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And it is important also to continue to stimulate competition. I personally feel a strong responsibility as the administrator and guardian of the Hospital Insurance trust fund to continue to search for new and better opportunities to make the medicare program more efficient and more effective, without compromising the availability of the needed services to our beneficiaries.

And I stand ready to work with this committee, as well as others, and look forward to our continuing dialog together. I think the most important thing is to recognize we do have time. That the trust fund at this moment is solvent until the end of this decade, and that does give us some time to change behavior.

[The prepared statement of Dr. Davis follows:)

PREPARED STATEMENT OF CAROLYNE K. DAVIS, PH.D. I am very happy to appear today to discuss issues related to long-term financing of the Medicare Hospital Insurance Trust Fund and some of our key reform proposals.

As you are aware, the prospective payment bill, a major and critical piece of the Administration's 1984 legislative proposal package, is only one step from becoming law. I would like to talk about this important bill for a moment, since I believe that the site of today's hearing is particularly appropriate. Much of the thinking that went into our prospective payment proposal came from what we learned from New Jersey's experience.

In 1975, New Jersey began setting payment rates for Blue Cross and Medicaid. The following year, the Department of Health signed a contract with Medicare to experiment with approaches to measuring patient case tax. In 1978, the New Jersey legislative enacted a bill which established the framework for adopting a statewide prospective payment system. One provision of the law extended the state's authority to control hospital reimbursement of all payors. The Health Care Financing Administration granted New Jersey authority to waive Medicare's cost reimbursement principles and establish prospective rates.

New Jersey's payment rates are based on diagnosis related groups (DRGs). This system was developed at Yale University

In the early 1970s. As you know, the DRGs are a method of classifying patients in order to reflect differences in the cost of treatment. The DRGs have been improved substantially in recent years to better measure differences in the cost of and case mix of patients.

Preliminary results from our study of New Jersey indicate that the state's program has had a positive effect upon hospital resource management. Hospitals now have a financial incentive to control both routine and ancillary costs and a standard by which to measure themselves. As a result, many hospitals have actively undertaken formal programs to identify and eliminate unnecessary costs in specific departments. Additionally, physicians have become more sensitive to the cost aspects of hospitalization and now consider more carefully the services they order.

Further, the New Jersey Hospital Rate Setting Commission has reported that New Jersey hospitals have become more efficient in a number of important respects.

Total operating expenses of New Jersey hospitals increased by 13.8 percent in 1981 compared to a National increase of 17.4 percent;

The increase in hospital inpatient costs per capita was 11.5 percent for New Jersey; 17.7 percent for the rest of the nation; and

The number of admissions and inpatient days declined in New Jersey while they rose in the result of the country.

After reviewing New Jersey's system, particularly its use of DRGs, we found that the system held considerable promise for a national program. While we did not adopt your State's use of reviewing individual hospital's budgets, much of the Administration's prospective payment legislation builds upon the experience of New Jersey.

I believe it is unnecessary to recite the data that show vividly how much hospital costs have risen over the past fifteen years. I believe it is important to point out though that a part of the reason for the huge increase in hospital costs—far above the national rate of inflation-has been a retrospective cost reimbursement system that rewards inefficiency. In constructing our prospective payment legislation, we

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tried to remove the disincentives of the cost-based system and substitute instead a system which:

Is easy to understand and simple to administer;
Can be implemented in the near future;
Ensures predictability of government outlays and hospital revenues;
Establishes the Federal Government as a prudent buyer of services;

Assures that Medicare expenditures for inpatient hospital services are no greater than the amount that would be spent if the present system of retrospective cost reimbursement with limitations were continued;

Provides incentives for hospital management flexibility, innovation, planning, control, and efficient use of hospital resources;

Reduces over time to cost reporting burden on hospitals; and
Continues to assure beneficiary access to appropriate quality care.

Although the bill passed by the Congress differs from ours, we believe that it still meets all of the objectives described above.

The passage of prospective payment, when coupled with the enactment of the National Commission on Social Security's recommendations, dramatically improves the short term financial situation of the Hospital Insurance (HI) Trust Fund. Nevertheless, it does not solve the basic solvency issue as, even with the passage of these revisions, the Fund will still be exhausted by the end of this decade.

This Administration last submitted a formal report to the Congress on the financial status of the Hospital Insurance program in April 1982 when the Annual Trustees Report was submitted. That Report indicated that under current law, the HI Fund would be depleted by 1987 under Alternative II-B (Intermediate) assumptions and by 1986 under more pessimistic Alternative III assumptions. The 1983 report will be submitted once we have completed incorporating the details of the effects of the recent legislation.

However, I have attached recently developed HI Fund projections using a variety of economic and legislative assumptions. These projections, which include prospective payment and provisions of the Bipartisan Agreement on Social Security Reform extended to the HI program, indicate that the HI Trust Fund will not be depleted until 1989 under Alternative II-B Assumptions or 1987 under the more pessimistic Alternative III assumptions. Additionally, assuming passage of the Administration's 1984 Medicare reform proposals, depletion of the HI Fund would be further delayed until 1990 under the Alternative II-B assumptions and until 1988 under the Alternative III assumptions.

There are several reasons for these current law projections to be different from those provided in April of 1982:

The Tax Equity, and Fiscal Responsibility Act of 1982 (TEFRA) made significant changes in the HI program;

The HI Trust Fund loaned $12.4 billion to the Old-Age and Survivors Insurance (OASI) Trust Fund pursuant to the interfund borrowing provisions of P.L. 97–123 (which restored minimum benefits under the Social Security Act); and

A more pessimistic set of economic assumptions has been adopted.

Looking at the long term picture, over an entire 25-year projection period from 1983 through 2007, the average cost of the program, expressed as a percent of payroll, will be 5.14 percent. During that same 25-year period, the average current law tax rate is 2.87 percent. In other words, either program costs will have to be reduced 44 percent or HI payroll taxes will have to be increased by 80 percent to keep the program solvent over the next 25 years.

As you know, the quadrennial Advisory Council on Social Security is currently analyzing the financial problems of the HI Trust Fund and exploring long range options for resolution of these problems. This prestigious group began its work last November and will report its findings and recommendations later this year.

Now, I would like to review some of our other proposed reforms, since, as I have indicated, we believe these are a critical next step in ensuring the continued viability of the HI fund. Our proposals are designed to change behavior for the better by removing perverse incentives for all sectors of the market—hositals, physicians, consumers, employers, and insurers. When all the participants work together and share the responsibility for controlling costs, the future status of the HI Fund should improve still more. The key remaining proposals of our "Health Incentives Reform Program” are: restructured medicare hospital cost sharing and catastrophic coverage, our voucher proposal, freezing physician reimbursement for one year, increases in the medicare Part B premium, and indexing the Part B deductible to the Medicare economic index. I will now discuss each of these proposals in some detail.

RESTRUCTURED MEDICARE COST SHARING AND HOSPITAL CATASTROPHIC COVERAGE A major element in the Administration's plan to correct system incentives is the proposal to restructure Medicare cost-sharing. This proposal would promote costconscious decisions while protecting beneficiaries against catastrophic hospital expenses. Most importantly, it would put the protection where Medicare beneficiaries need it most.

Under the current system, Medicare hospital coverage is limited to 90 days per spell of illness and 60 lifetime reserve days. This places the greatest financal burdens on the sickest patients. Less severely ill patients, and their physicians, are given little incentive to keep their hospital stays as short as possible because patient cost-sharing, other than paying the deductible, does not begin until the 61st day of hospitalization.

The Adminstration's proposal would change Part A cost-sharing to create incentives for savings where those incentives can work and to better protect the Medicare patient needing long hospitalization. Under the proposal, the beneficiary would pay the first day deductible provided for under current law and would then pay 8 percent of that amount-about $28 in 1984—for days 2 through 15 of hospital care in a spell of illness. For days 16 through 60 in a spell of illness, this amount would be reduced to 5 percent of the deductible—or about $17.50 per day. After the beneficiary had paid for 60 days of cost-sharing in a calendar year, there would be unlimited hospital days without additional cost-sharing.

In 1984, the proposal would cost a beneficiary $1,530 in out-of-pocket costs for a spell of illness with 150 hospital days compared with the $13,475 it would cost under current Medicare provisions (even assuming the beneficiary had not previously used any lifetime reserve days). The proposal would provide Medicare beneficiaries, for the first time, with catastrophic hospital coverage.

OPTIONAL MEDICARE VOUCHER Last year, Congress, with the support of the Adminstration, amended the Medicare statute to permit payments on a risk basis to HMOs and other competitive medical plans. This year we propose to expand this provision. The optional voucher provision would build on current law by allowing Medicare beneficiaries to use Medicare benefits to enroll in a wider array of private health plans, Medicare would contribute an amount equal to 95 percent of what it would have cost to care for the beneficiary if he or she had elected traditional Medicare coverage. If a beneficiary selects a private health plan that costs more than Medicare's contribution, the beneficiary must pay the difference. It the private plan costs less than Medicare's contribution, the beneficiary would qualify for a cash rebate. Enrollment in a private health plan would be voluntary. Once a year beneficiaries would have the opportunity to switch private health plans or to elect traditional Medicare coverage. A qualified health plan may be an HMO, an indemnity insurer, or a service benefit plan. At a minimum, all private plans must cover the services provided under Parts A and B of Medicare and must participate in a coordinated annual open enrollment period.

Cost-sharing for Medicare-covered services may not exceed comparable out-of pocket expenses under Medicare. so no beneficiary could purchase coverage less extensive than that provided by Medicare.


Medicare physician expenditures, the second largest component of Medicare spending, have been increasing at highly inflationary rates. In 1982, they increased 21 percent and are expected to rise 19 percent in 1983. Because of these large increases and because physicians have been largely unaffected by the cost control provisions of TEFRA and the Omnibus Budget Reconciliation Act of 1981, we propose to freeze Medicare's physician reimbursement levels for 1984 at 1983 levels. Physicians, too, must share the burden of slowing the rise in health care costs.


As part of our restructuring of the Medicare financing system, we propose to modify the timing and rate of increase in the Part B premium. The intent of this proposal is to move closer to the original balance between premium and general revenue financing of Part B, and to coordinate the timing of future premium increases with the date of annual Social Security payment increases.

When Medicare was established, premiums covered half of the estimated costs of Part B, with the remainder financed from general revenues. This balance has

eroded over the years until in 1981 premiums contributed less than one-quarter of the costs. TEFRA provisions suspended the limitation on annual premium increases and set a new premium level at 25 percent of projected costs for premium years beginning in July of 1983 and 1984.

Under our proposal, we would raise the Part B premium in stages: maintaining the current level of $12.20 per month from July 1, 1983 to the end of the year; increasing the premium to 25 percent of projected costs for calendar year 1984; and increasing the premium by equal increments of 2.5 percent beginning January 1, 1985 until it reaches 35 percent of projected costs in January of 1988. After January 1, 1988, the premium for each calendar year would be set at 35 percent of estimated costs. The proposal includes a “hold harmless” provision. Beneficiaries who have their premiums deducted from their Social Security checks (about 90 percent of the beneficiaries) will not have the dollar amount of those checks reduced below the previous year's level due to the premium increase.


We also propose to index the Part B deductible to the annual changes in the national Medicare economic index. This provision would help maintain the constant dollar value of the deductible, thereby maintaining the value of the deductible as a deterrent to unnecessary utilization. Current law does not provide for regular increases in the deductible to reflect increases in health care costs. As a result, the initial beneficiary liability for medical services has decreased in real terms over time, shifting most of these costs to taxpayers in general.

In addition to these major Medicare proposals, our legislative package includes several other proposals that would strengthen program management, improve incentives for efficiency, and produce savings in program spending. Included are pro posals to institute competitive bidding for laboratory services and durable medical equipment, create consistent reimbursement policies for durable medical equipment, initiate an enhanced Medicare contracting strategy, and delay entitlement to Medicare benefits for the elderly for one month.


We believe these proposals to improve Medicare reimbursement and financing represent complementary efforts to constrain health care costs. Not only are they based on working, market-place incentives, but also they follow consistent and understandable principles:

They enhance cost awareness for all parties, consumers and providers alike;
They act to restore the incentives for cost-effective health care;

They improve the structure of Medicare financing, reimbursement, and coverage, especially by providing catastrophic coverage;

They enhance the opportunity for choice among different health coverage plans; and

They stimulate competition in the health care sector.

These proposals, when coupled with the Bipartisan Agreement recommendations, represent a strong beginning and will achieve short term stability for the HI Fund. Long term resolution is an issue still before us. Additionally, I feel a strong responsibility as Administrator and guardian of the HI Fund to continue to search for new and better opportunities to make the Medicare program more efficient and effective, without compromising the availability of needed services to our beneficiaries. In this light we look forward to the recommendations yet to come from the Advisory Council on Social Security and to working with the Congress in seeking a resolution to this basic long term financing problem.

I will be glad to answer the Committee's questions at this time.



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Includes starting trust fund balance updated by Treasury Department. 2 Includes an interest repayment for the interfund loan of $12,437 million to OASI. The interest amounts of $1,362 million in 1983 and $1,337 million in 1984 and later are theoretical. If these payments are not made, the fund at the end of the year would be $6,825, $3,238, and - $1,409 million in calendar year 1983, 1984, and 1985, respectively.

3 Assets at beginning of year as a percentage of outgo during the year.



[Dollar amounts in millions)

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Includes starting trust fund balance updated by Treasury Department. Includes the lump-sum military transfer proposal for HI, Includes the prospective payments provision but does not include any fiscal year 1984 budget proposed law items.

2 Includes an interest repayment for the interfund loan of $12,437 million to OASI. The interest amounts of $1,362 million in 1983 and $1,337 million in 1984 and later are theoretical. If these payments are not made, the fund at the end of the year would be $10,286, $7,677, $5,311, $3,887, and - $166 million in calendar year 1983, 1984, 1985, 1986, and 1987, respectively.

3. Savings attributable to prospective payment are computed as the additional savings which would be generated in fiscal year 198 and later by eliminating the October 1985 sunset provision on the hospital rate-of-increase limits of section 101(b) of the Tax Equity and Fiscal Responsibility Act. The prospective payment legislation proposed by the administration does not mandate a system which would necessarily generate this level of savings. Instead, the level of the prospective payment rates is left to the discretion of the Secretary of HHS.

• Assets at beginning of year as a percentage of outgo during the year.



(Dollar amounts in millions)

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1983 1984 1985 1986. 1987 1988 1989 1990


$41,078 45,544 51,232 57,970 65,239 73,400 82,547 91,735


$11,734 12,149 13,564 16,517 17,556 15,629 9,770 - 555

415 1,415 2,953

1,039 - 1,927 -5,859 - 10,325

20 26 24 23 25 24 19 11

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