With the report of the National Bipartisan Commission on the Future of Medicare (the Medicare Commission) due out in March, Congress and the Clinton Administration have the unprecedented opportunity to enact into law a reform of Medicare that will address the program's long-term financial, inadequate benefit, and deep-seated organizational shortcomings. Moreover, it is possible to enact a reform that combines specific objectives many lawmakers assumed were irreconcilable.

One reason this breakthrough on reform is possible is that a bipartisan majority on the Medicare Commission co-chaired by Senator John Breaux (D-LA) and Representative William Thomas (R-CA) may be ready to embrace a new financing system for Medicare. This new system would achieve two key objectives: (1) keep costs to taxpayers under better control and (2) assure beneficiaries they can count on a good package of modern health services at reasonable cost. Another reason reform seems possible is that the Medicare Commission also appears ready to embrace key structural changes in the governance and organization of the Medicare system itself--changes that draw from the successful experience of federal workers enrolled in the Federal Employees Health Benefits Program (FEHBP). Senator Breaux unveiled a plan with these components as the basis for discussion.

For this potential breakthrough to become reality, the Medicare Commission, Congress, and the Clinton Administration should fashion a program to reform Medicare that is based on five basic principles that are compatible with the Breaux plan.

1. PROVIDING PREMIUM SUPPORT
Senior citizens must be assured of a statutory entitlement to adequate financial support to enable them to afford the cost of a core set of Medicare benefits, but they also must have a strong incentive to seek the most cost-effective way to obtain those services.

For some time, the Medicare debate has been portrayed as a clash between two irreconcilable approaches to providing financial support to the elderly that would enable them to pay for health care. One approach--which targets "defined benefits"--would guarantee those who are eligible for the program a comprehensive set of specific benefits regardless of the cost to Medicare of providing those services. This approach would protect beneficiaries from future increases in the cost of those services, but it has been criticized because it would place a huge financial risk on the shoulders of taxpayers. The other approach--which targets "defined contributions"--would provide seniors with a specific amount of financial help to pay for their benefits. This approach would limit the risk for taxpayers and create incentives for seniors to seek cost-effective plans, but it has been criticized because it would shift all future financial risk to beneficiaries.

A sensible compromise between these two approaches is implicit in the "premium support" approach favored by several members of the Medicare Commission. Although several variations of premium support are possible, under a premium support system senior citizens would receive a contribution to the cost of their chosen plan, but that contribution could be adjusted--or indexed--each year to reflect the market price of plans providing a core set of benefits. In this way, the elderly would be assured that they could afford the costs of standard coverage, but they would have a strong incentive to choose a cost-effective plan because the premium support they receive would be limited.

There are various ways this basic structure could be refined. One would combine an indexed, fixed amount of support and a percentage of the cost of a chosen plan above the standard amount, up to a certain dollar limit. Seniors who felt it necessary to choose a more expensive plan because of their medical condition or personal preference would pay only part of the extra cost. Such a percentage support system is used in the FEHBP and is incorporated into Senator Breaux's proposal.

A particularly important feature of the premium support approach is that it could be amended to achieve other objectives. For example, the base amount of premium support could be adjusted by income so that a low-income senior would have a larger amount of assistance. Senator Breaux favors this. Similarly, the base amount could be adjusted to account for the higher costs of certain medical conditions.

These various forms of a premium support approach address the understandable concerns of lawmakers who prefer a defined benefits system that covers only an indexed base premium or a percentage of a higher premium. These refined premium support approaches would achieve in large part the incentives of a defined contribution plan as well. Federal workers in the FEHBP know well that the premium support approach creates incentives for them to seek the best value for their money because they will experience financial gain by choosing a more economical plan.

2. DEPOLITICIZING CHANGES IN BENEFITS
A long-term reform of Medicare must end the structurally inefficient and politicized system of changing or modifying benefits over time.

When Medicare was created in 1965, its benefit package was based on the prevailing Blue Cross/Blue Shield package for working Americans in large firms. As such, it was seen as state-of-the-art coverage. Since that time, however, the benefits for Medicare recipients gradually slipped further behind the benefits routinely available to working Americans. For example, Medicare provides no outpatient prescription drug benefit. It would be virtually unthinkable for a large corporation today to offer its workers a plan without at least some coverage for outpatient pharmaceuticals, or, for that matter, protection against catastrophic medical costs.

The main reason that Medicare's benefits package is out of date--despite the general awareness that it needs to be updated--is that all major benefit changes require an act of Congress. Consequently, discussions about changing benefits (especially about introducing new benefits by reducing coverage for less important ones) are necessarily entangled in the political process. Providers included in the package fight diligently--and usually effectively--to block serious attempts to scale back outdated coverage for their specialties. Meanwhile, talk of upgrading the Medicare benefits package unleashes an intense lobbying battle among other specialties that seek to be included in the Medicare benefits package. Invariably, the result depends as much (if not more) on shrewd lobbying than on good medical practice. The understandable reluctance of most lawmakers to subject themselves to this pressure further slows the process of modernizing benefits.

More arcane is the complex administrative process of the Health Care Financing Administration (HCFA) to modify benefits, determine whether certain medical treatments or procedures are to be covered under Medicare, and define under what conditions or circumstances services are to be delivered and paid for. This byzantine process is marked by intense pleading by medical specialty societies, occasionally accompanied by congressional intervention.

Any long-term reform of Medicare must end this structurally inefficient and politicized process of changing or modifying benefits over time, in some combination of three methods:

1. Determining broad categories of benefits. Instead of setting specific benefits in legislation, Congress could confine itself to describing the broad categories of benefits that private plans competing in Medicare should provide (such as emergency care and drug benefits). Congress uses such an approach to determine benefits in the FEHBP program. With these broad categories established, the specific benefits can be determined by a board or through negotiations with individual plans (see below).

2. Creating a "Benefits Board." Instead of Congress's or the Administration's specifying the detailed benefits, Congress could create an independent "Benefits Board" to propose specific incremental changes in the core benefits for Medicare. Both the Administration and Congress could select members for this board for specific terms. The board's package of recommendations would be subject to an up-or-down vote by Congress. This would reduce political pressures on benefit decisions and take lawmakers out of the process of making detailed medical decisions, yet it would give Congress the final say in any changes in benefits.

3. Providing core benefits with options as a supplement. The broad categories for core benefits determined by Congress or a board could be confined to the "must-have" basic benefits expected of Medicare instead of the comprehensive package most seniors actually would obtain. In other words, Medicare coverage obtained by a senior (and eligible for premium support) would consist of a base set of benefits in every plan or in the traditional fee-for-service coverage, plus a variety of negotiated supplemental benefits according to the needs and desires of each senior. Over time, the typical supplementary coverage could be expected to adapt to changing needs, desires, and medical practice. This two-tier benefits package thus would allow gradual adjustments in benefits according to the desires of individual seniors and would not require legislation by Congress to permit changes over time. This is essentially the same process used to determine benefits for federal workers in the FEHBP: In the FEHBP, broad categories of coverage are required, but the specific levels of benefits, including the kind of medical treatment and procedure, offered by typical plans change with the times, according to pressures from enrollees and negotiations with the government. Plans know they must keep up with medical developments but remain cost-effective if they are to be selected by beneficiaries and thereby stay in business.

Had Medicare been able to evolve gradually like the FEHBP through ways that significantly depoliticize changes in benefits, Medicare no doubt today would be a modern, efficient system of providing benefits that is more like the FEHBP system and the Medicare program at its inception.

3. ENDING FORMULAS
Medicare reform must move decisively away from using formulas to set plans' payments and conditions and toward a process of bidding and negotiating benefits.

Medicare today uses a complex formula to determine its payments to managed care plans serving beneficiaries. Through legislation and regulation, the government tries to create a payment schedule that will work in all parts of the country and that takes into account local conditions. But as is typical of attempts by government to set payments by formula, these schedules rarely match the actual market, which constantly changes. As a result, policymakers and health care providers grumble constantly that the formula systematically and wastefully overpays some plans and underpays others.

It is time to sweep away these formula-set payments and instead institute the flexible process used in the FEHBP. In the FEHBP, a "call letter" is sent each spring to health plans to request them to submit proposals for providing a broadly defined set of benefits to federal workers, their dependents, and federal retirees. The plans must state the services they propose to cover as well as the premium they intend to charge. After these proposals are received, the White House's Office of Personnel Management (OPM), which is responsible for running the FEHBP, engages in rounds of negotiations with plans until a final proposal is made and accepted.

The negotiations between the OPM and the plans involve the design and scope of benefits, the premiums, the geographic area in which the plan will operate, and other conditions under which services will be delivered. Through this negotiation system, a set of benefits and prices is determined that is very close to market conditions. After the negotiations are complete, the OPM sends out standardized information on all plans to federal workers and retirees late in the fall each year, and FEHBP beneficiaries choose the plan in which they wish to enroll for the following year.

In this system, plans feel pressure to compete with one another; they also feel pressure from the government and federal workers to provide the best services for the price. Unlike a system of pricing based on formulas, plans cannot easily profit by exploiting a regulation or a poorly designed pricing formula; neither is the government required to overpay or underpay simply because of a legislated rule.

If Medicare were run on similar principles, the government could negotiate payment levels for plans that reflected local market conditions and avoid the chronic overspending or underpricing (which leads to poor quality or fewer plans) that is endemic to the current formula system. The government also could negotiate special prices and services for particular categories of special-needs beneficiaries and in other ways provide a better and more cost-effective service to seniors.

Further, the negotiation approach would allow Medicare gradually to modify benefits in line with medical developments. Moreover, it would permit experimentation with "risk adjustment" mechanisms to raise or lower total payments to plans depending on the health status of beneficiaries choosing each plan. This is a crucial feature of a negotiation model. There are legitimate concerns about giving flexibility to plans to vary benefits for fear that this would allow plans to "cherry-pick" good health risks. But "correcting" that risk with standardized benefits would lead to rigidity and discourage plan innovation. Negotiation, however, would permit varied benefits to be subjected to review--to check for cherry-picking--before they could be offered to seniors.

4. REDEFINING HCFA'S RESPONSIBILITIES
Long-term reform also should separate entirely the management of the Medicare market for managed care plans from the operation of the fee-for-service program.

Currently, HCFA is responsible for operating the traditional fee-for-service program. But it is responsible as well for establishing and managing the market for the increasing range of plans that are offered to seniors at a monthly premium.

HCFA cannot, and should not, carry out both these tasks. Over the years, the agency has developed a culture and expertise that focuses on regulating prices and services and identifying fraud and abuse. The training and skills of the staff reflect this general function. Staff members lack the experience and skills needed to establish ground rules for a competitive market, develop businesslike relationships with competing private health plans, and provide consumers with the information they need to get the best value in such a market. It is significant that plans complained about the regulations associated with the Medicare+Choice Program now being introduced, and very few have decided to offer services under the new program. In addition, HCFA has experienced great difficulty in preparing a handbook of information for beneficiaries that they actually can understand. It is not that the HCFA staff is incompetent, but that they have little training and expertise in these functions. It is a little like expecting experienced divorce lawyers suddenly to become good marriage counselors. Staff members at the OPM who operate the FEHBP, by contrast, have very different skills and backgrounds, and the agency has a different culture, which is the reason the OPM is successful at running a nationwide program with many competing plans in each area.

HCFA should not carry out those functions even if it has the skills to do so because it is extremely unwise to permit an organization to be responsible for setting the rules of a competitive market when it also has a direct interest in the success of one of the competitors. So long as HCFA runs the fee-for-service program of Medicare, it hardly can be expected to be benign in creating a market in which other plans compete directly with its traditional fee-for-service program.

To initiate long-term reform of Medicare to resolve this shortage of skills and the conflict of interest at HCFA, Congress should consider the following two steps:

1. Create a Medicare Board. Congress should transfer funds from HCFA to create a new, independent, and completely separate Medicare Board that could be completely independent or report to the Secretary of Health and Human Services. The board would establish the rules for the market of competing plans and would have the authority to negotiate directly with Medicare plans regarding benefits and premiums. The Medicare Board, like the OPM, should be staffed with individuals whose background is in managing employee benefits and health plans. Congress should prohibit contacts between the Medicare Board and HCFA in cases in which such contacts might influence rules established by the board for competition in Medicare.

2. Allow HCFA flexibility. In turn, Congress should refrain from locking HCFA into a statutory straightjacket, in which its primary function is the rigid and increasingly onerous and ineffective micromanagement of the financing and delivery of health care services for senior citizens. Instead, Congress should give HCFA greater flexibility to run the traditional fee-for-service program in ways that would make it an aggressive competitor to managed care plans and other emerging private-sector health care options in the next century. Whenever a competitive market is introduced, the government-provided service must be given every opportunity to redesign itself to compete effectively. This should be the case in Medicare as well. HCFA should be permitted to introduce innovations into the management of traditional fee-for-service Medicare. It should be allowed, for example, to make extensive use of preferred provider organizations of physicians and hospitals that provide the best value for money. HCFA also should be allowed to contract out the management of the traditional program in areas in which that practice might improve Medicare. There is no reason that public enterprises cannot be competitive and entrepreneurial. In virtually every state, the virtues of this type of innovation are evident in such areas as the delivery of social services to the management of public education. Congress, for example, should give HCFA the same kind of flexibility and entrepreneurial opportunity that many school districts provide teachers and principals to create charter schools.

5. REDESIGNING MEDICARE BEFORE DECIDING WHETHER ADDITIONAL FUNDING IS WARRANTED
Any savings in the cost of achieving Medicare solvency due to reforms should be used to help to save and improve Social Security.

President Bill Clinton's 1999 State of the Union proposal to earmark part of the anticipated budget surplus for Medicare sends a signal to lawmakers that they can avoid making tough decisions now because billions of dollars of general tax revenue will keep Medicare afloat until at least 2020. Regardless of whether an infusion of new money actually makes sense, merely proposing a bailout without requiring significant reforms risks allowing Medicare to continue as an out-of-date and inefficient program for decades to come. It would cut the Medicare Commission off at the knees by discouraging lawmakers from accepting the political risks inherent in supporting major reforms. Moreover, by 2020 the Baby Boom generation will be swelling the ranks of Medicare; it will become much more difficult for lawmakers to build public support for reform when the financial problems of Medicare become acute once again.

To avoid the unintended effect of derailing the modernization of Medicare, Congress and the Clinton Administration should agree that Medicare reform and fiscal solvency until a date certain should go hand-in-hand. The agreement should be that, instead of committing a specific amount of money to restore solvency, major reforms should be enacted. To the extent that improvements in Medicare's efficiency allow benefits to be improved and savings achieved, then any reductions in the projected amount of money needed for Medicare solvency should be transferred to fund a plan to save and upgrade Social Security.

Stuart M. Butler, Ph.D., is Vice President of Domestic and Economic Policy Studies at The Heritage Foundation.