The Omnibus Budget Reconciliation Act of 1989 (OBRA 1989) reformed the way Medicare pays for physician services in the traditional fee-for- service (FFS) program. OBRA 1989 required the establishment of a physician fee schedule and a system of spending growth targets, known as MVPS, that became effective in 1992. In 1998, the SGR system of spending targets replaced MVPS. Both spending target systems were designed to moderate growth in the volume and intensity of services provided to beneficiaries. Prior to the establishment of the fee schedule, Medicare payment rates for physician services were based on historical charges for these services. The establishment of a fee schedule was an attempt to break the link between physicians’ charges and Medicare payments. The fee schedule was not designed to reduce spending levels overall but to redistribute payments for services based on the relative resources used by physicians to provide different types of care. Under the fee schedule, Medicare pays for more than 7,000 physician services. To arrive at Medicare’s fee, the service’s relative value is multiplied by a dollar conversion factor. Currently, under SGR, the Centers for Medicare & Medicaid Services (CMS), the agency that administers Medicare, uses the dollar conversion factor to calculate Medicare fees and updates the conversion factor each calendar year to account for the change in the cost of providing physician services (as measured by the Medicare Economic Index (MEI)), adjusted for the extent to which actual spending aligns with spending targets. Fee updates represent the aggregate of increases and decreases across all services; the fees for specific services may rise or fall each year. In 1980, Medicare spending for physician services totaled $7.5 billion. (See fig. 1.) By 2003, Medicare spending on these services totaled $47.9 billion. During much of this period, increases in both the volume and intensity of services physicians provided to each beneficiary were an important factor in spending growth. Before the physician fee schedule was implemented, Medicare payments for physician services were largely based on historical charges. Experience in the 1980s repeated the experience of the prior decade: the Congress froze fees or limited fee increases, but spending continued to rise. From 1980 through 1991, for example, Medicare spending per beneficiary for physician services grew at an average annual rate of about 11.6 percent. (See fig. 2.) Total Medicare spending for physician services depends on the fee paid for each service, the number of beneficiaries served, the number of services provided to each beneficiary (volume), and the mix of those services—that is, the combination of more and less expensive services (intensity). Of these factors, physicians directly influence only the volume and intensity of services provided to beneficiaries. Much of the spending growth resulted from increases in the volume and intensity of services. For example, from 1986 until 1992, physician payment rates grew by less than 2 percent annually, while the volume and intensity of services rose, on average, by almost 8 percent per year. In 1986, the Congressional Budget Office stated that “oth the price and the volume of services must be controlled to constrain costs….” In 1989, citing the need for spending targets to limit spending growth for physician services, the Secretary of Health and Human Services (HHS) testified that “Medicare physician spending has increased at compound annual rates of 16 percent over the past 10 years. And in spite of our best efforts to control volume and rein in expenditures, Medicare physician spending is currently out of control…. An expenditure target…sets an acceptable level of growth in the volume and intensity of physician services.” Annual spending growth during the 1990s was far lower than in the preceding 10 years. Beginning in 1992, the Congress introduced spending targets for physician services to help constrain the rise in Medicare spending for physician services. Unlike prior attempts to control spending, spending target systems sought to limit the growth in the volume and intensity of services each year. From 1992 until 1999, the growth in the volume and intensity of physician services per Medicare beneficiary moderated. (See fig. 3.) During this time period, the average annual increase in Medicare spending due to changes in volume and intensity of services per beneficiary was about 1 percent, in contrast with the average annual growth of about 7 percent in the period from 1985 through 1991. The moderation of volume and intensity growth slowed the rate of increase in spending on physician services. This spending grew from $25.6 billion in 1992 to $36.9 billion in 2000an average annual rate of 4.7 percent. In contrast, from 1985 through 1991, total spending increased at an average annual rate of about 10.8 percent. Beginning in 2000, the growth in volume and intensity of services per Medicare beneficiary began to rise, although the average annual rate of growth remained substantially below that experienced before spending targets were introduced. From 2000 to 2003, volume and intensity rose at an average annual rate of 5 percent. CMS actuaries project an average annual growth in volume and intensity of 3 percent from 2004 through 2013. Total spending on physician services is projected to grow by an average of 8 percent a year from 2000 through 2005. A target for spending on physician services serves as a budgetary control by automatically lowering fee updates in response to excess volume and intensity growth. Under Medicare’s SGR spending target system and its MVPS predecessor, physician fees are adjusted annually to help bring actual spending in line with spending targets. Projected increases in volume and intensity, beyond what the current SGR targets allow, are expected to contribute to annual fee reductions for several years as the system tries to align spending with targets. The SGR system evolved from the MVPS system of spending targets, which was introduced with the physician fee schedule in 1992. The goal of MVPS was to provide an incentive for physicians to reduce volume and intensity growth and thus slow the high annual rate of increase in expenditures. Under MVPS, if a year’s actual spending growth exceeded the target, future payment rates would be reduced, relative to what they would have been if actual spending had equaled the target, to offset the excess spending. If a year’s actual spending growth fell short of the target, future payment rates would be increased. Concerns about the MVPS spending target prompted the Congress to create SGR’s system of spending targets. In its 1996 report to Congress, the Physician Payment Review Commission noted that, under MVPS, physician fees would fall over time unless there were continual declines in the volume and intensity of services provided. In response to the system’s perceived shortcomings, the Congress took action in 1997 to replace it with the SGR system. The SGR system was created in the Balanced Budget Act of 1997 (BBA) and revised by the Medicare, Medicaid, and SCHIP Balanced Budget Refinement Act of 1999 (BBRA) and, most recently, by MMA. Similar to MVPS, SGR sets spending targets for physician services and updates fees to bring spending in line with those targets. Under the SGR system, if spending exceeds the target, future fee updates are reduced. If spending falls short of the target, future fee updates are increased. By adjusting fees when prior-year spending has deviated from the target, SGR attempts to moderate the growth in total Medicare outlays for physician services. Specifically, the SGR formula establishes expenditure targets as follows: from a base year—1996—the targets are updated each year to account for four factors: (1) changes in the number of Medicare beneficiaries in traditional fee-for-service; (2) growth in the costs of providing physician services, laboratory tests, and Medicare-covered outpatient prescription drugs; (3) growth in the overall economy, as measured by changes in real per capita gross domestic product (GDP); and (4) changes in expenditures that result from changes in laws or regulations. Spending and targets are estimated from data available in the fall, when CMS sets physician fees for the next calendar year. Because SGR spending targets are cumulative, the target set for a specific year is affected by the targets set in all prior years. BBRA required CMS, in calculating each year’s SGR spending target and fee update, to revise the targets set for the two previous years using the most recent available data. SGR differs from MVPS in two key ways. The first relates to volume and intensity growth limits. MVPS relied, in part, on historical trends in volume and intensity growth to set new targets each year, whereas SGR ties allowable volume and intensity increases to the growth in real GDP per capita. Under SGR, real spending per beneficiary—that is, spending adjusted for the underlying cost of providing physician services—is allowed to grow at the same rate that the national economy grows over time on a per-capita basis—currently projected to be about 2 percent annually. If volume and intensity grow faster, the annual increase in physician fees will be less than the estimated increase in the cost of providing services. Conversely, if volume and intensity grow more slowly than 2 percent annually, the SGR system permits physicians to benefit from fee increases that exceed the increased cost of providing services. To reduce the effect of business cycles on physician fees, economic growth is measured as the 10-year moving average change in real per capita GDP. This measure is projected to range from 2.1 percent to 2.5 percent during the 2005 through 2014 period. A second difference is that MVPS compared target and actual expenditures in a single year, whereas SGR compares targets and actual expenditures cumulatively from a base year. The cumulative nature of SGR’s spending targets increases the potential volatility of physician fee updates because the system requires that excess spending in any year be recouped in future years. Conceptually, this means that if spending has exceeded the SGR targets, fee updates in future years must be lowered sufficiently to offset the excess spending. Conversely, the system also requires that if spending has fallen short of the targets, fees must be increased to boost future spending.