Total Medicare spending for physician services depends on actual payment rates, the volume of services provided, and the mix of those services. Medicare spending goes up when the price paid to physicians for each service increases, when the number of services provided rises, or when more intensive, and therefore more expensive, services replace less intensive ones. Since 1992, Medicare has paid for physician services using a fee schedule. The fee for each service is a dollar conversion factor, adjusted to reflect the resources required for that service relative to the resources required to provide all other physician services, and the differences in the costs of providing services across geographic areas. Along with the fee schedule, the Congress enacted a system of spending targets designed to control growth in total spending for physicians’ services. The Sustainable Growth Rate (SGR) system was created in the Balanced Budget Act of 1997 and revised in the Medicare, Medicaid, and SCHIP Balanced Budget Refinement Act of 1999 (BBRA). It replaced the first system of spending targets, implemented in 1992, known as the Volume Performance Standard. The SGR system sets spending targets for physician services and adjusts payment rates to bring spending in line with those targets. The SGR target for total spending is based on spending in an initial, or base, year and the estimated growth in real per capita GDP each year and three other factors that affect overall spending on physician services—the changes in the cost of inputs used to produce physicians’ services (as measured by the Medicare Economic Index (MEI)), the number of Medicare beneficiaries in the traditional fee-for-service program, and expenditures that result from changes in laws or regulations. The spending target for physician payments is applied by incorporating it into the adjustment to the conversion factor that determines the payment amount per service. The conversion factor is determined annually by adjusting the previous year’s conversion factor by the change in the MEI, to account for the cost of inputs for physician services, and adjusting this product on the basis of the relationship between the cumulative SGR target and Medicare physician spending. The conversion factor update is greater than the MEI when physician spending has been below the targets and is less than the MEI when physician spending has been higher. In response to escalating Medicare expenditures, the Congress made major changes in Medicare payment policies, beginning first by enacting the hospital inpatient prospective payment system, which was implemented in 1983, and then the Medicare physician fee schedule, implemented in 1992. When enacting the fee schedule, the Congress recognized that setting fees alone would not sufficiently restrain physician spending growth. Despite some constraints on physician fees since the 1970s, spending on physician services had grown dramatically in the 1980s as a result of increases in the volume and intensity of services provided. The Congress, therefore, provided that annual physician fee increases would depend upon whether total Medicare physician spending exceeded or fell short of cumulative spending targets. Since the implementation of the fee schedule and spending targets, the rise in Medicare spending for physician services has slowed significantly, reflecting lower growth in the volume and intensity of these services. Before the physician fee schedule was implemented, Medicare payments for physicians’ services were largely based on historical charges. Although during the 1970s the Congress introduced some controls on annual payment rate increases, Medicare spending for physician services continued to rise. This was also true in the 1980s—between 1980 and 1990, for example, Medicare spending per beneficiary for physician services grew at an average annual rate of more than 12 percent, tripling from $278 to $890 (see fig. 1). Much of the spending growth resulted from increases in the volume of services provided to each beneficiary and the substitution of more intensive and expensive services for less intensive and expensive ones. The Physician Payment Review Commission, which was charged with advising the Congress on Medicare physician payment issues, observed, “y the late 1980s. . . volume and intensity growth had become the primary cause of higher program spending. In fact, from 1986 until 1992, while physician payment rates grew by less than 2 percent annually, the volume and intensity of services rose by almost 8 percent per year.” The Congressional Budget Office in 1986 stated that “oth the price and the volume of services must be controlled to constrain costs . . ..”Spending targets were needed to limit growth in volume and intensity of physician services. In 1989 testimony, Health and Human Services Secretary Louis W. Sullivan said “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 reign 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.” The Congress introduced spending targets for physician services in conjunction with the physician fee schedule in 1992 to help constrain the rise in Medicare spending for physician services. The targets incorporated limited growth in the volume and intensity of services and were revised each year based on estimates of changes in the number of Medicare beneficiaries and physician input prices. If actual spending exceeded the targeted amounts, future payment rates would be reduced, relative to what they would have been if actual spending had equaled the targets, to offset the excess spending. If actual spending fell short of the targets, future payment rates would be increased. Since 1992, the growth in the volume and intensity of physicians’ services per Medicare beneficiary has moderated (see fig. 2). Between 1992 and 2000, the average annual increase in Medicare spending due to changes in volume and intensity of services per beneficiary was about 2 percent. In contrast, between 1985 and 1991, immediately before the introduction of spending targets, volume and intensity of services per beneficiary increased at an average annual rate of about 8 percent. The application of the SGR system in 2002 resulted in a 5.4 percent reduction in physician payment rates, despite an estimated 2.6 percent increase in the costs of inputs used to provide physician services. The reduction occurred because estimated cumulative physician services spending since 1996 exceeded the target for cumulative spending by approximately $8.9 billion, or 13 percent of projected 2002 spending. In part, the payment update reflects adjustments made to the spending targets for previous years for revisions in GDP estimates and for more accurate actual spending statistics. Correcting these errors in previous years’ targets and spending totals to reflect more recent data resulted in larger physician payment increases in those years than if accurate data had been used, and they contributed to the size of the reduction in payments in 2002. The SGR system sets spending targets for physician services and adjusts payment rates to bring spending in line with those targets. Conceptually, if spending equals the targeted amount, physician payment rates are updated to keep pace with the percentage change in input prices as measured by the MEI. If spending exceeds the target, the change in payment rates is smaller than the change in input prices. If spending falls short of the target, payment rates are allowed to grow faster than the rise in input prices. By adjusting payment rates when prior-year spending has been too high, the SGR system moderates the growth in Medicare outlays for physician services. The SGR adjustments to the input price update are determined by how much the cumulative physician spending since 1996 differs from the cumulative spending target since then. Spending and targets must both be estimated from information available each November when payment rates are set for the following year. Previously, those estimates were then used in subsequent years. Based on requirements in the BBRA, however, HCFA implemented a process for revising the most recent two years of spending and target estimates. Because the annual targets are determined by changes in four factors—the number of fee-for-service beneficiaries, real per capita GDP, input costs, and the effect of changes in laws or regulations—a revision to any of those factors, or to estimates of prior spending, can change the spending estimate. The SGR adjustments to the input price update can then take effect because of growth in the volume or intensity of services delivered, resulting in spending deviating from targets, or because of revised estimates for prior years’ targets and spending. In setting payment rates for 2002, CMS updated its estimates of past spending and recalculated past targets. The net effect of both revisions indicated that Medicare outlays were an estimated $8.9 billion too high. The SGR is designed to recover this excess amount by lowering payment rates in 2002 and future years. CMS’ original estimates of spending since 1998 were too low, in part because the agency had not included all appropriate claims in making these estimates. The original spending targets for 2000 and 2001 were too high, largely because the Bureau of Economic Analysis in the Department of Commerce revised its GDP and GDP growth estimates for those years. To some extent, the reduction in payment rates this year corrects for inaccuracies in previous estimates that produced physician fees that were too high in 2000 and 2001. In both years, payment rates increased by more than the change in input prices because the information available at the time those rates were established suggested that physician spending had been held below the targets. In 2000, payment rates increased 5.4 percent, while input costs increased 2.4 percent; in 2001, payment rates increased 4.5 percent, while input costs increased by 2.1 percent. The reason that 2002 payment rates fall 5.4 percent while input prices increase by 2.6 percent is that the revised estimates revealed that spending exceeded the targets in previous years. The reduction would have been almost 4 percentage points greater, but the SGR system limits how much fees can be adjusted for the differences between actual and target spending. Several measures could moderate the fluctuations in physician payment rates. Although these modifications to the SGR could mitigate the possible impact of rate instability or reductions in beneficiary access to needed services, doing so could also lessen the ability of spending targets to encourage fiscal discipline. Available data indicate that access is adequate, but more timely and detailed information is critical to promptly recognize potential deteriorations in access. The SGR system is designed to limit the fluctuations in payment rates, but its design could be modified to achieve greater rate stability.