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

January 30, 2017

The Tricky Math of Medicaid Block Grants: Balancing Strong Incentives and the Goals of Social Insurance

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 9:26 am

Most of the recent attention on the Republican health policy agenda is focused on the desire to repeal and replace the Affordable Care Act and the resulting impact on the ACA marketplaces. This make sense given that even the rhetoric about repeal may chase private firms from the marketplaces. However, we must not lose sight of the ultimate fate of Medicaid (both the original program and the ACA expansion), especially since any changes to Medicaid may touch more Americans.  We are talking, of course, about the proposal to replace the existing Medicaid program with block grants to the states. Politicians on both sides of the aisle have been blowing a lot of smoke about the costs and benefits of this proposal, so let’s try to clear the air.

To understand the issues, first let’s consider a very basic overview of the structure of Medicaid. Currently, the federal government pays a portion of each state’s Medicaid costs; this is called the federal medical assistance percentage. That percentage depends on the size of each program prior to the ACA (the feds picked up between approximately 50 and 75 percent of the pre-ACA program, depending on the wealth of the state) and the extent to which the program expanded with the ACA (the feds initially pick up 100 percent of the expansion population, though that figure is due to fall to 90 percent after 2019.)  The federal government sets rules that govern the programs, and these generally require broad service coverage and minimal cost sharing for the eligible population, although states can tinker around the edges and expand coverage using their own funds. All states must cover individuals in specific categories, including poor families with dependent children, as well as the elderly and the disabled.  For the latter two, Medicaid supplements Medicare, effectively eliminating all cost sharing for beneficiaries of these programs.  In fact, the majority of Medicaid spending goes to supplement the Medicare eligible population – this is especially important for long term and nursing home care, which is minimally covered by Medicare.

States have considerably more control over program design than they do over eligibility limits. For example, currently over three quarters of all Medicaid beneficiaries receive their benefits through some type of Medicaid managed care plan. In addition, at least 20 states have begun or are considering ACO like arrangements with integrated health providers.  The move towards managed care came about for many reasons, but it was primarily driven by a desire to decrease the rate of spending increases in Medicaid and provide some predictability for state budgets. To date, the Medicaid Managed Care (MMC) literature has not found consistent evidence of savings resulting from MMC programs.  Part of the reason is that MMC programs differ dramatically by state, as do the effects of the programs.

A little history lesson may help understand how we got to the existing structure (and provide some caution about changing it). Medicaid and Medicare replaced two state/federal partnerships.  In one program, the federal government matched state payments to medical providers on behalf of individuals receiving public assistance payments (i.e., welfare).  The second program, known as Kerr-Mills, subsidized state-sponsored programs for the medically-indigent elderly. State participation in both programs was spotty, with a few states like New York and Wisconsin offering generous coverage while neighboring states did not participate at all.  Many states found that by refusing to subsidize indigent care, they could keep their tax rates low and gain an upper hand in economic competition against other states. This reflected a race to the bottom mentality – few states could afford to maintain generous programs while their neighbors stole businesses and jobs thanks to lower taxes. Many policy makers, including those in states that refused to participate in these programs, argued that all states would be better off if their hands were tied and everyone had to participate.

So a key goal of Medicaid was to assure that every state participate at a fairly high minimum threshold, thereby avoiding the incentive for a state to defect and restart a race to the bottom. When introduced in 1966, states still had a fair amount of leeway in terms of coverage, with income eligibility thresholds varying by a factor of two across some neighboring states, but over time there has been considerable convergence.  This convergence came to an end with the ACA, as half the states have refused further expansion, in part to improve their competitiveness vis a vis other states.

History lesson over…let’s discuss the contemporary debate over the proposal to transition Medicaid from a federal-state partnership to block grants. The basic idea is simple. The federal government will give each state a fixed pot of money for Medicaid and lay down some minimum coverage rules. It is possible, even likely, that every state would get the same federal subsidies as they currently receive, at least at the start. States are then free to spend that money as they see fit, as long as they comply with the baseline rules. The history of state-sponsored indigent care reminds us that the pot of money had better be fairly large, and the rules fairly stringent, so as to avoid a renewed race to the bottom. If this can be avoided, then block grants could (emphasis on could) offer considerable benefits in terms of changes in program design.

The theory is that block grants will make each state responsible for 100 percent of marginal spending growth, unlike the present situation where most states pick up less than half of all new spending. This added incentive is important because states have considerable leeway over program design. As much as states already experiment under Medicaid, block grants should encourage even more experimentation. At a minimum, states will further seek to limit fraud and abuse.  More importantly, states will seek new ways to bend the cost curve.  For example, more states may choose to contract with ACOs, and these contracts may call for more aggressive risk sharing. To take another example, if federal rules permit, states could follow principles of value-based insurance design (VBID) and increase deductibles and copayments, especially for services of questionable value. The heightened incentives also imply that successful innovations will spread from one state to the other and potentially be adopted nationally. What’s not to like about heightened incentives?

But there are also meaningful risks. Deductibles and copayments have proven to be somewhat effective in controlling spending among the commercially insured.  However, recent and historical evidence suggest that unless cost sharing rules are carefully designed, patients may not reduce spending in an efficient manner. Recent work shows that even relatively sophisticated employees who are enrolled in high deductible plans decrease their spending primarily by limiting the use of services rather than shopping around for a lower price. This is not heartening. Focusing on the role of cost sharing in a low-income population, we are reminded that the old RAND National Health Insurance Experiment found that cost sharing was associated with poorer health outcomes for low income enrollees with chronic health issues. We should caution that the RAND study involved traditional non-integrated fee-for-service medicine, whereas today’s providers are increasingly attuned to the needs of chronically ill patients, and can use smart phones and other technologies to help assure that patients comply with treatment regiments, dietary recommendations, and so forth. So this is a risk but not a certainty.

These concerns notwithstanding, we are more worried about what will happen to funding levels over time.  Federal grants will serve as a floor to program size, but if a race to the bottom ensues, the programs may remain at that floor, with states contributing the barest minimum required to keep the grants. Feds could make block grants conditional on certain state contributions, such as 50 or 100 percent matching, and then allow states to bear all additional costs, but then we suspect most states would choose the minimum match amount in which case the block grants will have accomplished little in terms of incentive effects.

The basic funding mechanism creates an additional risk that has received little attention, a risk associated with changes in funding over time. While there are shockingly few details provided by those advocating switching Medicaid to block grants, experience with other social programs suggests that increases in block grants will be tied to the CPI or, at best, the medical price index. Choosing this rate is a balance of wanting to provide incentives for states to limit spending while acknowledging the reality that states have little control over the many features that drive the growth of medical spending. However, the rate of growth with inflation is not a minor question – CPI-adjusted block grants may quickly fall short of medical spending growth.

An even bigger funding problem results from the fact that the growth in Medicaid spending is not only a function of inflation but also macroeconomic conditions. In economic downturns, more individuals will require help and one of the most basic roles of a social insurance system is to provide assistance in those situations. Medicaid funding should be countercyclical. There are strong arguments why the federal government should be the countercyclical funding source.  First, macroeconomic shocks are not always homogeneous across the country and thus we can share the burden of these shocks across different areas.  In addition, the federal government can utilize deficit spending during downturns while nearly all states have some form of balance budget requirement. These reasons help justify why the current Medicaid funding rules is formulaically countercyclical.

The current funding mechanism ties our hands in a good way – as economic downturns cause local spending on Medicaid to increase, federal spending increases as well.  This mechanism may limit state incentives for cost control, but it assures access.  With block grants, incentives improve but access may suffer.  There is no reason why block grants couldn’t be countercyclical, but then we are asking the federal government to expand its contributions exactly when tax revenues are declining. Indeed, discussions of tying grants to the CPI suggest that the proponents of block grants do not plan to make them countercyclical.  Beyond that, even if federal funding is countercyclical, there is little reason to expect the states to follow suit.

It may be impossible to combine the hard-edged incentives of block grants with the access assured by the current funding mechanism.  But let’s at least recognize these trade-offs and choose a solution that, as much as possible, gets the best of both worlds.

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