The Congress created the Medicare risk contract program in 1982 to capitalize on the potential cost savings associated with HMOs. Under this program, HMOs are paid a flat fee for each Medicare beneficiary enrolled. The law sets HMO payments for comprehensive care at 95 percent of the estimated average cost (to Medicare) of treating the patient in the fee-for-service sector. HCFA calculates these payment rates using a three-step process in which it determines the following: The base rate: HCFA calculates the projected Medicare expenses nationwide for the average beneficiary in the next year. The adjusted average per capita cost (AAPCC): HCFA adjusts the base rate for differences in medical costs among geographic areas, generally counties, and multiplies the result by 0.95. The capitation rate after adjusting for health status risk: HCFA adjusts the AAPCC for enrollees’ demographic characteristics—age, sex, Medicaid eligibility, and residence in an institution such as a nursing home. This risk adjustment attempts to prevent HMOs from benefiting from favorable selection of health risks, which occurs when HMOs enroll beneficiaries who are healthier—and therefore less costly to care for—than those in the fee-for-service sector. Although in existence for over a decade, the risk contract option remains a relatively small part of the Medicare program. As of May 1995, about 7 percent of Medicare beneficiaries were enrolled in plans offered by the 164 HMOs participating in the program. Enrollment in the Medicare risk contract program may grow substantially in the next few years. HCFA reports that three-fourths of all Medicare beneficiaries now live in areas where they could enroll in a risk contract HMO. Although beneficiary enrollment in these HMOs is relatively low, the program has grown dramatically in recent years in both beneficiary enrollment and HMO participation. As of May 1995, about 2.6 million beneficiaries—about 7 percent of the total Medicare population—were enrolled in the risk contract program.Figure 1 shows that the percentage of Medicare beneficiaries enrolled is significantly higher than the national average in only a few states. HMO enrollment is further concentrated in urban areas. The 5 metropolitan statistical areas (MSA) with the largest risk contract enrollments accounted for 34 percent of nationwide risk program enrollment in 1995, and the top 10 MSAs accounted for 51 percent of nationwide risk program enrollment. Enrollment data for the top 100 MSAs appear in appendix II. Although the HMO share nationwide is small, recent HMO enrollment of Medicare beneficiaries has grown rapidly. From 1990 through 1992, enrollment grew by about 13 percent annually but, during 1993 and 1994, grew by an annual average of 23 percent. Preliminary data for 1995 suggest a growth rate approaching 30 percent. Similarly, the number of risk contract HMOs, which declined substantially during the early years of the program, has nearly doubled since 1991 from 83 to the current 164. (See fig. 2.) In 1994, the HMO enrollment rate in California and 14 other states—whose enrollees account for 55 percent of all Medicare beneficiaries—experienced double-digit increases. (See fig. 3.) Enrollment rates in other states showed no growth. For the most part, these states have had extremely low HMO market penetration. Our work suggests that Medicare’s HMO rate-setting methodology does not maximize the potential of managed care to yield cost savings and, in some cases, can even discourage HMO participation in the program. By linking HMO payments to Medicare costs in the fee-for-service sector, the current methodology causes three problems. First, the rate-setting formula restricts potential savings and ignores the ability of competitive market forces to help produce additional savings. Second, the lack of adequate risk adjusters in the formula allows some HMOs to be overcompensated given the health status of their enrollees. Third, the formula may discourage plan participation by setting payments that are too low in some areas and by causing rates to vary greatly both among geographic areas and over time. Under the present system, Medicare pays all HMOs in a county the same capitation (base) rate. With the payment rate fixed and independent of both HMO costs and the competitiveness of the local managed care environment, HMOs compete only for the enrollment of Medicare beneficiaries. Efficient, low-cost HMOs may be able to offer more generous benefit packages to enrollees and still prosper under the fixed capitation rate. Because the payment rate is fixed, however, the government derives little benefit from HMOs’ increased competition or increased efficiency. Moreover, Medicare beneficiaries have only limited incentives to seek care from low-cost health plans. Medicare may be underestimating HMOs’ efficiency and requiring an HMO discount from fee-for-service costs that is too modest. The HMO capitation rate is set by statute at 95 percent of the AAPCC: in other words, 5 percent below the estimated cost of serving beneficiaries in the fee-for-service sector. HMOs that can attract Medicare enrollees and provide health care for less than the capitation rate—for example, for 85 percent of fee-for-service costs—keep the difference (within limits) between their costs and the capitation payment. The recent surge in HMO participation indicates that many organizations now view Medicare risk contracts as potentially lucrative. In addition, in caring for Medicare beneficiaries, HMOs are estimated to achieve cost savings in excess of 5 percent. Research suggests that HMO costs for caring for their enrollees are at least 10 percent less than HCFA would have spent on fee-for-service care for them. Finally, some experience of private-sector employers with HMOs suggests that the 5-percent discount may be too low, especially in certain urban areas with mature managed care markets. In those markets, even a larger discount (lower capitation rate) might not significantly discourage HMOs’ participation in Medicare risk contracts. HCFA’s capitation payment to HMOs is currently risk adjusted for only four demographic factors: beneficiary age, sex, Medicaid status, and institutional status. These adjustments are designed to modify HMO payments for expected variations in medical costs. For example, the capitation payment is higher for older beneficiaries because they are expected to require more medical care than younger beneficiaries. This risk adjustment is inadequate, however, because it does not specifically adjust for the health status of enrollees. By enrolling the healthier individuals, HMOs deliver less health care but are compensated as if they had enrolled a costlier clientele of both the healthier and the sicker individuals. Our review of studies on risk selection shows that, because most HMOs benefit from favorable selection (the healthier individuals typically enroll in HMOs), Medicare has paid HMOs more than it would have paid for the same patients’ care by fee-for-service providers. Estimates of the excess payments range from almost 6 percent to 28 percent. However, these estimates have been criticized as too high for various technical reasons, such as the data analyzed (from 1991) no longer reflect current conditions. Nonetheless, our review suggests that favorable selection persists despite HMO enrollment expansion. HCFA officials agree that the risk contract program displays favorable selection, though they believe that excess payments are at the lower end of this range. Capitation rates are set separately for each U.S. county and vary considerably nationwide among regions and states, urban and rural counties, and even neighboring counties. This variation may discourage some HMOs from participating in risk contracts. For example, under the present system, an HMO is paid 27 percent less for serving a beneficiary living in Montgomery County, Maryland, than for serving an otherwise identical beneficiary living in neighboring Prince George’s County, Maryland—even if the two individuals are treated in the same facility by the same doctor. The disparity of payment rates among counties leads some HMOs to enroll beneficiaries from a limited portion of their service area. The formula’s link to local fee-for-service spending, which reflects local variations both in the price and volume of medical services used by Medicare beneficiaries, causes the disparity of the capitation rates among areas. Much of the occurring variation may, however, be attributable to underutilization of health care in some areas and overutilization in others instead of differences in the cost of providing appropriate health care. If fee-for-service beneficiaries use a large volume of services (either because beneficiaries demand these services or because their doctors order additional services), then HMO payment rates will be relatively high in that county. In contrast, if Medicare fee-for-service beneficiaries use few services—perhaps because of inadequate transportation or a lack of providers in rural areas—then HMO payment rates will be relatively low. As a result, rates in some areas are too low to induce HMO participation in the risk contract program, while rates in other areas are too high for Medicare to realize the potential cost savings generated by capitated payments. Modifying the present payment system could help generate Medicare savings. Our review of the private sector’s experience, reforms in other public health care programs, and empirical research suggests that several strategies hold promise. These strategies fall into three broad categories: fostering price competition among HMOs, developing better risk adjusters, and revising the AAPCC-based capitation rate. In our view, HCFA could generate the most Medicare savings if it would pursue strategies in all three categories concurrently. Trying to address all obstacles in a uniform way in all regions of the country is likely to fail. This is because the predominant challenges to saving costs in large cities are not necessarily the same ones that exist in rural counties and because the challenges vary from region to region even for otherwise similar communities. Consequently, a variety of strategies is warranted; local conditions would determine the particular strategies for any specific area. The details of implementing any strategy are important.