Medicare provides health insurance for nearly all elderly Americans (those aged 65 and older) and certain of the nation’s disabled. Most Medicare beneficiaries receive services through the fee-for-service sector. However, as of April 1998, roughly 15 percent of Medicare’s beneficiaries—up from about 7 percent in mid-1995—were enrolled in risk contract HMOs. Of these, about 50,000 beneficiaries are classified as institutionalized each month. HCFA, an agency within HHS, administers the Medicare program and is responsible for ensuring that Medicare HMOs comply with data reporting, beneficiary protection, and care delivery requirements. HCFA seeks to ensure that HMOs meet financial solvency and enrollment requirements, do not earn excessive profits, operate internal quality assurance systems, and establish grievance and appeals procedures. HCFA also implements the capitation rate formula authorized by legislation and calculates payments for each HMO. Further, HCFA is responsible for monitoring HMOs to ensure that all Medicare requirements are met, including that HMOs’ reports of beneficiaries’ institutional status are accurate. HCFA is also responsible for ensuring that corrective actions are taken if overpayments, underpayments, or other errors are discovered. HCFA established a national policy in 1994 permitting HMOs to seek retroactive payment adjustments—for either overpayments or underpayments—for the prior 3-year period. About 1 percent of Medicare’s roughly 5 million HMO enrollees are classified as living in institutions, as compared with about 7 percent of beneficiaries covered under Medicare fee-for-service. In 1997, Medicare paid $197 million more to HMOs because of their enrollees’ institutional status. The distribution of enrollees with institutional status varies among HMOs and among geographic regions. In December 1997, most institutional enrollment rates for individual HMOs ranged from 0 to about 10 percent, although one outlier exceeded 44 percent. (See fig. 1.) Medicare’s risk contract program was designed to save Medicare money by paying HMOs 95 percent of the amount Medicare estimated it would spend on similar beneficiaries in the fee-for-service sector. It was believed that HMOs would have lower costs because of their greater emphasis on preventive health services and their incentive to eliminate unnecessary services. The base capitation rate in each county—the amount an HMO receives each month for enrolling an average-cost beneficiary—is determined by law, largely on the basis of Medicare’s per capita fee-for-service spending. An HMO’s monthly capitation payment is adjusted for the expected care costs of each individual enrolled. To make the adjustment, HCFA assigns weights to defined risk classes of beneficiaries on the basis of age; sex; and disability, Medicaid, institutional, and employment status. The weights are expressed as ratios of the national average per capita costs for each risk class relative to the overall national average. For example, in 1997, compared with the national average weight set at 1.0, the weight assigned to the risk class for men aged 85 or older with institutional status was 2.25. Thus, HCFA’s estimate was that institutionalized men aged 85 and older would have health care costs that were 2.25 times the costs for the average beneficiary. HCFA adjusts capitation rates for most institutionalized beneficiaries upward to reflect the expected differential. The additional monthly payment amount associated with institutional status can be substantial. For example, in 1998 a Los Angeles HMO receives $618 more per month for a 65-year-old man living in an institution than for one who is not living in an institution ($1,071 instead of $453). (See fig. 2 for a comparison of monthly HMO payments in Los Angeles for institutional and noninstitutional enrollees.) In 2000, HCFA is required by the BBA to implement a new risk adjustment methodology that uses direct indicators of health status—in addition to any other demographic adjusters such as age and sex—to better reflect differences in individuals’ expected health care costs. Until recently, HCFA has defined the term “institution” to include skilled nursing facilities, nursing homes, sanitoriums, rest homes, convalescent homes, long-term care hospitals, domiciliary homes, swing-bed facilities,and intermediate-care facilities. HCFA based the higher payment rates for institutional status on historical evidence that beneficiaries living in these types of facilities had greater medical needs and higher medical costs than those who lived in the community. These types of facilities, however, have evolved to serve individuals with varied health care needs. Thus, HCFA’s broad criteria permitted an HMO to classify virtually any residential facility as an institution for payment purposes. Consequently, HMOs considered as institutions many facilities that were housing seniors whose expected health needs were at or below those of the average Medicare beneficiary. HMOs have had an incentive to broadly interpret HCFA’s institution criteria. For example, if an HMO classified a residential facility as an institution, the HMO would receive a much higher capitation payment—up to $766 more per month—for every enrollee living in that facility. In fact, the increased institutional payments to one relatively small HMO amounted to about an additional $135,000 for 1 month. For HMOs with larger institutionalized enrollment, the annual additional capitation payments could be on the order of $4 million to $9 million. Medicare’s payment system is based on the assumption that HMO enrollees living in institutions generate above-average health care costs. However, some facilities classified by HMOs as institutions clearly did not serve seniors with serious health problems. For example, among the designated institutions we visited, one (called by its manager an “independent living facility”) provided private apartments, meals in a communal setting, and field trips to tourist and shopping sites. About 12 percent of the residents owned and drove their own cars. The facility did not provide any medical care. Another facility we visited—a retirement center—was characterized by its marketing brochure as “a clean, comfortable home for those who do not need nursing care.” This facility employed a full-time activity director and housed several residents who drove their own cars. Moreover, HCFA’s institutional payment policy is unclear when a single facility offers a range of assistance levels—from independent living arrangements to skilled nursing care. For example, one residential community we visited consisted of two facilities: one, a skilled nursing care facility, provided subacute, skilled, and custodial care; the other, an independent living facility, provided limited assistance, such as helping individuals get to the communal dining room. An HMO planned to classify the entire residential community as an institution. However, the residential community’s manager disagreed that the independent living facility constituted an institution. Although the HMO ultimately chose not to classify those beneficiaries living in the independent facility as institutionalized, no HCFA policy would have prevented such classification. Facilities of this nature pose continued challenges in appropriately determining which beneficiaries should be classified as institutionalized for payment purposes. Even though some regional HCFA officials felt that some facilities should not have been classified as institutions, these officials believed they had little basis for challenging any classification. In a 1995 memorandum to HCFA headquarters, for example, the director of a HCFA region’s managed care operations noted that “the manual provides no guidance regarding the level of care provided to residents [needed to qualify for institutional status]” and that “HCFA has the obligation to provide better guidance to plans regarding the types of facilities which may be designated as ‘institutions.’” On July 24, 1997, HCFA issued a policy letter that narrowed the definition of eligible institutions effective January 1, 1998. The letter cited a history of interpretation problems in using the broader definition as well as the concerns we, the HHS Inspector General, and the agency itself have raised about the potential for making improper payments to HMOs. Under the new definition, only specified Medicare- or Medicaid-certified institutions are included, thus limiting eligibility to institutions qualifying under the Social Security Act, such as skilled nursing and nursing facilities; intermediate care facilities for the mentally retarded; and psychiatric, rehabilitation, long-term care, and swing-bed hospitals. Tying eligibility to certain Medicare- and Medicaid-certified institutions effectively rules out eligibility for independent or low-level assisted living facilities. In principle, this change could significantly improve HCFA’s ability to ensure that the higher capitation rate is being paid on behalf of only those beneficiaries likely to have higher health care needs and costs. However, in practice, the collocation of independent living arrangements with eligible institutions and HCFA’s infrequent and narrow review of HMO records, as discussed in the next section, may limit the practical impact of HCFA’s new policy. The process HCFA uses to verify that HMOs appropriately claim the institutional payment rate is inadequate. HCFA relies on the HMOs themselves to identify and report the names of beneficiaries for whom the HMOs should receive the institutional rate. Using these mostly unaudited, HMO-reported data, HCFA adjusts the capitation payments for the HMOs’ Medicare members who live in institutions. HCFA does not conduct either comprehensive or spot checks at the institutional facilities to assess the accuracy of the institutional status data reported by HMOs. Instead, HCFA regional staff make site visits to each HMO about every 2 years and examine a small sample of beneficiary records maintained by the HMO. Results of previous HHS Inspector General audits and our work show that the lack of effective oversight fails to hold HMOs accountable for submitting accurate records and thus does not ensure that HMOs receive appropriate payments. HCFA bases its institutional rate adjustments solely on HMO-reported data. Each HMO is responsible for establishing a system to identify and report its institutionalized beneficiaries to receive the pay adjustment from HCFA.