Medicaid Cost Pressures Intensify on States; Negative for Hospitals and the Drug Trades

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Richard Evans / Scott Hinds

203.901.1631 /.1632

richard@ / hinds@sector-sovereign.com

March 22, 2011

Medicaid Cost Pressures Intensify on States; Negative for Hospitals and the Drug Trades

  • Despite a slow improvement in general economic conditions, states’ fiscal problems intensify in FY2012, due largely to expiring federal subsidies and declining general and rainy-day fund balances. As a large component of state spending, Medicaid is likely to face more cuts in FY2012 than in FY2011
  • At currently forecasted rates of GDP and employment growth, and assuming a continuation of ’08 – ’10 per-person spending growth for both Medicaid and non-Medicaid services, on average states must either increase general revenues by more than 7 percent (thru higher tax rates), reduce per-person non-Medicaid spending by 2 percent, or reduce per-beneficiary Medicaid spending by 32 percent, on top of significant actions that have already been taken
  • States cannot reduce eligibility for Medicaid, and can only narrowly reduce the range of benefits offered, though most of these reductions have already been taken. This suggests states must reduce the cost of providing a given amount of care, i.e. states must cut input costs
  • Hospitals are an almost certain target; unlike many other providers (e.g. physicians) not-for-profit hospitals must accept Medicaid patients in order to remain not-for-profit, and so have little choice but to accept whatever Medicaid payments are offered. These payments have already fallen substantially since ’08, and Medicaid : commercial payment ratios are at a trough – but we see payments falling quite a bit further nonetheless
  • Drug benefits are a large state Medicaid expense, and generic dispensing mark-ups are a well understood source of potential savings. Intensifying state fiscal pressures increase the likelihood that the HHS Secretary publishes, and the states quickly use, generic acquisition costs. In turn, states’ reliance on these data should assure commercial plan sponsors that the data will be available over the longer term, facilitating the transition of commercial drug plans to generic acquisition cost benchmarks, instead of AWP. Generic dispensing margins would fall substantially as a result; PBMs are most at risk, followed by drug retailers, followed by drug wholesalers

The precarious nature of state budgets is an increasingly well worn theme, and Medicaid’s large share of state spending is well understood

Nevertheless, because of the severity and duration of the present economic downturn, the larger share of state budgets dedicated to Medicaid since prior downturns, and the pending expiry of enhanced federal Medicaid subsides, we see an inflection point in state budget pressures, particularly as they relate to Medicaid

On average, Medicaid represents about 15% of total national healthcare spending; Medicaid shares of nursing home and home health spending are well above this average, and shares of prescription and physician spending well below (Exhibit 1)

Medicaid consumes nearly a quarter of total state spending; however because states’ Medicaid spending is matched (in varying proportions) by federal dollars, Medicaid represents a smaller percentage of states’ general revenues. Since the beginning of the most recent recession, Medicaid spending has grown as a percent of total state spending; however the percent of states’ general revenues spent on Medicaid recently has fallen as a result of enhanced federal matching (Exhibit 2). The enhanced federal match is winding down in 1Q and 2Q11, and will expire at the end of 2Q11, at which point the percent of states’ general revenues required to meet Medicaid commitments will rise – in most cases substantially. Medicaid generally appears to be a larger state fiscal problem than in past recessions: Medicaid is now a larger percent of state spending, general revenues have fallen much further, and states’ general fund and rainy-day balances heading into this recession were no larger than in past recessions (Exhibit 3). Also the current economic downturn is likely to be more prolonged

Predictably, states’ fiscal circumstances are quite varied; states that had larger mid-year (FY 2011) shortfalls had more generous Medicaid programs (both in terms of generosity of benefits, and Medicaid spending per beneficiary), higher tax rates, less non-Medicaid spending per citizen, and more liberal political contexts (Exhibit 4). And, it appears as though these states were slower to cut Medicaid spending; states with larger FY 2011 shortfalls relied far less on Medicaid cuts to balance budgets in FY 2010 – and were thus far more reliant on Medicaid cuts in FY 2011 (also Exhibit 4). Per-beneficiary Medicaid spending has decelerated dramatically for practically all states; states with greater fiscal pressures also have had to cut growth in per-citizen spending on other services, whereas states in better fiscal condition have not (Exhibit 5). On net, these observations suggest that states with the most pressing fiscal problems tend to be less able to cut non-Medicaid spending (as they are well below the national average), less able to raise taxes (as their rates are well above the national average), and thus more reliant on cuts to Medicaid (where levels of spending and generosity are well above national averages) as a source of cost savings

We forecast states’ budgets through FY 2013; for all states we assume that general revenues grow at the rate of national GDP, that employment rises in line with Congressional Budget Office projections (roughly 2 percentage point drop in unemployment through 2013), that per-beneficiary Medicaid spending grows at the trailing rate (from 2008 to 2010); and, that non-Medicaid spending per beneficiary also grows at the trailing rate. Using these baseline inputs for revenue growth, non-Medicaid spending growth, and Medicaid spending growth, all 50 states would be expected to experience budget shortfalls in FY 2012

Exhibit 6 ranks the states according to their projected FY 2012 shortfall (the average shortfall would be roughly 13%) as compiled by the Center on Budget and Policy Priorities. Note that these projections already count at least 44 states projecting shortfalls in FY 2012, very consistent with our scenario modeling

Keeping the same order of states on the X-axis, we then analyze how far any of three individual policy actions (raise taxes, cut per-citizen non-Medicaid spending, or cut per-beneficiary Medicaid spending) would have to be pressed if only that specific policy action were used to balance the FY 2012 budget from our baseline scenario. On average, state general revenues (e.g. taxes) would have to rise more than 7 percent (Exhibit 7), per-citizen non-Medicaid spending would have to fall by 2 percent (Exhibit 8), or per-beneficiary Medicaid spending would have to fall by more than 32 percent (Exhibit 9).[1] In each case the magnitude of policy change needed to balance the budget varies greatly across the states

Bear in mind that the baselines used in these projections are from the 2008 to 2010 trailing period, during which states were already raising tax rates, cutting non-Medicaid spending, and/or cutting Medicaid – thus the baseline scenario in the analysis assumes that revenue raising and cost-cutting actions continue at the present rate. Even this continued high level of effort plainly is insufficient, which demonstrates that these states must intensify their revenue raising and/or cost-cutting actions in FY 2012. Also recall that the need for states to address Medicaid per-beneficiary spending is magnified by the expiry of enhanced federal matching which, on average, increases states’ share of per-beneficiary spending by roughly 25% in FY 2012 relative to FY 2011

Thus it’s very clear that states are faced with a ramping of budget pressures, that Medicaid spending is a major moving part of these pressures, and that states’ efforts to reduce Medicaid spending are likely to intensify. Yet states’ options for Medicaid savings are limited, not least because states must cover certain benefits for certain populations in order to qualify for matching federal funds. Many states’ programs are more generous than the federal minimums, however states’ have practically zero ability to roll back eligibility to the federal minimums: clauses in both American Recovery and Reinvestment Act of 2009 (ARRA) and Patient Protection and Affordable Care Act (ACA) require states to maintain eligibility at 2008 levels in order to qualify for enhanced federal matching. Being unable to reduce eligibility, states are left with two options: reduce or eliminate the optional benefits that eligible beneficiaries receive, and reduce the cost of producing a given amount of care. About

40 percent of Medicaid spending falls into categories that can be optional (Exhibit 10); however, whether a given category of spending is in fact optional depends on the beneficiary in question – e.g. less than 1 percent of benefit spending for children is optional, but more than 45 percent of spending on adults is optional. All in, we estimate that less than a third of Medicaid spending can be categorized as optional in a legal sense. As a practical matter, optional spending is further reduced by the fact that some ‘legally optional’ categories are essential in a health economic sense – for example prescription drug spending is the largest single optional category, but eliminating the drug benefit almost certainly would result in higher total costs as untreated patients arrived in need of more expensive care in more expensive settings. States have already gone quite far down the path of reducing or eliminating optional benefits: for example dental, vision, chiropractic, podiatric, mental health and acupuncture all have

been heavily affected

In addition to reducing the scope and generosity of optional benefits, states have also been working to reduce the cost of providing a given amount of care – more crudely, states are cutting prices. This has been especially true for providers (Exhibit 11), and among providers, for hospitals (Exhibit 12). States are generally free to set Medicaid payment rates to providers, subject only to the threat of providers refusing to see patients. Hospitals – especially not-for-profits – cannot make such a threat; not-for-profit hospitals are required to see Medicaid patients as a condition of maintaining their tax status. In contrast physicians can refuse to see Medicaid patients, thus payment rates to hospitals fall faster than to

physicians. Hospital payment rates have been pressed fairly far as evidenced by the near-trough ratio of Medicaid to commercial payment; though hospitals’ aggregate operating margins remain relatively healthy versus history (Exhibits 13, 14) We expect states to reduce payment rates to hospitals further, perhaps at an accelerated pace – and in fact, we know that as governors have submitted their 2012 budgets, reduced Medicaid payments to hospitals have featured prominently in, e.g., FL, IL, TX, VA, AZ, PA, MD. Exhibit 15 shows the exposure of the publicly-traded hospitals to Medicaid; on average these hospitals are less exposed than the not-for-profits, and the range of exposure is more than two fold

Summary and Conclusions

Despite slowly improving economic conditions, we expect states to face more fiscal pressures in FY2012 than in FY2011, largely because of the expiry of federal subsidies associated with ARRA, coupled with reduced general fund and rainy-day fund balances

States’ responsibility for per-beneficiary Medicaid costs jumps roughly 25% on average; to balance FY 2012 budgets states must grow general revenues faster than projected FY2012 GDP (i.e. increase tax rates), reduce non-Medicaid per-citizen spend, sharply reduce Medicaid per-beneficiary spend, or some combination of these

Because of Medicaid’s prominence in state budgets, further Medicaid cuts are near certain; and, because more savings are required in FY2012 than FY2011, we expect Medicaid cuts to accelerate

States cannot reduce eligibility, and are only narrowly able to reduce the benefits provided to those eligible, as most easy reductions have already been taken. Accordingly, states must focus more on reducing the cost of benefits provided. This puts hospitals squarely in the crosshairs; unlike physicians, not-for-profit hospitals cannot refuse to see Medicaid patients, thus states are able to reduce hospital payment rates more aggressively

To our minds the question of whether the HHS Secretary follows through on publishing a survey of generic acquisition costs must be set against the backdrop of state fiscal pressures generally, and Medicaid drug cost pressures specifically. Outsized generic dispensing margins are a well established feature of Medicaid drug benefits, and thus an obvious source of savings – so we fully expect the Secretary to carry through with making generic acquisition costs public, whether via survey, or via direct publication as called for by ACA. Further, we expect savings-hungry state Medicaid directors to make full use of these acquisition costs, immediately obviating the need for AWP in state re-imbursement schemes. States’ appetite for useful acquisition cost data increases the odds that such useful data are made available on a reliably permanent basis; as these data are far more beneficial to commercial plan sponsors than AWP, we expect commercial plan sponsors to insist on generic acquisition cost as a benchmark in commercial contracts, eventually obviating the need for AWP entirely. This almost certainly narrows margins for the drug trades; PBMs would be most adversely affected, followed by retailers, followed by drug wholesalers

Intuitively, we want to favor Medicaid managed care companies on an expectation of accelerating state Medicaid cost pressures. Medicaid managed care plans are responsible for a relatively small percent of total Medicaid payments (19.4% in 2009), despite having a very large percentage of total Medicaid enrollees (71.7%, again in 2009). This because the elderly and disabled tend not to be enrolled in Medicaid managed care, despite driving a disproportionate share of overall Medicaid costs. Thus the question of whether an acceleration of state Medicaid pressures drives business to Medicaid managed care companies becomes one of whether these companies can quickly address utilization among the elderly and disabled. We suspect the immediate answer is no: first, it’s unclear whether case management of the elderly and disabled has been able to reduce costs; second, the broader trend of moving patients out of nursing homes and into home- and community- based care settings is the bigger focus. Thus despite the intuitive appeal of being long Medicaid managed care into an acceleration of state Medicaid cost pressures, we cannot make a solid link between these mounting cost pressures and Medicaid managed care earnings expectations

  1. The required cuts in Medicaid spend per beneficiary are largely a function of the reduction in FMAP between 2010-2012. Keep in mind that for a state to save $1 in its net Medicaid spending it must cut at least $2 in benefits, after accounting for the federal contribution. This leverage effect clearly makes increasing benefits comparably cheap (as only half the costs are borne by the state), but reducing benefits costly (only half the savings are retained by the state).
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