Without meaningful reform, the long-term financial outlook for Medicare is bleak. Together, Hospital Insurance (HI) and Supplementary Medical Insurance (SMI) expenditures are expected to increase dramatically, rising from about 12 percent in 1999 to about a quarter of all federal revenues by mid-century, even without adding to the benefit package. Over the same time frame, Medicare’s expenditures are expected to double as a share of the economy, from 2.5 to 5.3 percent, as shown in figure 1. The progressive absorption of a greater share of the nation’s resources for health care, like Social Security, is in part a reflection of the rising share of the elderly population, but Medicare growth rates also reflect the escalation of health care costs at rates well exceeding general rates of inflation. Increases in the number and quality of health care services have been fueled by the explosive growth of medical technology. Moreover, the actual costs of health care consumption are not transparent. Third-party payers generally insulate consumers from the cost of health care decisions. In traditional Medicare, for example, the impact of the cost- sharing provisions designed to curb the use of services is muted because about 80 percent of beneficiaries have some form of supplemental health care coverage (such as Medigap insurance) that pays these costs. For these reasons, among others, Medicare represents a much greater and more complex fiscal challenge than even Social Security over the longer term. When viewed from the perspective of the entire budget and the economy, the growth in Medicare spending will become progressively unsustainable over the longer term. Our updated budget simulations show that to move into the future without making changes in the Social Security, Medicare, and Medicaid programs is to envision a very different role for the federal government. Assuming, for example, that the Congress and the President adhere to the often-stated goal of saving the Social Security surpluses, our long-term model shows a world by 2030 in which Social Security, Medicare, and Medicaid increasingly absorb available revenues within the federal budget. Under this scenario, these programs would require more than three-quarters of total federal revenue. (See fig. 2.) Budgetary flexibility would be drastically constrained and little room would be left for programs for national defense, the young, infrastructure, and law enforcement. *The “Eliminate non-Social Security surpluses” simulation can only be run through 2066 due to the elimination of the capital stock. Revenue as a share of GDP during the simulation period is lower than the 1999 level due to unspecified permanent policy actions that reduce revenue and increase spending to eliminate the non-Social Security surpluses. Medicare expenditure projections follow the Trustees’ 1999 intermediate assumptions. The projections reflect the current benefit and financing structure. When viewed together with Social Security, the financial burden of Medicare on future taxpayers becomes unsustainable, absent reform. As figure 3 shows, the cost of these two programs combined would nearly double as a share of the payroll tax base over the long term. Assuming no other changes, these programs would constitute an unimaginable drain on the earnings of our future workers. While the problems facing the Social Security program are significant, Medicare’s challenges are even more daunting. To close Social Security’s deficit today would require a 17 percent increase in the payroll tax, whereas the HI payroll tax would have to be raised 50 percent to restore actuarial balance to the HI trust fund. This analysis, moreover, does not incorporate the financing challenges associated with the SMI and Medicaid programs. The elements of restructuring of Medicare as proposed by the President and Breaux-Frist are best understood in light of Medicare’s current structure. From the perspective of the program’s benefit package, most beneficiaries have two broad choices: they can receive health care coverage through Medicare’s traditional fee-for-service program or through its managed care component, called Medicare+Choice. The latter consists of an array of private health plans whose availability to Medicare beneficiaries varies by county across the nation. The choice between traditional Medicare and a Medicare+Choice plan typically involves certain trade-offs related to selection of providers, services covered, and out-of-pocket costs. Another key difference pertains to program payment methods. Providerchoice. Under traditional Medicare, beneficiaries may obtain covered services from any physician, hospital, or other health care provider that receives Medicare payments. Because most providers accept Medicare payments, beneficiaries have virtually unlimited choice. In contrast, beneficiaries in managed care face a more restricted list of providers. Private plan enrollees can generally use only their plan’s network of doctors, hospitals, or other providers for nonemergency care. Servicesoffered. Although offering less provider choice, Medicare+Choice plans typically cover more services. For example, Medicare+Choice plans often cover routine physicals, outpatient prescription drugs, and dental care—services that traditional Medicare does not cover. Out-of-pocketcosts.Out-of-pocket costs are generally higher for beneficiaries in traditional Medicare than for those in Medicare+Choice. Traditional Medicare, which has a two-part benefit package, does not pay the full costs of most covered services. Part A has no premium and helps pay for hospitalization, skilled nursing facility care, some home health care, and hospice care. Part B, which is optional in traditional Medicare, requires a monthly premium ($45.50) and helps pay for physician services, clinical laboratory services, hospital outpatient care, and certain other medical services. In addition to the monthly premium, beneficiaries are responsible for an annual $100-deductible and for 20 percent of the Medicare-approved amount for most part B services. To cover these out- of-pocket expenses, many beneficiaries purchase private supplemental insurance, known as Medigap, or may have similar insurance through a former employer. In contrast, beneficiaries covered through a Medicare+Choice plan are required to pay part B premiums but often do not pay the plan a monthly premium or pay a monthly fee that is less than the cost of an equivalent Medigap policy. Plan enrollees may also pay a copayment for each visit or service. Programpayments.Another key difference between traditional Medicare and Medicare+Choice involves the program’s payment methods. In traditional Medicare, hospitals, physicians, and other providers receive a separate payment for each covered medical service or course of treatment provided. In contrast, Medicare+Choice plans receive a fixed monthly amount for each beneficiary they enroll, commonly known as a capitation payment. This amount covers the expected costs of all Medicare part A and part B services. If Medicare’s payment is projected to result in a plan’s earning above normal profits—that is, above the rate of return earned on its commercial contracts—the plan generally must use the excess to fund additional benefits. If the extra benefits—such as prescription drugs and lower cost-sharing— provided by Medicare+Choice plans resulted exclusively from efficiencies achieved by the plans, there would be no cause for taxpayers to be concerned. However, evidence shows that, because of flaws in Medicare’s methodology for computing payments, payments to plans are too high and plans turn these excess payments into extra benefits to attract beneficiaries. Instead of producing program savings as originally envisioned, Medicare’s managed care option has added substantially to program spending. Nevertheless, as we reported last year, program savings and extra benefits for Medicare beneficiaries are not mutually exclusive goals.According to their own data, many plans could make a normal profit and provide enhanced benefit packages, even if Medicare payments were reduced. However, to lower program spending would require a better method of adjusting plan payments for differences in the health status of beneficiaries, a process commonly known as risk adjustment. Medicare’s current risk adjustment methodology cannot adequately account for the fact that, on average, beneficiaries in Medicare+Choice are healthier than those in traditional Medicare. Extensive research and development over the past 10 years have led to new prescription drug therapies and improvements over existing therapies. In some instances, new medications have expanded the array of conditions and diseases that can be treated effectively. In other cases, they have replaced alternative health care interventions. For example, new medications for the treatment of ulcers have virtually eliminated the need for some surgical treatments. As a result of these innovations, the importance of prescription drugs as part of health care has grown. However, new drug therapies have also contributed to a significant increase in drug spending as a component of health care costs. The Medicare benefit package, largely designed in 1965, provides virtually no coverage. This does not mean, however, that all Medicare beneficiaries lack coverage for prescription drug costs. In 1996, almost one third of beneficiaries had employer-sponsored health coverage, as retirees, that included drug benefits. More than 10 percent of beneficiaries received coverage through Medicaid or other public programs. To protect against drug costs, the remainder of Medicare beneficiaries can choose to enroll in a Medicare+Choice plan with drug coverage if one is available in their area or purchase a Medigap policy. The burden of prescription drug costs falls most heavily on the Medicare beneficiaries who lack drug coverage or who have substantial health care needs. Drug coverage is less prevalent among beneficiaries with lower incomes. In 1995, 38 percent of beneficiaries with income below $20,000 were without drug coverage, compared to 30 percent of beneficiaries with higher incomes. Additionally, the 1995 data show that drug coverage is slightly higher among those with poorer self-reported health status. At the same time, however, beneficiaries without drug coverage and in poor health had drug expenditures that were $400 lower than the expenditures of beneficiaries with drug coverage and in poor health. This might indicate access problems for this segment of the population. Even for beneficiaries who have drug coverage, the extent of the protection it affords varies, and there are signs that this coverage could be eroding. The value of a beneficiary’s drug benefit is affected by the benefit design, including cost-sharing requirements and benefit limitations.