Erin Davis

Richard Kaglic

English

Research Papers in Economics

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK MARCH 2002
OF CHICAGO NUMBER 175
Chicago Fed Letter
Reining in Medicaid
spending—States respond
to declining revenues
Erin Davis, associate economist, and
Richard Kaglic, economist
Even before the current economic
downturn, states were finding it in-
creasingly difficult to fund their
Medicaid programs. In part, states
may have become victims of their own
recent good fortune. With the econ-
omy prospering in the latter half of
the 1990s and tax dollars flowing in,
few states saw the need for significant
cuts in Medicaid spending, as such
cuts could prove both socially painful
and politically unpopular.
Now that the economy has slowed
down and state revenues are falling
short of expectations, policymakers
are finding it necessary to address in-
creasing Medicaid costs in a more ag-
gressive fashion. Medicaid programs
are funded by states’ general revenues,
which are closely tied to the econom-
ic cycle, and matching funds from
the federal government. Currently,
Medicaid consumes the second larg-
est portion of states’ general revenue
spending, with only education com-
manding a larger share.1
This Chicago Fed Letter examines the
growth in Medicaid spending and
some of the measures that states in the
Seventh District are taking to control
costs as general tax revenues fall short
of original estimates.
What is Medicaid?
Medicaid is a joint federal and state
health insurance program that pro-
vides 1) health insurance for low-in-
come families with children and with
disabilities; 2) long-term care for the
elderly poor and individuals with dis-
abilities; and 3) supplemental coverage
for low-income Medicare recipients
for services not covered by Medicare.2
This means-tested program, the larg-
est in the federal “safety net” of public
assistance programs, traces its roots to
the Social Security Amendments of
1965, which also established Medicare.
Under broad federal guidelines, each
state is at liberty to determine its own
eligibility standards, benefits packages,
payment rates, and program admin-
istration. Subsequently, Medicaid is
actually 56 distinct programs, one for
each state and territory of the U.S.
The programs are jointly funded by
the state and federal governments,
with the federal contribution for
Medicaid services ranging from 50%
to 83%, depending on the state’s av-
erage per capita income levels.3
Up, up, and away!
The last two decades have brought
dramatic changes in both the scope
and costs of Medicaid.
Beginning in the late
1980s, Congress great-
ly expanded Medicaid
eligibility to include
many more pregnant
women, children, and
low-income Medicare
recipients. Then, both
legislation and court
decisions during this
period expanded
Medicaid eligibility to
include more learn-
ing disabled children,
as well as many indi-
viduals with specific
medical issues (AIDS
patients and substance
abuse cases, for exam-
ple). These changes
not only increased enrollment, but
by including these medically needy
populations, also increased per-en-
rollee expenditures. Finally, enroll-
ment also grew as a result of the
general economic slowdown, and the
accompanying increase in demand
for social services, in the early 1990s.
In addition, state accounting policies
designed to maximize the dollar match
from the federal government may have
distorted actual spending increases.
For example, some states shifted ser-
vices that had been financed through
other programs to Medicaid in order
to draw the federal match. One prac-
tice that substantially increased pay-
ments, however, was the way states
handled Medicaid’s Disproportionate
Share Hospital (DSH) provision. Many
states would impose a tax on, or re-
ceive contributions from DSHs. The
revenue collected from providers
would then be used for Medicaid re-
imbursements, allowing the states to
collect matching funds from the fed-
eral government.4
1. Growth in personal health care expenditures
percent change from previous year
Source: U.S. Department of Health and Human Services, Centers for
Medicare and Medicaid Services, 2000, "National health care expenditures,"
Washington, DC.
Total private
State Medicaid
1994 '95 '96 '97 '98 '99 '00
0
4
8
12
162. Inflation
Source: U.S. Department of Labor, Bureau of Labor Statistics.
percent change from previous year
All told, state and federal Medicaid
spending more than doubled between
1988 and 1992, rising from $53.5 bil-
lion to nearly $120 billion, with growth
averaging over 22% per year.
By the middle of the 1990s, however,
the yearly increases in state Medicaid
spending slowed to a more palatable
rate (see figure 1). Most of these pro-
gram expansions had worked their way
into the system, and the federal gov-
ernment had closed some, though not
all, of the loopholes that allowed states
to increase federal matching funds
through accounting changes. At the
same time, states were working to con-
tain Medicaid costs. The emergence
of managed care was an important
part of this effort; Medicaid managed
care penetration increased from
roughly 10% in 1991 to 56% in 2000.
Initial cost savings from managed care
were projected to be 5% to 15%,
which would be achieved primarily
through utilization management—
increasing preventive care and re-
ducing emergency room visits and
specialist care—while simultaneously
improving recipients’ overall access
to care. As a further limiting factor
to program cost increases, Medicaid
enrollment began to fall as a result of
the record economic expansion that
began in the early 1990s.
However, the rate of growth in states’
Medicaid spending remained high
relative to both the overall rate of
inflation and the rate
of growth in private
health care spending.
One of the many rea-
sons for this is that
medical care inflation
remained higher than
the overall growth rate
of consumer prices
(see figure 2), and, as
noted earlier, many
Medicaid enrollees
are higher-than-aver-
age consumers of
medical care. Also, in
many cases, the pre-
dicted cost savings
from managed care
failed to materialize.
Utilization was more
difficult to control
than anticipated, while administra-
tive burdens often increased.5
Medicaid spending in the
Seventh District
There is now a real sense of urgency
about the need for states to cut their
medical costs. This is because, unlike
the Medicare program, which has its
own trust fund, Medicaid programs
are funded by general revenues (for
example, sales, personal income, and
corporate income taxes) that are in-
extricably tied to the economic cycle.
Thus, when economic tides are rising,
so too are revenues, and policymakers
are not pressured to
make hard cost-con-
tainment decisions.
When that revenue
stream slows, policy-
makers are forced to
make painful decisions
as to which of a myri-
ad of vital programs
to fund. Since Medic-
aid is the second larg-
est and fastest growing
source of state gener-
al revenue spending,
from an accounting
perspective, it is an at-
tractive target for cuts.
As economic activity in
the nation began to
wane in 2000, so too
3. States’ general revenue growth
did states’ general revenue collec-
tions. Between 1995 and 2000, quar-
terly revenue growth averaged 6.7%
(change from year-earlier period).
That rate began to decline in the
fourth quarter of 2000 before turning
negative in the third quarter of 2001
(see figure 3). And the flow of tax dol-
lars continues to disappoint. Accord-
ing to a survey by the National
Conference of State Legislatures, 44
states reported that revenues fell
short of expectations in the early
months of fiscal year 2002.6 At the
same time, at least 20 states reported
that Medicaid expenditures were
higher than anticipated.7
All five Seventh District states,
Illinois, Indiana, Iowa, Michigan, and
Wisconsin, have reported that reve-
nues were below expectations. In re-
sponse, state governments have begun
to announce budget cuts, including
hundreds of millions of dollars of
Medicaid funding. The effects of these
cuts will be even more dramatic than
it may first appear; cutting state fund-
ing will mean losing an approximate-
ly equal amount of matching federal
funds. Some state efforts are fairly
broad-based, as governments seek to
spread the budget pain evenly. For
example, Iowa’s governor has asked
for across-the-board spending cuts
from state departments. Other plans
have been more specific and appear
to be focused on the three largest
1992 '93 '94 '95 '96 '97 '98 '99 '00 '01
Medical
CPI
1995 '96 '97 '98 '99 '00 '01
percent change from year ago
Source: The Rockefeller Institute, 2001, State Fiscal News, Vol. 1, No. 6,
November 7.Michael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; Charles
Evans, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research;  William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago.  The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department is
provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
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Chicago Fed Letter  and other Bank publications are
available on the World Wide Web at http://
www.chicagofed.org.
ISSN 0895-0164
components of state Medicaid spend-
ing: hospital care, nursing home care,
and prescription drugs.
Hospital care is the largest component
of states’ Medicaid spending, $28.7
billion in 2000, accounting for roughly
37% of total spending. As such, it is a
major target of funding cuts. Illinois
plans to reduce its reimbursements to
hospitals for extended stays and out-
patient care by approximately $100
million. These cuts will fall largely
on the shoulders of the state’s “safety
net” hospitals, which either serve a
disproportionately high number of
Medicaid recipients or are the sole
provider in a rural community.
Long-term care, 75% of which is nurs-
ing home care, has also been a target
of recent budget cuts. Medicaid pays
for two-thirds of all nursing home resi-
dents, which constitutes 24% of states’
total Medicaid spending. Indiana re-
cently announced Medicaid cuts of
$155 million, much of which will come
from nursing home care. The plan
reduces reimbursement rates and es-
tablishes a minimum occupancy re-
quirement for full reimbursement.
In addition to its announced budget
cuts, Iowa is also addressing this issue
by cracking down on asset divestiture
fraud, in which elderly parents hand
over their assets to their adult chil-
dren in order to qualify for Medicaid.
In September, Iowa had 500 such
cases pending, and had identified
approximately $1 million in improp-
er payments.
Much of the recent debate has also
centered on stemming the rising costs
of prescription drug programs, and
with good cause. State Medicaid spend-
ing on prescription drugs grew by
over 20% in 2000, making it the fast-
est growing component of Medicaid
spending. While prescription drugs
accounted for only 10% of states’ to-
tal Medicaid spending in 1999, they
accounted for 30% of total growth in
spending from 1999 to 2000 (see fig-
ure 4). The increase in prescription
drug spending is certainly alarming,
yet some would argue that prescrip-
tion drugs often pay for themselves
by reducing other health care costs.
For example, asthma medications
might reduce the costs for acute care
by much more than the price of the
medications themselves. Until very
recently, however, fee-for-service
Medicaid prescription drug programs
did not create incentives for either
recipients or providers to consider
cost when choosing between similar
drugs (unlike private insurance).
Michigan has developed a plan to
contain prescription drug costs, and
Indiana and Iowa are currently de-
veloping similar plans. In Michigan,
a medical panel created a relatively
restrictive prescription drug formu-
lary of at least two “best in class” drugs
in 40 therapeutic categories, from
which doctors may prescribe drugs
freely. Other drugs will require prior
authorization from the state, unless
the manufacturer is willing to match
the price of the formulary drug. While
Michigan estimates that the measure
will save $42 million in the next fiscal
year, it is unclear if the plan will come
to fruition. The Pharmaceutical Re-
search and Manufacturers of America,
a drug-industry trade group, has chal-
lenged the legality of the plan, arguing
that it denies patients needed drugs.
Conclusion
The onset of recession has put states’
budgets under increasing pressure as
general tax revenues have fallen well
below projections. At the same time,
the demand for social services contin-
ues to rise, due in part to the economic
slowdown. Unlike the federal govern-
ment, most states are legally bound to
balance their budgets. Furthermore,
state governments cannot simply move
funds from one account to another to
meet spending needs. Over 70% of
states’ general revenues are spent on
K–12 education, Medicaid, higher ed-
ucation, and corrections. The remain-
der is spent on public aid, economic
development, judicial functions, and
other general government programs.
Since Medicaid is the fastest growing
4. State Medicaid spending
A. State Medicaid spending, 1999
Hospital
care
37%
Nursing
home care
24%
Other
personal
care 13%
Prescription
drugs 10%
Physician
and clinical
services
10%
All
others
6%
B. Contribution to state Medicaid*
spending growth, 1999–2000
Hospital
care
34%
Nursing
home care
6%
Other
personal care
18%
Physician
and clinical
services
          10%
All
others
2%
Prescription
drugs
30%
*Medicaid spending on healthcare.
Source: U.S. Department of Health and Human Services,
Centers for Medicare and Medicaid Services.P
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1National Association of State Budget
Officers, 2001, “The fiscal survey of
states, December 2001,” Washington,
DC, December.
component of states’ general revenue
spending, policymakers are making
quick and painful decisions to rein in
spending. Initial public reaction to
cost containment measures, such as
advocacy group lobbying efforts and
lawsuits, demonstrates that some of
the states’ actions will not be popular,
nor will they go unchallenged. Yet, as
long as Medicaid spending is funded
by general revenues, we can expect
similar problems to develop in future
economic downturns.
2Medicare is a federally funded program
that provides health insurance primarily
for Social Security eligible people aged
65 and older and certain people with dis-
abilities. For more information, see
www.medicare.gov.
3U.S. Department of Health and Human
Services, Health Care Financing Admin-
istration, 2002, “A profile of Medicaid,”
Washington, DC, available on the Internet
at www.hcfa.gov./stats/2Tchartbk.pdf.
4Disproportionate share hospitals are
those hospitals that provide care to an
unusually high percentage of low-income
Medicaid patients, the indigent, and the
uninsured. DSH payments increased more
than tenfold between 1990 and 1996. For
more information, see Theresa Coughlin,
Leighton Ku, and Johnny Kim, 2000,
“Reforming the Medicaid disproportion-
ate share hospital program in the 1990s,”
Urban Institute, Washington, DC, Janu-
ary, available on the Internet at http://
newfederalism.urban.org/html/discussion
99-14.html.
5See, for example, Consumers Union
Southwest Regional Office, 1999, “Look-
ing back at the promises of Medicaid
managed care," Austin, TX,  April.
6National Conference of State Legisla-
tures, 2001, “State fiscal outlook for FY
2002: October update,” Washington, DC,
October.
7Kaiser Commission on Medicaid and the
Uninsured, 2001, “Medicaid budgets un-
der stress: Survey findings for state fiscal
year 2000, 2001, and 2002,” Washington,
DC, October.

Reining in Medicaid spending--states respond to declining revenues

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Reining in Medicaid spending--states respond to declining revenues

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