Medicare is central to fixing health care and the federal budget

Many failed political candidates can attest to the risks of supporting changes to Medicare. It is an easy issue to exploit in the heat of a campaign. At the same time, there is no avoiding the program’s centrality to two serious challenges: rising medical care expenses and the large increase in federal debt projected over the next 30 years. Neither can be addressed adequately without Medicare reform.

What connects both problems is the burden that undisciplined medical spending is imposing on American society. Rampant waste, excessive administrative costs, and irrationally elevated prices force households to pay higher than necessary premiums and taxes. They also contribute to government borrowing and debt.

Although Medicare pays lower rates for most medical services compared to commercial insurance because of strict regulations, the program does not have costs fully under control. Medicare’s extensive rules influence how hospitals, physician practices, and other suppliers of services organize themselves to care for patients. In general, Medicare’s fee-for-service billing system has encouraged fragmentation rather than coordination, which leads to higher costs. Medicare is not exempt from the resulting absence of discipline.

A major problem today is that patients receive many services that do not improve their health. Medicare’s payments are low relative to private plans, but some of the services the beneficiaries receive are not necessary. Further, even with regulations, Medicare’s payments are likely too high in some cases, in part because the program’s rules implicitly finance the high administrative expenses built into the hospital and physician billing systems.

There are two potential pathways for reform. One would rely on stricter government payment regulations and new federal efforts to improve value through bonuses and other incentives. The other would use market incentives to help consumers gravitate toward coverage and service providers that offer the best combination of high quality and low prices.

The market option requires rules that structure the competition because medical care is not like most other services or products. Patients know much less about the care they need than their physicians, and most consumers want to be protected by insurance so that they do not have to weigh the value of individual services against their costs.

However, with the right rules and incentives, Medicare beneficiaries will opt for lower-priced options if they are confident that they will still get the care they need to stay healthy or get better. To achieve this, the government should standardize Medicare beneficiaries’ choices to allow for easy apples-to-apples comparisons and ensure the savings are directed to those who decide to economize.

There are private coverage options today in Medicare — called Medicare Advantage plans — but the payment system does not reward cost-cutting. An important reform would tie payments in each market to a weighted average of bids from these plans and the measured per capita costs of traditional Medicare. The coverage offered would be the same across all options. Beneficiaries would get to keep the premium savings when they enroll in plans with premiums below the average (and pay more when opting for higher-priced coverage). The Congressional Budget Office (CBO) has estimated that this reform would reduce total spending by the government and Medicare beneficiaries by 7 percent.

Similarly, for certain services that are high-volume and can be scheduled, such as joint replacement surgery, Medicare should require those involved in caring for the affected patients to coordinate with each other to post the “all-in” prices they will charge, with the definition of the bundle standardized through regulation. Medicare patients could then see the pricing differences among those providing the service in their markets. If they were allowed to share in the savings, it is likely that many would opt for the surgery teams offering below-average prices.

Medicare is the largest payer of medical services in the U.S. It writes the rules that others must follow. If the program changed to encourage cost reduction through competition and consumer choice, the entire system would benefit from a renewed focus on efficiency in the provision of service to patients.

James C. Capretta is a senior fellow and the Milton Friedman Chair at the American Enterprise Institute.