CMS, an agency within HHS, is responsible for much of the federal government’s multi-billion-dollar payments for health care, primarily through the Medicare and Medicaid programs. Medicare—the nation’s largest health insurance program—covers about 40 million elderly and disabled beneficiaries. Medicaid is a state-administered health insurance program, jointly funded by the federal and state governments, that covers eligible low-income individuals including children and their parents, and aged, blind, and disabled individuals. Each state administers its own program and determines—under broad federal guidelines—eligibility for, coverage of, and reimbursement for, specific services and items. Most Medicare beneficiaries purchase part B insurance, which helps pay for certain physician, outpatient hospital, laboratory, and other services; medical supplies and durable medical equipment (such as oxygen, wheelchairs, hospital beds, and walkers); and certain outpatient drugs. Medicare part B pays for most medical equipment and supplies using a series of fee schedules. Medicare pays 80 percent, and the beneficiary pays the balance, of either the actual charge submitted by the supplier or the fee schedule amount, whichever is less. Generally, Medicare has a separate fee schedule for each state for most categories of items, and there are upper and lower limits on the allowable amounts that can be paid in different states to reduce variation in what Medicare pays for similar items in different parts of the country. The fee schedules specify a Medicare-allowable payment amount for each of about 1,900 groups of products. Each product group is identified by a Healthcare Common Procedure Coding System (HCPCS) Level II code, and all products grouped under a code are intended to be items that are alike and serve a similar health care function. For example, one code (E1130) describes a standard wheelchair with fixed arms. Many different brands can be billed under this code, so long as they fit the basic description. Medicare part B also covers roughly 450 outpatient drugs—generally those that cannot be self-administered and are related to physicians services, such as cancer chemotherapy, or are provided in conjunction with covered durable medical equipment, such as inhalation drugs used with a nebulizer. In addition, Medicare part B covers selected immunizations and certain outpatient drugs that can be self-administered, such as blood clotting factors and some oral drugs used in association with cancer treatment and immunosuppressive therapy. To administer Medicare part B fee-for-service claims, CMS contracts with insurance companies, referred to as carriers, who review and pay claims that have been submitted by physicians and other outpatient providers and suppliers. To ensure appropriate payment, carriers conduct claims reviews that determine, for example, whether the services claimed are covered by Medicare, are reasonable and necessary, and have been billed with the proper codes. Medicare’s size and complexity make it extremely challenging to develop payment methods that prudently reimburse providers while promoting beneficiary access to items and services. As Medicare’s steward, CMS cannot passively accept what providers want to charge the program. However, because of its size, Medicare profoundly influences health care markets. Medicare is often the dominant payer for services and products, and in such cases, it cannot rely on market prices to determine appropriate payment amounts because Medicare’s share of payments distorts the market. In addition, Medicare has had difficulty relying on competition to determine prices. Because of constraints on excluding any qualified provider from participating in the program, Medicare traditionally includes all such providers who want to participate. Finding ways of encouraging competition without excluding some providers—a normal leverage that purchasers use to make competition work—has been problematic. As a result, Medicare has had to administratively set payment amounts for thousands of services and items, trying to do so in ways that encourage efficient delivery, while ensuring beneficiary access to them. Adding to the complexity of setting payment amounts is Medicare’s status as a highly visible public program with certain obligations that may not be consistent with efficient business practices. For example, CMS is constrained from acting swiftly to reprice services and supplies even when prevailing market rates suggest that payments should be modified. When making substantive changes, Medicare’s enabling legislation generally requires public input. This minimizes the potential for actions to have unintended consequences. However, seeking and responding to public input from various provider and supplier groups can be a time-consuming process that can sometimes thwart efficient program management. Prior to 1987, Medicare payments for medical equipment and supplies were based on supplier charges, subject to some limitations. As part of their responsibilities to administer Medicare claims, individual Medicare carriers raised or lowered payments to suppliers in their local areas to align them with market prices. When carriers sought to adjust payments on this basis, they employed a process that involved gathering relevant pricing data from local area markets, determining new payment levels on the basis of the price information obtained, and notifying area suppliers of the changes. Although HCFA monitored carriers’ performance in carrying out these steps, it did not evaluate the appropriateness of the new payment levels established. In 1987, the Congress and HCFA began the process of moving the Medicare program from paying on the basis of individual providers’ charges for medical equipment and supplies and covered outpatient drugs, to developing payment methods intended to pay more prudently through use of program-determined amounts. Specifically, the Congress introduced fee schedules for medical equipment and supplies in 1987. Statewide fees were determined on the basis of average supplier charges on Medicare claims allowed in each state in 1986 and 1987, and were updated for inflation in some years. However, the agency lacked mechanisms to otherwise adjust fees to reflect marketplace changes. As a result, disparities between fee schedule amounts and market prices developed over time, and Medicare significantly overpaid for some medical equipment and supplies. In recent years, we and the HHS OIG reported on instances where Medicare payments for certain medical equipment and supplies and outpatient drugs were excessive compared with retail and other prices. One notable example of excessive Medicare payments is included in our 1995 report on surgical dressings. We estimated that Medicare could have saved almost $20 million in 1995 if it had paid the lowest wholesale prices available in a national catalog for 44 types of surgical dressings. Although Medicare’s fee schedule for surgical dressings was based on medians of retail prices found in supply catalogs when the schedule was set, Medicare’s statute did not permit HCFA to lower the fee schedule when retail prices for dressings decreased. Another instance of excessive Medicare payment was for home oxygen equipment and supplies provided to patients with pulmonary insufficiency. Medicare fee schedule allowances for home oxygen were significantly higher than the rates paid for almost identical services by the Department of Veterans Affairs (VA), which in fiscal year 1995 paid for home oxygen benefits for over 23,000 patients. In 1997, we estimated that Medicare could have saved over $500 million in fiscal year 1996 if it had paid rates for home oxygen comparable to those paid by VA. Medicare’s payments for outpatient drugs have been similarly excessive, although the methodology used to determine payment amounts is somewhat different and attempts to tie Medicare’s payments to market prices. In 1989, the Congress required that physician services be paid based on fee schedules beginning in 1992. The fee schedules developed by HCFA to comply with this requirement provided for all outpatient drugs furnished to Medicare beneficiaries not paid on a cost or prospective payment basis to be paid based on the lower of the estimated acquisition cost or the national average wholesale price (AWP). Manufacturers report AWPs to organizations that publish them in drug price compendia, which are typically updated annually, and Medicare carriers base providers’ payments on these published AWPs. In concept, such a payment method has the potential to be market-based and self-adjusting. The reality is, however, that AWP is neither an average nor a price that wholesalers charge. Because the term AWP is not defined in law or regulation, there are no requirements or conventions that AWP reflect the price of any actual sale of drugs by a manufacturer. Given the latitude manufacturers have in setting AWPs, Medicare’s payments are often not related to market prices that physicians and suppliers actually pay for the products. A June 1997 House Budget Committee report accompanying the bill that became the BBA, in explaining the reason for specifying a 5-percent reduction from AWP, cited a report by the HHS OIG regarding Medicare payments for outpatient drugs. Among the OIG findings were that Medicare payments ranged from 20 percent to nearly 1,000 percent of certain oncology drugs’ commercially available prices. Our recent work found that Medicare payments in 2001 for part B-covered outpatient drugs remained significantly higher than prices widely available to physicians and pharmacy suppliers. For example, most physician- administered drugs had widely available discounts ranging from 13 to 34 percent below AWP. Two other physician-administered drugs had discounts of 65 and 86 percent. Pharmacy suppliers—the predominant billers for 10 of the high-expenditure and high-volume drugs we analyzed—also purchased drugs at prices considerably lower than Medicare payments. For example, two inhalation drugs accounting for most of Medicare payments to pharmacy suppliers had widely available discounts averaging 78 percent and 85 percent from AWP. Despite such dramatic illustrations of disparities between Medicare payments and prices widely available to others acquiring medical equipment and supplies and covered outpatient drugs, Medicare has not had the tools to respond quickly in such instances. Carriers used to adjust payment amounts as part of their responsibility to appropriately pay Medicare claims, but in 1987, the Congress effectively prohibited use of this process to lower Medicare payment rates until 1991. In 1988, the Congress required use of a more formal “inherent reasonableness” process that could be accomplished only by HCFA, not by the carriers. In other reports, we have described this process as slow and cumbersome and have noted that it is not available for some items, such as surgical supplies.