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Finally, doing the right thing: Risk adjustment under Medicare

From the January 1999 ACP-ASIM Observer, copyright © 1999 by the American College of Physicians-American Society of Internal Medicine.

By Harold C. Sox, FACP

This month's column is about risk-adjusted capitated payments under Medicare+Choice, the expanded Medicare managed care program mandated by the Balanced Budget Act of 1997. The law also required HCFA to adjust the amount of the capitated payment for a patient to reflect the patient's medical risk, starting in the year 2000. In other words, HCFA will have to pay a health plan more for a very sick patient and less for a healthy one. Risk adjustment should be very good for sick patients and for their internists, and it's important for us to understand why.

Capitated Medicare is a form of risk-sharing. Medicare pays health plans the same premium for all participants (the adjusted annual per capita cost, or AAPCC). The healthy receive little benefit because they have low health care costs. The money Medicare receives for these healthy individuals pays for the care of those who are sick or have bad luck.

According to health economists such as Joseph Newhouse, PhD, however, inadequate risk adjustment undermines the socially desirable consequences of risk-sharing. (See "Risk adjustment and Medicare: taking a closer look" in the September/October 1997 issue of Health Affairs.) Inadequate risk adjustment is also bad for sick patients. When a health plan receives the same annual payment from Medicare regardless of a patient's expected costs to the plan, the costs incurred by sick patients eat into the profits generated by healthy patients. Inadequate risk adjustment creates incentives to avoid sick patients and socially valuable programs, such as having the best cancer care in town, that would attract them.

Inadequate risk adjustment encourages health plans to spend our tax dollars on services to attract good-risk, high-profit patients. That's why some health plans, using income derived from Medicare capitation payments, now provide free health club memberships—to attract healthy people who want to stay healthy. These practices enrich health plans and divert our tax dollars from socially productive uses.

Fee-for-service Medicare

Sick patients, fearful that health plans will stint on costly services, tend to stay in fee-for-service Medicare, where there are no incentives to skimp on care. Meanwhile, all low-risk patients who enroll in a capitated program take their AAPCC payment out of the fee-for-service system. If much of the money in Medicare goes into the profit margins of health plans that attract high-profit, low-health-risk patients, there won't be enough money in fee-for-service Medicare to provide good care. To remain solvent, fee-for-service Medicare will have to charge high co-payments, skimp on important benefits and reduce payments to doctors. A destitute fee-for-service Medicare will be very bad for sick patients—and for the physicians who have a professional duty to care for them.

The evidence suggests that, overall, health plans tend to attract patients whose expected Medicare spending is less than the AAPCC. This shift hasn't had much effect on the funding of fee-for-service Medicare because so few patients have enrolled in capitated Medicare plans.

As Medicare+Choice provides many more options and increases enrollment in these programs, however, the effect on fee-for-service Medicare may reach serious proportions.

Heading off problems

In anticipation of growth in capitated Medicare, HCFA can avoid the consequences of inadequate risk adjustment by assuring that capitation payments to health plans will cover the costs of providing services to sick patients. To achieve this goal, Medicare must find better ways to predict a patient's annual health care costs. If health plans know that capitated payments would reflect actual costs, they would be more interested in attracting the full range of Medicare patients.

When sick patients represent a source of profit instead of loss, health plans may seek ways to provide services to sick patients at lower cost. There is potential danger here because the plans may stint on needed services to sick patients in order to increase their profits. Therefore, as Medicare improves risk adjustment, it must also create strong incentives for health plans to provide high quality care.

Getting the risk adjuster right is one of the keys to avoiding the undesirable social costs of capitated programs in Medicare. The ideal risk adjuster would tell Medicare how much a patient will cost a plan if the patient has average luck during the year. Some patients will have bad luck and cost the plan money, but others will have good luck and the plan will make money on them.

Economists measure the performance of a risk adjuster by how well it accounts for the variation in spending between low-cost and high-cost patients. The risk adjusters currently used to calculate the AAPCC, for example, account for only 1% of the variation in Medicare spending. Adding a patient's cost to Medicare spending over the past several years to the risk adjustment formula would account for an additional 15% to 20% of the variation in spending. Factoring in Medicare costs for the last year, which would measure trends in a person's health such as a new diagnosis of stroke and cancer, would account for another 3% to 5% of variation in spending. If Medicare knew more about a person's very recent health events, such as a diagnosis of cancer, it could do an even better job of adjusting payments to the health plan to reflect the person's actual costs within the year that the new diagnosis occurred.

No one knows how good a risk adjuster has to be to encourage health plans to enroll sick patients. As medical information systems allow physicians to record more patient information, HCFA can improve on its risk adjustment techniques. In the meantime, HCFA could encourage health plans not to engage in risk selection by allowing them to designate a small percentage of patients, presumably the sickest Medicare beneficiaries, to receive fee-for-service payments. It could also pay a capitated rate that is a blend of predicted costs and recent actual costs.

Using market forces to control health care expenditures has social costs, including adverse risk selection by health plans. Risk-adjusted capitation payments will reward health plans for socially responsible behavior. If health plans then adjust their payments to individual physicians to reflect the burden of illness in their practice, physicians will share in the rewards of doing the right thing.

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