Analysis of the 2005-06 Budget Bill Legislative Analyst's Office February 2005

Medi-Cal (4260)

Overview of Medi-Cal Budget Proposal

The DHS budget proposes Medi-Cal expenditures totaling $34 billion from all funds for state operations and local assistance in 2005-06. The General Fund portion of this spending ($13.1 billion) increases by about $1 billion, or 8.2 percent, compared with estimated General Fund spending in the current year. The remaining expenditures for the program are mostly federal funds, which are budgeted at $19 billion, or 2.3 percent less than estimated to be received in the current year.

Figure 1 displays a summary of Medi-Cal General Fund expenditures in the DHS budget for the past, current, and budget years. The budget estimates that the General Fund share of Medi-Cal local assistance costs for the budget year will increase by about $984 million, or about 8.2 percent, compared with 2004-05. The bulk of this increase is for benefit costs, which will total an estimated $12 billion in 2005-06. The majority of the overall increase in General Fund spending results from (1) payments proposed for health care providers that will be offset by fees assessed on those providers, which are not included here; and (2) cost increases that occur because certain one-time savings actions taken in 2004-05 will not reappear in 2005-06. After adjusting for these effects, the underlying growth in General Fund expenditures for Medi-Cal caseload and costs is projected to be about $350 million, or 2.9 percent, in 2004-05.

The spending total for the Medi-Cal budget includes an estimated $1.9 billion in local government funds for payments to DSH hospitals. About $4.6 billion of total Medi-Cal spending consists of funds budgeted for programs operated by other departments, counties, and the University of California.

Key Changes in Current-Year Spending

Modest Surplus Projected. The Governor's budget projects a $58 million General Fund surplus in the current year relative to funds budgeted by the 2004-05 Budget Act and Chapter 875, Statutes of 2004 (AB 1629, Frommer). Lower-than-expected caseload for certain managed care plans known as County Organized Health Systems has decreased projected spending by $66 million General Fund, and the Governor's proposed use of Proposition 99 tobacco funds is expected to additionally reduce spending by $54 million General Fund.

Unanticipated delays in obtaining federal approval of "quality improvement fees" that are to be imposed on Medi-Cal managed care plans also contributes to the projected budget surplus in the current year. The delay means a reduction in Medi-Cal expenditures of $79 million General Fund due to the postponement of rate increases that had been budgeted to take effect for these providers in the current year. While the state Medi-Cal budget reflects these savings, we note that there is also a corresponding loss of state revenue related to the postponed imposition of those fees. (As we discuss later in this analysis, the administration now projects that both the rate increases and the fee revenues will take effect in the budget year.)

These and other lowered budget projections more than offset other changes that would increase General Fund expenditures, such as reduced savings estimates associated with antifraud efforts.

Governor's 2005-06 Budget Proposals

The Governor's proposed budget estimates that total General Fund spending for Medi-Cal local assistance will be $12.9 billion in 2005-06, a net increase of about $1 billion, or 8.2 percent, above the estimated spending in the current year. As summarized in the "Health and Social Services Overview" of this chapter of the Analysis, the spending plan proposes a number of significant adjustments and policy changes that are reflected in the budget year totals:

• Baseline Estimates. The budget plan reflects a proposed $381 million increase in expenditures for "baseline" costs—those unrelated to any change in state policy—due to estimated increases in caseload, costs, and utilization of services by aged, blind, and disabled beneficiaries. An additional $93 million was added to the budget for projected increases in baseline spending for caseload, costs, and utilization of services for families and children.
• Quality Improvement Fees. The proposed 2005-06 budget includes General Fund costs totaling $429 million for rate increases granted to both managed care plans and skilled nursing facilities that are to be offset by new revenue from quality improvement fees assessed on these providers. The Governor's budget projects that these revenues will result in a net gain to the state of $35 million General Fund in the budget year.
• Reversal of Savings From Checkwrite Delays. The estimated 2004-05 budget includes savings of $302 million General Fund generated by delaying the weekly Medi-Cal checkwrite one week on two separate occasions. These savings will not reoccur in 2005-06, and therefore these costs must be added back into the budget.
• Prenatal Care Funding Shift. The Governor's budget proposes to claim increased federal funds for prenatal care by providing these services to undocumented immigrants through the State Children's Health Insurance Program, which receives 65 percent federal funding, rather than through the current state-only program. This change is expected to result in $191 million in General Fund savings in Medi-Cal.
• Onetime Gain From Federal Medicare Reform. The recent federal Medicare Modernization Act, which we discuss in more detail later in this Analysis, is expected to shift prescription drug coverage for eligible Medi-Cal beneficiaries to the federal Medicare program effective January 1, 2006. The Governor's budget projects that, as a result of certain one-time factors, this shift in coverage will generate net Medi-Cal savings of about $100 million General Fund for 2005-06. However, the administration estimates that the new federal law will result in net General Fund costs to Medi-Cal beginning in 2006-07 and continuing for at least the next several years.
• Medicare Premiums. The Medi-Cal Program pays the Medicare premiums for Medi-Cal beneficiaries who also are eligible for Medicare, thereby obtaining 100 percent federal funding for those services covered by Medicare. The budget estimates that the General Fund cost of these so-called "buy-in" payments will increase by $156 million in 2005-06 due primarily to increases in Medicare premiums.
• Cost-Cutting Actions for Pharmaceuticals. The state's increasing costs for prescription drugs would be partly offset in the 2005-06 budget plan with an expected increase in savings from pharmacy reimbursement reductions initially implemented in the current year as well as efforts to increase the rebates on drugs paid by drug manufacturers. Together these actions are expected to generate $94 million in additional General Fund savings in 2005-06.
• Specialty Mental Health Services. The DHS Medi-Cal budget includes costs for some programs that are primarily administered by other state departments. Notably, General Fund expenditures for specialty mental health services provided under the Early and Periodic Screening, Diagnosis and Treatment Program administered by the Department of Mental Health are projected to increase by about $43 million due to increases in both caseload and program costs.
• Medi-Cal Redesign Efforts. As part of the Governor's proposal to redesign Medi-Cal, the 2005-06 budget proposal includes estimated savings of $25 million from a $1,000 annual limit on dental services provided to adults. Other reform proposals would initially add administrative costs to the Medi-Cal Program. Other components include expansion of managed care, the imposition of new premiums for higher-income beneficiaries, and restructuring of hospital revenue streams. We discuss these and other components of the Medi-Cal reform plan later in this analysis.

Budget Forecasts Increased Caseload and Costs

While the administration's overall Medi-Cal caseload projection is reasonable, we believe that the population component of nonwelfare families and children could be significantly higher or lower than budgeted due to the contradictory effects of various policy changes. We will monitor caseload trends and recommend appropriate adjustments at the time of the May Revision.

Administration's Cost and Caseload Projections. The budget projects that both the average monthly caseload of individuals eligible for Medi-Cal and the cost of benefits per eligible will grow in the current and budget years. The Governor's budget plan estimates caseload growth to be about 1 percent in 2004-05 and about 3 percent in 2005-06. The estimate for the current year is somewhat less than the overall estimated growth of California's population, while the Governor's estimated growth rate for the budget year is projected to somewhat exceed the overall state population growth rate.

The cost of benefits per eligible (excluding pass-through funding to other departments and local governments) would increase by about 4 percent in the current year according to the Governor's budget plan, and further increase by about 10 percent in the budget year. These increases can be partly attributed to higher rates for nursing facilities and managed care plans, and to the effect of one-time savings actions that reduced costs in previous years but do not recur.

Most Growth Among Nonwelfare Families. Figure 2 shows the budget's forecast for the Medi-Cal caseload in the current year and 2005-06. The majority of the projected Medi-Cal caseload increase occurs in the families and children eligibility categories. The budget plan estimates that the caseload for this group will increase by 3 percent in the current year and an additional 2 percent in the budget year. Within this category, nonwelfare families account for most of the changes. The budget estimates that the caseload of Medi-Cal eligible nonwelfare families will increase by about 8 percent in the current year and by an additional 5 percent in the budget year.

Some of the projected current-year and budget-year growth in the nonwelfare families and children caseload is the result of the continued implementation of a "gateway" in the Child Health and Disability Prevention (CHDP) program. The Governor's budget estimates that efforts to expedite the enrollment of CHDP children into more comprehensive health care coverage will result in the addition of nearly 134,000 eligibles to the Medi-Cal Program over the current and budget years.

The overall projection of nonwelfare families and children caseload growth is consistent with past trends. However, the effect of ongoing changes in the Medi-Cal Program is hard to predict, and significant revisions to the projection could occur for various reasons. For example, Medi-Cal enrollment from the CHDP gateway is now projected to grow by less than anticipated in the 2004-05 budget. The budget year caseload could also be lower than projected. The continued implementation of modifications of eligibility determination procedures approved in recent budgets, which were intended to more quickly identify and disenroll individuals who become ineligible for Medi-Cal, also adds uncertainty to the 2005-06 budget projection.

The same is true for a 2005-06 budget proposal to modify eligibility for CalWORKs. One major effect of such a change would be to shift some existing Medi-Cal beneficiaries from one eligibility category to another, but the implementation of such a change could have additional, unknown effects on the future growth rate of the Medi-Cal caseload.

Significant Growth in Medically Needy Aged and Disabled. Caseloads for the aged, blind, and disabled are expected to grow by about 45,000 beneficiaries or about 3 percent in the current year and by an additional 53,000 beneficiaries or about 3 percent in the budget year. The increase in the current year is consistent with underlying caseload growth trends. Caseload increases for the aged and disabled are being driven primarily by those aged and disabled individuals who qualify as medically needy. (The medically needy category includes those who do not quality for, or choose not to participate in, Supplemental Security Income/State Supplementary Program (SSI/SSP), such as low-income noncitizens or individuals who must pay a certain amount of medical costs themselves before Medi-Cal begins to pay for their care.) The aged caseload in this eligibility category is expected to grow by about 20,000 or 11 percent in 2005-06, and the disabled caseload is expected to grow by about 9,600 or 10 percent. The public assistance and long-term care eligibility categories for the aged, blind, and disabled all are projected to grow by less than 2 percent in 2005-06.

Analyst's Recommendations. Our analysis indicates that the Governor's budget request is reasonable and is generally in line with available Medi-Cal caseload data. Accordingly, we recommend approval of the budget request. However, we note that there is both upside and downside risk to the budget estimate as presented. While it is possible that the CHDP gateway program will result in fewer eligibles than assumed in the Governor's budget plan, it is also possible that recently enacted revisions to eligibility determination procedures will not reduce caseload by as much as the Governor's budget has estimated. Given this situation, we will continue to monitor Medi-Cal caseload trends and will recommend any appropriate adjustments to the budget estimate at the time of the May Revision.

Quality Improvement Fees

Fee Revenues Not Recognized in Governor's Budget.

Our analysis indicates that about $294 million in revenues from so-called quality improvement fees that have been imposed on certain classes of health care providers have not been counted as state revenues in the Governor's budget. We recommend that the Legislature recognize these fee revenues as it drafts its budget plan.

Quality Improvement Fees. Federal Medicaid law permits states to impose quality improvement fees on certain health care service providers and, in turn, offset the increased cost to the providers from the fee through increased reimbursements. (We discussed in detail how such fees can be imposed, and their potential benefit to the state, in the "Crosscutting Issues" section of the Health and Social Services chapter of the Analysis of the 2004-05 Budget Bill.) The revenues from these fees are to be deposited into the state General Fund.

The Legislature has approved and the state has fully implemented with federal approval a quality improvement fee for Intermediate Care Facilities for the Developmentally Disabled (ICF/DDs). With the further approval of the Legislature, the state is currently in the process of seeking federal approval to implement a separate quality improvement fee on Medi-Cal managed care plans as well as another fee affecting nursing homes which serve Medi-Cal patients.

Implementation of such fees can be a lengthy process because it generally involves seeking federal approval of a Medicaid State Plan amendment, a federal waiver of Medicaid law, or both. As a result, implementation of the fee for Medi-Cal managed care plans has previously been delayed, and under the Governor's 2005-06 budget plan would be further delayed until July 2005. Our analysis suggests that it is a reasonable assumption that the new fee finally will be implemented on that projected date, and that it is appropriate that the budget plan presented by the Governor assumes that the associated revenues will be deposited in the General Fund during 2005-06. We note that the Bush administration has recently proposed to limit these types of fees and change how they are applied.

Budget Plan Does Not Account for All Fee Revenues. The schedule of estimated state revenues for the Governor's budget plan reflects an assumption of $120 million in collections of the nursing home fees in the current fiscal year and an additional $257 million in the budget year. However, a review of state revenue projections indicates that the revenues from the quality improvement fees for ICF-DDs and Medi-Cal managed care plans have not been included in the schedule of revenues for the Governor's budget plan. That means that General Fund revenues are currently understated in his budget plan by a combined total of $294 million for the current and budget years.

Analyst's Recommendation. We recommend that the Legislature recognize in its budget plan (1) the $58 million in fee revenue projected to result from the quality improvement fee on ICF/DDs in the current year, (2) $29 million more from the ICF/DD fee expected in the budget year, and (3) $207 million expected from the fee for Medi-Cal managed care plans anticipated in the budget year. We will continue to monitor DHS' progress towards implementing the fees and recommend any appropriate budget adjustments.

Redesign Sound in Principle, But Needs Further Development

The 2005-06 Governor's budget plan includes a package of seven proposals intended to redesign the Medi-Cal program. The proposal would result in broad changes in Medi-Cal managed care and hospital financing as well as some limited changes in benefits, cost-sharing, and eligibility administration. Overall, we find that the Governor's proposals are conceptually sound but that the Legislature needs more information about some aspects of the package and some refinements of the proposals are warranted. (Reduce Item 4260-001-0001 by $602,000.)

A Multifaceted Medi-Cal Redesign Plan

In January 2004, the administration outlined a broad concept for redesign of the Medi-Cal Program and indicated that most of the detailed legislative and budget proposals to implement the proposal would be forthcoming. After a couple of postponements, the Governor's 2005-06 budget plan presents a package of seven proposals to redesign the program. The administration indicates that the purpose of its proposal is to maintain health care coverage for eligible Californians while containing state costs and making the program more efficient.

We summarize below the major components of the Governor's Medi-Cal redesign proposal, along with the administration's estimate of their annual net fiscal effect on the General Fund after they have been fully implemented:

• Expand Medi-Cal Managed Care. Enroll additional individuals who currently receive services through the fee-for-service system (which we explain later in this analysis) into managed care health plans or acute and long-term care integration projects in selected counties. Estimated savings: $85 million.
• Restructure Hospital Payment System. Stabilize the financing of "safety-net" hospitals through a comprehensive restructuring of the manner in which Medi-Cal pays for hospital services. Estimated cost: $1 million.
• Set Dental Benefit Limit for Adults. Modify the Medi-Cal dental benefit by capping dental benefit expenditures to $1,000 annually for certain adults. Estimated savings: $26 million.
• Establish Enrollee Premiums. Impose beneficiary cost-sharing through monthly premiums for certain individuals with incomes above 100 percent of the federal poverty level (FPL) and for aged and disabled individuals with incomes above the level needed to enroll in SSI/SSP. Estimated savings: $22 million.
• Streamline Eligibility Processing for Children. Modify the Medi-Cal eligibility determination process for children whose applications are submitted through the Healthy Families Program vendor, known as the "single point of entry." Estimated savings: $7 million.
• Monitor County Administration. Monitor county compliance with federal and state performance standards pertaining to initial eligibility determinations and annual redeterminations. Estimated cost: $2 million.
• Alter Enrollment for Health Care Providers. Improve the provider enrollment process. (Details of this proposal will not be available until spring 2005). Estimated cost or savings: Unknown.

Redesign Will Take Years to Fully Implement. Compared to the broad concepts for Medi-Cal redesign outlined in the 2004-05 Governor's Budget, the new proposal is more limited. Earlier concepts contemplated the establishment of broad tiers of beneficiaries who would pay varying copayments and premiums for different benefit packages. Other previously discussed concepts have also been dropped from the plan.

Nevertheless, the administration estimates that its current proposal for Medi-Cal redesign would take several years to implement fully. That is because some proposals would require approval by federal authorities, the development of new or modified information technology systems, and hiring and training of new departmental staff.

Below, we separately discuss each of the major components of the redesign package, and then comment on the proposal as a whole. We separately discuss the financial problems facing California hospitals, and how they would be addressed by the component of Medi-Cal redesign involving hospital finances, later in this analysis.

Managed Care Expansion

Overall, we find that the Medi-Cal redesign proposal to expand managed care is conceptually sound and that the projected state savings from these changes are achievable and may even be understated. However, we recommend that the Department of Health Services provide the Legislature with more detail about how it plans to strengthen the existing managed care system and ensure a smooth transition of beneficiaries into managed care in order to fully evaluate its merit.

Three Major Components

The box (see next page) provides a description of the existing fee-for-service and managed care systems of care for Medi-Cal beneficiaries. The Medi-Cal redesign plan has three major components relating to an expansion of managed care: (1) a geographic expansion of managed care into new counties, (2) a shift of a significant portion of the Medi-Cal caseload from fee-for-service into managed care in both existing and new locations, and (3) projects to integrate long-term care services for enrollees in three counties. A number of the changes proposed by the administration require federal approval, or changes in state law and regulations, or both. A more detailed explanation of these proposals is below.

Geographic Expansion. The budget plan proposes to expand managed care into 13 or 14 counties in addition to the 22 where it is already provided. The COHS model would be expanded into six or possibly seven of these counties and the GMC model would be expanded into six or seven of these counties. The remaining counties would continue to provide Medi-Cal services under the fee-for-service model. A caseload of about 262,000 families and children would be affected by these changes.

Shifts of Aged and Disabled Beneficiaries. The redesign proposal would mandate enrollment into managed care for aged or disabled in the 13 or 14 expansion counties and the 14 counties where managed care is already an option but where the aged and disabled are not currently required to participate in managed care. Eventually, this would result in a shift in the source of care for about 554,000 individuals. Some aged and disabled would be excluded from mandatory enrollment into managed care. For example, the Two-Plan and GMC plans would exclude so-called "dual eligibles" who are also enrolled in Medicare.

Expanding Options for Long-Term Care. The redesign proposal includes the development and implementation of Acute and Long-Term Care Integration plans in San Diego, Orange, and Contra Costa Counties. The plans would provide all Medi-Cal and Medicare services to enrolled individuals, including primary care, acute care, drugs, nursing facility care, and home and community-based services. Enrollment of the aged or disabled in the plans would be mandatory. San Diego and Contra Costa County enrollees would have the option of choosing from among two or more plans. In Orange County, the plan would be administered by the existing COHS. It is unknown at this time how many Medi-Cal beneficiaries would participate in these plans.

Combined Fiscal Impact of All Three Components. No state savings are assumed in the budget year from the expansion of managed care as only planning for these changes will occur in 2005-06. Savings would begin to accrue in 2006-07 as new enrollees were placed into managed care and others were phased in upon their annual eligibility redeterminations. The administration estimates that by 2008-09, the proposed expansion of managed care would result in General Fund savings of approximately $89 million ($177 million all funds).

Assessing the Governor's Proposal

The Advantages of Managed Care. Our analysis has found that, if implemented well, managed care has the potential to both improve health care outcomes for beneficiaries while reducing costs for the state. Managed care provides beneficiaries with a primary care physician who has access to each patient's medical history and better coordinates their health care. Preventative care and better overall access to care become more likely. Beneficiaries are ensured access to a network of primary care physicians and specialists. The DHS conducts reviews annually to measure the quality of services provided by health plans; no such reviews take place for Medi-Cal fee-for-service care. These changes can save the state money by preventing health problems and reducing the expensive hospitalization of patients.

Some Key Strategies Included, Others May Be Missing. In a policy report released by our office in March 2004, Better Care Reduces Health Care Costs for Aged and Disabled Persons, we provided a "blueprint" for expanding managed care that included key strategies to ensure a smooth transition of the aged and disabled into a managed care setting. Our analysis indicates that the administration's redesign proposal incorporates a number of these strategies, which are primarily intended to make sure that conditions are right for a shift of beneficiaries to managed care before such a shift occurs.

The DHS indicates that it intends to conduct "readiness reviews" of all new Medi-Cal managed care plans prior to these health plans becoming operational. For example, DHS would ensure that networks of doctors and other medical providers are adequate to meet patients' medical needs, that care is coordinated for consumers who need specialized services, and that the quality of services is monitored. The DHS also indicates that it will research the "lessons learned" from similar enrollments in other states, and identify "best practices" for providing managed care for the aged and disabled based on the experiences of the COHS plans.

Our report outlined needed improvements in the existing managed care system that should be part of any major expansion. Among other improvements, we recommended that DHS ensure that the data collection system the state uses to monitor managed care is working effectively, and that DHS develop quality indicators for the aged and disabled. However, during our review of the redesign proposal we were unable to determine what steps DHS would take to improve the existing managed care data collection systems or the capitation rate-setting process. Nor is it clear what new indicators will be implemented to measure the quality of care of aged and disabled persons. Generally, it appears that the redesign proposal intends to address these issues. However, until further detail is forthcoming, the Legislature will not be in a position to determine whether this is the case.

Savings Estimate Appears to Be Conservative. The administration estimates that expansion of managed care would result in net savings of $89 million for the General Fund by 2008-09. Our analysis indicates that these estimates are achievable and may understate the potential savings. The administration estimate is based on an assumption of 5 percent savings relative to estimated fee-for-service expenditures. However, additional savings could result from improved coordination of care and a greater emphasis on preventative care that could reduce expensive hospitalizations. The amount of these additional state savings is unknown, but could be in the low tens of millions annually.

Expansion of Managed Care Could Go Further. The Governor's redesign plan does not propose to expand managed care in any form to most rural counties, effectively leaving Medi-Cal beneficiaries in the fee-for-service system.

In a report titled HMOs and Rural California, released in August 2002, we examined the reasons for the withdrawal of health plans from California's rural areas, a situation that poses a major barrier to any expansion of Medi-Cal managed care to these communities. We recommended a number of steps to create a more attractive health care marketplace for health plans in these areas, and state assistance to rural counties to establish locally controlled health care systems that could have some of the benefits of managed care.

Analyst's Recommendations

In concept, we support the Governor's proposal to expand managed care, given its potential to both achieve state savings and to improve the quality and access to care in Medi-Cal. We note that the shift of beneficiaries to managed care could be impractical without successful implementation of another significant proposal in the redesign package—hospital payment restructuring—for reasons that we will explain later in this analysis. In any event, the Legislature should await more detailed information from DHS before it acts on the budget request and legislative changes that are proposed to carry out this component of the Governor's plan. Specifically, DHS should advise the Legislature on how it will strengthen the existing managed care system and what other measures it will take to ensure a smooth and successful transition of beneficiaries into managed care.

We further recommend that the Legislature explore other steps it could take at this time to make managed care an option in the future for Medi-Cal beneficiaries in rural counties. Some steps may not be possible to accomplish now because of their costs. However, others, such as enactment of a statutory model for locally controlled health plans or clarification of antitrust regulations in rural areas, have little cost and could move ahead.

Limitations on Adult Dental Benefits

We recommend that the Legislature defer action on the administration's proposal to limit adult dental benefits and direct the Department of Health Services to provide additional information on the proposed limit's potential impact on beneficiaries.

Annual Spending Cap Proposed for Adults

The Medi-Cal redesign proposal would establish an annual limit of $1,000 for certain dental services provided to adult Medi-Cal enrollees. In addition to excluding all children's dental benefits from this limit, this restriction would not apply to certain other dental services for adults, such as emergency services or services provided in hospitals. The DHS estimates that about 95,000 Medi-Cal adult enrollees would be affected by the limit (including 54,000 aged, blind, or disabled eligibles) and that it would result in net General Fund savings of about $26 million ($51 million all funds).

Assessing the Governor's Proposal

Proposal Seeks to Imitate Private Insurance. The administration's proposal seeks to more closely align Medi-Cal benefits with those offered by private dental insurance coverage, although the amount of the cap would differ from private sector coverage. Delta Dental, a private insurer that accounts for a majority of the private dental insurance market in California, limits benefits to $2,000 annually for its coverage for state workers. The DHS contends the proposed Medi-Cal limit is roughly equivalent to Delta's because Medi-Cal pays substantially lower rates to dentists, allowing the program to obtain dental services similar to private plans with a lower spending limit.

In concept, imposing a limit to contain Medi-Cal Program costs makes sense. The proposed limit would affect a relatively small group—about 3 percent of adult beneficiaries. While all Medi-Cal recipients have dental benefits, as many as 44 percent of Californians are estimated to have no dental coverage. For many, direct payment for basic dental services is viewed as a less expensive option than paying for insurance. The administration proposal could be implemented fairly easily in comparison to other Medi-Cal redesign components.

Some Complications Could Arise. The specific approach proposed by the administration raises some concerns. Some procedures such as root canals and tooth restorations that are commonly performed together could put Medi-Cal patients over their annual limit. The DHS has not provided information regarding how these proposed limits would affect dental services for the 95,000 affected beneficiaries. For example, it is possible that all 95,000 would lose a similar, moderate number of services each year under the proposed limit. However, another scenario could be that a small portion of the 95,000 would lose a significant number of services, while the rest would see only a modest reduction in services. Alternative approaches could provide Medi-Cal patients greater flexibility in use of their dental benefits while offering the state some significant savings. For example, a higher dollar limit established over a longer period of time (such as two years) could provide some savings while permitting more one-time procedures such as dentures that would exceed a lower limit.

Dental Managed Care Option. In addition to the administration proposal, or as an alternative, the Legislature could explore the concept of expanding dental managed care coverage for Medi-Cal beneficiaries. The state now provides dental services through capitated arrangements for beneficiaries in some areas. One study suggests that dental managed care plans both improve care and reduce state costs below the amounts paid for dental services on a fee-for-service basis.

Analyst's Recommendations

We concur generally with the concept of tailoring the Medi-Cal dental benefit for adults to conform more closely to private coverage. However, we believe the administration should provide the Legislature with additional information on the proposal's impact on beneficiaries. Accordingly, we recommend that the Legislature direct DHS to present the Legislature with more information regarding how its proposed limit would affect the services of Medi-Cal beneficiaries. The DHS should also provide the Legislature with an estimate of the potential savings from alternative approaches, such as a higher two-year cap or an expansion of dental managed care plans, that might provide additional flexibility to beneficiaries while still achieving some state savings.

Establishment of Enrollee Premiums

Another Medi-Cal redesign component would charge certain enrollees monthly premiums to participate in the program. While we support the imposition of premiums in concept, we recommend that the Legislature defer action on the administration's proposal and direct the Department of Health Services to present it with updated projections on the caseload and fiscal effects of the proposal and an analysis of alternatives.

Monthly Premiums Would Be Similar to Healthy Families

Poorest Beneficiaries Would Be Exempt. Under the Governor's budget proposal, certain Medi-Cal enrollees would pay monthly premiums of $4 per month for a child and $10 per month for adults, with a monthly cap of $27 for each family. Individuals with incomes greater than the federal poverty level (about $15,700 a year for a family of three) would be required to pay the premiums, as would aged, blind, and disabled enrollees with incomes above the CalWORKs eligibility level (about $9,700 per year for individuals and about $17,100 per year for a couple). Certain individuals would be exempt from the premiums, including infants under one year of age, and Medi-Cal "share-of-cost" enrollees who must already pay out of their own pocket for some of their medical expenses before receiving Medi-Cal coverage.

These premiums would be generally consistent with those charged by the Healthy Families Program, which also provides health insurance coverage for children. Similar to Healthy Families, the newly established Medi-Cal premiums would not be charged for coverage provided retroactively. Enrollees could pay the premiums through the mail, over the phone, at certain collection points, or through automated payroll deductions and bank withdrawals, with discounts of about 25 percent for payment of three months in advance. Medi-Cal would disenroll beneficiaries who did not pay the premiums for two consecutive months.

Timetable for Changes. Under the Governor's budget plan, enrollees would not begin paying premiums until January 2007. In the interim, the state would obtain necessary federal approval, contract with a vendor to collect the premiums, and identify the Medi-Cal enrollees required to pay them. The administration estimates that about 460,000 children and nondisabled adults and 90,000 aged and disabled individuals would be subject to premiums and that the change would result in annual General Fund savings of about $22 million ($43 million all funds) beginning in 2007-08.

Assessing the Governor's Proposal

Enrollment Decrease, But Extent of Drop Unclear. Research on the effects of cost-sharing in health programs indicates that some decrease in enrollment is almost certain to result from the imposition of premiums in programs such as Medi-Cal. However, the extent of the enrollment drop, and which income groups would most be affected, is unclear. Academic research on these points has been contradictory, for example, in regard to whether cost-sharing strategies such as premiums have more of an effect on those families with higher incomes or those with lower incomes.

Oregon has been cited as an example of a state where such changes greatly depressed program enrollment. However, Oregon's Medicaid program imposed premiums on certain enrollees with incomes below the federal poverty level, including enrollees with no reported income at all, and individuals were removed from the program for just one month of nonpayment. Because the design of the Oregon program is different from the Governor's proposal, its results may not apply to California.

Administration Reviewing Its Estimates. When it prepared its premium proposal, the administration estimated that the proposed premiums would result in a 20 percent reduction in enrollment among the affected eligibility categories. However, the actual decline in utilization of medical services is expected to be substantially less because many enrollees would rejoin the program as they needed medical services. Even so, disenrollment effects would account for over one-third of the estimated gross savings. However, DHS now indicates that it is reviewing whether its estimates of disenrollment, and its associated savings, are too high. Thus, the caseload and fiscal effects of the administration proposal are unclear.

Cost-Sharing Proposal Reasonable. The establishment of premiums is a reasonable cost-containment option for the Legislature to consider. Notably, many enrollees who would be subject to premiums were not eligible at all for Medi-Cal until eligibility for the program was expanded about five years ago. Could these Medi-Cal beneficiaries afford to pay premiums? One recent study by the Kaiser Commission on Medicaid and the Uninsured indicates that low-income families typically spend 7 percent of their income on health care and a combined 22 percent on entertainment, apparel, and other miscellaneous items. The administration's proposed premiums would amount to between 1 percent and 2 percent of the enrollees' incomes.

Finally, some research has indicated that some individuals may prefer to enroll in health programs that have characteristics, such as premiums, that make them comparable to private insurance plans. For these enrollees, there might be less of the stigma than they may otherwise attach to participation in public health coverage.

Are Premiums the Best Approach to Cost-Sharing? It is not clear that the form of cost-sharing proposed by the administration would be the most effective way to hold down costs in the Medi-Cal Program. Premiums required for participation in Medi-Cal are more likely to reduce utilization for all types of services, potentially reducing the use of preventive medical services (like regular doctor's checkups) that could catch medical problems early and prevent more costly medical problems later. One alternative approach would be to seek a federal waiver to impose meaningful copayments for a targeted list of services, such as the nonemergency use of emergency rooms. However, we note that some attempts by other states to impose such copayments have been blocked in the courts. Nonetheless, the Kaiser Commission indicates that new or increased copayments were imposed by 20 states in fiscal years ending in 2004 and nine states in fiscal years ending in 2005.

Analyst's Recommendation

While we support the imposition of premiums in concept, we recommend that the Legislature defer action on the administration's proposal and direct DHS to present updated projections on the caseload and fiscal effects of the premium proposal, and DHS' analysis of the alternative of imposing copayments for a targeted list of services.

County Administration Monitoring

One component of Medi-Cal redesign requests additional resources to monitor county administration of eligibility. We recommend approval of part of the requested staff to monitor counties' performance. The Legislature could further consider requests for additional monitoring resources after the Department of Health Services has provided the Legislature with (1) an accounting of the progress that has been made to date in improving county eligibility activities and (2) the required report on the county operating guidelines.

Eligibility Determinations Have Been a Problem

Counties Handle Processing Work. The state currently delegates most administration for Medi-Cal eligibility determinations and redeterminations to the counties and reimburses them with state and federal funds for this work. Federal and state laws require the counties to complete initial eligibility determinations within 45 days of application and to annually redetermine enrollees' eligibility. The state has recently taken steps to improve the process, including the establishment of county performance standards for completing eligibility determinations and redeterminations, and the imposition of requirements that counties more regularly reconcile their eligibility rolls with the state's central eligibility system. The DHS is also working with counties to develop operating guidelines covering staffing levels, overhead, and wage increases to control costs while also enabling timely eligibility processing.

The administration proposes that the state contract with a vendor to monitor compliance with the state performance standards for counties that were established in 2003. In effect, DHS is asking for resources in the 2005-06 budget to perform activities for which it was previously granted staff. In the 2003-04 budget, the Legislature authorized nine new DHS positions for this purpose. However, DHS selected these positions and the related funding for elimination as part of that year's mandated statewide reductions in state operations.

The current Medi-Cal redesign proposal is estimated to cost $1.5 million from the General Fund ($3.4 million total funds) once fully implemented. No additional savings from the proposed monitoring effort are assumed beyond those previously budgeted.

Assessing the Governor's Proposal

An Inconsistent Process. As we noted in our Analysis of the 2003-04 Budget Bill (see page C-56), state costs for the county eligibility processing have increased rapidly since the mid-1990s. Counties have been inconsistent in the way they interpret eligibility rules, in what they spend on making eligibility determinations, and in the time they take to process applications. The state's method of allocating funding for eligibility administration, which is partly based on county staffing levels, does not assess county productivity and may actually reward inefficient counties. The 2003-04 Analysis discusses several options for improving the county eligibility determination process.

Proposal May Be Premature. The Medi-Cal redesign proposal may be premature in that it requests additional resources to improve county eligibility administration before the effects of current efforts are known. For example, DHS is now working with seven counties that reportedly failed to meet the state's new performance standards. Also, the DHS has not yet submitted to the Legislature, as required, a progress report on the operating guidelines for county eligibility offices. Thus, a full accounting of the improvements achieved to date from these prior actions has not yet been provided to the Legislature.

Analyst's Recommendation

Absent a full report on the status of current reform efforts, the administration proposal to provide funding for a vendor for a full statewide monitoring effort is not justified. Nonetheless, some limited monitoring on a targeted basis may be prudent given that DHS currently relies on self-reporting by counties on their performance. The Legislature may wish to consider providing resources to monitor the limited number of counties that process most Medi-Cal applications or that may have encountered problems carrying out these duties in the past. Accordingly, we recommend approval of four two-year limited-term positions to monitor selected counties' performance on an exploratory basis. The Legislature could consider requests for additional monitoring resources after DHS has provided (1) a complete accounting of the progress made to date in improving county eligibility activities and (2) the required report on the county operating guidelines.

Streamlining Children's Eligibility Processing

Another component of the proposed Medi-Cal redesign would modify the way the state processes applications for Medi-Cal received through its single point of entry program. We recommend that the Legislature approve this proposal and provide on a limited-term basis a portion of staffing requested.

Single Point of Entry System

Some Applications Forwarded to Counties. In 1999, the state implemented a single point of entry (SPE) to process Healthy Families applications and some Medi-Cal applications to improve coordination of the two programs. An SPE contractor reviews certain applications and makes an initial determination when an applicant appears to be eligible for Medi-Cal. The application is then forwarded to the individual's county of residence, where a county eligibility officer makes the final determination. The DHS estimates that 83,000 applications will be handled this way in 2005-06.

While the SPE provides a uniform, centralized process for receiving, processing, and tracking health program applications, some current practices result in delays and increased Medi-Cal costs. For example, after the SPE determines a child to be initially eligible for Medi-Cal, he or she is placed on the Medi-Cal rolls on an interim basis. If the county later finds that the child is actually ineligible for Medi-Cal, the child is removed from the Medi-Cal rolls. In the interim, however, the state will have paid medical costs for an ineligible child.

State Savings Possible. One component of the Medi-Cal redesign would expand the SPE's role in making Medi-Cal eligibility determinations. After making its initial eligibility determination, the SPE would complete income and immigration status verifications and prepare an eligibility recommendation for the state. State workers, rather than county eligibility offices, would then make the final determination. The case would still be forwarded to the county for ongoing case management and future redeterminations of eligibility.

The DHS estimates that this would reduce state costs by shortening the time during which ineligible children were enrolled in Medi-Cal and by reducing county administration costs. Once fully implemented, the proposal is estimated to generate net General Fund savings of about $7 million ($9 million all funds) annually. It could further benefit the state by allowing eligibility rules to be applied in a more consistent fashion. Adoption of this change would also provide an opportunity to evaluate a centralized process for broader use in Medi-Cal. In our 2003-04 Analysis, we recommended that the Legislature study such an approach. We estimated that a $50 drop per eligibility determination could result in $150 million in General Fund savings statewide.

Analyst's Recommendation

Given the significant problems in the existing system for processing applications for Medi-Cal, and the prospects for testing the merit of centralizing all eligibility processing at the statewide level, we recommend that the Legislature approve this proposal and provide a portion of the staffing requested on a limited-term basis.

Alter Enrollment of Health Care Providers

The administration's Medi-Cal redesign plan provides little information about a proposal to expedite the processing of medical providers so that they may participate in the Medi-Cal Program. We withhold recommendation until a complete proposal is submitted to the Legislature.

Backlog in Medi-Cal Provider Enrollments

Health care providers who wish to participate in the Medi-Cal Program must undergo an application process and be certified. The state performs background checks to ensure they are high-quality providers and to reduce the risk of provider fraud. Processing has slowed in recent years, however, leading to a backlog of these applications. The Medi-Cal redesign package includes a proposal to improve automation and tracking systems, establish a call center to answer provider questions, and hire additional state staff to address the backlog. Information explaining this proposal is to be submitted to the Legislature this spring.

Analyst's Recommendation

We recommend that DHS be directed to submit its proposal to the Legislature no later than April 1 (concurrent with April Finance letters) to provide sufficient time to evaluate this proposal. We withhold recommendation pending receipt and review of the proposal.

Requested Support Resources Appear Excessive

The Department of Health Services has requested $19,410,000 ($7,141,000 General Fund) and 86.5 positions to implement its Medi-Cal redesign proposals. These requests include funding for staff, information technology consulting services, and contract services. Our analysis indicates that some of the proposed positions and related funding are unnecessary at this time. As such, we recommend that the Legislature approve 68.5 of the requested positions and $5,847,000 ($2,391,000 General Fund) of the related funding.

Request for Personnel. Figure 3 summarizes the positions requested to implement the proposed Medi-Cal Redesign components. Our analysis indicates that some of the positions requested exceed the number which are justified on a workload basis at this time. In addition, some positions appear to be a modification of continuing DHS workload rather than a true increase in workload. Others are not likely to be needed until the redesign proposals reach later stages in their proposed implementation, or will no longer be needed once the transition period of making these changes is over.

Analyst's Recommendations. We recommend that the Legislature approve 39 permanent positions and 29.5 limited-term positions in order to implement the Medi-Cal redesign proposals, for General Fund savings of about $600,000 in 2005-06 from a reduction in the requested positions. Our findings and recommendations regarding the requested staffing are summarized as follows:

• Expand Medi-Cal Managed Care. The additional workload necessary to implement this proposal does not justify the establishment of all 47.5 requested positions. We recommend approval of 42 positions, four of which should be limited-term.
• Restructure Hospital Payment System. The workload for some of the requested positions would replace existing tasks rather than be new workload. Other requested positions would likely be needed only in transition to a new system. We recommend approval of five of the 12 requested positions, four of which should be limited-term.
• Dental Benefit Limit for Adults. We withhold recommendation at this time pending additional information from the administration.
• Establish Enrollee Premiums. We withhold recommendation at this time pending additional information from the administration.
• Streamline Eligibility Processing for Children. We believe that this proposal should be viewed as a pilot program, the results of which should be reviewed at a later date. Much of the proposed workload would not begin until DHS prepares to implement the proposed process in early 2006, and it is unclear that all requested positions are necessary. As such, we recommend approval of 17.5 limited-term positions, four of which should be effective beginning July 1, 2005. The remaining 13.5 positions should be authorized beginning January 1, 2006.
• Monitor County Administration. We believe it would be more efficient for state staff to perform the proposed monitoring on a targeted basis rather than contracting out this function. Also, it is unclear at this time that the proposed workload is necessary on a long-term basis. We recommend authorization of four limited-term positions to perform this work in lieu of the staff and contract resources requested.

We withhold recommendation at this time on the request for staff and contract resources to move forward with information technology (IT) projects related to the redesign efforts. As we discuss in our analysis of the DHS state operations budget, the IT-related budget request was submitted to the Legislature without following state administrative procedures that ordinarily require completion of an approved feasibility study report (FSR) before such a project can be budgeted. No FSR is available at this time for these projects.

Conclusion

The administration's redesign proposals warrant careful consideration by the Legislature, given our projections of continued caseload and expenditure growth in the Medi-Cal Program and the state's fiscal difficulties. The Governor's approach for long-term changes to Medi-Cal addresses some of the key factors affecting the quality of services and the continuing growth in the cost of the program to the state.

Except with respect to the proposed managed care expansion and restructuring of hospital finances, the administration's redesign proposal is relatively modest. For this reason, the Legislature may wish to view the package as a starting point to implement a broader reform of the program.

Hospital Financing Plan Could Begin To Right Ailing System

California's hospitals continue to face a variety of fiscal challenges that weigh particularly heavily on public hospitals. In response to continuing financial troubles for hospitals and recent federal steps to alter central aspects of federal funding provided for them, the administration is negotiating with the federal government for a comprehensive redesign of hospital financing. Our review of the plan now under development suggests that it could help preserve the financial stability of California's public hospitals, but the plan also raises some significant fiscal and policy issues.

Public Hospitals Continue to Face Significant Fiscal Pressures

Three major groups of hospitals account for almost all hospital revenue in California. The first group consists of investor-owned hospitals, such as Tenet Healthcare, which generally are shareholder-owned businesses. A second group is the nonprofit hospitals, which include organizations such as Sutter Health and Catholic Healthcare West. Public hospitals comprise the third group, which, for purposes of this discussion, consists of hospitals owned and operated by county governments or the University of California (UC). In our Analysis of the 2002-03 Budget Bill (see page C-38), we described various financial pressures facing California hospitals. Our analysis indicates that these problems continue today.

The cost of providing uncompensated care—which is incurred whenever a patient is unable to fully or even partially pay for their care—is a major factor that has created financial pressures for many hospitals. This is particularly the case for public hospitals that serve large numbers of low-income patients. State-collected data indicate that California hospitals collectively incurred more than $4.7 billion in uncompensated care costs during 2003. County hospitals experienced the largest increase in uncompensated care costs per hospital during the past five years, as shown in Figure 4, and today bear the greatest share of these costs, as shown in Figure 5.

Regulations mandating hospitals to staff one nurse for every six patients on general medical floors, and a state law requiring that hospital buildings meet specified earthquake-safety standards in the future, are also adding to financial problems.

Key Federal Mechanisms Significantly Influence Hospital Financing

The federal government closely regulates Medicaid transactions with hospitals through the federal Centers for Medicare and Medicaid Services (CMS), the main federal agency responsible for the Medicaid Program (Medi-Cal in California). Two financial mechanisms permitted under federal law have had particularly significant influence on California hospital operations in recent years: waivers and intergovernmental transfers. We provide more detailed information below on what these financial mechanisms are, how they work, and what they mean for California hospitals.

Federal Medicaid Waivers Integral to Hospital Financing

The federal government authorizes state governments to operate outside the standard Medicaid rules by approving requests by states to waive specific requirements of the federal program. Two such Medi-Cal waivers—the Selective Provider Contracting Program (SPCP) waiver and the Los Angeles County (LA County) demonstration project waiver—govern the majority of Medi-Cal fee-for-service hospital inpatient care in California. By fee-for-service care, we mean that the state reimburses a hospital or other medical provider on the basis of billings submitted for each service provided to a Medi-Cal patient. In comparison, managed care organizations operate under a "capitated" arrangement, in which they receive a predetermined level of compensation each month for agreeing to provide care for each Medi-Cal patient who enrolls in their plan.

Selective Provider Contracting Program. Under the SPCP waiver, the California Medical Assistance Commission (CMAC) negotiates daily rates for general acute care hospital inpatient services on behalf of the Medi-Cal Program. By picking and choosing the hospitals that get most of the state's Medi-Cal business, and bargaining with them for the best rates, the state is generally able to negotiate lower rates for hospital services through CMAC than if it simply allowed all hospitals to serve Medi-Cal patients and bill the state for services.

The SPCP waiver is now a central component of the Medi-Cal program. For example, in 2002-03 (the most recent year for which complete data are available), hospitals with SPCP contracts provided 2.2 million days of inpatient care, about 90 percent of all fee-for-service inpatient hospital days for Medi-Cal patients and 18 percent of all general short-term hospital inpatient days in California. The SPCP hospitals also received 84 percent of all money spent under Medi-Cal in 2002-03 for fee-for-service general hospital inpatient days.

The SPCP waiver is ordinarily subject to renewal by federal authorities every two years. Medi-Cal recently received a six-month extension for its current two-year SPCP waiver, which is now set to expire June 30, 2005.

LA County Demonstration Project. The current LA County waiver, which we discuss in more detail later in this Analysis, provides an alternate reimbursement mechanism for certain county health care providers in order to financially stabilize the county's safety net for indigent health care. Under the terms of the waiver, LA County will have received an extra $900 million in federal funds and an extra $150 million in state funds over five years. Specifically, Medi-Cal (using federal and state funds) reimburses 100 percent of "reasonable costs" for 30 health care providers in LA County, including six hospitals that collectively received $1.2 billion (total funds) in Medi-Cal payments during 2003. This five-year waiver—the second such demonstration project for LA County permitted by federal authorities—will expire June 30, 2005.

Intergovernmental Transfer Funding for Public Hospitals

Various Intergovernmental Transfers. California uses so-called "intergovernmental transfers," or IGTs, as a means to obtain additional federal funds for payments to both public and private hospitals. Under an IGT mechanism, public entities, including county and UC hospitals, transfer funds to the state, which then pays the money back to hospitals, along with the matching federal funds available under the Medicaid Program. Variations of this mechanism have been employed in California since the early 1990s. As shown in Figure 6, IGT arrangements typically result in net financial gains to both the state government and, typically, to the local entities that put up the local funds used to draw down federal matching funds.

Medi-Cal makes use of IGT funding for two key hospital funding programs:

• Disproportionate Share Hospital (DSH) Program. The state began the DSH program in 1991 to obtain federal funds through IGTs to supplement public and private hospitals that serve a particularly high share of Medi-Cal and other low-income individuals. The DSH funds help to offset hospitals' uncompensated care costs. A hospital's eligibility for DSH funding is determined annually according to federal requirements and is based on the percentage of Medi-Cal and other low-income patients the hospital serves relative to its total number of patients. State law allocates DSH funds based on the number of Medi-Cal inpatient service days provided by each hospital. In 2003-04, 126 California hospitals received $990 million in federal DSH funds. In keeping with federal statute, Congress has allocated about $1 billion annually in DSH funds for California in federal fiscal years 2004 (October 2003-September 2004) and 2005 (October 2004-September 2005).
• Senate Bill 1255 Program. The Emergency Services and Supplemental Payments Fund, commonly called the SB 1255 program, also relies upon an IGT funding mechanism. Under this program, hospitals negotiate supplemental payments with CMAC as part of their contracts to provide inpatient services to Medi-Cal patients. To be eligible for SB 1255 funds, hospitals must contract with Medi-Cal for inpatient services, qualify for DSH funding, and generally provide certain emergency care services. The state provided SB 1255 payments totaling about $1.7 billion (state and federal funds) to 82 hospitals in 2003-04.

Funding Sources Vary Among Hospitals. Different categories of hospitals vary widely in the degree to which they rely on Medi-Cal, DSH payments, and SB 1255 or other supplemental payments. As shown in Figure 7, county hospitals receive about three-quarters of their total revenue from these three sources, corresponding to their status as safety net health care providers. Nonprofit and investor-owned hospitals, meanwhile, rely to a much greater extent on the federal Medicare program (described in detail later in this Analysis), which generally pays higher reimbursement rates than Medi-Cal. Private insurance payments (included under "All Other" in Figure 7) also make up a higher share of revenue for these hospitals.

Federal Rules Establish Limits for Federal Funding

Federal regulations establish various payment ceilings on how much Medicaid programs can pay hospitals for inpatient and outpatient services. One such limit, the federal upper payment limit (UPL), generally limits payments for the services provided under Medi-Cal to the equivalent rate that Medicare would pay for the same services. The UPLs apply to each of three major hospital categories: (1) state-owned hospitals, principally the UC hospitals; (2) nonstate government hospitals; and (3) privately owned hospitals, including both nonprofit and investor-owned facilities. The UPLs apply to each category in the aggregate, a situation that has effectively caused county and UC hospitals to increasingly rely on supplemental payments in recent years.

The UPL does not apply to Medicaid DSH payments, but other federal rules do limit these payments. Federal statute establishes, on a statewide basis, the total amount of federal funds available under DSH. In addition, federal law limits the DSH payments that can be made to any particular hospital. In California, an exemption in federal statute sets the limit at 175 percent of a hospital's uncompensated care costs.

Market and Regulatory Factors Threaten Status Quo

Public Hospital Performance Worsening Under Current System. Our review of financial data for hospitals for 2003 (the most recent year for which data are available) indicates that disparities exist in the financial health of different types of hospitals. Public hospitals are not generally faring as well financially as other categories of hospitals, primarily because of their heavier costs for uncompensated care and greater reliance on state and county health programs.

Notably, on average public hospitals reported an operating margin of negative 25 percent in 2003 as compared to negative 19 percent in 2000. (A negative operating margin indicates an operating loss, which eligible hospitals often seek to offset using nonoperating revenue such as SB 1255 supplemental payments or DSH payments.) While the general financial condition of public hospitals worsened, the operating margin for nonprofit hospitals improved, rising from a negative 2 percent operating margin in 2000 to roughly the break-even point (neither an operating profit nor a loss) in 2003. Investor-owned hospitals reported significant improvement as a group, reporting a positive operating margin of nearly 11 percent by 2003, compared to a positive operating margin of 2 percent in 2000.

Federal Steps to Eliminate Key Aspects of Current System. Recent trends in federal policy indicate that states' continued use of the current system for financing their hospitals may be short-lived. Reports of abusive practices by some states in the use of IGTs, as well as federal budget pressures, have prompted CMS to take a more aggressive approach in examining and challenging states' IGT practices. Federal auditors have documented that some states structured their IGT transactions in a way that inflated the federal share of Medicaid costs without really spending state or county dollars to draw down the federal funds. In some cases, states used the extra federal Medicaid funds for purposes unrelated to health care.

In response, the federal government has taken steps in recent years to restrict the use of IGTs. For example, until 2001, CMS applied its calculations of the UPL only to all hospitals in the aggregate, giving states greater flexibility to transfer IGT funds among the hospitals within their state. Now, as noted above, a separate UPL applies to each of three hospital categories within each state. More recently, CMS has begun to systematically evaluate the appropriateness of IGT programs in each state. The CMS has identified possible cases of "recycling" (in which federal funds are inappropriately drawn down without a real state or local match) in 30 states.

Financing Plan Primarily Targets Public Hospitals

Background

Federal Negotiations Continuing. In November 2004, the administration publicly released a draft framework the Governor is considering to restructure public financing of all hospitals in California that contract with Medi-Cal. The 2005-06 Governor's Budget plan does not present any new details for this proposed arrangement because negotiations with federal authorities over the proposal are still in progress. As negotiations continue, the department has not yet submitted an official waiver application to CMS to implement the new system. The Governor's 2005-06 budget does not propose any funding changes for Medi-Cal local assistance related to the hospital finance redesign. (We discuss staffing changes related to the hospital proposal as part of our overall assessment of the Medi-Cal redesign package earlier in this chapter.) However, the DHS indicates that without implementing a new waiver for hospital financing, hospitals in California would lose as much as $900 million in annual federal funds following the expiration of the current waivers that affect hospital finances.

At the time this analysis was prepared, the administration had indicated that the November 2004 plan was still the basis for its negotiations with CMS. For this reason, our analysis below is based primarily on the information available on how the state's public hospital finances would change if the November 2004 draft plan were implemented.

The administration indicates that it will present the Legislature with an official proposal as soon as DHS obtains preliminary approval of its plan from CMS. State legislation would be required to implement many components of the proposal. Depending upon when federal approval of the DHS plan is forthcoming and when that plan is submitted to the Legislature, there may be little time for legislative review and action before the June 30, 2005 expiration of the state's existing waivers for hospital financing.

Overview of Governor's Plan

The Governor's plan to redesign hospital financing would eliminate General Fund support for county and UC hospitals and replace it with federal DSH funds taken from private hospitals. More specifically, county and UC authorities would use a new claiming process, referred to as certified public expenditures (CPEs), in place of General Fund resources to draw down federal Medi-Cal funds, federal supplemental funds, and all of the federal DSH funds available to California. Some of these funds could be used to provide care for indigent patients and undocumented immigrants. Private hospitals would receive the General Fund money now used for county and UC hospitals in exchange for the DSH funds the private hospitals would lose to those hospitals.

According to the administration the proposal would result in additional federal funds in three areas. First, overall General Fund support for private and public hospitals in total would remain the same, but the redirection of DSH funds from private to county and UC hospitals would allow for an increase of about $226 million per year in federal funds to California. Second, about $180 million per year in additional federal funding would be made available to pay for county or UC indigent care. Finally, up to $50 million in additional federal funds would become available to adjust hospital finances for inflation in medical costs each year, with the potential to negotiate further hospital rate increases with the federal government in the future. The total potential increase in federal funds received each year would initially be about $450 million, with later increases possible that would bring the total to $700 million a year.

The proposed new financing structure seeks to cover hospitals' uncompensated care costs while addressing federal concerns about current funding practices. The administration states that its plan would (1) leave no hospital financially worse off than it is under the current system, and (2) improve the financial condition of some hospitals. The expiring SPCP and LA County waivers would be replaced by one new five-year waiver. We discuss the major components of the plan below. The key differences between the current and the proposed system are summarized in Figure 8.

Certified Public Expenditures Replace General Fund

A key component of the Governor's plan is to shift most public hospitals to a form of cost-based reimbursement known as CPEs. Twenty-one selected public hospitals, including the five UC hospitals, would be financed primarily on the basis of CPEs through claims of federal Medi-Cal, DSH, and supplemental funds. These CPEs, which would consist entirely of county or UC health care expenditures, would take the place of the General Fund in the Medi-Cal, DSH, and supplemental programs. In other words, federal funds would be matched directly to "local" expenditures, rather than to the state General Fund in the form of a negotiated payment to a hospital.

The selected 21 hospitals would claim CPEs based upon the annual cost data they submitted to the state, which they would certify as accurately representing their expenditures. These certified costs would be considered the "seed" money that drew down federal funds under the Medicaid Program rather than state General Fund. The DHS would reduce the federal funds generated in this way by some amount—perhaps 10 percent—and pass along the remainder of the federal funds to the hospitals. The 10 percent that was withheld would be kept until the end of the year so that the state could ensure that no hospital exceeded the upper payment limits established under federal rules.

A comparable system of certified costs would also become the basis for these public hospitals to obtain additional funding through other payment mechanisms to cover uncompensated care costs. Specifically, the 21 selected public hospitals would include their uncompensated care costs in their CPEs, thereby establishing the seed funds needed to obtain additional federal funding that can be generated through DSH and supplemental reimbursements. The DSH and supplemental payments made to the hospitals would be limited to ensure the hospitals did not exceed applicable federal limits. Also, the state would ensure that the same medical costs were not counted twice to claim both DSH and supplemental payments.

The remaining five or so public hospitals (those not among the 21 in the CPE reimbursement system) and all private hospitals, including nonprofit and investor-owned facilities, would not participate in the CPE system. They would continue to negotiate fee-for-service reimbursement rates with CMAC according to the current practice.

Use of IGT Payments Could Decrease

The use of the proposed CPEs would decrease, but not eliminate, the use of IGTs to finance DSH and supplemental payments to public and private hospitals. The administration is seeking confirmation that federal authorities will allow them to retain IGTs to reimburse these 21 public hospitals for the portion of their uncompensated care costs that exceeds the amount they can obtain through the CPE claiming process. The state contends it should be permitted by CMS to retain use of limited IGTs because of current federal law recognizing California's IGT arrangements.

Plan Could Expand Payments for Care for Indigents

The proposed use of a CPE claiming system creates new possibilities for expanding the collection of federal funds to pay for health care for indigents. In addition to the costs that would be claimed in the CPE process described above, counties and the UC system would separately claim CPEs for indigent care costs that are currently funded without a federal share. For example, costs from a county-operated clinic which provided medical assistance for indigent persons would be certified and used to claim federal funding. This would be comparable to an arrangement already in place for LA County under its federal waiver program.

Plan Could Obtain Funds for Undocumented Immigrant Costs

The restructuring plan would also obtain federal funds to pay the costs of caring for undocumented immigrants now otherwise prohibited under the regular Medicaid Program.

Currently, federal reimbursement is available under Medicaid for undocumented immigrants only for the costs of emergency services. Solely at its own expense, the state provides some additional nonemergency services for undocumented immigrants in its Medi-Cal Program. The proposed waiver would secure federal approval to include among the CPEs claimed by the selected county and UC hospitals the costs of providing care to undocumented immigrants. These costs constitute a significant portion of uncompensated care costs for many hospitals and county indigent programs.

Private Hospitals Would Shift to General Fund

Private hospitals would see more of their base of state support shifted to the General Fund under the Governor's plan. Under the present system, some private hospitals currently receive both DSH and SB 1255 supplemental funding, although these payments account for a relatively small share of their total revenue. Under the planned new hospital financing system, private hospitals would give up their DSH funding and instead receive General Fund resources that would in effect be freed up because they were no longer being used for the selected county and UC hospitals.

The exact means by which these state General Fund resources would be funneled to private hospitals is still undetermined. It could take the form of increased daily inpatient hospital reimbursement rates or other types of supplemental payments. In theory, private hospitals could receive the same level of payments overall that they now receive, but with all funding coming from the state General Fund. None of their support would henceforth come from DSH, and a much smaller portion, if any, would come from supplemental payments. It is unclear, however, whether the eligibility requirements now in place for the DSH and supplemental programs, namely serving Medi-Cal or indigent patients, would continue once General Fund payments replace funds from those programs.

As discussed above, complex federal hospital financing rules mean that this shift of DSH funding to the 21 county and UC hospitals and out of private hospitals could allow the state to claim additional federal funding for indigent care costs in the public hospital system that would otherwise receive no federal reimbursement. The administration estimates that the net gain from this complex set of transactions is about $226 million annually, which would go mainly to the 21 public hospitals.

Federal Payment Limits Would Accommodate Managed Care

The administration plan would change the way the federal UPLs are calculated to provide greater incentives for placing more Medi-Cal patients into managed-care health plans.

The current method for calculating the federal UPLs harms hospitals financially whenever Medi-Cal beneficiaries are shifted to managed care. That is because, in its current form, the calculation of the UPL includes Medi-Cal hospital service days provided on a fee-for-service basis, but not the days provided to patients in Medi-Cal managed care plans. The Governor's plan would seek federal approval to change the way the UPL is calculated for California so that a future reduction in the public hospital UPLs that would otherwise result from a switch to managed care would not hinder the state's ability to pay for indigent care.

Plan Could Move California Forward, But Presents Concerns

In General, Some Positive Steps

Our analysis indicates that, in its current form, the Governor's plan takes some positive steps toward establishing an improved hospital financing structure for California. If approved by CMS, it could allow hospitals to address their uncompensated care costs in a manner that (1) leaves no hospital worse off than it is under the current system and (2) improves the financial viability of some hospitals.

However, many key details of the plan are unclear at this time. As noted earlier, when negotiations with federal authorities have been completed, a more detailed plan prepared by the department will be presented to the Legislature. At that time, we recommend the Legislature assess the proposal primarily in light of the answers that are forthcoming to the following key questions:

• How much funding does the plan provide for the hospital system as a whole?
• How does the plan distribute funding among hospitals?
• Does it establish a reliable revenue stream for hospitals over time?
• Does it establish appropriate incentives to provide care in the most cost-effective manner?
• Does the plan allow for a reasonable implementation period?
• Does it take advantage of all available opportunities to leverage additional federal funding for the support of the state's health care system?

Below, we provide our preliminary comments on these matters based on what is known so far about the administration's hospital finance restructuring plan.

How Much Funding Is Generated Overall?

We find it likely that DHS will be able to obtain at least $275 million of the planned increase. The amount of additional federal funds assumed beyond that level involves uncertainty. Nonetheless, we believe that the plan's projected increase in federal funds of up to $700 million per year when fully implemented is a reasonable working assumption as the Legislature considers the administration's proposal.

Under federal rules, any state applying for a federal waiver must demonstrate "cost-neutrality" for its proposal, meaning that the federal government would end up paying no more for the affected public programs if the waiver is approved than it would without such a waiver. Cost-neutrality requirements for any waiver must take into account the possible growth in federal costs over its duration. As noted earlier, the department projects that its proposed new five-year waiver will generate up to $700 million a year in additional federal funding for the state's hospital system.

Despite this anticipated increase in federal resources, the administration's plan assumes that it will nonetheless meet the federal test of cost-neutrality requirements. The plan assumes that federal expenditures would grow just as much, if not more, if the current hospital financing system were kept in place. How this cost-neutrality issue is ultimately resolved in state and federal government negotiations is a key issue that should be central to the Legislature's consideration of a final waiver proposal.

How Would Funding Be Distributed Among Hospitals?

One key question is how the plan allocates funding among hospitals and whether this allocation would enable them to be financially stable. The proposed new method for distributing state and federal funding to UC and county hospitals is probably no less equitable than the existing system. The UC and county hospitals will be reimbursed through a mix of daily rates, and other sources of negotiated payment, over which the state has some discretion. As a result, the administration could ensure that no hospital would be worse off than under the current system, and that the financial condition of some hospitals could improve. However, this aspect of the Governor's plan also creates the potential for "winners" and "losers" among individual hospitals.

The Legislature should also consider whether the plan is equitable with respect to the five or so smaller public hospitals that would not be included among the 21 shifted to a new payment system. These smaller public hospitals may be struggling to meet the same financial challenges as their larger counterparts. The department has not clearly explained why it excludes them from this aspect of its plan. Absent such justification, the Legislature may wish to consider whether these other public hospitals should also be granted the option of participating in a revised hospital financing system.

The intent of the current plan means that no hospital would receive less funding under the new system than under the current structure. In any final proposal, however, the Legislature may wish to review the extent to which the department and CMAC would be granted discretion to allocate funding to hospitals, and to what extent these allocations should be based upon policies set by the Legislature.

Would the Revenue Stream Be Reliable Over Time?

Whether the Governor's plan would result in more reliable revenue streams for hospitals over time is difficult to assess because it would depend on future decisions at both the state and local levels regarding whether funding for hospitals was a priority. Our assessment is that county hospitals would probably become more dependent on local government decision making, while the state would likely have more discretion over the level of support provided for private hospitals.

Under the current system, the General Fund provides the seed money to obtain federal matching funds for all Medi-Cal fee-for-service hospital inpatient payments. The Governor's plan would instead require the selected county hospitals to put up their own resources as the seed money for this reimbursement. Thus, county governments would bear responsibility for providing funding to draw down regular federal Medi-Cal funds, not the state. (The UC hospitals would also use their CPEs to draw down federal funds, but since these are state entities the source of control would not shift as it would for county hospitals.) As discussed above, counties that have not committed as much of their own money to their health care systems would need to either increase their own funding commitment or obtain funds that the state would have the discretion to distribute. Also, if overall county funding for health care decreases, then the total federal funds available for California public hospitals could decrease.

Although the Governor's plan would likely make the affected county hospitals more reliant on local government decision making, it would also provide these hospitals with more certainty about the overall level of funding provided specifically to address their uncompensated care costs. This is because the total new federal funding to help offset uncompensated care costs would be dependable so long as the hospitals as a group could certify expenditures for their care.

Does the Plan Provide Incentives for Cost-Effective Care?

The Governor's plan would probably improve the cost-effectiveness of the state's medical care system in some respects. First, it would generate additional Medi-Cal reimbursement for indigent care provided in more cost-effective settings, such as clinics and other nonhospital locations. This new federal Medi-Cal money would allow county or UC providers to shift some care from relatively costly hospitals to clinics or other nonhospital locations without automatically losing federal funds.

Second, the Governor's plan would provide California with relief from a federal provision that would otherwise penalize the state for shifting more Medi-Cal beneficiaries into managed care. We believe that expansion of Medi-Cal managed care could generate significant state savings while also improving the quality of care and access to care for the affected beneficiaries. (See our discussion earlier in this chapter regarding the Governor's proposed managed care expansion.)

The new system would likely have some mixed results with respect to encouraging efficiency in hospital operations. The planned system would reduce the current incentive for hospitals to retain patients longer to increase revenues. However, the new financing structure likely would not encourage efficiency in certain other hospital operations in that there would be little incentive in the new cost-based system to reduce the cost of each day of a hospital stay. The net result of these effects is unclear.

Does the Plan Allow a Reasonable Period for Change?

The numerous changes to the structure of hospital finances planned by the administration are, in total, quite substantial. Given the large sums of money involved, and the current financial condition of some public hospitals, a slower pace of implementation of these changes may be advantageous both to the state and the hospital system.

The proposal to shift away from IGTs may be difficult to carry out at the pace suggested by the administration and may underestimate the willingness of the federal government to permit IGTs to be phased out over a longer time. A more incremental approach could shed light on unforeseen difficulties that could be corrected as the shift of financing was phased in. Also, hospitals might be more willing to "buy in" to a process of more gradual change.

The department has indicated that CMS will not permit states to continue using IGTs past the end of the states' current fiscal years unless they have an exemption in federal statute. However, a recent letter from CMS to Congress indicates that some states are being granted a longer phase out period. This appears to leave open the possibility that CMS would be amenable to retaining certain IGTs for a year or two more if the state made a firm commitment to a phase out of the practice.

Does the Plan Take Advantage of All Opportunities For Additional Federal Funds?

Although the Governor's plan could generate a significant amount of additional federal funds for California hospitals, we note that it overlooks the potential additional revenue that could be generated by imposing a "quality improvement fee" on hospitals.

We discussed how quality improvement fees could be used to increase the state's drawdown of federal Medicaid funds in the Crosscutting Issues section of the "Health and Social Services" chapter of our Analysis of the 2004-05 Budget Bill (page C-52). In summary, we found that federal Medicaid law permits state to impose fees on certain health care service providers and in turn repay the providers through increased reimbursements. Because the costs of Medicaid reimbursements are split between states and the federal government, this arrangement provides a mechanism by which states can draw down additional federal funds for the support of their Medicaid programs. These funds can then be used to offset state costs.

Some other states, such as Illinois and Missouri, have implemented such fees for hospitals, and our analysis suggests this approach might also be possible in California. We have estimated, for illustrative purposes, that the imposition of a 0.5 percent quality improvement fee on the gross inpatient revenue of all hospitals in the state could achieve a net financial gain to the state of as much as $100 million while providing California hospitals which serve Medi-Cal patients with about a 5 percent increase in funding for acute inpatient services.

A quality improvement fee for hospitals that was applied across the board could result in some "winners" and "losers." For example, a large private hospital that served few Medi-Cal beneficiaries would pay a relatively large fee but get a small return in increased Medi-Cal reimbursements. In addition, under the current system, county and UC hospitals that contract with Medi-Cal are less likely to benefit from a rate increase because these facilities are already operating at or above the federal maximum reimbursement amounts allowed for Medi-Cal patients. However, the Governor's planned system could enable the state to better use some portion of the fee revenue to assist these hospitals.

Notably, many private hospitals are not above the federal limits and thus would be able to benefit from such increases in reimbursements, especially if they served more Medi-Cal patients. A quality improvement fee could thus provide private hospitals a greater incentive to serve Medi-Cal beneficiaries. The state might also be able to seek a waiver (as it is now doing in regard to a fee for nursing homes) that would selectively target such a fee at private hospitals that served a substantial number of Medi-Cal patients.

Conclusion

The Legislature should give serious consideration to the Governor's hospital financing plan as presented to date. The declining financial health of public hospitals, the potential for changes in federal Medicaid policy, and the upcoming expiration of California's current waivers mean that changes in the way the state finances its hospital system are inevitable and unavoidable. Although key details remain to be explained and evaluated, we believe the administration's plan offers some positive steps toward preserving and expanding the fiscal stability of the state's public hospitals.

At the same time, the details that have emerged so far raise a number of important fiscal and policy questions, such as whether the new approach will provide better incentives to hold down health costs and encourage preventative care. Getting answers to the key questions we have outlined above can assist the Legislature in determining whether the major changes under consideration make sense.

Financial Assistance to LA County Ending

To ensure that the Legislature receives necessary information to minimize the risk of future budget shortfalls for the Los Angeles County (LA County) health care system, we recommend that the Legislature withhold $29 million in administrative funding for both the state Department of Health Services (DHS) and LA County until it receives already completed monitoring reports relating to the county's Medicaid Section 1115 Waiver. We also recommend that the Legislature require DHS to report at budget hearings on the fiscal impact on LA County of the proposed hospital financing waiver and Medi-Cal redesign.

Background

Collapse of "Safety Net" Feared. In 1995-96, LA County faced a $655 million budget deficit in health services operations and the potential collapse of its health "safety net" programs for the poor and uninsured if means were not found to close that financial gap. In response to this situation, state, federal, and county officials collaborated to develop a five-year plan that was intended to address the crisis by financially stabilizing the county health system and, over time, moving the county's safety net system away from expensive hospital-based services toward community-based outpatient primary care and preventative services. The federal government approved the plan as a Medicaid Section 1115 Waiver that ended June 30, 2000. The waiver provided LA County an additional $1.2 billion in federal funds for the initial waiver period.

The federal waiver was renewed for another five years for the period of 2000-01 through 2004-05 and provided for the commitment of an additional $900 million in federal funds, $150 million in state funds, and $400 million in county funds. The current waiver will expire June 30, 2005. The county estimates that, absent a further extension of its federal waiver, it would incur an annual deficit of at least $148 million in 2006-07 and a cumulative deficit of $630 million by 2007-08.

Where Does the LA County Situation Stand Today?

Monitoring Reports Completed, but Not Released. The DHS has hired an independent contractor, PricewaterhouseCoopers, to measure LA County's compliance with the current waiver's goals. The contractor was to assess LA County's performance in increasing its utilization of outpatient health care services and increasing the number of persons enrolled in Medi-Cal, Healthy Families, and other health coverage programs, among other measures. The contractor submitted its monitoring reports relating to the progress made by the county during the first two years of the current waiver period to DHS on December 31, 2003 for what was supposed to be a 60-day review period prior to public release. One year later, at the time this Analysis was prepared, the reports had not been released. The DHS' review, and a subsequent review by LA County, have taken much longer than anticipated due to disagreements about the manner in which the consultant's work was conducted and the validity of their findings. The DHS has advised us that the reports will be publicly released in February.

Budget Proposal Funds Monitoring Contract at a Reduced Level. The DHS terminated the monitoring contract in November 2003 as part of a budget reduction authorized under Control Section 4.10 of the 2003-04 Budget Act. The 2004-05 Budget Act restored a portion of the funding for monitoring by shifting $2 million in county administration funds that otherwise would have been provided to LA County for making Medi-Cal eligibility determinations. The Governor's 2005-06 budget proposes to shift $1 million to pay for the cost of the contract. The level of funding provided for monitoring the waiver through its duration was originally estimated to be nearly $29 million. Now it is anticipated that approximately $9 million will be spent through 2005-06, or about 69 percent less.

State Continues to Play Role in Addressing LA County's Financial Problems. Under the terms and conditions of the current waiver, the state has been providing financial assistance to LA County by paying essentially 100 percent of "reasonable" costs for nonemergency room hospital and clinic outpatient services delivered to Medi-Cal patients. Prior to the current waiver, these providers were paid a comprehensive "per visit" rate for services that was less generous. As a result, according to DHS, it has paid LA County an additional $56 million ($28 million General Fund) over the first four years of the current-waiver period. The enhanced reimbursement is scheduled to end on June 30, 2005 when the waiver expires.

The state is also taking other steps, anticipated to benefit the entire state, that would probably also have the effect of addressing, at least partially, the financial problems in LA County. Specifically, DHS is seeking a new federal Section 1115 waiver that would replace the state's current system for contracting for hospital services. (An analysis of this waiver is discussed elsewhere in our review of the Medi-Cal Program.) Under this new waiver, certain counties would be eligible to receive federal reimbursement—which they do not now receive—for health care expenditures incurred for indigents whose health care is the responsibility of the counties. Such reimbursements are intended to help provide financial stability for the county-based indigent care programs that are currently in place. We are advised that, at this time, neither LA County nor DHS are seeking a separate waiver that would provide financial assistance solely to LA County.

We are also advised that DHS is reviewing how hospital outpatient services in LA County (and other counties that operate safety net hospitals) could be affected by the proposal the administration is developing to redesign Medi-Cal. (The Medi-Cal redesign is discussed in more detail earlier in this analysis of the Medi-Cal Program.

Analyst's Recommendations

Contractor Reports Needed by Legislature. Because the LA County waiver monitoring reports are a year overdue, we recommend that a total of $29 million (General Fund) proposed in the 2005-06 budget for administrative funding be withheld until the Legislature receives copies of these reports. (The $29 million is the equivalent of the original amount estimated for the monitoring contract.) Given the state's prior decision to provide additional funding to LA County, it is important that the Legislature receive the monitoring reports that have been prepared by the state's contractor, but never released publicly. These reports will enable the Legislature to assess LA County's progress in complying with the terms and conditions of the waiver. The Legislature also needs these reports to determine the merit of the Governor's budget request for additional funding for monitoring activities.

We propose that the Legislature adopt the following budget bill language to withhold administrative funding of $14.5 million (General Fund) each from DHS and LA County until the reports are received:

4260-001-0001: Of the amount appropriated under Schedule (4) of this item, $14,500,000 shall not be provided to the department until such time as the Legislature receives the monitoring reports prepared by PriceWaterhouseCoopers and the response from Los Angeles County regarding the Los Angeles County Section 1115 waiver in effect from July 1, 2000, to June 30, 2005.

4260-101-0001: Of the amount appropriated under Schedule (1) of this item, $14,500,000 intended for Los Angeles County administrative costs shall not be provided to the department until such time as the Legislature receives the monitoring reports prepared by PriceWaterhouseCoopers and the response from Los Angeles County regarding the Los Angeles County Section 1115 waiver in effect from July 1, 2000, to June 30, 2005.

Fiscal Impact of Administration's Proposals on LA County Needed. At this time, there remains significant uncertainty surrounding the potential impact of the proposed hospital financing waiver and Medi-Cal redesign upon the financial condition of LA County. Accordingly, we further recommend that the Legislature direct DHS to provide the appropriate budget subcommittees with an update at budget hearings on the status of the federal hospital financing waiver that it is seeking and with an estimate of the financial assistance that LA County would receive under its proposal over the next five years.

We also recommend that the Legislature direct DHS to estimate, and report to the Legislature at budget hearings, the fiscal impact of Medi-Cal redesign on LA County. This information would enable the Legislature and LA County to determine the potential impact of proposed changes and enable the Legislature to assess the need for additional strategies to ensure the financial stability of LA County's safety net health system.

Part "D" Stands for "Deficit": How the Medicare Drug Benefit Affects Medi-Cal

The Medicare Prescription Drug, Improvement and Modernization Act, also referred to as the Medicare Modernization Act (MMA) makes significant changes to the federal Medicare program. The implementation of the Medicare drug benefit component of MMA, known as Part D, is likely to cause significant net financial losses to the state for years and have other major programmatic impacts on Medi-Cal. We recommend some limited actions and strategies the Legislature can take to address these potential problems.

Introduction

The Medicare Prescription Drug, Improvement and Modernization Act, also referred to as the Medicare Modernization Act (MMA), became law on December 8, 2003. The MMA makes significant changes to the federal Medicare program. The scope of the legislation is so broad that it may be years before all of its initiatives are fully implemented and its overall ramifications are completely understood. The measure will have a number of significant fiscal effects, positive and negative, on various state programs.

This analysis examines the major policy and fiscal implications the establishment of the Medicare prescription drug coverage plan has for the state's Medicaid Program, which is known as Medi-Cal in California. In particular, this analysis focuses on the impact implementation of the Medicare Part D drug benefit will have on dual eligibles—beneficiaries who are fully eligible for both Medicare and Medi-Cal benefits—since they will be the Medi-Cal beneficiaries that are most directly affected by Part D. We also analyze the potential fiscal effect on the state of providing "wrap-around" coverage to the dual eligibles, the requirement under Part D that the state make "clawback" payments to the federal government, and other aspects of the new federal law.

In addition to the Part D prescription drug benefits, the MMA also includes a number of other benefit changes, such as additional preventative care benefits. However, an analysis of all of the changes made by MMA and their implications for state health programs is beyond the scope of this report.

Background

Medicare at a Glance

Medicare is a federal health insurance program overseen by the Centers for Medicare and Medicaid Services (CMS) that provides coverage to eligible beneficiaries at federal expense through fee-for-service (FFS) and managed care arrangements. The FFS model is the traditional arrangement for health care in which providers are paid for each examination, procedure, or other service that they furnish. Medicare also contracts with selected managed care plans to provide services to beneficiaries. Medicare consists of four parts:

• Part A. The hospital insurance program that covers inpatient hospital, skilled nursing facility, hospice, and home health care.
• Part B. Optional supplementary medical insurance that covers physician and outpatient hospital care, laboratory tests, medical supplies, and home health care. About 95 percent of Part A recipients voluntarily enroll in Part B.
• Part C. These are managed care plans (referred to as Medicare Advantage) that provide both Part A and Part B benefits. Some of the plans provide prescription drug benefits, although many enrollees face restrictions on these benefits such as an annual cap on pharmaceutical expenditures or limitations on which drugs may be purchased.
• Part D. The new outpatient prescription drug benefit that will be implemented January 1, 2006.

Medicare Basics. Most individuals 65 and over are automatically entitled to Medicare Part A if they or their spouse are eligible for Social Security payments. People under 65 who receive Social Security cash payments due to a disability generally are eligible for Medicare after a two-year waiting period.

Medicare beneficiaries pay for their benefits through premiums, deductibles, coinsurance, and copayments which are defined below in Figure 9.

Medicare Drug Coverage Begins Soon. Medicare Part D will go into effect beginning January 1, 2006. As of that date, Medicare will begin to pay for outpatient prescription drugs through prescription drug plans (PDPs) or Medicare Advantage plans. Beneficiaries can remain in the traditional Medicare FFS program and enroll separately in PDPs, or they can enroll in integrated Medicare Advantage plans for all of their Medicare-covered benefits, including standard drug coverage. The PDPs and Medicare Advantage plans may also offer supplemental drug benefits beyond what is covered under the standard plan for an additional premium.

How Medicare and Medicaid Interact

The Two Major Federal Health Programs. The two major federal health insurance programs are Medicare and Medicaid. Above, we discussed who is eligible for Medicare. Medicaid (known as Medi-Cal in California) provides health care services to welfare recipients and other qualified low-income persons (primarily families with children and the aged, blind, or disabled). Medi-Cal is administered by DHS. The cost of Medi-Cal services is shared about equally between the state General Fund and federal funds.

Dual Eligibles. So-called "dual eligibles" are individuals who are entitled to Medicare Part A and/or Part B and who are also eligible for some form of Medicaid benefit. In California, there are about 1.1 million dual eligibles in the Medi-Cal Program. Dual eligibles tend to be in fair or poor health due to chronic illnesses and conditions such as heart problems or high blood pressure that require ongoing treatment.

Eligibility Determinations. Under federal law, state Medicaid programs are required to conduct eligibility determinations for certain Medicare programs in which the state shares in the cost, such as the Qualified Medicare Beneficiary program. Under the Medicare cost-sharing program, Medicaid programs may pay an individuals' Medicare costs. Because the medical care provided under Medicare is paid for at 100 percent federal expense, and because the federal government shares about 50 percent of the costs of Medicaid programs, this arrangement is favorable to the states.

In California, eligibility determinations for Medicare cost-sharing programs is delegated to county welfare offices. As we discuss later in this analysis, the implementation of the new Medicare Part D prescription drug benefit will require the county welfare offices to take on new eligibility determination responsibilities.

Medi-Cal Drug Benefits

Medi-Cal Offers a Wide-Ranging Prescription Drug Benefit. In order to remain in compliance with federal law, the Medi-Cal Program provides coverage for a wide range of prescription drugs. It currently spends about $3.3 billion total funds annually (net of rebates) on drug benefits, not including the significant additional but unknown cost of drugs provided to beneficiaries enrolled in Medi-Cal managed care health plans. The cost of prescription drugs for dual eligibles now accounts for about $1.8 billion total funds annually (net of rebates) or about 55 percent of total drug expenditures within the Medi-Cal fee-for-service program.

Preferred Drug Lists and Supplemental Rebates. Medicaid programs are permitted to have formularies or preferred drug lists (PDLs) that have the effect of establishing state preferences for the prescription of certain drugs, usually because they are deemed to be more cost-effective than other drugs in the same class. However, Medicaid formularies and PDLs are considered "open" because beneficiaries can still access nonformulary drugs that are not among those preferred if their doctor receives prior authorization from the state.

The PDL is a key tool that is often used by the state to bargain with drug manufacturers for supplemental rebates. The DHS so far has established contracts with nearly 100 manufacturers for supplemental rebates. When DHS and the manufacturer agree to a state supplemental rebate, the drug is placed on DHS' PDL which tends to increase the frequency of Medi-Cal prescriptions.

An Overview of the Medicare Prescription Drug Benefit

Eligibility and Enrollment. The MMA created the new Part D prescription benefit. Medicare will begin to pay for outpatient prescription drugs through private plans as of January 1, 2006. Medicare beneficiaries entitled to Part A or enrolled in Part B are eligible to enroll in part D and receive the new prescription drug benefit. For most Medicare beneficiaries, the initial open enrollment period will run from November 15, 2005 through May 15, 2006. Medicare beneficiaries who prefer not to have prescription drug coverage can choose not to sign up for the new benefit. Signups for drug coverage will be permitted after the May date. However, beneficiaries who choose to pass on enrolling during this initial period may face a late enrollment penalty.

Special Enrollment Requirements for Dual Eligibles. Because dual eligibles are eligible for Medicare, they are the Medi-Cal recipients most significantly affected by Part D. Dual eligibles are subject to special enrollment requirements under Part D. The enrollment period for dual eligibles begins November 15, 2005 and ends on December 31, 2005. During this voluntary enrollment period, dual eligibles may choose the PDP or Medicare Advantage plan that they determine best meets their needs. Any dual eligibles who have not enrolled in Part D during the voluntary enrollment period will automatically be enrolled in one of these plans as of January 1, 2006, and a Part D provider will be assigned to them. This automatic assignment of dual eligibles to drug plans will generally be made without any review as to whether a drug plan's formulary is the most appropriate one for them. However, dual eligibles will be permitted to transfer to another PDP or Medicare Advantage plan if they find that another provider would better meet their needs.

Drug Formularies and the Part D Benefit. The drugs covered under the Part D benefit would include biological products and insulin (such as medical supplies associated with injections) and some vaccines. However, drugs for which benefits are payable under Medicare Parts A and B are excluded from the Part D benefit. Also excluded from Part D coverage are certain categories of medication, such as, weight loss or fertility drugs.

The CMS contracted with United States Pharmacopoeia to develop a model drug classification system. The group recommended that prescription drug plans offer beneficiaries at least two drugs in each of 146 listed categories and classes. According to the CMS, the model guidelines provided by U.S. Pharmacopoeia are a starting point for PDPs and Medicare Advantage plans to use when structuring formulary categories and classes. The CMS will review individual formularies to ensure the adequacy of the drug benefit offered and prevent discriminatory practices. In addition, CMS has the authority to disapprove a PDP or Medicare Advantage plan with a benefit structure that would have the effect of discouraging the enrollment of certain groups of beneficiaries—for example, those who are mentally ill or who have AIDS.

The PDPs and Medicare Advantage Plans have the option of offering additional plans with richer benefits for an additional premium. In some cases, these plans with enriched benefits may better meet the needs of dual eligibles.

Appeals Process. The MMA requires that PDPs and Medicare Advantage Plans have in place grievance procedures and an appeals process in the event of disputes over which drugs they cover. Only beneficiaries can file an appeal and a physician or representative, such as a family member, can help in the appeals process. Beneficiaries could appeal a decision to deny them a drug that is not on a plan's formulary only in cases where the prescribing physician finds that all of the drugs on the plan's formulary for treatment of that medical condition would not be as effective or would have adverse effects on the patient.

How Part D Benefits Will Be Delivered. As noted earlier, Medicare Part D will be delivered through PDPs or Medicare Advantage health plans, under contract with the U.S. Department of Health and Human Services. The CMS is required by MMA to ensure that every Medicare beneficiary has a choice of at least two prescription drug plans, one of which must be a PDP. The CMS has established 34 separate regions of the nation in which PDPs will operate—every PDP must serve an entire region. California has been established as a separate region.

Effective January 1, 2006, PDPs and Medicare Advantage plans that choose to offer Part D benefits must offer at least one plan in each region that includes standard Part D coverage. To be standard, benefits must be offered to beneficiaries on the following terms:

Beneficiaries will on average pay:

• An estimated $35 per month in premiums in 2006, although premiums paid under any particular plan may vary.
• The first $250 in total drug costs (which constitutes the deductible).
• 25 percent of total drug costs from $251 to $2,250.
• 100 percent of total drug costs from $2,251 to $5,100 (a gap in drug coverage widely called the "doughnut hole").
• Once total drug costs for an individual exceed $5,100, they would be subject to copayments ($2 for generic drugs and $5 for brand-name drug prescriptions) or coinsurance costs of up to 5 percent of their drug costs.

Low-Income Assistance for Part D. The MMA provides varying types of assistance to low-income individuals who meet certain income and asset level requirements in obtaining their Part D drug coverage. For example, dual eligibles who are residents of nursing homes will have their drugs covered 100 percent by Medicare and will face no premium, deductible, copayments, or coinsurance. Dual eligibles who are not in nursing homes will pay no premiums or deductibles, but will pay copayments. Specifically, those dual eligibles with incomes under 100 percent of the federal poverty level will pay $1 to $3 copayments; those dual eligibles with higher incomes will pay $2 to $5 copayments.

Certain other low-income beneficiaries, including some who are not dual eligibles, would also receive various types of assistance with their premiums, copayments, coinsurance, and deductibles.

Aggressive Implementation Schedule Planned. The CMS has established an aggressive timeline for choosing the providers that will deliver Part D benefits:

• June 6, 2005. Deadline for submitting bids to the CMS to establish Medicare Advantage prescription drug plans and PDPs.
• September 2005. The CMS awards bids to Medicare Advantage plans and PDPs.
• November 15, 2005. Enrollment period begins for Part D benefits.

This tight schedule could complicate the rollout of the new drug benefit to consumers. Under CMS' timetable, efforts to disseminate information about Part D coverage to Medicare beneficiaries to encourage their enrollment would begin just six weeks after PDPs and Medicare Advantage plans are selected to deliver the new drug benefit. Moreover, the specific drugs that would be included in the formularies of the PDPs and Medicare Advantage plans are not likely to be known until a few weeks before the enrollment period opens on November 15. Whether or not a particular prescription drug is covered by a PDP or Medicare Advantage plan could significantly affect the decisions of individuals as to which Part D provider they choose.

Informing Beneficiaries About Their Part D Benefits. The CMS is increasing its efforts to provide information to beneficiaries about the new Part D drug benefit. The CMS indicates that it plans to mount an education campaign that will include the distribution of printed materials, a toll-free phone number, a Web site, and direct mailings to Medicare beneficiaries. The CMS also plans to work with the Social Security Administration and other federal agencies, states, employers, providers, pharmacists, and other health care providers to inform Medicare beneficiaries about the new benefit that will be available to them.

Governor's Budget Proposal

The Governor's budget plan would reduce General Fund expenditures for the Medi-Cal Program by about $747 million ($1.5 billion all funds) in the budget year in recognition of the savings to the state from no longer providing a drug benefit to the dual eligibles under Medi-Cal. These savings would be partially offset by a new payment that the state will have to make to the federal government known as a "phased-down state contribution" or, more commonly, as a "clawback" (we discuss the clawback provision in more detail below). This clawback payment is estimated to be $646 million General Fund in the budget year. As a result, the General Fund effect upon the Medi-Cal Program from the new Part D drug benefit is projected to result in net savings of about $100 million General Fund in 2005-06. As we discuss later in this analysis, this estimate of net savings is misleading when other factors relating to implementation of Part D have been taken into account.

Net Financial Losses Likely for Years

Savings Appear Short-Lived. Federal authorities, in their recent announcement of their new regulations to implement the new Medicare Part D benefit, have emphasized the potential savings that would accrue to the states under the new law. These savings to the states, they have indicated, would result primarily from a shift in drug coverage for Medicaid beneficiaries to the Medicare Program. Under Medicaid, their drug coverage is paid for partly at state expense. Under the Medicare Program, their costs would be borne primarily by the federal government.

Our analysis indicates, however, that the new Part D drug benefit will result in savings of about $100 million General Fund in 2005-06, but will probably be a losing proposition for the Medi-Cal Program beyond the budget year. This is partly due to the so-called clawback provision written into the new federal law, and the specific way this provision is being interpreted and implemented by CMS. The clawback provision and other important changes resulting from MMA probably mean that, after a short-lived one- to two-year gain, the Medi-Cal Program will end up experiencing large net financial losses for at least several years afterward.

For example, the $100 million net savings figure identified above for 2005-06 is misleading. As noted above, the state currently collects rebates from drug companies under the Medi-Cal Program about one year after the drugs are purchased. The reduction in the level of drug purchases made in 2005-06 as a result of Part D means the amount of rebates that DHS collects will drop by about $273 million in 2006-07. This loss of rebate revenues would more than offset the $100 million net gain that will show up on the Medi-Cal Program books in 2005-06.

We estimate that the combined effect of the reduction in drug expenditures, the clawback payments, and the loss of drug rebates associated with the dual eligibles will result in cumulative additional General Fund costs to the state through 2008-09 of about $758 million. Figure 10 provides our estimates of the fiscal effect that the MMA will have on Medi-Cal Program finances over the next four years.

Complications for Dual Eligibles. As pointed out above, dual eligibles are the Medi-Cal beneficiaries that are most directly affected by the implementation of Medicare Part D. Our analysis indicates that the new program has some potential pitfalls for dual eligibles whose drug coverage would be shifted from Medi-Cal to Medicare. In some cases, these individuals may not be able to get the same drugs under Medicare that they now get under Medi-Cal, with unknown medical consequences. As a result, the state faces the difficult choice of whether to continue their state-supported drug benefits without any further financial support from the federal government. We outline our concerns over the potential impact of the new federal law below.

In the sections that follow, we also discuss various factors related to Medicare Part D implementation that could increase cost pressures on the state. These are summarized in Figure 11.

Federal Clawback Formula Disadvantages California

State Becomes a Revenue Source for Federal Government. Effective January 1, 2006, Medicare Part D will offer outpatient prescription drug coverage to the approximately 1.1 million dual eligibles in California. As noted earlier, the proposed Medi-Cal budget assumes that state General Fund costs will decrease by $746 million in 2005-06 due to this shift in their coverage.

However, MMA does not allow California or other states to keep all of these savings. The measure includes a clawback provision that requires states to pay back most of their estimated savings to the Medicare program to help pay for the Part D benefit. States are required to pay the federal government 90 percent of their estimated savings in calendar year 2006. During the following nine years the clawback percentage is reduced by 1.66 percent per year until it reaches 75 percent, then remains set at that level.

Beginning in January 2006, California is required to make a monthly clawback payment that is to be deposited into a federal government account. The amount of each state's monthly payment is determined by a complex formula with several components, including the amount the state spent on drugs covered by Part D for dual eligibles in calendar year 2003 on a per-person basis and the rebates received by a state from drug manufacturers.

Federal Clawback Reduces Savings to States. The CMS has issued final regulations that will determine how the clawback formula will be applied to each state. The DHS concluded that the regulation adopted by CMS unduly disadvantages California by overstating the true net costs it had incurred in the past for providing prescription drugs to dual eligibles—a key component of the federal clawback formula. The DHS found that the proposed clawback formula inaccurately calculates the rebates collected from drug suppliers for 2003 by using the dollar amount of rebates collected in 2003. The department indicates a more appropriate calculation, which would have taken into account rebates collected in 2004, would reduce the state's clawback payments by $91 million a year. Although the regulations have been finalized, the CMS has not yet determined the amount of the state clawback payment. The deadline for the CMS to announce state clawback payments is October 15, 2005.

MMA Creates New Eligibility Administration Costs

New Federal Mandate. The MMA requires state Medicaid agencies and federal Social Security Administration offices to accept and evaluate the applications of Medicare beneficiaries seeking assistance under Medicare's Part D low-income assistance program. These agencies must also periodically recertify that the low-income beneficiaries are still eligible to receive the additional assistance from Medicare. In California, the responsibility for making Medicaid eligibility determinations has generally been delegated to county welfare offices, who receive state and federal funding under the Medi-Cal Program to carry out these duties. As a result, it appears all but certain that counties will incur at least some new administrative costs to carry out these new duties mandated under MMA. The Governor's budget plan does not propose any additional funding to the counties to reimburse them for this additional workload. At the time this analysis was prepared, the availability of federal funds to reimburse the counties for the additional workload was not clear.

The DHS has entered into discussions with federal authorities regarding how these costs might be minimized, such as by having the county welfare offices bundle together multiple Part D applications and forward them to Social Security Administration offices for eligibility determinations. However, at the time this analysis was prepared, no specific steps to reduce county costs had been announced.

These costs could be low if the public response to outreach efforts for the new Medicare Part D benefit is weak. If the public response is strong, however, the counties' new administrative duties under Medicare Part D could translate into cost pressures for the state.

"Woodwork Effect" Another Risk to State

The availability of low-income Part D drug subsidies could also indirectly increase state costs for the Medi-Cal Program in another way, often referred to as the woodwork effect. We noted earlier that state Medicaid programs are required to conduct eligibility determinations for certain Medicare cost-sharing programs under which Medicaid programs may pay an individual's Medicare costs. As county welfare offices perform eligibility determinations for Part D low-income assistance, they must also screen for eligibility for the Medicare cost-sharing programs. This could result in increased Medi-Cal caseload and costs for participants in these programs.

The exact effect on state Medi-Cal caseloads and expenditures is hard to predict and will depend largely on the effectiveness of the forthcoming federal campaign to encourage applications for Part D drug benefits. The additional costs will probably not be great compared to the current overall Medi-Cal Program enrollment—perhaps even as little as hundreds of new applicants on a statewide basis.

State's Leverage to Negotiate Rebates May Be Reduced

We noted earlier that DHS' budget proposal assumes that the rebates the state receives from drug manufacturers will decrease by about $273 million in 2006-07 as a result of the implementation of the Part D benefit and dual eligibles receiving their drugs under Medicare instead of Medi-Cal. That $273 million decline in rebates represents only the partial-year effect of Part D implementation. We estimate that the full annualized loss of Medi-Cal rebate revenues could be more than $620 million in 2007-08.

In addition to the direct reduction in rebates, the implementation of Part D could reduce the state's bargaining power with drug manufacturers for drug rebates under the Medi-Cal Program. The anticipated decrease of more than 50 percent in the amount of drug purchases being made under the fee-for-service component of Medi-Cal as a result of dual eligibles shifting from Medi-Cal drug coverage to Medicare drug coverage could weaken DHS' ability to successfully negotiate supplemental rebates with drug manufacturers, potentially increasing program costs by tens of millions of dollars annually.

Drug Coverage for Some Dual Eligibles Might Be Disrupted

Shift in Drug Coverage Could Be Disruptive. As we have discussed, the PDPs and Medicare Advantage Plans who begin to deliver the Part D drug benefit will not be obligated to cover all available drugs. They will be permitted to adopt formularies that pick and choose the most cost-effective drugs, within federal constraints, so long as those formularies comply with CMS rules. Thus, it is possible—even likely—that some Medi-Cal dual eligibles who currently receive a relatively wide-ranging drug benefit may not be permitted by their Medicare provider to continue to receive the same medication they are now taking.

The extent of this potential problem cannot be predicted at the time of this analysis because the CMS has not selected its Medicare Part D providers and those providers have not yet adopted their formularies.

A change in copayment requirements could also potentially disrupt the drug coverage now provided to Medi-Cal dual eligibles. In theory, Medicaid beneficiaries are obligated to make copayments toward the cost of their prescription drugs (as well as for other types of medical services). Medi-Cal requires a copayment of 50 cents to $3 per prescription. However, under federal Medicaid law, pharmacies (as well as other types of medical providers) are not permitted to deny access to prescription drugs to beneficiaries who indicate that they are unable to make a copayment. We are advised that for these reasons, pharmacies frequently do not collect these copayments. However, we are not aware of any similar constraint on collecting copayments for the new Medicare drug benefit established by the MMA. We believe providers may deny a drug prescription to any beneficiary who does not make a copayment.

"Wrap-Around" Coverage Would Be Costly to Provide. As noted earlier, Medi-Cal provides a wide-ranging drug benefit. This drug coverage remains in place under state law and does not automatically change with the implementation of Medicare Part D. Thus, absent a change in current law, the state will provide what amounts to wrap-around coverage to dual eligibles beginning January 1, 2006. The result would be that beneficiaries could keep their same medications without disruption and without copayments. Our analysis indicates, however, that providing wrap-around coverage would probably prove to be costly to the state in the short term and even more costly over time. As noted earlier, of the $3.3 billion total funds (net of rebates) the state currently spends on drugs, about 55 percent or about $1.8 billion is for dual eligibles.

Effective January 2006, the state loses almost all federal matching funds for drugs provided to dual eligibles under the Medi-Cal Program. As a result, almost any wrap-around coverage that the state provides for dual eligibles would be paid for entirely with state General Fund resources.

While the initial cost could be significant—potentially in the low hundreds of millions of dollars annually—these costs to the state could grow rapidly. To the extent that the private providers scaled back the coverage provided under the Part D drug benefit, such as by enforcing stricter formularies, more drug coverage and costs would almost automatically shift to the state's wrap-around coverage.

Over time, we believe these circumstances would take considerable pressure off of the federal government to provide a wide-ranging drug benefit to dual eligibles, since any dual eligible denied their preferred drug by a PDP or a Medicare Advantage Plan could receive it from a state wrap-around program—at no cost to the federal government.

Medicare Part D Could Result in Some Offsetting State Savings

While the clawback and other provisions of Medicare Part D could prove costly to the state over time, some aspects of the MMA could result in some partially offsetting reductions in state costs.

Drug Costs Embedded in Some State Program Budgets. Certain state agencies and groups of medical providers who provide services to Medicare beneficiaries have historically built the costs of drug coverage into their operations. For example, the cost of providing prescription drugs is embedded in the rates that the state now pays to certain Medi-Cal managed care providers, and in funding for developmental centers operated by the Department of Developmental Services (DDS) and state hospitals operated by the Department of Mental Health (DMH).

The implementation of Medicare Part D means that the drug costs in these programs will decrease as drug costs for Medicare patients shifts to the new Part D program. However, our analysis indicates that the budgets for these other programs have not been adjusted in the Governor's budget plan to reflect these potential savings. Their rates and funding levels could be adjusted to reflect this anticipated decrease in their drug costs.

We estimate that fully recognizing these adjustments for the startup of Medicare Part D drug coverage could collectively result in significant General Fund savings of about $100 million in 2005-06, and about $200 million annually by 2006-07.

Enrolling More in Medicare Might Reduce State Costs. While it is relatively easy to enroll aged persons in Medicare, federal eligibility rules make the enrollment of disabled persons, such as the mentally ill, a potentially lengthy and difficult process. For example, federal rules generally require that someone who qualifies as being disabled wait two years before they receive Medicare benefits. These potential barriers to Medicare enrollment mean it is likely that some state-supported programs that serve persons with disabilities, such as county mental health systems, may not have taken all steps possible to enroll all eligible persons who need medications on a long-term basis into the Medicare Program.

Many such individuals have their medication costs—long-term costs that can be significant—covered under Medi-Cal. Our preliminary analysis indicates that it might be possible for the state to eventually reduce its Medi-Cal prescription drug costs by enrolling more such disabled persons in Medicare. The potential savings that could be achieved under this approach are unknown at this time.

New Medicare Benefits Could Reduce Other Program Costs. The MMA made a range of other changes in Medicare benefits, such as authorization for certain forms of preventative care. It is possible that some of these preventative medical services are now being paid for entirely under the Medi-Cal Program because they were not previously covered by Medicare. To the extent this is the case, it may be possible for the state to recognize Medi-Cal savings by shifting the cost for these services to Medicare. However, no such adjustments for coverage are now reflected in the Governor's budget plan for Medi-Cal.

Analyst's Recommendations

Tough Choices, Little State Control. The arrival of Medicare Part D drug coverage leaves the state in a difficult position. For the most part, the effects of the new federal law are beyond the control of California and any other state. Nevertheless, there may also be some limited actions and strategies the Legislature could adopt to help to partly offset the deficits that will probably result from the advent of Part D drug coverage. We discuss our recommended approach below.

Recognize Savings From MMA for Some Departments and Programs. We recommend that the budgets of DDS and DMH be adjusted to take into account the reduction in their drug costs that is likely to result from the implementation of Medicare Part D. The Department of Finance (DOF) should be directed to work in consultation with these departments to provide the Legislature at budget hearings with an estimate of these savings after the effects of recent federal regulations to implement Part D have been evaluated. The Legislature should then adjust the 2005-06 budgets of these departments accordingly to reduce General Fund expenditures. Similarly, we recommend that the rates paid by the state Medi-Cal Program to managed care providers be adjusted to reflect the shift of drug coverage costs for dual eligibles served by these programs to Medicare Part D. Such an adjustment could achieve General Fund savings of as much as $100 million in 2005-06.

Avoid Commitment to Wrap-Around Coverage. In order to avoid a significant potential cost to the state, we recommend that the Legislature adopt the statutory language that the administration has proposed to eliminate wrap-around coverage. Our analysis indicates that providing wrap-around coverage would probably result in additional state expenditures in the low hundreds of millions of dollars annually—costs likely to increase significantly in the future. It is also premature to consider providing any form of wrap-around coverage for dual eligibles until the PDPs and Medicare Advantage Plans have been selected by the CMS and the specific formularies they will offer have been determined. If the state moves now to fill in any gaps in Medicare Part D coverage, it may unintentionally take the pressure off of CMS and its network of providers to provide wide-ranging drug coverage that will meet the needs of dual eligibles.

Seek Modifications in the MMA. Last year, the Legislature approved Senate Joint Resolution 25 (Ortiz) which urged the U.S. Congress and the President to modify the MMA in ways that would make the new federal law less burdensome to states. We recommend that the state continue to appeal to the federal government to make the Medicare Part D drug benefit for dual eligibles as comparable as possible to the drug benefit now available under Medicaid. For example, a modification of Medicare copayment rules to conform to Medicaid standards would ensure that dual eligibles who were unable to make copayments would not be denied their access to drugs. The state should also continue to make its case for modifications to the clawback calculations so that California's clawback payments will accurately reflect the drug rebates the state collected for 2003 and thereby avoid overpayments of about $91 million annually.

Examine How to Increase Enrollment in Medicare and Part D Coverage. In order to ensure a successful transition for dual eligibles from Medi-Cal drug benefits to Medicare Part D drug benefits, we recommend that the Legislature direct DHS to report at budget hearings on its outreach efforts to dual eligibles, whether federal funds are available to states to support such efforts, and what efforts are being made to obtain any available funds.

We also recommend that DMH be directed to assess and report to the Legislature at budget hearings regarding whether all disabled individuals in their community programs who have a significant long-term need for medications are being systematically enrolled in Medicare. If DMH were to determine that more of its clients could be enrolled in Medicare over time, the Legislature could then examine strategies to eventually shift them (after the required two-year waiting periods) from state-supported Medi-Cal drug coverage to the Medicare Part D program.

Defer Budget Adjustments for County Administration. At this time, we recommend against making any adjustments to the Medi-Cal budget for county eligibility administration. We recognize that counties could incur additional workload from the new federal mandate that they process applications for Part D assistance for low-income persons. In our view, how ever, it is the responsibility of the federal government to either provide financial assistance to counties to handle these tasks, or to permit counties, as DHS has suggested, to shift most of this workload to Social Security Administration offices. In any event, it is unclear at this time whether any significant increase in workload will be experienced at county welfare offices.

Defer Budget Adjustment for Medi-Cal Caseload. At this time, we recommend against making any caseload adjustments to account for the woodwork effect. We recognize that there is the potential for increased caseload in the Medicare cost-sharing program. However, we do not believe that any increase in caseload that may occur would be significant and any necessary adjustment could be made at a later time.

Adjust Medi-Cal Costs for New Medicare Benefits. Finally, DOF and DHS should examine whether the inclusion of preventative benefits for Medicare services authorized in the MMA would have the effect of reducing any present costs to the Medi-Cal Program of providing these same services. They should be required to report their findings at budget hearings, and the Legislature should reduce the Medi-Cal budget accordingly to reflect the shift of any such costs to the Medicare Program.

Disease Management Pilot Program: Further Actions Could Help Ensure Success

In enacting the 2003-04 Budget Act, the Legislature provided funds for a disease management pilot program which, if implemented properly, could significantly reduce costs for the medical services the state provides for aged, blind, and disabled persons covered by Medi-Cal. We recommend specific steps that the Legislature should take to ensure that the Department of Health Services follows through in a timely and effective manner on the implementation of the pilot program proposed to begin July 1, 2005.

Background

The administration has put forward a proposal to save state funds by "redesigning" Medi-Cal, in part by placing more of the aged, blind, and disabled in managed care. We believe that the changes proposed by the administration generally have merit and warrant consideration by the Legislature. We discuss the Governor's initiative in more detail elsewhere in this Analysis. However, we believe it is also important to recognize that the Legislature has already adopted a disease management (DM) strategy which, if implemented properly, could significantly reduce state costs for the medical services now being provided to this high-cost population.

Disease management is a set of interventions, such as using patient education programs to promote preventative self-care, designed to improve the health of individuals with chronic conditions (lasting a year or longer) such as diabetes, chronic heart failure, and asthma. More than 30 other states have implemented various types of DM programs since at least 1995. Based on indications that the implementation of such programs can reduce patient utilization of high-cost services, such as emergency rooms and hospitals, the Legislature provided nearly $100,000 General Fund for three staff as part of the 2003-04 Budget Act. Related budget implementation legislation, Chapter 230, Statutes of 2003 (AB 1762, Committee on Budget), required DHS to apply for a federal waiver to initiate DM pilot projects within the Medi-Cal Program.

Our office recommended that the Legislature approve these expenditures and new positions because of the potential for achieving state Medi-Cal savings. As shown in Figure 12, we estimated, for illustrative purposes, the range of potential savings that could be achieved in Medi-Cal fee-for-service expenditures for several medical conditions that are commonly targeted for DM services. We estimate, for example, that a 1 percent reduction in costs for five chronic conditions often targeted for disease management services could result in annual savings of $15 million ($7 million General Fund). A 10 percent reduction in costs for these same five diseases could result in estimated savings of $153 million ($76 million General Fund).

Budget Proposal. The Governor's proposed budget includes $4 million in 2005-06 ($2 million from the General Fund) for two contracts to establish disease management services. This funding is in addition to the three staff previously provided for implementation of the pilot project. The Governor's budget plan does not assume any Medi-Cal savings from the implementation of the pilot program in 2005-06. The DHS has indicated that this is because it is not yet certain that the pilot projects will result in savings. Notably, some Medicaid programs in other states have encountered difficulties in trying to quantify the savings, if any, that have resulted from their DM programs.

Progress to Date of Medi-Cal Disease Management Projects

Population Targeted for Participation. The DHS has been working closely with an existing contractor to define the general categories of patients likely to benefit from DM services. This determination is based on the type and severity of a Medi-Cal beneficiary's disease and historical hospital utilization related to that disease. Based on this review, DHS has concluded that the population that best meets these criteria is aged persons as well as blind and disabled persons over 21 years of age who receive care from fee-for-service health care providers. The state's DM program will focus on Medi-Cal beneficiaries who are not also enrolled in the Medicare program, given that the federal government, rather than the state, now bears most of the costs for medical services for persons with dual enrollment in Medi-Cal and Medicare.

Developing Proposal to Identify Vendors. We are advised that DHS intends to release by March 2005 a request for proposal (RFP) to identify a vendor or two to provide medication management services, coordinated care management, risk assessments, and development of outcome measures necessary for the operation of a DM program. The RFP is to be structured to guarantee savings to the state, or at least to ensure that the program results in no additional costs to DHS. If a vendor does not achieve an agreed-upon level of savings, the state will not pay some or all of the fees owed to the vendor. The department has not announced a specific date for the award of the contract. However, the last estimated date of an award was May 2005.

Seeking Federal Waiver. The DHS is seeking a waiver from the federal government that will enable it to focus the provision of DM services on this specific population, and now assumes it will receive approval of the waiver by May 2005. The pilot project is expected to begin July 1, 2005 and to continue for three years.

Components for Successful Implementation

Our analysis indicates that, in general, DHS is addressing many of the critical components of a successful DM program. However, we have identified two key components—beneficiary and physician participation—that we believe deserve additional attention to help ensure the success of the pilot projects. We discuss these issues further below.

Beneficiary Participation. One critical component of a successful DM program is obtaining the full participation of the patients targeted for these services. Some studies of DM programs indicate that this can be accomplished by mandating participation. Other states have attracted participants through voluntary marketing strategies, such as encouraging DM contractors and medical services providers to promote to beneficiaries the advantages of participation in a DM program.

At this time, DHS intends to require eligible beneficiaries to enroll in the DM program, but allow individuals to opt out within 30 days or to voluntarily disenroll from DM services at the end of any month. While such an approach would be likely to encourage greater initial participation, it could undermine the goal of continued participation in the DM program.

Physician Participation. Physician involvement in the Medi-Cal DM program is also important in order for such a program to be successful. Research has found that programs failing to engage beneficiaries' physicians may have limited success. However, physicians may be resistant to participation if they do not believe such programs are effective. Physicians may also fear that they will not be compensated for supplemental services that they provide under DM, such as answering patient questions via e-mail or coordinating prescription drug utilization information with a patient's other physicians.

At least one state has recognized the importance of physician participation and intends to provide doctors that participate in such programs with a modest rate increase, dependent on such actions as their attendance at certain educational training sessions on such topics as managing chronic illnesses. Other states have stressed the importance of educating providers about DM and fostering the belief that DM can improve the quality of care through activities such as educational seminars. At this time, DHS has not proposed to increase payments to physicians or provide any other incentives that would encourage physicians to participate in the DM program.

Legislature Needs Information About Interaction With Medi-Cal Redesign

One component of the redesign of Medi-Cal proposed by the administration in the 2005-06 Governor's Budget is to broaden the enrollment of aged, blind, and disabled Medi-Cal beneficiaries in managed care. Thus, the redesign could potentially affect some of the same fee-for-service beneficiaries that are being targeted for DM services. To the extent that managed care plans choose to offer DM services as a means to hold down medical costs, there exists in theory the possibility that the state could pay twice for DM services for the same beneficiaries—once through payments to a managed care plan and again through payments to a DM services contractor who is participating in the state's pilot projects.

For this reason, it will be important to coordinate the expansion of DM services and the expansion of managed care to ensure that no such overlap occurs. However, DHS has not yet provided the Legislature any information regarding the potential fiscal and programmatic interactions between the redesign of Medi-Cal and the DM pilot program. Absent such information, the Legislature does not have any way to assess whether such an overlap in services will be avoided.

Analyst's Recommendations

As noted above, our analysis has identified some specific potential weaknesses in DHS' developing proposal for a DM pilot program. Based on this we recommend that the Legislature take several actions that we believe would improve the odds of the program's success.

Approve Budget Request. We recommend that the Legislature approve the $4 million ($2 million General Fund) requested by the administration in the 2005-06 budget proposal. This will enable DHS to continue with implementation of the pilot program.

Encourage Beneficiary Participation. One potential problem, we have noted, is a possible fall off in participation by Medi-Cal beneficiaries in DM activities. The Legislature should consider, as an addition to DHS' proposal to initially mandate participation by beneficiaries in the DM program, a design in which DM contractors and physicians would promote the advantages of DM services to Medi-Cal patients on an ongoing basis in order to encourage their continued participation. For example, the Legislature could direct DHS to require the DM contractors to strengthen their relationships with beneficiaries by (1) making contact with all participants within a set number of months after enrollment in the program to help increase Medi-Cal patients awareness of the services and benefits associated with continued participation and (2) following up with clients by phone or home visits at set intervals to promote continued participation in DM activities.

Encourage Physician Participation With Incentives. To help ensure strong participation by physicians in the DM pilot projects, the Legislature should direct DHS to conduct educational seminars for Medi-Cal providers that would explain the purpose of DM services and demonstrate their potential effectiveness. The DHS could encourage "buy-in" to the program by providing physicians with regular and ongoing feedback on how the implementation of the DM pilot projects was affecting the quality of care of Medi-Cal patients.

The Legislature may also wish to eventually consider establishing financial incentives for Medi-Cal doctors to participate in the DM pilots. Such incentives as modest payments for the provision of DM services could be used to reward physicians for coordinating care with other physicians or providing other types of DM services. Our analysis suggests that the costs to pay for such financial incentives would probably be more than offset after several years by the savings the state would subsequently enjoy from the successful implementation of DM. We would note that there is likely a lag between when DM services are provided and when savings are realized. Thus, we believe it makes sense to phase in any financial incentives after savings are realized from the DM program.

Report at Budget Hearings. We further recommend that the Legislature direct DHS to report at budget hearings on the potential fiscal and programmatic interaction between the DM pilot project and the proposed Medi-Cal redesign. The department should explain how it will ensure that it does not pay twice for the same DM services for aged, blind, and disabled Medi-Cal beneficiaries who would be shifted into managed care.