LTC Bullet: Medicaid's Perverse Incentives

Wednesday, August 25, 2004


LTC Comment: Medicaid financing of long-term care crowds out private financing alternatives. Learn how and why the problem's so hard to fix. After the ***news.***

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LTC Comment: Medicaid is full of perverse incentives. You've heard us talk here many times about some of them. For example, the program's generous and elastic eligibility rules make publicly financed LTC available to practically anyone without spending down. Consequently, the public is asleep about long-term care risk, few people buy private insurance or utilize reverse mortgages to pay privately for care, and America's welfare-financed, nursing home based LTC system is rapidly spiraling toward total collapse.

But, alas, that's not even the worst of it. Much deeper perverse incentives permeate Medicaid, drive up its cost without improving quality, and make controlling, much less reforming, this fiscal monster almost impossible. We refer to the program's open-ended financing structure which incentivizes states to maximize federal matching funds, while punishing them for controlling expenditures. The result is very nearly a monopsony, i.e., a single-buyer public financing system for long-term care that crowds out other potential payers, such as private insurance, home equity conversion, and personal spenddown.

So what?, some people argue, "Medicaid spending contributes to the economy. The more we spend on Medicaid, the better," they say. Such specious reasoning is known by economists as the "broken window" fallacy. A broken window leads to more work for more people, such as glaziers, glass manufacturers, and their suppliers. Isn't that a good thing? By such reasoning, Hurricane Charley would have been a boon to the economy. Broken window arguments are fallacious because they ignore the productive economic activity that could have and would have occurred if resources had not had to be diverted to fix a problem. We have to fix broken windows, but it makes no sense to break them, just to fix them. We need Medicaid as a safety net, but it makes no sense to expand it at the expense of more productive, cost-effective and beneficial private sector alternatives.

Welcome to another dimension of the wacky world of Medicaid. Luckily, two new reports help to explain the program's perverse incentives and persistent growth. Below are excerpts from and links to those informative publications.


James Frogue, "Medicaid's Perverse Incentives," The State Factor, American Legislative Exchange Council, July 2004, Washington, DC: . Excerpts (footnotes omitted):

"State Medicaid programs across the country are in perennial financial crisis. Members of Congress and state legislators have come to realize that runaway Medicaid spending is unsustainable and presents a very real threat to other budget priorities such as education, highways and law enforcement. But these same leaders have too little appreciation of what is wrong with Medicaid and how to fix it.

"The root cause of Medicaid's problems is that the program is replete with perverse incentives from top to bottom. Every entity and individual from the federal government, through state capitals, providers, all the way down to the patient not only has no interest in providing and consuming care efficiently, most are actually rewarded financially for doing so inefficiently. Until federal and state legislators grasp this, Medicaid costs will continue to spiral out of control. Ironically, despite these massive and ever higher outlays, access to care for Medicaid patients continues to decline. . . .

"The federal match that states receive is open-ended. No matter how much a state spends on Medicaid, the federal government will add on the pre-determined match rate. This creates strong incentives for states to not only spend more on Medicaid, but also to be very creative with what constitutes 'Medicaid' spending so that they can maximize their match. A veritable army of highly paid lawyers, lobbyists, and consultants helps them do it. CMS State Operations Director Dennis Smith politely calls this a 'natural tension' for states to enhance their revenue at the expense of federal coffers. . . .

"Providers who accept Medicaid patients must contend with reimbursement rates that are 30 percent to 50 percent below what even Medicare pays. It is widely acknowledged that Medicare significantly low-balls private sector insurers and self-pay patients. So physicians and other providers who accept Medicaid patients have the incentive to over-treat, over-service, and over-medicate Medicaid patients in order to make ends meet. Such low fees make it almost necessary to throw in an extra x-ray or test to justify the time spent with a Medicaid patient. This is not to say all doctors behave this way, or that such behavior is limited to Medicaid (the structure of Medicare and many private employer- based insurance arrangements contain similar incentives). It is simply to say that the incentives for providers who accept Medicaid must be realigned.

"Medicaid patients have negligible, if any, cost-sharing requirements so they have no incentive to question the cost or frequency of the treatments they receive. Asking if there is a more efficient way to achieve the same health outcome and then pursuing that option does not result in any personal savings. To take it a step further, Medicaid unwittingly encourages patients to utilize high-cost emergency rooms for routine (or what should have been routine) visits instead of a primary care doctor. If the cost to patients for ER use is nothing or close to nothing, then it makes sense to visit an ER where appointments are not required, attention is immediate, and transportation via ambulance is free. . . .

"The open-ended federal match is most responsible for the fiscal problems with Medicaid. States and municipalities have every incentive to try and maximize that match and not always in ways that are legal. Unfortunately for taxpayers, both political parties are guilty of exploiting various loopholes to paper over their state budget gaps. As a result, there is little political momentum at the state level for changing the existing federal/state match. Indeed, any effort by Congress to reform the federal match would be met by stiff resistance from a nearly unified front of governors, state legislators, mayors, and county executives regardless of party affiliation."


James W. Fossett and Courtney E. Burke, "Medicaid and State Budgets in FY 2004: Why Medicaid Is So Hard to Cut," Rockefeller Institute of Government, Federalism Research Group, July 2004, Albany, New York: ; excerpts (footnotes omitted):

"Major Findings

"This report assesses how Medicaid was treated in fiscal year 2004 in the budgets of ten states. Drawing on detailed analyses of state budgets, it examines state budget-balancing strategies, with particular attention to changes in Medicaid spending and eligibility compared to other government functions. Major findings follow:

"1. The states in the sample were in weak financial condition in FY 2004. The gaps between revenues and expenditures states had to address were large by historical standards. In seven of the ten states these gaps exceeded 10 percent.

2. The major cause of state financial problems was revenue declines produced primarily by slowed economic growth and the decline in the stock market, rather than large increases in state spending. Political discussion of state financial problems did not focus on Medicaid as a major cause of the state's financial difficulties.

3. Most states relied on a mix of revenue increases and expenditure cuts to bring their FY 2004 budgets into balance, with more reliance on expenditure cuts in FY 2004 than in FY 2003.

4. Cutting Medicaid was not a major element of most states budget balancing strategies. While almost every state enacted some form of Medicaid expenditure reduction, most were modest compared to the size of the budget gap and total Medicaid expenditures. In three states, Medicaid spending cuts amounted to more than 10 percent of the state budget-balancing package.

5. The availability of additional Medicaid funding enacted by Congress in 2003 had little effect on state decisions about Medicaid expenditure cuts. In two states, the availability of these funds appeared to restore or limit cuts in Medicaid. Most states used these funds to support the state budget generally rather than prevent reductions in Medicaid.

6. Other state government functions were cut more than Medicaid, particularly public higher education, where official tuition rates were increased in many states.

7. The attitudes and actions of elected officials, particularly governors, were the most important influence on the nature and extent of Medicaid spending cuts. In four states, governors made more or less explicit decisions to protect Medicaid from significant spending cuts and were largely successful. In one state, legislators opposed cuts proposed by the Governor.


"Several factors appear to account for [Medicaid's] resilience. One is the financial incentive problems that Medicaid presents to budget cutters. Since state spending for Medicaid carries a federal match, cutting a state dollar from Medicaid causes total Medicaid spending to decline by at least two dollars and as many as four dollars. This makes cutting Medicaid less attractive than cutting programs funded solely by state funds where cutting a state dollar causes spending to decline by a dollar. In addition, cutting the Medicaid rolls rarely reduces the cost of treating former Medicaid clients, but rather transfers the financial burden for serving them to hospitals, county health programs, or other institutions.

"State governments benefit from Medicaid in two major ways. One is achieved by having Medicaid support programs that traditionally had been supported with state general funds. While precise numbers are difficult to come by, many states have realized considerable general fund savings by 'Medicaiding' programs in mental health, mental retardation, education, and other human service programs. Cutting Medicaid would jeopardize these savings and would require large cuts in state programs because of the loss of federal matching funds. States have also benefited considerably from 'creative financing' schemes under which states have been able to claim considerable federal reimbursement without spending their own money in more than an accounting sense. While the Clinton and Bush administrations have taken steps to limit excessive state claims under such schemes, many states can still claim significant amounts of federal funds this way. Cutting Medicaid services or enrollment appreciably could limit the ability of states to make claims under these schemes. Public-sector unions, too, have a big stake in Medicaid-funded jobs both in public and nonprofit health care institutions.

"A second factor that limits the appeal of large-scale Medicaid cutting is the program's substantial political constituencies. . . . Medicaid accounts for an average of one dollar in every eight spent on health care in these ten states, a figure which is below the national average. Its financial importance for health care industries is very large. Nationally, for example, Medicaid accounts for almost half of all nursing home spending, approximately, 15 percent of spending on hospitals, and also large (though difficult to quantify) fractions of spending in such program areas as mental health and services for the mentally retarded and developmentally disabled. Medicaid is the largest maternal and child health program in the country, covering approximately 25 percent of children and as many as half the births in some states. This extensive coverage has created a large, geographically dispersed network of providers (including hospitals, nursing homes and other long-term-care facilities and programs, residential and treatment facilities for the mentally ill and mentally retarded, pediatricians and obstetricians/gynecologists) who receive considerable income from Medicaid and might be expected to object to loss of this income. The geographic dispersion of these providers means that large numbers of state legislators have influential constituents with an economic interest in Medicaid to answer to."