Medicaid operates as a joint federal-state program to finance health care coverage for certain categories of low-income individuals, over 11 million of whom are elderly or disabled. In total, Medicaid cost almost $258 billion in fiscal year 2002, and the Congressional Budget Office (CBO) projects that fiscal year 2003 spending will double by 2012. Today, Medicaid ranks as the third largest mandatory spending program in the federal budget and represents the largest source of federal funds to the states, accounting for 41 percent of all federal outlays for grants to states and local governments in fiscal year 2001. In terms of overall state expenditures, outlays for Medicaid rank second only to elementary and secondary education, accounting for an estimated 15 percent of general fund expenditures in state fiscal year 2002. Within broad federal guidelines, states have considerable flexibility in how they administer their Medicaid programs. The federal statute requires state programs to cover certain services and populations, such as nursing home services for qualifying elderly and for disabled individuals aged 21 and over. Each state determines what medical services to cover, establishes eligibility requirements, sets provider payment rates, and develops its own administrative structure. As a result, Medicaid essentially operates as 56 separate programs: 1 in each of the 50 states, the District of Columbia, Puerto Rico, and each of the U.S. territories. Nursing homes care for people with a wide range of clinical conditions and provide a variety of services, including basic custodial care, medical social services, skilled nursing care, and rehabilitative therapies. Medicaid is the single largest funding source for nursing home services, providing about one-half of total expenditures for these services in 2003. Medicaid supports the care of an even larger share of nursing home residents, paying at least in part for the services provided to approximately two in three residents nationwide. Federal requirements regarding states’ methods for reimbursing nursing homes for the services they provide to Medicaid residents have changed over time. A 1972 amendment to the Social Security Act required that states reimburse nursing homes on a reasonable cost-related basis. Under this requirement, states developed methods to identify nursing homes’ reasonable costs as well as set rates based on these costs, both of which were subject to federal verification and approval. Nursing home providers filed a number of federal lawsuits contesting the adequacy of states’ payment rates. In 1980, Congress passed legislation, commonly referred to as the Boren Amendment, which provided that Medicaid payment rates for nursing homes had to be “reasonable and adequate to meet the costs which must be incurred by efficiently and economically operated facilities.” The Boren Amendment also transferred responsibility for verifying that rates complied with these standards from the federal government to states; however, it did not grant states unlimited discretion in developing payment rates. The 1980 Conference Report that accompanied the Boren Amendment stated that rates should not be developed “solely on the basis of budgetary appropriations” and required states to submit annual assurances to the Secretary of Health and Human Services that rates complied with Boren regulations. The Conference Report also clarified that while the Boren Amendment was intended to give states discretion to develop the methods and standards on which payment rates would be based, the federal government retained final authority in approving states’ rates. During the roughly 17 years following the enactment of the Boren Amendment, providers in many states filed suits alleging that Medicaid payment rates were not sufficient and therefore violated federal requirements that rates be reasonable and adequate to cover the costs of efficiently and economically operated nursing homes. In 1990, the Supreme Court found that the amendment imposed a binding obligation on states to adopt reasonable and adequate payment rates and held that providers could sue to enforce this obligation and challenge Medicaid payment rates in federal court. After this decision, nursing home providers continued to rely on the courts to review payment rates they considered insufficient and verify that these rates complied with federal payment standards. The Balanced Budget Act of 1997 (BBA) repealed the Boren Amendment, providing states with increased flexibility to develop approaches to pay nursing homes that participate in Medicaid. States are no longer required to submit annual rate findings to the federal government but instead must develop and implement a public process for determining rates, which requires that states publish all proposed and final rates—including their methodologies and justifications—and ensure that providers, beneficiaries, and their representatives are given reasonable opportunity to review and comment on rates. Additionally, states must continue to ensure that payments are consistent with efficiency, economy, and quality of care standards. In 2003, states faced their third consecutive year of fiscal pressure, with revenue collections again falling short of planned expenditures. A June 2003 survey conducted by NASBO and the National Governors Association (NGA) found that 30 states collected less revenue in fiscal year 2003 than they planned for in their budgets, with sales tax collections 2.5 percent lower than originally budgeted and personal and corporate income tax collections 8.6 percent and 8.3 percent lower than expected, respectively. According to an April 2003 survey conducted by the National Conference of State Legislatures (NCSL), 39 states and the District of Columbia faced budget shortfalls at some point during fiscal year 2003, totaling over $29 billion. At the same time states have experienced shortfalls in their expected revenue collections, they have also experienced significant growth in Medicaid expenditures. According to CMS, the state and local share of Medicaid spending grew almost 14 percent in fiscal year 2002 and is projected to grow almost 10 percent in 2003. In their June 2003 survey, NASBO and NGA reported that 25 states experienced Medicaid budget shortfalls in state fiscal year 2002, and 28 states reported these shortfalls in 2003. Fiscal pressures have compelled states to confront difficult choices, especially because 49 states and the District of Columbia are required to balance their budgets. Recognizing that the Medicaid program represents a large component of many states’ budgets, virtually all states have implemented or planned new cost-containment measures in order to control Medicaid spending growth in 2003, according to another recent state survey. For example, 45 states reported that they planned to reduce spending on prescription drugs, which is an optional benefit, during fiscal year 2003. In addition, benefit reductions, such as limits for vision care and dental services, and changes to eligibility requirements, such as a lowered income threshold for Medicaid program eligibility, were additional cost- containment measures used or proposed by states. In May 2003, Congress passed the Jobs and Growth Tax Relief Reconciliation Act, which included $20 billion in fiscal relief to state and local governments. Of these funds, $10 billion is earmarked for Medicaid, providing temporary enhancements to the federal share of Medicaid funding through June 2004 to help states maintain Medicaid services and eligibility. The remaining $10 billion in fiscal relief is divided among the states based on population and can be used to assist states in providing government services. Recognizing the importance of spending Medicaid dollars effectively, the 19 states we reviewed have designed methods to develop nursing home payment rates that include incentives for homes to deliver care efficiently, operate economically, and concentrate resources on direct resident care. While nursing home payment rates in most of these states are related to individual homes’ costs of delivering needed services, most states also limit payment for certain types of costs and many provide additional payments for direct resident care. Most of these states also regularly adjust rates to reflect changes in homes’ costs or in the care needs of the residents that homes serve. Table 1 provides an overview of various payment features used by the 19 states we reviewed as of September 2003. These features will be discussed below in greater detail. Because states pursue different strategies to meet their various objectives, methods to determine rates differ considerably among states. However, over half of the states we reviewed include at least five such features in their payment methods, with states most commonly using payment ceilings and annual rate updates. All 19 states we reviewed base the per diem, or daily, rate they pay to nursing homes on costs, as reported in cost reports. While 4 states— California, Massachusetts, Oregon, and Texas—use the average or median costs of all homes to pay the same, flat rate, with some adjustments, to all homes or homes within a specified group, the remaining 15 states compute a rate for each home based on the individual home’s costs. States that pay home-specific rates attempt to make more effective use of their resources for nursing homes. They avoid paying lower-cost homes rates significantly in excess of their costs, which can occur when rates are based on the average or median costs across homes. In addition, by not making such excess payments to lower-cost homes, states with home-specific rates can use the same overall budget to pay more higher-cost homes rates that are closer to their costs. States design their payment methods to encourage nursing homes to deliver care efficiently and economically. For example, all 19 states develop their payment rates prospectively, or prior to the time during which the rates apply, using historical cost reports. Prospective rates encourage nursing homes to operate efficiently and incur only necessary costs. Homes that deliver care for less than the payment amount profit; conversely, providers experience losses if costs are higher than the payment rate. Seven of the states we reviewed use explicit efficiency incentives to further encourage homes to minimize spending by providing them with additional payment if they keep their spending below a certain amount. For example, Connecticut nursing homes with indirect care or administrative costs below the median of all homes’ costs in these categories have up to 25 percent of this difference incorporated into their per diem rates. (See app. II for more detail on how states develop nursing home payment rates.) To further encourage homes to operate efficiently, the 15 of the 19 states that pay home-specific rates place ceilings, or limits, on the costs that are reflected in their nursing home payment rates.27, 28 These ceilings encourage homes to control spending as they will not be reimbursed for costs that exceed these ceilings. Since the majority of homes have demonstrated that they can provide care at costs below the ceiling, states may regard costs above the ceiling as excessive. In addition to imposing ceilings, many states use other mechanisms to limit the costs that they recognize when determining homes’ per diem rates. While in some cases these mechanisms may also encourage efficiency, in other cases they may result in fewer homes receiving their full costs than what the ceiling levels indicate. For example, regardless of increasing nursing home costs, Colorado limits the annual increase in administrative costs it recognizes to 6 percent, while South Dakota allows no more than an 8 percent annual increase in overall payment rates. In addition, although Rhode Island and North Dakota rebase their per diem rates regularly, they do not rebase cost-center ceilings as frequently. For example, Rhode Island inflates cost-center ceilings annually instead of rebasing them, and North Dakota rebases ceilings every 3 years on average, inflating them during the interim years. (See app. II for descriptions of additional limits states place on nursing home payments.) The ceiling is typically based on a percentage of the median costs, or a certain percentile of costs, for all homes in the state or within a category of homes. Individual homes’ rates are typically determined by the lower of their own costs or the ceiling. In the four states that generally pay a flat rate to all homes or to all homes in a group, the flat rate also promotes efficiency since homes with costs below the rate are able to retain the difference. have similar labor markets and associated wage costs or homes of comparable size (i.e., homes with a large or small number of beds) that should operate at similar levels of efficiency. For example, since costs per day may vary by geographic location—such as urban versus rural areas— establishing peer groups by location allows states to set higher ceilings for homes in the more costly areas. Peer groups may be unnecessary in states with ceilings that are set well above the median costs and where most homes have costs below the ceilings or in states where wages vary little across areas. Despite the various ways states encourage nursing home efficiency, industry representatives and industry-sponsored studies nonetheless raise concerns that Medicaid payments do not cover the full costs of all nursing homes. For example, a 2002 industry-sponsored study reported that nursing home costs for Medicaid-covered residents in 2000 exceeded Medicaid payment rates an average of $10 per resident day in the 37 states included in the study. In addition, industry representatives in 7 of the states we reviewed expressed concern that state payment methods do not adequately account for increases in certain costs, such as liability insurance or direct resident care staff wages and benefits. However, by incorporating certain features, such as ceilings, into their nursing home payment methods, states have intentionally designed their payment methods so that not all homes receive their full costs and so that lower- cost homes, which are more likely to be efficient and economical, have payment rates nearer to their costs. Through the design of their payment methods, states generally seek to encourage nursing home spending on direct resident care. All 19 states we reviewed divide nursing home costs into categories, or cost centers, with common categories being direct resident care, indirect care, administrative, and capital (see table 2). By varying their payment policies for each category, most states seek to target more of their funds to direct resident care. How states establish ceilings or efficiency incentives for each cost center may encourage nursing homes to spend more money on direct resident care than other areas. In nine of the states we reviewed that pay home- specific rates, the direct resident care ceiling is higher than the administrative ceiling, thus allowing a higher proportion of homes to have their payments based on their total direct resident care costs than is the case for their administrative costs. For example, for all homes within each peer group in Connecticut, the direct resident care ceiling is set at 135 percent of the median direct resident care costs while the administrative ceiling is set at 100 percent of the median administrative costs. In addition, five of the seven states with efficiency incentives that reward homes for spending less do not apply them to direct resident care costs, thereby minimizing the incentive for homes to restrict spending in this area. Further, nine of the states we reviewed used add-on payments to reimburse wages or other expenses for staff who provide direct resident care or to promote the provision of high-quality direct resident care. For example, in 2000, Massachusetts began providing an add-on payment to nursing homes for certified nursing assistants (CNA), who assist residents with activities such as bathing and eating. This add-on is based on CNA salaries and Medicaid nursing home utilization. Because homes often use add-on payments to increase their spending on direct resident care, these payments may lead to higher costs on homes’ cost reports and therefore could result in higher future per diem rates. To reflect changes in nursing homes’ costs, 17 of the 19 states we reviewed regularly calculate new payment rates or adjust existing rates for inflation. To rebase, or calculate new rates, states generally use costs as reported in nursing homes’ most recent cost reports that reflect inflation or other cost changes such as those due to more expensive technologies, a different staff mix, or changing direct resident care needs. Nine of the 19 states we reviewed rebase rates annually, and 8 states rebase homes’ rates every 2 to 4 years. The 2 remaining states, however, rebase infrequently, if ever; Illinois has only rebased rates once in the past 9 years, and New York has not fully rebased homes’ rates since 1986. Most states we reviewed also apply a standard inflation factor, such as the Consumer Price Index (CPI) or the SNF market basket index, to adjust rates during years they do not rebase or to reflect inflation between the midpoint of the cost report year and the midpoint of the year when the rates will be paid, a period that generally ranges from 18 to 36 months. However, Illinois has not consistently updated rates for inflation during non-rebase years since 1994, and Iowa’s new nursing home payment method, which was fully implemented on July 1, 2003, does not have a provision for adjusting rates during non-rebase years. In addition, rather than using a standard inflation factor, Connecticut and Illinois use legislatively determined amounts to update rates when they do not rebase. These amounts vary from year to year and are influenced by budget availability. Instead of paying rates that are based on the costs required to care for a nursing home’s residents during the cost reporting period, 12 of the 19 states we reviewed use case-mix systems to tie payment to the costs associated with a home’s current resident care needs. Using a variety of methods, states classify homes’ residents by the level of care they require and adjust payment rates to reflect the costs associated with treating current residents with different levels of need. While the rate adjustment occurs with varying frequency, most states adjust rates for case-mix two to four times a year. Adjusting rates for case-mix may encourage homes to accept residents who require more expensive care, and it also provides states with a tool to compare more appropriately homes’ costs and to not penalize homes that have higher costs due to a more costly mix of residents. In addition, case- mix adjusted rates particularly help target payments in states that otherwise pay the same, flat rate. Three of the four flat-rate states we reviewed make case-mix adjustments to the rates so payments more closely approximate the costs likely incurred by individual homes for treating residents. Recent state fiscal pressures have not resulted in widespread reductions in Medicaid payment rates to nursing homes in most states we reviewed, although all of these states modified how they pay nursing homes from fiscal years 1998 through 2004. While in some cases modifications to payment methods have clearly increased or decreased payment rates, in other instances the effect of these modifications on payment rates for individual homes is mixed. Further, in nearly three-quarters of the states we reviewed, nursing home per diem rates grew, on average, by an amount that exceeded the SNF market basket index for state fiscal years 2001 through 2003, similar to the years immediately following the repeal of the Boren Amendment. To avoid making significant changes to nursing homes’ payment rates, many states reported that they relied on existing resources, such as budget stabilization funds and tax increases, to generate additional funding. Other factors have also influenced the nature and extent of states’ changes to nursing home payment rates. Even with recent temporary federal fiscal relief, however, officials in some states suggest that nursing home payment reductions are possible in the future. Over the past several years, the states we reviewed have faced increasing budget pressures, and all reported experiencing fiscal pressure in fiscal year 2003. These budget pressures followed consecutive years of significant economic growth in many states. For example, through state fiscal year 2000, Connecticut experienced 10 years of budget surpluses; however, in state fiscal year 2001 the surpluses ended, and the state’s deficit was over $800 million. Also, in 2001, Massachusetts began experiencing increased fiscal pressures mainly because of decreased tax revenues and lower capital gains. Irrespective of shifting fiscal pressures experienced by these states, their modifications to nursing home payment methods have not resulted in widespread payment reductions to nursing homes from fiscal years 1998 through 2004. During this time, all 19 states we reviewed either modified components of their payment methods, such as changing cost-center ceilings or implementing case-mix systems, or created new payment methods, as was the case in Arkansas and Iowa. However, the extent to which states changed specific features of their payment methods generally remained constant during this time, with varying effects on payment rates to individual homes within states. (See app. III for a list of selected state changes.) In addition, despite each of the 19 states experiencing recent fiscal pressure, only 4 states—Illinois, Massachusetts, Michigan, and Texas— explicitly cut the per diem rates paid to all nursing homes at some point during state fiscal years 1998 through 2004, and the rate reduction was for less than 1 year in 2 of these states. For example, for the 3-month period of March through May 2003, Massachusetts reduced payment rates to nursing homes by approximately 2.5 percent, but increased payment rates in June 2003 by about 6.3 percent. Similarly, Michigan reduced nursing home rates from January through September 2002 by approximately 1 percent. With the start of Michigan’s fiscal year 2003 (October 1, 2002), this reduction was lifted; however, facing budgetary constraints, the state again reduced nursing home payment rates from March 2003 through September 2003 by roughly 1.85 percent. While reductions in per diem rates were temporary in these 2 states, the reduction in per diem rates in Illinois and Texas were for longer periods of time. Illinois, for example, implemented an across-the-board 5.9 percent cut to existing rates to all Medicaid providers, including nursing homes, in July 2002, and froze payment rates at this reduced level for fiscal year 2004, which began on July 1, 2003. Similarly, in its 2004/2005 biennial budget, which began September 1, 2003, Texas reduced payment rates to Medicaid providers, with nursing home per diem rates being reduced by 1.75 percent from their fiscal year 2003 levels. In addition to these four states, Oregon froze Medicaid payment rates to nursing homes in fiscal year 2003 at fiscal year 2002 rates and extended this freeze at the beginning of fiscal year 2004. Beginning on July 1, 2003, Connecticut froze Medicaid payment rates to nursing homes at January 2003 levels and also reduced the level of payment increases granted to other Medicaid long-term care providers. The effect of states’ other modifications on payment methods varies. While some changes have obvious positive or negative effects on payment rates, the effect of other changes on payments to individual nursing homes is mixed. For example, New Jersey’s decreased ceiling for administrative and indirect care costs—from 105 to 100 percent of the median costs for all homes—and Michigan’s elimination of add-on payments for quality incentives and direct resident care staff wages likely lowered payment rates to some extent for some nursing homes. Conversely, payment to some nursing homes in New York and Vermont increased because of recently implemented add-on payments for direct resident care staff wages. Effects of other changes on nursing home payments, such as Colorado’s implementation of a case-mix system in 2000 or the addition of two counties to California’s Bay Area peer group in 2002, could either increase or decrease payment rates depending on the home. Although the effect that changes to payment methods have on rates for individual nursing homes may be mixed, average per diem rates in the states we reviewed generally have kept pace with increasing nursing home costs as measured by the SNF market basket index from state fiscal years 1998 through 2003. As figure 1 shows, from state fiscal years 2001 through 2003—a period during which all 19 states we reviewed were experiencing increased fiscal pressures—the average annual percentage change in states’ average per diem rates in 14 of the 19 states exceeded the SNF market basket index. This trend is similar to what occurred to rates during the years immediately following the repeal of the Boren Amendment—1998 through 2000—when states’ fiscal conditions were generally much more positive. In that earlier period, the average annual percentage change in states’ average per diem rates met or exceeded the SNF market basket index in 14 of these states, although the states that fell below the SNF market basket index differed somewhat between the two periods. From state fiscal years 2001 through 2003, the average annual change in per diem rates fell below the SNF market basket index in five states— California, Connecticut, Illinois, Massachusetts, and New York. The factors that contributed to per diem rates falling below this index varied among these states. For example, Illinois’ rate reduction in fiscal year 2003 of almost 6 percent contributed to the average rate change falling below the SNF market basket index. In addition, the lack of regular rebasing likely contributed to lower per diem rates in Illinois and New York. Illinois rebased rates only once from fiscal years 1994 through 2001, and as previously noted, New York has not fully rebased rates since 1986. In addition, industry officials in some states told us that the inflation factor used to update rates in non-rebase years is insufficient to meet nursing homes’ changing costs. For example, industry officials in New York said that the inflation factor the state uses to update homes’ rates annually, the CPI, does not reflect increasing health care costs. In addition, Connecticut—which rebases rates at least once every 2 to 4 years—uses a legislatively set inflation factor to increase rates in non-rebase years, which for the past several years has been limited to approximately 2 percent. Industry and Medicaid officials contend that this legislated amount, which has consistently fallen below the SNF market basket index, does not correspond with increases in actual nursing home costs. To help balance their budgets, states we reviewed have relied on alternative funding sources—including budget stabilization and tobacco settlement funds— and have enhanced revenue by increasing taxes (see table 3). Sixteen of the 19 states we reviewed reported using alternative funding sources, such as tobacco settlement, budget stabilization, cigarette tax increases, and Medicaid trust funds to deal with their states’ budgetary pressures. Most commonly, states relied on tobacco settlement funds to ease fiscal pressures. While many of the states we reviewed have employed alternative funding sources or cigarette tax increases, not all the states relied on these funds to cope with their budget situations. For instance, all 19 states received tobacco settlement funds, yet only 12 used these funds from 1998 through 2003 to respond to fiscal pressures. To help fund Medicaid nursing home payments in particular, several states rely on nursing home provider taxes, and in light of recent fiscal pressures, an increasing number of states have recently adopted or proposed these taxes in an effort to fund nursing home payments or to avert service reductions. Of the 19 states we reviewed, 8 currently have provider taxes for nursing homes, with at least 4 of these states implementing the tax since 2001, when fiscal pressures began increasing in many states. In addition, 5 of the states reviewed currently have pending for CMS’s approval a proposal to adopt a provider tax on nursing homes (see table 4). Of all types of providers, nursing homes were most commonly subject to new provider taxes in state fiscal years 2003 and 2004, according to a recent survey of all 50 states and the District of Columbia. Officials in some states told us that they have avoided making substantial reductions to nursing home payment rates because of other factors. For example, state legislative or regulatory action is typically required to change nursing home payment methods, and garnering sufficient support for such changes—especially for rate reductions—is often difficult. In addition, the nursing home industry has actively worked to avoid decreases in payment rates in several states. For example, industry officials in Alabama, Iowa, and Texas cited campaigns that they considered successful in various ways, such as preventing rate reductions or encouraging rate increases. Specifically, nursing home industry officials in Iowa said that two proposed nursing home rate cuts were defeated in part because of their opposition. Also, industry officials in Texas said that through their efforts, nursing homes were able to obtain rate increases for fiscal year 2002. Although the extent of states’ continued fiscal pressure is unknown, states expect their poor fiscal situations to continue through fiscal year 2004. According to an April 2003 NCSL study, 28 states and the District of Columbia expected budget shortfalls totaling over $53 billion in fiscal year 2004. These budget gaps may be difficult to fill as many states reported that they have depleted or nearly depleted their alternative funding sources. Over half of the states we reviewed that used budget stabilization funds, and 3 of the 12 states that used tobacco settlement funds, reported having depleted or nearly depleted these sources. Some states we reviewed reported their plans to confront continuing budget pressures in fiscal year 2004. As previously noted, at least six of these states reduced or froze their nursing home payment rates at some point during the past 2 fiscal years. In addition, these and other states have recently undertaken or are currently considering actions to reduce future nursing home payment rates. For example, California rebased nursing home rates for the 2004 rate year, which began on August 1, 2003, but has already frozen 2005 payment rates at current levels. Similarly, in August 2003, Connecticut froze per diem rates at their January 2003 levels through December 2004. Even with recent temporary federal fiscal relief, officials in some states suggest that nursing home payment reductions are possible in the future. For example, a Michigan state official indicated that reductions in 2004 per diem rates are probable because the legislative appropriation is likely insufficient to rebase rates. We provided a draft of this report to the Medicaid Director in each of the 19 study states for technical review. All states generally agreed with our characterization of their respective nursing home payment methods and, when necessary, provided clarifying or technical comments, which we incorporated as appropriate. In addition, we obtained oral comments on a draft of this report from representatives of two nursing home associations, the American Health Care Association (AHCA) and the American Association of Homes and Services for the Aging (AAHSA). We have modified the report, as appropriate, in response to their technical comments. As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days after its issue date. At that time, we will send copies to the Administrator of CMS and appropriate congressional committees. We will also make copies available to others upon request. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov. If you or your staffs have any questions, please contact me at (202) 512- 7118. An additional contact and other staff members who made contributions to this report are listed in appendix IV. To examine Medicaid nursing home payment methods and rates, we selected 20 states for our review. The 20 states included the following: 10 states (1 from each of the 10 Centers for Medicare & Medicaid Services (CMS) regions) with the largest decline or smallest growth in revenue from 2000 through 2002 within their regions, based on data in the November 2002 fiscal survey of states conducted by the National Association of State Budget Officers (NASBO) and the National Governors Association (NGA); 5 states with the largest population based on 2000 Census data; and 5 states with the highest number of Medicaid nursing home residents per capita, as indicated by the most recent data in CMS’s Online Survey Certification and Reporting (OSCAR) database (see table 5). Nationwide, these 20 states represented approximately 62 percent of Medicaid nursing home expenditures in fiscal year 2001 and 59 percent of Medicaid nursing home residents in fiscal year 2000, according to the most recently available CMS data. In each of the 20 states, we interviewed officials from the Medicaid and budget offices. From these officials, we obtained information about nursing home payment methods (including changes) for state fiscal years 1998 through 2004 and per diem rates for state fiscal years 1998 through 2003. In addition, to gain a broader understanding of Medicaid nursing home payments, we interviewed representatives from the offices of the American Health Care Association (AHCA) and/or the American Association of Homes and Services for the Aging (AAHSA) in each of the 20 states. We also interviewed national representatives of AHCA and AAHSA and consultants and experts in the field of Medicaid nursing home payment. Because Arizona’s Medicaid program is predominantly a managed care system, the state determines payment rates for only 5 percent of the nursing home population. Therefore, this report excludes Arizona and presents our findings from analyses of the other 19 states. To examine the extent to which states base nursing home payment rates on homes’ costs, we reviewed documentation, including some state laws and regulations. Relying on these documents as well as our interviews with state officials, we also identified key features of payment methods, such as whether rates are home-specific and how frequently states update or rebase the rates they pay nursing homes. In addition, we summarized the extent to which states’ payment methods incorporate features such as peer grouping, cost-center ceilings, and case-mix adjustment systems. To determine how state fiscal pressures have affected Medicaid programs with regard to nursing home payment rates and methods, we collected per diem rates from state fiscal years 1998 through 2003, fiscal year 2003 being the most current year for which per diem rates were available, and information about changes made to nursing home payment methods from state fiscal years 1998 through 2004. We used the per diem rate data to compare the average annual percentage change in states’ average nursing home payment rates from state fiscal years 1998 through 2003 to the corresponding years’ change in the skilled nursing facility (SNF) market basket index. The SNF market basket index, which is developed and updated annually by Global Insights, Inc., is used by CMS to reflect changes in the prices of goods and services included in the Medicare SNF prospective payment system. States typically provided us with their average Medicaid nursing home per diem rates weighted by resident days; however, in a few instances we had to use a state’s home-specific rates and resident days to calculate the weighted average per diem rate. For 2003, an average per diem rate was not available in Michigan, and projected per diem rates were provided by Arkansas and Pennsylvania. We encountered limitations with data provided by two other states. For example, North Dakota law generally prohibits nursing homes from charging private-pay residents more than the Medicaid rate; however, rates provided to us by the state were based on total resident days, which include payments for 3 to 5 percent of residents whose care is paid at typically higher Medicare rates. Therefore, the rates provided to us may be slightly higher than the average Medicaid rate. Conversely, the rates provided by Pennsylvania may be slightly lower than the actual average nursing home Medicaid rate because they include nursing homes residents’ temporary hospital stays, which account for approximately 1 percent of total resident days and for which homes only receive one-third of the per diem rate. Finally, we reviewed information compiled by NASBO, NGA, and NCSL related to states’ fiscal outlook and possible future reductions in the Medicaid program, including reductions affecting nursing homes. States use many of the same features within their payment methods. We describe below certain features of the payment methods used in the states we reviewed: peer groups, cost-center ceilings, efficiency incentives, case- mix systems, and occupancy standards. Ten states we reviewed classify homes into peer groups, or categories based on characteristics such as size or location, and typically set separate cost-center ceilings for each peer group. The states we reviewed most commonly categorize nursing homes by geographic region or home type. However, how states use peer groups varies (see table 6). For example, some states, such as New Jersey, use peer groups within all cost centers, while other states, such as Alabama, only group homes in one cost center. Further, states differ in the number and type of peer grouping categories they use. For example, Illinois’s peer grouping uses seven geographic regions in all cost centers; Connecticut bases its peer grouping on two geographic regions and two home types in the direct resident care cost center; and Florida’s peer grouping is based on three geographic regions and two home sizes in both the direct resident care and administrative cost centers. To limit the maximum amount states pay for costs within a given cost center, ceilings are typically set at a percentage of median costs, or a certain percentile of costs, for all nursing homes in a state or a subset of nursing homes with similar characteristics in states that pay home-specific rates. Homes in these states generally receive rates based on the lower of their actual costs or the ceiling. While most states we reviewed divide their operating costs into three centers—direct resident care, indirect care, and administration—plus a center for capital costs—the number of cost centers in the states we reviewed ranges from two in Oregon to seven in Rhode Island. In addition, states differ in how they categorize costs. For example, 8 states combine indirect care and administrative costs into a single cost center. Similarly, states may differ in how they categorize certain costs. For instance, Pennsylvania’s direct resident care center includes medical supplies, which are considered indirect costs in Connecticut and Rhode Island. Table 7 describes ceilings for operating costs in the 15 states that pay individual/home-specific rates, and table 8 describes how the remaining 4 states—California, Massachusetts, Oregon, and Texas—develop their flat rates, which serve as a type of ceiling, to pay for all nursing homes in the state. Seven states we reviewed include efficiency incentives in their payment methods, which typically allow nursing homes with costs below a predetermined amount (generally the cost-center ceiling or the median costs) in one or more cost centers to have a portion of the difference incorporated into their per diem rates (see table 9). For example, Connecticut uses efficiency incentives in both its indirect care and administrative cost centers. In the indirect care center, nursing homes with costs below the median have 25 percent of the difference between their costs and the median costs added to their per diem rates. The following hypothetical example demonstrates how this efficiency incentive generally would work. If a home’s costs were $20 per day in the indirect care cost center, and the median indirect care costs for all homes were $24 per day, then the home has costs that are $4 below the median and would have 25 percent of the difference between its costs and the median, or $1, added to its rate. Each of the seven states applies efficiency incentives differently. Case-mix systems categorize residents into groups based on the level of care they need and adjust payment rates to homes accordingly. Twelve of the 19 states we reviewed use case-mix systems, although the type of system and the number of case-mix categories vary widely. While 5 states have designed their own systems to measure case-mix, the remaining 7 states rely on some variation of the Resource Utilization Group (RUG) Patient Classification System, which is also used to determine the acuity level of nursing home residents in the Medicare program. The 7 states that use various versions of the RUG Patient Classification System place residents in 16 to 44 resident classification groups. In contrast, Oregon places residents into one of two groups, basic or complex care. The case- mix classification system used by each state is shown in table 10. By applying an occupancy standard, states reduce the per diem rates paid to nursing homes with occupancy below the state-established minimum levels. Of the 19 states reviewed, 17 use occupancy standards, which vary from 75 percent in Arkansas to 98 percent in Rhode Island, to determine nursing home payment rates. The following hypothetical example demonstrates how a state may apply an occupancy standard. A state applies an occupancy standard of 85 percent in the indirect care cost center, but a nursing home has a 75 percent occupancy level (along with annual costs of $200,000 in the indirect care cost center and 36 beds). Using the home’s actual occupancy, its payment rate for the indirect care cost center would be $20.29 (or $200,000/), whereas adjusting the home’s payment in the indirect care cost center for the state’s occupancy standard results in a lower rate of $17.91 ($200,000/). The extent to which states apply occupancy standards varies. Three of the states we reviewed—Alabama, Arkansas, and Iowa—apply the occupancy standard to only one cost center, and 7 others—Connecticut, Florida, Massachusetts, Michigan, New York, Rhode Island, and South Dakota—apply the occupancy standard to all cost centers (see table 11). Officials in the states we reviewed identified changes to payment rates or to the methods their respective Medicaid programs use to determine nursing home payment rates from state fiscal years 1998 through 2004 (see table 12). While some changes have obvious positive or negative effects on payment rates, the effect of other changes can be mixed. For example, while Colorado’s elimination of its quality incentive add-on payment likely lowers payment to some nursing homes, payment to some nursing homes in Vermont increased because of recently implemented add-on payments for direct resident care staff wages. The effect of other changes, such as California adding two counties to the Bay Area peer group in 2002, are likely to affect rates in both directions for different homes. In addition to changes to how they paid nursing homes, two states— Arkansas and Iowa—designed and implemented completely new payment methodologies during this time. For example, Iowa’s prior payment method did not classify homes into peer groups, did not adjust rates for the costs related to homes’ resident care needs, and limited payment to the 70th percentile of all homes’ total costs. Under the state’s new payment method, which was phased in completely in July 2003, homes are classified into peer groups, rates are adjusted for resident care costs using the RUG-III classification system, and a ceiling of 120 percent of median costs for all homes is imposed on payment for direct resident care costs. Christine DeMars, Behn M. Kelly, Sari B. Shuman, Margaret Smith, and Christi Turner made key contributions to this report. Nursing Home Quality: Prevalence of Serious Problems, While Declining, Reinforces Importance of Enhanced Oversight. GAO-03-561. Washington, D.C.: July 15, 2003. Medicaid Formula: Differences in Funding Ability among States Often Are Widened. GAO-03-620. Washington, D.C.: July 10, 2003. Nursing Homes: Quality of Care More Related to Staffing than Spending. GAO-02-431R. Washington, D.C.: June 13, 2002. Medicaid: HCFA Reversed Its Position and Approved Additional State Financing Schemes. GAO-02-147. Washington, D.C.: October 30, 2001. Nursing Workforce: Multiple Factors Create Nurse Recruitment and Retention Problems. GAO-01-912T. Washington, D.C.: June 27, 2001. Nursing Workforce: Recruitment and Retention of Nurses and Nurse Aides Is a Growing Concern. GAO-01-750T. Washington, D.C.: May 17, 2001. Long-Term Care: Baby Boom Generation Increases Challenge of Financing Needed Services. GAO-01-563T. Washington, D.C.: March 27, 2001. Medicaid: State Financing Schemes Again Drive Up Federal Payments. GAO/T-HEHS-00-193. Washington, D.C.: September 6, 2000. Medicaid Formula: Effects of Proposed Formula on Federal Shares of State Spending. GAO/HEHS-99-29R. Washington, D.C.: February 19, 1999. Long-Term Care: Baby Boom Generation Presents Financing Challenges. GAO/T-HEHS-98-107. Washington, D.C.: March 9, 1998.

Summary: Almost half of all Americans over the age of 65 will rely on nursing home care at some point in their lives, and two in three nursing home residents have their care covered at least in part by Medicaid. Under Medicaid, states set nursing home payment rates and the federal government reimburses a share of state spending. According to the most recently available data, Medicaid nursing home expenditures exceed $43 billion, and total Medicaid spending for fiscal year 2003 is expected to double by 2012. Such projections of increased Medicaid spending come as most states are confronting their third consecutive year of fiscal pressure. According to the National Association of State Budget Officers (NASBO), in fiscal year 2003, 30 states collected less revenue than they budgeted for, and 37 states reduced enacted budgets by almost $14.5 billion. In light of concerns about the adequacy of nursing home resources, GAO was asked to examine how state Medicaid programs determine nursing home payment rates and whether these payment methods or rates have changed given recent state fiscal pressures. GAO interviewed state and nursing home industry officials in 19 states and obtained documentation about nursing home payment rates and methods, including state methods to determine nursing home per diem rates for fiscal years 1998 through 2004. Recognizing the large share of Medicaid spending that is allocated to nursing homes and the importance of spending their Medicaid dollars effectively, the 19 states GAO reviewed have designed multifaceted approaches to setting nursing home payment rates. All of these states base payment rates on homes' actual costs and most develop rates specific to each home. These payment methods also generally incorporate incentives to achieve certain goals, such as promoting efficiency or encouraging homes to target spending toward resident care. States typically update payment rates regularly to reflect changes in nursing homes' costs due to factors such as inflation or residents' changing care needs. Although each of the 19 states experienced recent fiscal pressure, states' nursing home payment rates have remained largely unaffected. Any future changes, however, remain uncertain. During fiscal years 1998 through 2004, only 4 of these states--Illinois, Massachusetts, Michigan, and Texas--cut the per diem rates paid to all nursing homes at some point, and in 2 of these states, the rate reduction was for less than 1 year. Two other states--Connecticut and Oregon--also froze nursing home per diem rates for a portion of this period. In addition, all 19 states modified the methods they use to determine nursing home payment rates during this time, such as changing ceilings on payment rates; however, irrespective of shifting fiscal pressure, the extent to which states changed specific features of their payment methods generally remained constant, with varying effects on payment rates to individual homes within states. Further, in over three-quarters of these states, nursing home per diem rates grew, on average, by an amount that exceeded the skilled nursing facility market basket index, the index used by the Centers for Medicare & Medicaid Services to measure changes in the price of nursing home goods and services for Medicare, from fiscal years 1998 through 2003. Many states were able to avoid making significant changes to nursing home payment rates by relying on existing resources, such as tobacco settlement and budget stabilization funds, and increasing revenue by imposing cigarette or nursing home provider taxes. Even with these alternative funding sources and recent temporary federal fiscal relief, however, officials in some states suggest that nursing home payment reductions are possible in the future. GAO received comments on a draft of this report from Medicaid officials in the 19 states reviewed, who generally agreed with the characterization of their respective nursing home payment methods. GAO also received technical comments from representatives of two organizations that represent the nursing home industry.