Although the current focus of concern is largely on the potential for several years of declining physician fees, the historic and continuing challenge for Medicare is 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 in the 1980s, 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 required the establishment of both a national fee schedule and a system of spending targets, which together first affected physician fees in 1992. From 1992 through 1997, annual spending growth for physician services was far lower than in 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 more than 5 percent from 2000 through 2005. Although this average annual rate of growth remains 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 spending increases caused by excess growth in volume and intensity. Services covered by the SGR system’s spending targets include physician services and other items and services, such as clinical laboratory services, specified by the Secretary of HHS, that are commonly performed or furnished by physicians or in a physician’s office. The SGR system’s spending targets do not cap expenditures for SGR-covered 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 spending for SGR-covered services and thus serves as an automatic budgetary control device. In addition, reduced fee updates signal physicians collectively and Congress that spending because of 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 for spending on SGR-covered 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 and other SGR-covered services; (2) the average number of Medicare beneficiaries in the traditional fee-for- service program; (3) national economic output, as measured by real (inflation-adjusted) GDP per capita; and (4) expected expenditures for physician services and other SGR-covered services resulting from changes in laws or regulations. SGR spending targets are cumulative. That is, the sum of all spending for SGR-covered services 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. Under the SGR system, the volume and intensity of physician services and other SGR-covered services—that is, spending per beneficiary adjusted for the estimated underlying cost of providing those services—is allowed to grow at the same rate that the national economy grows over time on a per capita basis. When the SGR system was established, economic growth was seen as a benchmark that would allow for affordable increases in volume and intensity. Currently, the SGR system’s benchmark for volume and intensity growth is projected to be about 2.2 percent annually. Consequently, volume and intensity growth that exceeds 2.2 percent causes Medicare SGR-covered spending to exceed the SGR system’s target, while slower volume and intensity growth leads to spending that falls below the SGR target. If cumulative spending on SGR-covered services is in line with the SGR system’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 annual physician fee update will be less than the change in MEI or may even be negative. Conversely, if cumulative spending falls short of the target, physicians benefit because the update will exceed the change in MEI. The SGR system places limits 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. 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 by reducing fees to lower future spending. From 2000 through 2005, based on an analysis of physician services claims from April of each year, average annual growth in the volume and intensity of Medicare physician services exceeded 5 percent—more than double the approximately 2.2 percent growth rate permitted under the SGR system. To offset the resulting excess spending, the SGR system calls for reductions in physician fees. 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 other items and services commonly performed by physicians or furnished in a physician’s office, expenditures for both types of services were included when spending targets were introduced. To the extent that spending for these other 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 SGR-covered services which are not paid for under the fee schedule. Legislated minimum updates for 2004 through 2006 have also contributed to future physician fee cuts. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) and the Deficit Reduction Act of 2005 (DRA) averted fee reductions projected for 2004 through 2006 by specifying minimum updates to physician fees for those years. The MMA-specified minimum annual increase of 1.5 percent replaced SGR system fee reductions of 4.5 percent in 2004 and 3.3 percent in 2005. DRA had the effect of replacing a fee reduction of 4.4 percent in 2006 with a 0.2 percent fee increase. These legislated minimum fee updates have resulted in additional aggregate spending. Because neither MMA nor DRA made corresponding revisions to the SGR system’s spending targets, the SGR system must offset the additional spending by reducing fees beginning in 2007. From 2000 through 2005, Medicare spending on physician services grew far faster than the growth in physician fees and the number of eligible beneficiaries. Our analysis of Medicare claims data for services provided during the first 28 days of April of each year indicates that from April 2000 to April 2005 a growing percentage of beneficiaries obtained services from physicians. Among those beneficiaries who obtained such services, there were increases in the average number of services provided. Overall, the volume of services provided increased as well as the intensity (and thus costliness) of the services provided. Our analysis also found that the number of physicians billing Medicare and allowed charges per physician increased over the period as did the proportion of claims for which physicians accepted Medicare payment as payment in full. From 2000 through 2005, while Medicare physician fees rose by 4.5 percent, program spending on physician services grew by nearly 60 percent. On a per beneficiary basis, spending for physician services grew by approximately 45 percent. Annual per beneficiary spending increases ranged from a low of 2 percent in 2002 to a high of about 11 percent in both 2001 and 2004. (See fig. 2.) It is important to note that even in 2002, a year in which fees were reduced by nearly 5 percent, Medicare spending per beneficiary for physician services went up. In general, the proportion of beneficiaries who received services from a physician rose during the period covered in our review. (See fig. 3.) Specifically, from 2000 through 2005, the proportion of beneficiaries receiving services during the month of April rose from about 41 percent to about 45 percent. Although this measure declined slightly in April 2003, the proportion of beneficiaries receiving services remained a percentage point higher than in April 2000 and the upward trend resumed in 2004. Nationwide, this measure increased in both urban and rural areas. The proportion of beneficiaries receiving services rose from about 42 percent in April 2000 to about 46 percent in April 2005 in urban areas and from about 39 percent in April 2000 to about 42 percent in April 2005 in rural areas. From April 2000 to April 2005, an increasing number of services were provided to beneficiaries who were treated by a physician.