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Medicare is one of the most important payers in the U.S. health care system. It is health insurance for the elderly and has four parts – A, B, C & D.

Traditional Medicare (Part A & B)

During the Great Depression, hospitals began noticing that people couldn’t afford the care as treatments were becoming more advanced and costly. When Harry Truman (after WWII) suggested that the Federal government should sponsor healthcare for all Americans, the American Medical Association (AMA) went on a campaign to defeat any legislation. However, the AMA felt the government would come in between the patient-physician relationship.

Before it was passed in the 1960s, most of the groups that supported government-sponsored health insurance were groups who wanted the government to help the disadvantaged population (such as farmers union, nurses, retired people’s association). The groups that were against Medicare were the American Hospital Association, AMA, and sizeable private insurance firms. At this point, doctor groups were mostly independent and entrepreneurial.

The election of Lyndon Johnson ensured a significant Democratic presence in the House and the Senate. However, the Republicans wanted some say in the bill, so they offered to cover physician services (at the time, it was only hospitals) and made Medicare income-eligible only.

Part A – this is the most significant piece. It is the hospital part.
Part B – this is the physician piece (it was voluntary). Beneficiaries had to pay for almost 50% of the cost.

Introduction to medicare

As a part of this legislation, Medicaid was also introduced with income eligibility requirements.

The Evolution of Medicare

In 1989 Medicare catastrophic coverage (Medicare did not have an out of pocket limit) and prescription drug coverage was repealed because the beneficiaries had to pay 100% of costs. Now people can buy catastrophic coverage through the Medigap market or employer-sponsored plans or Medicare Advantage (which is the Medicare managed care program).

Medicare Benefit Expansion

The graph below shows the various sources of supplemental coverage that Medicare beneficiaries sought out to expand their original coverage.

Medicare sources of supplemental coverage

Other Major Policy Changes

Evolution of Medicare

1. Inpatient Diagnosis Related Groups (DRG)

The DRG is what hospitals are paid, as an average cost, to take care of a patient with a particular disease.

2. Resource-Based Relative Value Units (RBRVU)

The RBRVU determines what Medicare pays for physician services. It took into account the time, stress and skill doctors put in to take care of a patient. This standard was hard to measure but was eventually implemented by private insurance too. Initially, Medicare paid physicians what is considered “usual, customary and reasonable.” When Medicare made these changes, it resulted in spikes of payment growths for other sectors (post-acute, physician services when DRG was addressed).

Medicare Cost Provisions

In 2003, Congress enacted the Medicare 45% Trigger, which meant only 45% of Medicare expenditures could come out of the Treasury,

3. Sustainable Growth Rate (SGR)

This legislation states that physician payment rate growth shouldn’t exceed the percentage growth of GDP. This temporary fix worked until the economy collapsed in 2001, and the SGR has been greater than GDP ever since. Congress has been “freezing the doc fix,” which is a permanent solution to the distortion between what physicians should be and what they currently are. If the government paid physicians according to SGR, then it would have reduced their payment rates by 25% in 2014. However, this didn’t happen as Congress elected to ignore the problem again.

Impact of Medicare

Medicare impact

The American population is aging quickly and a larger portion of the population will now be eligible for Medicare, while advancements in medicine have allowed people to live for longer.

Medicare forms a significant portion of the elderly’s security. Majority of them have incomes less than $22,000 and savings below $77,000. 40% have more than three chronic conditions. 20% of the elderly are eligible for Medicare and Medicaid.

Total revenue for Medicare – $532.7 billion (2012)

Medicare revenue

Where does the money for Medicare originate?

  • 40% – General Budget
  • 38% – Payroll Taxes
  • 13% – Beneficiary Premiums
  • The rest comes from the states

Where does Medicare spend all its money?

Medicare spending

Future of Medicare Financing

There is concern that the program was relying on the general treasury for its bills. The payroll taxes trust fund will not be able to support it at the current rate, but this situation has been projected in the past, so Congress has always made changes to the program to keep it sustainable (like changing the DRG rates).

Projected Medicare Financing

The white space (Hi deficit) is the part where the payments will exceed the funds.

How can Medicare increase its sustainability?

  • Increase payroll taxes
  • Increase beneficiary premiums
  • Reduce provider payments
  • Change provider financial incentives
  • Reduce benefits

Currently the elderly pay 25% of their Social Security benefit (which is their main source of income) towards their premiums. In 1996, 5 workers supported 1 person (through payroll tax). In 2006, 3.9 workers supported 1 person, and it is projected to be 2.4 workers per person in 2030.

The Affordable Care Act & Medicare

The ACA is trying to get costs under control, making Medicare more sustainable by reducing the rate of growth of costs.

Biggest sources of cost savings

  1. Reducing payments to providers –  $196.3 billion
  2. Reducing the amount paid to hospitals for the uninsured – $22 billion
  3. Reducing payments to Medicare Advantage to what it would’ve cost in traditional Medicare – $135 billion
  4. Increasing high-income individual premiums – $25 billion (Part B)
  5. Creating an independent payment advisory board (recommend proposals to Congress if the rate of Medicare exceeds certain targets, can only recommend payment reductions) – $16 billion
  6. Reform delivery system and payment incentives – <$20 billion because there isn’t much to estimate this on.
Prateek Agarwal
Prateek Agarwal
Member since June 20, 2011
Prateek Agarwal’s passion for economics began during his undergrad career at USC, where he studied economics and business. He started Intelligent Economist in 2011 as a way of teaching current and fellow students about the intricacies of the subject. Since then he has researched the field extensively and has published over 200 articles. If you have any questions, comments or suggestions, please email me or connect with me on LinkedIn -

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