Issue Brief

May 2002

Physician Payment Formula in Medicare    

Why Should Anyone Care?

“Setting prices correctly in Medicare…is essential to maintain access to services for Medicare beneficiaries.”  Glenn M. Hackbarth, Chairman of the Medicare Payment Advisory Commission.

I.  Introduction
There has been a significant amount of controversy this year about recent cuts in Medicare reimbursements for physician services.  Normally this would be an arcane “formula problem”   of interest only to physicians and others whose income is derived from these payments. 

This may not be a normal time, however, and there is a growing concern that seniors may be losing access to health care because of these cuts.  Several recent newspaper and journal articles have suggested that doctors are cutting back on their Medicare patients or are leaving the program altogether.  It is too soon to tell if this anecdotal evidence will be borne out by more systematic analysis, but the stories are causing grave concern among senior advocates and Members of Congress.

This issue brief will try to explain why these cuts have occurred and what is happening in the policy arena to deal with them.

II.  Background
Over the 37 years since the Medicare program was enacted there have been several distinct periods in which physician payments were changed.  These changes in payment method were a direct result of the government’s effort to control the cost of the program, both to taxpayers and beneficiaries. 

This year, Congress is again confronted with the dilemma of finding an appropriate way to pay physicians and others for the services they provide without “breaking the federal bank” or creating undue burdens for seniors and their children.  It should be noted that other professionals including physical therapists and nurse practitioners are also reimbursed under this formula.

A.  The First Phase - 1965 to 1984 - Customary and Usual Fees 
In the beginning when the program was created, physicians were paid fees based on charges, similar to the way in which reimbursement was made by private insurers. Generally this was referred to as the customary, prevailing, and reasonable rate system.  If an individual physician charged more than the normal rate in his or her area, he or she was paid the lesser amount that was standard for the area.  Otherwise physicians were paid based on their charges.  At that time, Medicare also allowed physicians to bill their patients for the amount their charges exceeded the Medicare reimbursement, a practice known as balance billing.   (For instance, if a doctor charged $100 for a service and Medicare only reimbursed $80 for that service, the doctor could bill the patient for the remaining $20 – hence the term “balance billing”.)

This charge-based system of reimbursement created incentives for doctors to increase their charges from year to year, and soon policymakers became concerned about inflation in the system.  In 1972, Congress mandated that the increase in physician fees allowed each year be limited by a special measure of medical inflation called the Medicare Economic Index (MEI). 

B.  The second Phase -- 1984 to 1991 - Legislated Fees 
Unfortunately, the effort to limit increases in fees to medical inflation was not enough to keep costs down to an acceptable level so in 1984 Congress tried a new approach.  First, Congress enacted legislation that froze fees from 1984 through 1986.  Following the freeze, it legislated specific amounts for fee updates.

Unfortunately, as Congress was acting to rein in the cost of physician services, beneficiaries were picking up an increasing part of the tab through balance billing.  The average liability per beneficiary grew from $56 in 1980 to $94 in 1986. 

At that point, Congress also imposed limits on balance billing and today balance billing is limited to 109.25% of Medicare’s fees.  These limits are helpful to beneficiaries but they have the negative side effect of removing a safety valve from the system.  Further, without balance billing there is no longer an early warning signal that fees may be below the level necessary to keep doctors serving Medicare beneficiaries.  While few people would advocate a return to unlimited balance billing, it is important that a way be found to set fees that are adequate to keep doctors in the system without overloading the budget.

A second concern that emerged during the 1980s was the observation of many analysts and policymakers that Medicare’s reimbursement structure was distorted by factors that allowed fees to vary widely.  This resulted in doctors in different specialties or different regions of the country receiving widely variant fees for comparable services.  This phenomenon was greatly troubling to Congress and resulted in the 1992 implementation of the Medicare Fee Schedule (MFS).

C.  The Third Phase - 1992 to 2000 - Volume Limits 
Beginning in 1992 Congress tried to do two different things simultaneously in the Medicare reimbursement formula for physicians.  First, it tried to standardize fees within specialties and around the country, and secondly it tried to control volume. 

The Medicare Fee Schedule (MFS) was implemented to establish a new approach for making payments for individual services.  The MFS was a fee system that based payments on measures of the resources used to provide services.  It used a two-part formula and it was intended to promote equity and be budget neutral.  For instance, in 1992 the formula was set so that expenditures would equal what expenditures would have been under the earlier system.  As  such, it was not designed to control costs.

At the same time, Congress had noticed earlier that when it limited fees, doctors started to order a greater number of tests and services.  Although the fee structure may have been affordable, the cost of the program escalated because of the increased volume. This experience created real pressure to control volume.  As a result of those pressures, Congress put a Volume Performance Standard (VPS) in place overlaying the MFS system. The VPS approach provided a mechanism for adjusting fees to keep total physician spending under a given target. 

The VPS was designed expressly to control costs.  It had a fairly simple formula but it resulted in great volatility in the system.  Essentially, what the VPS did was set an overall expenditure target based on historical trends in volume.  If spending exceeded the target, a reduction in fees was implemented two years later.  If spending was under the target, fees were increased. 

In the mid-90s there was a decline in the historical volume trend that resulted in large increases in Medicare’s fees for physician services.  Because Congress was experiencing a difficult time with budget deficits at that time, those rich fees became an appealing target for budget cutters and they were cut.  As a result of those cuts, the Medicare fee update mechanism was seriously destabilized.  In the years when VPS was in effect (1992-1998), medical inflation was measured by the MEI, which varied from 2 percent to 3.2 percent.  At the same time, the annual update for physician fees varied from a low of 0.6 percent to a high of 7.5 percent.  It hardly seems likely that doctors’ costs would have been that out of line with general medical inflation. 

This volatility led Congress to change the VPS; in the Balanced Budget Act of 1997 the VPS was replaced with the sustainable growth rate system (SGR).  This system is in effect today and it is the source of the current problems with physician payments.

III.  The Current Problem
One of the main arguments for switching systems was to reduce the volatility created under the old volume control system. 

Like its predecessor, the SGR system uses an overall target to adjust future payment rates to control the growth in total Medicare expenditures.  Whereas the old system used an historical trend in volume to set overall spending targets, the SGR approach relies on the growth in gross domestic product (GDP) to establish its overall spending limit. 

When it was established in 1997, policy makers believed the use of the GDP would provide more objective and stable targets for the program.  After all the GDP is a measure of the growth in resources available to society, and it looked like a more objective measure than volume of physician services.  Growth in GDP has also been more stable than change in the volume of physician services.

In spite of the apparent logic of those ideas, the updates under the SGR system have proven to be volatile as well.  Up until this year that volatility tended to benefit the physicians.  In fact, under the first three years of the SGR system, the update was almost twice as high as medical inflation shown in the MEI. 

In 2000 the payment update was an increase of 5.4 percent and in 2001 it was 4.5 percent, significantly higher than overall inflation or medical inflation.  In 2002, however the formula produced a cut of 5.4 percent and, for the first time in ten years, physicians’ fees have been reduced.  This has produced many complaints from doctors and other providers covered by the system and the cut has resulted in concerns that some Medicare beneficiaries might lose access to care.

According to the Congressional Budget Office, several factors contributed to this reduction.  A quick overview of them illustrates the complexity of these formulas.

1.      In November 2001 the cumulative spending target that was used to set physician fees was reduced.  This was caused largely by a slower growth in the GDP than had been expected.

2.      Cumulative spending for physicians’ services far exceeded the spending target and that necessitated a cut.

3.      A large part of the discrepancy between expected spending and actual spending was due to coding errors and counting errors in the Centers for Medicare and Medicaid Services (CMS).

The counting errors of CMS were a major factor in the large increases doctors received in their fees in 2000 and 2001.  Unfortunately, from the doctors’ point of view, these mistaken gains now have to be recouped by the government under its own budget rules, and that error accounts for some of the reduction in reimbursements for professional services in 2002.

IV.  Policy Options
There are several different ways to respond to the current concerns over the physician payment formula.  One is to do nothing; another is to legislate temporary relief but not change the general formula; a third option is to eliminate spending targets and continue to update fees under the rest of the formula or some variant of it.

The President has said he supports fixing the “problem” but it must be done in a budget-neutral fashion.  That sets up the potential for serious conflict among provider groups – i.e. hospitals versus doctors – and would make it very difficult to find enough money for long-term formula reform.

A. Option One - Doing Nothing
It is not clear yet that the change in reimbursements is causing an access problem for Medicare beneficiaries; however, several people including many doctors, nurse practitioners, physical therapists, and beneficiary advocates are very concerned.  If there were only one year of cuts the concerns might not be so grave, but the formula projects payment cuts through 2005. 

Since the formula covers so many people serving seniors, it is unlikely that it will not be adjusted in some way.  There are those, however, who argue that these providers were overpaid in the past and now they must give some back.   

Even though nothing has been done yet, it is unlikely that this argument will hold sway with members of Congress who are up for reelection this year.  Although they are having trouble putting the pieces together at the current time, there will likely be some legislation this year dealing with physician payments.

B. Option Two - Provide Temporary Relief 
This choice is a very real possibility for the current year.  There are several bills floating around that suggest canceling the cut and freezing the rates at last year’s levels while the experts study the problem.  One of these proposals might be considered the most effective way to deal with the problem in the short term and would probably not cost as much as a long-term formula change.

There also have been efforts (unsuccessful so far) to include a one-year fix in the supplemental appropriation bill currently moving through Congress.

C.  Option Three - Eliminate Overall Spending Targets 
This is the choice favored by the Medicare Payment Advisory Committee (MedPAC), an independent federal body that advises Congress on issues affecting the Medicare program.  They have offered a proposal to replace the current SGR system with an annual update based on factors influencing the cost of providing physician services.   This would provide physicians with a formula for updating their fees similar to the system used for other Medicare providers. 

One problem with this proposal is that it is very costly.  The Congressional Budget Office and the actuaries in the Department of Health and Human Services estimate an approximate cost for the proposal of $126 billion over the next ten years. 

Opponents of this idea note that it would lock in place the overstated payments and fees set in earlier years.  It would also end the use of expenditure targets, thereby opening the door to large spending increases driven by volume. 

Physicians are unique in their ability to determine the volume of services they can provide and this puts very real cost pressure on the program.  Government officials with direct responsibility for the federal budget worry that this type of change would blow the budget out of the water.

V.  Conclusion 
It is unlikely that a radically new design for setting physician fees in Medicare will emerge this year, but it is not out of the question for the future.  In response to the Institute of Medicine’s ongoing critique of quality problems in the American healthcare system, there are many different efforts in process.

Recently, the NIHP hosted two series of events in the Twin Cities that focused on the issue of quality.  The first was a day of meetings with Ken Kizer, President and CEO of the National Quality Forum.  He regularly talks about the way in which the current payment system subverts quality in the practice of medicine.  As Dr. Kizer’s group and others work on this matter, it is likely they will develop new ideas about how to pay physicians that could result in better quality health care. 

In April, after the Kizer meetings, the NIHP had an opportunity to host a series of events with Thomas Scully, Administrator of CMS.  Because of the extensive work being done on quality improvement and measurement in the Midwest, the NIHP presented a preliminary proposal to Mr. Scully for a demonstration project on paying for quality in the Medicare program.  He was very responsive to this idea, and the NIHP is currently developing a more detailed proposal to present to CMS.

With a little bit of luck, these efforts and others may ultimately help the government find better ways of assuring access to high quality care for seniors and appropriate payment for the providers of that care.

Note:  This Issue Brief was written by Eileen Baumgartner, NIHP Senior Researcher and   former Democratic Staff Director of the House Budget Committee.

Sources:
“Report to the Congress: Medicare Payment Policy, March 2002”, Medicare Payment Advisory Commission, Washington, DC.

 “Chapter 2:  Updating payments for physician services and for care provided in hospital outpatient departments”, Report to the Congress:  Medicare Payment Policy, March 2001, Medicare Payment Advisory Commission, Washington, DC.

Statement of Dan L. Crippen, Director, Congressional Budget Office, Subcommittee on Health, Committee on Ways and Means, United States House of Representatives, Washington, DC, February 28, 2002.

Statement of Glenn M. Hackbarth, J.D., Chairman, Medicare Payment Advisory Commission, Subcommittee on Health, Committee on Ways and Means, United States House of Representatives, Washington, DC, February 28, 2002.

Statement of Stephen M. Levine, PT, on behalf of the American Physical Therapy Association, Subcommittee on Health, Committee on Ways and Means, United States House of Representatives, Washington, DC, February 28, 2002.

Statement of Paul B. Ginsburg, Ph.D., President, Center for Studying Health System Change, Subcommittee on Health, Committee on Ways and Means, United States House of Representatives, Washington, DC, February 28, 2002.

Statement of Donald J. Palmisano, M.D., J.D., Secretary-Treasurer, American Medical Association, Subcommittee on Health, Committee on Ways and Means, United States House of Representatives, Washington, DC, February 28, 2002.

Statement of John E. Mayer, Jr., M.D., Chairman Council on Health Policy, Society of Thoracic Surgeons, Subcommittee on Health, Committee on Ways and Means, United States House of Representatives, Washington, DC, February 28, 2002.

Statement of The Honorable Thomas Scully, Administrator of the Centers for Medicare and Medicaid Services, Subcommittee on Health, Committee on Energy and Commerce, United States House of Representatives, Washington, DC, February 14, 2002.

Statement of Martha McSteen, President, National Committee to Preserve Social Security and Medicare, Subcommittee on Health, Committee on Energy and Commerce, United States House of Representatives, Washington, DC, February 14, 2002.

Statement of Allison Shuren, CPNP, CNS, JD, American College of Nurse Practitioners, Subcommittee on Health, Committee on Energy and Commerce, United States House of Representatives, Washington, DC. February 14, 2002.

“Are Medicare docs taking off?”, AARP Bulletin, AARP, Washington, DC, May 2002.

“Resource-based relative value units: a primer for academic family physicians”, SE Johnson and WP Newton, Family Medicine, March 2002.

“Lawmakers Urge Change in Physician Pay Formula Baseline”, Markian Hawryluk, American Medical News, Chicago, April 8, 2002.

“Accepting Medicare is Going to Cost You”, Markian Hawryluk, American Medical News, Chicago, April 22-29, 2002.

"HHS Favors Minor Tweaks to Fix Medicare Payment", Markian Hawryluk, American Medical News, Chicago, April 1, 2002.

“New Bill Offers Medicare Physician Pay Formula Fix”, Markian Hawryluk, American Medical News, Chicago, March 25, 2002.

“Many Doctors Say They Are Refusing Medicare Patients”, Robert Pear, New York Times, March 17, 2002.

“Dissent in House G.O.P. Forces Leaders to Change Plan for Medicare Drug Benefit, Robert Pear, New York Times, May 13, 2002.

“Breaking a Solemn Promise”, editorial US News, April 1, 2002.

“$126 billion question: How do you fix physician payment updates?”, Therese Droste, Modern Physician, March 1, 2002.

“Just another hand out: Effort to ease cuts in Medicare doc fee schedule faces tough competition”, Lovern, Modern Healthcare, December 3, 2001.