Inherent in Medicare’s FFS program is an incentive for providers to deliver more services than necessary because each additional service generates additional provider revenue. Policymakers have therefore looked to managed care plans to curb unnecessary spending. Plans have a financial incentive to provide care efficiently because they receive a fixed monthly amount for each beneficiary, regardless of what the individual enrollee’s care actually costs. These potential efficiencies cannot result in actual savings for Medicare if plan payments are higher than beneficiaries’ expected FFS costs. Before 1998, plan payment rates were based on average local FFS spending. Although payments were adjusted for certain beneficiary characteristics such as age and sex, this adjustment did not adequately account for differences in enrollees’ health and expected health care costs. The BBA changed how plan payments were calculated beginning in 1998 and, beginning in 2000, required adjustments to make payment rates better reflect differences in beneficiary health status. Before 1998, Medicare’s HMO capitation rates, established separately for each county, were set at 95 percent of the estimated average cost of care for the FFS population. The rates were discounted 5 percent under the assumption that the managed care plans provided care more efficiently than the less-restrictive FFS program and that the government should share in the savings. Under this methodology, county rates varied widely because they reflected the substantial differences in FFS per-beneficiary spending among counties. In 1997, for example, county rates ranged from a low of $221 per month in Arthur County, Nebraska, to a high of $767 in Richmond County (Staten Island), New York. The rates paid to plans for enrollees were also adjusted up or down in an attempt to account for estimated cost differences among beneficiaries due to variations in health care needs—a refinement known as risk adjustment. Risk adjustment is necessary because individuals differ in the extent to which they use various health care services and their health care costs vary accordingly. Medicare’s risk adjuster has relied on beneficiary age, sex, and other demographic factors to predict expected health care utilization. This demographic-based risk adjuster could reflect only gross differences— such as the lower expected health care costs of 65-year-olds relative to 80- year-olds. If two individuals shared the same demographic characteristics, Medicare paid plans the same amount for both of them, even if one was in poor health and required extensive medical care while the other was in excellent health and rarely needed to see a physician. Consequently, if a plan attracted a disproportionate share of beneficiaries in better-than-average health, an outcome known as favorable selection, Medicare’s payments to the plan would exceed the expected FFS cost of providing Medicare-covered benefits to the plan’s enrollees.Our 1997 study of Medicare payments to California HMOs found that, on average, payments exceeded the expected FFS costs of the plans’ enrollees by approximately 19 percent in 1995.Other studies have also found substantial excess plan payments. A 1996 survey of Medicare beneficiaries also indicated that plans likely experienced favorable selection (see table 1). Medicare beneficiaries enrolled in plans were more likely than beneficiaries in the FFS program to report that they were in good or excellent health. Moreover, these health status differences translate into cost differences. For example, in 1996, average per-person Medicare FFS spending for beneficiaries who reported they were in excellent health was approximately $2,100, whereas for beneficiaries reporting poor health the average was about $11,700. In establishing the Medicare+Choice program, the BBA also changed the methodology used to set plan payments. Although 1997 county rates formed the foundation for county rates in 1998 and subsequent years, annual rate increases were no longer tied to changes in local FFS spending. Specifically, each county’s rate was to be set at the highest of a minimum amount, or “floor,” set at $367 in 1998 and increased an amount 2 percent higher than the previous year’s county rate; or an amount reflecting a blend or weighted average of the county rate and a price-adjusted national rate. The floor was meant to encourage plans to offer services in areas that historically had low payment rates and few if any participating plans— primarily rural counties. The blended rate—which is to be phased-in over 6 years—was designed to reduce the geographic variation in rates that had resulted from tying county rates to local FFS. The blending mechanism moves all county rates closer to the national average by assigning above- average payment rate increases to low-payment-rate areas, and below- average payment rate increases to high-payment-rate areas. The BBA also sought to reduce the excess in Medicare’s managed care payments by holding down per capita rate increases for 5 years. Specifically, the BBA set the annual factor used to update floor and blended payment rates equal to the projected national growth in per capita Medicare spending minus a specified percent: 0.8 percent in 1998 and 0.5 percent in each of the following 4 years. In 1998, 1999, and 2001 no county received a blended rate.Instead, counties were either assigned the floor payment rate or the 2-percent minimum increase. This occurred because of a budget neutrality provision in the BBA. The law specified that estimated total Medicare+Choice payments should equal the amount that would have been spent if 1997 county rates had been trended forward by the national annual update factor. However, national per capita spending grew relatively slowly and the guaranteed 2-percent increase and floor payments pushed total estimated Medicare+Choice spending above the budget neutrality amount in these 3 years. The blending provision could not be implemented because doing so would have further increased spending.If low-payment-rate counties received higher than average payment rate increases, the additional spending could not be offset by lowering the increases in the high-payment-rate counties because those counties were guaranteed a 2- percent minimum increase. The BBA required HCFA to develop and implement a health-based risk adjuster by January 1, 2000.The law authorized HCFA initially to collect hospital inpatient data from plans and later to collect more comprehensive medical encounter data to use in developing the risk adjuster. HCFA announced a phase-in schedule that called for gradually applying an interim risk adjuster, based on hospital admissions data only, first to a fraction (10 percent) of a plan’s Medicare payments and then to greater shares each year. HCFA proposed to apply an improved risk adjuster, based on a more comprehensive set of medical services, to 100 percent of payments by 2004. The BBRA slowed the proposed phase-in schedule of the interim risk adjuster and called for additional studies by HCFA and the Medicare Payment Advisory Commission on risk adjustment implementation issues. Our analysis shows that Medicare+Choice payments in 1998 were 21 percent, or $5.2 billion, higher than the amount Medicare would have spent if plan beneficiaries had received care in the traditional FFS program. While Medicare payments to plans on behalf of these enrollees totaled $29.8 billion, we estimate that total FFS payments for the same population would have been $24.6 billion. Approximately $3.2 billion of the $5.2 billion difference was the result of inadequate risk adjustment. That is, Medicare payments were not adjusted sufficiently to account for the generally better health, and lower expected costs, of plan enrollees.Excess payments due to inadequate risk adjustment will persist as long as there is favorable selection and plan payment rates do not sufficiently account for beneficiary health status. The remaining $2 billion resulted from errors in the Medicare spending forecasts used to establish the 1998 county payment rates. These excess payments will diminish over time as future county rates are adjusted to correct errors in prior spending forecasts. Table 2 summarizes our findings on aggregate excess payments. As a group, beneficiaries who join plans tend to be healthier and use fewer Medicare services than beneficiaries who remain in FFS. For example, in 1997 Medicare spent about 30 percent less on those beneficiaries who joined a plan in 1998 than it spent on demographically similar beneficiaries who remained in FFS. Our analysis suggests beneficiaries who have been plan members for several years continue to use fewer health care services than FFS beneficiaries, although the gap is much narrower. Medicare’s risk adjustment methodology, unchanged in 1998 from previous years, did not adequately address differences in beneficiary health status. While health plans tended to enroll less-expensive beneficiaries, Medicare’s payments were too generous because they were based on the expected costs of enrollees in average health.Consequently, we estimate that in 1998 Medicare paid plans an average of 13.2 percent more than it would have spent if the plans’ enrollees had received care under the traditional FFS arrangement. In the aggregate, the lack of an adequate risk adjustment methodology in the face of favorable selection increased Medicare spending by approximately $3.2 billion. Our results suggest that HCFA’s new health-based interim risk adjuster, when fully implemented, may only eliminate half of the excess payments due to favorable selection. The first year of plan-submitted data on beneficiaries’ service use indicates that full implementation of the interim risk adjuster would have reduced plan payments by about 5.9 percent in 2000.Its failure to eliminate more of the excess payments may be due to its reliance on limited data. The interim risk adjuster uses only certain hospital inpatient data to measure beneficiary health status because those are the only service-level data plans provide to HCFA. Although it represents a significant improvement over the previous methodology based strictly on demographic data, a risk adjuster that used more complete beneficiary data could set payments that better reflect beneficiaries’ expected health care costs. In 2004, HCFA intends to implement a refined risk adjuster that would use medical data from physicians’ offices and hospital outpatient departments, in addition to hospital inpatient data. Payment rates for Medicare+Choice plans are set partly on the basis of forecasted growth in national per capita spending in Medicare’s FFS program. Consequently, inaccurate forecasts can result in plan payment rates that are overstated or understated compared to actual FFS spending per beneficiary in a particular year. The BBA’s guaranteed 2-percent minimum annual increase and other payment provisions can also cause payment rates to deviate from expected per capita FFS spending. Our analysis indicates that the combination of a spending forecast error and the BBA payment provisions resulted in aggregate plan payments that exceeded enrollees’ estimated FFS costs by approximately 8 percent, or $2 billion, in 1998. HCFA estimates that the 1997 county rates were set too high and overstated average FFS spending by about 3 percent. Prior to the BBA, this error would have had a limited effect on future county rates because rates in each subsequent year were based on spending forecasts that were corrected for previous errors.In establishing the Medicare+Choice program, however, the BBA specified that 1997 county rates be used as the basis for all future county rates and did not allow an adjustment for prior forecasting errors. Under the prior methodology, HCFA would have increased average 1998 rates by approximately 1 percent. Instead, nearly all Medicare+Choice plans received the BBA’s 2-percent minimum payment rate increase in 1998. Plans that served beneficiaries living in counties subject to the floor rate received higher rate increases. In contrast to the payment rate increases received by plans, per capita FFS spending on the aged actually declined by about 3 percent between 1997 and 1998. Thus, even without considering the effects of favorable selection, the combination of the forecast error in the 1997 rates and the minimum annual rate increase resulted in $2 billion in excess payments to Medicare+Choice plans in 1998. Although it may take more than 5 years, the effect of the 1997 forecast error will be largely mitigated by the BBA provision that slows Medicare+Choice rate increases relative to the growth in FFS spending between 1998 and 2002. Furthermore, the BBA does allow HCFA to correct post-1997 forecast errors when setting 1999 and later county rates. However, the agency’s actions are constrained by the law’s minimum payment provisions. For example, 2001 payment rates would be lowered by more than 1 percent if HCFA fully corrected the 1998, 1999, and 2000 FFS spending estimates and applied the reduced update factor. However, to fulfill the BBA’s minimum payment rate requirements all county rates will have to be increased by at least 2 percent. Our current findings suggest that many of the additional benefits enjoyed by plan enrollees may have been the result of Medicare’s overly generous payment rates, not of efficiencies achieved under managed care. Medicare+Choice plans must, at a minimum, provide all of the services available to beneficiaries under the traditional FFS program. However, plans have typically provided substantial additional benefits, such as reduced beneficiary cost sharing, coverage for outpatient prescription drugs, dental care, and routine vision care, while charging modest or no premiums. Plans offered some of these additional benefits to fulfill Medicare requirements. If a plan projects that its Medicare revenues will be higher than the projected cost of providing basic Medicare services, the plan must contract to deliver additional benefits at no additional cost to beneficiaries. Many plans, however, exceeded these minimum requirements and voluntarily provided extra benefits in an effort to retain existing members and attract new ones. Based on data submitted by plans, HCFA estimates that Medicare+Choice plans are using 22 percent of their Medicare revenues to provide additional benefits in 2000. This figure is consistent with our previously reported analysis of plans’ 1997 data. The effect of Medicare’s inadequate risk adjustment methodology varied among plans because of differences in the health status of their enrollees. The vast majority of plans in our study (201 out of 210) served beneficiaries who tended to be healthier than FFS beneficiaries and thus received payments that exceeded their enrollees’ expected FFS costs. Nine plans, however, served beneficiaries who were generally less healthy than FFS beneficiaries. Medicare paid these plans less than it would have spent to serve these plans’ members in the FFS program.Nevertheless, the widespread finding of excess payments counters claims that favorable selection is not a problem in markets with substantial Medicare+Choice enrollment. A few plans had an excess payment rate above 30 percent, but the median excess payment rate was approximately 12 percent. Among the nine plans in our study that were disadvantaged because their enrollees tended to be in below-average health, Medicare’s payments were as much as 10.6 percent below enrollees’ expected heath care costs (see fig. 1). The amount of excess payment that plans received depends upon both the degree to which they experience favorable selection and the number of Medicare beneficiaries they served. In 1998, 40 plans each received more than $20 million in excess payments due to inadequate risk adjustment. The largest estimated excess payment to an individual plan totaled $334 million, or 40 percent more than Medicare would have spent if the plan’s enrollees had been covered under FFS. Among the nine plans that were paid less than their enrollees’ estimated FFS costs, the largest difference between estimated costs and payments was $8.4 million (see table 3). However, when excess payments due to forecast error are included, only 2 plans were paid less ($1.7 million and $175,000) than their enrollees’ expected costs. While the lack of an adequate risk adjuster can lead to excess payments, it can also result in plans being penalized if they serve a disproportionate share of Medicare beneficiaries with expensive health care needs. This can discourage a plan from seeking to enroll those beneficiaries, or developing programs that would foster a reputation for effectively treating certain costly diseases. Some analysts have suggested that favorable selection might diminish over time. They hypothesize that health status differences between beneficiaries in health plans and beneficiaries in FFS could disappear as plan enrollment grows. However, our results indicate that this is not likely. Most plans that were well-established, enrolled a substantial number of beneficiaries, and were located in areas with relatively high rates of Medicare managed care enrollment experienced some level of favorable selection and therefore received excess payments. For example, a plan in our sample had an estimated excess payment rate of 18.5 percent and received more than $100 million in excess payments, even though it had been serving Medicare beneficiaries for more than a decade, had well over 200,000 enrollees in 1998, and was a dominant plan located in an area where over 33 percent of the Medicare beneficiaries were enrolled in Medicare+Choice plans. Excess payments persisted, in part, because total enrollment in managed care plans continued to grow and because many of the new enrollees were in relatively good health. In 1998, about 15 percent of all enrollees in our sample had been in FFS the previous year. On average, these beneficiaries used about 30 percent less Medicare services (in dollar terms) in the year before they switched from FFS to managed care than demographically similar beneficiaries who remained in FFS. The difference between the health care needs of plan beneficiaries and FFS beneficiaries is smaller for beneficiaries who have been plan members for several years. However, our analysis indicates that for up to 8 years, plan beneficiaries continue to have somewhat lower expected costs than their demographic counterparts who remained in FFS. Almost three-quarters of the enrollees in our 1998 sample were in managed care plans for 5 years or less, so that the effect of enrollees’ better-than-average health produced excess payments for most plans. In creating the Medicare managed care program that preceded Medicare+Choice, the Congress sought a mechanism to better control program spending. However, evidence indicated that the payment methods used in the earlier program resulted in Medicare paying more, not less, for beneficiaries enrolled in plans. To address this and other problems, the BBA substantially changed the methodology used to set plan payments, beginning in 1998. Some industry representatives have suggested that the BBA’s payment reforms were too severe. They point to the recent plan withdrawals to support their claims that the Medicare+Choice program is in danger. Our current study indicates that, in 1998, Medicare paid plans $5.2 billion, or 21 percent, more than the estimated FFS costs of plans’ Medicare beneficiaries. The seeming paradox between our findings and the industry’s position is resolvable. Medicare+Choice plans are being paid too much for what was originally intended—providing beneficiaries the package of Medicare-covered services at less cost than the traditional FFS program. However, Medicare+Choice plans may not be paid enough for what they have been offering to attract beneficiaries—a more comprehensive benefit package beyond that covered for FFS beneficiaries for only modest or no premiums. The problem of excess payments can be addressed in part by better adjusting payments for the actual health status of enrollees. Such a step would also protect those plans that attract sicker-than-average enrollees. This year, HCFA began to implement a new risk adjuster that does a better job of calibrating payments to reflect differences in beneficiary health status. The agency also is developing an even more refined risk adjustment methodology. However, because of the slow and uncertain phase-in schedules, it may be several years before excess payments caused by health status differences are reduced substantially. The decision on whether to adjust the county rates so that the remaining excess payments are eliminated or to heed plans’ calls for higher Medicare+Choice payment rates will require balancing the concerns of beneficiaries, taxpayers, and plans. Adjusting plan payments so that the program pays no more for a Medicare+Choice enrollee than for a traditional Medicare beneficiary with equivalent health status is going to mean smaller payments and most likely lower profits for plans, fewer plans participating, and less-generous extra benefits for enrollees. These consequences raise for the Congress the question of whether payments should be modified to protect plans and the fraction of the Medicare beneficiary population enrolled—even if that protection results in Medicare spending more on the Medicare+Choice enrollee than for the traditional FFS Medicare beneficiary and increases the difficulty of financially sustaining the Medicare program. In commenting on our report, HCFA agreed that Medicare spends more on Medicare+Choice enrollees than it would have spent if those enrollees had received services through the traditional FFS program. The agency said that our findings were consistent with previous studies of favorable selection, which also concluded that Medicare managed care plans tend to attract beneficiaries with better-than-average health status. In addition, HCFA agreed that the BBA payment provisions and a 1997 spending forecast error had contributed to excess plan payments. HCFA noted that it is phasing in a risk adjustment method based on hospital diagnosis data to help reduce excess payments caused by favorable selection. If the method were fully implemented, plan payments would be reduced by an average of 5.9 percent. In 2004, HCFA will begin phasing in a risk adjustment method based on more comprehensive information that will more accurately measure health status and help avoid excess payments. The agency commented that our report reinforces the importance of proceeding with the implementation of risk adjustment. Finally, HCFA agreed with our conclusion that Medicare+Choice payments are too high for providing the Medicare benefit package, but may not be enough for the expanded benefit package that plans have offered to attract beneficiaries. According to its own analysis, approximately 76 percent of Medicare+Choice payments support Medicare-covered services. Plans use the remaining 24 percent to provide extra health care benefits (9 percent) and to reduce beneficiaries’ premiums and cost sharing (15 percent). It acknowledged that some plans may not find Medicare payments adequate to finance Medicare-covered services and the additional benefits they have been offering. The full text of HCFA’s comments appears in app. II. We are sending copies of this report to the Honorable Donna E. Shalala, Secretary of Health and Human Services; the Honorable Nancy-Ann Min DeParle, Administrator of HCFA; and other interested parties. We will also make copies available to others upon request. If you or your staffs have any questions about this report, please call me on (202) 512-7114 or Laura A. Dummit on (202) 512-7119. Other major contributors to this report included James C. Cosgrove, Hannah F. Fein, Jim S. Hahn, and Richard M. Lipinski. We developed a methodology to estimate how much Medicare would have spent on each Medicare+Choice plan enrollee if he or she received services under the traditional fee-for-service (FFS) arrangement in 1998.The difference between the estimated FFS costs of a plan’s enrollees and Medicare’s payments to that plan is a measure of excess (or under-) payment. The aggregate excess payments we report are the sum of the excess payments made to the 210 plans in our sample. These plans served approximately 87 percent of all beneficiaries in Medicare+Choice plans in 1998. We excluded plans that had relatively few new enrollees (typically, small plans), so our aggregate excess payment amount is not an estimate of national excess payments. To conduct our analysis, we obtained HCFA data from the following sources: (1) the Standard Analytic File, a repository of claims information; (2) the Continuous Medicare History Sample (CMHS), a database that contains longitudinal cost and enrollment information on a sample of Medicare beneficiaries from 1974 to the present; (3) the Group Health Plan file, a database that contains health plan enrollment information; and (4) the 1997 Adjusted Average per Capita Cost (AAPCC) rate book and accompanying worksheets, which contain summary demographic and cost information on Medicare beneficiaries in each county, and the 1998 payment rate file. We classified Medicare+Choice enrollees into two groups—survivors (beneficiaries who did not die in 1998) and decedents (beneficiaries who died in 1998)—and developed slightly different methodologies to estimate FFS costs for each group. Although relatively few beneficiaries die each year, their health care costs before death tend to be high and may follow a different pattern than other beneficiaries’ costs. We then aggregated the estimated FFS costs by plan and compared them to Medicare+Choice payments to estimate excess plan payments. To estimate the FFS costs of plan enrollees who survived 1998, we analyzed the 1997 FFS costs of beneficiaries who switched from FFS to a plan between 1997 and 1998. We then extrapolated from their cost patterns to estimate the FFS costs of all plan enrollees. To implement this approach we had to (1) estimate a base rate that reflected 1997 per capita spending on FFS survivors in each county, (2) calculate a joiner cost ratio for each plan that measured 1997 FFS spending on new plan enrollees relative to spending on demographically similar beneficiaries who remained in FFS, (3) derive a set of regression-toward-the-mean (RTM) factors for each plan that estimate how much FFS costs of enrollees in the plan differ from joiner’s 1997 FFS costs, and (4) develop a national update factor to convert 1997 spending levels to equivalent 1998 spending. The following describes the four steps. 1. Estimateabaserateforeachcountythatreflectsthecostofservingthe averageFFSbeneficiarywhodidnotdieduring1997. (Separate base costs were estimated for the aged and disabled Medicare populations.) We began with the 1997 county per capita costs, which represent HCFA’s estimated cost of providing Medicare-covered services to the average FFS beneficiary in each county.However, these rates reflect the cost experience of a county’s entire FFS population and thus include the typically high costs associated with persons who died during the year.To estimate the cost of survivors only, we used the fact that each county’s per capita costs can be expressed as a weighted average of the per capita costs of survivors and the per capita costs of decedents. That is, We then used the CMHS to estimate a national death factor that measures the difference in costs between persons who die and those who survive during the calendar year.Separate death factors were estimated for the aged and disabled Medicare populations.As shown in table 4, the cost of aged decedents is approximately 4 times the cost of aged survivors while the cost of disabled decedents is nearly 5 times the cost of disabled survivors. Average decedent costs could then be expressed as the product of the death factor and average survivor costs in equation 1. We combined terms and rearranged equation 1 to solve for average survivor costs in terms of the county per capita costs, proportions of survivors and decedents, and the national death factor.This yielded equation 2: Because the demographic mix of survivors varies among counties, we then adjusted each county’s costs using the average demographic factor for FFS survivors in that county. The result is our estimate of the base cost in each county.2. ComputeajoinercostratioforeachplanthatmeasurespriorFFS spendingonthatplan’snewenrolleesrelativetoaverageFFSspendingon demographicallysimilarbeneficiariesinthesamecounty. We computed 1997 Medicare spending on each beneficiary who left FFS and joined a plan in 1998 (these beneficiaries were termed joiners).We then compared that spending to the base rate for demographically similar beneficiaries in the joiner’s county of residence.The ratio of aggregate FFS spending on each plan’s joiners to the spending of demographically similar beneficiaries is the plan’s joiner cost ratio. For example, a joiner cost ratio of 0.75 indicates that a plan’s joiners had costs that were three-fourths of those of demographically comparable FFS beneficiaries in the year before enrollment. In our study, the weighted average joiner cost ratio was 0.67, and 93 percent of plans had a ratio of 0.80 or lower. The joiner cost ratio did not vary substantially with the number of years since the start of a plan’s Medicare contract or the size of a plan, but tended to be slightly higher among plans operating in markets with relatively high percentages of beneficiaries enrolled in plans (see table 5).However, even in those areas where Medicare managed care has a significant presence, beneficiaries who join plans generally have costs that are substantially below those of comparable FFS beneficiaries. 3. Computeasetofregression-toward-the-mean(RTM)factorsforeach planthatindicatehowlonger-termmembers’FFScostscomparetojoiners’ costs. The RTM factors account for the tendency of individual enrollee costs to converge toward the group mean over time. Beneficiaries who had lower-than-average costs before enrollment in a plan may incur increased costs in subsequent years. Conversely, beneficiaries who had higher-than- average costs before enrollment may experience reduced costs. That is, enrollees’ costs tend to regress toward the mean the longer they remain plan members.The RTM factors specify the degree to which enrollees’ estimated FFS costs differ from the pre-enrollment FFS costs of new enrollees. We used CMHS data to analyze how FFS costs changed for a sample of beneficiaries over a 5-year period.We grouped beneficiaries into eight cost cohorts based on their 1993 FFS costs relative to the overall sample mean cost in that year ($2,575).We then computed average FFS spending for each cohort relative to the sample mean FFS costs in each of the following 4 years. For example, among beneficiaries who had the lowest FFS costs in 1993, the average cost was 3 percent of the sample mean. (Many beneficiaries in this group had no Medicare costs.) In 1994, FFS costs for the same individuals averaged 44 percent of that year’s sample mean. By 1997, the group’s FFS costs averaged 59 percent of the year’s sample mean. In contrast, average spending on the group of beneficiaries who were most expensive in 1993 dropped from 1,678 percent of the sample mean in 1993 to 317 percent of the sample mean in 1997. We then extrapolated the CMHS cost trends to impute an additional 4 years of relative spending for each cost cohort. We then computed plan-specific joiner cost ratios from the CMHS cost trends and estimated each enrollee’s 1998 FFS costs relative to the average cost of a demographically similar beneficiary in FFS. An average cost trend for each plan was computed by using the distribution of its joiners’ 1997 FFS costs to weight the eight CMHS cost trends. Each enrollee was then assigned a plan-specific RTM factor based on the number of years he or she had been a plan member.These factors express the relationship between estimated relative FFS costs and the plan’s joiner cost ratio. For example, figure 2 illustrates the estimated RTM for beneficiaries enrolled in a hypothetical plan Z, which has a joiner ratio and RTM factors typical of an average plan in our sample. Joiners to the plan had 1997 FFS costs that equaled 67 percent of the average FFS cost for demographically similar beneficiaries who did not enroll in a plan. However, the CMHS cost trends indicate that in 1998—during their first year of plan membership—plan joiners’ FFS costs would have increased to 85 percent of average FFS costs. Thus the RTM factor for plan Z enrollees in their first year of membership is 1.27 (0.67 x 1.27 = 0.85). We similarly estimated relative FFS costs for enrollees with 8 or fewer years of plan membership. We assumed that there was no difference between plan enrollees’ costs and FFS beneficiaries’ costs for enrollees who had 9 or more years of plan membership.4. Computeanationalupdatefactorthatadjustsestimated1997spending to1998levels. As a result of BBA, HCFA no longer calculates AAPCC rates. Therefore, we multiplied 1997 FFS spending by the ratio of 1997 national per capita spending to 1998 national per capita spending to estimate 1998 spending. Because per capita FFS spending fell between 1997 and 1998, the update factor was 0.97 for aged beneficiaries and 0.96 for disabled beneficiaries. After we completed the preceding subtasks, imputing the 1998 FFS cost of each survivor enrolled in a plan involved multiplying a series of terms. Essentially, for each month in which a surviving beneficiary was enrolled in a plan, we began with the 1997 base rate multiplied by the beneficiary’s risk adjustment factor to obtain the expected average cost of a demographically comparable FFS beneficiary who was alive for the entire preceding year. We then multiplied that amount by the plan’s joiner cost ratio and the RTM factor applicable for the beneficiary’s tenure in a Medicare plan. Finally, we updated the resulting estimate to account for the change in the base rate between 1997 and 1998. This process is illustrated for one survivor by equation 3. Our approach assumes that when longer-term plan members first enrolled in a plan, they had FFS spending that was similar to the spending for current joiners. That is, we assume that a plan that experienced favorable or adverse selection of enrollees (healthier or sicker than average) in 1998 experienced similar favorable or adverse selection in previous years. This approach allows us to estimate costs for all plan enrollees based on the subset of enrollees who had FFS costs in the prior year.Some plan representatives have indicated that new enrollees in recent years have been less healthy and more costly compared to new enrollees in earlier years. To the extent this is true, our joiner ratios will overestimate what was spent on long-term enrollees when they were last in FFS and result in an underestimate of excess payments. We assumed that decedents in plans have the same costs as decedents in FFS and that these costs can be expressed as a fixed ratio, referred to as a death factor, of the average annual cost of FFS survivors. Consequently, we estimated the total costs associated with a decedent as the product of three terms: the annualized base rate, the death factor, and the cost update factor. We then aggregated the decedent-related costs experienced by each plan. These steps are illustrated for a single decedent by equation 4. We used 1998 Medicare+Choice payment rates, along with the number and demographic characteristics of each plan’s enrollees, to calculate plans’ monthly Medicare payments. We then subtracted from this amount the estimated FFS costs of the plan’s enrollees (both survivors and decedents). The difference between these amounts is our measure of excess payments (or underpayments). The excess payment rate expresses excess payments as a proportion of total estimated costs. This is illustrated in equation 5. The first copy of each GAO report is free. Additional copies of reports are $2 each. A check or money order should be made out to the Superintendent of Documents. VISA and MasterCard credit cards are accepted, also. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent. Ordersbymail: U.S. General Accounting Office P.O. Box 37050 Washington, DC 20013 Ordersbyvisiting: Room 1100 700 4th St. NW (corner of 4th and G Sts. NW) U.S. General Accounting Office Washington, DC Ordersbyphone: (202) 512-6000 fax: (202) 512-6061 TDD (202) 512-2537 Each day, GAO issues a list of newly available reports and testimony. To receive facsimile copies of the daily list or any list from the past 30 days, please call (202) 512-6000 using a touchtone phone. A recorded menu will provide information on how to obtain these lists. Web site: http://www.gao.gov/fraudnet/fraudnet.htm e-mail: fraudnet@gao.gov 1-800-424-5454 (automated answering system)

Summary: Pursuant to a congressional request, GAO reviewed Medicare Choice program payment issues, focusing on: (1) whether program spending for Medicare Choice plan enrollees has exceeded what Medicare-covered care for these beneficiaries would have cost in the fee-for-service (FFS) Medicare program; and (2) the extent to which payments to individual plans differ from expected FFS costs. GAO noted that: (1) Medicare Choice has not been successful in achieving Medicare savings; (2) Medicare Choice plans attracted a disproportionate selection of healthier and less-expensive beneficiaries relative to traditional FFS Medicare (a phenomenon known as favorable selection), while payment rates largely continued to reflect the expected FFS costs of beneficiaries in average health; (3) consequently, in 1998 GAO estimated that the program spent about $3.2 billion, or 13.2 percent, more on health plan enrollees than if they had received services through traditional FFS Medicare; (4) this year the Health Care Financing Administration implemented a new methodology to adjust payments for beneficiary health status; (5) however, GAO's results suggest that this new methodology, which will be phased in over several years, may ultimately remove less than half of the excess payments caused by favorable selection; (6) in addition, the combination of spending forecast errors built into plan payment rates and Balanced Budget Act payment provisions caused an additional $2.0 billion, or 8 percent, in excess payments to plans; (7) instead of paying less for health plan enrollees, GAO estimates that aggregate payments to Medicare Choice plans in 1998 were about $5.2 billion (21 percent), or approximately $1,000 per enrollee, more than if the plans' enrollees had received care in the traditional FFS program; (8) it is largely these excess payments, and not managed care efficiencies, that enable plans to attract beneficiaries by offering a benefit package that is more comprehensive than the one available to FFS beneficiaries, while charging modest or no premiums; (9) nearly all of the 210 plans in GAO's study received payments in 1998 that exceeded expected FFS costs because their enrollees were healthier than average beneficiaries; (10) however, the percentage of estimated excess payments varied substantially among plans; (11) about two-thirds of the plans received payments that were at least 10 percent more than enrollees would have cost Medicare in the traditional program, even without considering excess payments due to forecast errors; (12) the largest estimated excess payment to an individual plan totalled $334 million, or 40 percent more than Medicare would have spent if the plan's enrollees had been covered under FFS; (13) GAO also estimated that nine plans received payments below its enrollees' expected FFS costs; and (14) however, when excess payments due to forecast error are included, only 2 of the 210 plans were paid less ($1.7 million and $175,000) than its enrollees' expected FFS costs.