taxes than it spends. Largely because of the known  demographic trends I have described, this situation will change. Under the  Trustees’ 2003 intermediate assumptions, program outlays are expected to  begin to exceed program tax revenues in 2013. (See fig. 3.) To finance  these cash deficits, HI will need to draw on the special-issue Treasury  securities acquired during the years of cash surpluses. For HI to “redeem”  its securities, the government will need to obtain cash through some  combination of increased taxes, spending cuts, and/or increased  borrowing from the public (or, if the unified budget is in surplus, less debt  reduction than would otherwise have been the case). Neither the decline  in the cash surpluses nor the cash deficits will affect the payment of  benefits, but the negative cash flow will place increased pressure on the  federal budget to raise the resources necessary to meet the program’s  ongoing costs. This pressure will only increase when Social Security also  experiences negative cash flow and joins HI as a net claimant on the rest  of the budget.
The gap between HI income and costs shows the severity of HI’s financing  problem over the longer term. This gap can also be expressed relative to  taxable payroll (the HI Trust Fund’s funding base) over a 75-year period.
This year, under the Trustees’ 2003 intermediate estimates, the 75-year  actuarial deficit is projected to be 2.40 percent of taxable payroll—a  significant increase from last year’s projected deficit of 2.02 percent. This  means that to bring the HI Trust Fund into balance over the 75-year  period, either program outlays would have to be immediately reduced by  42 percent or program income immediately increased by 71 percent, or  some combination of the two. These estimates of what it would take to  achieve 75-year trust fund solvency understate the extent of the problem  because the program’s financial imbalance gets worse in the 76th and  subsequent years. As each year passes, we drop a positive year and add a  much bigger deficit year.
The projected exhaustion date of the HI Trust Fund is a commonly used  indicator of HI’s financial condition. Under the Trustees’ 2003 intermediate  estimates, the HI Trust Fund is projected to exhaust its assets in 2026. This  solvency indicator provides information about HI’s financial condition, but  it is not an adequate measure of Medicare’s sustainability for several  reasons. In fact, the solvency measure can be misleading and can serve to  give a false sense of security as to Medicare’s true financial condition.  Specifically, HI Trust Fund balances do not provide meaningful  information on the government’s fiscal capacity to pay benefits when  program cash inflows fall below program outlays. As I have described, the  government would need to come up with cash from other sources to pay  for benefits once outlays exceeded program tax income.
In addition, the HI Trust Fund measure provides no information on SMI.  SMI’s expenditures, which currently account for about 43 percent of total  Medicare spending, are projected to grow even faster than those of HI in  the near future. Moreover, Medicare’s complex structure and financing  arrangements mean that a shift of expenditures from HI to SMI can extend  the solvency of the HI Trust Fund, creating the appearance of an  improvement in the program’s financial condition. For example, the  Balanced Budget Act of 1997 modified the home health benefit, which  resulted in shifting a portion of home health spending from the HI Trust  Fund to SMI. Although this shift extended HI Trust Fund solvency, it  increased the draw on general revenues and beneficiary SMI premiums  while generating little net savings.
Ultimately, the critical question is not how much a trust fund has in assets,  but whether the government as a whole and the economy can afford the  promised benefits now and in the future and at what cost to other claims  on available resources. To better monitor and communicate changes in  future total program spending, new measures of Medicare’s sustainability  are needed. As program changes are made, a continued need will exist for  measures of program sustainability that can signal potential future fiscal  imbalance. Such measures might include the percentage of program  funding provided by general revenues, the percentage of total federal  revenues or gross domestic product (GDP) devoted to Medicare, or  program spending per enrollee. As such measures are developed,  questions would need to be asked about actions to be taken if projections  showed that program expenditures would exceed the chosen level.
section_title: Absent Reform of Medicare and Other Entitlements for the Elderly, Budgetary Flexibility Will Disappear
paragraphs: Taken together, Medicare’s HI and SMI expenditures are expected to  increase dramatically, rising from about 12 percent of federal revenues in  2002 to more than one-quarter by midcentury. The budgetary challenge  posed by the growth in Medicare becomes even more significant in  combination with the expected growth in Medicaid and Social Security  spending. As shown in figure 4, Medicare, Medicaid, and Social Security  have already grown from 13 percent of federal spending in 1962 before  Medicare and Medicaid were created to 42 percent in 2002.
This growth in spending on federal entitlements for retirees will become  increasingly unsustainable over the longer term, compounding an ongoing  decline in budgetary flexibility. Over the past few decades, spending on  mandatory programs has consumed an ever-increasing share of the federal  budget. In 1962, prior to the creation of the Medicare and Medicaid  programs, spending for mandatory programs plus net interest accounted  for about 32 percent of total federal spending. By 2002, this share had  almost doubled to approximately 63 percent of the budget. (See fig. 5.)
In much of the past decade, reductions in defense spending helped  accommodate the growth in these entitlement programs. However, even  before the terrorist attacks of September 11, 2001, this ceased to be a  viable option. Indeed, spending on defense and homeland security will  grow as we seek to combat new threats to our nation’s security.
GAO prepares long-term budget simulations that seek to illustrate the  likely fiscal consequences of the coming demographic tidal wave and  rising health care costs. These simulations continue to show that to move  into the future with no changes in federal retirement and health programs  is to envision a very different role for the federal government. Assuming,  for example, that the tax reductions enacted in 2001 do not sunset and  discretionary spending keeps pace with the economy, by midcentury  federal revenues may not even be adequate to pay Social Security and  interest on the federal debt. Spending for the current Medicare program— without any additional new benefits—is projected to account for more  than one-quarter of all federal revenues. To obtain budget balance,  massive spending cuts, tax increases, or some combination of the two  would be necessary. (See fig. 6.) Neither slowing the growth of  discretionary spending nor allowing the tax reductions to sunset  eliminates the imbalance. In addition, while additional economic growth  would help ease our burden, the projected fiscal gap is too great for us to  grow our way out of the problem.
Indeed, long-term budgetary flexibility is about more than Social Security  and Medicare. While these programs dominate the long-term outlook, they  are not the only federal programs or activities that bind the future. The  federal government undertakes a wide range of programs, responsibilities,  and activities that obligate it to future spending or create an expectation  for spending. A recent GAO report describes the range and measurement  of such fiscal exposures—from explicit liabilities such as environmental  cleanup requirements to the more implicit obligations presented by life- cycle costs of capital acquisition or disaster assistance. Making  government fit the challenges of the future will require not only dealing  with the drivers—such as entitlements for the elderly—but also looking at  the range of other federal activities. A fundamental review of what the  federal government does and how it does it will be needed. This involves  looking at the base of all major spending and tax policies to assess their  appropriateness, priority, affordability, and sustainability in the years  ahead.
section_title: Medicare Is Projected to Absorb Ever- Increasing Shares of the Economy
paragraphs: At the same time, it is important to look beyond the federal budget to the  economy as a whole. Figure 7 shows the total future draw on the economy  represented by Medicare, Medicaid, and Social Security. Under the 2003  Trustees’ intermediate estimates and the Congressional Budget Office’s  (CBO) most recent long-term Medicaid estimates, spending for these  entitlement programs combined will grow to 14 percent of GDP in 2030  from today’s 8.4 percent. Taken together, Social Security, Medicare, and  Medicaid represent an unsustainable burden on future generations.
Although real incomes are projected to continue to rise, they are expected  to grow more slowly than has historically been the case. At the same time,  the demographic trends and projected rates of growth in health care  spending I have described will mean rapid growth in entitlement spending.
Taken together, these projections raise serious questions about the  capacity of the relatively smaller number of future workers to absorb the  rapidly escalating costs of these programs.
As HI trust fund assets are redeemed to pay Medicare benefits and SMI  expenditures continue to grow, the program will constitute a claim on real  resources in the future. As a result, taking action now to increase the  future pool of resources is important. To echo Federal Reserve Chairman  Alan Greenspan, the crucial issue of saving in our economy relates to our  ability to build an adequate capital stock to produce enough goods and  services in the future to accommodate both retirees and workers in the  future. The most direct way the federal government can raise national  saving is by increasing government saving; that is, as the economy returns  to a higher growth path, a balanced fiscal policy that recognizes our long- term challenges can help provide a strong foundation for economic growth  and can enhance our future budgetary flexibility. It is my hope that we will  think about the unprecedented challenge facing future generations in our  aging society. Putting Medicare on a sustainable path for the future would  help fulfill this generation’s stewardship responsibility to succeeding  generations. It would also help to preserve some capacity for future  generations to make their own choices for what role they want the federal  government to play.
As with Social Security, both sustainability and solvency considerations  drive us to address Medicare’s fiscal challenges sooner rather than later.  HI Trust Fund exhaustion may be more than 20 years away, but the  squeeze on the federal budget will begin as the baby boom generation  begins to retire. This will begin as early as 2008, when the leading edge of  the baby boom generation becomes eligible for early retirement. CBO’s  current 10-year budget and economic outlook reflects this. CBO projects  that economic growth will slow from an average of 3.2 percent a year from  2005 through 2008 to 2.7 percent from 2009 through 2013, reflecting slower  labor force growth. At the same time, annual rates of growth in entitlement  spending will begin to rise. Annual growth in Social Security outlays is  projected to accelerate from 5.2 percent in 2007 to 6.6 percent in 2013.  Annual growth in Medicare enrollees is expected to accelerate from 1.1  percent today to 2.9 percent in 2013. Acting sooner rather than later is  essential to ease future fiscal pressures and also provide a more  reasonable planning horizon for future retirees. We are now at a critical  juncture. In less than a decade, the profound demographic shift that is a  certainty will have begun.
section_title: As Bleak Fiscal Future Looms, Efforts to Address Medicare Coverage Gaps Are Being Considered
paragraphs: Despite a common awareness of Medicare’s current and future fiscal  plight, pressure has been building to address recognized gaps in Medicare  coverage, especially the lack of a prescription drug benefit and protection  against financially devastating medical costs. Filling these gaps could add  significant expenses to an already fiscally overburdened program. Under  the Trustees’ 2003 intermediate assumptions, the present value of HI’s  actuarial deficit is $6.2 trillion, a 20-percent increase from the prior year.  This difficult situation argues for tackling the greatest needs first and for  making any benefit additions part of a larger structural reform effort.
The Medicare benefit package, largely designed in 1965, provides virtually  no outpatient drug coverage. Beneficiaries may fill this coverage gap in  various ways. According to the Medicare Current Beneficiary Survey,  nearly two-thirds of Medicare beneficiaries had some form of drug  coverage from a supplemental insurance policy, health plan, or public  program at some point during 1999. All beneficiaries have the option to  purchase supplemental policies—Medigap—when they first become  eligible for Medicare at age 65. Those policies that include drug coverage  tend to be expensive and provide only limited benefits. Some beneficiaries  have access to coverage through employer-sponsored policies or private  health plans that contract to serve Medicare beneficiaries. In recent years,  coverage through these sources has become more expensive and less  widely available. Beneficiaries whose incomes fall below certain  thresholds may qualify for Medicaid or other public programs. More than  one-third may lack drug coverage altogether.
In recent years, prescription drug expenditures have grown substantially,  both in total and as a share of all heath care outlays. Prescription drug  spending grew an average of 15.9 percent per year from 1996 to 2001, more  than double the 6.5 percent average growth rate for health care  expenditures overall. (See table 1.) As a result, prescription drugs account  for a growing share of health care spending, rising from 6.5 percent in 1996  to 9.9 percent in 2001. By 2012, prescription drug expenditures are  expected to account for almost 15 percent of total health expenditures.
In 2002, CBO projected that the average Medicare beneficiary would use  $2,440 worth of prescription drugs in 2003. This is a substantial amount  considering that some beneficiaries lack any drug coverage and others  may have less coverage than in previous years. Moreover, significant  numbers of beneficiaries have drug expenses much higher than those of  the average beneficiary. CBO also estimated that, in 2005, 12 percent of  Medicare beneficiaries would have expenditures above $6,000.
In focusing on the need for prescription drug coverage, we should not  forget that Medicare does not provide complete protection from  catastrophic losses. Under Medicare, beneficiaries have no limit on their  out-of-pocket costs attributable to cost sharing. The average beneficiary  who obtained services had a total liability for Medicare-covered services  of $1,700, consisting of $1,154 in Medicare copayments and deductibles in  addition to the $546 in annual part B premiums in 1999, the most recent  year for which data are available on the distribution of these costs. For  beneficiaries with extensive health care needs, the burden can be much  higher. In 1999, about 1 million beneficiaries were liable for more than  $5,000, and about 260,000 were liable for more than $10,000 for covered  services. In contrast, employer-sponsored health plans for active workers  typically limited maximum annual out-of-pocket costs for covered services  to less than $2,000 per year for single coverage.
Recently, several proposals have been made to add a prescription drug  benefit to the Medicare program. While different in scope and detail, the  proposals have certain features in common—including use of a third-party  entity to administer the new drug benefit. The remainder of my remarks  will focus on the lessons learned from our work regarding the private  sector’s use of such an entity to manage the drug benefits of insurers’  policyholders and health plans’ enrollees.
section_title: Private Sector Strategies for Controlling Drug Expenditures May Be Instructive for Medicare
paragraphs: Some proposals to add a Medicare outpatient prescription drug benefit  look to private sector strategies as a means to administer a drug benefit  and control costs. Most employer-sponsored health plans contract with  private entities, known as pharmacy benefit managers (PBM), to  administer their prescription drug benefits, and those that do not contract  with PBMs may have units in their organizations that serve the same  administrative purpose. Typically, on behalf of the health plans, PBMs  negotiate drug prices with pharmacies, negotiate rebates with drug  manufacturers, process drug claims, operate mail-order pharmacies, and  employ various cost-control techniques, such as formulary management  and drug utilization reviews. In 2001, nearly 200 million Americans had  their prescription drug benefits administered through PBMs. This year, we  reported on the use of PBMs by health plans in the Federal Employees’  Health Benefits Program (FEHBP). In considering the application of  these findings to Medicare, we are reminded that Medicare’s unique role  and nature may temper how the strategies and potential efficiency gains  afforded by private sector PBMs may be transferred to benefit the  program.
subsections: section_title: Private Sector Uses PBMs to Leverage Price Negotiations through Volume Purchasing
paragraphs: PBMs use purchasing volume to leverage their negotiations with  pharmacies and drug manufacturers in seeking favorable prices in the  form of discounts, rebates, or other advantages. Through negotiations,  PBMs create networks of participating retail pharmacies, promising the  pharmacies a greater volume of customers in exchange for discounted  prices. PBMs may be able to secure larger discounts by limiting the  number of network pharmacies. However, smaller networks provide  beneficiaries fewer choices of retailers, thereby limiting convenient  access. These are trade-offs health plans must consider in deciding how  extensive a pharmacy network they want their PBMs to offer beneficiaries.  The health plans we reviewed in our FEHBP study generally provided  broad retail pharmacy networks. The average discounted prices PBMs  obtained for drugs from retail pharmacies were about 18 percent below  the average prices cash-paying customers without drug coverage would  have paid for 14 selected widely used brand-name drugs. For 4 selected  generic drugs, the PBM-negotiated retail pharmacy prices were 47 percent  below the price paid by cash-paying customers.
PBMs also use their leverage to negotiate with drug manufacturers for  rebates. Rebates generally depend on the volume of a manufacturer’s  products purchased. Health plans and PBMs can add to that volume by  concentrating beneficiaries’ purchases for particular types of drugs with  certain manufacturers. Health plans can steer their beneficiaries’  purchases to specific drugs through the use of a formulary—that is, a list  of prescription drugs that health plans encourage physicians to prescribe  and beneficiaries to use. Determining whether a drug should be on the  formulary involves clinical evaluations based on a drug’s safety and  effectiveness, and decisions on whether several drugs are therapeutically  equivalent. Restricting the formulary to fewer drugs within a therapeutic  class can provide the PBMs with greater leverage in negotiating higher  rebates because they can help increase the manufacturer’s market share  for certain drugs. However, a restricted formulary provides beneficiaries  with fewer preferred drug alternatives and makes the policies governing  coverage of nonformulary drugs or the cost sharing for them critical to  beneficiaries.
The FEHBP plans and PBMs we reviewed provided enrollees with  generally nonrestrictive drug formularies across a broad range of drugs  and therapeutic categories. The manufacturer rebates that the PBMs  passed through to the FEHBP plans effectively reduced plans’ annual  spending on prescription drugs by a range of 3 percent to 9 percent. The  share of rebates PBMs passed through to the FEHBP plans varied subject  to contractual agreements negotiated between the plans and the PBMs.
PBMs also assisted the FEHBP plans by providing a less expensive mail- order drug option. Mail-order prices for the FEHBP plans we reviewed  averaged about 27 percent lower than cash-paying customers would pay  for the same quantity at retail pharmacies for 14 brand-name drugs and 53  percent lower for 4 generic drugs. The FEHBP plans generally had lower  cost-sharing requirements for drugs purchased through mail order,  particularly for more expensive brand-name drugs or maintenance  medications for chronic conditions.
The claims and information processing capabilities PBMs offered also  helped the FEHBP plans to manage drug costs and monitor quality of care.  PBMs maintain a centralized database on each enrollee’s drug history that  can be used to review for potential adverse drug interactions or potentially  less expensive alternative medications. They also use claims data to  monitor patterns of patient use, physician prescribing practices, and  pharmacy dispensing practices. Their systems provide “real-time” claims  adjudication capabilities that allow a customer’s claim for a drug purchase  to be approved or denied at the time the pharmacist begins the process of  filling a prescription. Two plans in our FEHBP study reported savings  ranging from 6 to 9 percent of the plan’s annual drug spending; the savings  were associated primarily with real-time claims denials preventing early  drug refills and safety advisories cautioning pharmacists about potential  adverse interactions or therapy duplications.
section_title: Use of Private-Sector Strategies in Medicare Would Represent Departure from Traditional Policies and Practices
paragraphs: While Medicare’s sheer size would provide it with significant leverage in  negotiating with pharmacies and drug manufacturers, doing so would  represent a departure from traditional Medicare. Medicare beneficiaries  represent less than 15 percent of the population but a disproportionately  higher share—about 40 percent—of prescription drug spending. However,  because of Medicare’s design and obligations as a public program, its  current purchasing strategies vary considerably from those of the private  sector.
Any willing provider. In contrast with private payers’ reliance on  selective contracting with providers and suppliers, the traditional  Medicare program has generally allowed any hospital, physician, or other  provider willing to accept Medicare’s reimbursements and requirements to  participate in the program. With respect to drug purchasing in particular,  private plans determine the extent of their enrollees’ access by the choices  they make about the size of their participating pharmacy network and  breadth of their drug formulary. Allowing any pharmacy willing to meet  Medicare’s terms to participate or allowing all therapeutically equivalent  drugs equal coverage on a formulary would restrict the program’s ability to  secure advantageous prices. Moreover, health plans and PBMs currently  make formulary determinations privately. In contrast, Medicare’s policies  have historically been open to public comment.
Administrative rate-setting. Whereas private health plans typically rely  on price negotiations to establish payment rates, Medicare generally  establishes payment rates administratively. As discussed earlier,  Medicare’s rates often exceed market prices and this is the case for some  of the few outpatient prescription drugs covered by Medicare. The  program’s method of paying for these drugs is prescribed in statute: In  essence, Medicare pays 95 percent of a drug’s “average wholesale price”  (AWP). Despite its name, however, AWP is not necessarily a price that  wholesalers charge and is not based on the price of any actual sale of  drugs by a manufacturer. AWPs are published by manufacturers in drug  price compendia, and Medicare bases providers’ payments on these  published AWPs. Other public and private purchasers typically use the  leverage of volume and competition to secure better prices. By statute,  Medicaid, the nation’s health insurance program for certain low-income  Americans, is guaranteed manufacturers’ rebates based on prices charged  other purchasers. Certain other public payers can pay at rates set in the  federal supply schedule, which uses verifiable confidential information on  the prices drug manufacturers charge their “most favored” private  customers. Manufacturers agree to these prices, in part, in exchange for  the right to sell drugs to the more than 40 million Medicaid beneficiaries.
Low-budget program administration. Duplicating the type of controls  PBMs have exercised over private-sector drug benefits would likely  involve devoting a larger share of total expenditures to administration  than is spent by Medicare currently. Medicare’s administrative costs  historically have been extremely low, averaging about 2 percent of the  cost of the services themselves. This level of expenditure may not be  consistent with the level needed to review the volumes of claims data  associated with prescription drugs for the elderly or acquire and maintain  the on-line systems and databases PBMs use to employ such utilization  controls as real-time claims adjudication. The number of prescriptions for  Medicare beneficiaries could easily exceed the current number of claims  for all other services combined, or over 1 billion annually.
section_title: Decisions about the Extent of Latitude and Competition Allowed Are Critical to Administering a Medicare Drug Benefit
paragraphs: Medicare would undoubtedly need assistance from external entities to  administer a drug benefit, just as it has used insurers to process claims in  the traditional program and Medicare+Choice plans to go further by also  managing services and assuming risk. Decisions about the roles assigned  an entity or entities and the latitude allowed them in carrying out those  roles would be critical. These decisions would undoubtedly affect the  benefit’s value to beneficiaries and the efficiencies and savings secured for  both beneficiaries and taxpayers. Some of these decisions parallel those  made by FEHBP plans that I discussed—trade-offs about beneficiaries’  interests in broad pharmacy networks and formularies versus potential  savings. Others stem from the uniqueness of Medicare, its likely  disproportionate share of the drug market, and its position as a public  program requiring transparency and fairness.
Insurers and PBMs have been successful in securing some savings on drug  purchases by leveraging their volume to move market share from one  product to another. Medicare’s leverage, given that purchases by the  elderly constitute about 40 percent of the drug market, could be  considerable. Yet the large market share may also be likely to attract  considerable attention. The administration of a Medicare drug benefit  could then be subject to the same intensity of external pressures from  interested parties regarding program prices and rules that can often inhibit  the program from operating efficiently today. The potential for  micromanagement could compromise trying to use the very flexibility  PBMs have employed in negotiating prices and selecting preferred  providers in order to generate savings. An alternative would be to sacrifice  some of the program’s leverage and grant flexibility to multiple PBMs or  similar entities so that any one entity would be responsible for  administering only a share of the market.
Contracting with multiple PBMs or similar entities, however, would pose  other challenges. If each had exclusive responsibility for a geographic  area, beneficiaries who wanted certain drugs could be advantaged or  disadvantaged merely because they lived in a particular area. To minimize  inequities, Medicare could, like some private sector purchasers, specify  core benefit characteristics or maintain clinical control over formulary  decisions instead of delegating those decisions to its contractors.
If multiple PBMs or similar entities operated in a designated area,  beneficiaries could choose among them to administer their drug benefits.  These organizations would compete for consumers directly on the basis of  differences in their drug benefit offerings and administration. This  contrasts with the private sector where drug benefits are typically part of  an overall insurance plan, and PBMs typically compete for contracts with  insurers or other purchasers. Competition could be favorable to  beneficiaries if they were adequately informed about differences among  competing entities offering drug benefits and shared in the savings.  However, adequate oversight would need to be in place to ensure that fair  and effective competition was maintained. For example, a means to ensure  that beneficiaries received comprehensive user-friendly information about  policy and benefit differences among competing entities would be  necessary. Monitoring marketing and customer recruitment strategies and  holding entities accountable for complying with federal requirements  would require adequate investment. The contracting entities could need  protections as well. Some mechanism would be needed to risk adjust  payments for differences in beneficiaries’ health status so that those  entities enrolling a disproportionate share of high-use beneficiaries would  not be disadvantaged.
section_title: Concluding Observations
paragraphs: Medicare’s financial challenge is very real and growing. The 21st century  has arrived and our demographic tidal wave is on the horizon. Within 5  years, individuals in the vanguard of the baby boom generation will be  eligible for Social Security and 3 years after that they will be eligible for  Medicare. The future costs of serving the baby boomers are already  becoming a factor in CBO’s short-term cost projections.
Frankly, we know that incorporating a prescription drug benefit into the  existing Medicare program will add hundreds of billions of dollars to  program spending over just the next 10 years. For this reason, I cannot  overstate the importance of adopting meaningful reforms to ensure that  Medicare remains viable for future generations. Adding a drug benefit to  Medicare requires serious consideration of how that benefit will affect  overall program spending. If competing private entities are to be used to  administer a drug benefit, it is important to understand how these entities  can be used in the Medicare context to provide a benefit that balances  beneficiary needs and cost containment.
Medicare reform would be done best with considerable lead time to phase  in changes and before the changes that are needed become dramatic and  disruptive. Given the size of Medicare’s financial challenge, it is only  realistic to expect that reforms intended to bring down future costs will  have to proceed incrementally. We should begin this now, when retirees  are still a far smaller proportion of the population than they will be in the  future. The sooner we get started, the less difficult the task will be.