FROM ISSUE NUMBER 15 ~ SPRING 2013 GO TO TABLE OF CONTENTS

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A Prescription for Medicaid

PAUL HOWARD

Medicaid — the enormous federal-state program that provides health-care coverage to the poor — has never been at the center of America's political attention. It was tacked on to the Social Security Act Amendments of 1965, the law that also created Medicare, almost as an afterthought. The program's beneficiaries are not as politically active as Medicare's. Its complex, hybrid funding structure and its state-specific administration mean that there are, in effect, 50 different Medicaid programs — making it difficult for lawmakers to focus on the program as a whole.

But that focus is now sorely needed. In the nearly five decades since Medicaid was established, spending on the program has quietly grown from 0.5% of gross domestic product to 2.8%, now costing federal and state governments more than $400 billion a year. In just the past decade, between 2002 and 2011, total growth in spending on Medicaid was a staggering 64%. States try to control these costs mainly by under-compensating providers — paying just 40% to 80% of Medicare's already low reimbursement rate, even as Medicaid covers more Americans today than Medicare does (56 million versus 51 million). This practice creates serious access problems for Medicaid beneficiaries.

And while it may seem logical that times of economic trouble would produce more Medicaid enrollees, a great deal of the recent expansion in both spending and enrollment has been driven not by increasing numbers of poor beneficiaries but by growing participation among the middle class. Indeed, this "safety net" program now provides health insurance to more American families living above the poverty line than below it.

Unfortunately, the problems with Medicaid are about to get much worse. The program is set to grow even faster over the next several years thanks to the Patient Protection and Affordable Care Act (otherwise known as Obamacare), the centerpiece of which is a dramatic expansion of Medicaid eligibility. According to projections from the Congressional Budget Office, by 2020, Medicaid enrollment will approach 83 million people — an increase of 24%. This unsustainable expansion threatens Medicaid's core mission of providing care for the vulnerable and disabled, and will also crowd out state spending on other vital public priorities such as education, law enforcement, and infrastructure.

Fortunately, these problems also present opportunities. Because Medicaid is so bloated, and because it has a lower profile than other major government programs, it is a better target for near-term reforms than Medicare is. Medicaid's growing threat to state budgets, meanwhile, provides real motivation for governors of both parties to support fundamental reforms.

Perhaps most important, the Medicaid expansion in Obamacare offers state lawmakers crucial leverage. State cooperation is essential to Obamacare's implementation, a fact that puts governors in a position to negotiate with the Obama administration on fixes to Medicaid that will help their states avoid a looming fiscal catastrophe. The key is to pursue the right reforms — those that combine political feasibility with fiscal reality, eliminate waste and increase efficiency, and, above all, improve Medicaid for those Americans truly in need.

WHAT'S THE MATTER WITH MEDICAID?

Government health-care schemes are not known for their cost effectiveness, but Medicaid's financial problems are in a class of their own. In large part, this stems from several quirks and flaws in the structure of Medicaid itself — features that make the program not only hugely expensive, but also difficult to reform.

First among these flaws is the way the program is financed. Medicaid is an unusual hybrid, with funding responsibilities shared between the federal government and the states. Each state must meet certain federal guidelines, but each state administers its own Medicaid program. A state thus establishes the reimbursement levels for its health-care providers and can, with federal approval, add optional benefits to Medicaid coverage and expand eligibility beyond the populations identified by the federal baselines.

The level of federal funding also varies greatly by state, with poorer states receiving larger shares from the federal government. According to the most recent figures, Mississippi receives the greatest federal share (73%), while 14 states — including heavily populated states like California and New York as well as more rural states like Alaska and Wyoming — receive the minimum level of 50%. On average, about 57% of Medicaid funding comes from the federal government (according to CMS, this will rise to between 58% and 60% under Obamacare). The states must make up the rest.

Because each state has an incentive to minimize its own financial responsibility for Medicaid — and because each state has significant latitude in the operation of its own Medicaid program (particularly in setting eligibility requirements) — states find ever more "creative" (and sometimes legally questionable) ways to draw down additional federal dollars. The result of such schemes is a web of arcane formulas, cross subsidies, and supplemental payments that, while allowing states to pocket more federal funds, makes Medicaid as a whole needlessly expensive.

The disparities between state Medicaid programs — their various reimbursement rates and coverage levels, as well as their distinctive funding gimmicks — also make evaluation extremely difficult. The price for the same Medicaid-funded service (an MRI, for instance) can vary enormously depending on the state and the setting in which it is delivered (a hospital clinic in Illinois, say, versus a physician's office in Alabama). It becomes nearly impossible for Medicaid's administrators to assess the true effectiveness of individual health-care providers subsidized by the program. State and federal taxpayers, meanwhile, are left with no real measure of whether they are receiving good value for their money.

Medicaid also suffers from the fact that the program serves several populations. It covers pregnant women and children, parents (and in some states adults without children), the disabled, and poor, elderly recipients who may require extensive long-term care at home or in nursing facilities. Obviously, these very different populations have very different needs, and Medicaid administrators are hard pressed to structure the program in a way that can efficiently (and cost-effectively) address them all. And for the low-income elderly who are eligible for both Medicaid and Medicare, cost and responsibility for medical care are split between the programs. This division of labor further hinders efficiency and accountability.

One of the greatest problems besetting Medicaid is the prevalence of fraud. Indeed, since 2003, the Government Accountability Office has flagged the program as being at high risk for waste, fraud, and abuse. While the variations in federal and state compliance efforts make precise numbers difficult to come by, an April 2012 study from the RAND Corporation estimated that Medicare and Medicaid may lose as much as $98 billion a year to fraud and abuse. Medicaid's share of that figure is undoubtedly in the tens of billions of dollars. Some experts estimate the expenses caused by waste, fraud, and abuse at 20% or even 30% of Medicaid's total annual spending — in a program that is estimated to have spent more than $432 billion in 2012.

To make matters worse, even as Medicaid becomes more expensive, it is increasingly failing in its core purpose: to provide quality medical care to the poor. Despite the program's enormous cost, Medicaid reimbursements are so low in many states that providers often refuse to treat Medicaid patients altogether. The result is that the program's beneficiaries have rich medical coverage in theory, but very limited health-care access in fact. Indeed, a recent Health Affairs study found that more than 30% of physicians (both primary-care doctors and specialists) would not accept new Medicaid patients. While Obamacare will raise primary-care provider reimbursement rates for Medicaid patients to the same levels as those for Medicare patients, the increase is only temporary, scheduled to last just two years. (The reimbursement rate for specialists will not increase at all.) States will either be on the hook for these costs after the federal funding expires or will have to cut reimbursement rates — creating further headaches for state lawmakers. Meanwhile, Medicaid's incentives encourage providers to focus on high-cost institutional care (for which they can receive more money) rather than on disease prevention and management for high-risk populations. The result is that there is little relationship between Medicaid's open-ended spending and improvement in beneficiaries' health outcomes.

Moreover, the Medicaid system as a whole is deeply regressive, harming the poorest Americans in the poorest states. While the federal government does pay for larger shares of the Medicaid programs in poorer states, those states are still limited in the overall benefits they can provide. They tend to have higher proportions of poor and uninsured citizens, and their lower average incomes constrain their ability to finance more generous levels of coverage. In their 2010 book, Medicaid Everyone Can Count On, Thomas Grannemann and Mark Pauly note:

In general, Medicaid benefits are considerably higher in higher-income states than in lower-income states, as are Medicaid payments per beneficiary, despite the much higher federal matching percentage share in lower income states. This spending level is about 89 percent greater in the highest quintile of states by income compared to the lowest.

Pauly and Grannemann's observation is confirmed by the experience of New York, which is something of a case study in all that is wrong with Medicaid. While the Empire State has only 7% of the nation's population, it accounts for more than 13% of national Medicaid spending (the price tag for New York's Medicaid program is estimated at $54 billion for the 2012-13 fiscal year). In 2009, New York spent $8,960 per Medicaid enrollee, while Mississippi spent just $4,890, according to the Kaiser Family Foundation. New York in fact spends 62% more per Medicaid enrollee than the national average and spends more than almost any other state across every Medicaid category: In 2009, New York spent 47% more per adult enrollee than the national average ($4,277 versus $2,900), 89% more per disabled enrollee ($29,881 versus $15,841), and 71% more per elderly enrollee ($22,494 versus $13,149). Spending on children was comparatively modest: New York spent only about 9% more than the national average, $2,505 versus $2,305. While differences in cost of living explain some of the disparity between New York's figures and those of the rest of the nation, much of the gap results from the regressive nature of a program that, in theory, is supposed to be part of a progressive national scheme of welfare benefits to the poor.

The state's program is also notoriously plagued by fraud and shoddy accounting controls. In 2012, reports from the Congressional Committee on Oversight and Government Reform and the Office of the Inspector General at the U.S. Department of Health and Human Services revealed that New York had systematically overbilled federal taxpayers for Medicaid services for the mentally disabled for nearly 20 years. New York's state developmental centers — which offer treatment and housing for individuals with severe developmental disabilities — had received a staggering $1.5 million annually per resident in 2009, for a total of $2.3 billion. Of that amount, the HHS Inspector General found $1.7 billion to be above actual reported costs. State centers were compensated at Medicaid payment rates ten times higher than the Medicaid rates paid to comparable privately run developmental centers.

How did this gross overpayment go unchecked for nearly two decades? According to the congressional oversight-committee report, the overbilling resulted from a funding formula agreed to by HHS and state Medicaid officials in 1990. Over the course of the following 20 years, however, HHS never bothered to audit the payment rate to ensure that it was still in line with actual costs. State officials, of course, had no incentive to bring the overpayment to the attention of federal regulators. As a result, New York pocketed at least $15 billion in excessive payments.

Despite this lavish spending, New York's health-care outcomes generally range from poor to average compared with other states'. For example, in a 2009 report by the Commonwealth Fund, New York ranked 50th in avoidable hospital admissions. Indeed, Governor Andrew Cuomo's Medicaid Redesign Team, tasked with slowing program growth, has readily conceded that the state's Medicaid program offers poor value for both enrollees and state taxpayers — in part because of its excessive focus on institutional and hospital care instead of on primary care and on disease-prevention and -management programs.

Yet as glaring as New York's Medicaid problems are, and as costly as the program is to federal and state taxpayers, any attempt to fix the problems or control the costs is likely to face significant popular resistance. Medicaid has deep roots in state economies, where it is a significant source of revenue for hospitals, nursing homes, and personal-care providers. Medicaid is the single largest payer of the costs of long-term care services for the elderly and nursing-home care, accounting for more than 40% of both markets. It also pays for around 40% of all U.S. births, according to the National Association of Medicaid Directors. As a result, health-care providers and others who rely on Medicaid for a significant share of their incomes protest vigorously against any federal efforts to cut Medicaid spending or to even slow its growth.

State lawmakers, however, may soon have no choice but to overcome this resistance. On average, Medicaid expenditures are the single largest item on state budgets — about 24% of state spending in fiscal year 2011. (In some states, like Pennsylvania, one-third of the budget is spent on Medicaid.) Nationally, Medicaid expenditures are projected to rise faster than state revenues, crowding out funding for other critical state priorities. A recent report from the non-partisan State Budget Crisis Task Force projects that if recent trends in Medicaid spending and tax revenues hold, Medicaid will grow at an annual rate of 7.2%, while revenues will grow at just 3.9%.

A disastrous combination of poor program design, perverse incentives, waste, fraud, and abuse has thus saddled states with an unsustainable fiscal burden. While the urgency of the problems posed by Medicaid has brought some states to the point of favoring broad-based changes, their conversions are, unfortunately, ill timed. The work of reform is about to become exponentially harder, thanks to the massive expansion of Medicaid — and the exacerbation of all of Medicaid's flaws — soon to begin under Obamacare.

FROM BAD TO WORSE

Medicaid is clearly at the heart of Obamacare. The law provides for an expansion of Medicaid eligibility to cover nearly all Americans below 138% of the federal poverty level — thus significantly broadening the categories of individuals who can be covered and increasing the income eligibility ceiling for coverage. In the summer of 2012, the Supreme Court ruled that the states must be given a choice about whether to participate in this expansion. As of mid-March 2013, 25 states had announced they would do so, but many others were still considering their options.

The expansion appeals to many governors because, under the law, the federal government will pay for the entirety of the added costs through 2016, when its share will begin declining each year until it reaches 90% in 2020, where it will remain from then on. This expansion of Medicaid is the source of much of Obamacare's projected expansion of health coverage. Nearly half of the net increase in insurance coverage under the law will come from the Medicaid expansion — some 12 million new enrollees by 2023, according to the Congressional Budget Office (though the final number will depend on how many states choose to participate).

But even though the relative state share of Medicaid spending will fall under Obamacare as a result of Washington's covering the bulk of the new costs, the high "teaser rate" for federal funding under the expansion has done little to reassure governors whose states are already facing crushing Medicaid costs. Their costs will still increase by about $63 billion over 11 years (relative to what they would have been without Obamacare), according to CBO.

States will also face substantial new expenses beyond paying 10% of the cost of Obamacare's Medicaid expansion after 2019. In particular, states with large uninsured populations will take on significant administrative costs and potentially devastating coverage costs. Why? Obamacare requires the states to make signing up for Medicaid simpler and easier than it has been in the past by standardizing and simplifying the process; the law's implementation will also involve a federally funded awareness campaign to encourage eligible people to sign up. Millions of low-income residents who are eligible under current Medicaid funding rules but have not signed up will thus be enticed by the new law to do so — a phenomenon called the "woodwork effect." But the federal government will not pick up 100% (or 90% after 2019) of the tab for covering these new enrollees. Rather, for people who were eligible for Medicaid before the expansion but simply chose not to sign up, the states and the federal government will foot the bill at the original Medicaid cost-sharing levels. Many states will pay as much as 50% of the added expense.

The scale of this problem is demonstrated by the challenge facing Texas, which has the nation's highest percentage of uninsured residents. If the state were to accept Obamacare's Medicaid expansion, it would receive $77 billion in new federal funds over the next decade to cover about 1.8 million people. But because of the woodwork effect, Texas will likely have an additional $9.6 billion in new costs over the same period, according to the Urban Institute — because an estimated 600,000 Texans are expected to sign up under the old Medicaid match rates and because the match rate falls to 90% by 2019. Moreover, a 2012 survey from the Texas Medical Association found that only 31% of Texas doctors are accepting new Medicaid patients, down from 42% just two years before — foreshadowing the worsening access to care facing millions of new Medicaid recipients beginning in 2014.

Other states can expect similar difficulties. According to an April 2012 GAO report, the states will experience a steadily worsening fiscal position for the next half century — and Obamacare's Medicaid expansion bears a large measure of the blame. "State costs," the agency notes, "will likely increase most where current Medicaid eligibility requirements now provide less coverage than that required by PPACA."

To make matters worse, as Obamacare requires a vast expansion of state Medicaid programs, it limits governors' ability to manage those programs as they see fit. The law includes "maintenance of effort" provisions that prohibit states from tightening their Medicaid eligibility requirements or reducing benefits. The idea was to prevent states from throwing people off the rolls only to have them later regain eligibility under Obamacare's Medicaid expansion — except this time with greater federal funding. But the effect has been to severely restrict the states' ability to change their Medicaid programs in a difficult economic time. Thus, even as the immense fiscal burden posed by Obamacare makes Medicaid reform all the more urgent, it severely constrains governors' ability to implement meaningful changes.

Given the significant burdens of the Affordable Care Act, it perhaps comes as little surprise that many governors are taking advantage of the Supreme Court's Obamacare decision allowing states to forgo participation in the law's Medicaid expansion. As noted earlier, only 25 states and the District of Columbia have said that they will implement the Medicaid expansion. Fourteen states have said that they will not participate, and three more (Alaska, Nebraska, and Wyoming) are leaning against participation. Two more are leaning toward it, and six states (Indiana, Kansas, Tennessee, Utah, Virginia, and West Virginia) are undecided.

Those states resisting the Medicaid expansion are a source of concern for the Obama administration and other advocates of the Affordable Care Act. In designing the law, the administration placed enormous responsibility for Obamacare's implementation and funding on the states; should enough states decline those responsibilities, the entire edifice of the law could crumble. In particular, a refusal by states to expand Medicaid could result in a situation whereby millions of middle-class Americans (those earning between 138% and 400% of the federal poverty level) benefit from Obamacare's exchanges and subsidies, while the uninsured poor go without coverage. Wavering and reluctant governors thus have leverage in dealing with the administration; for them, Obamacare could turn out to be an opportunity to push for genuine reforms that would actually help the most needy and vulnerable in a sustainable way.

The holdout states should seize that opportunity by agreeing to the Medicaid expansion in exchange for greater authority to manage their own Medicaid programs in accordance with the needs of their people. Many states, after all, have tried to slow the rate of growth in Medicaid with the limited tools at their disposal (by cutting payment rates for physicians and other providers, or by moving their care-delivery systems away from wasteful "fee for service" schemes and toward managed-care plans run by private insurers). But the potential of such reform efforts has been severely limited by the fact that any state wishing to make meaningful changes to its Medicaid program must first enter into lengthy, and often fruitless, negotiations with the Centers for Medicare and Medicaid Services for a waiver from federal Medicaid requirements. (CMS is much more open to expanding Medicaid to new populations or offering new services than it is to allowing states to trim benefits or charge co-pays to different Medicaid populations.)

By agreeing to Obamacare's Medicaid expansion in exchange for significant autonomy over their own Medicaid programs, however, the states could secure the freedom to implement serious reforms — reforms that, over time, could dramatically improve care and bring costs under control.

REAL REFORMS

The question, of course, is what should those reforms look like? How should the federal government empower the states, and what should the states do with that power?

To begin, any reform must address the lack of accountability and the perverse incentives that are currently Medicaid's hallmarks. Policymakers must focus on the way in which the joint federal-state character of the program prevents both the federal government and the states from assuming responsibility for the reforms Medicaid now needs. They must also find ways to keep the federal government from using clever gimmickry to push costs onto the states, and vice versa. And they must find ways to keep health-care providers from gaming both federal and state governments through fraud, abuse, and needless treatments that do little to improve patients' health.

To move toward these goals, Congress should set some cap on federal Medicaid spending. In exchange, states would receive much greater flexibility to manage their programs as they saw fit — designing eligibility requirements, co-payment levels, and patient benefits to best meet the needs of the particular Medicaid populations within their own borders.

Increasing states' responsibility for Medicaid spending would encourage states to get the most value for every Medicaid dollar. It would reduce the appeal of colluding with providers to siphon additional federal funding. It would allow states to introduce mechanisms that would encourage health-care providers to achieve greater cost effectiveness — by paying providers per patient rather than per procedure, or by using market competition (through competitive-bidding or selective-contracting programs for Medicaid goods and services) to bring prices down.

Perhaps the best way for Congress to impose such a cap and improve the incentives for states to run Medicaid more efficiently is through block-granting. Under today's open-ended funding structure, a state effectively bills the federal government for its share of the state's Medicaid expenses on a rolling basis. This continuous access to virtually unlimited funding creates enormous incentives for states to keep pushing their Medicaid expenses ever upward; without any predictable limits on annual federal funding, there is no disciplining force to drive states to keep spending in check. Providing federal Medicaid funding through block grants — once-yearly, fixed transfers to states — would require state lawmakers to keep their annual Medicaid spending within established constraints. They would benefit both from the predictability of knowing exactly how much money they have to spend on Medicaid in a given year as well as from the need to find ways to keep overall Medicaid expenses below the pre-determined yearly threshold.

Block-granting could also have major advantages for Medicaid beneficiaries. A block grant that provided predictable sources of federal funding for specific categories of Medicaid enrollees — healthy adults and children, the disabled, the elderly — would produce a more stable reimbursement system for health-care providers, because providers would be less concerned about cuts during economic downturns. This greater stability would in turn entice more doctors and caregivers to participate in Medicaid and to take more Medicaid patients, improving beneficiaries' access to care.

Moreover, a Medicaid block grant could be designed to move the poor to private health insurance, by allowing states to "bundle" Medicaid funds with contributions from employers or other sources. (Ideally, this would be accomplished with federal reforms that created a uniform deduction or tax credit for health insurance, truly empowering the poor to control their own insurance.) A transition to stable, high-quality private coverage would further improve Medicaid beneficiaries' access to doctors and caregivers, and would reduce the churn between Medicaid and private insurance, improving continuity of coverage for vulnerable patients.

In designing Medicaid block grants, the federal government would be wise to look to the model of the 1996 welfare-reform law and the program it created: Temporary Assistance for Needy Families (TANF). Through TANF, states received block grants that they could use to support low-income residents in return for meeting a few policy goals established by the federal government. States were tasked with providing assistance to needy families so that children could be cared for in their own homes or in the homes of relatives. State programs had to work toward ending the dependence of needy parents on government benefits by promoting job training, work, and marriage. And any approved state program had to help reduce out-of-wedlock pregnancies (establishing clear numerical goals to measure the reduction) and to encourage the formation and maintenance of two-parent families. The point of TANF was to serve federal lawmakers' priorities — focused on reducing cycles of welfare dependency — while giving states increased flexibility to design their own approaches to welfare in order to best serve the needs of their particular populations. Thus any state activity that reasonably advances the federal aims is supported with a TANF block grant.

It is also worth noting that the fixed amounts of the TANF block grants have helped constrain welfare costs. The program that TANF replaced, Aid to Families with Dependent Children (AFDC), suffered from many of the same problems that currently afflict Medicaid: It was an open-ended benefit; responsibility for program administration was shared uneasily by the federal government and the states; there were many incentives for recipients to game the system to extract more benefits; and fraud was rampant. As a result, by the time the '96 reform was adopted, AFDC caseloads and costs had become a major fiscal burden. The use of block grants for TANF, however, has kept costs under control: Funding for the program remains at its 1996 levels 17 years later.

Learning from TANF's successes, reformers should use it as a model for Medicaid. As with TANF's block grants, lawmakers should design Medicaid block grants in pursuit of some key federal goals: providing assistance tailored to individuals and families, improving patients' health outcomes, reducing long-term dependence on government benefits, and improving access to medical care by helping beneficiaries obtain private health insurance.

As with TANF, the federal government should issue broad directives to states as to how to advance these goals. The details of implementation would be left up to state lawmakers, but any activity or policy constituting a reasonable response to the federal directives would be eligible for support through the state's Medicaid block grant.

What ought those directives to be? First, states should be required to design coverage and care arrangements that improve health outcomes for Medicaid recipients. This could include special-needs plans for targeted populations (diabetics, for instance), tiered co-pays to reduce unnecessary emergency-room visits, and competitive-bidding and selective-contracting arrangements that reward providers who improve outcomes for Medicaid enrollees.

Second, states should be required to coordinate and deliver care in a cost-effective fashion. In particular, state lawmakers should design their Medicaid programs to emphasize wellness and preventive care, with the goal of helping beneficiaries avoid needless ailments that require extremely costly hospital care and treatment. Encouraging patients to take more responsibility for maintaining good health would not only enhance Medicaid beneficiaries' quality of life, but also help keep the program's costs under control. Indeed, one small bright spot in Obamacare is an $85 million demonstration project, the Medicaid Incentives for the Prevention of Chronic Diseases grant program, which will test health-incentive programs for Medicaid recipients. The program should be expanded, and states given additional flexibility in program design.

Third, states should be required to help able-bodied Medicaid enrollees transition to private health insurance. For instance, rather than reimbursing health-care providers for the services they provide after the fact, states could bundle Medicaid payments in the form of defined contributions to beneficiaries. With this fixed sum of money each year to put toward premiums, Medicaid enrollees could shop among competing private health-insurance plans through health-insurance exchanges.

One benefit of greater reliance on private coverage would be improved access to medical care, as Medicaid enrollees would no longer find themselves at a disadvantage when competing with privately insured patients for doctors' services (as they do today). A push toward private insurance would also help ensure that Medicaid does not become a "trap" that keeps recipients in poverty by threatening to cut them off from health coverage if their incomes get too high.

There are also savings to be pursued through private Medicaid managed-care plans. Managed-care plans try to create networks of efficient doctors and hospitals that offer better health outcomes at lower costs. As regulations are structured now, however, there is little way for the managed-care organizations to pass any reductions in cost along to Medicaid beneficiaries, as both state and federal regulations limit the financial incentives these companies can offer Medicaid enrollees. As a result, Medicaid beneficiaries using managed-care plans have little reason to try to keep their own consumption of medical care down, since none of the cost savings will accrue to them. One way to improve these incentives would be for the federal government and the states to grant managed-care plans broad ability to share savings with patients who meet reasonable health-maintenance and disease-management goals that lower overall health-care costs. Medicaid programs could also contract with non-traditional providers, such as retail clinics located in stores like Walmart, to offer more accessible and affordable health-care options.

Additionally, the federal government should use block grants as an opportunity to revise its approach to allocating federal Medicaid funding among the states. Currently, the federal share of Medicaid funding for each state is determined by the state's per-capita income and how it compares against national per-capita income. States ranking on the wealthier end — those with per-capita incomes significantly higher than the national average — receive lower levels of federal funding for their Medicaid programs; those states with per-capita incomes well below the national per-capita income receive much higher levels of federal funding.

But while a state's per-capita income can roughly indicate the state's need for Medicaid funding, it neglects several crucial factors. Per-capita income may not accurately measure the number of people in a state living in poverty, for instance. Populous states with large disparities of wealth — like California or New York — may have higher average incomes, raised by the earnings of the super-wealthy, but also larger proportions of people living in poverty than do states with somewhat lower average per-capita incomes in which most people's earnings are relatively close to the average. The current formula also does not take account of differences in cost of living by state; people living in states with both high per-capita incomes and very high costs of living may not have much more money to spend on health care (which may well cost more in their states) than people living in states with lower per-capita incomes. Perhaps most important, the current formula does not take account of how many disabled people live in each state. Care for the disabled is by far the costliest component of Medicaid, and some states are particularly burdened by these expenses.

As part of a switch to block grants, the federal government should take account of these factors in allocating Medicaid funding among the states. Just as each state's per-capita income can be weighed against the national average to determine which states should get more federal support and which states less, state poverty rates can be evaluated against national poverty rates to determine which states actually have the largest populations of truly poor residents. Those states with the largest percentages of their populations living in poverty should receive more federal funding than those with relatively low percentages. Likewise, those states with larger populations of disabled residents (as a percentage of the total state population) relative to other states should receive more funding. Variations in cost of living, too, should be taken into account in setting the amount of each state's annual grant.

Reformers should also seek to control costs by making Medicaid explicitly countercyclical. Today, Medicaid funding does not automatically rise and fall in line with economic conditions, so when Congress increases funding to address a severe downturn, the increase often becomes permanent. Instead, federal assistance to the states should grow in the event of a prolonged recession, but then be brought back down to pre-recession levels once the economic climate improves. Such a mechanism could be worked into the federal funding formula itself (such as a statutory trigger that increases funding when GDP declines for two consecutive quarters). States could also be required to use at least a portion of the money they save from other Medicaid reforms to create a "rainy day" fund to protect their Medicaid budgets from the effects of economic downturns.

In granting states greater autonomy over their Medicaid programs through block grants or other capped funding mechanisms, federal policymakers should not simply write a check to the states and wash their hands of the matter. They should — and indeed they have an obligation to — help taxpayers understand how their money is being used, and which Medicaid programs provide good value for public dollars. Congress should, for instance, establish transparent performance measures for Medicaid health outcomes (perhaps in consultation with the National Committee for Quality Assurance) that would allow the public to evaluate states' successes and failures in providing affordable, high-quality care for Medicaid enrollees. Congress should also require (and fund) the creation of state-based provider databases that allow easy comparisons of health-care providers' costs and performance in dealing with common conditions for similar groups of patients (like, for example, the management of uncomplicated diabetes). This would enhance transparency and accountability, and encourage insurers to create networks of low-cost, high-performing health-care providers for Medicaid enrollees.

Finally, Congress should rescind the "maintenance of effort" restrictions under the Affordable Care Act that currently limit governors' ability to make the adjustments their Medicaid programs desperately need.

There will, of course, be objections and obstacles to these suggested reforms. High-spending Medicaid states and their provider lobbies will protest vigorously against systemic Medicaid reforms that enhance state accountability and transparency. To make a cap on federal Medicaid spending politically plausible under such circumstances, total federal spending on Medicaid should begin from current, high levels, but the growth rate for federal support should be lowered gradually and eventually capped at a more sustainable rate. States should also be allowed to offer additional benefits or expand subsidized health coverage to higher income levels, as long as they use only state funds to pay for the expansion. Vermont and Utah should be allowed to go their own separate ways on Medicaid reform.

The most likely criticism of any block-grant program is that it will encourage a "race to the bottom," as states slash coverage and benefits to increase savings in their Medicaid programs and thereby increase the amount of the federal block grant that they can pocket. But state experiments with welfare reform in the 1990s should put this myth to rest. Predictions that states would abandon their obligations to welfare recipients turned out to be untrue, and millions of women with children were successfully moved out of welfare and into the work force. Indeed, states should consider similar work requirements and time limits for Medicaid eligibility, to encourage recipients to seek out higher-paying occupations and avoid the welfare-program poverty trap.

Perhaps the most convincing evidence that Medicaid reform can be carried out successfully, however, is the fact that some states are already experimenting with it and achieving promising results. It is therefore worth examining what these states have been able to accomplish to draw lessons about plausible first steps to take in implementing larger-scale reforms of Medicaid.

STATES AT THE VANGUARD

Three states in particular — Rhode Island, Indiana, and New York — have embraced innovations that show how state policymakers can use increased flexibility in their Medicaid programs wisely. These states have pursued patient-focused reforms that are now poised to help lower costs and improve health-care efficiency.

Rhode Island's approach has involved a variation on a block grant: a capped allotment system. Beginning in 2009, Rhode Island accepted a five-year cap on combined state and federal Medicaid spending of $12.075 billion as part of a global waiver from CMS (the number was determined based on historical spending trends and actuarial projections of future spending rates). If Rhode Island's Medicaid spending exceeds the cap, the state bears full responsibility for paying the difference.

Rhode Island sought the Medicaid waiver as a way to achieve a few key goals. The first was to "re-balance" the state's long-term care program, moving from an emphasis on traditional (and costly) nursing-home care toward more preventive care, increased access to home- and community-based services, and improved care coordination across public programs (like Medicaid, Medicare, welfare, and the State Children's Health Insurance Program). The state also aimed to ensure that Medicaid patients have access to primary-care doctors, the lack of which is a particularly acute problem for Medicaid enrollees. Rhode Island policymakers sought to establish cost-effective strategies for procuring Medicaid services — including using selective contracting — and to use federal funding for services that were not generally eligible for a federal Medicaid match but that might improve the program's cost effectiveness (such as reforms to inpatient and outpatient payment methods, as well as services for uninsured adults with mental illnesses or drug-abuse problems who might not otherwise qualify for Medicaid).

Early evidence suggests that Rhode Island's use of its Medicaid waiver is helping the state reach these goals. An independent assessment of the Rhode Island global-waiver program conducted in December 2011 by the Lewin Group found that the state's re-balancing of long-term care reduced the average number of nursing-home users over the three-year period studied by 3%. Home- and community-based long-term care services, meanwhile, increased by 9.5%. The strategy saved the state an estimated $35.7 million over three years. Changes to payment rates and acuity adjustments (in which pay is based on the level of patient need) for nursing-home care saved the state another $15 million.

Rhode Island also achieved significant savings by increasing reliance on the medical-home model, in which a patient is treated by a unified group of providers working as a team (as opposed to his seeking specialty care on his own from disparate physicians). The state automatically enrolled children with special needs and adults with disabilities in care-management programs to ensure access to medical homes, which reduced total expenditures compared with the previous fee-for-service model. The program also lowered emergency-room use and improved access to physician care, resulting in an estimated $5 million in savings. Children and adults with chronic illnesses (such as asthma, diabetes, cardiac conditions, and mental-health disorders) who used this care-management system also had reduced emergency-room use and improved access to physician services.

Overall, Rhode Island projects that the waiver helped reduce the state's projected annual growth in Medicaid spending from 8% to 3%. Most important, the cap helped change the culture and incentives in Rhode Island's Medicaid program to emphasize more efficient coordinated care.

Indiana, too, has experimented successfully with significant Medicaid reforms. The state has introduced consumer-directed health plans for uninsured, low-income residents under its Healthy Indiana Plan (HIP). HIP also operates under a Medicaid waiver, and covers residents who earn up to 200% of the federal poverty level, have been uninsured for at least six months, and do not qualify for employer-sponsored insurance. Using money reallocated from the state's Medicaid Disproportionate Share Hospital funding along with revenue from cigarette taxes, HIP pairs catastrophic coverage with a Personal Wellness and Responsibility (or POWER) health-savings account. The state subsidizes the accounts based on individuals' incomes, but enrollees must, if they are financially able, make monthly payments into their POWER accounts of up to 5% of gross family income.

POWER accounts allow enrollees to pay for routine out-of-pocket health-care costs, but HIP includes first-dollar coverage for preventive services like mammograms and prostate-cancer screenings — up to $500 annually. HIP members who can afford to make monthly payments into their accounts but do not do so are penalized with exclusion from HIP coverage for a year, giving enrollees a sense of responsibility for maintaining their own care. As of 2010, HIP had a very low rate of non-payment — just 3% — and HIP members were likelier to maintain coverage than were traditional Medicaid recipients. To date, HIP has nearly 40,000 enrollees, and 99% of enrollees surveyed in 2010 said they would re-enroll.

Early evidence suggests that HIP members are also enjoying better quality of care. About 69% of established HIP enrollees use preventive services, and members are less likely to use emergency rooms than are traditional Medicaid beneficiaries. For HIP participants who made monthly contributions to POWER accounts, emergency-room use declined by 15% during their first six months in the program. Even enrollees whose POWER accounts were 100% state-subsidized showed a 5% decrease in emergency-room use. On the whole, 94% of HIP clients surveyed said that they were satisfied with the program.

Even New York — finally recognizing the magnitude of its Medicaid problems — has pursued reforms. In 2011, the Empire State embraced a global cap on a substantial fraction of its Medicaid expenditures (excluding spending on disabled Medicaid recipients and on services related to addiction and mental-health problems). The cap will increase by 4% a year, based on a ten-year rolling average for inflation in the cost of medical services. While 4% may seem significant, it is still well below historical growth rates for New York's Medicaid program: From 1991 to 2009, spending in New York's Medicaid program grew at an average annual rate of 6.2%, according to a December 2011 report from CMS.

As part of the reforms embraced under the cap, New York's health-care providers have been granted increased flexibility to bring costs down — like reducing unnecessary testing and using care coordinators to ensure patients get the help they need. Recognizing the need for still further improvements, New York is now seeking a CMS waiver to move populations that are currently in fee-for-service Medicaid — such as the disabled — into managed-care arrangements like those that have succeeded in Rhode Island.

These ongoing experiments are just the tip of the iceberg when it comes to the innovations that can, and should, be applied to Medicaid more broadly. The task now is for federal lawmakers to provide states, insurers, doctors, and hospitals the flexibility and incentives to pursue those innovations.

CHANGING MEDICAID'S INCENTIVES

Some federal lawmakers are already moving in this direction. In the last Congress, Representative Bill Cassidy, a Louisiana Republican, introduced a promising bill — the Medicaid Accountability and Care Act of 2012 — which would create a capped Medicaid grant program. Cassidy's legislation would establish a uniform national Medicaid eligibility standard (100% of the federal poverty level) and a per-beneficiary, per-month federal match for different categories of Medicaid recipients. This would effectively create a per-capita cap on federal Medicaid spending. Under this bill, many states would experience an increase in their current Medicaid funding, and federal payments would fluctuate based on state Medicaid enrollment. But the legislation also adjusts federal payments over time to reduce state variation in provider reimbursements: Eventually, no state would receive a federal per-enrollee payment higher than 10% of the national average, thereby providing an important incentive for health-care providers and policymakers to ensure that care is delivered efficiently, rather than to simply pass costs along to taxpayers.

Cassidy's bill, along with earlier Medicaid block-grant proposals from House Budget Committee chairman Paul Ryan, offer useful templates for future Medicaid-reform discussions. It is important, however, to recognize that block-granting will not solve all of Medicaid's problems. For some Medicaid populations — particularly the elderly who are also eligible for Medicare, disabled people, and those with serious mental illnesses — much more experimentation is needed to determine the best way to provide high-quality care at an affordable cost.

But the urgent fiscal challenge Medicaid poses to the states means that they must pursue whatever reforms they can. The key is to make the case for reform, and especially the case for Medicaid block grants, in the right way — emphasizing the enormous shortcomings of the current system. Reformers should also highlight the goals shared by patients, lawmakers, taxpayers, doctors, and insurers — including improving enrollees' access to primary-care physicians, increasing care coordination, and rewarding the most efficient and effective health-care providers.

Here, again, policymakers can learn from the example of the 1996 welfare reform. During the fight over that law, critics said that the states could not be trusted to protect the poor — but it turns out they could. Skeptics thought that Congress would lard the program with new, unfunded mandates — but it didn't. Opponents of comprehensive reforms to safety-net programs always warn that the sky will fall — and somehow it doesn't.

The lesson to be drawn from that experience is that state policymakers, like all human beings, respond to incentives. The challenge is to get the incentives right to produce a Medicaid program that leads to better outcomes for everyone, and most of all for the millions of low-income Americans who rely on Medicaid for access to life-saving care.

Paul Howard is a senior fellow at the Manhattan Institute and director of the institute's Center for Medical Progress.