Medicare Does a Bad Job Setting Fees

Traditional "fee-for-service" (FFS) Medicare — which pays providers a fee for each service delivered — is the nation's largest health-insurance program, enrolling 38.1 million aged and disabled beneficiaries in 2014. The program pays more than 200 million claims for inpatient hospital admissions and home-health-care visits each year, and 1 billion claims for doctors' services. There are about 10,000 different services for doctors alone, and each of these fees is set through an administrative process that attempts to discern the cost of producing that service — called the "relative value" — in terms of the costs of physician work, practice expenses, and liability insurance.

Not surprisingly, Medicare fees substantially influence the prices that private-sector insurers pay for services. To save time and effort in developing their own fee schedules, many private payers have adopted the Medicare fees outright. And when Medicare raises its fees, private insurers have to go along to some degree, or else providers will become less likely to see privately insured patients.

But FFS Medicare does a bad job of setting these fees. A new analysis that we conducted for the Mercatus Center at George Mason University explains why — and suggests how to fix the system.

We focused on the fees for doctors' services, although much of our analysis applies to the fees that Medicare pays for hospital admissions as well. For doctors, the program has struggled for many years to increase the value of "evaluation and management" services — think of these as "primary care" — in relation to tests and procedures. Evaluation and management services are vital for managing the health of aged and disabled Medicare beneficiaries, many of whom have multiple chronic health problems.

In principle, Medicare could collect fine-grained data on medical costs from a representative sample of physicians. Instead, the data are collected, and updates to the fees are recommended, by a private body whose committees are drawn disproportionately from the major specialty societies. This body, known as the Relative Value Scale Update Committee or RUC, resists rebalancing the fees, despite advances in technology that have reduced the cost of tests and procedures.

Conflicts of interest are not the only problem with the fee-setting process. The RUC relies on flawed surveys to determine the relative values of different services. It sometimes cherry-picks the results if the data are deemed to be flawed or incomplete. And it often uses unrealistic assumptions that inflate the cost of the equipment that is used for diagnostic testing.

Part of the blame can be laid at the door of the Centers for Medicare and Medicaid Services, the government agency that oversees Medicare and reviews the recommendations coming from the RUC, though its performance has improved in recent years. In the past, CMS almost always accepted the RUC's recommendations, but substantial changes in the oversight process have given the agency more authority and funding. It now accepts only about half of the RUC's recommendations.

But even if CMS could collect unbiased data and evaluate it in a neutral manner, the fee-setting process still would be flawed until its deeper assumptions were challenged. Most important is the assumption that physicians' fees should be based on administrative data, in an attempt to create a semblance of market prices.

Medicare fees indeed should reflect market prices. Unfortunately, it's impossible for a government agency to set prices that replicate those resulting from millions of independent transactions between buyers and sellers in a competitive market. But CMS can do better, by harnessing the power of actual competition instead of relying on administrative data.

We suggest having providers bid on the fee schedule or bundles of services, and then using the bids to set Medicare fees. Providers could set their prices wherever they liked, but those with higher bids would be placed in higher tiers. Medicare beneficiaries would pay higher out-of-pocket costs for providers in higher tiers — a strategy that has worked in the private sector. This already happens to some extent with hospital admissions, but it could be extended to bundles of services that include outpatient care.

For this system to be effective, beneficiaries would have to care about the higher cost of higher-tier providers. This form of exposure has been difficult in the past, because many FFS Medicare beneficiaries buy "Medigap" policies that cover some out-of-pocket costs. A key part of any reform must be to prevent these policies from insulating beneficiaries from the added cost of more expensive providers — providers we know are more expensive because they have told us so, in their bids.

Medicare needs to find a new way to set fees. A bidding system could be the solution — but for this to be successful, beneficiaries must have some skin in the game.