The Congress created the Medicare risk contract program in 1982 to capitalize on the potential cost savings associated with HMOs. Under this program, HMOs are paid a flat fee for each Medicare beneficiary enrolled. The law sets HMO payments for comprehensive care at 95 percent of the estimated average cost (to Medicare) of treating the patient in the fee-for-service sector. HCFA calculates these payment rates using a three-step process in which it determines the following: The base rate: HCFA calculates the projected Medicare expenses nationwide for the average beneficiary in the next year. The adjusted average per capita cost (AAPCC): HCFA adjusts the base rate for differences in medical costs among geographic areas, generally counties, and multiplies the result by 0.95. The capitation rate after adjusting for health status risk: HCFA adjusts the AAPCC for enrollees’ demographic characteristics—age, sex, Medicaid eligibility, and residence in an institution such as a nursing home. This risk adjustment attempts to prevent HMOs from benefiting from favorable selection of health risks, which occurs when HMOs enroll beneficiaries who are healthier—and therefore less costly to care for—than those in the fee-for-service sector. Although in existence for over a decade, the risk contract option remains a relatively small part of the Medicare program. As of May 1995, about 7 percent of Medicare beneficiaries were enrolled in plans offered by the 164 HMOs participating in the program. Enrollment in the Medicare risk contract program may grow substantially in the next few years. HCFA reports that three-fourths of all Medicare beneficiaries now live in areas where they could enroll in a risk contract HMO. Although beneficiary enrollment in these HMOs is relatively low, the program has grown dramatically in recent years in both beneficiary enrollment and HMO participation. As of May 1995, about 2.6 million beneficiaries—about 7 percent of the total Medicare population—were enrolled in the risk contract program.Figure 1 shows that the percentage of Medicare beneficiaries enrolled is significantly higher than the national average in only a few states. HMO enrollment is further concentrated in urban areas. The 5 metropolitan statistical areas (MSA) with the largest risk contract enrollments accounted for 34 percent of nationwide risk program enrollment in 1995, and the top 10 MSAs accounted for 51 percent of nationwide risk program enrollment. Enrollment data for the top 100 MSAs appear in appendix II. Although the HMO share nationwide is small, recent HMO enrollment of Medicare beneficiaries has grown rapidly. From 1990 through 1992, enrollment grew by about 13 percent annually but, during 1993 and 1994, grew by an annual average of 23 percent. Preliminary data for 1995 suggest a growth rate approaching 30 percent. Similarly, the number of risk contract HMOs, which declined substantially during the early years of the program, has nearly doubled since 1991 from 83 to the current 164. (See fig. 2.) In 1994, the HMO enrollment rate in California and 14 other states—whose enrollees account for 55 percent of all Medicare beneficiaries—experienced double-digit increases. (See fig. 3.) Enrollment rates in other states showed no growth. For the most part, these states have had extremely low HMO market penetration. Our work suggests that Medicare’s HMO rate-setting methodology does not maximize the potential of managed care to yield cost savings and, in some cases, can even discourage HMO participation in the program. By linking HMO payments to Medicare costs in the fee-for-service sector, the current methodology causes three problems. First, the rate-setting formula restricts potential savings and ignores the ability of competitive market forces to help produce additional savings. Second, the lack of adequate risk adjusters in the formula allows some HMOs to be overcompensated given the health status of their enrollees. Third, the formula may discourage plan participation by setting payments that are too low in some areas and by causing rates to vary greatly both among geographic areas and over time. Under the present system, Medicare pays all HMOs in a county the same capitation (base) rate. With the payment rate fixed and independent of both HMO costs and the competitiveness of the local managed care environment, HMOs compete only for the enrollment of Medicare beneficiaries. Efficient, low-cost HMOs may be able to offer more generous benefit packages to enrollees and still prosper under the fixed capitation rate. Because the payment rate is fixed, however, the government derives little benefit from HMOs’ increased competition or increased efficiency. Moreover, Medicare beneficiaries have only limited incentives to seek care from low-cost health plans. Medicare may be underestimating HMOs’ efficiency and requiring an HMO discount from fee-for-service costs that is too modest. The HMO capitation rate is set by statute at 95 percent of the AAPCC: in other words, 5 percent below the estimated cost of serving beneficiaries in the fee-for-service sector. HMOs that can attract Medicare enrollees and provide health care for less than the capitation rate—for example, for 85 percent of fee-for-service costs—keep the difference (within limits) between their costs and the capitation payment. The recent surge in HMO participation indicates that many organizations now view Medicare risk contracts as potentially lucrative. In addition, in caring for Medicare beneficiaries, HMOs are estimated to achieve cost savings in excess of 5 percent. Research suggests that HMO costs for caring for their enrollees are at least 10 percent less than HCFA would have spent on fee-for-service care for them. Finally, some experience of private-sector employers with HMOs suggests that the 5-percent discount may be too low, especially in certain urban areas with mature managed care markets. In those markets, even a larger discount (lower capitation rate) might not significantly discourage HMOs’ participation in Medicare risk contracts. HCFA’s capitation payment to HMOs is currently risk adjusted for only four demographic factors: beneficiary age, sex, Medicaid status, and institutional status. These adjustments are designed to modify HMO payments for expected variations in medical costs. For example, the capitation payment is higher for older beneficiaries because they are expected to require more medical care than younger beneficiaries. This risk adjustment is inadequate, however, because it does not specifically adjust for the health status of enrollees. By enrolling the healthier individuals, HMOs deliver less health care but are compensated as if they had enrolled a costlier clientele of both the healthier and the sicker individuals. Our review of studies on risk selection shows that, because most HMOs benefit from favorable selection (the healthier individuals typically enroll in HMOs), Medicare has paid HMOs more than it would have paid for the same patients’ care by fee-for-service providers. Estimates of the excess payments range from almost 6 percent to 28 percent. However, these estimates have been criticized as too high for various technical reasons, such as the data analyzed (from 1991) no longer reflect current conditions. Nonetheless, our review suggests that favorable selection persists despite HMO enrollment expansion. HCFA officials agree that the risk contract program displays favorable selection, though they believe that excess payments are at the lower end of this range. Capitation rates are set separately for each U.S. county and vary considerably nationwide among regions and states, urban and rural counties, and even neighboring counties. This variation may discourage some HMOs from participating in risk contracts. For example, under the present system, an HMO is paid 27 percent less for serving a beneficiary living in Montgomery County, Maryland, than for serving an otherwise identical beneficiary living in neighboring Prince George’s County, Maryland—even if the two individuals are treated in the same facility by the same doctor. The disparity of payment rates among counties leads some HMOs to enroll beneficiaries from a limited portion of their service area. The formula’s link to local fee-for-service spending, which reflects local variations both in the price and volume of medical services used by Medicare beneficiaries, causes the disparity of the capitation rates among areas. Much of the occurring variation may, however, be attributable to underutilization of health care in some areas and overutilization in others instead of differences in the cost of providing appropriate health care. If fee-for-service beneficiaries use a large volume of services (either because beneficiaries demand these services or because their doctors order additional services), then HMO payment rates will be relatively high in that county. In contrast, if Medicare fee-for-service beneficiaries use few services—perhaps because of inadequate transportation or a lack of providers in rural areas—then HMO payment rates will be relatively low. As a result, rates in some areas are too low to induce HMO participation in the risk contract program, while rates in other areas are too high for Medicare to realize the potential cost savings generated by capitated payments. Modifying the present payment system could help generate Medicare savings. Our review of the private sector’s experience, reforms in other public health care programs, and empirical research suggests that several strategies hold promise. These strategies fall into three broad categories: fostering price competition among HMOs, developing better risk adjusters, and revising the AAPCC-based capitation rate. In our view, HCFA could generate the most Medicare savings if it would pursue strategies in all three categories concurrently. Trying to address all obstacles in a uniform way in all regions of the country is likely to fail. This is because the predominant challenges to saving costs in large cities are not necessarily the same ones that exist in rural counties and because the challenges vary from region to region even for otherwise similar communities. Consequently, a variety of strategies is warranted; local conditions would determine the particular strategies for any specific area. The details of implementing any strategy are important. Changing Medicare’s rates for paying HMOs could affect their decision to participate in risk contracts and the benefits they provide. This, in turn, could affect Medicare beneficiaries’ decisions to enroll in managed care plans and the quality of care they receive in those plans. Thus, estimating the dollar savings and determining the best method of implementing specific strategies would be possible only after quickly conducting and evaluating demonstrations. Requiring qualified HMOs to submit competitive bids could encourage price competition that would enlist market forces to help contain Medicare costs. The accepted bid would set the capitated rate at which HMOs would provide comprehensive care to Medicare enrollees in an area. This approach completely decouples capitation rates from average fee-for-service spending. Under a competitive bidding system, HMOs would have an incentive to submit bids that reflect their actual costs of providing health care to Medicare enrollees. Low bidders would be rewarded with risk contracts. High bidders could be excluded, included if they accepted the winning bid amount, or included but subject to a financial penalty. A competitive bidding strategy would be most effective in locations likely to attract many bidders—typically urban areas with well-developed managed care markets. Table 1 indicates that competitive bidding looks promising in at least 17 urban areas (accounting for about 50 percent of all risk contract beneficiaries) because each has 10 or more participating HMOs. Competitive bidding might not be viable, however, in at least 47 other urban areas (accounting for about 11 percent of enrollees) where three or fewer HMOs participate in Medicare. Unless the competitive bidding structure were to attract additional HMOs, many locations likely would not be good candidates for determining HMO rates through competitive bidding. Consequently, an alternative rate-setting methodology would need to coexist with a competitive bidding approach. Competitive bidding, rate negotiation, and beneficiary incentive approaches have been used successfully in other public health insurance programs. Arizona, for example, since 1982 has delivered health care to its indigent population mostly through capitated managed care organizations in which the capitation rates are set through a competitive bidding process. A recent study concluded that, compared with traditional Medicaid programs (predominately fee for service), Arizona achieved significant cost savings and a lower rate of expenditure growth. CalPERS, serving about 1 million members, also relies on price competition among health plans and consumer incentives to control costs. Negotiating rates with HMOs has helped CalPERS to reduce premiums in each of the past 3 years; reductions ranged from 0.4 percent in 1993-94 to 5.2 percent in 1995-96. Designing a good competitive bidding system requires attention to many issues, such as whether beneficiaries in plans that lose the bidding must shift to the winning plan. In addition, savings may not be realized immediately because of high initial start-up costs—for example, developing the bidding process and establishing the necessary management information systems. Administrative expenses may be high as well. Arizona’s experience illustrates these points. Arizona spends on Medicaid administration an amount equal to over 7 percent of its program’s acute care medical costs. This is more than comparable states spend on administering their traditional fee-for-service Medicaid programs. This suggests that the effective use of managed care may require strong administrative structures to adequately oversee and efficiently manage program resources. Even so, Arizona’s experiment with competitive bidding has succeeded in providing health care to beneficiaries while saving the state money. Other strategies besides competitive bidding could introduce market forces. These include strategies to encourage Medicare enrollees to be more price sensitive. Such strategies range from requiring newly eligible Medicare beneficiaries who choose a fee-for-service plan to pay slightly more than beneficiaries who choose a managed care plan to approaches that would allow beneficiaries to “price shop” from a list of approved HMOs and share a portion of any cost savings with the government. Because these strategies are so far untried, the extent to which they would increase beneficiaries’ price sensitivity and help control Medicare costs is unknown. As with competitive bidding, a wide variety of approaches may be used to implement these strategies. A fuller discussion of such approaches, however, is beyond the scope of this report. In earlier reports, we noted that researchers have proposed several alternative risk adjustment methods to reduce HMOs’ incentives to enroll only relatively healthy Medicare beneficiaries. Each of these alternative methods attempts to measure the health status of enrollees more fully than HCFA’s method and can be judged according to several generally accepted operational criteria. For example, a good risk adjuster would be inexpensive to administer, reduce favorable selection, create incentives for HMOs to provide appropriate care, and not be subject to manipulation by participating HMOs. No single risk adjuster is likely to exhibit all these positive traits, however, because these criteria have trade-offs. For example, a more complex risk adjuster may better succeed in reducing favorable selection but may do so only at a high administrative cost. Recently, we evaluated 10 possible risk adjusters. None emerged as the definitive solution to the current method’s problem. However, 4 of the 10 adjusters we examined were potentially superior to the current method and seemed to entail less administrative burden than the most sophisticated risk adjusters. One of these adjusters—clinical indicators—would adjust capitation rates for the presence or absence of a particular chronic health condition (such as heart disease, stroke, or cancer). Two other promising clinically based risk adjusters include information not only on a beneficiary’s specific condition but also on its severity. In the fourth approach, HMO capitation payments would be linked to beneficiaries’ own views of their physical and emotional health. With new legislative authority, HCFA could require steeper discounts from HMOs than the present 5-percent discount off the estimated local fee-for-service cost. Although this would lower payments to HMOs, it may not necessarily have a large impact on their participation in Medicare risk contracts. Previous research indicates that enrollment of healthier than average beneficiaries, combined with an imperfect method of risk adjustment, results in excessive payments to HMOs—even after factoring in the 5-percent discount. Recent evidence suggests that HMOs find participation in the risk contract program to be lucrative under current payment rates. Specifically, the number of HMOs obtaining risk contracts has increased from 109 to 164 in less than a year and a half, and the percentage of risk contract HMOs charging Medicare beneficiaries a zero premium has increased from 28 (23 plans) in 1993 to 49 (77 plans) in 1995.Thus, HMOs may continue to find Medicare risk contracts attractive—even at a somewhat larger discount. However, if health plans react by offering less generous benefit packages, fewer seniors may be attracted to HMOs, and some current enrollees may disenroll. The method used for calculating the AAPCC could also be improved by assigning a greater weight to the influence of local medical prices and a lesser weight to the influence of local service utilization patterns in the fee-for-service sector. Modifications could also be made so that the AAPCC would reflect HMO market areas rather than artificial political boundaries. For example, defining a single capitation rate for a metropolitan area would eliminate the possibility that an HMO would receive more for serving a senior in one county than it would for serving an otherwise identical senior in an adjacent county. These changes would also tend to reduce the volatility of the AAPCC over time and consequently increase HMO participation in the risk contract program. HCFA is planning to conduct demonstration projects to examine several proposals for modifying or replacing the current method of determining payment rates to HMOs. Early results from some demonstrations could emerge during fiscal year 1996, but we believe that a thorough assessment of the demonstrations is, at best, several years away. The projects are at various stages, from solicitation of proposals from private contractors to implementation of the demonstration. Table 2 summarizes information about the demonstration projects. While hopeful that these demonstrations will provide valuable information on alterative payment approaches, HCFA officials believe that the design and results for some projects could be improved if the legislative authority to conduct demonstrations were expanded. HCFA’s legislative authority, established in 1967 and modified in 1972, does not discuss Medicare managed care options explicitly. This limits HCFA’s ability, for example, to mandate that HMOs remaining in the Medicare program participate in a demonstration. In our view, these demonstration projects are steps in the right direction. Nonetheless, in light of Medicare’s current losses due to the risk contract program—estimated at between $0.8 billion and $4.0 billion per year—HCFA might take other, more immediate steps to stem losses. For example, the Congress could grant HCFA authority to increase the HMO discount from its current 5 percent in certain areas. These might be areas where Medicare HMO enrollment is growing rapidly or where most HMOs do not currently charge beneficiaries a premium for expensive extra benefits. HMOs appear to provide care to Medicare beneficiaries at lower cost than traditional fee-for-service care, but Medicare’s method of paying HMOs has limited the program’s ability to save money for the federal budget and the taxpayer. The potential savings from fixing Medicare’s payment method have grown along with the number of Medicare HMO enrollees, which has risen rapidly in certain urban areas. To realize these savings requires redesigning Medicare’s HMO payment method by correcting three flaws. First, the rigidity of the forumula-based fixed payment rate does not allow Medicare to capitalize on the competition among HMOs that, in the private market, leads to lower rates. Second, rate adjustment for differences in beneficiaries’ health status are so imprecise that Medicare overpays HMOs that enroll beneficiaries in good health. Third, the method’s reliance on a county’s fee-for-service health care costs to establish a payment rate produces rates that vary considerably within market areas. The government does not benefit from the low rates because they deter HMOs from enrolling Medicare beneficiaries. Moreover, the government incurs excess costs because high rates overcompensate HMOs that do participate. With respect to pricing capitated health plans in Medicare, we believe that one size does not fit all. Market conditions vary too much and in important ways, even among metropolitan areas. A sensible approach would be to pursue three promising strategies concurrently—foster price competition among HMOs, improve risk adjusters’ accuracy, and allow for adjustments in the current formula to reflect market competition and HMOs’ local health care costs. Recently, HCFA initiated two steps to correct the current payment method. First, it solicited proposals from private contractors to plan a demonstration project on competitive bidding. Second, it began work on two demonstration projects on improved risk adjustment—one soon to be implemented, the other to begin in 1996. These HCFA projects are steps in the right direction, but considerable time will elapse before the results are fully evaluated. Consequently, HCFA needs to complement longer term improvements with quick action to mitigate Medicare losses as risk contract HMO enrollment grows. For example, HCFA needs to implement a better risk adjuster quickly. HCFA can select from four risk adjusters that we identified last year as showing promise in accuracy and administrative feasibility. Furthermore, in implementing a new risk adjuster, or testing any new rate-setting approach, HCFA could adopt a strategy to reduce its response time to lessons learned from project results. This would entail developing information on the design and implementation of the new approach while testing is under way, without waiting for comprehensive evaluation results. In light of the increasingly urgent need to realize savings from the Medicare HMO program and to develop viable new methods of paying HMOs, Congress may wish to consider giving the Secretary of the Department of Health and Human Services authority to selectively reduce Medicare HMO payment rates (the AAPCC rate) in areas where market data indicate that the Medicare rates are too high and expand HCFA’s authority to mandate HMO participation in demonstration projects in order to conduct more meaningful studies of alternative payment methods. The Department of Health and Human Services reviewed a draft of this report and provided written comments. All of the comments were of a technical or clarification nature and have been addressed in the report where appropriate. Copies of this report are being sent to the Secretary of Health and Human Services, the Administrator of HCFA, and other interested parties. We will also make copies available to others upon request. Please call me at (202) 512-7119 or Scott Smith, Assistant Director, at (202) 512-5713 if you or your staff have any questions about this report. Percent change in rate of enrollment in a risk HMO (Dec. 1993-Dec. 1994) (continued) Percent change in rate of enrollment in a risk HMO (Dec. 1993- Dec. 1994) Los Angeles-Long-Beach, Cal. Riverside-San Bernardino, Cal. San Diego, Cal. Phoenix-Mesa, Ariz. Orange County, Cal. Fort Lauderdale, Fla. Miami, Fla. Portland-Vancouver, Ore.-Wash. Tampa-St. Petersburg-Clearwater, Fla. Chicago, Ill. Minneapolis-St. Paul, Minn.-Wis. New York-Newark, N.Y.-N.J.-Pa. West Palm Beach-Boca Raton, Fla. Seattle-Bellevue-Everett, Wash. Philadelphia, Pa.-N.J. San Francisco, Cal. Denver, Colo. Boston-Brockton-Nashua, Mass.-N.H. Tuscon, Ariz. San Antonio, Tex. Oakland, Cal. Las Vegas, Nev.-Ariz. Sacramento, Cal. Daytona Beach, Fla. Nassau-Suffolk, N.Y. San Jose, Cal. Orlando, Fla. Houston, Tex. Albuquerque, N.M. Ventura, Cal. Bakersfield, Cal. (continued) Percent change in rate of enrollment in a risk HMO (Dec. 1993- Dec. 1994) Kansas City, Mo.-Kans. Santa Barbara-Santa Maria-Lompo, Cal. Modesto, Cal. Santa Rosa, Cal. Jacksonville, Fla. Providence-Warwick, R.I. Salem, Ore. Rochester, N.Y. Tulsa, Okla. San Luis Obispo-Atascadero-Paso, Cal. Buffalo-Niagara Falls, N.Y. Fresno, Cal. Dallas, Tex. Corpus Christi, Tex. Oklahoma City, Okla. Vallejo-Fairfield-Napa, Cal. Lansing-East Lansing, Mich. Tacoma, Wash. Boulder-Longmont, Colo. Fort Worth-Arlington, Tex. Omaha, Nebr.-Ia. Olympia, Wash. Chico-Paradise, Cal. Detroit, Mich. Eugene-Springfield, Ore. Louisville, Ky.-Ind. Austin-San Marcos, Tex. Pittsburgh, Pa. Scranton-Wilkes Barre-Hazleton, Pa. Stockton-Lodi, Cal. Indianapolis, Ind. Medford-Ashland, Ore. Wichita, Kans. (continued) Percent change in rate of enrollment in a risk HMO (Dec. 1993- Dec. 1994) St. Louis, Mo.-Ill. Ocala, Fla. Birmingham, Ala. Bremerton, Wash. New Orleans, La. Santa Fe, N.M. Yolo, Cal. Norfolk-Virginia Beach- Newport News, Va. Gainesville, Fla. Allentown-Bethlehem-Easton, Pa. Santa Cruz-Watsonville, Cal. Baltimore, Md. Washington, D.C.,Md.,Va.,W.Va. Bergen-Passaic, N.J. Monmouth-Ocean, N.J. Galveston-Texas City, Tex. Spokane, Wash. Sarasota-Bradenton, Fla. Colorado Springs, Colo. Salinas, Cal. Yuba City, Cal. Baton Rouge, La. Bellingham, Wash. Newark, N.J. Fort Pierce-Port St. Lucie, Fla. Merced, Cal. Atlantic City-Cape May, N.J. Gary, Ind. Middlesex-Somerset-Hunterdon, N.J. Trenton, N.J. Cincinnati, Ohio-Ky.-Ind. Lakeland-Winter Haven, Fla. Medicare: Opportunities Are Available to Apply Managed Care Strategies (GAO/T-HEHS-95-81, Feb. 10, 1995). Health Care Reform: Considerations for Risk Adjustment Under Community Rating (GAO/HEHS-94-173, Sept. 22, 1994). Medicare: Changes to HMO Rate Setting Method Are Needed to Reduce Program Costs (GAO/HEHS-94-119, Sept. 2, 1994). Managed Health Care: Effect on Employers’ Costs Difficult to Measure (GAO/HRD-94-3, Oct. 19, 1993). Medicare: HCFA Needs to Take Stronger Actions Against HMOs Violating Federal Standards (GAO/HRD-92-11, Nov. 12, 1991). Medicare: PRO Review Does Not Assure Quality of Care Provided by Risk HMOs (GAO/HRD-91-48, Mar. 13, 1991). Medicare: Increase in HMO Reimbursement Would Eliminate Potential Savings (GAO/HRD-90-38, Nov. 1, 1989). Medicare: Reasonableness of Health Maintenance Organization Payments Not Assured (GAO/HRD-89-41, Mar. 7, 1989). Medicare: Health Maintenance Organization Rate Setting Issues (GAO/HRD-89-46, Jan. 31, 1989). Medicare: Physician Incentive Payments by Prepaid Health Plans Could Lower Quality of Care (GAO/HRD-89-29, Dec. 12, 1988). Medicare: Experience Shows Ways to Improve Oversight of Health Maintenance Organizations (GAO/HRD-88-73, Aug. 17, 1988). Medicare: Uncertainties Surround Proposal to Expand Prepaid Health Contracting (GAO/HRD-88-14, Nov. 2, 1987). Medicare: Issues Raised by Florida Health Maintenance Organization Demonstrations (GAO/HRD-86-97, July 16, 1986). Problems in Administering Medicare’s Health Maintenance Organization Demonstration Projects in Florida (GAO/HRD-85-48, Mar. 8, 1985). The first copy of each GAO report and testimony is free. Additional copies are $2 each. Orders should be sent to the following address, accompanied by a check or money order made out to the Superintendent of Documents, when necessary. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent. U.S. General Accounting Office P.O. Box 6015 Gaithersburg, MD 20884-6015 Room 1100 700 4th St. NW (corner of 4th and G Sts. NW) U.S. General Accounting Office Washington, DC Orders may also be placed by calling (202) 512-6000 or by using fax number (301) 258-4066, or TDD (301) 413-0006. Each day, GAO issues a list of newly available reports and testimony. 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Summary: Pursuant to a congressional request, GAO reviewed Medicare payments to health maintenance organizations (HMO), focusing on: (1) current trends in Medicare beneficiary enrollment in HMO; (2) flaws in Medicare's rate-setting method that prevent it from realizing potential savings from HMO; and (3) the Health Care Financing Administration's (HCFA) efforts to test HMO payment reforms. GAO found that: (1) since 1993, the annual increase in Medicare beneficiary HMO enrollment has exceeded 20 percent; (2) HMO enrollment increases have been concentrated in 15 states; (3) Medicare links HMO payment rates to the average cost of fee-for-service care and fails to adjust HMO payment rates to reflect beneficiaries' health status or local differences in utilization rates; (4) strategies to improve Medicare HMO payments include giving HCFA new authority to use competitive bidding or to negotiate with HMO, modifying the HMO rate-setting formula to include a health status risk adjuster, and requiring larger discounts from HMO in areas where HMO payment rates are too high; (5) HCFA could generate the most savings if it combines all three cost-reduction strategies and tailors the strategy to local conditions; and (6) although HCFA is planning demonstration projects using competitive bidding and improved risk adjustments, HCFA needs to gather and use available data to adjust HMO payments.