Code Red: Two Economists Examine the U.S. Healthcare System

April 5, 2013

Restoring Medicare Advantage Payment Rates: A Lesson in Procurement

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 8:08 am

The big health policy news this week is the CMS decision to postpone a scheduled 7 percent cut to Medicare Advantage (MA) plans. CMS acted in response to a bipartisan plea from 160 legislators whose jurisdictions include a large number of seniors enrolled in MA plans and, especially, the big insurers that stood to lose billions of dollars had the cuts survived. The Wall Street Journal cheered the support for a private sector alternative to traditional Medicare, but many health economists are disappointed.

Media coverage has focused on whether MA plans are profitable without getting into the underlying economic rationale for the cutbacks. To make real sense of the proposed cutbacks, it is necessary to spend a few moments considering how the federal government buys stuff. The government can’t let a “purchasing agent” decide what to buy; that approach is too easily corrupted. So the government usually allows open bidding in a process known as procurement. Whether buying bomber planes or mechanical pencils, the government tends to be very careful, because procurement has many pitfalls. Suppose the government wanted to purchase computers and made the following proposal: “We will purchase 10,000 computers from the lowest bidder.” We can imagine what would happen. Someone would make a lowball bid and then dump onto the government some third rate computers (Commodore 64s?). To avoid this, government procurement contracts for computers are highly detailed, specifying processing speed, memory, operating system, and so forth.

For much the same reason, CMS specifies a long list of requirements for MA plans. But there are two important distinctions between MA and other goods and services procured by the government. The first is that CMS is already in the business of health insurance, through the traditional Medicare program. So CMS not only specifies MA plans must look like, it also sets the price based on what it costs to cover enrollees in traditional Medicare.

This is where the second distinction comes in. Unlike bomber planes, mechanical pencils, and personal computers, the cost of health insurance depends, to a large extent, on who is buying it. Simply stated, it costs more to insure sicker enrollees. CMS uses a price setting formula that is based on enrollee health information. But this formula is far from perfect – there are simply too many variables affecting health spending. Health economists have shown that MA plans exploit these imperfections by enrolling members whose costs are lower than what is predicted by the formula. Such favorable selection allows MA plans to prosper without necessarily being more efficient.

The rollback in payments to MA plans was meant to correct this flaw in the CMS formula. If MA plans could deliver care more efficiently, they could still prosper. But they would no longer be able to take the easy way out by enrolling relatively healthy enrollees.

This is sound reasoning, but there is another aspect of procurement to consider. The government doesn’t like to entrench monopolists, so it often awards contracts to two or more bidders, even though this raises the short run cost of the contract. In the same way, there is great virtue in having private MA plans compete with traditional Medicare; public monopolies are no better than private monopolies. A generous CMS formula encourages such competition. This may drive up costs in the short run (and boost profits of MA plans), but it provides much needed market discipline for traditional Medicare.

The CMS formula for MA pricing has always been a moving target. Perhaps in the past CMS has been too generous. But it may be too stingy in the future, and when that happens MA plans will quickly disappear. I suspect that this is the real political motive for cutting MA reimbursements – to restore the federal Medicare monopoly. In my book that would be a far bigger problem than the profits enjoyed by private insurers.


  1. David
    –If I understand you correctly, for political reasons, CMS reversed their end run around the MA plans by overturning the cuts.
    –Long ball, they desire to put MA plans out of business to acquire monopsony power?
    –And the rates, while too generous in the past, now have become too stingy.
    –But CMS cut anyway, again for power
    –They lost round one?

    Is that right?


    Comment by Brad F — April 5, 2013 @ 5:11 pm

    • I don’t know if CMS wants the monopsony so much as the Obama administration does. But yes, the current political pressure (from an interesting mix of Democrats and Republicans) has forestalled that possibility.

      Comment by dranove — April 5, 2013 @ 5:40 pm

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