LAO 2006-07 Budget Analysis: Health and Social Services

Analysis of the 2006-07 Budget Bill

Legislative Analyst's Office
February 2006

Medi-Cal (4260)

In California, the federal Medicaid Program is administered by the state as the California Medical Assistance Program (Medi-Cal). This program provides health care services to welfare recipients and other qualified low-income persons (primarily families with children and the aged, blind, or disabled). Expenditures for medical benefits are shared about equally by the General Fund and by federal funds. The Medi-Cal budget also includes federal funds for (1)†disproportionate share hospital (DSH) payments and other supplemental payments, which provide additional funds to certain hospitals that serve Medi-Cal or other low-income patients; and (2)†matching funds for state and local funds in other related programs.

Governorís 2006-07 Medi-Cal Budget Proposal

The budget proposes Medi-Cal expenditures totaling $35†billion from all funds for state operations and local assistance in 2006-07. Figure†1 displays a summary of Medi-Cal General Fund expenditures in the Department of Health Services (DHS) budget for the past, current, and budget years. The General Fund portion of the spending for local assistance ($13.7†billion) increases by about $542†million, or 4.1†percent, compared with estimated General Fund spending in the current year. However, this understates expenditure growth in this program. This is because about $359†million that would have previously been included in the DHS General Fund budget for Medi-Cal (about $340†million in base costs for mental health services plus $19†million in related caseload growth) is proposed to be shifted to the Department of Mental Health (DMH) budget in a purely technical change. If these funds were to remain in the Medi-Cal budget, General Fund expenditures for Medi-Cal would total $14.1†billion, an increase of $901†million, or 6.8†percent.


Figure 1

Medi-Cal General Fund Budget Summarya
Department of Health Services

(Dollars in Millions)




Change From








Local Assistance














County administration







Fiscal intermediaries
(claims processing)







  local assistance














(state operations)
















Excludes General Fund Medi-Cal budgeted in other departments.

b The Medi-Cal total General Fund budget would have increased by $901 million, or 6.8 percent, if
$359 million in spending were not shifted to the Department of Mental Health.

   Detail may not total due to rounding.


The remaining expenditures for the program are mostly federal funds, which are budgeted at $20†billion, or 2.3†percent more than estimated to be received in the current year. In addition, the spending total for the Medi-Cal budget includes an estimated $708†million in local government funds for payments to DSH hospitals. About $3.9†billion of total Medi-Cal spending consists of funds budgeted for programs operated by other departments, counties, and the University of California.

As summarized in the ďHealth and Social Services OverviewĒ 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.

Caseload Projection Reasonable

While the administrationís 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 unknown effects of the budget proposal to increase childrenís enrollment and continuing effects of recent policy changes. We will monitor caseload trends and recommend appropriate adjustments at the May Revision.

Administrationís Caseload Projections. The budget projects that the average monthly caseload of individuals enrolled in Medi-Cal will grow in the current and budget years. However, we note that the current-year projections are nearly 60,000 below the caseload assumed in the 2005-06 Budget Act. The Governorís budget plan estimates caseload growth from 2004-05 to be 1.5†percent in 2005-06 and nearly 2†percent in 2006-07. The Governorís estimated growth rates for the current and budget year are projected to somewhat exceed the overall state population growth rates.

Nonwelfare Families Caseload Continues to Grow. Figure†2 shows the budgetís forecast for the Medi-Cal caseload in the current year and 2006-07. 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 1.2†percent in the current year and an additional 1.4†percent in the budget year, although these overall increases mask some larger, contrasting trends within this category. Nonwelfare families account for most of the caseload increases. The budget estimates that the caseload of Medi-Cal eligible nonwelfare families will increase by about 4†percent in the current year and by an additional 2†percent in the budget year. Some of this projected budget year growth is the result of the Governorís proposal to simplify the annual redetermination form, which is expected to result in a caseload increase of 18,000. However, caseload for the California Work Opportunity and Responsiblity to Kids (CalWORKs) families is expected to decline by 3.7†percent in the current year and remain flat in the budget year, reflecting overall CalWORKs trends.


Figure 2

Medi-Cal Caseload Continues to Increase in
Governorís Budget Estimate

(Eligibles in Thousands)




Change From 2004‑05


Change From 2005‑06























  Nonwelfare families








  Pregnant women
































  Disabled (includes blind)








Undocumented persons















a    California Work Opportunity and Responsibility to Kids.

b    Detail may not total due to rounding.


The overall projection of nonwelfare families and children caseload growth appears consistent with recent trends and generally reflects growth rates that may be gradually slowing. However, the impact of ongoing changes in Medi-Cal is hard to predict, and significant revisions to the projection could be occurring for various reasons. The Governorís budget proposals to increase childrenís enrollment in Medi-Cal and the continuing effects of recent policy changes, such as funding Medi-Cal application assistance in the 2005 budget, add uncertainty to the 2006-07 caseload projection.

Significant Growth in Medically Needy Aged and Disabled. Caseloads for the aged, blind, and disabled are expected to grow by about 51,000 beneficiaries, or about 3†percent, in the current year and by an additional 56,000 beneficiaries, or about 3†percent, in the budget year. The increase in the current year is consistent with underlying population 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, 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 20,500, or 11†percent, in 2006-07, and the disabled caseload is expected to grow by about 11,200 or 10†percent. Some of the projected growth in the aged and disabled population that qualifies as medically needed is also expected to result from the Governorís proposal to simplify the annual eligibility redetermination form.

The public assistance and long-term care eligibility categories project modest growth of less than 2†percent for the aged, blind, and disabled in 2006-07. These categories are not assumed to be affected by the Governorís proposal to change the annual eligibility redetermination form.

Analystís Recommendations. Our analysis indicates that the Governorís 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 simplification of the annual eligibility redetermination form will result in fewer eligibles than assumed in the Governorís budget plan, it is also possible that this action, combined with other actions to increase the children and families caseload, could result in caseload growth that is greater than projected. Given this situation, we will continue to monitor Medi-Cal caseload trends and will recommend any appropriate adjustments to the budget estimate at the May Revision.

The Effect of the Medicare Drug Benefit on Medi-Cal

The January 1, 2006 rollout of the new Medicare Part D prescription drug benefit has had a direct and immediate impact on the stateís Medi-Cal Program and the approximately one million beneficiaries whose drug coverage was shifted from Medi-Cal to Medicare. In this analysis, we briefly review implementation of Part D, describe the stateís response to recent implementation problems, and recommend that the Legislature reduce state spending by about $330†million in the current year and budget year combined to adjust for this rapidly changing situation. (Reduce Item 4260-101-0001 by $275†million.)


The Medicare Prescription Drug, Improvement and Modernization Act, also referred to as the Medicare Modernization Act (MMA), became law on December 8, 2003. The Medicare drug benefit component of MMA, known as Part†D, went into effect beginning January 1, 2006. As of that date, Medicare began to pay for outpatient prescription drugs through prescription drug plans (PDPs) and through Medicare managed care plans known as Medicare Advantage. The implementation of Medicare Part D has already had far-reaching fiscal and policy implications for the state, which we describe in more detail later in this analysis. For further information on the Medicare Part†D drug benefit and its impact on the state, please see our Analysis of the 2005-06 Budget Bill (page C-105, ďPart ĎDí Stands for ĎDeficití: How the Medicare Drug Benefit Affects Medi-CalĒ).

Medicare and Medicaid. The two major federally supported health programs are Medicare and Medicaid, both of which are administered by the U.S. Centers for Medicare and Medicaid Services (CMS). Medicare is a federal health insurance program that provides coverage to eligible seniors and persons with disabilities (SPDs). Most individuals 65 and over are automatically entitled to some Medicare coverage 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.

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 SPDs. Medi-Cal is administered by the state Department of Health Services (DHS). Medi-Cal costs are shared about equally between the state General Fund and federal funds.

Dual Eligibles. So-called ďdual eligiblesĒ are individuals who are entitled to some Medicare benefits and some Medicaid benefits. In California, about one million dual eligibles are enrolled in Medicare and Medi-Cal. Dual eligibles tend more often than the population generally to be in fair or poor health due to chronic illnesses and conditions that require ongoing treatment.

Mandatory Transition for Dual Eligibles to Part D. As of January 1, 2006, dual eligibles who had been receiving their drugs through the Medi-Cal Program began to receive their drugs instead through the new Part D benefit. Those dual eligibles that had not enrolled with a PDP or a Medicare Advantage plan during a voluntary enrollment period that began November 15, 2005 and ended December 31, 2005 were automatically assigned to a Part D provider. Generally, this assignment was made without any review as to whether a drug planís formulary is the most appropriate for the patient. However, dual eligibles are permitted to transfer to another PDP or Medicare Advantage plan if they find another provider would better meet their needs.

Also effective January 1, 2006, the state lost almost all federal matching funds for drugs that had previously been provided to the dual eligibles under the Medi-Cal Program. (The federal government will continue to share in the cost of these drugs for other Medi-Cal beneficiaries.) As a result, under the terms of MMA, any continued coverage the state were to provide for dual eligibles would generally be paid for entirely with state General Fund resources. The state is able to receive a federal match for certain drugs for dual eligibles that are not covered under Medicare Part D, such as over-the-counter drugs or certain medical supplies. Coverage for these drugs is often termed ďwraparoundĒ coverage.

The Effect of Part D on the Medi-Cal Budget

The implementation of the Part D benefit affects the Medi-Cal budget in several important respects. The DHS estimates that, after a series of separate budgetary components of Part D have been taken into account, the overall result will be a net General Fund savings to Medi-Cal local assistance of about $205†million in 2005-06 and that cost and savings will mostly offset each other in 2006-07.

However, we note that these budget estimates were prepared by the administration before a recent decision by federal CMS administrators that could significantly increase the state savings in the Medi-Cal Program that will result from the implementation of the new Medicare drug benefit. We discuss these recent developments later in this analysis.

Below we describe several of the major components of implementing Part D that affect the Medi-Cal budget in the near term. Figure†3 summarizes the fiscal effects of Part D as it is reflected in the 2006-07 Governorís Budget proposal.


Figure 3

Medicare Part D General Fund Impact
As Reflected in the Governorís Budget Plan

(In Millions)




Medicare Part D Drug Benefit






Drug rebate


Managed care savings



Wraparound coverage



100-day prescription drug supply


Miscellaneous costs






a  Does not reflect a reduction in California's clawback assessment announced by federal authorities
on February 6, 2006.


Medicare Part D Drug Benefit. As a result of the transition of dual eligibles from Medi-Cal drug coverage to Medicare Part D, the state will no longer pay for drugs for dual eligibles (with a few exceptions that we discuss later). These costs will be funded by the federal government. As a result, the Governorís budget plan assumes that General Fund costs for drugs for Medi-Cal dual eligibles will decrease by $706†million General Fund in 2005-06 and by about $1.8†billion in 2006-07.

Clawback. The MMA does not allow California or other states to keep all of the savings they will realize from the reduction in their drug costs due to the implementation of Part D drug coverage for dual eligibles. The measure includes a so-called ďclawbackĒ provision that is intended to require each state to pay back much of its estimated savings on dual eligible drug coverage to the Medicare Program. The MMA requires the states 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 state contributions reach†75†percent of their estimated drug savings on dual eligibles. The clawback payments would then remain set at that percentage of their estimated savings.

The Governorís budget plan estimates that the stateís clawback payment will be about $503†million from the General Fund for 2005-06 and at $1.3†billion for 2006-07, the first full year of these payments to the federal government. However, on February 6, 2006, CMS announced that it had reduced the clawback payments it had previously assessed to California and other states on the basis of updated estimates of prescription drug costs for dual eligibles. For California, the revisions will mean a reduction in clawback payments of more than $110†million in the 2006 calendar year. This recent federal action is not reflected in the Governorís budget plan.

The state Attorney General has announced that California will challenge the clawback payment in court. We provide more detail on this lawsuit in the text box.

Attorney General to Sue Over Clawback

The state Attorney General announced February 1, 2006, that California will join with other states in a lawsuit against the federal government to challenge the clawback payments required under Medicare Modernization Act (MMA). A multistate complaint was expected to be filed for this purpose in February with the U.S. Supreme Court.

The state Attorney General contends that the clawback provisions of the MMA (which were described earlier in this analysis) violate provisions of the U.S. Constitution. Specifically, the lawsuit is expected to assert that the clawback requirement impermissibly infringes on statesí legislative power by requiring them to pay for a federal program, in effect imposing a federal tax on states and infringing on state sovereignty with an invalid condition on the receipt of federal funds. We note that the Attorney General announced plans for the lawsuit before the U.S. Centers for Medicare and Medicaid Services informed the state that its clawback payment had been reduced.

The State Controllerís Office has announced that it intends to refuse to send the clawback payment to the federal government when the first bill comes in February†2006. We will continue to monitor these developments because of their potentially significant fiscal impact on the Medi-Cal Program.

Drug Rebates. Under federal law, California and other states may obtain rebates from drug manufacturers that partly offset the cost of the drug coverage they provide for their Medicaid beneficiaries. The shift of dual eligibles to Medicare Part D coverage means that the Medi-Cal Program will receive lower amounts of these rebates in the future since these beneficiaries will no longer receive their drug coverage from Medi-Cal. This decline in the collection of these rebates has the effect of eventually increasing state General Fund costs for the support of the Medi-Cal Program to make up for the loss of these state revenues.

The effect on Medi-Cal from the shift of dual eligibles is likely to be particularly significant because, prior to implementation of Part D, dual eligibles had accounted for about 57†percent of total Medi-Cal drug purchases. Because the collection of rebates often lags as much as a year behind the date when the drugs were initially provided to Medi-Cal beneficiaries, the loss of rebates is not expected to begin to affect the Medi-Cal budget until 2006-07. Specifically, the Governorís budget plan assumes that the loss of rebates due to Part D coverage will increase state General Fund costs by $544†million in 2006-07.

Managed Care Savings. The Governorís budget plan reduces the capitation rates paid to Medi-Cal managed care plans for the dual eligible enrollees. This adjustment accounts for the savings that will be realized by these plans on pharmaceutical costs for dual eligibles that will now be covered under Part D. As a result, the Governorís budget plan assumes that General Fund costs for Medi-Cal managed care plans will decline by about $58†million in 2005-06 and by $115†million in 2006-07.

Wraparound Coverage. As noted earlier, Medi-Cal will continue to provide coverage for dual eligibles of certain drugs that are excluded from Part D coverage. The Governorís budget assumes that the General Fund cost of wraparound coverage to the Medi-Cal Program will be about $41†million in 2005-06 and about $103†million in 2006-07.

100-Day Prescription Drug Supply. In order to assist in the transition of dual eligiles to Part D, the Governorís budget plan provided for some added drug benefits in the current year. Specifically, dual eligibles were allowed to obtain 100-day prescription refills in December 2005, in effect allowing them to obtain a larger supply of drugs for which they normally would only have been able to obtain a 30-day prescription. This change was intended to address concerns that implementation of Part D might disrupt dual eligiblesí prescription drug supplies. The Governorís budget plan assumes the 100-day supply allowance will result in state General Fund costs of about $19†million in the current year.

Miscellaneous Costs Associated With Part D. In addition to the major state fiscal impacts described above, the implementation of Part D was anticipated to result in other, smaller costs to the Medi-Cal Program. This included the costs of beneficiary outreach, provider relations, and eligibility systems changes. The Governorís budget plan assumes these factors will result in a combined increase in General Fund costs of about $1.8†million General Fund in 2005-06 and $55,000 in 2006-07. The implementation of Part D is also estimated in the Governorís budget plan to result in state savings on processing of treatment authorization requests, adjudication of claims, and other changes that are expected to amount to about $5.8†million from the General Fund in 2005-06 and about $11†million in 2006-07.

Ongoing Staff Workload for Part D Implementation. The administration budget plan requests four staff positions for DHS in the budget year at a cost of $264,000 from all fund sources ($66,000 from the General Fund) for the third-party liability unit at DHS. This unit has additional workload created by the implementation of the federal Medicare Part D drug benefit, such as resolving problems related to the enrollment of Medi-Cal beneficiaries into Medicare Part D and ensuring that Medi-Cal is the payer of last resort for medical benefits.

State Taking Action to Help Transition to Part D

In our 2005-06 Analysis, we noted that the MMA and CMS had established an aggressive timeline for choosing the providers that will deliver Part D benefits and that this tight schedule could complicate the rollout of the new drug benefit to Medicare beneficiaries. The DHS also voiced concerns at the time that the federal rollout of the Part D benefit would likely result in confusion and uncertainty for dual eligibles.

To address these concerns, the Legislature approved some measures in the 2005-06 Budget Act to assist the dual eligibles with this transition. For example, the Legislature approved about $1.1†million from the General Fund for beneficiary outreach that was conducted by DHS and adopted statutory language directing DHS to develop a plan to provide drug coverage to dual eligibles in the event that the federal implementation of Part D was problematic. However, DHS did not request funds for the implementation of such a plan in the proposed 2006-07 Medi-Cal budget.

Federal Implementation of Part D Has Been Problematic

Medicare Part D coverage for dual eligibles began on January 1, 2006 and, almost immediately, some beneficiaries experienced difficulty obtaining their drugs or were unable to obtain their drugs at all. In response, the state stepped in to ensure that dual eligibles would be able to obtain their drugs while Part D implementation problems were addressed by federal authorities.

Specifically, the Legislature and Governor approved a deficiency request providing $22.5†million in General Fund resources to reimburse pharmacists for prescription drugs given to dual eligibles who were unable to obtain their medications under Part D. The program began on January 12, 2006 and originally was approved to continue on an emergency basis for five days. On January 20, additional legislation was enacted (Chapter†2, Statutes of 2006 [AB 132, NuŮez]), bringing the total General Fund appropriation for these purposes to $150†million from the General Fund so that this emergency drug coverage for dual eligibles could be extended in phases until February 11, 2006. Then, on February 9, legislation was enacted (Chapter†7, Statutes of 2006 [SB†1233, Perata]), to extend this emergency drug coverage to at least February 15, 2006 and, with advance notice to the Legislature, for additional 30-day periods of time until May 16, 2006.

We note that federal authorities have indicated that the states will be reimbursed for most of the costs that they incurred to maintain drug coverage for dual eligibles. However, at the time this analysis was prepared, it was unclear how much of these costs would be reimbursed or the time frame for reimbursement.

Adjustments to Governorís Budget Plan Warranted

Our analysis of the Governorís budget plan indicates that the state is likely overbudgeted in several areas as it takes into account the various fiscal effects of Medicare Part D. We outline our findings below.

Federal Clawback Calculations Have Changed. As noted earlier, the Governorís budget plan does not take into account the most recent CMS determination of Californiaís clawback payment. As part of the Presidentís proposed new federal budget plan, the assessment to California and other states will be revised downward to reflect slower growth in the prescription drug costs for dual eligibles than it had assumed. Previously, CMS assumed a 36†percent increase in the cost of providing drugs for Medi-Cal dual eligibles. The CMS has now revised its rate of growth in these costs to about 25†percent.

On this basis, federal authorities estimate that the stateís clawback payments for the 2006 calendar year would decrease by more than $110†million. This roughly 10†percentage point reduction in clawback costs would result in as much as a $55†million reduction in General Fund spending for Medi-Cal local assistance in the current fiscal year, which ends in June. Assuming these lower clawback assessments stay in place through 2007, we estimate that General Fund support for Medi-Cal local assistance is similarly overbudgeted by as much as $150†million in the budget year.

Impact of Drug Rebates Overstated in the Budget Year. Our analysis indicates that the loss of drug rebates, and the resulting increase in General Fund costs for the Medi-Cal Program due to the implementation of Part D, is overstated by as much as $125†million in the budget year.

The Governorís budget estimates that this loss of rebates will be $544†million in 2005-06. We are advised by DHS that this estimate assumes that about 97†percent of drug rebates are ordinarily collected within six months after the drugs are provided to Medi-Cal beneficiaries. However, the data we have reviewed indicate that it sometimes can actually take up to a year for DHS to collect some rebates. If this is the case, then the loss of rebates in 2006-07 is significantly overstated in the budget plan.

Most Emergency Drug Coverage Funds Likely To Go Unspent. The DHS indicated on February 1, 2006 that, of the $150†million in General Fund appropriated to date for emergency drug coverage for dual eligibles, only about $12†million to $15†million had actually been spent. At this spending rate, it is unlikely that much more of the $150†million that was made available will be needed.

Moreover, as we discussed above, federal authorities have indicated that they will reimburse the states for most of the costs of providing emergency drug coverage to the dual eligibles.

Chapter†2 provides that any unspent funds would revert to the General Fund as of June 30, 2007. However, reversion of these funds at the end of the budget year means they would not be available for other purposes as the Legislature deliberates on a budget for 2006-07.

100-Day Drug Prescriptions May Be Overbudgeted. As noted above, the Governorís budget provided $19†million in General Fund support in the current year for providing 100-day subscriptions in December 2005 for dual eligibles. We are advised that preliminary data indicates that fewer than expected dual eligibles actually obtained 100-day subscriptions. Thus, the budget plan likely provides more funding for this purpose than was necessary.

Further Part D Adjustments Warranted. State law requires Medi-Cal providers to submit treatment authorization requests (TARs) for reimbursement for specific procedures and services, such as prescription drugs. The volume of prescription drugs paid for by Medi-Cal is expected to decrease by 57†percent beginning January 2006 because of the implementation of Medicare Part D. It is likely that the TAR volume for prescription drugs will decrease by at least an equivalent amount.

The 2006-07 budget proposes a reduction of $4.8†million (with a savings of $1.2†million to the General Fund) for contract staff, including pharmacists and support staff, who process TARs. Seven contract pharmacist positions would remain, however, in addition to some support staff. Also, none of the 55 state pharmacist positions or state support positions have been proposed for reduction. The relatively small staff reduction raises a question as to whether further adjustments in DHS staffing are warranted.

At this time, the Legislature does not have sufficient information to evaluate DHSí separate budget proposal requesting additional staff for the third-party liability unit. The ongoing level of workload that would justify the continuation of these positions is not clear.

Analystís Recommendations

Based on the above findings, we recommend that the Legislature adopt the following adjustments to the Medi-Cal budget and other DHS budgets:

A Targeted Strategy to Constrain Medi-Cal Costs And Improve Access to Community Care

We recommend that the Legislature take advantage of the opportunities now being provided by federal authorities to deter costly nonemergency visits to emergency rooms (ERs) and to improve access and quality of care at clinics and alternative sources of community care. In order to implement this strategy, we recommend that the Legislature establish effective copayments on the inappropriate use of ERs and seek available federal grant funds to improve access to primary care in the community.

Care Not Always Delivered in the Best Medical Setting

Californiaís projected 6.8†million Medi-Cal beneficiaries qualify for a wide range of medical services, including primary care in doctorsí offices or community clinics for prevention and treatment of less serious illnesses and injuries. In addition, emergency services provided in hospital ERs are intended mainly to treat immediate care needs that result from severe trauma and other life-threatening problems. However, Medi-Cal beneficiaries do not always receive medical care in the most medically effective and cost-efficient setting. For example, many Medi-Cal beneficiaries with relatively minor medical illnesses seek care in ERs instead of in doctorís offices or community clinics.

Below, we examine how and why this is often the case for participants in the Medi-Cal Program, and how this situation often contributes to the state paying more for health care than might otherwise be the case.

ERs Frequently Used for Nonemergency Care. Crowded conditions have been widely reported in many ERs in recent years. One major factor contributing to ER crowding is the frequent use of ERs by some patients as a source of nonemergency care. Various academic studies have documented the frequent use of emergency rooms by patients for primary care services or other nonemergency conditions that could have been provided in a less costly medical setting. Estimates of such nonemergency use of ERs have varied. A 2004 report by the California Institute for County Government cited data from the California Office of Statewide Health Planning and Development indicating that about 40†percent of all hospital ER visits for Medi-Cal and other patients in California are for conditions classified as ďnonurgent.Ē

Why arenít more patients going to clinics or doctorís offices instead of emergency rooms? One study of children in Medicaid who suffer from asthma found that their mothers cited a number of barriers to primary care as the reasons for seeking care at hospital ERs. These barriers included limited availability of appointments from primary care providers, limited availability of appointments after regular work hours, and a perception that primary care providers wanted them to use the ER. Also, the relatively low rates paid to physicians voluntarily participating in the Medi-Cal Program could be affecting access by patients to primary care and specialists in some communities. The Kaiser Family Foundation indicates that Medi-Cal payments for primary care services have recently fallen to 51†percent of Medicare levels (based on 2003 data), placing California 44th among states by that measure.

Payment Rates Vary by Care Setting. Where Medi-Cal patients receive their health care services can have significant fiscal ramifications for the state. In many cases, Medi-Cal pays different rates for the same medical procedure depending on the setting in which that service is provided. For example, Medi-Cal payment rates for many procedures are 24†percent higher when the procedure is performed in an ER rather than a physicianís office. Medi-Cal must typically also pay a facility charge for care obtained in an ER in addition to the payment for the health care practitionerís services. Various studies have concluded that many services provided in hospital emergency rooms cost more than when the patient receives the same services in nonemergency settings.

The potential higher cost of this health care is of particular concern given the stateís ongoing fiscal problems and rising hospital costs. General Fund spending for Medi-Cal outpatient hospital services (including part of the cost of ER services) is projected to increase by more than $100†million, or 50†percent, between 2000-01 and 2006-07, as shown in Figure†4.

Copayments Commonplace in Health Care Systems

Other Health Systems. Many private and public health care systems require their beneficiaries to make copayments, which are specified fees that patients must contribute to a provider in order to receive services. Medicare, the Veterans Administration system, and California Public Employeesí Retirement System health coverage all employ copayments to discourage overutilization of health care.

Current Medi-Cal Copayments Not Frequently Collected. Copayments are also authorized under federal and state rules in the Medi-Cal Program. In theory, Medi-Cal allows $5 to be charged per visit for a nonemergency visit to an ER, $1 per drug prescription filled, and $1 per visit for a variety of other types of providers, such as physicians, optometrists, and chiropractors. This copayment is ordinarily supposed to be collected by the medical provider.

However, relatively few such copayments are actually now being collected. That is primarily because federal law, until very recently, prohibited the denial of health care services if a patient cannot or does not make the copayment. In addition, federal and state law had specified that copayments generally cannot be required for Medi-Cal beneficiaries who are 18 years old and under, for those 21 years old or younger living in boarding homes or institutions, and for any children living in foster care. Also generally exempted from copayments were pregnant women, institutionalized individuals, and beneficiaries receiving family planning services. Individuals receiving emergency services could not be charged copayments, although persons receiving nonemergency services in emergency rooms were subject to them.

Medi-Cal providersí inability to actually collect copayments and the limits on which beneficiaries must pay them have rendered Medi-Cal copayments largely ineffective as a deterrent to the inappropriate use of medical services, including in ERs. That is the case even though there is substantial evidence, as discussed below, that copayments could be an effective strategy to reshape the way these services are provided in the Medi-Cal Program.

Copayments Can Affect Utilization of Services. Various studies published in health care journals have sought to determine the effect of different forms of cost-sharing on health care utilization. Some studies indicate that copayments appear to reduce unnecessary utilization of medical services, with even nominal cost-sharing leading to decreased use. However, the evidence regarding copaymentsí effectiveness also raises additional issues. Some research studies caution that such cost-sharing requirements can do more than curb overutilization of services by creating obstacles to appropriate and medically necessary care. Thus, the particular design of copayments is important because of the significant potential effects on the overall provision of health care.

Notably, California experimented in the early 1970s with a new copayment on Medi-Cal doctor visits while leaving hospital care free of charge. A subsequent study by RAND found some evidence that this copayment policy likely reduced the demand for doctor visits by 8†percent, while demand for more costly hospital inpatient service increased by 17†percent.

Recent Federal Policy Changes Provide Opportunities to Reshape System

Findings from the RAND study and other research raise a further important question: Could Medi-Cal copayments be structured in a way to accomplish just the reverse of what occurred in California in the early 1970s? That is to say, could Medi-Cal copayments be established to encourage less costly primary care and discourage the inappropriate or excessive use of more costly hospital services? Our analysis indicates that recent changes in federal law and other recent developments in federal policy are opening the door to such a strategy.

Copayment Rules Easing. In recent years, CMS, the federal agency which administers the Medicaid Program (of which Medi-Cal is a part), granted some states greater flexibility in applying copayments by approving waivers of federal laws. Some states have used such waivers to enact copayments above the nominal level for various services, including the nonemergency use of ERs. In addition, the recently enacted federal Deficit Reduction Act of 2005 further increases statesí flexibility to establish Medicaid copayments without first obtaining waivers. (See the nearby text box for a summary of several key changes contained in the new federal measure.) The measure contains a number of significant provisions regarding copayment levels and collections as well as various restrictions on who can be required to share in such costs. However, the federal measure maintains the authority of CMS to grant waivers to states to implement differing copayment options.

The Federal Deficit Reduction Act of 2005

Congress recently made changes to a variety of federal programs through the passage of S. 1932, the Deficit Reduction Act of 2005. Key provisions of this bill potentially affecting copayments and access within the Medi-Cal Program include the following:

  • Collectibility of Copayments. Health providers would now be allowed to refuse to provide services if the beneficiary does not make the copayment.

  • Limitations Maintained for Certain Groups. Copayments still may not be required for specified eligibility and income groups, such as the aged and disabled or pregnant women and infants under specified income levels.

  • Payments Capped. Copayments generally would be capped at 5†percent of the familyís income.

  • Certain Services Exempt. Copayments could not be charged for preventive services, pregnancy services, or emergency services, among others.

  • ďNominalĒ Copayment Limits Linked to Inflation. The nominal level at which copayment levels are set in federal law (generally $3 for most services) could be adjusted by the state each year for inflation.

  • Emergency Room Copayments. States could charge copayments of up to $6 for the nonemergency use of emergency rooms, provided that the hospital provides beneficiaries with (1) the name and location of an alternate available medical provider that could provide the services without copayments, and (2) a referral to coordinate the scheduling of the treatment.

  • Copayments for Prescription Drug. In order to increase use of more cost-effective drugs, states could designate a ďpreferredĒ drug within each class and then charge copayments (or higher copayments) for others in that class to encourage more frequent prescription of the preferred drug.

  • Grants for Improved Nonemergency Access. The sum of $50†million would be appropriated over four years for grants to improve Medicaid beneficiariesí access to primary care services.

  • Grant Funding for Medicaid Innovations. An additional $150†million in grant funds would be available over two years for projects that improve Medicaid efficiency and effectiveness.

New Federal Funding Could Help Improve Emergency Room Alternatives. On their own, copayments for nonemergency ER use may be insufficient to encourage use of primary care providers because of the barriers beneficiaries face in accessing such providers. The recently enacted federal law offers states an opportunity to try to address these issues through newly available federal grant funds ($200†million nationwide) earmarked for improving access to primary care systems and implementing innovative programs to reduce Medicaid costs. These monies could contribute to implementing new approaches that would help ďsafety netĒ clinics and other primary care providers attract more Medi-Cal patients so that fewer would seek care at ERs.

While the federal grant amounts available to individual states are likely to be modest, California has demonstrated that it can operate a successful program to improve access to community care with limited resources. The Rural Health Demonstration Project (RHDP), operated by the Managed Risk Medical Insurance Board (MRMIB) to improve access to primary care for children under the Healthy Families Program, could serve as a model for using any additional funds available to the state in targeted areas. The program awards grants to address specific areas of need, such as increasing the number of hours that clinics are open on nights and on weekends and subsidizing the rates paid to providers so that they will offer care. A 2002 evaluation by MRMIB indicated that many clinics that received grants continued to offer expanded hours after their RHDP grants expired.

A Targeted Strategy to Reduce Medi-Cal Costs and Improve Community Care

As discussed above, recent changes in federal law and policy have created an opportunity to begin reshaping the Medi-Cal Program to provide better access to preventive-oriented community care and to reduce state spending for inappropriate visits to sometimes overcrowded ERs. At least one state has demonstrated that such a strategy could be effective. A review of a Medicaid demonstration project in Florida found, for example, that there was reduced use of ERs by Medicaid children resulting from coordinated efforts that included expansion of clinic or doctorís office hours and copayments for certain ER use.

Accordingly, we recommend that the Legislature take steps now, primarily though the enactment of policy legislation, to implement a new strategy that takes advantage of these opportunities. We summarize below the key components of this strategy:

State and County Savings Likely. If an effective and meaningful copayment is established for receiving nonemergency services in ERs, some Medi-Cal ER users would likely seek care from appropriate primary care providers, which are generally less expensive than ER care. Some studies have indicated that in some cases copayments may deter visits to health care facilities that are medically unnecessary. In these cases, beneficiaries may decide to forego receiving nonurgent care in any setting, resulting in further savings. Based on our review of data on Medi-Cal payments to hospitals for 2004, such a change could result in significant state and county savings if ER use by Medi-Cal patients could be deterred or redirected to less costly care settings. These savings could be realized in both fee-for-service and managed care Medi-Cal. On a fee-for-service basis, payments per beneficiary would likely decrease. In managed care, additional savings to the state might eventually be realized through reduced pressure to increase rates for managed care organizations, which in turn would probably pay less in the future for services provided to their Medi-Cal enrollees.

In addition, we believe there would probably also be significant positive fiscal impacts (and positive health outcomes) from directing more patients to an improved primary care system. This improved system could lead to more preventive care that encourages Medi-Cal patients to maintain good health, as opposed to their current overreliance on episodic care, in which individuals inappropriately wait until they are seriously ill before seeking health care.

The amount of the combined savings to the state and counties from these direct and indirect fiscal effects are unknown but would probably eventually amount to the tens of millions of dollars annually.

Administrative Costs. Administrative costs to the state to implement this proposal are likely to be minimal if the amount of the copayment was strictly limited to the level outlined in the new federal legislation. Establishing them at higher levels and for a larger portion of the Medi-Cal population, such as we have proposed, would require a federal waiver and probably result in modestly higher state administrative costs. For example, some additional staffing and funding may be needed by DHS to monitor care trends in areas that receive grants or to make one-time adjustments to eligibility information systems. However, these largely one-time administrative costs would eventually be much less than the savings we have identified above. The administrative costs for ERs themselves to collect the copayments (including UC and county hospitals) would likely not be significant because hospitals already typically collect copayments from privately insured individuals.

Analystís Recommendation

We recommend that the Legislature enact policy legislation to promote use of the most cost-effective and medically appropriate settings for primary care for Medi-Cal beneficiaries. This could be accomplished through a combination of (1) a targeted copayment for nonemergency use of ERs and (2) the use of available federal grant funding to improve access to primary care through a program comparable to the existing RHDP. We believe that this approach would improve health care outcomes for beneficiaries, in part by linking them more closely to preventive care instead of episodic care. We believe this approach would also be cost-effective for the state.

Hospital Waiver Increasing State General Fund Costs

The Governorís budget proposal estimates that a new federal hospital financing waiver will result in a net increase of state General Fund costs over the first two years of about $39†million. However, the waiver could instead be implemented in a manner that avoids these costs and generates significant state savings. Accordingly, we recommend that the Legislature shift support for additional ďsafety netĒ health care programs to federal hospital funds so as to achieve net General Fund savings for the state. (Reduce Item 4260-111-0001 by $35†million.)


Federal Waiver and Related State Legislation. In June 2005, the state received general approval from the Centers for Medicare and Medicaid Services (CMS) for a new waiver program that restructures the way Medi-Cal funding is used to finance inpatient hospital services in the state. The Legislature subsequently approved legislation (Chapter†560, Statutes of 2005 [SB 1100, Perata]) that in effect ratifies and implements this waiver package.

Waiver Had Several Key Goals. The key goals of the waiver included increasing the overall federal funding that would be available for hospital inpatient services while ensuring that no hospital now participating in the Medi-Cal Program would lose funding as a result of these changes. The waiver also sought to curb the stateís use of transactions known as intergovernmental transfers, some of which CMS contended inappropriately increased federal reimbursements for hospital services. (See page C-87 of our Analysis of the 2005-06 Budget Bill for a more detailed description of the waiver and related state fiscal issues.)

State-Only Programs Authorized for Federal Funding. Under the waiver terms, General Fund spending for state safety net health care programs can be offset with federal funds. Chapter†560 authorized the use of a designated part of the new federal hospital funds to offset specific state General Fund costs. Chapter†560 selected four existing programs operated by DHS for potential use in this way: the Medi-Cal Medically Indigent Adults Long-Term Care Program, the Medi-Cal Breast and Cervical Cancer Treatment Program, the California Childrenís Services Program, and the Genetically Handicapped Persons Program (GHPP). Under the waiverĎs terms, the state could have offset more General Fund spending for additional state-only programs with federal hospital funds.

Governorís Budget Proposal

Hospital Funding Shifts. The 2006-07 Governorís Budget implements the hospital financing waiver agreement through various shifts of General Fund, local funding, and federal funds for the support of both private and public hospitals and other state safety net health care programs for the poor. Figure 5 provides a summary of the various detailed funding changes that are proposed in the Governorís budget plan. These changes have a number of significant net fiscal effects in both the current fiscal year and the budget year that we discuss below.


Figure 5

Hospital Waiver Increases General Fund Costs

(In Millions)a




Two-Year Total





Hospital programs




Shift Medi-Cal match from General Fund to local expenditures for large public hospitals




Shift funding from intergovernmental transfers to General Fund for private and smaller public




Eliminate state administration fee




Transition costs—one-time General Fund
payments for 2004-05 services







Shift of Medi-Cal programs from
General Fund to federal funds




Medically Indigent Adult—Long-Term Care




Breast and Cervical Cancer Treatment Program








    Net Effects on Medi-Cal Expenditures




Shift of other health programs from
General Fund to federal funds




California Children's Services




Genetically Handicapped Persons Program








    Total Net Effects on General Fundb





a  Positive numbers indicate General Fund costs. Negative numbers indicate General Fund savings.

b  Detail may not total due to rounding.


Resources for Waiver Administration. For 2006-07, the Governorís budget plan also requests $748,000 from the General Fund ($1.5†million from all fund sources) for the establishment of 13 new positions and the continuation of seven existing limited-term positions to administer the hospital waiver. The proposed budget also includes a shift in support to the General Fund for 21 existing positions previously supported through intergovernmental transfers.

Waiver Projected to Increase Net General Fund Costs

Net Loss to State Over Two Years. Our analysis of the Governorís budget plan to implement the hospital waiver takes into account the planís fiscal effects on the Medi-Cal hospital allocations as well as DHS safety net health care programs for the poor referred to earlier in this analysis. Viewed on this basis, the proposal results in a net cost to the state General Fund for the combined two-year period of 2005-06 and 2006-07.

Specifically, the Governorís budget plan would result in a net increase in General Fund spending of about $94†million in the current year above the level of funding provided for these programs in the 2005-06 Budget Act. Increased General Fund costs for Medi-Cal hospital allocations would be partly offset with a lesser amount of General Fund savings achieved in the four safety net health care programs. For 2006-07, the waiver in total results in net General Fund savings of about $55†million. This is because General Fund savings in the four safety net programs would exceed the additional costs to the state in the budget year for Medi-Cal hospital allocations. Thus, the combined effect of these changes in 2005-06 and 2006-07 is projected to be a net cost to the state of about $39†million.

Why the Budget Plan Reflects a State Loss From the Waiver. When the waiver proposal was under discussion last year, DHS had indicated that the waiver would be implemented in a way that was ďcost-neutralĒ to the state. Why does the proposed budget plan now reflect a net loss to the state General Fund? Two main factors explain this situation.

First, the earlier representation about state cost-neutrality did not take into account the one-time transition costs of moving to the new hospital finance system. Hospital payments that lagged several months in arrears under the previous system now will be made in the same month that services are rendered. This means that Medi-Cal, which uses a cash-based system of accounting, will have to make extra payments for hospitals in the current fiscal year. We estimate the one-time cost to Medi-Cal in 2005-06 for this technical adjustment at about $122†million.

Second, state General Fund costs have also increased to reflect updated information about the payments that are required to reimburse various types of hospitals for inpatient services. The net effect of recognizing updated estimates of costs for various public and private hospitals is an increase in General Fund costs of about $30†million in the current year and $35†million in the budget year.

Budget Assumes More Federal Funds, But Additional Funding Possible

The Governorís budget proposal would result in an increase in the amount of federal funds available for the support of California hospitals, but the proposal also passes up an opportunity to obtain additional federal funding. We discuss these findings below.

Federal Funds for Hospitals Would Increase. While the waiver, as implemented in the Governorís budget plan, results in a net loss to the state General Fund over two years, it assumes that California hospitals will receive a significant increase in federal funding. Specifically, according to DHS, the federal funds available to California hospitals would increase by $303†million in 2005-06 above the amounts otherwise received under the prior hospital finance system. In 2006-07, the federal funding increase for inpatient services is assumed to be $660†million above the level included in the 2005-06 Budget Act. While perspectives may differ regarding how much of these amounts is truly ďnewĒ funding, a significant portion would likely not be available without the waiver.

We note that these amounts assume that all available federal funds will actually be drawn down in each year. However, some portion of these additional federal payments may not actually be realized by hospitals. This is because the waiver approved by CMS left unresolved which specific health care expenses incurred by county and UC hospitals could be counted in order to draw down these federal funds. Thus, depending upon how this issue is ultimately resolved with CMS, the actual increases in federal funding that accrue to California hospitals could be significantly less than the amounts mentioned above.

Waiver Deal Provided Additional Federal Funds. Among various changes, the waiver agreement also made available to California hospitals an additional $900†million in federal funds, which could be drawn down each year in equal installments of up to $180†million. However, the waiver agreement specified that the receipt of these additional funds was contingent upon the state meeting certain specified conditions.

During the first two years of the waiver-2005-06 and 2006-07-receipt of the annual $180†million installments (for a total of $360†million) is contingent upon the enactment of the expansion of Medi-Cal managed care to seniors and persons with disabilities (SPDs) in a form consistent with a 2005 administration proposal.

The Legislature and Governor jointly decided last year to exclude this policy decision from the state legislation to implement the waiver. At the time, the administration indicated that it believed more time was needed to develop a proposal that would both satisfy legislative concerns and meet federal waiver conditions. Under the terms of the waiver agreement, a portion of the available funds is lost for each month that the federal conditions are not met. As a result, about $315†million of the original $360†million in federal funds would remain available to the state as of the end of March†2006.

The Governorís 2006-07 budget plan does include some additional Medi-Cal Program pilot projects to expand managed care, but does not include a managed care expansion proposal of sufficient scope to meet the federal conditions for the $360†million. The administration indicates it has chosen to forego the balance of these federal monies by seeking legislative approval of only its more limited managed-care proposals.

This choice has important ramifications for the Medi-Cal Program. We examined the issue of expanding Medi-Cal managed care in our 2004 report Better Care Reduces Health Care Costs for Aged and Disabled Persons and in our 2005-06 Analysis of the Governorís proposal for a full-scale expansion of managed care. We noted that, while an expansion should proceed carefully so as not to disrupt patient care, such changes provided real opportunities to improve access to care and quality of care for these Medi-Cal beneficiaries while eventually achieving significant savings for the state.

Additional Federal Fund Opportunities Will Be Available. The waiver agreement provides the state another opportunity to obtain additional federal funds for California hospitals. Another $180†million in federal funds will be available in 2007-08, 2008-09, and 2009-10 ($540†million in all), if the state enacts an initiative to expand health care coverage options for persons who currently lack health coverage. Matching funds must be found at the state or local level to draw down the federal allotments.

The waiver agreement also established certain deadlines that the state must meet in order to access the additional federal funds. The DHS complied with the first deadline by submitting a concept paper for the coverage initiative to CMS at the end of January 2006. This paper lays out broad guidelines and goals for the initiative, such as limiting participation to uninsured individuals not already in Medi-Cal or the Healthy Families Program. However, the concept paper does not specify how the program would actually operate.

By September 1, 2006, the state must submit to CMS a waiver amendment outlining the initiativeís structure, eligibility criteria, and the benefits provided to participants. The DHS has indicated that state legislation will be necessary to move forward with such an initiative.

Need for Additional Waiver Staffing Unclear. Our analysis indicates that there are a number of significant issues to be resolved relating to the Governorís budget proposal to add positions to implement the waiver and the proposed funding shift for the 21 existing DHS staff. These issues include the workload justification for these positions and several technical questions. Until these questions have been resolved, the Legislature is not in a position to decide whether the Governorís budget request is warranted.

Analystís Recommendations

As we noted earlier, the state could use additional federal hospital funds to reduce state General Fund costs for safety net programs. In light of the unexpected projection of a net cost to the state General Fund from implementation of the hospital finance waiver, we recommend that the Legislature enact statutory changes that would increase General Fund savings and result in net savings over two years from these changes. Specifically, we recommend that the Legislature modify the state law that implemented the waiver agreement so that additional federal hospital funds could be used in lieu of state General Fund support for two additional safety net health care programs for the poor-the Expanded Access for Primary Care program and the AIDS Drug Assistance Program. We estimate that about $46†million in additional General Fund savings could be obtained in this way in 2005-06, with about $35†million in additional General Fund savings possible in 2006-07. The Legislature also has the option of achieving a lesser or greater amount of savings from such changes.

Our proposed approach would require state statutory changes because the recently enacted Chapter†560 limited the use of federal hospital funds by the state to only the four safety net programs already included in the administration budget plan. We would note that it is possible that alternative safety net programs could be identified, in lieu of the ones we have proposed here, to achieve this same level of savings.

In regard to the potential for obtaining additional federal funds, we recommend that the Legislature reconsider the administrationís decision to forego the balance of the $360†million in federal hospital funds associated with implementing managed care for SPDs. We believe it would be both good health policy and good fiscal policy for the state to pursue a larger-scale expansion of managed care even if the $360†million in additional federal funds for hospitals were not at stake.

Finally, because of unresolved questions regarding the Governorís request for additional staff to implement the hospital waiver, as well as the proposed funding shift for some existing staff, we withhold our recommendation regarding these proposed positions and funding at this time.

Medi-Calís Bitter Pill: High Payments to Pharmacies

The Medi-Cal Program lacks accurate information about the prices of prescription drugs sold by drug manufacturers. In some instances, this means that Medi-Cal is reimbursing pharmacies significantly more than would appear to be reasonable. We recommend the enactment of legislation giving the Department of Health Services greater authority to ensure that reimbursement for prescription drugs is set at more appropriate levels.

How the Medi-Cal Drug Benefit Works

Multiple Players Involved in Medi-Cal Drug Benefit. There are four major players involved in the process of providing prescription and over-the-counter drugs to Medi-Cal patients: (1) drug manufacturers, (2) wholesalers that purchase drugs from the manufacturers, (3) pharmacies that buy drugs from wholesalers and then dispense them to Medi-Cal patients, and (4) Medi-Cal. Medi-Cal generally does not purchase drugs directly from drug manufacturers or wholesalers, but instead reimburses pharmacies for furnishing drugs to Medi-Cal beneficiaries at preestablished prices in keeping with various requirements established in federal and state law. The cost to the state of reimbursing pharmacies for providing drugs to persons enrolled in Medi-Cal is projected to be about $1.5†billion from the General Fund under the Governorís budget proposal.

State Relies on Average Wholesale Price (AWP). Most private and public entities reimburse pharmacies for drug costs relying on the price reported by drug manufacturers. This price is typically published in commercial publications and is referred to as AWP. Manufacturers represent AWP as being the average price paid by wholesalers to drug manufacturers for their drugs. However, the term AWP is not legally defined in federal or state law or regulations. Moreover, the reference publications essentially reprint the pricing information provided by drug manufacturers with no verification that the listed price is actually the price at which the drug was sold.

Nevertheless, most states and many private organizations rely on the AWP price data to help determine what they will pay for drugs because there is no alternative source of accurate pricing information available to them. Most state Medicaid programs, including Medi-Cal, also use AWP prices as the basis for reimbursing pharmacies for prescription drugs furnished to their beneficiaries.

Medi-Cal Reimbursement for Prescription Drugs. Under state law, Medi-Cal pays pharmacies a two-part reimbursement. Pharmacies receive:

The ďSpreadĒ Is Costly to Medi-Cal

AWP Prices Seen as Inflated. The drug prices included in AWP lists are widely regarded by many, including consumer advocates, drug procurement experts, and the federal Office of the Inspector General as being inflated, with one common remark being that AWP really stands for ďAinít Whatís Paid.Ē As a result, there is sometimes a significant difference between the ingredient fee paid by the state to a pharmacy and the much lower amount that the pharmacy actually paid to a wholesaler for the drug. This gap is widely called the spread. This phenomenon can apply both to brand-name drugs and generics.

Drug procurement experts note that a drug offering a pharmacy a relatively big spread is likely to be dispensed more frequently. For example, when pharmacies have a choice about which brand of drug to dispense, such as is often the case for generics, they have a strong financial incentive to dispense the particular drug that nets them the greatest profit. In return, over time, the choice by the pharmacy to dispense the drug that nets the largest profit could significantly increase the manufacturerís market share for its product.

Figure†6 illustrates how the spread can be costly to Medi-Cal. (This example is based on actual reimbursement data for the generic drug, Ipratropium bromide-an inhaler used to treat pulmonary disease.) In this example, a pharmacy buys the drug from a wholesaler for $0.47. The manufacturer reports, however, that it sold the drug to the wholesaler for $39.35, and this price becomes the official AWP published for that medication. Under state law, the reimbursement paid by Medi-Cal to the pharmacy for the ingredient cost of the drug is set at AWP minus 17†percent, or, in this case, $32.66. Since the pharmacyís actual out-of-pocket cost for the drug was only $0.47, the spread gained by the pharmacy is $32.19 ($32.66 minus $0.47). That amounts to a 99†percent profit to the pharmacy on the ingredient cost, and does not include the additional $7.25 dispensing fee paid to the pharmacy for each prescription that it fills of this drug.

Medi-Cal Reimbursement Significantly Exceeds Cost of Certain Drugs. As shown in Figure†7, recently collected Medi-Cal reimbursement information shows that the state has potentially paid a very large spread for some prescription drug products. For comparative purposes, and because California price data are not publicly available, our analysis uses drug cost information reported for another state to estimate the average price that is being paid by California pharmacies to wholesalers for medications used for the Medi-Cal Program. This information suggests that the state is paying high reimbursements for Medi-Cal drugs. The level of overpayments is unknown but could potentially amount to the tens of millions of dollars annually.


Figure 7

Examples of How Spread Is Increasing State Costs


Generic Name

Payment by

Estimated Price Paid by Pharmacies to Wholesalerb

Pharmacy Spread

Spread as a Percentage of State

Gammar 5 g. vial





Ipratropium Bromide 0.02 solution





Saline 0.45 solution





Haloperidol 1 mg. tablet





Albuterol 90 mcg. inhaler





Atenolol 50 mg.






a  Reimbursement based on average wholesale price-17 percent. Does not include dispensing fee.

b  Data provided by the Attorney General based on prices paid by a pharmacy in another state.



State Suing Drug Manufacturers for Fraud. The state Attorney General is now suing numerous drug manufacturers for engaging in these practices, alleging that the state is being defrauded into paying inflated reimbursement rates. (Several other states have filed lawsuits similar to Californiaís.) The Attorney General has alleged that these practices have created an inappropriate incentive for doctors and pharmacies to promote the prescription of those particular drug products offering the highest spread.

While the legal case proceeds, Medi-Cal continues to reimburse providers of certain prescription drugs at inflated rates based on the AWP because it now lacks any way to independently acquire accurate drug price information.

Federal Measure Would Reduce Drug Costs

As noted earlier, the AWP pricing system has resulted in high payments by California and other states for prescription drugs. Because the federal government shares in the cost of providing the Medi-Cal drug benefit (generally, 50†percent of the cost in California), these practices have also resulted in high payments of federal funds for the program.

Concerns about the federal government paying more than is appropriate has prompted Congress to include various provisions in the Federal Deficit Reduction Act (S. 1932) that are intended to reduce drug costs for state Medicaid programs. We discuss below these key changes that appear likely to help address Medi-Calís drug-pricing problems. These proposed actions are likely to reduce drug costs for both the states and for the federal government and make drug prices for state Medicaid programs known to the public.

Federal Upper Payment Limit for Multiple Source Drugs. The federal measure would modify a previously existing federal upper payment limit for generics to limit reimbursement to 250†percent of the average manufacturerís price, a measure of drug prices known widely as AMP. The AMP is based on actual price data that drug manufacturers are required under federal law to report to the federal government, and is not a reference-type price such as AWP. The measure also amends federal law so that more drugs on the market would be considered generics and thus be subject to these price limits. (See nearby box for a comparison of the three ways that drug manufacturerís costs are reimbursed.)

Three Types of Drug Prices and What They Mean

  • Average Wholesale Price. The average price reported by drug manufacturers as being paid by wholesalers.

  • Average Selling Price (ASP). The average price actually paid by wholesalers for drugs based on sales to all classes of trade, including retailers, hospitals, and nursing homes.

  • Average Manufacturers Price. The average price actually paid by wholesalers based on sales of drugs to retail pharmacies. Since manufacturers typically charge retail pharmacies more for drugs than other classes of trade, such as hospitals, these prices can be higher than ASP.

AMP Data Made Public. Under the federal measure, information about AMP for generic drugs would be reported to states on a monthly basis and also be made publicly available. This change is intended to provide states with a potentially more accurate pricing measure than AWP that could bring reimbursements to pharmacies for their reported ingredient costs more in line with the actual prices being paid for the drugs. In other words, this change should help reduce the spread being gained by pharmacies under the current system.

Other Reporting Requirements. The federal measure also requires that, beginning January 2007, state Medicaid plans must report to CMS annually various data, including the rates they are paying for drugs. This would permit federal authorities, as well as state officials in California and other states, to compare their performance in getting these drugs at the lowest prices. In addition, CMS will compare the retail sales prices being paid in each state by consumers for the 50 most widely prescribed drugs.

State Has Planned a New Measure-Average Wholesale Price

State Has Taken Some Actions Intended to Address the Spread Issue. In addition to pursuing fraud allegations against drug makers over drug-pricing practices, the state has taken other steps intended to help address the high cost of drugs to Medi-Cal. Notably, a 2004 state law authorized the Medi-Cal Program to impose a new type of price limit on ingredients that could be even lower than AWP minus 17†percent. This new pricing measure was termed the ďaverage selling priceĒ or ASP. The ASP was to be based on the actual average price paid by wholesalers for drugs in order to more accurately capture their true cost. Rather than continue to use AWP reference prices, the 2004 law authorized DHS to collect pricing information from drug makers to establish its own list of ASP prices that could be used to determine appropriate Medi-Cal reimbursement rates for pharmacies.

Obstacles to Implementing ASP. Two years after it was authorized by state law, DHS has yet to implement the ASP system or begin to collect the new pricing information that would be needed for it to go into effect. State officials say the complicated nature of creating such a system has slowed their efforts to date. Recent federal developments pose additional obstacles as discussed below.

When Californiaís ASP law was enacted, there had been indications that federal authorities intended to create their own ASP system in which California and other state Medicaid programs could eventually participate. The new federal deficit reduction measure instead relies on AMP rather than ASP as the basis for setting pharmacy reimbursement. Thus, it may no longer make sense for the state to incur the significant administrative costs and operational problems likely to result from creating its own new and separate pricing system now that AMP price data may soon be available for establishing Medi-Cal reimbursement rates. The state may be able to accomplish the same aim by piggybacking on such a new federal system, assuming one actually is implemented at the federal level.

We would note that additional future changes in addressing the spread issue are possible. For example, federal authorities might focus on ASP or altogether different strategies in the future to constrain payments for drugs.

Analystís Recommendation

Given these changing circumstances, we believe it is important that the Legislature and DHS take a flexible approach to setting reimbursement rates for pharmacies that ensures that reimbursement for prescription drugs is set at more appropriate levels.

Specifically, we propose that the existing state ASP law be amended to give DHS greater authority to choose whether to use AMP, ASP, or other yet-unidentified pricing mechanisms to set reimbursements to pharmacies for drugs, especially generics. State law should provide DHS the authority to limit pharmacy reimbursements under whichever method it determines will result in the lowest net effective prices for the state for drugs after taking into account state administrative costs.

The legislation should also require DHS to report to the appropriate budget and health policy committees by April 1, 2007, regarding its timetable and plans for using the provisions in the revised statute to obtain lower prices on these drugs for Medi-Cal.

We believe this approach is likely to result in state savings of up to the tens of millions of dollars annually for Medi-Cal drug benefits once more accurate drug pricing information becomes available.

Other Program Adjustments

Coordinated Care Proposals Should Be Modified

We recommend the Legislature not approve a new coordinated care management pilot project that would be largely duplicative of a disease management pilot project now in development. However, we recommend approval of another proposed pilot project to assist Medi-Cal beneficiaries who have both mental health and physical health problems, with a modification to use Proposition†63 mental health funding in lieu of General Fund support. (Reduce Item 4260-001-0001 by $208,000, reduce Item 4260-001-0890 by $79,000, and increase Item 4260-001-3085 by $127,000.)

Budget Proposes Two Pilot Projects. The Governorís budget requests five additional staff positions and $473,000 from all fund sources ($208,000 from the General Fund) for DHS to implement two ďcoordinated care managementĒ pilot projects. One pilot would focus on persons with one or more chronic health conditions and who also have a serious mental illness. The other would focus on SPDs who have chronic medical conditions or who may be seriously ill and near the end of life.

Care Management Similar to Disease Management. Coordinated care management is very similar in concept to disease management services in that both health care strategies are intended to improve the coordination of health care services for persons with chronic diseases that put them at risk of expensive hospitalization or treatment if their care is not well-managed. In fact, some health care experts use the two terms interchangeably. In general, disease management programs are more likely to focus on helping a patient to manage one or a few chronic diseases. A coordinated care management program, on the other hand, is more likely to address all aspects of health care for an individual.

Efforts to better coordinate the care for persons with chronic health problems, such as disease management and care coordination management programs, have the potential to both reduce state health care costs and to improve the quality of care provided for SPDs. For these reasons, we initially proposed the disease management pilot project that was included in the 2003-04 Budget Act.

As discussed earlier in this analysis, the Medi-Cal Program is now in the process of preparing an RFP to implement several disease management pilot projects that were authorized by the Legislature in 2003-04. The administrationís 2006-07 budget proposal would initiate new and separate pilot projects that would be designated as efforts to provide coordinated care management for Medi-Cal beneficiaries.

First Pilot: Coordinated Care for Individuals With Mental Illness. In general, we conclude that the proposed new pilot project for coordinated care management focused on Medi-Cal beneficiaries who are mentally ill has merit. We believe this effort would provide new information about the potential for simultaneously improving the mental health and physical health of a population that often finds it difficult to cope with both types of health problems. However, we believe that an alternative funding source in lieu of General Fund should be considered for its support. Specifically, Proposition†63 imposed an income tax surcharge to finance an expansion of mental health services. These funds could be used in lieu of General Fund, and in combination with federal funds, to support this pilot project. The proposed pilot project appears to be consistent with the goals set forth in Proposition†63 of providing mental health services in a manner that integrates mental health services with the other health and social services needs of these patients in an innovative manner.

To accomplish such a funding shift, DHS could enter into an interagency agreement with DMH to reimburse DHS with Proposition†63 funding for activities related to this pilot project. We note that the Governorís budget similarly proposes to use Proposition†63 funding for another unrelated project partnering DHS and DMH, known as the California Mental Health Disease Management Program.

Second Pilot: Coordinated Care Project for SPDs. We recommend that the Legislature not approve the coordinated care management pilot project for SPDs with chronic illnesses because this new effort would be largely duplicative of the disease management pilots that are to get under way later this year. Rather than initiate another similar but separate pilot project, we believe a better strategy would be for DHS to concentrate its efforts on the successful implementation of the disease management pilot projects, which are to commence operation later this year.

Fiscal Impact of LAO Recommendations. Because only one pilot project would proceed under our recommendation, fewer staff would be needed than DHS has requested. Accordingly, we recommend that three of the five proposed positions be approved. Accordingly, the Legislature should reduce the General Fund request by $208,000, and make an adjustment in the DHS state operations budget to reflect the substitution of $127,000 in Proposition†63 funds for an equivalent amount of General Fund support. In addition, the appropriation of federal funds should be reduced by $79,000.

Reduce Funding for Disease Management Contract

We recommend the Legislature reduce Medi-Cal expenditures by $750,000 ($375,000 General Fund) in the current year and by $750,000 ($375,000 General Fund) in 2006-07 to reflect the delay in implementing the disease management pilot project.

Contract Release Delayed. The DHS plans to test the efficacy of providing disease management services to fee-for-service Medi-Cal beneficiaries with chronic conditions such as heart disease. To do so, the department intends to award a competitively bid contract to a disease management organization. Release of the request for proposals (RFP) for this pilot project was initially delayed from March†2005 to December 2005, and we are advised by DHS that it is now likely that the RFP will be further delayed until February 2006 or later. As a result, it is unlikely that the contract will be awarded on March†1, 2006, or that payments to the contractor will begin in May 2006, as assumed in the Governorís budget plan. Given the delays to date, we estimate that the contract will not be awarded until July 2006, and that implementation of disease management services will not begin until September 2006 at the earliest.

Analystís Recommendation. We recommend that the Legislature reduce Item 4260-101-0001 by $375,000 in 2005-06 and by $375,000 in 2006-07 to reflect the delay in awarding the contract. Appropriate further budget adjustments should also be made to reflect a lower appropriation of federal funds.

Requests for Added Staff Excessive

The budget request for the Department of Health Services includes $17.3†million ($7.8†million General Fund) to implement various proposals generally related to the administration of the Medi-Cal Program. We recommend that some of the requests for funding for additional staff and contract resources be approved, but recommend a reduction of $3.5†million General Fund because others are not justified on a workload basis. We further recommend a $2†million General Fund reduction in Medi-Cal local assistance to reflect some savings that will be achieved with additional staff.

Governorís Budget Proposal. The 2006-07 Governorís Budget proposes additional staff positions and contract resources in DHS to implement various proposals generally related to the administration of the Medi-Cal Program. Some of these requests, and our related findings and recommendations, were discussed separately earlier in this analysis. These include budget proposals related to chronic care management, various long-term care pilot programs, the hospital financing waiver, and the implementation of Medicareís coverage of prescription drugs for persons enrolled in Medi-Cal and Medicare.

This analysis examines the 12 proposals summarized in Figure†8. The figure shows the general purpose of each request, the total costs and General Fund share, and the number of associated staff positions requested.


Figure 8

Medi-Cal Administration
Proposals for Positions and Related Funding

(Dollars in Thousands)


Position Request

General Fund

Total Funds

Nursing home quality assurance fee




Breast and Cervical Cancer Treatment Program backlog




Antifraud program




Implementation of managed care expansion




Managed care expansion: California Medical
Assistance Commission



Outreach to increase managed care enrollment




Third party liability: convert limited-term positions




Drug rebate program: extend limited-term positions




Treatment Authorization Request processing




Audit county administration cost claims




Medi-Cal fiscal intermediary oversight




Implementation of Self-Directed Services Waiver










Evaluating the Governorís Budget Requests

Our analysis of these 12 budget requests for DHS included a review of the departmentís overall staffing resources as well as an analysis of the justification offered by the administration for these specific proposals. The information we reviewed supports some of the DHS proposals, but raises questions about others.

Department Already Has More Positions Than It Can Fill

High Vacancy Rate at DHS. The 2005-06 Budget Act provided the funding needed to support nearly 6,000 positions for DHS. It is not unusual for a portion of a departmentĎs authorized positions to be vacant during the course of a fiscal year, as staff members leave for other jobs or retire and as efforts are made to recruit their replacements. The ordinary vacancy rate, which is ďbuilt inĒ to the budgets for most state functions, is about 5†percent. However, staffing data provided by the State Controllerís Office indicate that a much higher portion of staff positions authorized for DHS-about 14†percent-was vacant as of January 2006.

DHS Has Some Flexibility to Meet Its Staffing Priorities. A number of factors can lead to this high staffing vacancy rate. These include a surge of staff members reaching retirement age and difficulties in recruiting for specialized staff in fields where the public sector is in competition with the private sector and other public agencies for staff. In any event, this situation means that, generally, DHS has more position authority and funding in the 2005-06 Budget Act than it is now likely to use in the current year. If this situation were to continue into the budget year, as seems highly likely, it also means that DHS has some flexibility to reallocate funding and reclassify positions (with the consent of other control agencies) to meet its staffing priorities.

Justification Lacking for Some Budget Requests

Our analysis indicates that some of the specific requests for position authority and contract resources for Medi-Cal administrative activities are not justified on a workload basis at this time. We discuss the specific budget requests that we have concerns about below.

Nursing Facility Quality Assurance Fee. The 2006-07 budget requests additional resources to continue the implementation of a nursing facility quality assurance fee and facility-specific rates as required by Chapter†875, Statutes of 2004 (AB 1629, Frommer). Based on our analysis, 10 of the 41 positions requested are not justified on a workload basis. Moreover, the $500,000 ($250,000 General Fund) proposed for a contractor to assist in these efforts would duplicate the work that would be accomplished by existing DHS staff.

A combination of General Fund and federal funds are proposed to fund the positions. However, we believe it would be more appropriate to fund the General Fund share of the cost for five positions out of the proposed Licensing and Certification Fund. This would be consistent with the administrationís proposal to fund activities associated with the licensing and certification of nursing homes with license fees rather than General Fund.

Cancer Treatment Program Backlog. The 2006-07 Governorís Budget proposes to continue an effort that began two years ago to reduce a backlog of applications and review the eligibility of participants in the Breast and Cervical Cancer Treatment Program (BCCTP). The DHS received 11 limited-term positions to address the backlog two years ago. Our review of the caseload indicates that a backlog still exists, but that the number of positions requested to address this situation is excessive based on a comparison of the caseload to staff productivity. We believe only 11.5 positions of the requested 20.5 positions are warranted, and that 9.5 of these should be limited-term because the workload associated with the backlog is temporary.

Our review also indicates that the Medi-Cal budget request does not account for local assistance savings that are likely to result as the backlog of eligibility reviews is addressed with these new positions. Specifically, the cost of services is likely to decrease as eligibility reviews shift some participants from the full-scope program to more limited state-only benefits. We estimate that this switch would reduce benefit costs for BCCTP participants by about $2†million General Fund ($6†million all funds) in 2006-07.

Antifraud Activities. The Governorís budget proposes to make permanent 20 limited-term positions authorized in 2003-04 that are set to expire at the end of June 2006. We believe the Legislature needs more information about the current nature of the Medi-Cal fraud problem before it can assess this proposal. The 2003-04 Budget Act provided DHS with resources to complete an annual Medi-Cal error rate study to quantify the level of fraud in various areas of Medi-Cal. Our discussions with DHS indicate that the 2005 error rate report has been delayed from its expected release in December 2005, but will be available shortly.

Managed Care Expansion. The 2006-07 budget requests additional resources to continue the implementation of the expansion of Medi-Cal managed care plans to 13 additional counties approved last year by the Legislature. The staffing request does not reflect the fact that the expansion will be phased-in over 2006-07 and 2007-08 and is likely to be delayed in some counties. For example, Imperial County, one of the expansion counties for which DHS resources are requested, has indicated that it is not supportive of implementing managed care by March†2007 as assumed in the budget plan. The 2005-06 Budget Act provided 27 positions to begin the initial development and start-up work necessary for the expansion. Thus, we believe only 5 of the 17 additional positions requested in DHS are warranted at this time. We also do not believe that the related request for an additional position in the California Medical Assistance Commission is warranted because it should have sufficient staff to absorb this additional workload.

Outreach to Increase Enrollment in Managed Care. The DHS proposes several activities to increase the capacity of the Medi-Cal managed care system to serve SPDs. Another related budget proposal would mandate that SPDs who reside in two counties where enrollment is currently voluntary enroll in Medi-Cal managed care plans. We believe these proposals have merit and should help DHS to develop the systems needed to ensure that quality care is provided to SPDs enrolled in managed care plans. However, our analysis shows that only three of the requested nine staff positions are warranted at this time. We believe that other separate budget requests for Medi-Cal managed care activities-proposals that we recommend the Legislature approve-would provide sufficient staff to ensure that the managed care infrastructure is adequate.

Resolution of Drug Rebate Disputes. The administration proposes to continue its efforts to resolve an outstanding backlog of disputes over rebates believed to be owed to the state from drug makers. We believe the proposal to continue 11 temporary positions for this purpose for one additional year may be warranted. However, we withhold recommendation on the request at this time so that we can review at the time of the May Revision whether any of these 11 positions is vacant. The request should be adjusted to eliminate any positions that are vacant at that time because it is unlikely that newly hired staff would be productive during the one-year extension. According to the department, new staff takes an average of nine months to reach proficiency in collecting outstanding rebates.

Treatment Authorization Requests (TARs). Medi-Cal requires some services, such as certain prescription drugs and hospital inpatient care, to be approved in advance based on TARs submitted by providers to Medi-Cal field offices. The Governorís budget plan includes additional staff resources to improve the consistency of TAR processing statewide and increase the use of electronic TAR processing. A discussion of TAR issues can be found on page C-92 of our Analysis of the 2004-05 Budget Bill. We find no justification for the six additional staff positions requested to address the same issues for which the Legislature provided 18 staff two years ago. Moreover, DHS indicates that the percentage of pharmacy TARs submitted using a new electronic ďe-TARĒ submission process rose fourfold in 2005, while the percentage of medical TARs submitted using e-TAR roughly doubled. This growth in the use of e-TAR should reduce staff workload by more than enough for DHS to undertake its proposed new projects to improve the TAR process without the additional staff requested in the 2006-07 budget plan.

Auditing of County Administration Claims. The Governorís budget proposes to conduct on-site fiscal reviews to verify the accuracy of administrative costs claimed by counties for eligibility determinations for Medi-Cal beneficiaries. Our analysis indicates that the additional workload (which involves conducting one audit a year in each of the 20 counties with the greatest population and less frequently for smaller counties) for this purpose justifies only three of the five requested positions.

Self-Directed Services Waiver. The DHS provides administrative oversight and monitors consumers enrolled in the Department of Developmental Servicesí Independence Plus Home and Community-Based Services Waiver. Based on a workload analysis only one of two requested positions is justified.

Analystís Recommendations

As noted above, some administration requests warrant approval but others lack justification on a workload basis. In addition, the 14†percent vacancy rate now being experienced by DHS calls into question whether the addition of a large number of staff is appropriate at this time.

Accordingly, we recommend that some of the administration proposals be approved as proposed, that others be modified (in most cases to reduce the number of positions requested and the associated operating expenses and equipment), and that some be disapproved by the Legislature. In summary, our recommendations would result in a reduction of 47 of the 150.5 requested positions. The amount of funding provided for these specific 12 proposals would be reduced by $3.5†million from the General Fund and $7.2†million from all fund sources, including a reduction we propose for contract funding for the quality assurance fee implementation. Also, we withhold recommendation regarding the requested extension of the 20 antifraud positions pending the release of the 2005 error rate report and the extension of the 11 limited-term positions for the drug rebate program.

In addition, the Medi-Cal local assistance budget should be reduced by $2†million General Fund in 2006-07 as a result of adding positions to more quickly perform eligibility functions in the BCCTP.

Our specific recommendations for each of the budget requests discussed in this analysis are summarized in Figure†9.


Figure 9

Summary of Requested DHS Positions and
LAO Recommendations




Nursing home quality assurance fee



Breast and Cervical Cancer
Treatment Program backlog



Antifraud program



Implementation of managed care expansion



Managed care expansion: California Medical
Assistance Commission


Outreach to increase managed care enrollment



Third party liability: convert limited-term positions



Drug rebate program: extend limited-term positions



Treatment Authorization Request processing


Audit county administration cost claims



Medi-Cal fiscal intermediary oversight



Implementation of Self-Directed Services Waiver







a  Total recommended does not include the request for 20 antifraud positions or the request for
11 positions for the drug rebate program, for which we withhold recommendations at this time.


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