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September 2003

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Privatizing Medicare

By Kip Sullivan
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September 2003
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R epublicans have publicly supported the privatization of Medicare since they took control of Congress in 1995. Democrats have supported adding drug coverage to Medicare since 1999. In 2003, Republicans linked the issues.  

President Bush announced last January that he would support adding a scrawny drug benefit to Medicare on the condition that Medicare beneficiaries be given financial inducements to join HMOs, and on June 12 House Republican leaders introduced a bill that adds scrawny drug coverage to Medicare and puts great financial pressure on seniors to join HMOs beginning in 2010. On June 27, the House passed the Republican bill by a single vote. The bill must now be reconciled with a similar Senate bill that also passed on June 27, which puts considerably less pressure on seniors to enroll in HMOs. 

The media has given the drug coverage portion of this story extensive coverage and has done a good job of reporting on Bush’s campaign to hold drug coverage hostage to his privatization plans. But the media has devoted very little ink to explaining how privatization would work under the Bush and House proposals. Worst of all, the mainstream media has made no effort to represent the views of experts who believe HMOs cannot possibly save Medicare money and might damage the quality of care. 

The New York Times ’ coverage represents the best and the worst of the media’s coverage of the drug and privatization issues. Last January, the Times was the first news outlet to report that Bush intended to give the two issues high priority in 2003. The article, which ran on January 3, made it clear that Bush was seriously considering making seniors leave the traditional Medi- care program (where 89 percent get their coverage now) and enroll in an HMO (where the other 11 percent are covered), and that some Democrats were opposed to such a plan. The article quoted the chief of staff of Rep. Pete Stark (D-CA) saying, “If the price of a prescription drug benefit is the end of Medicare as we know it, that’s not a price worth paying.”  

But the lengthy article gave no indication that a substantial body of research demonstrates that the HMOs that are now insuring seniors add to rather than lower Medicare’s costs. In fact, the article created the impression that HMOs were lowering costs by describing HMOs as “more efficient [and] less costly” than traditional Medicare, and by presenting the HMO industry’s claim that Medicare doesn’t pay HMOs enough. 

Two factors make it impossible for HMOs to insure the elderly for less money than the traditional Medicare program does: HMOs have overhead costs that providers (doctors and hospitals) serving traditional Medicare patients do not incur and that Medicare therefore does not pay for; and HMOs pay providers more than traditional Medicare does. 

HMO overhead expenditures, that is, their payments for things other than medical care, equal about 20 percent of total HMO revenues. The main categories of HMO overhead expenditures are marketing, policing doctors, lobbying, obscene salaries and perks for management, and profit for insurance company shareholders. Under the traditional Medicare program, Medicare pays providers directly; there is no HMO middleperson and, therefore, no HMO overhead to siphon off 20 percent of Medicare’s payments before it reaches providers. But under the HMO portion of the Medicare program, Medicare pays the HMO middlepeople and HMOs, in turn, pay providers, but only after the HMOs have scraped off 20 percent of their payments from Medicare to cover their overhead. 

The evidence that HMOs have overhead costs in the range of 20 percent of revenues comes from Wall Street. On Wall Street, HMOs brag about their “medical loss” ratios—the ratio of their medical expenditures (their payments to providers) to their total revenues. An HMO loss-to-revenue ratio of 70 percent is considered great for investors whereas a ratio of 90 percent is considered abysmal. No one has calculated the average medical loss ratio for the entire US health insurance industry, but it’s possible to do so for the largest insurers. In 1999, the medical expenditures of today’s four largest health insurance companies (United Health- Care, Aetna, Cigna, and Wellpoint) averaged about 80 percent of the revenues of these companies.  

The existence of HMO overhead means that HMOs have to reduce their medical costs by more than 20 percent in order to save Medicare money. That’s an enormous handicap. But huge overhead is not the only HMO handicap. HMOs also pay higher rates to providers than traditional Medicare does. The New York Times was apparently the only major news outlet to report this fact. Paul Ginsburg, president of the Center for Studying Health System Change, recently told the Times , “In most areas of the country, payment rates for hospitals and physicians that are negotiated by private plans are higher than those paid by the [traditional] Medicare ...program.” According to the Medicare Payment Advisory Commission, which advises Congress, hospitals charge HMOs about 40 percent more than they charge Medicare and physicians charge HMOs about 15 percent more. Together, these differences in provider rates add another 20 percent to HMO costs. 

Medicare’s ability to pay lower fees is due to its size. With 36 million people, traditional Medicare is far and away the nation’s largest insurance program. It’s so big and provides such a large portion of the average provider’s revenues that providers can’t afford to walk away from the Medicare population. 

When we add HMOs’ higher overhead (20 percent) to their fee disadvantage (20 percent), we’re looking at a handicap equal to roughly 40 percent. HMOs have only two ways to offset this enormous handicap: (1) they can deny much more medical care to their patients than traditional Medicare denies its patients; (2) they can seek to avoid the sickest patients and enroll only the healthy. Neither strategy is morally or politically acceptable. 

The HMO industry’s efforts to ration health care in the nonelderly market backfired so badly in the mid-1990s that the industry has begun to back away from its most aggressive managed-care tactics. If the nation wouldn’t tolerate aggressive rationing by HMOs among the nonelderly, it would certainly not tolerate even more aggressive rationing among the elderly. 

That leaves the HMOs with only one strategy: to enroll only the healthiest seniors—a tactic called cherry picking—but get paid as if they were enrolling average seniors. At least two dozen studies have demonstrated that HMOs have benefited from this strategy for at least the last two decades. Congress has been apprised repeatedly of this fact. The U.S. General Accounting Office (GAO), the Congressional Budget Office, and the Medicare Payment Advisory Commission have all sent reports to Congress stating that Medicare is overpaying Medicare HMOs by large amounts because the HMOs attract disproportionately healthy seniors. The GAO reported in 1999, for example, “studies conducted by us, ...the Medicare Payment Advisory Commission...and others demonstrated that the Medicare program spent more on beneficiaries enrolled in health plans than it would have if the same individuals had been in  [traditional Medicare]. This unexpected result occurred because Medicare  payments were based on the estimated cost of... beneficiaries [in traditional Medi- care] in average health and were not adequately adjusted to reflect the fact that plans tended to enroll beneficiaries with better- than- average health....” 

The studies the GAO cited indicate the Medicare overpayment to HMOs lies somewhere in the range of 15 to 45 percent. If this seems hard to believe, consider just one of the studies the GAO was referring to—a study by the Physician Payment Review Commission, a predecessor to the Medicare Payment Advisory Commission. In its 1996 report to Congress, this commission reported a study it had done which found that the seniors who enrolled in Medicare HMOs were so healthy they cost the HMOs only 60 percent of the average cost of Medicare beneficiaries. 

If we tack on another type of overpayment—this one equal to about 5 percent of Medicare payments to HMOs—caused by HMOs fraudulently inflating their administrative costs, a problem documented by a 1998 report of the Department of Health and Human Services, we may say Medicare has been overpaying the average HMO by somewhere in the range of 20 to 50 percent. It is this gigantic, unintended overpayment that makes it possible for some HMOs to survive in the Medicare “market” despite big handicaps—high overhead and relatively high provider payments. 

Medicare HMOs may continue forever to get away with inflating their administrative costs and inducing Medicare to pay it (the Clinton administration showed, and the Bush administration has so far shown, no interest in preventing HMOs from padding their Medicare charges), but they can’t continue forever to cherry pick. Enrolling the healthiest of the Medi- care population is possible only as long as the HMOs enroll a tiny proportion of that population. If and when HMOs begin to enroll a growing proportion of the Medicare population, which is the Republicans’ goal, HMOs will find it more and more difficult to avoid their share of the sick. As the HMO industry’s share of Medicare beneficiaries rises from its current level of 11 percent, and as the typical HMO enrollee becomes more typical of the Medicare population, the unintended cherry-picking subsidy to the HMOs will vanish. 

HMOs start out with two financial disadvantages against traditional Medicare: (1) they generate administrative costs equal to roughly 20 percent of their revenues; (2) they pay higher provider fees equal to about another 20 percent. It’s conceivable that a pro-HMO Congress could eliminate the latter handicap by simply ordering providers to charge Medicare HMOs no more than they charge the traditional Medical program. But even if Congress would do that over the objections of the physicians, hospitals, and (if drug coverage is added to Medicare) the drug companies, the HMO overhead problem would still remain. The HMOs’ two remaining weapons—rationing and cherry picking—will be nowhere near potent enough to offset their overheads. Aggressive rationing of Medicare beneficiaries by HMOs is not politically and morally acceptable, and the HMO cherry-picking advantage will disappear as privatization gradually brings a larger and larger portion of the Medicare population into HMOs. 

Privatization cannot save Medicare money. Republicans should drop their privatization proposal and kick the HMOs out of Medi- care all together.

Kip Sullivan lives in Minneapolis. He writes frequently about health policy. 
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