Short-Term Fixes to the Sustainable Growth Rate Process . 3.0 Modeling the SGR Process

Analysis of the SGR process might be helpful in setting the stage for refinements that can be implemented to overcome current flaws resulting from the formula, as well as suggesting longer run changes that might be considered for more substantive changes to the payment update process in the future.  A spreadsheet model of the SGR process was constructed.  First, rules underlying payment updates announced by CMS were reviewed and data used to calculate these updates were compiled.  CMS’s calculations of annual updates that are implemented in January of each year are generally based on data available to CMS no later than November of the previous year (e.g., rules defining the update for CY 2006 were published in the Federal Register in November, 2005) and updated the following month as described via memoranda available from the CMS website.⁶

Second, a spreadsheet version of the update process was developed.  The model consists of three SGR formulas for each year, covering the years 2000-2014 (described in Figure 2).  One formula calculates the SGR from data on the costs of practice and changes in GDP and Medicare enrollment.  The second formula calculates the UAF from data on target and actual spending from prior years.  The third formula calculates the update for the year, using results from the first two formulas. 

Outputs of the three-formula model include the payment update and CF for the year.  The CF is then used to estimate spending for the year (which appears in the UAF formula for the following year’s CF).  For example, the update for 2007 is based in part on the SGR for 2007 and the UAF for 2007.  The latter is determined by comparing actual and target spending for 2006.  When the model is used to study effects of a hypothetical change in the formula, for example, and the simulated CF for year t differs from the CF under baseline assumptions, this different CF is used to adjust baseline spending for that year upwards/downwards to reflect the higher/lower CF produced by the model.  The spreadsheet model is designed to cumulate actual and target spending amounts over time, amounts that are carried forward into the formulas used to calculate updates and spending for subsequent years.  Spending estimates from the model (and presented below) are tabulated separately for SGR physician services (sometimes by type of service, depending on the option under study), for spending on lab and drugs combined, and in total. 

Application of the SGR formulas over time is complicated by the fact that data items used to calculate updates are subject to change over time.  Thus, for example, the estimate of spending for 2005 that was used to calculate the CF for 2006 may change in late 2006 and again in later years.  Updated spending estimates are used in calculating the spending amounts that enter the formula for the CF for 2007 and beyond, but not to retroactively change the 2006 update.  In a similar fashion, details of the payment update for 2003 were published in the Federal Register on December 21, 2002.  CMS revised these estimates in February 2003, and again in November 2004 and November 2005.  Revisions cannot be used to retroactively change values of updates affecting payment levels of previous years, but are made to data used in future applications of the formula.  Adjustment factors have been developed to ensure that estimates of spending obtained from the model reflect adjustments in data made each year by CMS.⁷

Simulation of payment updates for future years is of more interest from a policy perspective than what payments would have been.  Data items required to estimate updates for these years, of course, are not known and had to be predicted.  Predicted levels of future spending are required by the SGR formula, as well as predictions for Part B enrollment, the cost of inputs faced by physicians, the measure of physician productivity (used to adjust cost changes measured by the MEI), and the fee index used to estimate the SGR factor (that is used, in turn, to estimate the spending target).  Analysts with CMS’s Office of the Actuary predict future spending for the three categories of services that enter the SGR formula: most physician services, certain lab procedures, and selected physician-administered drugs physician services.  These are estimated separately and summed to obtain annual estimates of total SGR spending for use in calculating future payment updates.  Information on the rates of per beneficiary growth in the three spending components and total SGR spending over time (from the 2006 Trustees Report) was used to estimate dollar spending streams for the SGR physician, lab, and drug components of spending and for total spending as described in the Appendix.⁸  These baseline spending estimates are adjusted by the spreadsheet model as updates depart from baseline values.   

 One of the challenges confronting Medicare payment policymakers is that changes in payments may alter behavior in unanticipated ways and in ways counter to program goals.  Traditional economic theory suggests that physicians will shift toward supplying services with relatively higher prices and away from services that generate lower payments.  This is the theory, for example, that supports policymakers seeking to increase payments for primary care services believed to be under-utilized.  It is also the theory that underlies arguments by physicians’ associations that payment reductions will threaten access to services (presumably because the supply of those services will be reduced).  This view implies that there is unmet demand for services that are reimbursed more generously (e.g., services covered by some private insurers), and that labor supplied by physicians is not easily augmentable in the short-run, but shifted toward those services with higher prices.  An alternative theory, however, suggests that physicians seek to maintain a target level of income, and simply increase the number of services provided when payment per unit of service declines.  Under this perspective, reductions in price result in volume increases, not decreases.  This perspective implies that there is unmet demand (or demand can be generated) for services for which payment has declined, and that physicians seek to maintain their income levels by providing more of those services for which payments have declined.   

The evolution of Medicare physician payment policy reflects both theories.  Efforts to increase use of primary care services by increasing payments for these services reflect perspectives of traditional economics, as do efforts to limit spending with reductions in the CF.  By contrast, the target income theory of behavior is asserted when policymakers argue that spending estimates include a behavioral offset to correct for the belief that volume will increase if payment declines. ⁹ Solid evidence on the direction and magnitude of provider responses to payment changes is lacking, in part because of difficulties in attributing changes in behavior to payment changes when many other (non-price) factors are also changing.  Given the challenges of estimating provider response to payment changes, the spreadsheet model of the SGR process used to examine effects of changes in CFs and spending does not include adjustment for behavioral effects predicated on changes in payment levels.  No behavioral responses, on the part of any agents affected by the update process -- including providers, Medicare beneficiaries, and Congress -- have been incorporated into the structure of the spreadsheet model and predicted effects on updates and program spending.  This also means that future estimates derived from the model are based on the assumption that Congress will not intervene in the future, despite the fact that Congress has intervened in recent years.

On the surface, study of the SGR payment process is straightforward.  The process can be described as a recursive model, consisting of a set of algebraic relationships that are linked over time.  This view, however, is somewhat naïve, as noted above.  Changes in data alter future but not past values of SGR process relationships, and predictions of updates for future years are subject to uncertainties.  Application of the process’ relationships is straightforward at each point in time, but data in each year’s calculations are subject to change in future years.  CMS incorporates these changes into calculations over time (e.g., the accumulation of actual and target spending as spending data change and components of the SGR change), but payment updates cannot be changed retroactively.  For example, changes in estimated SGR expenditures for 2004 due to more complete data for 2004 in 2006 can be factored into future calculations using the formula, but are not used to change the update paid to physicians for work performed in 2005, even though the update would have differed had full information been available when the 2005 update was calculated.  Projected values of the update for future years require projections on various components of spending that enter the SGR calculations. 

The primary baseline against which changes to the SGR mechanism will be analyzed below is the SGR process under current law.  Payment updates and spending estimates are displayed in Tables 7a and 7b.  SGR values beginning in 2005 are subject to change, as are other data items used to calculate the update (see Figure 2) beginning in 2007.  

The conversion factor for CY 2000 was about $36.61, an increase of over 5 percent relative to the average conversion factor (CF) implemented (under VPS) for 1999 (Table 7a).  Part of this increase reflected spending during 1999 that did not exceed the target for that year.  The CF for 2001 increased by 4.5 percent.  During 2001, however, actual SGR spending exceeded target spending (by $7.0 billion), a consequence of which was that the CF for CY 2002 declined by 5.4 percent.  Even though over-spending continued through 2002, the CF increased for CY 2003 because the MEI more than offset the UAF penalty for spending through 2002. 

During the years 2003-2005, actual spending exceeded target levels.  (Over-spending amounts used to estimate corresponding CFs for years 2004-2006 were $6 billion, $8 billion, and $13 billion.)  For each of these three years, the UAF was negative and the factor’s magnitude exceeded 7 percent each year.  These UAFs activated the floor of the UAF to -7 percent.  Conversion factors for the years 2004-2006 (based on spending during 2003 through 2005, respectively) would have declined, had not Congress intervened.  Rather than payment reductions of 4.5 percent and 4.3 percent for 2004 and 2005, Congressional intervention propped updates at 1.5 percent for these years.  Rules for CY 2006 published in November 2005 called for a payment reduction of about 4.5 percent, but Congressional action negated the payment reduction, keeping the CF for 2006 at the 2005 level. 

Application of the current SGR process is expected to lead to continued declines in the CF from 2007 through 2014.  For each of these years, the UAF is expected to exceed 7 percent in magnitude, which triggers the implementation of the UAF floor (-7 percent).  The model predicts over-spending (spending in excess of target levels) for years 2006-2013, during which time the UAF is -7 percent each year.  The SGR model predicts that by the end of 2013, total spending will exceed target spending since 1996 by about $117 billion.  

Baseline spending between 2006 and 2010 is expected to be about $501 billion, more than 80 percent for physician services and the remainder for laboratory and drug spending that are currently part of total SGR spending (Table 7b).  Total spending for years 2000 through 2013 is expected to exceed $1,264 billion.