The VPS was replaced with the SGR process, following passage of the Balanced Budget Act of 1997. As was VPS, the SGR process was designed to allow for increases in Medicare payments while ensuring that growth in aggregate spending would be contained.^{4} Unlike the VPS when it was replaced, the SGR system produces a single update.

**Figure 2. Calculating the SGR for the CY 2006 Physician Payment Update**

*For CY 2006:*

2005 Conversion Factor: $37.8972

MEI Factor: 1.0290

Update Adjustment Factor (UAF) By formula: 0.9300

Other Adjustments (Laws and Regulations): 0.9985

Total Update Factor (= MEI x UAF x Other): 0.9555

2006 Conversion Factor: $ 36.2121

2006 Conversion Factor after Congressional intervention: $37.8972

CMS, Office of the Actuary, “Estimated Sustainable Growth Rate and Conversion Factor, for Medicare Payments to Physicians in 2002,” http://www.hcfa.gov/pubforms/actuary/sgr, March 19, 2001.

The payment update calculation updates the MFS CF annually. The update reflects changes in the cost of providing care, the update adjustment factor (UAF), and other adjustments (Figure 2). The cost of providing care is measured by the MEI. The UAF adjusts for previous over-/under-spending relative to targets set in previous years. Other adjustments include adjustments to payments deemed necessary or required by CMS, e.g., to implement fixes in the resource-based relative value scale in a budget-neutral fashion.

Conceptually, the SGR^{5} may be viewed as the rate at which physician expenditures under Medicare should increase, ‘should’ referring to CMS’s interpretation of the intent of Congress, which in turn represents—in some sense—society’s statement of how many additional real dollars are to be targeted to cover per capita medical expenses of the elderly. In actuality, and in the context of program cost containment, the SGR process intends to allow for increases in Medicare payments, but at rates that ensure that growth in aggregate Medicare spending will be contained. The numerical value of the SGR is determined by how the economy at large is growing, as measured by changes in per capita Gross Domestic Product (GDP), the total number of Part B fee-for-service beneficiaries, the cost of producing services covered by the Medicare Fee Schedule, and laws and regulations governing the Medicare program (bottom frame, Figure 2).

A key part of the SGR process is the UAF. The UAF, defined by formula, penalizes/rewards providers for over-/under-spending. This is the portion of the SGR process that has given rise to recent declines in the payment update. There are two parts to the formula, which can be written as follows:

UAFt = { 0.75 * [ (targett-1 – actualt-1) / actualt-1 ] }

+ { 0.33 * [ (targetc – actualc) / (actualt-1 * SGRt) ] }

where

targett-1 is target spending for year t-1;

actualt-1 is actual spending;

targetc is the sum of previous years’ targets (back through part of 1996); and

actualc is the sum of previous years’ actual spending.

The first part of the formula accounts for over-/under-spending in the prior year (year t-1). Over-/under-spending is expressed as a fraction of spending for the year. The second part of the formula accounts for *cumulated* over-/under-spending. The denominator of the cumulated spending term is spending during the previous year, updated by the current year’s SGR – a measure of next year’s target spending. Thus, the second term expresses cumulated spending as a fraction of what spending is expected next year if the target is met. Because the SGR enters the UAF formula, the UAF indirectly depends on those factors that influence the value of the SGR (Figure 2). The UAF formula’s ‘ingredients’ include the weights attached to the previous and cumulated spending terms (currently, set at 0.75 and 0.33, respectively). Currently, the UAF has floor and ceiling values that limit its effects: the floor is -0.07 and ceiling is 0.03, a maximum penalty of 7 percent and a maximum reward of 3 percent.

Using calculation of the CF for 2006 as an example of how the SGR process works, the cost of practice factor (measured by MEI as fraction plus 1) was 1.029, indicating that the cost of providing services increased by 2.9 percent over the previous year. The UAF, 0.9300, means that over-spending in the previous and prior years contributed to a reduction of 7 percent in the CF relative to CY 2005. In 2005, spending exceeded the target by about $13 billion (target and actual spending were $80.4 and $93.3 billion, respectively), about 14 percent of 2005 spending. Cumulated spending exceeded the cumulated target by $30.7 billion (cumulated spending and target amounts were $611.8 and $642.5 billion, respectively), and cumulated overspending was about 32 percent of 2005 spending updated by the SGR. The value of the UAF, after applying the formula weights, was -0.21, considerably below the floor of -0.07. Thus, the UAF is 1-0.07, or 0.9300. The impacts of other adjustments reduced the CF (relative to CY 2005) by another 0.15 percent, so the corresponding factor is 0.9985 (1-0.15). The CF for CY 2006 was to be the product of the CF for CY 2005, multiplied by the set of factors in Figure 1:

CF2006 = $37.8972 * 1.029 * 0.9300 * 0.9985

= $37.8972 x 0.9555

= $36.2121

In other words, the update would be a 4.5 percent reduction in payment, from $37.90 to $36.21 per relative value unit of service. Congress intervened, however, defining the update to be 0, so CF2006 remained as in CY 2005.

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