Inherent in Medicare’s FFS program is an incentive for providers to deliver more services than necessary because each additional service generates additional provider revenue. Policymakers have therefore looked to managed care plans to curb unnecessary spending. Plans have a financial incentive to provide care efficiently because they receive a fixed monthly amount for each beneficiary, regardless of what the individual enrollee’s care actually costs. These potential efficiencies cannot result in actual savings for Medicare if plan payments are higher than beneficiaries’ expected FFS costs. Before 1998, plan payment rates were based on average local FFS spending. Although payments were adjusted for certain beneficiary characteristics such as age and sex, this adjustment did not adequately account for differences in enrollees’ health and expected health care costs. The BBA changed how plan payments were calculated beginning in 1998 and, beginning in 2000, required adjustments to make payment rates better reflect differences in beneficiary health status. Before 1998, Medicare’s HMO capitation rates, established separately for each county, were set at 95 percent of the estimated average cost of care for the FFS population. The rates were discounted 5 percent under the assumption that the managed care plans provided care more efficiently than the less-restrictive FFS program and that the government should share in the savings. Under this methodology, county rates varied widely because they reflected the substantial differences in FFS per-beneficiary spending among counties. In 1997, for example, county rates ranged from a low of $221 per month in Arthur County, Nebraska, to a high of $767 in Richmond County (Staten Island), New York. The rates paid to plans for enrollees were also adjusted up or down in an attempt to account for estimated cost differences among beneficiaries due to variations in health care needs—a refinement known as risk adjustment. Risk adjustment is necessary because individuals differ in the extent to which they use various health care services and their health care costs vary accordingly. Medicare’s risk adjuster has relied on beneficiary age, sex, and other demographic factors to predict expected health care utilization. This demographic-based risk adjuster could reflect only gross differences— such as the lower expected health care costs of 65-year-olds relative to 80- year-olds. If two individuals shared the same demographic characteristics, Medicare paid plans the same amount for both of them, even if one was in poor health and required extensive medical care while the other was in excellent health and rarely needed to see a physician. Consequently, if a plan attracted a disproportionate share of beneficiaries in better-than-average health, an outcome known as favorable selection, Medicare’s payments to the plan would exceed the expected FFS cost of providing Medicare-covered benefits to the plan’s enrollees.Our 1997 study of Medicare payments to California HMOs found that, on average, payments exceeded the expected FFS costs of the plans’ enrollees by approximately 19 percent in 1995.Other studies have also found substantial excess plan payments. A 1996 survey of Medicare beneficiaries also indicated that plans likely experienced favorable selection (see table 1). Medicare beneficiaries enrolled in plans were more likely than beneficiaries in the FFS program to report that they were in good or excellent health. Moreover, these health status differences translate into cost differences. For example, in 1996, average per-person Medicare FFS spending for beneficiaries who reported they were in excellent health was approximately $2,100, whereas for beneficiaries reporting poor health the average was about $11,700. In establishing the Medicare+Choice program, the BBA also changed the methodology used to set plan payments. Although 1997 county rates formed the foundation for county rates in 1998 and subsequent years, annual rate increases were no longer tied to changes in local FFS spending. Specifically, each county’s rate was to be set at the highest of a minimum amount, or “floor,” set at $367 in 1998 and increased an amount 2 percent higher than the previous year’s county rate; or an amount reflecting a blend or weighted average of the county rate and a price-adjusted national rate. The floor was meant to encourage plans to offer services in areas that historically had low payment rates and few if any participating plans— primarily rural counties. The blended rate—which is to be phased-in over 6 years—was designed to reduce the geographic variation in rates that had resulted from tying county rates to local FFS. The blending mechanism moves all county rates closer to the national average by assigning above- average payment rate increases to low-payment-rate areas, and below- average payment rate increases to high-payment-rate areas. The BBA also sought to reduce the excess in Medicare’s managed care payments by holding down per capita rate increases for 5 years. Specifically, the BBA set the annual factor used to update floor and blended payment rates equal to the projected national growth in per capita Medicare spending minus a specified percent: 0.8 percent in 1998 and 0.5 percent in each of the following 4 years. In 1998, 1999, and 2001 no county received a blended rate.Instead, counties were either assigned the floor payment rate or the 2-percent minimum increase. This occurred because of a budget neutrality provision in the BBA. The law specified that estimated total Medicare+Choice payments should equal the amount that would have been spent if 1997 county rates had been trended forward by the national annual update factor. However, national per capita spending grew relatively slowly and the guaranteed 2-percent increase and floor payments pushed total estimated Medicare+Choice spending above the budget neutrality amount in these 3 years. The blending provision could not be implemented because doing so would have further increased spending.If low-payment-rate counties received higher than average payment rate increases, the additional spending could not be offset by lowering the increases in the high-payment-rate counties because those counties were guaranteed a 2- percent minimum increase. The BBA required HCFA to develop and implement a health-based risk adjuster by January 1, 2000.The law authorized HCFA initially to collect hospital inpatient data from plans and later to collect more comprehensive medical encounter data to use in developing the risk adjuster. HCFA announced a phase-in schedule that called for gradually applying an interim risk adjuster, based on hospital admissions data only, first to a fraction (10 percent) of a plan’s Medicare payments and then to greater shares each year. HCFA proposed to apply an improved risk adjuster, based on a more comprehensive set of medical services, to 100 percent of payments by 2004. The BBRA slowed the proposed phase-in schedule of the interim risk adjuster and called for additional studies by HCFA and the Medicare Payment Advisory Commission on risk adjustment implementation issues. Our analysis shows that Medicare+Choice payments in 1998 were 21 percent, or $5.2 billion, higher than the amount Medicare would have spent if plan beneficiaries had received care in the traditional FFS program. While Medicare payments to plans on behalf of these enrollees totaled $29.8 billion, we estimate that total FFS payments for the same population would have been $24.6 billion. Approximately $3.2 billion of the $5.2 billion difference was the result of inadequate risk adjustment. That is, Medicare payments were not adjusted sufficiently to account for the generally better health, and lower expected costs, of plan enrollees.Excess payments due to inadequate risk adjustment will persist as long as there is favorable selection and plan payment rates do not sufficiently account for beneficiary health status. The remaining $2 billion resulted from errors in the Medicare spending forecasts used to establish the 1998 county payment rates. These excess payments will diminish over time as future county rates are adjusted to correct errors in prior spending forecasts. Table 2 summarizes our findings on aggregate excess payments. As a group, beneficiaries who join plans tend to be healthier and use fewer Medicare services than beneficiaries who remain in FFS. For example, in 1997 Medicare spent about 30 percent less on those beneficiaries who joined a plan in 1998 than it spent on demographically similar beneficiaries who remained in FFS. Our analysis suggests beneficiaries who have been plan members for several years continue to use fewer health care services than FFS beneficiaries, although the gap is much narrower. Medicare’s risk adjustment methodology, unchanged in 1998 from previous years, did not adequately address differences in beneficiary health status. While health plans tended to enroll less-expensive beneficiaries, Medicare’s payments were too generous because they were based on the expected costs of enrollees in average health.Consequently, we estimate that in 1998 Medicare paid plans an average of 13.2 percent more than it would have spent if the plans’ enrollees had received care under the traditional FFS arrangement. In the aggregate, the lack of an adequate risk adjustment methodology in the face of favorable selection increased Medicare spending by approximately $3.2 billion. Our results suggest that HCFA’s new health-based interim risk adjuster, when fully implemented, may only eliminate half of the excess payments due to favorable selection. The first year of plan-submitted data on beneficiaries’ service use indicates that full implementation of the interim risk adjuster would have reduced plan payments by about 5.9 percent in 2000.Its failure to eliminate more of the excess payments may be due to its reliance on limited data. The interim risk adjuster uses only certain hospital inpatient data to measure beneficiary health status because those are the only service-level data plans provide to HCFA. Although it represents a significant improvement over the previous methodology based strictly on demographic data, a risk adjuster that used more complete beneficiary data could set payments that better reflect beneficiaries’ expected health care costs. In 2004, HCFA intends to implement a refined risk adjuster that would use medical data from physicians’ offices and hospital outpatient departments, in addition to hospital inpatient data. Payment rates for Medicare+Choice plans are set partly on the basis of forecasted growth in national per capita spending in Medicare’s FFS program.