Although the current focus of concern is largely on the potential for several years of declining physician fees, the historic challenge for Medicare has been to find ways to moderate the rapid growth in spending for physician services. Before 1992, the fees that Medicare paid for those services were largely based on physicians’ historical charges. Spending for physician services grew rapidly in the 1980s, at a rate that the Secretary of Health and Human Services (HHS) characterized as out of control. Although Congress froze fees or limited fee increases, spending continued to rise because of increases in the volume and intensity of physician services. From 1980 through 1991, for example, Medicare spending per beneficiary for physician services grew at an average annual rate of 11.6 percent. The ineffectiveness of fee controls alone led Congress to reform the way that Medicare set physician fees. The Omnibus Budget Reconciliation Act of 1989 (OBRA 1989) established both a national fee schedule and a system of spending targets, which first affected physician fees in 1992. From 1992 through 1997, annual spending growth for physician services was far lower than the previous decade. The decline in spending growth was the result in large part of slower volume and intensity growth. (See fig. 1.) Over time, Medicare’s spending target system has been revised and renamed. The SGR system, Medicare’s current system for updating physician fees, was established in the Balanced Budget Act of 1997 (BBA) and was first used to adjust fees in 1999. Following the implementation of the fee schedule and spending targets in 1992, through 1999, average annual growth in volume and intensity of service use per beneficiary fell to 1.1 percent. More recently volume and intensity growth has trended upward, rising at an average annual rate of about 5 percent from 2000 through 2003. Although this average annual rate of growth remains substantially below that experienced before spending targets were introduced, the recent increases in volume and intensity growth are a reminder that inflationary pressures continue to challenge efforts to moderate growth in physician expenditures. The SGR system establishes spending targets to moderate physician services spending increases caused by excess growth in volume and intensity. SGR’s spending targets do not cap expenditures for physician services. Instead, spending in excess of the target triggers a reduced fee update or a fee cut. In this way, the SGR system applies financial brakes to physician services spending and thus serves as an automatic budgetary control device. In addition, reduced fee updates signal physicians collectively and Congress that spending due to volume and intensity has increased more than allowed. To apply the SGR system, every year the Centers for Medicare & Medicaid Services (CMS) follows a statutory formula to estimate the allowed rate of increase in spending for physician services and uses that rate to construct the spending target for the following calendar year. The sustainable growth rate is the product of the estimated percentage change in (1) input prices for physician services;9, 10 (2) the average number of Medicare beneficiaries in the traditional fee-for-service (FFS) program; (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. SGR spending targets are cumulative. That is, the sum of all physician services spending since 1996 is compared to the sum of all annual targets since the same year to determine whether spending has fallen short of, equaled, or exceeded the SGR targets. The use of cumulative targets means, for example, that if actual spending has exceeded the SGR system targets, fee updates in future years must be lowered sufficiently both to offset the accumulated excess spending and to slow expected spending for the coming year. CMS calculates changes in physician input prices based on the growth in the costs of providing physician services as measured by the Medicare Economic Index, growth in the costs of providing laboratory tests as measured by the consumer price index for urban consumers, and growth in the cost of Medicare Part B prescription drugs included in SGR spending. Under the SGR and MVPS systems, the Secretary of Health and Human Services defined physician services to include “services and supplies incident to physicians’ services,” such as laboratory tests and most Part B prescription drugs. Under SGR, spending per beneficiary adjusted for the estimated underlying cost of providing physician services is allowed to grow at the same rate that the national economy grows over time on a per-capita basis—currently projected to be slightly more than 2 percent annually. If volume and intensity grow faster, the annual increase in physician fees will be less than the estimated increase in the cost of providing services. Conversely, if volume and intensity grow more slowly than 2 percent annually, the SGR system permits physicians to benefit from fee increases that exceed the increased cost of providing services. To reduce the effect of business cycles on physician fees, MMA modified the SGR system to require that economic growth be measured as the 10-year moving average change in real per capita GDP. 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. In its 1995 annual report to Congress, the Physician Payment Review Commission 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 105th Congress thought the nation could afford to spend on volume and intensity increases. If cumulative spending on physician services is in line with SGR’s target, the physician fee schedule update for the next calendar year is set equal to the estimated increase in the average cost of providing physician services as measured by the Medicare Economic Index (MEI). If cumulative spending exceeds the target, the fee update will be less than the change in MEI or may even be negative. If cumulative spending falls short of the target, the update will exceed the change in MEI. The SGR system places bounds on the extent to which fee updates can deviate from MEI. In general, with an MEI of about 2 percent, the largest allowable fee decrease would be about 5 percent and the largest fee increase would be about 5 percent. The 2004 Medicare Trustees Report announced that the projected physician fee update would be about negative 5 percent for 7 consecutive years beginning in 2006; the result is a cumulative reduction in physician fees of more than 31 percent from 2005 to 2012, while physicians’ costs of providing services, as measured by MEI, are projected to rise by 19 percent. According to projections made by CMS Office of the Actuary (OACT) in July 2004, maximum fee reductions will be in effect from 2006 through 2012, while fee updates will be positive in 2014. (See fig. 2.) There are two principal reasons for the projected fee declines: increases in volume and intensity that exceed the SGR’s allowance—partly as a result of spending for Part B prescription drugs—and the minimum fee updates for 2004 and 2005 specified by MMA. Recent growth in spending due to volume and intensity increases has been larger than SGR targets allow, resulting in excess spending that must be recouped through reduced fee updates. In general, the SGR system allows physician fee updates to equal or exceed the MEI as long as spending growth due to volume and intensity increases is no higher than the average growth in real GDP per capita—about 2.3 percent annually. However, in July 2004, CMS OACT projected that the volume and intensity of physician services paid for under the physician fee schedule would grow by 3 percent per year. To offset the resulting excess spending, the SGR system will have to reduce future physician fee updates. Additional downward pressure on physician fees arises from the growth in spending for other Medicare services that are included in the SGR system, but that are not paid for under the physician fee schedule. Such services include laboratory tests and many Part B outpatient prescription drugs that physicians provide to patients. Because physicians influence the volume of services they provide directly—that is, fee schedule services— as well as these other services, defined by the Secretary of HHS as “incident to” physician services, expenditures for both types of services were included when spending targets were introduced. In July 2004, CMS OACT projected that SGR-covered Part B drug expenditures would grow more rapidly than other physician service expenditures, thus increasing the likelihood that future spending would exceed SGR system targets. To the extent that spending for SGR Part B drugs and other “incident to” services grows larger as a share of overall SGR spending, additional pressure is put on fee adjustments to offset excess spending and bring overall SGR spending in line with the system’s targets. This occurs because the SGR system attempts to moderate spending only through the fee schedule, even when the excess spending is caused by expenditures for “incident to” services, such as Part B drugs, which are not paid for under the fee schedule. The MMA averted 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 3.3 percent in 2005 and thus will result in additional aggregate spending. Because MMA did not make corresponding revisions to the SGR system’s spending targets, the SGR system must offset the additional spending by reducing fees beginning in 2006. An examination of the SGR fee update that would have gone into effect in 2005, absent the MMA minimum updates, illustrates the impact of the system’s cumulative spending targets. To begin with, actual expenditures under the SGR system in 2004 are estimated to be $84.9 billion, whereas target expenditures for 2004 were $77.1 billion.