Who Belongs in Managed Care? Using Premium Policy
to Achieve an Eﬃcient Assignment in Medicare
Thomas G. McGuire
Tel Aviv University
Harvard Medical School
February 26, 2009
Acknowledgments: The authors are grateful to the National Institute of Aging for support
through P01 XXXXX. The Role of Private Plans in Medicare, J. Newhouse, PI. This paper
grew out of discussions with Rhema Vaithianathan. Mike Chernew, Richard Frank and Joe
Newhouse provided helpful comments on an earlier draft. The opinions and conclusions in this
paper are the authors’ alone.
This version is for presentation and discussion at the BU/Harvard/MIT Health Economics
Workshop. Comments welcome. Please do not circulate.
Beneﬁciaries in Medicare, the federal health insurance program for the elderly and disabled,
choose between two major options: traditional Medicare and a set of private health insurance
plans, including managed care plans, oﬀered under Medicare Part C. Part C has suﬀered
severe criticism since its inception more than twenty ﬁve years ago, and remains very
controversial. Nonetheless, Part C, currently known as Medicare Advantage, is the main hope
for modernizing Medicare through introduction of the cost and quality management
techniques common in private health insurance. Most research on the economics of Medicare
Advantage (M A) focuses on the supply prices Medicare pays to M A plans. Many papers
study the rules by which Medicare pays plans, including the risk adjustment of plan
payments, and their eﬀect on plan behavior. Demand prices paid by Medicare beneﬁciaries
receive much less attention.
At present, the M A plan chooses the premium beneﬁciaries pay to join an M A plan (subject
to Medicare regulation), and this premium is the same for low and high-demand beneﬁciaries.
M A plans can thus employ the classic and powerful selection device identiﬁed by Rothschild
and Stiglitz (1976): low premiums attract those with a low demand for health care. We
consider whether instead of allowing plans to set premiums, Medicare should set the M A plan
premium. If Medicare sets beneﬁciary premiums for both T M and M A, it can do so
conditioned on some beneﬁciary characteristics. Medicare now conditions its plan payments
on certain demand factors, but not others. Risk adjustment of Medicare payments pays plans
more for beneﬁciaries who use more health care because of factors related to measured health
status.1 Demand for health care is also related to nonhealth factors, such as income or wealth,
which are not part of risk adjustment.2 These demand-related factors can, however, be part of
1Medicare risk adjusts payments to M A plans using Diagnostic Cost Groups which measure health status
based on diagnoses on hospital claims from the previous year. See Pope et al. (2004).
2Cross-sectional studies generally report a positive income elasticity of demand that is less than one. The
premium policy. This paper shows that pairing health status based plan payments by
Medicare with beneﬁciary premiums adjusted for other demand factors can radically improve
the performance of Medicare Part C.
After presenting institutional background on Medicare and the M A program in Section 2,
Section 3 sets out our model of Medicare. Beneﬁciaries vary in their demand for health care
according to health status and a nonhealth status factor, “income.” T M and M A allocate
health care spending in diﬀerent ways. T M accommodates demand (from lower health status
or higher income) but creates the familiar moral hazard ineﬃciency. M A rations care by
health status but does not recognize income-related preferences. Section 4 characterizes the
eﬃcient assignment of beneﬁciaries to M A and T M in light of the way care is rationed in the
two forms of health insurance. Our welfare framework is the conventional one in economics,
but we recognize the needs-based as well as demand-based approach to welfare, and discuss in
a later section how our analysis would change with a shift to a needs-based approach. An
“assignment” refers to a division of beneﬁciaries between M A and T M . The eﬃcient
assignment looks quite diﬀerent than we see at present. Under current policies, healthy,
low-income beneﬁciaries tend towards M A while the sick and higher income groups stay in
T M .3 We argue that an eﬃcient assignment avoids the T M -associated moral hazard costs for
the high-demand groups, not the low-demand ones. The eﬃcient assignment we describe has
the high-income groups in M A and the low-income groups in T M .
Section 5 contains a series of results about the role of the premiums beneﬁciaries pay in
implementing an eﬃcient assignment in Medicare. First, we show that given all beneﬁciaries
pay the same for T M , no policy in which all beneﬁciaries pay the same for joining M A can
Rand Health Insurance Experiment, for example, found income elasticities of between .1 and .2. (Newhouse
et al., 1993). Studies using longitudinal variation in income ﬁnd much larger elasticities, generally classifying
health care as a “luxury good” with income elasticities exceeding 1.0. See Fogel (2008).
3Low-income beneﬁciaries also eligible for Medicaid (dual-eligibles) pay no premium for T M and face little
T M cost sharing. These low-income beneﬁciaries are almost all in T M .
achieve an eﬃcient allocation. Interestingly, risk adjustment of plan payments cannot ﬁx this
problem. Also, this result is robust to whether it is Medicare or the plan that sets the
premium. Second, an eﬃcient allocation can be attained if Medicare ﬁxes a single premium
for M A, and sets an income-related premium for joining T M .4 Third, even if Medicare sets
an income-related premium for T M if Medicare allows the M A plans to set the premium,
eﬃciency can not be attained.
Health status risk-adjusted Medicare payments to M A plans are part of the payment system
required to achieve eﬃciency, though risk adjustment in direct proportion to health-status
based demand (conventional risk adjustment) is not part of the optimal mechanism. We show
that a division of labor between Medicare plan payments conditioned on health status and
beneﬁciary premiums conditioned on income can sort beneﬁciaries eﬃciently into M A and
T M and achieve the (second-best) eﬃcient allocation of health care, subject to the rationing
rules characterizing M A and T M .
Section 6 considers some extensions of our analysis and turns to issues related to Medicare
costs and alternative welfare frameworks. Section 7 brieﬂy summarizes the paper and points
to issues for further research. The main message of our paper is that Medicare should set
premiums for both M A and T M , and that premium policy and plan payment policy should
be considered jointly. An income-related premium policy by Medicare need not be a marginal
adjustment to what happens in Part C, but could lead to a fundamental realignment of the
role of M A plans in the Medicare program, a realignment we argue in the next section is
4By 2009, Medicare phased in a small income-related premium for Part B, eﬀectively equivalent to an
income-related premium for T M . Higher premiums are expected to aﬀect only 5 percent of beneﬁciaries. Part
D also has income-related premiums. See CMS (2008). Beneﬁciaries also eligible for Medicaid pay no premium,
introducing a second connection between income and premiums under current policy.
Medicare and Medicare Advantage
At age 65, most Americans become eligible for Medicare.5 If beneﬁciaries do not elect an M A
plan, they are automatically enrolled in Part A of Medicare at no cost to them. Part A is
ﬁnanced largely by a payroll tax shared by employees and employers (Kaiser Family
Foundation, 2008). Part A covers inpatient hospital services, some post-hospital stays in
nursing facilities and home health care, and hospice care, but requires considerable beneﬁciary
cost sharing. Beneﬁciaries may also enroll in Part B, which covers doctors visits, other
ambulatory services and some drugs at federally deﬁned beneﬁts. The Part B premium,
$96.40 per month for 2009, pays only about 25 percent of Medicare’s cost of Part B, the
balance being paid for by general revenues (KFF, 2008). The vast majority of beneﬁciaries in
T M enroll in Part B. Beneﬁciaries are also subject to cost sharing in Part B, including an
annual deductible of $135 in 2009, and 20 percent cost sharing on Medicare allowed charges.
Since 2004, beneﬁciaries may join a Part D plan covering prescription drug costs. Part D
plans receive about 25 percent of their federal revenue from general revenues, are oﬀered by
private insurers and vary in coverage. Premiums for Part D are set by the Part D insurers,
and only low-income beneﬁciaries receive a subsidy. Beneﬁciaries with Part A and the
optional Parts B and D, are in “traditional Medicare.”
Virtually all hospitals and practicing physicians participate in traditional Medicare giving
beneﬁciaries wide choice of providers. Medicare and its regional intermediaries make broad
coverage decisions but do not interfere in physician and patient choice of treatment. Health
care in T M has been criticized as being uncoordinated and costly (Newhouse, 2002). T M
contends with cost issues by provider payment policy: Medicare payments to physicians and
5Medicare also provides health insurance for qualiﬁed disabled beneﬁciaries below age 65. These beneﬁciaries
may also choose to join the same M A plans on the same terms as the elderly beneﬁciaries.
hospitals are lower than private plans on average (refs and speciﬁcs).6
Most beneﬁciaries in T M avoid cost sharing in Parts A and B via supplemental
coverage.(refs) Medicaid pays cost sharing for eligible low-income beneﬁciaries. Some
employers buy wrap-around coverage for retirees. Finally, most beneﬁciaries not in either of
these groups buy “medigap” policies to cover some or all of the cost sharing.
The Medicare Modernization Act of 2003 (MMA) created M A to replace the short-lived
Medicare + Choice (M+C) version of Part C. M A plans are private, must cover all Part A
and B beneﬁts, and may supplement these beneﬁts by reduced cost sharing or coverage for
additional services not part of T M , such as vision or dental care (Gold, 2008).7 M A plans
may or may not include drug coverage. Those that do are referred to as MA-PD (i.e., “Part
The MMA created new plan types within M A and the higher payments mandated in the
legislation awakened dormant plan types established earlier. We distinguish between what we
consider to be bona ﬁde managed care plans and others. We count Health Maintenance
Organizations (HMOs), the oldest and largest plan type, and the mostly tightly managed,
along with Preferred Provider (PPOs) and the small number of Provider-Sponsored
Organizations (PSOs) as managed care. The other plan types, notably the Regional PPOs
and Private Fee-for-Service (PFFS) plans, are not in this category.8 Our model of M A plan
behavior laid out below applies to managed care plans only. 13.3 percent of Medicare
beneﬁciaries were in bona ﬁde managed care plans as of December 2007,9 with 3.8 percent in
6In traditional Medicare, physicians are paid for each procedure according to a fee schedule. Hospitals are
paid according to the diagnosis-related group (DRG) in which a patient is classiﬁed at discharge. The hospital
payment system is partly “prospective,” embodies some incentives to the hospital to economize on resources
during the hospital stay. For an overview of Medicare payment policies applying to physicians, hospitals and
health plans, See Newhouse (2002).
7Gold and her colleagues at Mathematica Policy Research have tracked policy, enrollment, plan types and
other data on Part C for a number of years in a useful series of publications.
8Part C also includes Special Needs Plans (SPNs) intended for beneﬁciaries in long-term care.
9Gold (2008) p.20
PFFS plans and the balance of beneﬁciaries in traditional Medicare.
So far, the performance of Part C has been disappointing. The original intention of Part C
was to allow Medicare to share in the cost savings achieved by managed care by paying plans
at 95 percent of the expected cost in T M . Favorable selection into plans thwarted Medicare
savings goals from the ﬁrst.10 Attempting to address the unfavorable impact of selection,
M+C introduced more sophisticated risk adjustment of plan payments and limited increases
in some plan payments. Taken together, these changes drove plans from Part C. The number
of contracting plans fell 50 percent under M+C, and as Gold et al. (2004) concluded, M+C
was “widely viewed as a failure.” In response, the MMA raised payment rates. By buying its
way out of trouble, Medicare has revitalized Part C but sacriﬁced any cost savings potential.
Analyses by the Congressional Budget Oﬃce (Orszag, 2007) and MedPAC (Miller, 2007)
report that Medicare pays about 15 percent more for beneﬁciaries in M A plans than for
beneﬁciaries in T M . No wonder that M A falls in Washington’s cross hairs. Part C not only
moves few beneﬁciaries into real managed care plans, it costs rather than saves Medicare
The recent increases in Medicare payments have expanded the supply of M A plans to
beneﬁciaries, including those that live in rural areas. In 2008, every beneﬁciary could choose
among multiple M A plans, though residents of many rural counties still had no oﬀering of a
bona ﬁde managed care plan, largely because of the diﬃculty of assembling a network of
providers in sparsely served areas.11 The HMO form of M A plan serves the majority of
beneﬁciaries, currently 70 percent, down from 84 percent in 1999. In absolute terms, the
number of beneﬁciaries in HMOs is no higher than 1999, indicating that all the growth in MA
enrollment since then has been in other plan types.
10Brown (1993) estimated that favorable selection cost Medicare 5.7% over T M costs, thus more than oﬀsetting
the eﬃciency discount Medicare was seeking.
11For recent data on M A plans, see Gold (2009).
Some of the mechanics of M A are helpful to know before proceeding with our analysis. All
beneﬁciaries in M A enroll in Part B. HMOs set premiums below the Medicare Part B
premium of $96.40 beneﬁciaries pay in T M . The average HMO premium was $24 per month
in 2008, with 65% of HMOs setting a zero premium, the minimum possible under Medicare
regulations.12 These plans also typically have reduced cost sharing and other additional
coverage so that the average beneﬁciary electing these plans can expect lower health care
payments and can avoid buying Medicare supplemental (Medigap) coverage.
M A costs rather than saves Medicare because of the way Medicare pays M A plans. Medicare
payments to plans are based on a Medicare “benchmark” rate set for each county and the
plan’s “bid.”13 The benchmark is based on the maximum of the CMS estimate of Medicare
costs for a typical beneﬁciary in Parts A and B (CMS should have stopped here) and the past
payment rate for the county trended forward at national average Medicare cost growth rates.
These grandfathered rates pre-date the MMA and are in some cases much higher than
estimates of current average cost. They are the ﬁrst reason why payments to M A plans exceed
expected T M costs. The second reason has to do with a “budget neutrality” adjustment.
Until 2010, no plan can have its payment reduced by risk adjustment; risk adjustment only
aﬀects the magnitude of any increase. Medicare had to raise the average benchmark enough
so that even the plan attracting the healthiest beneﬁciaries would not see a negative impact.
This is hard to believe, but, “Because of the budget neutrality adjustment, all of the county’s
benchmarks for 2007 are above Medicare’s projected FFS costs.” (Merlis, 2007, page 7).
Medicare payments are also aﬀected by the plan’s bid. A plan’s bid is intended to be an
estimate of what regular beneﬁts from Part A and B would cost the plan. It would be that,
and, incidentally a way to rescue Medicare from its benchmark rules, if accounting principles
12The Part B premium is paid to Medicare whether a beneﬁciary joins an M A plan or elects Part B in T M .
When an HMO or other M A plan reduces the premium to the beneﬁciary the plan in eﬀect pays the premium
13Merlis (2007) is an excellent primer.
trumped economic incentives. The incentives push plans to “bid” at least the benchmark. If
the bid is above the benchmark, the plan is paid the benchmark. If the bid falls below the
benchmark, Medicare pays the bid plus 75% of the benchmark bid diﬀerence. The idea is that
Medicare gets 25% of the “savings” (diﬀerence between benchmark and bid) and the plan
must use the balance to reduce beneﬁciary premiums or provide additional coverage and
beneﬁts. The problem is that plans can increase their payment by increasing their bid up to
the benchmark. In 2006, the average Plan bid was 99% of the benchmark, slightly lower
(97%) for HMOs, and above the benchmark for other types of plans. In essence, plans are
paid very close to the benchmark.14 Any excess payments Medicare makes to M A plans is
exacerbated by selection of low-cost beneﬁciaries into M A. As fare as we know, patterns of
selection in M A are yet to be studied.
Our paper is related to a literature in public ﬁnance concerned with the public provision of
private goods. Health care is a private good ﬁnanced collectively for reasons, among others,
related to equity. In Besley and Coate (1991), rich and poor consumers demand a good that
could be provided by government with an equal consumption requirement, or left to the
market. Some redistribution to the poor can be achieved by providing a base level to everyone
ﬁnanced collectively by progressive taxes, and letting the rich opt out to the private system.15
Within a health care context, researchers study resource allocation in public systems, and how
a private sector fringe aﬀects public costs and eﬃciency (Barros and Olivella, 2005). Grassi
and Ma (2008) analyze the interaction between a budget-constrained public health care
system that allocates by rationing and a private sector that accommodates demand but may
14A bid close to the benchmark, indicating that the benchmark payment is needed to cover basic Medicare
services, seems inconsistent with M A plan’s ability to buy down the premium and often additional services.
15Normative models of local public goods trade oﬀ production eﬃciencies and service of heterogeneity in
tastes. Oates (1972) compares ineﬃciencies associated with higher or lower level of government provision of
set prices. Consumers diﬀer according to wealth and cost. Our paper shares with this
literature consumers’ option to leave the public sector-like rationing plan (our M A plan). In
our analysis of Medicare, however, our alternative system, T M is also publicly ﬁnanced and
subject to regulation.
A focus on the premiums paid by beneﬁciaries harks back to the work of Rothschild and
Stiglitz (1976) who recognized the premium as a powerful selection device. In a Medicare
context, the emphasis in the literature has instead been on skimping on services as a tool for
selection.16 A recent literature identiﬁes which services among the many provided by a health
plan are subject to the strongest incentive for a plan to use as a selection device. The
premium charged by a plan can ﬁt within the same framework as service-level selection. In
Ellis and McGuire’s (2007) terms, services that are predictable and predictive of total health
care costs would be rationed tightly. The premium is perfectly predictable (and therefore a
powerful selection device) but completely uncorrelated with total health care costs (because it
is a constant). The service-level selection literature implies that the “service” of a dollar
payment to join (negative premium) would be overprovided by proﬁt-oriented plans.
There are two approaches in the literature to rationing in managed care, quantity setting
(Pauly and Ramsey, 1999; Baumgartner, 1991) and shadow-prices (Keeler, Carter, Newhouse,
1998; Frank, Glazer and McGuire, 2000). The quantity-setting approach sees the plan as
setting the level (or maximum level) of service available to members irrespective of their
demand. The shadow-price approach emanates from a distinction between the bottom-line
oriented plan ﬁnancial leadership and the health-minded clinicians. The plan sets a budget for
health care or components of health care, and clinicians ration their resources according to
the health needs of the enrollees. In papers applying the shadow price approach to date, no
16The early literature made overall cost comparisons between managed care and traditional Medicare. The
more recent literature on service-level selection studies categories of expenditures. See Ellis and McGuire (2007)
for review of some papers.