Medicare spending per beneficiary on physician services has varied substantially—both among geographic areas and in its growth over time. The geographic variation in spending—unrelated to beneficiary health status or outcomes—provides evidence that health needs alone do not determine spending. Consequently, policymakers have deemed it both reasonable and desirable to question the appropriateness of current and projected physician services spending and to explicitly consider the affordability of such spending when setting physician fees. The implementation of a national fee schedule and spending targets in 1992, for example, was designed, in part, to address issues of affordability and program sustainability by slowing spending growth. Moderating this growth remains part of the larger effort to ensure future Medicare program sustainability. In 1989, the Physician Payment Review Commission (PPRC) reported that from 1979 through 1989 (the decade prior to the establishment of spending targets), Medicare spending on physician services per beneficiary more than tripled, rising much more rapidly than general inflation. At that time, PPRC recommended an expenditure target for controlling aggregate spending on physician services. The target was to apply initially to all physician services nationally and later to evolve to separate targets for regions, categories of physician services, or both. Then, as now, utilization of physician services varied widely by geographic area, while the Medicare patient populations in these areas differed little from one another in their illnesses. Some studies report that variation in service use indicates that in some parts of the country compared with others, there was either overuse or underuse of services. Recent studies of Medicare expenditures show that regional variation in the use of medical services remains and that the spending disparities among areas are explained by physicians’ discretionary practices rather than by differences in patient populations’ health status. Three periods from 1980 to the present describe Medicare’s recent experience in spending for physician services. Figure 1 shows growth in Medicare spending per beneficiary for physician services during the three periods. In the first period, 1980 through 1991, Medicare’s payment rates for physician services were based on historical charges for these services, and limits were placed on fees and fee updates but not on aggregate spending. In the 1992 through 1997 period, physician services were paid under a national fee schedule, and the first spending target system—called the Medicare volume performance standard (MVPS)—set an allowable growth rate for aggregate spending that was used to adjust physician fees. From 1998 on, services continue to be paid under a fee schedule and the SGR system replaced the MVPS system and uses a different method to set an acceptable growth rate for aggregate spending. In the 1980s, Medicare paid physicians on the basis of “reasonable charge,” defined as the lowest of the physician’s actual charge, the customary charge (the amount the physician usually charged for the service), or the prevailing charge (based on comparable physicians’ customary charges). Under this system, payment inconsistencies existed among physicians by services, specialties, and locations. The system also had an inflationary bias, as a rise in customary charges could increase prevailing charges over time. During this decade, expenditures for physician services grew rapidly: from 1980 through 1991, Medicare spending per beneficiary for physician services grew at an average annual rate of 11.6 percent. Although the Congress froze fees or limited fee increases in the 1980s, spending continued to rise because there were no limits on growth in the volume and intensity of services physicians provided to beneficiaries. Recognizing that the expenditure growth of the 1980s was not sustainable, the Congress reformed the way Medicare paid for physician services in the traditional FFS program by requiring the establishment of a national fee schedule for physician services and a system for controlling aggregate physician service spending, MVPS. The establishment of a fee schedule in 1992 was an attempt to break the link between physicians’ charges and Medicare payments. The fee schedule was designed to pay for services based on the relative resources used by physicians to provide different types of care and to address the inflationary bias of the charge-based system. The adoption of a spending target system was an attempt to control spending growth attributable to increases in the volume and intensity of physician services. Under MVPS, a performance standard for a given year was set, indicating a growth rate for expenditures that should not be exceeded. The extent to which actual expenditure growth fell above or below the performance standard helped to determine the update to physician fees 2 years later. For example, in 1993, CMS compared actual spending in 1992 with the performance standard for 1992; the difference largely determined the update to physician fees in 1994. The performance standard was based on changes in four factors: the number of FFS Medicare beneficiaries, practice cost inflation, the historical growth in volume and intensity, and laws and regulations that could affect spending for physician services. From 1992 through 1997—the period that MVPS was used to set fee updates—annual spending growth for physician services was far lower than in the preceding decade. The decline in spending growth during this period was the result, in large part, of slower volume and intensity growth. For example, from 1985 through 1991, spending per beneficiary grew at an average annual rate of 10.8 percent; during that period, volume and intensity of service use per beneficiary rose an average 7 percent annually. From 1992 through 1997, the growth in spending per beneficiary fell to 4.4 percent; during that period, average annual growth in volume and intensity of service use per beneficiary fell to 1 percent. (See fig. 2.) Physician Payment Review Commission, 1995 Annual Report to Congress (Washington, D.C.: 1995). system’s perceived shortcomings, the Congress took action in BBA in 1997 to replace it with the SGR system. In 1998 and 1999, the first 2 years of the SGR system, volume and intensity growth remained similar to the rate under MVPS. However, from 2000 through 2003, volume and intensity growth rose at an average annual rate of about 5 percent. Over the 1998– 2003 SGR system period, the average growth in volume and intensity of services per Medicare beneficiary was higher than the average for the 1992–1997 MVPS period—but substantially below that experienced before spending targets were introduced. Since the introduction of the SGR system, total spending on physician services is projected to grow by an average of 8 percent a year from 2000 through 2005. The MVPS spending target was based, in part, on a 5-year historical trend in volume and intensity reduced by a specified number of percentage points. Because of this design and the fact that volume and intensity growth dropped dramatically after the adoption of the MVPS system, the target for future volume and intensity increases fell too. in its present form. In light of physician service expenditures’ significant contribution to aggregate spending, containing their growth plays an important role in helping to address the program’s long-range and fundamental financing problem. The SGR system is designed to impose fiscal discipline and to moderate spending for physician services by adjusting annual fee updates to bring spending in line with targets. The SGR system, similar to the predecessor MVPS system, relies on spending targets because earlier attempts to achieve fiscal discipline through limits on fee increases did not control the spending that resulted from volume and intensity growth. The SGR system uses a formula specified in statute to establish each year an allowed spending growth rate, a spending target, and a fee update. Like MVPS, the SGR system includes an allowance for volume and intensity increases but, unlike MVPS, ties the allowance to a measure of the growth of the national economy. As noted, spending targets were established—first under MVPS and later under the SGR system—because policymakers contended that the fee schedule alone would not have adequately constrained expenditure growth for physician services. The fee schedule limits payment for individual services but does not moderate spending growth resulting from volume and intensity increases. Although the SGR system’s spending target does not cap expenditures for physician services, it serves as a budgetary control by automatically lowering fee updates in response to excess spending due to volume and intensity growth. In addition, reduced fee updates serve as a signal to physicians collectively and to the Congress that spending due to volume and intensity has increased more than allowed. An additional reason for spending targets was advanced by PPRC in its 1995 report to the Congress. PPRC explained that spending targets were intended, in part, to create a collective incentive for physicians. Specifically, the report stated that spending targets “provid the medical profession with a collective incentive to reduce inappropriate care by, for instance, developing and disseminating practice guidelines that promote cost-effective practice styles.” Every year, CMS must estimate the allowed rate of increase in spending for physician services and use that rate to construct the annual spending target for the following calendar year. The sustainable growth rate is the product of the estimated percentage change in (1) input prices for physicians’ services; 27, 28 (2) the average number of Medicare beneficiaries in traditional FFS; (3) national economic output, as measured by real (inflation-adjusted) GDP per capita; and (4) expected expenditures for physician services resulting from changes in laws or regulations. CMS’s current estimate of the sustainable growth rate for 2005 is 4.6 percent, based on the agency’s estimates of the four factors. (See table 1.) Every fall, CMS determines whether the fee update for the following calendar year must be adjusted to help align spending with targets. To do so, the agency compares actual spending, measured cumulatively since 1996, to the cumulative value of the annual targets, measured over the same period. If the two are equal, the fee update is set to equal the estimated increase in physicians’ average cost of providing services—as measured by MEI. Otherwise, a performance adjustment factor (PAF) is used to increase or decrease the update relative to MEI in order to help bring spending back in line with the targets. (See app. I for the formula used to calculate the PAF.) The PAF is subject to limits and may not cause the update to be set at more than 3 percent above MEI or 7 percent below MEI. In part because of these limits, adjustments to realign actual cumulative spending with cumulative targets are spread out over more than 1 year. See BBRA, §211(b), 113 Stat. 1501A348-49. Revisions to targets first affected fee updates in 2001. In setting the target for that year, CMS revised only the 2000 SGR target. According to CMS, the agency was not authorized to revise the 1998 or 1999 SGR targets. The fee for each service is determined using a resource-based relative value scale in which the resources required for a service are valued in relation to the resources required to provide all other physician services adjusted for the differences in the costs of providing services across geographic areas. To arrive at a fee, the service’s relative value is multiplied by the dollar conversion factor. The update to the dollar conversion factor represents the aggregate of increases and decreases across all services. Because the relative value of individual services can change yearly, fee changes for specific services may be different than the overall fee update. Under SGR’s system of cumulative spending targets, excess spending that is not offset in one year accumulates in succeeding years until it is recouped. For 2005, MMA increased actual spending but did not adjust the target for this additional spending. Now the gap between actual spending and the target will result in an additional deficit that under the SGR system will have to be recouped through negative updates in future years. The parameters of the SGR system allow spending due to the volume and intensity of physician services to increase, but limit that growth to the same rate that the national economy (GDP) grows in real terms (that is, adjusted for inflation) over time on a per capita basis. Under the SGR system, if the volume and intensity of physician service use grows faster than the national economy, the annual increase in physician fees will be less than the estimated increase in the cost of providing services. Conversely, if volume and intensity grows more slowly, the SGR system permits physicians to benefit from fee increases that exceed the increased cost of providing services. To reduce the effect of yearly business cycles on physician fees, MMA required that economic growth be measured as the 10-year moving average change in real GDP per capita for each year beginning in 2003. This measure is projected to range from 2.1 percent to 2.5 percent during the 2005 through 2014 period. When the SGR system was established, GDP growth was seen as a benchmark that would allow for affordable increases in volume and intensity and also one that represented a significant improvement over the benchmark included in the previous MVPS system. In its 1995 annual report to the Congress, PPRC stated that limiting real expenditure growth to 1 or 2 percentage points above GDP would be a “realistic and affordable goal.” Ultimately, BBA specified the growth rate of GDP alone. This limit was an indicator of what the nation could afford to spend on volume and intensity increases. Whether this rate is a sufficient and appropriate allowance for volume and intensity increases is uncertain. Currently, volume and intensity is projected to grow by more than 4 percent per year, whereas the allowance for this growth under the SGR system is about 2.3 percent annually. Such excess volume and intensity growth is a key contributing factor to negative fee updates. Physician groups are dissatisfied with SGR as a system to update physician fees and have raised various concerns about its key components. Noting that physicians are uniquely subject to a system of fee updates that are explicitly linked to spending controls, the groups contend that the SGR system has caused payment rates in recent years to fall behind physicians’ cost of providing services. The groups’ concerns with specific SGR system components center on the following issues: the fairness of including Medicare-covered outpatient drugs in the calculation of physician service expenditures; the appropriateness of tying allowable volume and intensity increases to the average growth in real GDP per capita; and the completeness, accuracy, and transparency of the method used to account for spending increases due to changes in laws and regulations. Physician groups are concerned that physicians are the only Medicare provider type whose annual payment updates are subject to a spending target system. Payment rate updates for hospitals and other institutional providers, they note, are typically based on changes in the cost of providing services. However, as CBO, MedPAC, and others have noted, physicians are different from other providers in certain ways, which helps to provide a rationale for the application of targets solely to physician expenditures. Specifically, they note that physicians determine the services they deliver to their patients and influence the care delivered by other providers. In addition, under Medicare payment policies, physicians receive a separate payment for each service they provide. Thus, they can boost income by increasing the volume or intensity of services they provide. For example, a physician may follow up a patient’s visit by scheduling another visit, even when such a follow-up visit is discretionary and could be substituted with a telephone call. In contrast, Medicare typically pays institutional providers a fixed amount for a bundle of services; under this arrangement, no inherent incentive exists to provide extra services, as doing so would not increase payments. One of physician groups’ chief concerns is that through fee schedule updates, the SGR system holds physicians accountable for the escalating growth in Medicare expenditures for the majority of Part B-covered drugs. (Drugs included in the SGR system are largely physician administered and do not include all Part B-covered drugs.) The groups contend that the SGR system should not include these drugs in the calculation of aggregate physician service expenditures or the spending targets. Although the targets account for increases in the drugs’ prices, the targets do not explicitly account for increases in their utilization or the substitution of more expensive drugs for less expensive ones. Physician groups note that the use of the outpatient drugs currently covered by Medicare is largely nondiscretionary and that physicians should not be penalized for prescribing these drugs. To the extent that expenditures for these Medicare-covered outpatient drugs grow faster than real GDP per capita—which is the SGR system’s allowance for volume and intensity increases—other physician spending must grow more slowly or aggregate spending will exceed the targets and fee updates for physician services will be reduced. In 2002, Medicare covered approximately 450 outpatient prescription drugs. The drugs that account for most of Medicare’s Part B drug expenditures are physician administered, such as those for cancer chemotherapy, accounting for 80 percent of total Medicare spending for Part B drugs in 2001. In 2001, oncologists submitted about 42 percent of prescription drug claims, while urologists accounted for 17 percent. Part B prescription drugs are not covered by the physician fee schedule, but the expenditures for most Part B drugs are included in the SGR system expenditures because, at the time spending targets were first introduced, the Secretary of Health and Human Services (HHS) included these drugs as services and supplies “incident to” physicians’ services. Since that time, Medicare spending for all Part B drugs has grown substantially, from about $700 million in 1992 to an estimated $8.5 billion in 2002. Much of the spending growth has resulted from increases in utilization and the substitution of newer, more expensive medications. Because SGR-covered Part B drug expenditures have grown more rapidly than other physician service expenditures, drug expenditures as a proportion of allowable spending under the targets have grown from 8.7 percent in 2002 to an estimated 12.3 percent in 2004. Such rapid growth in drug expenditures increases the likelihood that actual spending will exceed SGR system targets. Moreover, because only payments for services included in the physician fee schedule are offset when physician service spending deviates from the spending targets, the increase in the share of total expenditures attributed to prescription drugs magnifies the adjustment that must be made to the update to bring spending in line with the targets. Physician groups have expressed concern that the SGR system’s allowance for volume and intensity growth—the 10-year moving average growth in real GDP per capita—is both too low and inflexible. They contend that tying the allowance to GDP results in targets that do not adequately account for appropriate increases in the demand for physician services and changes in medical practice, such as the following: A sicker beneficiary population. Physician groups reason that although health status drives demand for services, the GDP growth allowance would not account for any increases in physician spending that could be due to greater care demands per beneficiary. Technological advances. The groups note that new, expensive medical technologies can provide meaningful health gains for Medicare beneficiaries but that these technology costs are likely to grow faster than GDP. Site-of-service shifts. The groups note that patients with complex conditions formerly treated in hospitals are increasingly treated in physician offices and that treating such patients, who may require frequent office visits and costly procedures, is likely to contribute to volume and intensity growth. The MVPS system provided an explicit opportunity to address some of these concerns procedurally. In addition to the allowance for volume and intensity growth specified in statute, the MVPS system also provided specific authority for the HHS Secretary to recommend revising the allowed increase based on factors such as changes in technology and concerns about access to physician services. Under the MVPS system, the Secretary never exercised the authority to make recommendations other than implementing the MVPS default formula, but it still remained an option. The SGR system is designed to account for changes in law and regulation that could affect aggregate spending for physician services. For example, for 2005, CMS estimates that increased spending resulting from MMA’s coverage of a preventive physical examination for new beneficiaries, cardiovascular screening blood tests, and diabetes screening tests, among other new increases, will be almost fully offset by new MMA-required payment adjustments for Part B drugs, which will lower physician service spending. Physician groups we spoke with contend that the process for developing such estimates may not be accurate or complete. Assessing the accuracy and completeness of these estimates is difficult, as CMS’s process for identifying the applicable statutory and regulatory changes and the methods used to arrive at dollar estimates are not fully transparent. Either data are lacking to quantify the effects of changes or consensus is lacking on the assumptions and interpretations made about the changes and their effects. Currently, CMS does not use a formal mechanism for soliciting input from physician groups or other experts before obtaining public comment when future fees are announced in the Federal Register. Physician groups contend that at least including physician representatives in the process of assessing changes in laws and regulations would improve CMS’s analysis of effects and would be more efficient than waiting for the public comment period. Fee updates under the SGR system have varied widely within an allowed range, principally because of annual fluctuations in the growth of the volume and intensity of services that physicians provide to beneficiaries. Two of the SGR system’s design characteristics—the cumulative nature of spending targets and the use of estimated data elements in the spending target—also serve to reduce the stability and predictability of updates. The MMA provision that revised the allowance for growth in service volume and intensity from real GDP per capita growth rates each year to a 10-year moving average will reduce some of the swings in future SGR system updates. Annual fluctuations in the growth of the volume and intensity of services that physicians provide to beneficiaries have been a principal cause of the instability of physician fee updates. Since the SGR system was implemented in 1998, volume and intensity growth has ranged from 1.2 percent in 1999 to 6.1 percent in 2002. (See fig. 2.) It is uncertain how much physicians’ discretion in the provision of their services contributes to the fluctuation in volume and intensity growth. Several studies have found that physicians respond to reduced fee updates by increasing the volume and intensity of services they provide to help maintain their total Medicare income. In estimating future spending and fee updates, both CMS and CBO assume that physicians will compensate, through volume and intensity increases, for a portion of any fee reductions. Consequently, both CMS and CBO project that for example, a 1 percent fee reduction would cause aggregate spending to fall by less than 1 percent. In addition, CBO assumes that physicians will respond to fee increases by reducing volume and intensity. Physician groups contend that volume and intensity growth is a necessary response to increased demand caused by factors outside of physicians’ control as noted earlier, such as the declining health status of Medicare beneficiaries, Medicare coverage of new benefits, and changing medical technology and practices that encourage beneficiaries to schedule more appointments with physicians. As long as the contributing factors are not fully understood and predictable, unexpected volume and intensity fluctuations will result in uncertain fee updates year to year. The cumulative nature of the SGR system’s spending targets increases the potential fluctuation of physician fee updates, as the system requires that excess spending in any year be recouped in future years. Conceptually, this means that if actual spending has exceeded the SGR system targets, fee updates in future years must be lowered sufficiently to both offset the accumulated excess spending and slow expected spending for the coming year. Conversely, the system also requires that if spending were to fall short of the targets, fees would need to be increased so that future spending would be raised to align with target spending. Estimation of the 2005 fee update illustrates how excess spending that is not addressed affects future fee updates. In 2004 actual expenditures under the SGR system are estimated to be $83.4 billion, whereas target expenditures for the same year will be $77.3 billion. As a result, 2005 fee updates need to offset a $6.1 billion deficit from excess spending in 2004 (plus accumulated excess spending of $5.8 billion in past years) and to realign the year’s expected spending with target spending. Because the SGR system is designed to offset accumulated excess spending over a period of years, the deficit for 2004 and preceding years will reduce fee updates for multiple years. According to projections made by CMS OACT, maximum fee reductions will be in effect from 2006 through 2012. Fee updates will be positive in 2014. (See fig. 3.) The stability of fee updates under the SGR system depends, in part, on CMS’s ability to accurately estimate current spending and annual changes in the four factors that determine the sustainable growth rate: input prices, FFS enrollment, the 10-year moving average of real GDP per capita, and expenditures due to changes in laws and regulations. If reality proves different from these estimates, then the estimates are revised to incorporate more complete data, thereby contributing to the year to year fluctuation in fee updates. For example, in the fall of 2004, when CMS determines the update for 2005, the agency must estimate cumulative expenditures through the end of 2004 based on incomplete data. If actual spending is underestimated, the 2005 update will be set higher than it would have been set without the estimation error. This underestimate will be corrected, because in setting a fee update, the SGR system requires CMS to revise the spending estimates and the sustainable growth rates for the 2 preceding years. Therefore, when more complete spending data become available, the agency will revise its previous cumulative spending estimates through 2004 and reduce future fee updates relative to what they would have been if spending had not been underestimated. Uncertainty in long-term projections of FFS enrollment, in conjunction with the cumulative nature of the SGR system’s targets, makes long-term estimates of fee updates less predictable. Because the SGR system offsets accumulated excess spending by reducing the update for the fee paid for each service, a decline in the number of services results in less spending being offset. For example, currently, CMS estimates that over the next 10 years, enrollment in FFS will decline as more beneficiaries join private plans. CMS projects that the percentage of Medicare beneficiaries in the FFS program will decline from about 85 percent in 2005 to 67 percent in 2014. With fewer beneficiaries in FFS, fewer services would be provided. Therefore, the SGR system would call for more severe update reductions to offset accumulated excess spending relative to what would have occurred if FFS enrollment had remained stable. In contrast, CBO projected that FFS enrollment will increase over the 10-year period at about the same rate as the increase in overall Medicare enrollment. With more beneficiaries in FFS, and thus more services provided, update reductions would not need to be as severe to offset accumulated excess spending. Therefore, under CBO’s FFS projection, positive fee updates would be expected to return sooner than under CMS’s FFS projection. MMA changed the SGR system formula to use a 10-year moving average of real GDP per capita, which is currently 2.3 percent. As noted in our 2002 testimony, this change will eliminate much of the cyclical variation in this factor that occurred in previous years under the formula when the SGR system target was tied to the yearly change in real GDP per capita. (See fig. 4.) Including a more stable measure of economic growth in the SGR system formula will help increase the stability of fee updates. The projected sustained period of declining physician fees and the potential for beneficiaries’ access to physician services to be disrupted have heightened interest in alternatives for the current SGR system. In general, potential alternatives we identified cluster around two approaches. One approach would end the use of spending targets as a method for updating physician fees and encouraging fiscal discipline. The other approach would retain spending targets but modify the current SGR system to address perceived shortcomings. These modifications could include one or more of the following options: removing the Part B prescription drug expenditures that are currently counted in the SGR system; resetting the targets and not requiring the system to recoup previous excess spending; using annual, rather than cumulative, targets; raising the allowance for increased spending due to volume and intensity growth; and permitting some flexibility in setting the volume and intensity allowance. The projections are included to aid comparisons among the various options and are not intended to serve as predictions for what would occur if the SGR system was replaced or modified. In addition, there is a degree of uncertainty surrounding any projection and that uncertainty tends to increase with the number of years for which the projection is made. For some of these options we present, CBO has developed budget scores, which are specific cost estimates that include only federal expenditures and exclude spending from other sources, such as beneficiary cost sharing. When available, we present CBO’s cost estimates for the options. use the same assumptions regarding volume and intensity growth for physician services and future FFS enrollment. In its March 2001 report to the Congress, MedPAC recommended eliminating the SGR system of spending targets and replacing it with an approach that would base annual fee updates on changes in the cost of efficiently providing care. Under this approach, efforts to control aggregate spending would be separate from the mechanism used to update fees. The advantage of eliminating spending targets would be greater fee update stability. However, CMS OACT estimates that this approach, compared with the current law projection, would result in cumulative expenditures that are 22 percent greater over a 10-year period. MedPAC reported that its recommendation could be implemented, in part, by basing the update on forecast changes in MEI. It suggested that other adjustments to the update might be necessary, for example, to ensure overall payment adequacy or correct for previous MEI forecast errors. In subsequent annual reports to the Congress, MedPAC has continued to recommend a physician fee update based on MEI. In its March 2004 report, for example, MedPAC stated that current Medicare payments for physician services were adequate and recommended an update of approximately 2.6 percent for 2005 to “help maintain physician willingness and ability to furnish services to Medicare beneficiaries.” MedPAC’s recommendation contrasts with the 1.5 percent minimum update provided for by MMA and the negative 3.6 percent update specified by the SGR system. In 2004 testimony, MedPAC stated that fee updates for physician services should not be automatic, but should be informed by changes in beneficiaries’ access to services, the quality of services provided, the appropriateness of cost increases, and other factors. Basing the update on MEI would result in positive and relatively stable fee updates. (See fig. 5.) According to CMS OACT simulations, such an approach would likely produce fee updates that ranged from 2.1 percent to 2.4 percent over the period from 2006 through 2014. Because physician fees would increase each year during the entire period, rather than decreasing each year until positive updates returned in 2014 as they would under the current SGR system, Medicare spending for physician services would rise. For the 10-year period from 2005 through 2014, CMS OACT estimates that this approach would result in cumulative expenditures that are 22 percent greater than projected under current law. (See fig. 6.) CMS OACT projects that under current law the net present value of total Medicare spending (both federal and beneficiary) over the next 75 years on all Part B services will be $16.9 trillion. If physician fee updates are based on the change in MEI, CMS OACT estimates that the net present value of total Medicare spending (both federal and beneficiary) over the next 75 years on Part B services would equal $19.1 trillion. Real spending per beneficiary would increase from $2,157 in 2005 to $2,802 in 2014, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 7.) Although MedPAC’s recommended update approach would limit annual increases in the price Medicare pays for each service, the approach does not contain an explicit mechanism for constraining aggregate spending resulting from increases in the volume and intensity of services physician provide. In 2001, when MedPAC first recommended eliminating the SGR system, it stated that volume and intensity increases had not been a major concern since 1992. It added, however, that if volume and intensity growth reemerged as a concern, Medicare might address the problem by trying to achieve appropriate use of services through outcomes and effectiveness research, disseminating practice guidelines and other tools for applying this research, and developing evidence-based measures to assess the application of the research findings. Since MedPAC’s 2001 report, volume and intensity growth has increased considerably. (See fig. 2.) Subsequent MedPAC reports and testimony have discussed trends in the use of physician services and have identified particular services—such as diagnostic imaging—that are growing rapidly, but the reports have not made recommendations for addressing volume and intensity growth. However, in 2004 testimony, MedPAC stated that it planned to study the efficacy of private insurers’ strategies for controlling spending for high-growth services and whether Medicare might be able to emulate them. Another approach for addressing the perceived shortcoming of the current SGR system would retain spending targets but modify one or more elements of the system. The key distinction of this approach, in contrast to basing updates on MEI, is that fiscal controls designed to moderate spending would continue to be integral to the system used to update fees. The advantage of retaining spending targets as part of the system for updating fees is that the system would automatically work to moderate spending if volume and intensity growth began to increase above allowable rates. Although many options are possible under this approach, six are discussed below. All six would produce fee updates that are higher during the 10-year period from 2005 through 2014 than those projected under current law but would also result in higher aggregate spending ranging from 4 percent to 23 percent more, depending on the modification. The Secretary of HHS could, under current authority, consider excluding Part B drugs from the definition of services furnished incident to physician services for purposes of the SGR system. As discussed earlier, expenditures for these drugs have been growing rapidly, which, in turn, has put downward pressure on the fees paid to Medicare physicians. However, according to CMS OACT simulations, removing Part B drugs from the SGR system beginning in 2005 would not prevent several years of fee declines and would not decrease the volatility in the updates. Fees would decline by about 5 percent per year from 2006 through 2010. (See fig. 8.) There would be a positive update in 2011—3 years earlier than is projected under current law. From 2012 through 2014, fees would increase by approximately 5 percent per year. CMS OACT estimates that removing Part B drugs from the SGR system would result in cumulative spending over the 10-year period from 2005 through 2014 that is 5 percent higher than is projected under current law. (See fig. 9.) Real spending per beneficiary would increase from $2,157 in 2005 to $2,240 in 2014, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 10.) In 2002, we testified that physician spending targets and fees may need to be adjusted periodically as health needs change, technology improves, or health care markets evolve. Such adjustments could involve specifying a new base year from which to set future targets. Currently, the SGR system uses spending from 1996, trended forward by the sustainable growth rate computed for each year, to determine allowable spending. MMA avoided a fee decline in 2004, and a projected fee decline for 2005, by stipulating a minimum update of 1.5 percent in each of those 2 years, but the law did not similarly adjust the spending targets to account for the additional spending that would result from the minimum update. Consequently, under the SGR system the additional MMA spending and other accumulated excess spending will have to be recouped through fee reductions beginning in 2006. If policymakers believe that the resulting negative fee updates are inappropriately low, one solution is to use actual spending from a recent year as a basis for setting future SGR system targets. Using such an approach, policymakers could essentially forgive the accumulated excess spending attributable to MMA and other factors. The effect would be to increase future updates and, as with other alternatives presented here, overall spending. According to CMS OACT simulations, forgiving the accumulated excess spending as of 2005—that is, resetting the cumulative spending target so that it equals cumulative actual spending—would raise fees in 2006. (See fig. 11.) However, because volume and intensity growth is projected to exceed the SGR system’s allowance for such growth, negative updates would return beginning in 2008 and continue through 2013. Resulting cumulative spending over the 10-year period from 2005 through 2014 would be 13 percent higher than is projected under current law. (See fig. 12.) Real spending per beneficiary for physician services would grow from $2,157 in 2005 to $2,334 in 2014, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 13.) One option for reducing the fluctuation in fee updates would be to eliminate the cumulative aspect of the SGR system’s spending targets and return to a system of annual targets, as was used under MVPS. As previously discussed, the cumulative aspect of the SGR system’s spending targets—although rigorous as a budgetary tool—can produce updates that swing from the maximum fee reduction to the maximum fee increase. In contrast, MVPS’s annual spending target approach traded off some fiscal control for increased fee stability. The MVPS update for a year depended, in part, on whether actual spending 2 years earlier had exceeded or fallen short of the annual spending target for that year. For example, the MVPS update for 1996, which was determined in 1995, was affected by the relationship between actual and target spending in 1994. In principle, under MVPS excess spending from a single year, up to a limit specified by its update formula, was required to be recouped. Excess spending that could not be made up within those limits would, in essence, be forgiven. According to CMS OACT simulations, eliminating the cumulative aspect of the SGR system would result in fee updates that vary less than projected updates under current law. For example, under an MVPS-like system of annual targets, from 2006 through 2014, the largest negative update would be negative 0.6 percent instead of negative 5.0 percent under current law, and the largest positive update would be 0.9 percent instead of 3.9 percent. (See fig. 14.) Fees would be essentially flat over the period, instead of swinging from large fee declines to fee increases as they are expected to do under the SGR system. Relative to spending projected under current law, under an MVPS-like system total spending would be greater each year from 2006 through 2014. CMS OACT estimates that cumulative expenditures over the 10-year period from 2005 through 2014 would be 15 percent higher than under current law. (See fig. 15.) Real spending per beneficiary would increase from $2,157 in 2005 to $2,442 in 2014, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 16.) If policymakers agree with physician groups that the current SGR system’s allowance for volume and intensity growth does not adequately account for appropriate spending increases that result from technological innovation or changes in medical practice, the allowance could be increased by some factor above the percentage change in real GDP per capita. As stated earlier, the current SGR system’s allowance for volume and intensity growth is approximately 2.3 percent per year—the 10-year moving average in real GDP per capita—while projected volume and intensity growth is higher—about 3 percent per year for physician services alone, and about 4 percent per year including Part B drugs. To offset the increased spending associated with the higher volume and intensity growth, the SGR system will reduce updates below the increase in MEI. In its 1997 report to the Congress, PPRC recommended adopting an allowance equal to real GDP per capita plus 1 or 2 percentage points “to allow for advancements in medical capabilities.” According to CMS OACT simulations, increasing the allowance for volume and intensity growth to GDP plus 1 percentage point would likely produce positive fee updates beginning in 2012—2 years earlier than is projected under current law. (See fig. 17.) Because fee updates would be on average greater than under current law during the 10-year period from 2005 through 2014, Medicare spending for physician services would rise. CMS OACT estimates that cumulative expenditures over the 10-year period would increase by 4 percent more than under current law. (See fig. 18.) Real spending per beneficiary would change little from $2,157 in 2005 to $2,158 in 2014, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 19.) Congress could also modify the SGR system’s allowance for volume and intensity growth by providing flexibility similar to that afforded by the MVPS system. Although that earlier system of spending targets specified a default volume and intensity increase, it also allowed the HHS Secretary to recommend a different increase if changes in medical technology, beneficiary access to physician services, or other factors warranted an allowance that was higher or lower than the default increase. Two alternatives illustrate the effects of combining individual options. For example, together the Congress and CMS could modify the SGR system by removing Part B drugs, resetting the base, and increasing allowed volume and intensity growth to GDP plus 1 percentage point. According to CMS OACT simulations, this combination of options would result in positive updates ranging from 2.2 percent to 2.8 percent for the 2006–2014 period. (See fig. 20.) CMS OACT projects that the combined options would increase aggregate spending by 23 percent over the 10-year period (see fig. 21.) and that real spending per beneficiary for physician services would increase from $2,157 to $2,866, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 22.) Another example of combined options could involve removing Part B drugs and implementing an MVPS-like system of annual targets, but not increasing the volume and intensity allowance. CMS OACT simulations project that this combination would result in fee updates that range from 0.8 percent to 1.3 percent over the period from 2006 through 2014. (See fig. 23.) Over the 10-year period from 2005 through 2014, cumulative spending for physician services would exceed those projected under current law by 18 percent. (See fig. 24.) Real spending per beneficiary for physician services would increase from $2,157 to $2,615, compared with real spending per beneficiary under current law, which would decrease to $1,774 in 2014. (See fig. 25.) Medicare faces the challenge of moderating the growth in spending for physician services while ensuring that physicians are paid fairly so that beneficiaries have appropriate access to their services. Under the current SGR system, fees are projected to fall by about 5 percent per year for the next several years. Total payments to physicians will continue to rise because of expected increases in volume and intensity. However, on a per capita basis, real spending per beneficiary will decline, raising concerns that a sustained period of falling fees could discourage some physicians from participating in the Medicare program and serving beneficiaries. These concerns have prompted policymakers to consider alternative approaches for updating physician fees. One approach under consideration for solving the problem of declining fees is for Medicare to abandon the use of spending targets and separate the program’s attempts to control spending from its method for adjusting physician fees each year. This is the approach that has been recommended by MedPAC. Although projected future fee increases would be positive and relatively stable, eliminating spending targets would increase spending. The extent to which spending growth would be moderated would depend upon the efficacy of separate efforts to address growth in volume and intensity. Similarly, the other approach of retaining spending targets but modifying the SGR system to overcome its current perceived shortcomings, would also increase spending. These alternative approaches could also be augmented by separate efforts to moderate spending. Alternatives under this approach seek to preserve the fiscal discipline of spending targets while providing for reasonable fee updates. These alternative approaches could also be augmented by other efforts to moderate spending. To the extent that the growth in spending is moderated, physicians would benefit from an increase in fees that would be triggered under a spending target system. Almost any change to the SGR system is likely to increase Medicare spending above the amount that is currently projected. Either of the two broad types of approaches discussed above—replacing the SGR system and revising the SGR system—could be implemented in a way that would likely generate positive fee updates. Therefore, the choice between the two approaches under consideration may hinge on whether primary importance should be given to stable fee increases or to the need for fiscal discipline within the Medicare program. In written comments on a draft of this report, CMS agreed with our concluding observations that appropriately updating the physician payment rates requires a balance between adjusting physician fees in a stable and predictable manner and encouraging fiscal discipline with scarce Medicare resources. CMS expressed its commitment to ensuring that Medicare beneficiaries have access to high-quality health care and noted that achieving this goal requires paying physicians appropriately. CMS mentioned several administrative actions it has taken to improve Medicare’s payments to physicians, including specific adjustments to MEI that have both made the index a more accurate representation of inflation in physician practice costs and resulted in higher payments to physicians. In addition, the agency committed to considering further administrative actions and discussed ongoing efforts to implement various provisions of MMA that may reduce adverse incentives in the current payment system, allow the program to pay for higher quality care, and uncover innovative methods to control spending growth in the future. We have reprinted CMS’s letter in appendix III. We obtained oral comments from officials representing the American Medical Association (AMA), the Medical Group Management Association (MGMA), the American College of Physicians (ACP), and the Alliance for Specialty Medicine (ASM). In discussing the draft report with these groups, their overall reaction was that the report was a good analysis of the problems with the SGR system; however, they raised a number of concerns about the draft report. The bulk of their comments focused on OACT’s estimates of aggregate spending on physician services, the SGR system’s use of MEI as a measure of input price inflation for physician services, and the draft’s discussion of physicians’ concerns about the SGR system. The rest of their comments pertained to either issues related to physician behavior or to topics outside the scope of our review. A summary of the physician groups’ comments and our evaluation is provided below. Representatives from all four groups commented on CMS OACT’s estimates illustrating each option’s additional aggregate spending over a 10-year period relative to current law spending over the same period. The groups were confused by the difference between CMS OACT’s estimates and CBO’s budget impact estimates, which were available for some of the options. CBO’s budget scores—that is, cost estimates that show the impact of legislative changes on the federal budget—include only federal expenditures and exclude spending from other sources, such as beneficiary cost sharing. In contrast, CMS OACT’s aggregate spending estimates include both federal outlays and beneficiary cost sharing. Because any changes to the SGR system that result in increased spending would not only affect taxpayers but also Medicare beneficiaries (through increased cost sharing and part B premiums), we believe it is appropriate to include the estimated increase in aggregate spending. Nevertheless, because our focus is on the relative costliness of each option, we revised the draft to highlight the proportional difference between current law spending and the spending estimated for each option. In addition, we now include CBO’s budget scores for each option, where available. All four physician groups also expressed concern that the draft report did not discuss the use of MEI as a measure of input price inflation for physician services. The groups contended that MEI does not contain sufficiently current data on physician practice costs, stating that it does not account for or keep pace with the cost of items such as information technology. Examining MEI and other indices included in the SGR system was outside the scope of our report. Moreover, in responding to public comments on a federal regulation, CMS stated that the various expense categories constituting MEI capture all practice expenses and are based on the most recent available data. The physician groups commented that the projected payment reductions of 5 percent a year from 2006 through 2014 are unrealistically severe and that the draft report did not sufficiently emphasize the access problems that beneficiaries would experience in the event of these cuts. They further noted that the Congress has regularly made adjustments to the SGR system and would probably act again. We noted in the draft report that policymakers, physicians, and others are concerned about the impact that the projected fee reductions would have on beneficiary access to physician services, noting that the Medicare Trustees and other parties believe it is unlikely that the projected fee reductions will take place. Representatives from both ACP and ASM asserted that we should include a discussion about the effect of the spending targets on physician behavior and volume and intensity. They noted that evidence is lacking that directly correlates the introduction of both spending targets and the physician fee schedule in 1992 with the corresponding drop in volume and intensity in that year. They believe this reduction was likely caused by something other than the spending target, such as initiatives aimed at correctly coding claims for physician services. ACP stated that for the Congress to evaluate any alternatives, there must be a discussion of how the SGR system affects the volume and intensity of physician services. As noted in the draft report, we do not claim that spending targets and the fee schedule influenced individual behavior and reduced the volume and intensity of physician services in the early 1990s, we noted that PPRC claimed that a spending target system would provide a collective incentive for physicians to develop practice guidelines and control unnecessary utilization. Further, in the draft report we described spending targets as a method for automatically imposing fiscal discipline, not as a tool to modify the behavior of individual physicians. Representatives from ACP further noted that while the draft report included a discussion of geographic variation in physician service use, it did not mention that the SGR system is a blunt instrument in that it applies nationally to all physicians. In a year in which fees are reduced, physicians in regions that could be characterized as low spending would receive the same fee reduction as physicians in higher-spending regions. We agree that the SGR system does not distinguish between physicians whose discretionary practice patterns result in higher Medicare spending and those physicians whose practice patterns do not. As we stated in the draft report, at the time PPRC recommended expenditure targets, it initially envisioned a national target that would apply to all physician services and later the evolution of separate targets that would apply to regions, categories of physician services, or both. The physician groups raised additional topics that were beyond the scope of our study. For example, AMA contended that Medicare’s new preventive benefits and government-sponsored health campaigns create a government-induced demand among beneficiaries for services that, in turn, could increase volume and intensity of service use. To date, studies have not been conducted on whether new benefits and federal health campaigns have directly affected Medicare beneficiaries’ use of physician services. Our report notes, however, that the SGR system’s allowance for volume and intensity growth, unlike that of the MVPS system, is inflexible and would not take such factors into account. ACP noted that increased spending on physician services may be appropriate, as it may result in other program savings, such as reduced spending for hospital care. Whether such savings have been or can be achieved would require research outside this study’s scope. We are sending copies of this report to the Secretary of Health and Human Services and interested congressional committees. We will also provide copies to others on request. In addition, this report is available at no charge on the GAO Web site at http://www.gao.gov. If you or your staff have questions about this report, please contact me at (202) 512-7101 or James Cosgrove at (202) 512-7029. Other contributors to this report include Jessica Farb, Hannah Fein, and Jennifer Podulka. Each year, CMS follows a statutory formula to compute a performance adjustment factor (PAF) and determines whether the physician fee update should be adjusted relative to the percentage change in the Medicare Economic Index (MEI) and, if so, by how much. (See fig. 26.) The PAF takes into account the difference between actual and target expenditures. If spending has equaled the targets, the PAF is equal to 1 and the update will equal the percentage change in MEI. If spending has been below the targets, the PAF is greater than 1, thus increasing the update. If spending has been above the targets, the PAF is less than 1, thus reducing the update. The PAF is a blend of the relative difference between target and actual spending in the current year, accounting for 75 percent, and the relative cumulative difference in expenditures from April 1996 through the current year, accounting for 33 percent. The weights were developed by the Centers for Medicare & Medicaid Services’ (CMS) Office of the Actuary (OACT) and included in statute to minimize the volatility of both fee updates and the time required to align actual spending with the targets. Applying these weights causes the difference between cumulative actual expenditures and cumulative target expenditures to be adjusted over several years rather than during a single year. As a result, the fee update is less volatile than would be the case if the full adjustment were made in 1 year. The PAF is subject to statutory limits and may not cause the fee update to be set at more than 3 percent above MEI or 7 percent below MEI. These limits may further increase the time necessary to align spending with targets. Since the introduction of the fee schedule in 1992 through 2001, physicians generally experienced real increases in their fee updates—that is, fee updates increased more than the increase in the cost of providing physician services, as measured by MEI. Specifically, during that period, fee updates increased by 39.7 percent, whereas MEI increased by 25.9 percent. In 2002, however, the sustainable growth rate (SGR) system reduced fees by 4.8 percent, despite an estimated 2.6 percent increase in the costs of providing physician services. (See fig. 27.) In 2002, corrections to prior estimation errors caused the SGR system’s cumulative targets to begin producing negative updates. The SGR system reduced fees in 2002 because estimated spending for physician services— cumulative since 1996—exceeded the target by about $8.9 billion, or 13 percent of projected 2002 spending. In part, the fee reduction occurred because CMS revised upward its estimates of previous years’ actual spending. Specifically, CMS found that its previous estimates had omitted a portion of actual spending for 1998, 1999, and 2000. In addition, in 2002 CMS lowered the 2 previous years’ spending targets based on revised gross domestic product (GDP) data from the Department of Commerce. Based on the new higher spending estimates and lower targets, CMS determined that fees had been too high in 2000 and 2001. In setting the 2002 physician fees, the SGR system reduced fees to recoup previous excess spending. The update would have been about negative 9 percent if the SGR system had not limited its decrease to 7 percent below MEI. Because the previous overpayments were not fully recouped in 2002, and because of volume and intensity increases, by 2003, physicians were facing several more years of fee reductions to bring cumulative Medicare spending on physician services in line with cumulative targets. Despite its recognition of errors, CMS had determined that its authority to revise previous spending targets was limited. In 2002, CMS noted that the 1998 and 1999 spending targets had been based on estimated growth rates for beneficiary FFS enrollment and real GDP per capita; actual experience had shown these growth rates to be too low. If the estimates could have been revised, the targets for those and subsequent years would have been increased. However, at the time that CMS acknowledged these errors, the agency concluded that it was not allowed to revise these estimates. Without such revisions, the cumulative spending targets remained lower than if errors had not been made. In late 2002, the estimate of the sustainable growth rate called for a negative 4.4 percent fee update in 2003. With the passage of the Consolidated Appropriations Resolution of 2003, CMS determined that it was authorized to correct the 1998 and 1999 spending targets. Because SGR system targets are cumulative measures, these corrections resulted in an average 1.4 percent increase in physician fees for services for 2003. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) averted additional fee reductions projected for 2004 and 2005 by specifying an update to physician fees of no less than 1.5 percent for those 2 years. The MMA increases replaced SGR system fee reductions of 4.5 percent in 2004 and an estimated 3.6 percent in 2005. The fee increases will result in additional aggregate spending. Because MMA did not make corresponding revisions to the SGR system’s spending targets, its fee increases will require the SGR system to offset the additional spending by reducing fees beginning in 2006. In addition, recent growth in spending due to volume and intensity, which has been larger than SGR system targets allow, will further compound the excess spending that needs to be recouped. The Government Accountability Office, the audit, evaluation and investigative arm of Congress, exists to support Congress in meeting its constitutional responsibilities and to help improve the performance and accountability of the federal government for the American people. GAO examines the use of public funds; evaluates federal programs and policies; and provides analyses, recommendations, and other assistance to help Congress make informed oversight, policy, and funding decisions. GAO’s commitment to good government is reflected in its core values of accountability, integrity, and reliability. 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Summary: Concerns were raised about the current system Medicare uses to determine annual changes to physician fees--the sustainable growth rate (SGR) system--when fees were reduced by 5.4 percent in 2002. Subsequent administrative and legislative actions modified or overrode the SGR system, resulting in fee increases for 2003, 2004, and 2005. However, projected fee reductions for 2006-2012 have raised new concerns about the SGR system. Policymakers are considering whether to eliminate spending targets or modify them. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) required that GAO study SGR and potential alternatives to the system. This report examines (1) how the SGR system is designed to control spending for physician services, (2) what concerns have been raised about the SGR system and its components, (3) what affects the stability and predictability of physician fee updates under the SGR system, and (4) what alternatives to the current SGR system exist. GAO reviewed relevant laws and regulations and interviewed officials and organizations representing physicians. On the basis of this information, GAO identified potential alternatives to the SGR system and requested illustrative simulations of fee updates and spending on physician services from the Centers for Medicare & Medicaid Services (CMS). To moderate Medicare spending for physician services, the SGR system sets spending targets and adjusts physician fees based on the extent to which actual spending aligns with specified targets. If growth in the number of services provided to each beneficiary--referred to as volume--and in the average complexity and costliness of services--referred to as intensity--is high enough to cause spending to exceed the SGR target, fee updates are set lower than inflation in the cost of operating a medical practice. A wide enough gap between spending and the target results in fee reductions. Physician groups are dissatisfied with SGR as a system to update physician fees. For example, they question the fairness of including rapidly growing spending for physician-administered drugs in the SGR system's definition of physician services expenditures. The groups also contend that the allowance for growth in volume and intensity is too low and lacks the flexibility to allow for factors outside physicians' control. Fee updates under the SGR system have varied widely within an allowed range largely because of annual fluctuations in the growth of the volume and intensity of services that physicians provide to beneficiaries. Certain system design features, such as the use of cumulative spending targets and the need to estimate data, also reduce the stability and predictability of updates. However, MMA's revision of the allowance for growth in volume and intensity of services from an annual change to a 10-year moving average will help to make future updates more stable and predictable. Possible alternatives to the SGR system cluster around the two broad approaches under consideration: (1) end the use of spending targets and separate fee updates from explicit efforts to moderate spending growth or (2) retain spending targets but modify the current SGR system to address perceived shortcomings. CMS projects that either of the two approaches will result in higher aggregate spending, thereby increasing the difficulty of addressing Medicare's long-run financial challenges. The first approach emphasizes stable fee updates, while the second approach automatically adjusts fee updates if spending growth deviates from a predetermined target. While seeking to pay physicians appropriately, it is important to consider how modifications or alterations to the SGR system would affect the long-term sustainability and affordability of the Medicare program. In this context, the choice between the two approaches may hinge on whether primary consideration should be given to stable fee increases or to the need for fiscal discipline within the Medicare program. CMS agreed with the concluding observations in the draft report. Groups representing physicians commented that overall, the draft report offered a good analysis of problems with the SGR system, but did not fully reflect their concerns. We modified the draft as appropriate.