Medicare is a federal program that helps pay for a variety of health care services and items on behalf of about 41 million elderly and disabled beneficiaries. Medicare part B covers DME for the beneficiary’s use in the home, prosthetics, orthotics, and supplies if they are medically necessary and prescribed by a physician. Part B also covers certain outpatient prescription drugs that are used with DME or that are not usually self- administered by the patient. Some of these drugs are classified as supplies. In submitting claims for Medicare payment, suppliers use codes in the Healthcare Common Procedure Coding System (HCPCS) to identify DME, prosthetics, orthotics, and supplies that they are providing to beneficiaries. These codes are used for health insurance billing purposes to identify health care services, equipment, and supplies used in beneficiaries’ diagnoses and treatments. Individual HCPCS codes used by suppliers can cover a broad range of items that serve the same general purpose, but vary in price, characteristics, and quality. The HCPCS National Panel, a group composed of CMS and other insurers, maintains the HCPCS codes. Medicare uses a variety of methodologies, which are specified in law, for determining what it will pay for specific types of DME, prosthetics, orthotics, and supplies. Medicare has established a fee schedule for DME and supplies, which lists the fees paid for these items in each state. Prosthetics and orthotics are paid according to 10 regional fee schedules. Prior to the passage of MMA, outpatient prescription drugs covered by Medicare part B were paid on a fee schedule based on 95 percent of the manufacturers’ average wholesale price (AWP), a price determined by manufacturers themselves. Except for these outpatient prescription drugs, the amounts paid under the fee schedules are generally based on the amounts charged by suppliers in 1986 and 1987 (or the amount set by Medicare if the item was subsequently added to the fee schedule). Suppliers are reimbursed according to the supplier’s actual charge or the Medicare fee schedule amount, whichever is lower. Over the years, we have reported that Medicare fees for certain medical equipment, supplies, and outpatient drugs were excessive compared with retail and other prices. For example, in 2000, we reported that retail price data collected by the four DME regional carriers showed that Medicare payments were much higher than the median surveyed retail prices for five commonly used medical products. While Medicare paid 5 percent less than AWP for covered prescription drugs, in 2001 we reported that prices widely available to physicians averaged from 13 percent to 34 percent less than AWP for a sample of physician-administered drugs. For two inhalation drugs covered by Medicare—albuterol and ipratropium bromide—prices widely available to pharmacy suppliers in 2001 reflected average discounts of 85 percent and 78 percent from AWP, respectively. In 1997, BBA required CMS to establish up to five demonstration projects to be operated over 3-year periods that used competitive bidding to set fees for Medicare part B items and services. BBA required that at least one demonstration project include oxygen and oxygen equipment; all demonstration areas be metropolitan statistical areas (MSA) or parts of MSAs; and criteria for selecting demonstration areas include availability and accessibility of services and probability of savings. CMS contracted with one of the four DME regional carriers—Palmetto Government Benefits Administrators (Palmetto)—to implement the competitive bidding demonstration for DME, prosthetics, orthotics, and supplies. The demonstration was implemented in two locations—Polk County, Florida, and the San Antonio, Texas, area. Two cycles of bidding took place in Polk County, with competitively set fees effective from October 1, 1999, to September 30, 2001, and from October 1, 2001, to September 30, 2002. There was one cycle of bidding in San Antonio, and competitively set fees were effective from February 1, 2001, to December 31, 2002. Bidding and implementation processes were similar at both locations. CMS set up competitive bidding for groups of related DME, prosthetics, orthotics, and supplies and held a separate competition for each group. Items included in the demonstration were identified by HCPCS codes. Suppliers were required to bid on each HCPCS code included in the product group in which they were competing. Table 1 shows the eight product groups in CMS’s competitive bidding demonstration at the two locations. The competitive bidding process was used to determine the suppliers included in the demonstration and the rates they would be paid. From among the bidders, the agency and Palmetto selected multiple demonstration suppliers to provide items in each group of related products. These suppliers were not guaranteed that they would increase their business or serve a specific number of Medicare beneficiaries. Instead, the demonstration suppliers had to compete for beneficiaries’ business. With few exceptions, only demonstration suppliers were reimbursed by Medicare for competitively bid items provided to beneficiaries permanently residing in the demonstration area. However, beneficiaries already receiving certain items were allowed to continue to use their existing nondemonstration suppliers. All demonstration suppliers were reimbursed for each competitively bid item provided to beneficiaries at the demonstration fee schedule amounts. The new fee schedules were based on the winning suppliers’ bids for items included in the demonstration. Any Medicare supplier that served demonstration locations could provide items not included in the demonstration to beneficiaries. About 1 year after CMS’s demonstration authority ended, MMA required the agency to conduct competitive bidding for DME, supplies, off-the-shelf orthotics, and enteral nutrients and related equipment and supplies. Competition is to be implemented in 10 of the largest MSAs in 2007, 80 of the largest MSAs in 2009, and additional areas thereafter. Items excluded from this authority are inhalation drugs; parenteral nutrients, equipment, and supplies; Class III devices; and customized orthotics that require expertise to fit individual beneficiaries. CMS may phase in implementation of competitive bidding first for the highest cost and highest volume items or those items with the greatest savings potential. The law requires that a Program Advisory and Oversight Committee be established to provide recommendations to CMS on its implementation of competitive bidding. MMA also gives CMS significant new authority to use competitive bidding results as a basis for determining reasonable payment rates throughout the country in 2009. CMS has the authority to apply the information obtained from competitive bidding to adjust payments in parts of the country outside of the competitive areas for DME, supplies, off-the-shelf orthotics, and enteral nutrients and related equipment and supplies. Thus, CMS will be able to more easily adjust its payment rates nationally to reflect market prices within the largest MSAs by using information gleaned through competitive bidding. While MMA sets specific requirements for competitive bidding, it also leaves certain implementation issues to CMS. As CMS implements competitive bidding, its payment- setting experience in the demonstration will prove useful as the agency considers items for competitive bidding and approaches to streamline implementation, collect information on specific items provided to beneficiaries, and ensure that beneficiaries’ access to quality items and services is not compromised. Selecting items with high levels of Medicare spending may prove fruitful in generating significant savings in the first years of large-scale competitive bidding efforts. The demonstration provided CMS with experience in item selection, and MMA provides direction and guidance for future efforts. By including items that accounted for a large share of Medicare spending, the demonstration generated estimated gross savings that were substantially more than its implementation costs. In addition to the items included in the demonstration, others are worth considering for selection in future competitive bidding. For the competitive bidding demonstration, Palmetto and CMS chose items from six of the eight product groups that accounted for almost 78 percent of Medicare allowed charges in calendar year 2002, as table 2 shows. The demonstration also included items from two other product groups with lower levels of Medicare spending—urological supplies and surgical dressings. According to a CMS official, CMS did not include glucose monitors and supplies in competitive bidding because beneficiaries must frequently use brand-name supplies with their monitors. Ensuring that specific brands of glucose test strips were included would have complicated the first test of competitive bidding in the demonstration. However, the CMS official noted that CMS could consider including glucose supplies in future competitive bidding. Similarly, lower and upper limb prosthetics were not included because these items are generally custom made or fitted to beneficiaries and, for simplicity, the demonstration focused on noncustomized items. Our analysis of national Medicare spending for DME, prosthetics, orthotics, and supplies found that items included in the demonstration accounted for about half of all Medicare allowed charges in 2002. This was less than the total billing for all items in the product group because not all the individual items identified by HCPCS codes within product groups were included in the demonstration. For example, CMS excluded power wheelchairs from the competition. Estimated savings for competitively bid items in the demonstration would total about 20 percent of the fee schedule amounts, according to the demonstration evaluators. This equaled an estimated gross savings of $8.5 million in allowed charges, which include Medicare payments and beneficiary cost-sharing amounts. The estimated cost of the demonstration was about $4.8 million—about 40 percent lower than the estimated $8.5 million reduction in allowed charges associated with the demonstration. The demonstration’s $4.8 million cost included $1.2 million for planning and development from September 1, 1995, through July 1, 1998, and $3.6 million for demonstration operating expenses through December 2002. For future efforts, MMA states that initial competitive bidding may include items with the highest Medicare cost and volume or items determined by the agency to have the largest savings potential. Working within these parameters for competitive bidding, CMS could select some items included in the demonstration as well as items with high Medicare spending that were not included in the demonstration. For example, nondemonstration items that CMS could choose include power wheelchairs and lancets and test strips used by diabetics.