Medicaid is a joint federal-state program that funds medical services and long-term care for moderate-income families. Medicaid is one of the largest items in the federal budget, and its costs are growing at a rapid and unsustainable rate. The program should be overhauled to substantially reduce the taxpayer burden.

State governments administer Medicaid, but they receive an open-ended funding match from the federal government. As states have expanded benefits over the years, federal taxpayers have picked up most of the additional costs. The current funding structure encourages overexpansion and provides the states with little incentive to control the program's extensive fraud and waste. At the same time, the top-down regulatory structure of the program creates distortions in health care markets.

The Patient Protection and Affordable Care Act of 2010 (the "2010 Health Act") will greatly increase Medicaid's costs in coming years, and it doesn't fix any of the program's fundamental problems.¹ The law expands Medicaid eligibility by about 16 million people, adds to the health services covered, and increases the federal share of the program's costs. The federal costs of the expansion in Medicaid will be about $100 billion annually by 2020.²

Policymakers need to reverse direction and restructure Medicaid to control costs. One idea is turn the program into a block grant, which would provide a fixed amount of federal funding to each state. Block granting was the successful approach taken with federal welfare reform in 1996. A block grant would provide strong incentives for states to trim their Medicaid programs, combat fraud and abuse, and pursue more innovative and cost-effective health care solutions.

Another idea is to convert Medicaid into a system of direct aid to recipients by means of a voucher or refundable tax credit. Low-income individuals would receive an annual payment from the government and use it to buy a health insurance plan in the private market. As with block grant reforms, this reform approach would help the federal government control program spending and reduce it over time.

Federal debt is spiraling out of control, and federal health programs are one of the main reasons why. Health programs need to be cut. Reforming Medicaid through either block grants or individual vouchers would allow spending to be controlled, while also encouraging innovative and cost-effective approaches to health care for low-income people.
 

Rapid Growth

Medicaid was enacted in 1965 to provide medical aid to a limited group of low-income people on welfare.³ Federal and state legislation over the decades has greatly expanded the program to cover a wider range of services and a larger group of individuals at higher income levels.

Medicaid provides comprehensive medical coverage to beneficiaries. It covers inpatient hospital stays, visits to doctor's offices, and prescription drugs. It also covers items not usually included in private insurance plans such as nursing-home care. Federal rules require states to provide certain minimum levels of Medicaid coverage, but the states are free to expand benefits further—and they receive a federal matching payment when they do so.

The costs of Medicaid have grown explosively. Spending jumped from $118 billion in 2000 to $275 billion by 2010.⁴ And even before the 2010 Health Act was passed, spending on the program was expected to double in cost to $487 billion by 2020.⁵ The 2010 law will boost Medicaid's cost by about $100 billion a year by 2020.⁶

One reason why Medicaid's costs have risen so rapidly is that services are generally offered free to beneficiaries without co-payments or deductibles. Beneficiaries can even receive free transportation to their health care appointments. The program's generous benefits—with little or no out-of-pocket costs—has spurred excess demand and an overutilization of services.  

Another reason why Medicaid spending has risen rapidly is that policymakers have passed numerous expansions in eligibility and benefits over the years. Medicaid enrollment has skyrocketed from 25 million in 1990, to 43 million in 2000, to 64 million by 2009.⁷ The 2010 health law will expand enrollment by another 16 million by 2019.⁸ Even though it is widely known that Medicaid is fiscally unsustainable, federal and state policymakers have continued to expand enrollment and benefits.

One factor exacerbating the fiscal situation is that the costs of Medicaid expansions have nearly always exceeded what legislators promised. For example, Congress added a special hospitals subsidy to Medicaid in 1987 to aid facilities that served large numbers of uninsured patients. When enacted, it was supposed to cost less than $1 billion annually by 1992, but it ended up costing a stunning $17 billion that year.⁹

Another pattern evident in Medicaid—and other federal subsidy programs—is that each expansion spawns further expansions down the road. In 1997, Congress built on Medicaid by creating the Children's Health Insurance Program. CHIP provides federal grants to the states to subsidize health care costs for families who have higher incomes than those eligible for Medicaid. The program currently provides benefits to more than 8 million people.¹⁰ CHIP was expanded in 2009, and then extended in the 2010 Health Act.

In addition to health care services, Medicaid covers long-term nursing home and home-based care for the elderly. Long-term care represents about one-third of overall Medicaid spending, and, remarkably, Medicaid finances about 40 percent of all long-term care costs in the nation.¹¹ The costs of Medicaid's long-term care subsidies have exploded, partly as a result of fraud and abuse, as discussed below.

The 2010 Health Act increased Medicaid benefits, while reducing the ability of state governments to limit program costs.¹² The Act raised Medicaid reimbursement rates for doctors and it expanded the types of services that states are required to cover. More importantly, the Act greatly expanded eligibility for the program. Previously, state governments were required to cover pregnant women and children under the age of 6 who had incomes below 133 percent of the official poverty level, and also children between the ages of 6 and 18 who were below 100 percent of the poverty level. Adults with no children were generally excluded from Medicaid coverage unless disabled.¹³

The 2010 Health Act extends eligibility to all people under age 65 with incomes below 133 percent of the poverty level. Some people in this broader group were already covered in many states, but the Act imposes the expanded requirement on all states. Nearly all the costs of the expanded Medicaid coverage will be borne by federal taxpayers, as opposed to state taxpayers. The law made the program more of a national program with more federal funding and more top-down rules on the states, which was exactly the wrong direction to go.

The 2010 Health Act also built on Medicaid's long-term care subsidies by adding coverage for home-care services in those states that don't currently provide it. In addition, the law creates a new long-term care program called the Community Living Assistance Services and Supports Act. Workers over the age of 18 will be able to enroll in this new program individually or through their employer, and they will collect benefits for in-home care and other services if they become disabled.

All in all, the 2010 Health Act is a giant budget-buster. By increasing program benefits and further federalizing Medicaid, the law throws gasoline on the fiscal fire of runaway government health care spending. Even before the Act, Medicaid costs were expected to double by 2020. The Act will make spending balloon even more. A related essay discusses all the major changes of the new health care legislation.
 

Incentives to Expand

As the federal government has expanded Medicaid over the decades, state governments have had incentives to continuously expand the program as well. Since Medicaid is an open-ended federal matching grant, the states receive additional federal cash whenever they expand eligibility or covered services.

Each expansion draws more federal funding to a state based on a federal matching formula called FMAP—the federal medical assistance percentage. For every dollar of additional spending on the program, the federal government kicks in 50 to 83 percent of the costs, with higher-income states receiving a lower federal match and lower-income states receiving a higher federal match. The average matching rate is 57 percent, so as states increase spending, they mail a bill for 57 percent of the costs to Washington, on average.

A state with a 75 percent match could expand its program by $4 million and the federal government would pay $3 million. A state with a 50 percent match could expand its program by $2 million and the federal government would pay $1 million. The economic stimulus legislation passed in 2009 made federal funding even more generous by temporarily increasing these matching rates. The 2010 health care law greatly expanded the program, and federal taxpayers will be picking up more than 90 percent of the extra costs.¹⁴

Medicaid's federal matching grants provide a big incentive for the states to expand their programs beyond reasonable levels. The grants provide state policymakers with seemingly "free" money to shower benefits on their constituents. At the same time, the states have little political incentive to rout out program inefficiencies because they would need to cut their programs by two dollars or more to save state taxpayers one dollar.

The generous federal match has encouraged states to abuse Medicaid by creating essentially fraudulent schemes to maximize aid, which the Washington Post has called a "swindle."¹⁵ As an example, many states impose taxes on health care providers and then channel that revenue back to the providers. The effect is to increase reported state Medicaid spending and boost federal matching funds. As of 2009, 22 states have significant health care provider or hospital taxes.¹⁶

Even if states wanted to cut their Medicaid programs, federal rules can prevent them from doing so. As noted, the federal government imposes various eligibility requirements on the states. It also imposes "maintenance of effort" requirements. For example, the 2009 economic stimulus bill prevented states that received the extra funds from trimming their programs in certain ways to help balance their state budgets. The 2010 Health Act also imposed maintenance of effort requirements.¹⁷ In sum, the intergovernmental nature of Medicaid discourages frugal-minded policymaking.
 

Misallocation of Spending

Aside from encouraging excess spending, the intergovernmental nature of Medicaid has created an illogical distribution of funding across the states. Current grant formulas are based on each state's per-capita income, such that poorer states receive a higher federal matching rate. However, it is often wealthier states that end up doing better from the program. Thomas Grannemann and Mark Pauly have studied the issue in detail, and they find that Medicaid "directs a disproportionate share of federal dollars to a small number of high-benefit states, many of which are … higher-income states."¹⁸

The reason is that the federal Medicaid match has encouraged wealthier states to expand their programs more than poorer states.¹⁹ When federal Medicaid spending is measured by dollars per person below the poverty line, it reveals the rich-state advantage. In 2007, federal Medicaid spending per poor person in the five poorest states averaged $3,547.²⁰ By contrast, spending per poor person in the five wealthiest states that year averaged $5,405.

Overall Medicaid spending is three times higher in states such as New York and Massachusetts than it is in states such as Alabama and Mississippi.²¹ Grannemann and Pauly conclude that the distribution of Medicaid's grants is "poorly calibrated to support benefits in lower-income states."²²

It is not a proper role of the federal government to act as Robin Hood by transferring resources from rich states to poor states. But even if such transfers were a good idea, the data show that the current Medicaid program does not do the job. Note that it is a general problem of federal grant programs to create an illogical allocation of aid across the states. Federal grants for K–12 education, for example, are generally supposed to aid the neediest school districts, but a lot of the funding goes to the wealthiest districts.²³ The misallocation of grants is one of many reasons the whole federal aid system, including Medicaid, should be downsized, as I've discussed elsewhere.
 

Distortions to the Economy

Medicaid should be reformed not just for fiscal reasons, but to reduce broader distortions created by the program and improve the nation's health care system. The current Medicaid system is based on top-down regulatory controls from Washington. Millions of reimbursements are provided to health care providers for services rendered based on a complex system of prices, set bureaucratically, on thousands of medical products and services.

These price controls create costly distortions. For example, "many states underpay physicians and overpay hospitals, encouraging hospital-based treatment instead of less expensive care in doctors' offices."²⁴ Rep. Paul Ryan (R-WI) notes that under Medicaid, "providers are paid based on bureaucratically determined formulas that do not reflect the market. As a result, fewer and fewer providers are willing to participate in the program, meaning longer lines for beneficiaries, fewer operational clinics, and insufficient care. Patients suffer as a result."²⁵ Because of below-market reimbursements, a substantial share of the nation's doctors do not take Medicaid patients.

Expanding Medicaid without changing the basic structure of the program will just make these sorts of distortions worse. The 2010 Health Act increased reimbursements for health providers, but it didn't alter the system of top-down regulations and price controls that continue to cause large amounts of waste.

As a means-tested subsidy program for the low-income population, Medicaid also creates broader damage to society and the economy. As with other welfare programs, Medicaid targets benefits to people below certain income and asset cut-off levels. Such limits on eligibility tend to discourage individual savings, self-help, and greater individual work efforts because recipients don't want to lose their current benefits.²⁶ Medicaid promotes an unhealthy dependence on government the same way that housing subsidies, farm subsidies, business subsidies, and other aid does.

A final type of distortion created by Medicaid is that it tends to "crowd out" possible private efforts to improve health care for low-income families. There may be innovative ways that private charities could provide health care for the poor. Lower-cost types of private health insurance might be designed. But the existence of Medicaid and various regulations and insurance mandates stifles such private efforts.

We know, for example, that past Medicaid and CHIP expansions were partly offset by reductions in private coverage.²⁷ We also know that when Medicare was introduced in the 1960s, it had the effect of squelching a large and growing private industry of elderly health insurance and services.²⁸ In sum, government spending has a large cost, not just in a pocketbook sense, but in the private activities that cease to exist or are never given a chance to be created.
 

Fraud and Abuse

Federal health programs have had giant fraud and abuse problem for decades despite various efforts at reducing it. The source of the problem is the basic structure of Medicaid and Medicare that hands out billions of dollars in reimbursements every year to thousands of health care providers. The Government Accountability Office estimates that improper Medicaid payments cost more than $30 billion a year, or about 10 percent of the program's spending.²⁹

The GAO's estimate of 10 percent waste is probably optimistic. Harvard University's Malcolm Sparrow, an expert on health care fraud, estimates that fraud and improper payments could be 20 percent of the cost of federal health programs, which would mean Medicaid waste of more than $60 billion a year.³⁰ The Inspector General of the Department of Health and Human Service said: "Although it is not possible to measure precisely the extent of fraud in Medicare and Medicaid, everywhere it looks the Office of Inspector General continues to find fraud against these programs."³¹

New York has a particularly expensive and fraud-ridden Medicaid system. The former chief investigator of the state's Medicaid fraud office believes that about 10 percent of the state's Medicaid budget is consumed by pure fraud, while another 20 to 30 percent is consumed by dubious spending that might not cross the line of being outright criminal.³²

A 2005 investigation by the New York Times found brazen examples of fraud and abuse in New York's Medicaid. The Times noted that the program has "become so huge, so complex, and so lightly policed that it is easily exploited … the program has been misspending billions of dollars annually because of fraud, waste, and profiteering."³³

Here is some of the waste found by the Times:

• A dentist stole more than $1 million from New York's Medicaid by making claims for fictitious patients and procedures. She even made claims for 991 separate procedures supposedly performed in a single day.
• Medicaid's subsidies for transportation are widely abused. The program pays $50 per trip for handicapped persons to go to doctor's appointments, but investigators found that many people using the service were not handicapped and that many transportation firms were rigging the system to earn unjustified profits.
• New York schools charged Medicaid more than $1 billion for unneeded or unprovided special education activities as a way to bilk the state out of Medicaid grant money.
• Criminal gangs diverted Medicaid-covered muscle-building drugs that were intended for AIDS patients to bodybuilders.

Similar schemes to bilk federal health programs are routinely uncovered across the nation. Federal health investigators say that they play "whack-a-mole" with organized criminals, because when they crack down on them in one area of the country, they move to a different area and continue scamming federal programs.³⁴

A classic type of fraud is double-billing. In one case, the University of Medicine and Dentistry of New Jersey double-billed Medicaid repeatedly over the years by directly submitting claims for outpatient physician services at the same time doctors working in the hospital's outpatient centers were submitting their own claims for exactly the same procedures.³⁵

There is a huge fraud problem in Medicaid's long-term care program, which covers the costs of nursing homes and home care for the elderly poor. The program has complex rules for eligibility related to one's income and assets. But nursing homes are expensive, and so the program creates an incentive for middle- and higher-income families to try and qualify for it. An industry of financial consultants helps seniors hide their income and assets to gain eligibility.³⁶ This sort of abuse is estimated to cost taxpayers about one-fifth of the total cost of the long-term care program.³⁷

One reason why Medicaid has high levels of fraud is that it is a federal matching aid program. The states administer the program and decide how much to spend, but the federal government pays most of the costs. That creates a disincentive for state officials to deal with fraud and abuse. For every two or more dollars of fraud that a state can cut, the state budget only saves one dollar. The solution is to end the matching nature of federal aid, and simply provide states with a fixed annual Medicaid block grant.
 

Reforming with Block Grants

From a budget perspective, a good way to reform Medicaid would be to turn it into a block grant. The federal government would give each state a lump-sum grant amount each year, allowing federal taxpayer costs to be directly controlled. Federal aid to the states could be ratcheted down over time, but the states would have greater flexibility to design more cost-effective health care programs.

Under the current system, the more states spend, the more they gain at the expense of federal taxpayers who live in other states. But under a block grant, states would have a strong incentive to spend Medicaid funds more efficiently and to pursue innovative reforms unencumbered by federal regulations. The block grant approach to federal aid was a big success with welfare reform in 1996, which converted the open-ended funding of Aid to Families with Dependent Children with fixed grants under Temporary Assistance for Needy Families.

Reformers have long sought to turn Medicaid into a block grant. In his 1982 budget, President Ronald Reagan proposed turning Medicaid into a block grant and capping annual growth at 5 percent.³⁸ The Senate passed a modified version of his proposal, but the reform was rejected by the House.

Congressional Republicans proposed similar reforms in their 1996 budget plan. Those reforms would have turned Medicaid into a block grant and slowed the annual growth to 4 percent, while cutting costs by $163 billion over seven years.³⁹ Unfortunately, President Clinton vetoed this legislation and Republicans generally abandoned their efforts at the time to cut health costs.

In his 2004 budget, President George W. Bush proposed Medicaid block grant reforms.⁴⁰ His proposal would have allowed states to receive their Medicaid funds in the usual structure or in the form of a block grant with the inducement of more flexibility and higher initial funding levels. The plan would have been a step forward, but the administration did not push it very hard and it was quickly forgotten.

In arguing for a Medicaid block grant, the Bush administration pointed to common complaints that the "complex array of Medicaid laws, regulations, and administrative guidance is confusing, overly burdensome, and serves to stifle state innovation and flexibility."⁴¹ Block granting would be a way to reduce the enormous bureaucratic structures that are needed to administer the current program.

The Congressional Budget Office has examined the cost savings of turning the acute care portion of Medicaid into a block grant. Acute care includes hospital care, doctor visits, and drug costs, which together accounts for about two-thirds of overall Medicaid spending. Block granting acute care and allowing federal funding to grow by the general inflation rate would save federal taxpayers $625 billion over the 10-year period from 2010–2019, including about $125 billion by 2019.⁴²

A better reform would be to block-grant the entire Medicaid program, including both acute care and long-term care, and freeze outlays at the current level. If policymakers block-granted the program and froze spending at the 2011 level, the savings would total about $760 billion over the 2012–2020 period, and annual spending would be reduced by about $190 billion by 2020.⁴³ These estimates are based on Medicaid projections before the 2010 Health Act was passed.

With a fixed amount of federal funding and fewer federal regulations, the states would be strongly encouraged to target their most needy populations and to reduce coverage for nonessential services. The states would have an incentive to experiment with major reforms to their delivery systems, particularly consumer-driver reforms that could reduce costs and improve quality. Limiting federal subsidies may also encourage states to repeal insurance laws that prevent lower-cost private insurance options from arising. A fixed federal block grant would be the mother of invention for state health care innovation and reform.
 

Reforming with Vouchers

Another leading reform idea is to convert Medicaid into a consumer-driven system based on individual vouchers or refundable tax credits. The government would provide cash directly to beneficiaries to purchase private insurance coverage, rather than reimbursing health-care providers for particular services rendered.

Individuals would be empowered to choose among different insurance and health-care options, trading off the various costs and benefits. Individuals could choose to purchase a high-deductible insurance plan, for example, and deposit their remaining voucher or tax credit amount into a tax-free health savings account.

Under such a consumer-directed structure, much of Medicaid's regulatory apparatus would be eliminated. The government wouldn't have to bureaucratically set the prices for thousands of services provided by doctors and hospitals. Fraud and abuse would be reduced because the government wouldn't be making millions of provider reimbursements. And the federal government would have fixed and controllable costs because it would directly set voucher or tax credit amounts.

Rep. Paul Ryan (R-WI) has proposed consumer-directed reforms for Medicaid, within a broader plan to reform the U.S. health care system.⁴⁴ Under Ryan's plan, the current tax exclusion for employer-based health insurance would be repealed, and all Americans under age 65 would receive a refundable tax credit to help purchase a private insurance plan individually or through their employer. The tax credit would be $2,300 for individuals and up to $5,700 for families.

The current Medicaid system would be repealed and low-income families would receive the tax credit under the Ryan plan plus a voucher of up to $5,000. The standard tax credit and voucher payment for families below the poverty line would be almost $11,000, which is about the average cost of a health insurance plan today. Families with incomes above the poverty line but below twice the poverty level would receive a smaller voucher amount. The vouchers would be risk-adjusted, meaning that individuals with excessive insurance premium costs would receive additional aid. 

Ryan's plan would have the beneficial effect of integrating low-income families into the private health insurance system alongside other Americans. Many doctors currently don't take Medicaid patients, but the tax credit and voucher approach would allow low-income families broader access to health care services. Ryan describes the advantages of his plan:

The payment will be made directly to the health plan designated by the individual, allowing those who use the health care to choose the insurance product that best suits their needs. Any individual who obtains health coverage that costs less than the credit will receive any leftover amount as a payment from the health plan. Alternatively, those who choose to purchase policies with premiums higher than the credit will assume responsibility for the additional amount themselves. This will encourage individuals to shop for policies best suited to their needs, at the best prices; and as a result, every American will play a role in restraining health insurance premiums, and enhancing the quality of health care services.

For long-term care, which accounts for about one-third of Medicaid spending, the Ryan plan would turn it into a block grant for the states. That would allow the federal government to directly restrain spending, while encouraging state governments to crack down on the excessive fraud and abuse in this program.

Reforming Medicaid through block grants would probably result in less federal micromanagment of state health care markets than reforming the program through federal vouchers. However, both reform approachs would allow the federal government to directly control program costs. Under either approach, policymakers could steadily reduce federal spending over time to help combat huge budget deficits. Even without the expansions under the 2010 Health Act, Medicaid is expected to grow at about 7 percent annually for most of the next decade.⁴⁵ By reforming the program with block grants or vouchers, policymakers would be able to immediately start cutting this high growth rate. As for the 2010 Health Act, it should be repealed as an unaffordable expansion in government subsidies, as discussed in a related essay.

In the long run, federal Medicaid spending should be phased out completely. After all, funding for the program comes from taxpayers in the 50 states, so we may as well keep the money in the states and allow each state government to determine what sort of health care policy it wants to pursue. Reforming Medicaid through a either block grant or individual vouchers would help limit federal spending and move decisionmaking for the nation's health care system out of Washington.