Medicaid: Spending Pressures Drive States Toward Program Reinvention
Released: 1995-04-04T00:00:00

Letter

Introduction

In 1993, Medicaid, the government’s health financing program for certain low-income populations, cost the federal and state governments $131 billion—almost $100 billion more than just a decade ago. During that same period, the number of Medicaid beneficiaries increased from 22 million to 33 million. Although about three-quarters of the beneficiaries are poor children and their parents, two-thirds of the expenditures are for poor elderly, blind, and disabled individuals. Funding is a shared responsibility between the federal and state governments, with respective federal and state shares determined through a statutory matching formula. Federal law mandates coverage of certain medical services and population groups. It also includes coverage options, allowing states to choose whether to cover additional services or low-income population groups.

Not 1, but 56 Separate Medicaid Programs

Dramatic differences in Medicaid programs across states reflect spending priorities of the states, their ability to pay, and incentives inherent in the federal matching formula. States partly determine the extent of their Medicaid program when they set eligibility requirements for receiving cash assistance (primarily Aid to Families with Dependent Children—AFDC).Under federal law, AFDC recipients are automatically eligible for Medicaid. States also determine program scope by selecting which optional services or groups to include in their programs. With some discretion to modify eligibility and benefit provisions, the proportion of the poor (as defined by the federal poverty level) and near-poor served by Medicaid varies greatly by state. For example, for every 1,000 people with incomes under 150 percent of the federal poverty level, Rhode Island serves 913 beneficiaries, whereas Nevada serves 284. Nationally, in 1994 Medicaid covered medical services for 58 percent of people under age 65 living in poverty.

State Medicaid programs also vary in the levels of benefits provided. For example, some states limit their Medicaid coverage of inpatient days (a required service) to a certain number per person. States also have the discretion to drop their coverage of optional services, such as dental or optical care. The average Medicaid benefit (that is, total medical spending divided by total beneficiaries) ranges from $2,372 in Mississippi to $7,286 in New York. (See fig. 1.1 for grouping of states by their average benefit level and table 1.1 for state-by-state data.) States with higher Medicaid benefits tend to cover a greater proportion of poor people, relative to states with lower benefits. Thus, the differences among states in spending per poor person are even greater than the differences among states in spending per beneficiary.

Services for Elderly and Disabled Consume Greatest Share of Funding

By far, the majority of Medicaid funds are paid on behalf of poor elderly, blind, and disabled individuals. Representing only slightly more than a fourth of all Medicaid beneficiaries, these groups incurred about 66 percent ($82.2 billion) of Medicaid’s 1993 expenditures, as shown in figure 1.2. The average per person spending for these beneficiaries exceeded $9,200—four times more than was spent on other adults ($2,292) and seven times more than was spent on other children ($1,360). The per person spending for all Medicaid beneficiaries averaged nearly $3,900; in contrast, health spending per person for the U.S. population averaged about $3,300.

In 1993, about 35 percent of Medicaid spending was for long-term care, including nursing home care payments. Medicaid pays about 52 cents of every nursing home care dollar. About 46 percent of all Medicaid spending was for acute care. (See fig. 1.3 for a breakdown of Medicaid spending.)

Federal Medical Assistance Payments Based on Per Capita Income

The financing of Medicaid is shared by the federal government and the states. The federal share paid to a state is based on the federal medical assistance percentage (FMAP). Determined separately for each state, the FMAP ranges from a minimum of 50 percent to a maximum of 83 percent of total Medicaid costs.

The formula for determining the FMAP is based on a state’s per capita income. It is designed to provide a higher federal match to states with low per capita incomes. In fiscal year 1993, Mississippi, West Virginia, and Utah had the highest federal match percentages; each received more than 75 percent of its Medicaid program funding from the federal government. Alternatively for that year, the federal government paid 50 percent of Medicaid costs, the minimum match, in 12 states and the District of Columbia.

In spite of the formula’s sliding match rate, federal spending per Medicaid beneficiary tends to be highest in states with high per capita incomes. Because high-income states tend to offer relatively generous benefits, the absolute amount of federal spending per beneficiary is high, even though the match rate is only 50 percent. For example, New York—a high-income state with a 50-percent match—receives $3,600 per beneficiary in federal aid, while Mississippi—a low-income state with approximately an 80-percent match—receives $1,900 per beneficiary in federal aid.

Reporting on this subject in 1983, 1990, and 1993, we noted that the FMAP formula could be improved to meet federal goals. The federal assistance formula is designed to reduce differences among the states in medical care coverage of the poor and distribute fairly among the states the burden of financing program benefits. However, the formula’s reliance on a state’s per capita income does not adequately address these equity goals. In fiscal year 1991, for example, the District of Columbia and Nevada received the same FMAP, despite the District’s greater proportion of people eligible for Medicaid. Our prior work in this area concluded that the formula could better adjust for states’ different needs and varying abilities to fund benefits by considering a state’s number of persons in poverty and more comprehensive measures of taxing capacity.

Section 1115 Waivers Permit Major Program Changes Without Congressional Debate

In recent years, many states have been experimenting with health financing reforms. Under Medicaid law, states proposing to implement payment and service delivery innovations outside the range allowed by federal rules must seek approval to waive certain federal requirements. Until recently, though, Medicaid experiments have been relatively limited.

However, states have been seeking approval for broader changes under section 1115 waivers, so called because of the statutory provision authorizing them, which offer more open-ended opportunities to make major changes in Medicaid than program waivers. Changes proposed in section 1115 waiver applications are considered demonstration projects. Unlike the routine approvals for program waivers, approvals for demonstration waivers are subject to much greater discretion by the Secretary of the Department of Health and Human Services (HHS). (The Health Care Financing Administration (HCFA) and the Office of Management and Budget (OMB) have also been key players in the waiver approval process.) Section 1115 waivers can exempt states from compliance with normal Medicaid requirements and allow them to receive federal funding for expenditures normally not eligible for such assistance. HHS requires that waiver applications include a formal research or experimental methodology, and historically waivers have not been considered automatically renewable. Section 1115 waivers typically involve limited research projects, but since 1993 several statewide demonstration projects have been approved.

Among other things, recent section 1115 waivers have allowed states to mandate enrollment of all their beneficiaries in Medicaid-participating managed care plans and to prevent disenrollment for specific periods of time, usually 6 to 12 months. States with recently approved waivers have proposed expanding coverage of their indigent citizens by recycling savings anticipated in changing from a fee-for-service to a managed care system and redirecting other Medicaid and state funds. If these states’ demonstrations are implemented as planned, the states would be covering some low-income individuals that would not otherwise qualify for Medicaid. We discuss the significance of these waivers to the restructuring of the Medicaid program in chapter 3 and their potential impact on the federal budget in chapter 4.

Objectives, Scope, and Methodology

The House Budget Committee asked us to examine (1) the nature of federal and state Medicaid spending in recent years, (2) some states’ efforts to contain Medicaid costs and expand coverage through waivers of certain federal requirements, and (3) the potential impact of the waivers on federal spending and on Medicaid’s program structure overall.

Collecting Information on Medicaid Spending and Waivers

To address the issue of federal and state Medicaid spending, we analyzed data contained in HCFA statistical reports and also reviewed and synthesized information from research articles and major studies that focused on Medicaid costs. To obtain information on states’ efforts to contain Medicaid costs and expand coverage through waivers, we interviewed Medicaid program and other state agency officials, providers, advocacy groups, and state legislators in five of the eight states with approved waivers. We also interviewed HCFA officials responsible for examining waiver proposals and reviewed documentation for the approved and pending projects as well as statistical and other reports on the Medicaid program.

Examining the Potential Impact of Waivers

We determined the potential impact of waivers on federal spending by developing and applying a consistent framework that compares spending limits approved in each waiver with a benchmark incorporating current services budgeting concepts. To eliminate the effect of accelerated program growth from past years—acceleration due in part to high medical inflation, large increases in state disproportionate share hospital (DSH) payments, and mandated expansions in program eligibility—we compared the waiver spending limits with a projection of spending for each state’s current Medicaid program over the life of the waiver. To make these projections we used the administration’s estimated rate of growth of Medicaid current services outlays for the nation as a whole. These estimated growth rates are based only on expected increases to medical inflation and program population growth—without any change in eligibility requirements.

To make the current services projection for each state’s Medicaid program (what we call our budget-neutrality benchmark) we multiplied each state’s base-year estimates of Medicaid funding (for the segment of the population to be covered by their waiver) by the administration’s estimates of national program growth made when HCFA approved the waiver. We adjusted our baseline, when necessary, to reflect constraints on the growth of DSH payments in each state’s Medicaid program. The actual process varied slightly, depending on whether the state’s waiver was subject to an aggregate or per capita funding limit.

Once we had determined our administration-based estimate of current services outlays, we compared it with the estimated program funding from the waiver agreements. In states with aggregate caps, we compared our estimates with actual program caps. In states with per capita caps, we compared our estimates with state program funding levels consistent with the enrollment figures found in the waiver applications, recognizing that actual funding ceilings would be higher or lower, depending on actual enrollment.

We subtracted our annual, budget-neutrality benchmark figures from the waiver agreement figures and then discounted this amount to determine the present value of potential annual savings or increased funding. The difference—if positive—showed the amount of program funds above our benchmark amount that might be needed to finance the program and—if negative—showed the amount the program might save.

We did our work for this report and other related studies between August 1994 and March 1995 in accordance with generally accepted government auditing standards.

Despite a Recent Slowdown, Medicaid Consumes a Growing Share of the Federal Budget

Medicaid has become one of the fastest growing components of federal and state budgets. In part, this is the result of program expansions. After remaining relatively stable for a decade, the number of Medicaid beneficiaries began to climb rapidly after the mid-1980s. Since that time, the number of beneficiaries served annually has increased by over 11 million, reaching 33.4 million in 1993. However, costs have grown even faster than the number of beneficiaries. (See fig. 2.1.) Between 1985 and 1993, federal Medicaid expenditures grew each year, on average, by 16 percent. During this time, state Medicaid expenditures grew at a slightly slower rate of 15 percent. In 5 years, Medicaid spending is expected to exceed $260 billion annually. (See fig. 2.2.)

Medicaid Coverage Has Expanded Since 1984

The federal government influences total Medicaid spending indirectly by specifying the percentage of state Medicaid expenditures the federal government will pay (higher matching rates encourage greater state spending), and directly by specifying some eligibility and benefit requirements. Between 1984 and 1990, the Congress expanded Medicaid coverage by mandating that states serve certain low-income groups and provide certain services, and allowing optional coverage for other low-income groups and services. (See app. I.)

The mandates extended coverage primarily to additional low-income pregnant women, children, and Medicare beneficiaries. The mandates also extended transitional Medicaid coverage for families leaving AFDC for gainful employment, established a new categorically needy coverage group for severely impaired individuals under the age of 65, and added coverage of certain chronically ill or disabled individuals. The Kaiser Commission on the Future of Medicaid noted that between 1990 and 1992, enrollment increased by about 6 million individuals, with about one-third of this increase attributable to pregnant women and children. Since some states provided benefits when coverage of these groups was optional, the mandates tended to equalize benefits among states.

Because both the mandates and options tied coverage to the federal poverty level, which is uniform across states, they greatly increased the number of persons receiving Medicaid who were not eligible for cash assistance. (See fig. 2.3.) This resulted in a decline in the proportion of beneficiaries eligible for Medicaid through a cash-assistance-related category. In 1993, about 60 percent of the beneficiaries were eligible for Medicaid coverage under a cash-assistance-related category, down from 68 percent in 1990.

Medicaid Grew Faster Than Medical Inflation, Other Spending

During most of the 1980s, spending for Medicaid, private health insurance, and Medicare grew at an annual rate of 10 to 11 percent. In 1989, however, Medicaid’s spending growth began to rise sharply. In 1991 Medicaid’s 27-percent annual growth rate was over three times greater than the growth rate for national health expenditures and over four times greater than the rate for Medicare. (See fig. 2.4.) In 1992 Medicaid’s annual growth rate reached a record high of about 29 percent. Even though it fell to 11 percent in 1993, Medicaid’s annual growth rate continued to outpace the consumer price index and, except for Medicare, other key indicators used to measure health care spending. Medicaid consumes slightly more than 14 cents of every personal health care dollar.

Figure 2.5 illustrates spending by Medicaid and Medicare since 1981. Historically, Medicaid spending on health care services for the poor has been significantly less than Medicare spending for the nation’s elderly. In the 1980s, the gap widened, and by 1990, Medicare spending exceeded Medicaid’s by over $37 billion. By 1992, however, the difference had narrowed to $14 billion.

Medicaid spending has also increased sharply when compared with spending for other federal social programs. (See fig. 2.6.) In 1993, Medicaid consumed 46 percent of all the funds spent on means-tested programs, over three times more than its closest competitor—Food Stamps. By the year 2000, federal spending for Medicaid is expected to reach $149 billion, or about 51 percent of the dollars spent on means-tested programs.

Medicaid Spending Grew Faster Than Enrollment

Enrollment growth—over 11 million between 1983 and 1993—does not fully explain the rise in Medicaid spending. For example, the Kaiser Commission estimated that enrollment growth accounted for less than half of the increase in Medicaid costs during the period 1990 to 1992. The federal mandates of the 1980s that added low-income pregnant women and low-income children to the rolls were a minor factor in increasing costs, accounting for about 6.5 percent of spending growth. Although the mandates added a large number of beneficiaries, the populations added—low-income pregnant women and children—are relatively inexpensive to serve. In contrast, low-income elderly, disabled, and blind beneficiaries were responsible for about 25 percent of the total expenditure growth, even though they accounted for only 18 percent of the enrollment growth from 1990 to 1992.

In addition to enrollment increases, medical price inflation, higher provider reimbursements (that, to some extent, have been fueled by the Boren amendment), utilization growth, and creative financing mechanisms have also contributed to the significant growth in Medicaid expenditures. The importance of each of these factors in explaining cost growth depends upon the specific time period selected. For example, in 1993 the Kaiser Commission reported that enrollment expansions, medical price inflation, and increases in expenditures per beneficiary above inflation each accounted for about one-third of the $37 billion increase in annual Medicaid expenditures from 1988 through 1991.

Disproportionate Share Hospital Payments Responsible for Huge Rise in 1991-92 Spending

Disproportionate share hospital (DSH) payments were the most important cost driver in 1991 and 1992, when Medicaid spending grew by 27 percent and 29 percent, respectively. These are supplemental payments to hospitals that serve large numbers (a disproportionate share) of Medicaid and other low-income patients. The payments are intended to partially reimburse hospitals for the cost of providing care not covered by public or private insurance. In 2 years, DSH payments grew from slightly less than $1 billion in 1990 to $17.4 billion in 1992 and represented about $1 of every $7 Medicaid spent on medical services.

DSH payments grew rapidly because they were part of creative financing mechanisms that allowed states to gain additional federal dollars and effectively increase the federal government’s share of Medicaid funding. Beginning in the mid-1980s, states were allowed to use revenue raised from “provider-specific” taxes—that is, taxes imposed on hospitals serving Medicaid patients—and “voluntary contributions” (called donations), as part of the state share eligible for federal matching funds. States then returned to providers the funds collected from such taxes and donations along with part of the matching federal payments. In some cases, a portion of the federal matching funds was then redirected to state general revenues and spent on nonhealth-care services. This swapping and redirecting of revenues among providers, the state, and the federal government resulted in increased federal spending, increased funds for providers, and—in some cases—additional revenue for states’ treasuries. (See app. II for examples of how states used provider-specific taxes and donations to obtain federal matching dollars without actually spending state funds.)

DSH payments are now capped as a result of the Medicaid Voluntary Contribution and Provider-Specific Tax Amendments of 1991 and will not be a significant cost driver in the future. In 1993, DSH payments fell slightly to about $16.7 billion. The 1991 amendments also severely restricted states’ ability to use provider-specific taxes and donations (but not intergovernmental transfers) as a source of matching funds, and capped DSH payments at 12 percent of the Medicaid program. States that relied heavily on this financing mechanism are now seeking a new revenue source, cutting their Medicaid programs, or dramatically restructuring their programs under a section 1115 waiver (see ch. 3).

Medicaid’s Share of Federal Budget Expected to Grow

Medicaid’s tremendous spending growth of the late 1980s and early 1990s is not likely to recur. In 1994, Medicaid spending is expected to have grown about 8 percent. The Congressional Budget Office estimates that program spending will grow by 10.7 percent annually over the next 5 years. As in the past, future growth will be determined by medical inflation, provider reimbursement, utilization, and enrollment increases. Although no new eligibility or benefit mandates are foreseen, some of those already legislated are still being phased in. Mandatory coverage of poor children under the age of 19 will not be fully effective until 2002. Furthermore, the number of disabled individuals covered by Medicaid, although relatively small, is rising rapidly (12 percent between 1992 and 1993) and will increase costs.

Some States Use Medicaid Waivers to Increase Managed Care and Expand Coverage

In the past, some states solved their health care financing problems by capitalizing on the use of federal subsidies. Most notably, the DSH payment mechanisms mentioned earlier were used to augment a state’s total Medicaid spending to obtain higher federal matching payments: the higher the state’s own spending on Medicaid, the higher the federal match. However, since the limits on state DSH payments that were enacted in 1991, continuing budget shortfalls have pressured states to seek alternative financing measures. Now some states are seeking waivers from federal requirements in order to make greater use of alternatives such as prepaid, or HMO-type, managed care.

Under the broad authority of section 1115 of the Social Security Act, HHS has allowed some states to waive certain federal requirements in exchange for the states’ expansion of Medicaid coverage and agreement to specific federal funding limits. The waiver authority, as recently granted, permits states to mandate enrollment in managed care health plans; subsidize health care coverage for people with incomes above the federal poverty level; and use funding from other sources, such as public and mental health programs, to finance these efforts.

As of April 1995, 8 states have HHS-approved waivers, 12 have applications pending, and 3 have made inquiries about submitting waiver applications. (See table 3.1 and fig. 3.1.) Together, these 23 states have about 50 percent of the Medicaid beneficiaries in the country.

Waivers Ease Restrictions on Use of Managed Care for Medicaid Population

Waivers Increase Managed Care Options

To constrain rising health care costs, states are increasingly turning to the mandatory enrollment of portions of their Medicaid population into prepaid managed care delivery plans that limit enrollees to certain provider networks as a way to control utilization and costs. Because federal Medicaid law requires that beneficiaries have freedom to choose among providers willing to accept Medicaid reimbursement, states have had to seek approval to waive this freedom-of-choice requirement. The Secretary of HHS may waive this requirement under two sections of the Social Security Act. Section 1915(b) allows states, among other things, to implement a primary care case management system, to contract with HMOs, and to selectively contract with a limited set of providers. Section 1115 waivers, which are more difficult to obtain, allow states greater flexibility in the use of managed care options, particularly HMO-type delivery. As described in chapter 1, under section 1115 waivers, states can establish criteria to designate prepaid plans that serve only Medicaid enrollees and can prohibit disenrollment from these plans for a certain period of time—two provisions not generally permitted by Medicaid law.

State Experience Indicates Need for Careful Planning When Implementing New Managed Care Networks

States are seeking waivers of managed care requirements because they believe managed care financing and delivery systems can cut health care costs as well as improve access to and quality of care. In our 1993 studies of Medicaid managed care and private sector managed care, we reported that a combination of factors rendered findings of cost savings inconclusive. Because the term managed care refers to a range of financing arrangements—including traditional fee-for-service plans with very few care management features, such as prior approval of hospitalization—our studies of cost savings are quick to distinguish among the various forms of managed care. For the most service-restrictive form of managed care—the “capitated” HMO—reported evidence of lower utilization is straightforward. This promise of lower utilization has made HMO-type plans attractive to the states.

As of June 1994, 15 percent of Medicaid beneficiaries were enrolled in fully capitated health plans. In one year (June 1993 to June 1994), Medicaid full-risk capitation enrollment grew by 91 percent, in part because of the statewide managed care demonstrations obtained through the section 1115 waivers. In the past, the elderly and disabled Medicaid population, which consumes the largest share of state Medicaid budgets (about 66 percent), has rarely been covered by managed care programs. Increasingly, however, states are including or plan to include these populations as well.

When we and others reported in the 1970s on quality of care problems and other abuses in some Medicaid managed care experiments, the Congress placed restrictions on HMO enrollment for Medicaid beneficiaries. In general, these restrictions were designed to ensure that HMOs provide Medicaid beneficiaries a standard of care equal to that provided to private patients. Under section 1115 waivers, HCFA can waive these restrictions to help states enlist HMOs to serve Medicaid beneficiaries. HCFA can waive the “75-25 rule,” which specifies that HMOs serving Medicaid beneficiaries must have at least 25 percent of their enrollment consist of private patients (with certain limited exceptions), a rule that—in effect—prohibits Medicaid-only HMOs. HCFA can also waive a federal provision permitting beneficiaries to terminate their enrollment in an HMO at any time; this provision prevents the “lock-in” of beneficiaries that are dissatisfied with a plan. From the beneficiary’s perspective, these provisions provide some protection against the possibility of being enrolled by an HMO seeking excessive profit at the expense of quality. From the HMO’s perspective, however, the provision allowing beneficiaries to disenroll at will makes planning for financial stability difficult and therefore makes the enrollment of Medicaid patients less attractive.

In February 1995 we testified that, with the Medicare program (which covers medical services for the nation’s elderly and certain other groups) HCFA has not aggressively enforced compliance with federal HMO standards. Similar concerns arise about enforcement of standards for plans that enroll Medicaid beneficiaries, particularly because large-scale enrollment in prepaid HMOs is a recent occurrence and state Medicaid departments have limited experience in overseeing such delivery systems. Advocacy groups in some states with waivers have stated that while HMO-type managed care may potentially expand beneficiaries’ access to providers, quality of care and access problems will go undetected without adequate beneficiary education and vigorous state and federal oversight.

The recent experience of Tennessee’s section 1115 demonstration program illustrates the need to proceed cautiously when implementing a capitated HMO program statewide. In response to escalating Medicaid costs, Tennessee sought a section 1115 waiver in 1993. The state proposed “TennCare,” a demonstration to enroll in managed care organizations all its Medicaid beneficiaries, in addition to its medically uninsurable citizens and certain other uninsured residents.

In fewer than 2 months after HCFA granted the waiver, Tennessee implemented TennCare. In 1993, the year before the demonstration began, about 2.7 percent of the state’s Medicaid population was enrolled in managed care, compared with about 12.4 percent nationally. As of January 1, 1994—TennCare’s “opening day”—plans for contracting with provider networks were incomplete, and many of the state’s physicians had not yet determined which networks, if any, they might join. Some beneficiaries were initially required to choose a plan without knowing which ones would include their physicians. Systems to process bills were not fully developed, and some providers reported slow or no payments for services during the first months of the waiver. The submission of encounter data to the state, which allow officials to monitor access and quality, was not complete even 1 year after the program began. The most recent beneficiary satisfaction survey taken in 1994 reported that 45 percent of enrollees who had previously received care under Medicaid’s fee-for-service program were less than satisfied with TennCare. Individuals who were previously uninsured, however, were not as dissatisfied (8 percent).

Section 1115 Waivers Permit States to Expand Eligibility Beyond Traditional Medicaid Population

States are also using section 1115 waivers to expand Medicaid coverage to more individuals. Most states’ demonstrations expand coverage to low-income individuals and families who were previously ineligible for Medicaid (although income and categorical requirements for these new eligibles vary considerably from state to state). In sheer numbers, Tennessee, Florida, and Ohio have the most ambitious expansion programs. Oregon, Kentucky, Hawaii, and Rhode Island plan more modest expansions. (See table 3.2.)

If all states were granted waivers that permitted eligibility expansions, the number of individuals in Medicaid-supported programs could be sizeable. In a recent study, the Urban Institute estimates that expanding coverage up to 200 percent of the federal poverty level would increase the number of beneficiaries between 18 million and 45 million, depending on the extent to which eligible people apply. A more limited expansion covering individuals with incomes up to the federal poverty level, as approved for Oregon and Kentucky, would increase the number of beneficiaries between 8 million and 14 million.

As Growing Number of States Seek Section 1115 Waivers, Controversy Ensues

Section 1115 waivers are granted for research purposes to test program improvements in keeping with Medicaid goals or examine issues of interest to HCFA. Until Oregon’s application was approved in March 1993, only Arizona had been granted authority to run its demonstration statewide. Before that time, most section 1115 demonstrations were relatively small and affected only a small geographic area, target population, or provider group.

Objecting to the section 1115 demonstrations, a legal challenge has been mounted against the waivers. In June 1994, the National Association of Community Health Centers (NACHC) filed suit in federal court (NACHC v. Shalala). NACHC argues, among other things, that the Secretary of HHS acted beyond her statutory powers in approving these statewide section 1115 waivers. The suit challenges the award of waivers granted before the suit was filed and seeks injunctive relief against subsequent approval of similar waivers. Waiver approvals for Hawaii, Kentucky, Oregon, Rhode Island, and Tennessee preceded the suit. Since the suit was filed, Florida and Ohio have also been granted section 1115 waivers.

The issue of expanded coverage may stall the implementation of proposed section 1115 demonstrations in certain states. Florida, Kentucky, and Ohio have waivers approved by HCFA but not by their own state legislatures. Lawmakers in these states are concerned that implementation of the waivers will increase, not decrease, state costs. The Kentucky legislature has required that the state realize savings from managed care before coverage is expanded.

Some Section 1115 Demonstrations Could Increase Federal Expenditures

Some states with approved section 1115 waivers could be eligible for more federal Medicaid funds than they might have received without the waivers. Some states have proposed ambitious coverage expansions, which, through the waivers, would be financed in part by the Medicaid program. While estimating the demonstration projects’ potential impact on federal spending is difficult, the administration’s approval of the waivers as budget neutral depends on a number of critical assumptions that could be subject to challenge. Furthermore, it is not clear that the administration’s rationale for defining budget neutrality in the approved statewide waivers is consistent across all waivers.

We have been evaluating the budget neutrality of approved waivers using a consistent framework that compares approved budgets with a benchmark using current services budgeting concepts. While more extensive analysis is in progress, it appears that one of the four waivers we analyzed may be budget neutral, but three others may not be if fully implemented by the states. In Tennessee, our analysis indicates that federal spending on the Medicaid demonstration program could be lower over the life of the waiver, compared with what might have been spent without the waiver. However, the demonstration programs in Hawaii, Florida, and Oregon may increase federal spending on Medicaid acute care. Because the waiver agreements only specify ceilings on federal spending, the total amount of new federal dollars that could be required by the demonstrations depends upon several factors, including future action by the states. For example, federal spending for Florida will depend, partly, upon how many of the planned maximum 1,100,000 newly eligible individuals that state will actually cover.

The potential net spending impact associated with the four state waivers we analyzed, while it could amount to hundreds of millions of additional federal dollars, is small relative to overall federal Medicaid spending. However, the impact of the section 1115 demonstrations could increase substantially if the waivers pending or proposed by several additional states—or even a few large states—are not budget neutral.

Budget Neutrality Redefined

Since the early 1980s, the administration has required that federal spending on a state’s section 1115 demonstration project be budget neutral—that is, federal expenditures may not exceed what would have been spent without the waiver. This budget-neutrality policy is still in force. Since 1993, however, the administration has applied the financial test in such a way as to allow states more flexibility in showing that their proposed projects would be budget neutral.

Projecting future spending for the current program is a critical element in determining budget neutrality since this amount represents the baseline against which spending for the demonstration project is compared. The two key steps in developing projections for the current program are estimating (1) base, or initial-year, spending and (2) future annual increases. From a state’s perspective, higher base costs or higher annual increases make it easier to claim budget neutrality. That is, a higher baseline makes it possible for planned spending to increase while still meeting the definition of budget neutrality. States have used one or both of the following arguments to secure access to increased federal funds while complying with the current budget-neutrality policy.

Hypothetical Expansion Argument. Four states—Hawaii, Rhode Island, Kentucky, and Ohio—successfully argued that their baselines should include the cost of extending coverage to optional eligibility groups that could have been, but were not then, served by the state’s Medicaid program. These hypothetical expansions primarily covered women and children (but may also include elderly and disabled individuals), whose coverage was optional. Although in Hawaii many of these individuals received limited benefits under one of two state-funded programs, these groups were not served at all in the Medicaid programs. The states argued that since they could have submitted a state plan amendment and thus received federal medical assistance payments for providing health services to these groups, an equivalent amount of federal funding for the Medicaid demonstration project, which would include them, should be considered budget neutral. Including the section 1902(r)(2) population increased Hawaii’s baseline by about $58 million over 5 years. Although the Kentucky legislature suspended implementation of the state’s waiver, inclusion of the section 1902(r)(2) populations that included the elderly and disabled with incomes up to the federal poverty level would have added about $524 million to the baseline over 5 years.

Historical Inflation Argument. The administration allowed some states to project increases in their baseline costs at rates higher than the administration’s existing projections of national Medicaid spending growth. These states successfully argued that past years’ spending increases exceeded average national spending growth and thus justified a higher or faster growing baseline. For example, in the first year of their waivers, Florida and Tennessee received relatively large increases (about 16 percent) compared with the previous year. Florida also received large annual increases for the remaining years of the waiver.

Because Medicaid costs in the late 1980s and the early 1990s grew for reasons not expected to affect future spending, estimates of future Medicaid expenditures that rely on historical cost growth may be inflated. For example, although the states’ use of provider taxes and donations contributed to the rapid rise of DSH payments between 1989 and 1993, recent legislation strictly limits DSH growth. Also, some of the past cost increases were due to the absorption of mandated and optional populations and changes in benefits. Major new mandates have not been added since 1991 and are not likely to be added in the foreseeable future. Furthermore, continued rapid Medicaid cost increases may have been unsustainable because of the great strain they placed on state budgets. Facing rapid cost increases, states would have increased incentive to adopt cost-containment measures. For example, Tennessee officials said the state would have faced massive health care coverage reductions had the waiver not been approved. In another example, after refusing to approve the waiver, the Kentucky legislature reduced physician reimbursements by $50 million.

Another part of the policy change since 1993 is to allow demonstrations to show budget neutrality over the life of the waiver, but not to require it year by year. HCFA agreed that states’ demonstration projects may involve temporary start-up costs and permitted increased federal funding to help pay these initial costs, as long as states expected to offset these costs by reduced federal funding in later years. Oregon, and perhaps some of the other states with waivers approved since 1993, expect that lower Medicaid cost growth in later years will compensate the federal government for higher expenses in the early years of the demonstrations.

Partial Caps May Limit Federal Liability While Heightening State Risk

Each of the waiver agreements ensures some limits on federal spending and holds some financial risk for the states. Because of the bilateral nature of the negotiations between the states and HHS, and because of the discretion granted to the Secretary of HHS in approving the waivers, the terms and conditions for each state are unique. Thus, the net effect on federal spending resulting from the waiver states’ Medicaid programs after the 5-year life of the demonstrations may be different for each state. Under any of the negotiated waivers, however, states are not to receive federal assistance in paying for costs above the agreed-upon limits.

Hawaii, Kentucky, Ohio, Oregon, and Rhode Island have agreed to federal spending limits called per capita caps, which are based on Medicaid spending per person. As shown in table 4.1, these caps allow per person spending to increase by a fixed percentage (plus the percentage change in medical prices in Hawaii and Kentucky). Thus, if the number of eligibles rises or, in Hawaii and Kentucky, if medical prices increase, the states can obtain additional funding. However, if spending rises because of greater utilization of services or a change in the mix of services provided, the states are financially liable.

Under the waiver agreements for Tennessee and Florida, “aggregate caps,” or limits on total spending, limit the federal government’s financial exposure. In Tennessee, the state and the federal government agreed to set a maximum for federal funding for each year of the waiver. Under these terms, spending for Tennessee’s Medicaid program may increase from $2.7 billion in 1993 to $4.1 billion in 1998. Florida and the federal government also set a maximum for annual federal Medicaid funding. Unlike Tennessee’s agreement, however, federal spending can exceed the specified amounts if the number of traditional Medicaid beneficiaries exceeds the projected number by more than 3 percent. This means the state’s financial risk is limited if the Medicaid rolls swell because of an economic downturn, for example. The two caps also differ in that Tennessee’s covers long-term care expenditures, while Florida’s does not.

Some states may find funding their planned expansions difficult. Hawaii is experiencing financial problems largely because more new eligibles enrolled than expected. Oregon may also face difficulty, due in part to higher than anticipated enrollment of new eligibles and the continuing effects of a tax initiative passed in 1990 that limits state funds available for Medicaid and other programs. Oregon is considering reducing the capitation rate, changing eligibility rules, implementing premiums and copayments, delaying full implementation of mental health services, and reducing benefits, but will need HCFA approval before doing so. Moreover, a state analysis suggests the program will not be budget neutral without the cost savings anticipated from an employer mandate, for which the state must obtain congressional action. Even with the necessary congressional action, however, state political support for the mandate has eroded because of business opposition and changes in the makeup of the state legislature.

The impact of higher than anticipated costs on federal funding depends on the specific waiver agreement and HCFA’s enforcement. In Florida’s case, HCFA would help pay for the increased costs over the life of the waiver, but expects to get paid back for the excess costs at the end of the 5-year project. Ohio’s agreement is similar to Florida’s, except that it specifies cumulative cost overrun ceilings. If Ohio’s cumulative spending exceeds the ceiling, the state must submit a corrective action plan. In Tennessee, the budget-neutrality agreement has a formula to prevent federal expenditures from exceeding the yearly cap by more than a specified percentage. Tennessee has agreed to take steps such as limiting enrollment when this happens.

The total amount of federal funding required for the demonstrations also depends, in part, on how HCFA defines and enforces its methodology for determining the federal expenditure cap in states with per capita limits. For example, even though the Oregon demonstration has been operating for more than a year, HCFA and the state have yet to agree on a specific methodology. The difference between two possible methods for calculating the upper limit on federal spending amounts to more than 5 percent of the state’s Medicaid demonstration budget.

Observations on Medicaid’s Future

Millions of Americans—not only poor mothers and children, but also poor elderly, blind, and disabled individuals—depend upon health care made possible by the Medicaid program. Medicaid pays for both acute care and long-term care services. The program underwrites the deliveries of about one-third of the babies born in the United States each year and finances about 50 cents of every dollar paid to nursing homes.

Medicaid is an expensive program. It currently consumes about 6 percent of all federal outlays (3 times the share devoted to Food Stamps and 5 times the share devoted to AFDC). Moreover, Medicaid’s slice of the federal budget is growing faster than most other major budget items, including Medicare. If Medicaid continues indefinitely at its forecast growth rate (10.7 percent), federal spending on the program will double roughly every 5 to 7 years.

Success in containing cost growth in Medicaid, as for the health care sector at large, has been elusive. Care for the elderly, blind, and disabled populations—particularly long-term care—is expensive, consuming more than $80 billion of the $130 billion cost of Medicaid in 1993. For acute care services, however, the promise of lower utilization has made the capitated payment features of managed care plans attractive to the states.

Federal restrictions on the use of managed care reflect concerns for quality, because capitated payments allow profits to be earned from underservice. For example, the 75-25 rule seeks to ensure that Medicaid managed care plans are of sufficient quality, as demonstrated by their ability to attract private enrollees. At the same time, states believe that restrictions like this hamper their efforts to implement managed care effectively and that the need to obtain section 1115 waiver approval poses unnecessary obstacles. Requiring states to seek waivers before implementing these health care delivery system reforms may be burdensome, especially if alternatives for addressing quality of care concerns exist. Nonetheless, continuous oversight of managed care systems is required to protect Medicaid beneficiaries from inappropriate denial of care and federal dollars from payment abuses.

Section 1115 waivers, while freeing states to implement managed care cost-containment strategies, could in the long run undermine efforts to contain federal expenditures. Our study of the section 1115 waivers approved to date raises the following concerns:

The administration is allowing states to apply the federal share of Medicaid savings from managed care to finance coverage of additional populations not included under Medicaid law. To meet the budget-neutrality terms of section 1115 waivers, the administration and states assume that the enrollment of the Medicaid populations in HMOs will save states enough money to cover additional low-income people in the state at no extra cost to the federal government. Even if the proposed demonstrations will not require new federal dollars, the administration’s approval of coverage expansions means that anticipated Medicaid cost savings (from more aggressive use of capitated care) will not be used to reduce federal spending. At issue is whether the federal treasury should benefit from these savings. Also of concern is whether eligibility should be made available for new groups only after congressional debate and legislative action.

The administration’s method for determining budget neutrality may allow states access to more federal funding than they would have received without the waiver. Our initial examination of four states’ proposed demonstrations suggests that claims of budget neutrality for these states may not be sustainable in all cases. While Tennessee’s demonstration project may be budget neutral, the demonstrations in Florida, Hawaii, and Oregon may require increased financial commitment from the federal government. Relative to overall federal Medicaid spending, the amount spent in states with approved section 1115 waivers is small. However, the methods used by the administration to assess the budget neutrality of pending and future waiver proposals may greatly affect federal Medicaid spending in the years to come.

The Congress may find it difficult to scale back section 1115 demonstrations if they prove more costly than forecast. A demonstration waiver, granted for a limited period of time, may be a shortsighted approach to reducing states’ uninsured populations. If at the end of 5 years the demonstrations have cost much more than estimated, the Congress may face the choice of increasing federal funding or relying on the states to reduce benefits or deny coverage to hundreds of thousands of people newly enrolled under the waivers.

For these reasons, we believe that the granting of additional section 1115 waivers merits close scrutiny.

Agency Comments and Our Evaluation

The administration’s comments focused on two aspects of this report: waiver review policy changes and our approach to analyzing the budget neutrality of approved statewide section 1115 waivers, with which it disagreed. In brief, our approach begins with a uniform and consistent budget “neutrality” benchmark—OMB’s current services projections of future Medicaid growth—for assessing the potential budget impact of waivers. The administration contends that by using OMB’s national estimate of projected Medicaid spending growth, we do not accurately capture the variation in state spending patterns. Moreover, it maintains that current services is an inappropriate tool for establishing budget neutrality.

Changes in Waiver Review Policy

The administration’s response notes that its approach both to reviewing waivers and to determining budget neutrality represents a departure from previous administrations’ policies. Overall, it characterized its new approach as “more flexible.”

Although budget neutrality is not specifically defined by regulation or statute, the administration’s new approach is characterized by (1) flexibility in determining appropriate baseline expenditures and (2) assessment of budget neutrality over the life of the waiver rather than year by year. Our analysis recognizes these key differences. In fact, we conclude that the administration’s new approach represents a redefinition of budget neutrality.

The Administration’s Budget-Neutrality Methodology

The administration characterizes its budget-neutrality policy as “state-specific,” reflecting the historically “dramatic variation in state Medicaid programs.” These variations, the administration notes, have resulted in “radically different levels of expenditures and growth rates across the states.” Lacking a state-specific Medicaid baseline, the administration compares its national estimate of growth in Medicaid for the nation as a whole with state historical expenditure growth in determining a budget-neutrality benchmark.

Furthermore, the administration points out that it relies on current federal law in establishing a state-specific neutrality benchmark. It notes that “under current federal law states are able to engage in program expansions and contractions” and that, in establishing a state-specific budget-neutrality baseline, some judgment about states’ behavior should be involved.

Our discussion of the administration’s approach to budget neutrality recognizes the state-specific nature of its methodology. Thus, in chapter 4, we indicate that the waiver funding agreements for Florida and Tennessee were based on an analysis of large annual growth rates over the past 5 years. We conclude, however, that some of the factors underlying Medicaid’s very rapid and recent cost growth will be much less significant in the future and that relying on historical cost growth is inappropriate. For example, a major cause of Medicaid’s rapid growth in the past—DSH payments—has been strictly limited by 1991 and 1993 legislation. In addition, major new mandatory coverage expansions are not likely to be undertaken in the foreseeable future.

Demonstration Nature of the Section 1115 Waivers

The administration disputes our contention that the comprehensive scope of the waiver demonstrations makes it controversial to characterize them as experimental. It notes that the waivers allow states to experiment with innovative delivery and payments systems for their Medicaid and low-income populations and that each demonstration has unique components deemed worthy of evaluation. We view the sheer magnitude of some of the waiver projects as what makes it difficult to consider them experimental. Once coverage has been extended to several hundred thousand people, we anticipate significant difficulty in terminating a demonstration if the innovations being tested fail to achieve the intended objectives.

Key Areas of Disagreement

As suggested by the administration, in our initial analysis we have applied a more rigid method for assessing budget neutrality. We take a more uniform base—previous-year spending—and allow it to grow at the rate of increase expected by OMB for the national program. Because we recognize the significant differences in state Medicaid programs’ experiences, our preference would have been to use consistently generated state forecasts of expected Medicaid spending. However, neither OMB nor the Congressional Budget Office has developed such forecasts. We believe that using states’ historical experiences without adjustments may not be a good guide for the future. In our ongoing work, we are examining state-specific information to determine what adjustments to the national forecasts might be appropriate.

In contrast to our efforts to develop a consistent methodology, the administration’s budget-neutrality assessments appear not to be consistent. Thus, in some states, aggregate spending trends over the past 5 years appear to have been the dominant factor used to project budget-neutral spending over the next 5 years. In other states, trends in average costs per person were the major factor used to define budget-neutral trends over the life of the waiver. By using unique methods in each state, the administration has created the potential for budget-neutrality decisions to be based on the technique most favorable to a particular state. We continue to believe that a consistent approach is more appropriate for budget purposes.

If state-specific reasons exist for future Medicaid program growth above (or below) national standards, they should be well documented. However, in reviewing state waiver submissions, no special factors were identified that would justify future growth above a national benchmark.

Finally, the administration suggests that a current law baseline is more appropriate than a current services baseline in assessing budget neutrality. That is, the budget-neutrality assessment should be based on “what states might do” under current law rather than “what states are doing.” However, the administration also notes that the President’s budget does not distinguish between current services and current law. Although current law gives states the latitude to expand coverage to optional populations, not all states have chosen to do so. We continue to believe that “what states are doing” should be the basis for determining budget neutrality.

The complete text of the administration’s comments is in appendix IV.