Medicaid was established in 1965 as a jointly funded federal-state program providing medical assistance to qualified low-income persons. Each state designs and administers its own Medicaid program, subject to federal requirements for eligibility, services covered, and provider payments. States decide whether to cover optional services and how much to reimburse providers for a particular service. The federal government pays a portion of whatever qualifying expenditures a state Medicaid program incurs. At the federal level, the program is administered by the Health Care Financing Administration (HCFA), an HHS agency. In recent years, Medicaid costs have escalated. To control these costs, some states have sought to move some or most of their Medicaid population into a capitated managed care system. However, certain provisions of the Medicaid law—such as freedom of choice and the “75-25” beneficiary requirements—inhibit states’ use of managed care. States may obtain waivers of these provisions from HCFA under the authority of section 1115 of the Social Security Act. Section 1115 of the act offers HCFA the authority to waive a broad range of Medicaid requirements for state demonstration projects. In granting a waiver, HCFA requires the applying state to demonstrate that its proposal is budget neutral—that is, that federal expenditures for the entire demonstration project will not exceed costs projected for the existing Medicaid program. Until recently, budget neutrality was expected to be achieved in each year of the demonstration. However, HCFA now allows increased costs in some years as long as states achieve budget neutrality for the entire demonstration. HCFA may also require the state to implement improved quality assurance systems, which may include data collection on enrollee medical care utilization and an assessment of these data to determine the adequacy of enrollee access to and quality of medical care. As of June 1995, 10 states had HHS-approved statewide waivers, 8 had applications pending, and 5 had inquired about submitting waiver applications. In November 1993, 5 months after Tennessee submitted its 1115 waiver application, HHS approved it. On January 1, 1994, Tennessee became the first state to move its Medicaid program enrollees to a statewide demonstration project. To meet our reporting objectives, we interviewed officials and reviewed documents from the TennCare Bureau and HCFA’s Central Office in Baltimore and its Regional Office in Atlanta. In addition, we spoke with Tennessee officials from the Department of Finance and Administration and the Department of Commerce and Insurance, as well as officials from the Tennessee Medical Association (TMA), Tennessee Hospital Association, Tennessee Health Care Campaign, MCOs, federally qualified health centers, hospitals, physicians, and other advocacy groups. We also reviewed the results of provider and beneficiary surveys conducted by HCFA, the University of Tennessee, TMA, and the Tennessee Association of Legal Services and other available literature and studies. We also obtained financial data from MCOs and from financial reports filed with the Tennessee Department of Commerce and Insurance. Much of the MCO financial data were unaudited, and we did not attempt to verify them. Our work was performed between April 1994 and May 1995 in accordance with generally accepted government auditing standards. Tennessee’s demonstration project was designed to use a capitated managed care system to expand coverage to the uninsured population and to control total program and state costs. TennCare’s ceilings on total allowable federal funding are intended to be budget neutral—a requirement for HCFA approval of all demonstration projects. The state-federal sharing arrangements of the financing plan tend to favor the state since several waiver provisions allow it to effectively reduce its share of total spending. In addition, the waiver includes provisions to monitor and ensure enrollee access to quality care. TennCare was designed to expand health coverage by allowing non-Medicaid eligible persons to enroll and by extending the period of coverage for Medicaid-eligible persons. It also increased the scope of coverage by lifting restrictions on many services and by allowing additional types of services to all enrollees. In addition to including all Medicaid eligible persons, TennCare offered insurance to uninsured and uninsurable persons regardless of income who were not eligible for Medicaid. To qualify as an uninsured enrollee, a person must not have had access to health insurance on or after March 1, 1993. Therefore, a person must have been uninsured at least 10 months to qualify for TennCare as an uninsured person on January 1, 1994. To stay within budget ceilings, the state limited total enrollment to 1.3 million for the first year and 1.5 million in succeeding years. Tennessee expected enrollment of uninsured and uninsurables of 300,000 in the first year and 500,000 in succeeding years. The state expected that the 500,000 would include most of its uninsured. Under TennCare, enrollees who are not eligible for Medicaid and have incomes above the poverty level would be required to pay monthly premiums based on their income. At the MCO’s option, these enrollees also may be required to pay a deductible and make copayments for costs that exceed the deductible as medical costs are incurred. However, TennCare enrollees cannot be required to make deductible payments or copayments for preventive care, and copayments depend on the enrollee’s gross income. TennCare limits the total enrollee out-of-pocket expense. TennCare also extended the period of health coverage for many persons qualifying under Medicaid. Under TennCare, over 65 percent of Medicaid-eligible persons are effectively guaranteed 12 months of coverage at no cost to themselves because TennCare eligibility redeterminations are made only once every 12 months. If, after that time, these enrollees no longer qualify for Medicaid, they can continue in TennCare, subject to the same requirements as the formerly uninsured. In addition, TennCare expanded services to include inpatient psychiatric facility services for persons between 21 and 65 years old and outpatient substance abuse treatment programs. TennCare also lifted many restrictions and limitations, such as the allowable number of inpatient physician services, outpatient visits, home health visits, and prescriptions. To implement its prepaid managed care system, the state contracted with 12 MCOs to provide delivery of all Medicaid acute and primary care services and to handle claims processing in exchange for a monthly payment per enrollee. In addition to these monthly payments, MCOs having enrollees with high-cost chronic conditions and higher than average utilization rates would receive additional payments. Subject to the availability of unallocated TennCare funds, MCOs could also receive payments for the cost of providing the first 30 days of care to uninsured and uninsurable enrollees and one-time payments for financial difficulties attributed to TennCare start-up. MCOs are not responsible for long-term care services or for special services to the severely and persistently mentally ill or to Children’s Plan enrollees. TennCare contracts with health maintenance organizations (HMO) and preferred provider organizations (PPO) to operate as MCOs. The state requires HMOs to be licensed as such. The primary contractual distinctions between these types of organizations are that (1) administrative fees and operating profits are restricted for PPOs but not for HMOs and (2) the TennCare Bureau required on January 1, 1994, that HMOs assign each of their enrollees to a primary care physician responsible for managing and coordinating the enrollee’s care; the contract with PPOs allows them until January 1, 1997, to assign enrollees to primary care physicians. Most enrollees have a choice of four MCOs, and enrollees in metropolitan areas have a choice of as many as seven. Figure 1 shows the geographic divisions of the state and the number of MCOs participating in each division. The two largest MCOs, BlueCross BlueShield and Access MedPLUS, operate statewide and account for 73 percent of enrollees. Table 1 lists each MCO and shows the type of contract, number of enrollees, and percent of total enrollees. The table lists MCOs in descending order according to the percentage of total TennCare enrollees in the MCO. In addition to making capitated payments to MCOs, TennCare seeks to encourage managed care in several ways. TennCare requires that by 1997, all MCOs assign their enrollees to primary care physicians responsible for managing and coordinating enrollee care. As of February 1995, MCOs had assigned approximately half of all enrollees to primary care physicians. TennCare promotes continuity of care by requiring enrollees to stay with the same MCO for a year, by providing extended enrollment periods to many Medicaid eligibles, and by allowing persons to continue in TennCare as “uninsured” if they lose their Medicaid eligibility. TennCare also encourages preventive care by not allowing deductibles and copayments for preventive care services. TennCare provides for incentive payments to physicians and allows several types of supplemental payments to hospitals based on the availability of unallocated funds. TennCare’s design provides for two types of annual incentive payments to participating physicians: one to physicians that have a greater than average TennCare patient load and another to physicians whose practices are at least 10 percent TennCare to pay a portion of their malpractice insurance premiums. Subject to the availability of unallocated funds, TennCare may also make supplemental payments to hospitals for graduate medical education and care provided to those eligible for, but not enrolled in, TennCare as well as payments to hospitals that provide care to large numbers of TennCare or indigent persons. To finance expanded coverage while keeping Medicaid expenditures within the budget limits set by the waiver agreement, Tennessee set capitation rates that are substantially below historical Medicaid costs. Further, it discontinued its DSH program and established a smaller Primary Care Provider Fund. In setting capitation rates, the state began with the average annual cost per Medicaid-eligible person and then made “charity care” adjustments, which reduced the average capitation rate by 22 percent.