Medicare spending per beneficiary on physician services has varied substantially—both among geographic areas and in its growth over time. The geographic variation in spending—unrelated to beneficiary health status or outcomes—provides evidence that health needs alone do not determine spending. Consequently, policymakers have deemed it both reasonable and desirable to question the appropriateness of current and projected physician services spending and to explicitly consider the affordability of such spending when setting physician fees. The implementation of a national fee schedule and spending targets in 1992, for example, was designed, in part, to address issues of affordability and program sustainability by slowing spending growth. Moderating this growth remains part of the larger effort to ensure future Medicare program sustainability. In 1989, the Physician Payment Review Commission (PPRC) reported that from 1979 through 1989 (the decade prior to the establishment of spending targets), Medicare spending on physician services per beneficiary more than tripled, rising much more rapidly than general inflation. At that time, PPRC recommended an expenditure target for controlling aggregate spending on physician services. The target was to apply initially to all physician services nationally and later to evolve to separate targets for regions, categories of physician services, or both. Then, as now, utilization of physician services varied widely by geographic area, while the Medicare patient populations in these areas differed little from one another in their illnesses. Some studies report that variation in service use indicates that in some parts of the country compared with others, there was either overuse or underuse of services. Recent studies of Medicare expenditures show that regional variation in the use of medical services remains and that the spending disparities among areas are explained by physicians’ discretionary practices rather than by differences in patient populations’ health status. Three periods from 1980 to the present describe Medicare’s recent experience in spending for physician services. Figure 1 shows growth in Medicare spending per beneficiary for physician services during the three periods. In the first period, 1980 through 1991, Medicare’s payment rates for physician services were based on historical charges for these services, and limits were placed on fees and fee updates but not on aggregate spending. In the 1992 through 1997 period, physician services were paid under a national fee schedule, and the first spending target system—called the Medicare volume performance standard (MVPS)—set an allowable growth rate for aggregate spending that was used to adjust physician fees. From 1998 on, services continue to be paid under a fee schedule and the SGR system replaced the MVPS system and uses a different method to set an acceptable growth rate for aggregate spending. In the 1980s, Medicare paid physicians on the basis of “reasonable charge,” defined as the lowest of the physician’s actual charge, the customary charge (the amount the physician usually charged for the service), or the prevailing charge (based on comparable physicians’ customary charges). Under this system, payment inconsistencies existed among physicians by services, specialties, and locations. The system also had an inflationary bias, as a rise in customary charges could increase prevailing charges over time. During this decade, expenditures for physician services grew rapidly: from 1980 through 1991, Medicare spending per beneficiary for physician services grew at an average annual rate of 11.6 percent. Although the Congress froze fees or limited fee increases in the 1980s, spending continued to rise because there were no limits on growth in the volume and intensity of services physicians provided to beneficiaries. Recognizing that the expenditure growth of the 1980s was not sustainable, the Congress reformed the way Medicare paid for physician services in the traditional FFS program by requiring the establishment of a national fee schedule for physician services and a system for controlling aggregate physician service spending, MVPS. The establishment of a fee schedule in 1992 was an attempt to break the link between physicians’ charges and Medicare payments. The fee schedule was designed to pay for services based on the relative resources used by physicians to provide different types of care and to address the inflationary bias of the charge-based system. The adoption of a spending target system was an attempt to control spending growth attributable to increases in the volume and intensity of physician services. Under MVPS, a performance standard for a given year was set, indicating a growth rate for expenditures that should not be exceeded. The extent to which actual expenditure growth fell above or below the performance standard helped to determine the update to physician fees 2 years later. For example, in 1993, CMS compared actual spending in 1992 with the performance standard for 1992; the difference largely determined the update to physician fees in 1994. The performance standard was based on changes in four factors: the number of FFS Medicare beneficiaries, practice cost inflation, the historical growth in volume and intensity, and laws and regulations that could affect spending for physician services. From 1992 through 1997—the period that MVPS was used to set fee updates—annual spending growth for physician services was far lower than in the preceding decade. The decline in spending growth during this period was the result, in large part, of slower volume and intensity growth. For example, from 1985 through 1991, spending per beneficiary grew at an average annual rate of 10.8 percent; during that period, volume and intensity of service use per beneficiary rose an average 7 percent annually. From 1992 through 1997, the growth in spending per beneficiary fell to 4.4 percent; during that period, average annual growth in volume and intensity of service use per beneficiary fell to 1 percent. (See fig. 2.) Physician Payment Review Commission, 1995 Annual Report to Congress (Washington, D.C.: 1995). system’s perceived shortcomings, the Congress took action in BBA in 1997 to replace it with the SGR system. In 1998 and 1999, the first 2 years of the SGR system, volume and intensity growth remained similar to the rate under MVPS. However, from 2000 through 2003, volume and intensity growth rose at an average annual rate of about 5 percent. Over the 1998– 2003 SGR system period, the average growth in volume and intensity of services per Medicare beneficiary was higher than the average for the 1992–1997 MVPS period—but substantially below that experienced before spending targets were introduced. Since the introduction of the SGR system, total spending on physician services is projected to grow by an average of 8 percent a year from 2000 through 2005. The MVPS spending target was based, in part, on a 5-year historical trend in volume and intensity reduced by a specified number of percentage points. Because of this design and the fact that volume and intensity growth dropped dramatically after the adoption of the MVPS system, the target for future volume and intensity increases fell too. in its present form. In light of physician service expenditures’ significant contribution to aggregate spending, containing their growth plays an important role in helping to address the program’s long-range and fundamental financing problem. The SGR system is designed to impose fiscal discipline and to moderate spending for physician services by adjusting annual fee updates to bring spending in line with targets. The SGR system, similar to the predecessor MVPS system, relies on spending targets because earlier attempts to achieve fiscal discipline through limits on fee increases did not control the spending that resulted from volume and intensity growth. The SGR system uses a formula specified in statute to establish each year an allowed spending growth rate, a spending target, and a fee update. Like MVPS, the SGR system includes an allowance for volume and intensity increases but, unlike MVPS, ties the allowance to a measure of the growth of the national economy. As noted, spending targets were established—first under MVPS and later under the SGR system—because policymakers contended that the fee schedule alone would not have adequately constrained expenditure growth for physician services. The fee schedule limits payment for individual services but does not moderate spending growth resulting from volume and intensity increases. Although the SGR system’s spending target does not cap expenditures for physician services, it serves as a budgetary control by automatically lowering fee updates in response to excess spending due to volume and intensity growth. In addition, reduced fee updates serve as a signal to physicians collectively and to the Congress that spending due to volume and intensity has increased more than allowed. An additional reason for spending targets was advanced by PPRC in its 1995 report to the Congress. PPRC explained that spending targets were intended, in part, to create a collective incentive for physicians. Specifically, the report stated that spending targets “provid the medical profession with a collective incentive to reduce inappropriate care by, for instance, developing and disseminating practice guidelines that promote cost-effective practice styles.” Every year, CMS must estimate the allowed rate of increase in spending for physician services and use that rate to construct the annual spending target for the following calendar year. The sustainable growth rate is the product of the estimated percentage change in (1) input prices for physicians’ services; 27, 28 (2) the average number of Medicare beneficiaries in traditional FFS; (3) national economic output, as measured by real (inflation-adjusted) GDP per capita; and (4) expected expenditures for physician services resulting from changes in laws or regulations. CMS’s current estimate of the sustainable growth rate for 2005 is 4.6 percent, based on the agency’s estimates of the four factors. (See table 1.) Every fall, CMS determines whether the fee update for the following calendar year must be adjusted to help align spending with targets. To do so, the agency compares actual spending, measured cumulatively since 1996, to the cumulative value of the annual targets, measured over the same period. If the two are equal, the fee update is set to equal the estimated increase in physicians’ average cost of providing services—as measured by MEI. Otherwise, a performance adjustment factor (PAF) is used to increase or decrease the update relative to MEI in order to help bring spending back in line with the targets. (See app. I for the formula used to calculate the PAF.) The PAF is subject to limits and may not cause the update to be set at more than 3 percent above MEI or 7 percent below MEI.