Medicare is a federal health insurance program designed to assist elderly and disabled beneficiaries. Hospital insurance, or part A, covers inpatient hospital, skilled nursing facility, hospice care, and certain home health services. Supplemental medical insurance, or part B, covers physician and outpatient hospital services, laboratory and other services. Claims are paid by a network of 49 claims administration contractors called intermediaries and carriers. Intermediaries process claims from hospitals and other institutional providers under part A while carriers process part B claims. The intermediaries’ and carriers’ responsibilities include: reviewing and paying claims; maintaining program safeguards to prevent inappropriate payment; and educating and responding to provider and beneficiary concerns. Medicare contracting for intermediaries and carriers differs from that of most federal programs. Most federal agencies, under the Competition in Contracting Act and its implementing regulations known as the Federal Acquisition Regulation (FAR), generally may contract with any qualified entity for any authorized purpose so long as that entity is not debarred from government contracting and the contract is not for what is essentially a government function. Agencies are to use contractors that have a track record of successful past performance or that demonstrate a current superior ability to perform. The FAR generally requires agencies to conduct full and open competition for contracts and allows contractors to earn profits. Medicare, however, is authorized to deviate from the FAR under provisions of the Social Security Act enacted in 1965. For example, there is no full and open competition for intermediary or carrier contracts. Rather, intermediaries are selected in a process called nomination by provider associations, such as the American Hospital Association. This provision was intended at the time of Medicare’s creation to encourage hospitals to participate by giving them some choice in their claims processor. Currently, there are three intermediary contracts, including the national Blue Cross Blue Shield Association, which serves as the prime contractor for 26 local member plan subcontractors. When one of the local Blue plans declines to renew its subcontract, the Association nominates the replacement contractor. Carriers are chosen by the Secretary of Health and Human Services from a small pool of health insurers, and the number of such companies seeking Medicare claims-processing work has been dwindling in recent years. The Social Security Act also generally calls for the use of cost-based reimbursement contracts under which contractors are reimbursed for necessary and proper costs of carrying out Medicare activities but does not expressly provide for profit. Further, Medicare contractors cannot be terminated from the program unless they are first provided with an opportunity for a public hearing––a process not afforded under the FAR. Medicare could benefit from various contracting reforms. Freeing the program to directly choose contractors on a competitive basis from a broader array of entities able to perform needed tasks would enable Medicare to benefit from efficiency and performance improvements related to competition. It also could address concerns about the dwindling number of insurers with which the program now contracts. Allowing Medicare to have contractors specialize in specific functions rather than assume all claims-related activities, as is the case now, also could lead to greater efficiency and better performance. Authorizing Medicare to pay contractors based on how well they perform rather than simply reimbursing them for their costs, as well as allowing the program to terminate contracts more efficiently when program needs change or performance is inadequate, could also result in better program management. Since Medicare was implemented in 1966, the program has used health insurers to process and pay claims. Before Medicare’s enactment, providers feared that the program would give the government too much control over health care. To win acceptance, the program was designed to be administered by health insurers like Blue Cross and Blue Shield. Subsequent regulations and decades of the agency’s own practices have further limited how the program contracts for claims administration services. The result is that agency officials believe they must contract with health insurers to handle all aspects of administering Medicare claims, even though the number of such companies willing to serve as Medicare contractors has declined and the number of other entities capable of doing the work has increased. While using only health insurers for claims administration may have made sense when Medicare was created, that may be much less so today. The explosion in information technology has increased the potential for Medicare to use new types of business entities to administer its claims processing and related functions. Additionally, the need to broaden the pool of entities allowed to be contractors has increased in light of contractor attrition. Since 1980, the number of contractors has dropped by more than half, as many have decided to concentrate on other lines of business. This has left the program with fewer choices when one contractor withdraws, or is terminated, and another must be chosen to replace it. Since 1993, the agency has repeatedly submitted legislative proposals to repeal the provider nomination authority and make explicit its authority to contract for claims administration with entities other than health insurers. Just this month, the Secretary of Health and Human Services told the Senate Finance Committee that CMS should be able to competitively award contracts to the entities best qualified to perform these functions and stated that such changes would require legislative action. With such changes, when a contractor leaves the program, CMS could award its workload on a competitive basis to any qualified company or combination of companies—including those outside the existing contractor pool, such as data processing firms. Allowing Medicare to have separate contractors for specific claims administration activities—also called functional contracting—could further improve program management. Functional contracting would enable CMS to select contractors that are more skilled at certain tasks and allow these contractors to concentrate on those tasks, potentially resulting in better program service. For example, the agency could establish specific contractors to improve and bring uniformity to efforts to educate and respond to providers and beneficiaries, efforts that now vary widely among existing contractors. Currently, CMS interprets the Social Security Act and the regulations implementing it as constraining the agency from awarding separate contracts for individual claims administration activities, such as handling beneficiary inquiries or educating providers about program policies. Current regulations stipulate that, to qualify as an intermediary or carrier, the contracting organization must perform all of the Medicare claims administration functions. Thus, agency officials feel precluded from consolidating one or more functions into a single contract or a few regional contracts to achieve economies of scale and allow specialization to enhance performance. CMS has had some experience with functional contracting under authority granted in 1996 to hire entities other than health insurers to focus on program safeguards. CMS has contracted with 12 program safeguard contractors (PSC) who compete among themselves to perform task- specific contracts called task orders. These entities represent a mix of health insurers, including many with prior experience as Medicare contractors, along with consulting organizations, and other types of firms. The experience with PSCs, however, makes clear that functional contracting has challenges of its own, which are discussed later in this testimony. Allowing Medicare to offer financial incentives to contractors for high- quality performance also may have benefits. According to CMS, the Social Security Act now precludes the program from offering such incentives because it generally stipulates that payments be based on costs. Contractors are paid for necessary and proper costs of carrying out Medicare activities but do not make a profit. Repeal of cost-based restrictions would free CMS to award different types of contracts–– including those that provide contractors with financial incentives and permit them to earn profits. CMS could test different payment options to determine which work best. If effective in encouraging contractor performance, such contracts could lead to improved program operations and, potentially, to lower administrative costs. Again, implementing performance-based contracting will not be without significant challenges. Allowing Medicare to terminate contractors more efficiently may also promote better program management. The Social Security Act now limits the agency’s ability to terminate intermediaries and carriers, and the provisions are one-sided. Intermediaries and carriers may terminate their contracts without cause simply by providing CMS with 180 days notice. CMS, on the other hand, must demonstrate, that (1) the contractor has failed substantially to carry out its contract or that (2) continuation of the contract is disadvantageous or inconsistent with the effective administration of Medicare. CMS must provide the contractor with an opportunity for a public hearing prior to termination. Furthermore, CMS may not terminate a contractor without cause as can most federal agencies under the FAR. In past years, the agency has requested statutory authority to eliminate the public hearing requirement and the ability of contractors to unilaterally initiate contract termination. Such changes would bring Medicare claims administration contractors under the same legal framework as other government contractors and provide greater flexibility to more quickly terminate poor performers. Eliminating contractors’ ability to unilaterally terminate contracts also may help address challenges the agency faces in finding replacement contractors on short notice. While Medicare could benefit from greater contracting flexibility, time and care would be needed to implement changes to effectively promote better performance and accountability and avoid disrupting program services. Competitive contracting with new entities for specific claims administration services in particular will pose new challenges to CMS–– challenges that will likely take significant time to fully address. These include preparing clear statements of work and contractor selection criteria, efficiently integrating the new contractors into Medicare’s claims processing operations, and developing sound evaluation criteria for assessing performance. Because these challenges are so significant, CMS would be wise to adopt an experimental, incremental approach. The experience with authority granted in 1996 to hire special contractors for specific tasks related to program integrity can provide valuable lessons for CMS officials if new contracting authorities are granted. If given authority to contract competitively with new entities, CMS would need time to accomplish several tasks. First among these would be development of clear statements of work and associated requests for proposals detailing work to be performed and how performance will be assessed. CMS has relatively little experience in this area for Medicare claims administration because current contracts instead incorporate by reference all regulations and general instructions issued by the Secretary of Health and Human Services to define contractor responsibilities. CMS has experience with competitive contracting from hiring PSCs. It did take 3 years to determine how best to implement the new authority through its broad umbrella contract, develop the statement of work, issue the proposed regulations governing the PSCs, develop selection criteria, review proposals, and select contractors.