Order Code RL31199
Report for Congress
Received through the CRS Web
Medicare: Payments to Physicians
Updated March 3, 2003
Jennifer O’Sullivan
Specialist in Social Legislation
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress

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Medicare: Payments to Physicians
Summary
Medicare law specifies a formula for calculating the annual update in payments
for physicians services. The formula resulted in an actual negative update in
payments per service for 2002. An additional reduction was slated to go into effect
in 2003, but was prevented by recent congressional action. Many Members were
concerned about reports that some doctors had stopped seeing new Medicare patients
in response to payment reductions.
Medicare payments for services of physicians and certain non-physician
practitioners are made on the basis of a fee schedule. The fee schedule, in place since
1992, is intended to relate payments for a given service to the actual resources used
in providing that service. Payments under the fee schedule were estimated at $42.8
billion in 2002 (17% of total benefit payments). The fee schedule assigns relative
values to services which reflect physician work (i.e., the time, skill, and intensity it
takes to provide the service), practice expenses, and malpractice costs. The relative
values are adjusted for geographic variations in costs. The adjusted relative values
are then converted into a dollar payment amount by a conversion factor. The
conversion factor for 2001 was $38.2581. The conversion factor for 2002 dropped
5.4% to $36.1992. Recent congressional action prevented an additional 4.4% cut on
March 1, 2003.
The law provides a specific formula for calculating the annual update to the
conversion factor. The intent of the formula is to place a restraint on overall
increases in spending for physicians’ services. Several factors enter into the
calculation of the formula. These include: (1) the Medicare economic index (MEI),
which measures inflation in the inputs needed to produce physicians’ services; (2) the
sustainable growth rate (SGR), which is essentially a target for Medicare spending
growth for physicians’ services; and (3) an adjustment that modifies the update,
which would otherwise be allowed by the MEI, to bring spending in line with the
SGR target. The SGR target is not a limit on expenditures. Rather, the fee schedule
update reflects the success or failure in meeting the target. If expenditures exceed the
target, the update for a future year is reduced. This is what occurred for 2002. It was
also slated to occur in 2003.
The Administration had stated that if it were allowed to go back and update the
data used in calculations of the formula for previous years (which was not allowed
under prior law) the update for 2003 would be 1.6%. On February 20, 2003, the
President signed into law the Consolidated Appropriations Resolution of 2003 (P.L.
108-7). This law permitted redeterminations of the SGR for prior years. These
redeterminations were included in the final regulation published on February 28,
2003. That regulation also set the 2003 conversion factor at $36.7856, a 1.6%
increase over the 2002 level. P.L.108-7 did not, however, address the underlying
issues related to application of the formula for the annual payment update. It is
possible that the Congress may look at this issue later this year as part of the overall
discussion on Medicare reform issues. This report will be updated to reflect any
legislative action.

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Contents
Introduction: Medicare Fee Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Why Fee Schedule Was Enacted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Calculation of Fee Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Relative Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Geographic Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Conversion Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Bonus Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Publication of Fee Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Beneficiary Protections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Participation Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Submission of Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Refinements in Relative Value Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Calculation of Annual Update to the Fee Schedule . . . . . . . . . . . . . . . . . . . . . . . . 8
General Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Update Adjustment Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Sustainable Growth Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Calculation Periods; Revisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Calculation for 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Conversion Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Sustainable Growth Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Calculation For 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Conversion Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Update Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Background on SGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Current Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Legislation in the 107th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Legislation in the 108th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Other Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Access . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Geographic Variation in Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Practice Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
BBA 97 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
New Practice Expense Relative Value Units . . . . . . . . . . . . . . . . . . . . 18
Refinements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Payments for Oncology Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Required GAO Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Documentation for Evaluation and Management Services . . . . . . . . . . . . . 22
Private Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
How Private Contracting Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Current Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

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Current Prospects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Appendix: Geographic Adjustments to the Physician Fee Schedule . . . . . . . . . 28
Legislative Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Work Component . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Practice Expense Component . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Malpractice component . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
List of Tables
Table 1. Medicare and Physicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 2. Billing Provisions Applicable to Claims Denied by Medicare . . . . . . . . 6
Table 3. Calculation of the 2002 Conversion Factor . . . . . . . . . . . . . . . . . . . . . 11
Table 4. Calculation of the 2003 Conversion Factor . . . . . . . . . . . . . . . . . . . . . 12

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Medicare: Payments to Physicians
Introduction: Medicare Fee Schedule
Medicare is a nationwide program which offers health insurance protection for
40 million aged and disabled persons. Currently, 86% of beneficiaries obtain
covered services through the “original Medicare” program (also referred to as “fee-
for-service Medicare”). Under this program, beneficiaries obtain services through
providers of their choice and Medicare makes payments for each service rendered
(i.e., fee-for-service) or for each episode of care. Approximately 14% of
beneficiaries are enrolled in managed care organizations under the Medicare+Choice
program. These entities assume the risk for providing all covered services in return
for a fixed monthly per capita payment.
Medicare law and regulations contain very detailed rules governing payments
to physicians and other providers under the fee-for-service system. Payments for
physicians services under fee-for-service Medicare are made on the basis of a fee
schedule. The fee schedule also applies to services provided by certain nonphysician
practitioners such as physician assistants and nurse practitioners as well as the limited
number of Medicare-covered services provided by limited licensed practitioners
(chiropractors, podiatrists, and optometrists). Payments under the fee schedule are
estimated at $40.4 billion in 2001 and $42.8 billion in 2002 (over one-sixth of total
Medicare benefit payments).1
Why Fee Schedule Was Enacted
The fee schedule, established by the Omnibus Budget Reconciliation Act of
1989 (OBRA 1989), went into effect January 1, 1992. The physician fee schedule
replaced the reasonable charge payment method which, with minor changes, had been
in place since the implementation of Medicare in 1966. Observers of the reasonable
charge system cited a number of concerns including the rapid rise in program
payments and the fact that payments frequently did not reflect the resources used.
They noted the wide variations in fees by geographic region; they also noted that
physicians in different specialties could receive different payments for the same
service. The reasonable charge system was also criticized for the fact that while a
high price might initially be justified for a new procedure, prices did not decline over
time even when the procedure became part of the usual pattern of care. Further, it
was suggested that differentials between recognized charges for physicians visits and
other primary care services versus those for procedural and other technical services
were in excess of those justified by the overall resources used.
1 Congressional Budget Office. March 2002 Baseline.

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The fee schedule was intended to respond to these concerns by beginning to
relate payments for a given service to the actual resources used in providing that
service. The design of the fee schedule reflected many of the recommendations made
by the Physician Payment Review Commission (PPRC), a congressionally
established advisory body. The PPRC was replaced by the Medicare Payment
Advisory Commission (MedPAC) on September 30, 1997; it is responsible for
advising the Congress on the full range of Medicare payment issues.
Calculation of Fee Schedule
The fee schedule has three components: the relative value for the service; a
geographic adjustment, and a national dollar conversion factor.
Relative Value. The relative value for a service compares the relative
physician work involved in performing one service with the work involved in
providing other physicians’ services. It also reflects average practice expenses and
malpractice expenses associated with the particular service. Each of the
approximately 7,500 physician service codes is assigned its own relative value. The
scale used to compare the value of one service with another is known as a resource-
based relative value scale (RBRVS).
The relative value for each service is the sum of three components:
! Physician work component, which measures physician time, skill,
and intensity in providing a service;
! Practice expense component, which measures average practice
expenses such as office rents and employee wages (which, for
certain services can vary depending on whether the service is
performed in a facility, such as an ambulatory surgical facility, or in
a non-facility setting); and
! Malpractice expense component, which reflects average insurance
costs.
Geographic Adjustment. The geographic adjustment is designed to account
for variations in the costs of practicing medicine. A separate geographic adjustment
is made for each of the three components of the relative value unit, namely a work

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CRS-3
adjustment, a practice expense adjustment, and a malpractice adjustment.2, 3 These
are added together to produce an indexed relative value unit for the service for the
locality. There are 92 service localities nationwide.
Conversion Factor. The conversion factor is a dollar figure that converts the
geographically adjusted relative value for a service into a dollar payment amount.
The conversion factor is updated each year.4
The 2001 conversion factor was $38.2581. Thus, the payment for a service with
an adjusted relative value of 2.3 was $87.99.5 Anesthesiologists are paid under a
separate fee schedule which uses base and time units; a separate conversion factor
($17.83 in 2001) applies.
The 2002 conversion factor was $36.1992 ($16.60 for anesthesiology services).
The 2003 conversion factor is $36.7856 ($17.05 for anesthesiology services). The
new conversion factor is effective for services provided on or after March 1, 2003.
(See Calculation of Annual Update to the Fee Schedule section for a discussion of
the decrease from 2001 to 2002 and the increase from 2002 to 2003.)
Bonus Payments. The law specifies that physicians who provide covered
services in any rural or urban health professional shortage area (HPSA) are entitled
to an incentive payment. This is a 10% bonus over the amount which would
otherwise be paid under the fee schedule. The bonus is only paid if the services are
actually provided in the HPSA, as designated under the Public Health Service Act.
2 The geographic adjustments are indexes that reflect cost differences among areas compared
to the national average in a “market basket” of goods. The work adjustment is based on a
sample of median hourly earnings of workers in six professional specialty occupation
categories. The practice expense adjustment is based on employee wages, office rents,
medical equipment and supplies, and other miscellaneous expenses. The malpractice
adjustment reflects malpractice insurance costs. The law specifies that the practice expense
and malpractice indices reflect the full relative differences. However, the work index must
reflect only one-quarter of the difference. Using only one-quarter of the difference
generally means that rural and small urban areas would receive higher payments and large
urban areas lower payments than if the full difference were used.
3 For a detailed description of how the geographic adjustments are calculated, see the
Appendix.
4 Initially there was one conversion factor. By 1997, there were three factors: one for
surgical services; one for primary care services; and one for all other services. The
Balanced Budget Act of 1997 (BBA 97) provided for the use of a single conversion factor
beginning in 1998.
5 The law requires that changes to the relative value units under the fee schedule can not
cause expenditures to increase or decrease by more than $20 million from the amount of
expenditures that would have otherwise been made. This “budget neutrality” requirement
is implemented through an adjustment to the conversion factor

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Publication of Fee Schedule. Medicare is administered by the Centers for
Medicare and Medicaid Services (CMS).6 Each fall, CMS publishes in the Federal
Register the relative values and conversion factor that will apply for the following
calendar year. Updates to the geographic adjustment are published at least every 3
years.
The fee schedule is generally published by November 1 and is effective January
1. Due to some technical glitches, the 2003 fee schedule was not published until
December 31, 2002. It was slated to become effective March 1, 2003. On February
20, 2003 the President signed into law the Consolidated Appropriations Resolution
of 2003 (P.L.108-7). This law provided for a recalculation of the formula used in
determining the annual payment update. On February 28, 2003, a new regulation was
issued which contained a new update for 2003 and replaced the update provisions of
the December regulation. The other provisions in the December rule continue to
apply. All provisions are effective March 1, 2003.
Beneficiary Protections
Medicare pays 80% of the fee schedule amount for physicians’ services after
beneficiaries have met the $100 annual Part B deductible. Beneficiaries are
responsible for the remaining 20%, known as coinsurance. A physician may choose
whether or not to accept assignment on a claim.7 In the case of an assigned claim,
Medicare pays the physician 80% of the approved amount. The physician can only
bill the beneficiary the 20% coinsurance plus any unmet deductible.
When a physician agrees to accept assignment on all Medicare claims in a given
year, the physician is referred to as a participating physician. Physicians who do
not agree to accept assignment on all Medicare claims in a given year are referred to
as nonparticipating physicians. It should be noted that the term “nonparticipating
physician” does not mean that the physician doesn’t deal with Medicare.
Nonparticipating physicians still treat Medicare patients and receive Medicare
payments for providing covered services.
There are a number of incentives for physicians to participate, chief of which
is that the fee schedule payment amount for nonparticipating physicians is only 95%
of the recognized amount for participating physicians, regardless of whether they
accept assignment for the particular service or not.
Nonparticipating physicians may charge beneficiaries more than the fee
schedule amount on nonassigned claims; these balance billing charges are subject
to certain limits. The limit is 115% of the fee schedule amount for nonparticipating
6 Prior to June 14, 2001, this agency was known as the Health Care Financing
Administration (HCFA).
7 Nonphysician practitioners (such as nurse practitioners and physician assistants) paid
under the fee schedule are required to accept assignment on all claims. These practitioners
are different from limited licensed practitioners (such as podiatrists and chiropractors)who
have the option of whether or not to accept assignment.

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physicians (which is only 9.25% higher than the amount recognized for participating
physicians i.e., 115% x .95 = 1.0925). (See Table 1)
As of January 2002, 89.7% of physicians (and limited licensed practitioners)
billing Medicare were participating physicians. Close to 98% of Medicare claims
were assigned.8
Participation Agreements
Physicians who wish to become participating physicians are generally required
to sign a participation agreement prior to January 1 of the year involved. The
agreement is automatically renewed each year unless the physician notifies the
Medicare carrier (i.e., the entity processing claims) that he or she wishes to terminate
the agreement for the forthcoming year.
Due to the delay in issuing the 2003 fee schedule, the participation enrollment
period for 2003 runs until April 14, 2003.
Submission of Claims
Physicians and practitioners are required to submit all claims for covered
services to Medicare carriers. These claims must be submitted within 1 year of the
service date. An exception is permitted if a beneficiary requests that the claim not
be submitted. This situation is most likely to occur when a beneficiary does not want
to disclose sensitive information (for example, treatment for mental illness or AIDS).
In these cases, the physician may not bill more than the limiting charge. The
beneficiary is fully liable for the bill. If the beneficiary subsequently requests that the
claim be submitted to Medicare, the physician must comply. Such exceptions should
occur in only a very limited number of cases.
A physician or practitioner may furnish a service that Medicare may cover under
some circumstances but which the physician or practitioner anticipates would not be
covered in the particular case (for example, multiple nursing home visits). In this
case, the physician or practitioner should give the beneficiary an “Advance
Beneficiary Notice” (ABN) that the service may not be covered. If the claim is
subsequently denied by Medicare, there are no limits on what may be charged for the
service. If, however, the physician or practitioner does not give the beneficiary an
ABN, and the claim is denied because the service does not meet coverage criteria, the
physician cannot bill the patient. (See Table 2.)
8 Department of Health and Human Services, Centers for Medicare and Medicaid Services.
2001 Data Compendium. September 2001.

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Table 1. Medicare and Physicians
Type of physician
Balance billing
and claim
Medicare pays
Beneficiary pays
charges
Participating physician
— Must take ALL claims
80% of fee schedule
20% of fee schedule
None permitted
on assignment during the
amount
amount (plus any
calendar year. (Signs a
unmet deductible)
participation agreement)
Nonparticipating
physician — May take or
not take assignment on a
claim-by-claim basis
(A) Takes assignment
80% of fee schedule
20% of fee schedule
None permitted
on a claim
amount (recognized
amount recognized
fee schedule amount
for nonparticipating
= 95% of recognized
physicians (plus any
amount for
unmet deductible)
participating
physicians)
(B) Does not take
80% of fee schedule
(a) 20% of fee
Total bill cannot
assignment on a claim
amount (recognized
schedule amount
exceed 115% of
fee schedule amount
recognized for
recognized fee
= 95% of recognized
nonparticipating
schedule amount
amount for
physicians (plus any
(actually 109.25% of
participating
unmet deductible);
amount recognized
physicians)
plus (b) any balance
for participating
billing charges.
physicians, i.e., 115%
x 95%)
Table 2. Billing Provisions Applicable
to Claims Denied by Medicare
Claim submission
Billing limits on
to Medicare
Claim denied
denied claim
Claim submitted without (A) Denied because the service is No limits on amounts physician
advance beneficiary notice categorically not covered (e.g., can charge.
(ABN)
hearing aids)
Physician submits claim
according to billing rules for
assigned or unassigned claims,
as appropriate.
(B) Denied because service does Physician cannot bill beneficiary
not meet coverage criteria.
and must refund any amounts
beneficiary may have paid.*

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Claim submission
Billing limits on
to Medicare
Claim denied
denied claim
Claim submitted with (A) Denied because the service is No limits on amounts physician
advance beneficiary notice categorically not covered. (e.g., can charge.
(ABN)
hearing aids)
Physician submits claim
according to billing rules for
assigned or unassigned claims,
as appropriate.
(B) Denied because service does No limits on amounts physician
not meet coverage criteria.
can charge.
* If Medicare pays under a “waiver of liability” because the physician had no reason to know claim
would not be paid, regular billing rules apply.
There is another condition under which physicians and practitioners do not
submit claims for services which would otherwise be covered by Medicare. This
occurs if the physician or practitioner is under a private contacting arrangement (See
discussion under Other Issues, below.) In this case, physicians are precluded from
billing Medicare or receiving any payment from Medicare for 2 years.

Refinements in Relative Value Units
On average, the work component represents 54.5% of a service’s relative value,
the practice expense component represents 42.3%, and the malpractice component
represents 3.2%.9 The law provides for refinements in relative value units.
The work relative value units incorporated in the initial fee schedule were
developed after extensive input from the physician community. Refinements in
existing values and establishment of values for new services have been included in
the annual fee schedule updates. This refinement and update process is based in part
on recommendations made by the American Medical Association’s Specialty Society
Relative Value Update Committee (RUC) which receives input from 100 specialty
societies. The law requires a review every 5 years. The 1997 fee schedule update
reflected the results of the first 5-year review. The 2002 fee schedule reflected the
results of the second 5-year review.
While the calculation of work relative value units has always been based on
resources used in providing a service, the values for the practice expense components
and malpractice expense components were initially based on historical charges. The
Social Security Amendments of 1994 (P.L. 103-432) required the Secretary to
develop a methodology for a resource-based system for practice expenses which
would be implemented in 1998. Subsequently, the Secretary developed a system.
BBA 97 delayed its implementation. It provided for a limited adjustment in practice
expense values for certain services in 1998. It further provided for implementation
9 Medicare Payment Advisory Commission. Report to the Congress: Medicare Payment
Policy. March 2001.

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of a new resource-based methodology to be phased-in beginning in 1999. The
system would be fully phased in by 2002. (See Other Issues section for a discussion
of this item.)
BBA 97 also directed HCFA (now CMS) to develop and implement a resource-
based methodology for the malpractice expense component. HCFA developed the
methodology based on malpractice premium data. Malpractice premiums were used
because they represent actual expenses to physicians and are widely available. The
system was incorporated into the fee schedule beginning in 2000.
Calculation of Annual Update to the Fee Schedule
As noted, the conversion factor is a dollar figure that converts the
geographically adjusted relative value for a service into a dollar payment amount.
The conversion factor is the same for all services. It is updated each year according
to a complicated formula specified in law. The intent of the formula is to place a
restraint on overall spending for physicians’ services. Several factors enter into the
calculation of the formula. These include: 1) the sustainable growth rate (SGR)
which is essentially a target for Medicare spending growth; 2) the Medicare
economic index (MEI) which measures inflation in the inputs needed to produce
physicians services; and 3) the update adjustment factor which modifies the update,
which would otherwise be allowed by the MEI, to bring spending in line with the
SGR target.
The SGR system was established because of the concern that the fee schedule
itself would not adequately constrain increases in spending for physicians’ services.
While the fee schedule specifies a limit on payments per service, it does not place a
limit on the volume or mix of services. The use of SGR targets is intended to serve
as a restraint on aggregate spending. The SGR targets are not limits on expenditures.
Rather the fee schedule update reflects the success or failure in meeting the target.
If expenditures exceed the target, the update for a future year is reduced. If
expenditures are less than the target, the update is increased.
This section provides an overview of how the update percentage is calculated,
shows the calculation for 2002 and 2003, and discusses some of the issues raised by
the statutory formula.
General Rules
The annual percentage update to the conversion factor, equals the MEI, subject
to an adjustment (known as the update adjustment factor) to match target spending
for physicians services under the SGR system.10
Update Adjustment Factor. The update adjustment sets the conversion
factor at a level so that projected spending for the year will meet allowed spending
10 During a transition period (2001-2005), an additional adjustment is made to achieve
budget neutrality. The adjustment is: -0.2% for the first 4 years and + 0.8% in the last year.

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by the end of the year. Allowed spending for the year is calculated using the SGR.
However, in no case can the update adjustment factor be less than minus 7% or more
than plus 3%.
The technical calculation of the adjustment factor has changed several times.
Beginning in 2001, the update adjustment factor is the sum of: (1) the prior year
adjustment component, and (2) the cumulative adjustment component. The prior year
adjustment component is determined by: (1) computing the difference between
allowed expenditures for physicians’ services for the prior year and the amount of
actual expenditures for that year; (2) dividing this amount by the actual expenditures
for that year; and (3) multiplying that amount by 0.75. The cumulative adjustment
component is determined by: (1) computing the difference between allowed
expenditures for physicians’ services from April 1, 1996 through the end of the prior
year and the amount of actual expenditures during such period; (2) dividing that
difference by actual expenditures for the prior year as increased by the SGR for the
year for which the update adjustment factor is to be determined; and (3) multiplying
that amount by 0.33. Use of both the prior year adjustment component and the
cumulative adjustment component allows any deviation between cumulative actual
expenditures and cumulative allowed expenditures to be corrected over several years
rather than a single year.
Sustainable Growth Rate. The law specifies a formula for calculating the
SGR. It is based on changes in four factors: (1) estimated changes in fees; (2)
estimated change in the average number of Part B enrollees (excluding
Medicare+Choice beneficiaries); (3) estimated projected growth in real gross
domestic product (GDP) growth per capita; and (4) estimated change in expenditures
due to changes in law or regulations.
Calculation Periods; Revisions. Since the implementation of the fee
schedule in 1992, the update to the conversion factor has been linked to an
expenditure target mechanism. Initially this was the Medicare Volume Performance
Standard or MVPS. Beginning in 1999, the SGR mechanism has been used. The
calculations of both the SGR and the update adjustment factor were revised by the
Balanced Budget and Refinement Act of 1999 (BBRA 99).
Prior to BBRA, data for various measurement periods were used for the
calculation of the SGR and the update adjustment factor. BBRA provided that after
a transition period (which used both fiscal years (FY) and calendar years (CY)) all
calculations are to be made on a calendar year basis. The legislation also provided
that any deviation between cumulative actual expenditures and cumulative allowed
expenditures are corrected over several years rather than in a single year, thus
resulting in less year-to-year volatility in the fee schedule update. Further, the law
provided for two updates to allowed expenditures and actual expenditures to reflect
more recent data. Any revisions that result from the revision in the estimates would
be reflected in the adjustment factor for the following year.
By November 1 of each year, (using the best data available as of September 1),
CMS is required to publish in the Federal Register, the SGRs for three time periods.
These periods are the upcoming year, the current year, and the preceding year. Thus
the SGR is estimated and revised twice, based on later data. There are no further

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CRS-10
revisions to the SGR once it has been estimated and subsequently revised in each of
the 2 years following the initial estimates. For example, by November 1, 2001, CMS
was required to revise the SGRs for FY2000 and CY200011 and CY2001 and to
establish the SGR for CY2002 based on the best available data as of September 1,
2001. There can be no further revisions to the FY2000 and CY2000 data after this
time.
By November 1, 2002, CMS was to publish an estimate of the SGR for
CY2003, a revision of the CY2002 SGR estimated in 2001 and a revision of the
CY2001 SGR first estimated 2 years earlier and revised 1 year earlier. Publication
of these amounts was first delayed until December 31, 2002. These amounts were
subsequently revised as a result of the enactment of the Consolidated Appropriations
Act of 2003 (P.L. 108-7) which allowed CMS to go back and use actual data to
determine the SGRs for FY 1998 and FY1999 for the purposes of determining future
fee schedule updates. Two factors in the SGR calculation accounted for the major
differences between estimated and actual data. These were fee-for-service
enrollment in Medicare (because fewer people than expected enrolled in managed
care) and changes in the real per capita growth in the GDP. Changing the FY1998
and FY1999 numbers to reflect actual data had the effect of increasing the SGR used
for the calculation of the 2003 update.
Calculation for 2002
Conversion Factor. On November 1, 2001, CMS announced the conversion
factor update for 2002. The update was actually negative: -5.4% (compared to a
4.5% increase in 2001). Thus, the conversion factor for 2002 ($36.1992) is 5.4% less
than the conversion factor for 2001 ($38.2581). While a negative update had been
expected, the percentage reduction was somewhat larger than previously estimated.
CMS noted that the formula for calculating the update is specified in law; it therefore
did not have leeway to modify the update.
As noted above, the update reflects the MEI plus an adjustment to reflect the
success or failure in meeting the SGR target. The update derived from these
calculations resulted in an update of: -4.8%. In addition, certain required budget
neutrality adjustments are made through adjustments to the conversion factor. Thus,
the final update to the conversion factor is: -5.4%.
Update Adjustment. The MEI for 2002 was 2.6%. The update adjustment
factor (after applying the formula described above) was 0.93 (i.e., -7.0%). The
reduction would actually have been larger (based on the difference between allowed
spending and actual spending); however, the maximum reduction allowed under the
law is 7%. An additional statutory reduction (-0.2 %) applied in 2002. These three
items taken together resulted in the -4.8% update. (See Table 3)
11 As noted, the calculation of the update adjustment factor is based on a calculation of
allowed and actual expenditures. Allowed expenditures for the first 3 months of CY2000
use the FY2000 SGR; the remaining 9 months use the CY2000 SGR. Calendar years are
used for all future calculation periods.

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CRS-11
Additional Adjustments. In addition to the update calculation, the law
requires that changes to relative value units can not cause expenditures to increase
or decrease more than $20 million from the amount of expenditures that would
otherwise have been made. CMS implements this requirement through a budget
neutrality adjustment to the conversion factor. For 2002, two adjustments were made
to meet this requirement. The first was a 0.46% reduction to account for the increase
in the work relative values resulting from the 5-year review. The second was a
0.18% reduction to account for an anticipated increase in the volume and intensity
of services in response to the final year of the implementation of resource-based
practice expense relative value units.
Table 3. Calculation of the 2002 Conversion Factor
2001 Conversion factor
$38.2581
Multiply by Update (product of: MEI plus 1 (1.026), update
adjustment factor (0.93), and additional statutory reduction (.998,
i.e., a 0.2% reduction))
x 0.9523
Multiply by Budget Neutrality Adjustment for revision of relative
value units as a result of 5-year review (.9954, i.e., a 0.46%
reduction)
x 0.9954
Multiply by Budget Neutrality Adjustment for Practice Expense
Transition (.9982, i.e., a 0.18% reduction)
x 0.9982
2002 Conversion factor
$36.1992
Sustainable Growth Rate. The negative update adjustment factor for 2002
reflected the application of the SGR system. This system is designed to adjust for
how well actual expenditures meet SGR target expenditures. Three items had
particular importance for the 2002 calculation. First, is the fact that allowed
expenditures under the SGR system declined from earlier estimates in part because
GDP growth was lower than anticipated. Second, claims data for physicians services
in the first half of 2001 showed higher than expected spending over the period and
raised estimates for all of 2001. Third, certain technical errors in the calculations for
previous years (which raised the updates in those years) further reduced the 2002
update. These factors taken together mean that the reduction in the update
adjustment factor, and by extension the conversion factor, were greater than
previously estimated.
As required by law, the November 1, 2001 fee schedule regulation contained the
initial estimate for the SGR for 2002 (5.6%), a revised estimate for the SGR for 2001
(6.1%), and final estimates for the SGRs for FY2000 (6.9%) and CY2000 (7.3%).
As noted earlier, the law provided for two updates to allowed expenditures and actual
expenditures to reflect more recent data. Any changes that result from the revision
in the estimates are reflected in the adjustment factor for the following year. Thus,
any changes for 2001 and 2002 are reflected in subsequent calculations.

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CRS-12
Calculation For 2003
Conversion Factor. As noted, the law requires the fee schedule for the
following year to be issued by November 1. However, due to technical
complications, publication of the 2003 fee schedule was first delayed until December
31, 2002 and revised on February 28, 2003 in response to the enactment of the
Consolidated Appropriations Resolution of 2003 (CAR). As a result of the delays,
the 2003 fee schedule is effective March 1, 2003. The December regulation would
have set the 2003 update at a negative 4.4%. As a result of the CAR provision, the
update for 2003 is 1.6%.
Update Adjustment. The MEI for 2003 is 3.0%. The update adjustment
factor (after applying the formula described above) is 0.989. An additional statutory
reduction (-0.2 %) applies in 2003. An additional budget neutrality adjustment (-0.4)
is made to account for the increase in work relative values for anesthesia services
resulting from the 5-year review. (See Table 4)
Table 4. Calculation of the 2003 Conversion Factor
2002 Conversion factor
$36.1992
Multiply by Update (product of: MEI plus 1 (1.030), update
adjustment factor (0.989), and additional statutory reduction (.998,
i.e., a 0.2% reduction))
x 1.0166
Multiply by budget neutrality adjustment (- 0.4%) to account for
increase in anesthesia work relative values
x 0.9996
2003 Conversion factor
$36.7856
Issues
The negative update for 2002 (as well as the possibility that the 2003 update
would also have been negative) raised concerns for many observers. There is
increasing concern that some physicians may be unwilling to accept new Medicare
patients. As noted, the negative update is a direct result of the application of the SGR
system. Some observers have suggested that this system should be replaced.
Background on SGR. As noted earlier, the fee schedule was included in
OBRA 89 in order to respond to two major concerns with the then existing
reasonable charge payment methodology. First, observers noted that payments for
individual services under the reasonable charge methodology were not related to the
actual resources used. Second, they noted that overall Medicare payments for
physicians’ services were rising at a rapid pace. The fee schedule itself responded
to the first concern by beginning to relate payments for individual services to actual
resources used. However, a number of observers suggested that physicians could
potentially respond to the cuts in payments for individual services by increasing the
overall volume of services. As a result, enactment of the fee schedule itself might
not slow the overall growth rate in expenditures.

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CRS-13
The Congress responded to this concern by establishing, in OBRA 89, an
expenditure target mechanism known as the Medicare Volume Performance Standard
(MVPS). Under the MVPS, an annual expenditure target for physicians’ services
was established. The use of the target was intended to serve as a restraint on
aggregate Medicare spending for physicians’ services. If expenditures fell below the
target in a year, the increase to the conversion factor in a future year would be larger
than the MEI. Conversely, if expenditures were above the target in a year, the
increase to the conversion factor in a future year would be less than the MEI.
Several statutory changes to the MVPS and conversion factor calculation rules
were included in subsequent budget reconciliation bills. Subsequently, the PPRC,
among others, identified several methodological flaws with the revised MVPS
system. The MVPS was replaced in 1999 by the SGR, in part based on PPRC
recommendations. The SGR system is quite different from the MVPS. Under the
MVPS system, a new MVPS was calculated each year, and a conversion factor
update in a year was based on the success in meeting the target in a prior period. The
key difference between the MVPS and the SGR system is that the SGR system looks
at cumulative spending since April 1, 1996.
CMS states that the SGR system worked well for physicians for the first years
it was in effect. For the period 1998-2001, the cumulative increase in the update was
15.9 % compared to a medical inflation increase of 9.3%.12 However, beginning in
2002, the trend reversed.
Current Concerns. MedPAC, which replaced the PPRC, has reported that
the SGR system continues to have methodological flaws. In 2001, it recommended
that:
... the Congress replace the SGR system with an annual update based on factors
influencing the unit costs of efficiently providing physician services. MedPac’s
recommendation would correct three problems. First, although the SGR system
accounts for changes in input prices, it fails to account for other factors affecting
the cost of providing physician services, such as scientific and technological
advances and new federal regulations. Second, it is difficult to set an appropriate
expenditure target with the SGR system because spending for physician services
is influenced by many factors not explicitly addressed, including shifts of
services among settings and the diffusion of technology. The SGR system
attempts to sidestep this problem with an expenditure target based on growth in
real GDP, but such a target helps ensure that spending is affordable without
necessarily accounting for changes in beneficiaries’ needs for care. Third,
enforcing the expenditure target is problematic. An individual physician
reducing volume in response to incentives provided by the SGR system would
not receive a proportional increase in payments. Instead the increase would be
distributed among all physicians providing services to Medicare beneficiaries.
These problems with the SGR system can have serious consequences. Updates
under the SGR system will nearly always lead to payments that diverge from
costs because actual spending is unlikely to be the same as the target. When this
12 Centers for Medicare and Medicaid Services (CMS). CMS Announces Physician Pay
Changes for 2002. Press Release, October 31, 2001.

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CRS-14
occurs, payments will either be too low, potentially jeopardizing beneficiary
access to care, or too high, making spending higher than necessary.13
MedPAC’s March 2002 report specifically recommended repeal of the SGR
system. It recommended requiring the Secretary to update payments for physicians
services based on the estimated change in input prices for the coming year less an
adjustment for savings attributable to increased productivity.(A so-called “multifactor
productivity” factor would be used.) At the time, CBO estimated that making the
changes recommended by MedPAC would cost $126 billion over 10 years.14
As noted, there was a further problem with the SGR system. When CMS issued
its December 2002 regulation, it stated that is was unable, under the then existing
law, to go back and revise previous estimates which were used in calculating the
SGR for previous years. Errors in previous estimates meant that payment updates in
some earlier years were higher than they should have been; in turn, this meant that
spending was higher in those years than it would otherwise have been. Higher
spending meant that updates in future periods were less in order to keep spending in
line with the SGR target. As noted, the CAR, enacted February 20, 2003, enabled
CMS to revise FY 1998 and FY 1999 numbers; thereby resulting in a positive, rather
than a negative, update for 2003. However, this legislation did not address the
underlying issues related to application of the formula for the annual payment update.
Legislation in the 107th Congress
On June 28, 2002, the House passed the Medicare Modernization and
Prescription Drug Act of 2002 (H.R. 4954). This legislation included provisions
relating to physician payments. While the bill did not incorporate a long-term
modification to the sustainable growth rate system, it did modify the update
calculation for 3 years. It specified that the update for 2003 would be 2%. In
addition, the calculation for 2004 and 2005 would be modified, thereby making it
less likely that physician spending would reach levels that would trigger reductions
in the conversion factor. The legislation would have made the following changes:
! When calculating the update adjustment factor for 2004 and 2005,
actual 2002 spending data would be used as the measure of
allowable costs for 2002.
! Spending from January 1, 2002, rather than April 1, 1996 would be
used as the beginning date for calculating the base period for the
SGR calculation.
! The formula for calculating the sustainable growth rate would be
modified. For 2003, 2004, and 2005, 1 percentage point would be
added to the GDP factor.
13 Medicare Payment Advisory Commission. Medicare in Rural America. Report to
Congress, June 2001.
14 Congressional Budget Office. Medicare’s Payments to Physicians, statement by Dan L.
Crippen, before the House Committee on Ways and Means, Subcommittee on Health,
February 28, 2002.

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! A permanent change would be made in the computation of the GDP,
beginning for 2002. The current factor which measures the 1-year
change from the preceding year would be replaced with a factor that
measures the annual average change over the preceding 10 years.
A similar provision was included in a measure (S. 3018) introduced by the
Chairman and Ranking Member of the Senate Finance Committee (Senators Baucus
and Grassley). The Committee did not hold a markup on the measure because
Members were unable to come to agreement on the scope of a Medicare bill.
At the end of the session there was an attempt in the House to just address the
physician payment issue. The House-passed H.R. 5063, the Armed Forces Tax
Fairness Act of 2002. This bill included a provision which would have protected
CMS from suits if it made redeterminations of SGRs for prior years. The bill would
not have required such redeterminations. The Senate did not approve this provision.
However, this was the approach subsequently included in the CAR, enacted February
20, 2003.
Despite the fact that most Members agreed that the physician payment issue
should be addressed, the 107th Congress did not take final action. This was because
the Congress was unable to come to agreement on the scope of a Medicare bill.
Many Members, including Senators Grassley and Baucus, were unwilling to pass a
bill that addressed only physician payment issues without also increasing payments
for some other health care provider categories. Further, many Members expressed
reluctance to pass any “give-back” measure without enacting a drug benefit for
beneficiaries.
Legislation in the 108th Congress
On January 7, 2003, Congressman Thomas, Chairman of the House Ways and
Means Committee, introduced a measure (H.J.Res. 3) which would have
disapproved, under the Congressional Review Act, the fee schedule update published
December 31, 2002. Under the Congressional Review Act, the Congress is given 60
days to disapprove the implementation of a major regulation. However, this authority
has been exercised only once during the 6 years it has been in effect. Use of the
authority under the Congressional Review Act would have had the effect of freezing
the rates at the 2002 level until a revised regulation was issued. However, some
observers, noted that H.J.Res. 3 would disapprove the entire fee schedule regulation,
not just the update. They suggested that this could nullify some positive changes
incorporated in the regulation.
The Senate addressed the issue by including a provision in its version of
H.J.Res. 2 (the CAR) which would have frozen physician payments at the 2002 level
through September 30, 2003. As noted earlier, the conference agreement of the CAR
included a provision which had the effect of increasing the conversion factor for 2003
by 1.6%. The President signed the bill into law on February 20, 2003, P.L. 108-7.
The provisions of the December rule not relating to the conversion factor continue
to apply.

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CRS-16
Other Issues
Access
Recently questions have been raised about beneficiaries continued access to
care. Press reports in many part of the country have documented many cases where
beneficiaries have been unable to find a physician because physicians in their area are
refusing to accept new Medicare patients. The primary reason given was the 5.4%
cut in the conversion factor in 2002. A number of physicians are claiming that
program payments fall significantly short of expenses. Many observers contended
that the problem would grow worse if an additional cut in payments had been
allowed to go through in 2003.
Periodic analyses by PPRC, and subsequently MedPAC, as well as CMS
showed that access to physicians’ services generally remained good for most
beneficiaries through 1999.15 Detailed data is not available for a subsequent period;
however, several surveys have shown a decline in the percentage of physicians
accepting new Medicare patients. For example, a survey by the Center for Studying
Health Systems Change reports that the percentage dropped from 72% to 68% from
1997 to 2001. The sharpest decline occurred for surgical specialists, while there was
a modest increase for medical specialists. The declines were also sharpest for
physicians with low Medicare revenues.16 Another survey by American Family of
Family Physicians reported that the number of physicians turning away new Medicare
patients had jumped 28% (from 17% to 21.7% of surveyed physicians) over the
figure recorded a year earlier.17
Geographic Variation in Payments
As noted earlier, Medicare makes a geographic adjustment to each component
of the physician fee schedule.18 This adjustment is intended to reflect the actual
differences in the costs of providing services in various parts of the country.
Recently some observers, particularly those in states with lower than average
payment levels, have objected to the payment variation. In part, this may reflect the
concern with the overall reduction in payment rates from 2001 to 2002. It should be
noted that under current law any modifications to the geographic adjustments would
15 1) Medicare Payment Advisory Commission. Medicare Beneficiaries Access to Quality
Health Care. Report to Congress: Medicare Payment Policy. March 2000; and 2)
Schoenman, Julie A., Kevin Hayes, and C. Michael Cheng. Medicare Physician Payment
Changes: Impact on Physicians and Beneficiaries, Health Affairs, v. 20, no.2, March/April
2001.
16 Center for Studying Health Systems Change. Testimony of Paul Ginsburg before the
House Committee on Ways and Means, Subcommittee on Health, February 28,2002.
17 [http://www.aafp.org], Number of Physicians Turning Away New Medicare Patients
Jumps 28%. Press Release, July 24, 2002; accessed August 13, 2002.
18 See the Appendix for a discussion of how these adjustments are calculated.

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CRS-17
have to be budget neutral. Thus, if payments were increased for some areas, they
would have to be offset by payment reductions in other areas.
Some have also suggested that states with lower than average per capita
payments (excluding managed care payments) for all Medicare services are being
shortchanged. It should be noted that the data reflect a variety of factors, few of
which can be easily quantified. These include variations in practice patterns, size and
age distribution of the beneficiary population, variations in managed care penetration,
and the extent to which other federal programs (such as those operated by the
Department of Defense or Veterans Affairs) are paying for beneficiaries care.19
Practice Expenses
Background. The relative value for a service is the sum of three components:
physician work, practice expenses, and malpractice expenses. Practice expenses
include both direct costs (such as clinical personnel time and medical supplies used
to provide a specific service to an individual patient) and indirect costs (such as rent,
utilities, and business costs associated with maintaining a physician practice). When
the fee schedule was first implemented in 1992, the calculation of work relative value
units was based on resource costs. At the time, there was insufficient information to
determine resource costs associated with practice expenses (and malpractice costs).
Therefore payment for these items continued to be based on historical charges.
A number of observers felt that the use of historical charges provided an
inaccurate measure of actual resources used. The Social Security Act Amendments
of 1994 (P.L. 103-432) required the Secretary of Health and Human Services to
develop a methodology for a resource-based system which would be implemented
in CY1998. HCFA developed a proposed methodology which was published as
proposed rule-making June 18, 1997. Under the proposal, expert panels would
estimate the actual direct costs (such as equipment and supplies) by procedure;
HCFA then assigned indirect expenses (such as office rent and supplies) to each
procedure. This “bottom up” methodology proved quite controversial. A number of
observers suggested that sufficient accurate data had not been collected. They also
cited the potential large scale payment reductions that might result for some
physician specialties, particularly surgical specialties.
BBA 97. BBA 97 delayed implementation of the practice expense
methodology while a new methodology was developed and refined. BBA 97
provided that only interim payment adjustments to existing historical charge-based
practice expenses would be made in 1998. It established a process for the
development of new relative values for practice expenses and provided that the new
resource-based system would be phased-in beginning in CY1999. In 1999, 75% of
the payment would be based on the 1998 charge-based relative value unit and 25%
on the resource-based relative value. In 2000, the percentages would be 50% charge-
based and 50% resource-based. For 2001, the percentages would be 25% charge-
19 For a further discussion of this issue see CRS Congressional Distribution memorandum:
Geographic Variation in Medicare Fee-For-Service Spending, by Sibyl Tilson, April 9,
2002.

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CRS-18
based and 75% resource-based. Beginning in 2002, the values would be totally
resource-based.
New Practice Expense Relative Value Units. During 1998, HCFA
developed a new methodology for determining relative values for practice expenses.
This methodology, in use since the beginning of the phase-in process in 1999, has
been labeled the “top down” approach. For each medical specialty, HCFA estimates
aggregate spending for six categories of direct and indirect practice expenses using
the American Medical Association’s (AMA’s) Socioeconomic Monitoring System
(SMS) survey data and Medicare claims data. Each of the direct expense totals (for
clinical labor, medical equipment, and medical supplies) are allocated to individual
procedures based on estimates from the specialty’s clinical practice expert panels
(CPEPs). Indirect costs (for office expenses, administrative labor, and other
expenses) are allocated to procedures based on a combination of the procedure’s
work relative value units and the direct practice expense estimates. If the procedure
is performed by more than one specialty, a weighted average is computed; this
average is based on the frequency with which each specialty performs the procedure
on Medicare patients. The final step is a budget neutrality adjustment to assure that
aggregate Medicare expenses are no more or less than they would be if the system
had not been implemented.
Refinements. The “top down” approach was less controversial than the
original “bottom up” approach proposed in 1997. However, a number of groups
continued to express concerns, particularly with the perceived limitations in the
survey data. In 1999, the General Accounting Office (GAO) issued a report on
practice expenses; it had reviewed HCFA’s methodology and concluded that it was
acceptable for establishing practice expense relative values. GAO noted that HCFA
used what were generally recognized as the best available data, namely the SMS
annual survey and CPEP data. However, it noted that several data limitations had
been identified and should be overcome.20
Supplemental Data. During the phase-in period, Congress and others
continued to evidence concern regarding the survey data being used. BBRA 99
required the Secretary to establish by regulation a process (including data collection
standards) for determining practice expense relative values. Under this process, the
Secretary would accept for use and would use to the maximum extent practicable and
consistent with sound data practices, data collected or developed outside HHS.
These outside data would supplement data normally developed by HHS for
determining the practice expense component. The Secretary would first promulgate
the regulation on an interim basis in a manner that permitted submission and use of
outside data in the computation of relative value units for 2001. The Secretary issued
an interim final rule on May 3, 2000, for criteria applicable to supplemental survey
data submitted by August 1, 2000; in addition a 60-day comment period was
provided on these criteria. The November 1, 2000 final fee schedule regulation for
2001 incorporated modifications to the criteria.
20 U.S. GAO. Medicare Physician Payments: Need to Refine Practice Expenses During
Transition and Long Term. Report to Congressional Committees. GAO/HEHS-99-30,
February 1999.

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In the November 1, 1999, final fee schedule regulation for 2000, HCFA
accepted supplemental survey data from thoracic surgeons and in the November 1,
2000, final rule for 2001 accepted supplemental survey data from vascular surgeons.
Three organizations submitted supplemental survey data for consideration for use in
2002. However, in the November 1, 2001, final rule for 2002, CMS decided not to
use the data because none of the surveys met all of its stated criteria.21 The final rule
issued December 31, 2002 for 2003 accepted supplemental survey data from physical
therapists.
Other Activities. CMS is continuing its refinement of practice expense
relative value units. Assisting in this process is a multispecialty subcommittee of the
AMA’s RUC. This subcommittee, the Practice Expense Advisory Committee
(PEAC), is reviewing CPEP clinical staff, equipment, and supply data for physicians’
services. It makes recommendations to CMS based on this review. CMS has
implemented most of the refinements recommended by the RUC and PEAC.
Legislation; GAO Studies. The Medicare, Medicaid, and SCHIP Benefits
Improvement Act of 2000 (BIPA 2000) required GAO to conduct a study on
refinements to practice expense relative value units during the transition to the full
resource-based system in 2002. The study was to examine how the Secretary
accepted and used practice expense data developed outside HHS (as required by
BBRA 99). The report was also to include recommendations on: (1) improvements
in the process for acceptance and use of outside data; (2) any change that is
appropriate to ensure full access to a spectrum of care for beneficiaries; and (3) the
appropriateness of payments for physicians. In a separate report, the Secretary was
required to report on specialist services furnished in physicians’ offices and hospital
outpatient departments; the study was to assess whether resource-based practice
expenses create an incentive to furnish services in physicians’ offices rather than
hospital outpatient departments. Both reports were due July 1, 2001. As of this
writing these studies have not been issued, though GAO has released related studies
on oncology payments. (See below)
Payments for Oncology Services
Background. The level of payments for practice expenses has become a
major issue for oncologists who frequently administer chemotherapy drugs in their
offices. In general, Medicare does not cover outpatient prescription drugs. However,
certain categories of outpatient drugs are covered. Included are drugs which cannot
be self-administered and which are provided as incident to a physician’s service, such
as chemotherapy.22 A number of recent reports, including those by the HHS Office
21 U.S. DHHS. Centers for Medicare and Medicaid Services. Medicare Program; Revisions
to Payment Policies and Five-Year Review of and Adjustments to the Relative Value Units
Under the Physician Fee Schedule for Calendar Year 2002. Final rule. Federal Register,
v. 66, no. 212, November 1, 2001.
22 Medicare also covers certain oral cancer drugs. Covered drugs are those that have the
same active ingredients and are used for the same indications as chemotherapy drugs which
would be covered if they were not self-administered and were administered as incident to
(continued...)

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CRS-20
of Inspector General and the Department of Justice (DOJ) have found that
Medicare’s payments for some of these drugs are substantially in excess of
physicians’ and other providers’ costs of acquiring them. However, oncologists have
stated that the overpayments on the drug side are being used to offset underpayments
for practice expenses associated with administration of the chemotherapy drugs.
Medicare payment for drugs equals 95% of the average wholesale price (AWP).
AWPs are “list prices” set by drug manufacturers.23 The Inspector General and the
DOJ found that AWPs are often substantially in excess of actual acquisition costs.
In response, HCFA issued a memorandum in September 2000 authorizing the use of
prices obtained by the DOJ to set Medicare payments for certain categories of drugs.
The memorandum included pricing information for oncology drugs, but stated that
the information was not to be used to set payments them. However, oncologists
continued to voice concerns. HCFA withdrew the policy in November 2000.
Further, BIPA 2000 prohibited the Secretary from implementing any payment
reduction for drugs until GAO prepared and the Secretary reviewed a report on
revised payment methodologies for drugs. (See below)
Required GAO Reports. BBRA 99 required GAO to conduct a study on the
resources required to provide safe and effective outpatient cancer therapy. In making
the determination, the GAO was required to determine the adequacy of: (1) practice
expense relative value units associated with the utilization of such clinical resources;
and (2) work units which are used in the practice expense formula.
BIPA 2000 required GAO to prepare another report, to be coordinated with the
report required by BBRA 99. The report required by BIPA 2000 was to include
recommendations on revised payment methodologies for drugs. The report could
include: (1) proposals to make adjustments to the practice expense component for the
costs incurred in the administration, handling, or storage of certain categories of
drugs, and (2) proposals for new payments to providers or suppliers for such costs,
if appropriate.
On September 21, 2001, GAO issued a report on Medicare drug payments. The
report again noted that physicians are generally able to obtain Medicare-covered
drugs at prices significantly below current Medicare payments.
... For most physician-administered drugs, the average discount from AWP
ranged from 13 to 34%... Our survey of physicians who billed Medicare for low
volumes of drugs used in cancer treatment indicated they received discounts that
were as large or larger than widely available discounts for 11 of the 16 products
for which they were able to produce price information. Physicians are
reimbursed under the physician fee schedule for the costs of administering
chemotherapy drugs, which account for most of Medicare’s drug spending.
HCFA deviated from the basic methodology for determining practice expense
payments for certain services, including chemotherapy administration by
22 (...continued)
a physician’s professional service.
23 For a discussion of AWP, see: CRS Report RL31419, Medicare: Payments for Covered
Prescription Drugs, by Jennifer O’Sullivan.

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nonphysicians, which reduced Medicare’s practice expense payment for most
chemotherapy administration services. However, even with this alternative
methodology, oncologists’ average practice expense payments in 2001 are 8%
higher than what they would have been had charge-based payments continued.24
In October 2001, GAO issued its report on practice expense payments for
oncologists. This report again cited the 8% higher payments and expanded on the
information provided in the September report.
... Oncology’s practice expense payments compared to their estimated practice
expenses are about the same as the average for all physicians. Oncology
representatives continue to have concerns that the data HCFA used and the
adjustments it made result in their practice expenses, and consequently their
payments, being understated. For example, HCFA appropriately reduced
oncology’s reported supply expenses to exclude the costs of drugs, which are
paid for separately, before calculating practice expense payments. However,
HCFA based its reduction on average physician supply expenses rather than on
oncology’s supply expenses. An adjustment based on oncology-specific
information may result in higher payments to oncologists. Addressing other data
and methodological issues raised by oncologists would have an uncertain impact
on oncologists’ payments under the fee schedule ...25
As noted above, CMS has established a methodology for determining practice
expenses across specialties. Some observers felt that this methodology resulted in
low payments for certain services (such as many chemotherapy administration
services) which do not have direct physician involvement. In response, CMS
developed an alternative methodology for determining these costs. Contrary to
expectations, the alternative method resulted in reduced payments for some of these
nonphysician services; at the same time payments for services with direct physician
involvement increased.
The GAO recommended that CMS examine the effect, across all specialties and
classes of services, of the adjustments made to the basic methodology. It further
recommended that it improve the allocation of indirect expenses across all services.
In addition, it recommended using the basic method for calculation of payments for
services without direct physician involvement, and, if necessary validating the
underlying resource-based estimates of direct practice expenses for all nonphysician
services. In March 2002, the GAO reported that if these recommendations had been
followed, oncologists would have been paid about $51 million more in 2001.
GAO is currently working on a congressionally-mandated report on practice
expenses (see above). That report is expected to examine the issues related to the
adequacy of the data underlying practice expense payments for all services and ways
CMS could improve these data. That study is expected to involve discussion with
a variety of physician organizations.
24 U.S. GAO. Medicare: Payments for Covered Outpatient Drugs Exceed Providers’ Cost.
Report to Congressional Committees. GAO-01-1118, September 21, 2001.
25 U.S. GAO. Practice Expense Payments to Oncologists Indicate Need for Overall
Refinements. Report to Congressional Committees. GAO-02-53, October 2001.

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It must be remembered that any reallocation of payments among services must
still meet budget neutrality requirements. The use of more current or accurate
practice expenses data would also have an impact on practice expense relative values
for other services. It is not clear what the net impact would be for oncologists. The
practice expense relative values for oncology services versus other services could
potentially increase, decrease, or remain relatively unchanged. Therefore, payments
for these services could also potentially increase, decrease, or remain relatively
unchanged.
Documentation for Evaluation and Management Services
Approximately 40% of Medicare payments for physician services are for
services which are classified as evaluation and management services (i.e., physician
visits). There are several levels of evaluation and management codes. There is a
concern that physicians have not been coding services uniformly nationwide. Efforts
to verify that the correct level of care is billed are frequently hampered by the absence
of appropriate documentation. This was highlighted in a July 1997 financial audit
report from the Office of the Inspector General. That report stated that in FY1996,
there were $23 billion in questionable Medicare payments for all service categories
(14% of total fee-for-service payments); 47% of these were attributed to
documentation problems. Improper payments have declined. The 2002 report
estimated that there were $12.1 billion in improper payments in FY2001 (6.3% of
total fee-for-service spending); of this amount 42.9% (the highest percentage in 4
years) were attributed to documentation problems.26
Initial evaluation and management documentation guidelines were issued in
1995. Subsequently, HCFA worked with the AMA to develop a new set of
guidelines. These guidelines were first released in May 1997 and subsequently
revised in November 1997. The guidelines detailed for the first time specific medical
documentation requirements for single-organ system examinations and included
slightly stricter clinical standards for multisystem exams. Proponents of increased
medical record documentation considered it an important element contributing to
high quality patient care. They contended that an appropriately documented record
would assist Medicare in validating the site of service, medical necessity and
appropriateness of the service, and that services were accurately reported. Use of
medical documentation guidelines was expected to assist physicians who are audited
by carriers and could serve, if necessary, as a legal document to verify the care
provided.
Many physicians have viewed the guidelines as cumbersome and an interference
to patient care. In an effort to respond to these concerns, HCFA released new draft
documentation guidelines in June 2000 and updated them in December 2000. HCFA
described this version as simpler than the previous versions. The agency stated that
it intended to pilot test the guidelines after it developed, in conjunction with a
contractor (Aspen Systems), clinical examples illustrating the guidelines. This
26 U.S. DHHS. Office of the Inspector General. Improper Fiscal Year 2001 Medicare Fee-
For Service Payments. Report A-17-01-02002, February 21, 2002.

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CRS-23
process continued to prove controversial with many physicians arguing that the
guidelines continued to be unworkable. The AMA stated that:
The E&M guidelines continue to be an extremely burdensome problem for
physicians. In a recent AMA survey, three-fifths of respondents identified these
guidelines as the most onerous Medicare paperwork burden. Many physicians
regard the guidelines and associated clinical examples... as “overly complex” and
“unworkable.” We have reached the point where physicians create
documentation in their patients’ charts often not for the benefit of the patients’
care, but purely to meet the government’s demands. These regulatory
requirements have resulted in voluminous charts filled with layers and layers of
extraneous information. In fact, this additional documentation in patients’ charts
can actually hurt patients since care is unnecessarily delayed while physicians are
forced to search through pages and pages of documentation to identify the truly
relevant information. It is like trying to find the needle in the haystack, and
when a patient needs emergency treatment, for example, physicians do not have
the luxury of researching voluminous patient records. The pertinent medical
information needs to be immediately available so that the patient can be treated
appropriately. The current E&M documentation requirements make this nearly
impossible.27
On July 19, 2001, Secretary Thompson announced that HHS would step back
and reexamine the whole issue.
We had hoped that this current effort would be a way to reduce burdens on
physicians, but it appears it needs another look. So I have directed Aspen
Systems to stop their work on this current draft while we reassess and re-tune our
effort. Additionally, I am turning to the physician community to help design
constructive solutions. After 6 years of confusion, I think it makes sense to try
to step back and assess what we are trying to achieve. We need to go back and
re-examine the actual codes for billing doctor visits. For the system to work, the
codes for billing these visits need to be simple and unambiguous. I look forward
to working with the AMA and other physician groups to simplify the codes and
make them as understandable as possible.28
Private Contracting
Private contracting is the term used to describe situations where a physician and
a patient agree not to submit a claim for a service which would otherwise be covered
and paid for by Medicare. Under private contracting, physicians can bill patients at
their discretion without being subject to upper payment limits specified by Medicare.
HCFA (now CMS) had interpreted Medicare law to preclude such private contracts.
BBA 97 included language permitting a limited opportunity for private contracting,
effective January 1, 1998. However, if and when a physician decides to enter a
27 AMA. AMA Statement to the Practicing Physicians Advisory Council re: E&M
Guidelines and Other Issues. Statement submitted June 25, 2001.
[http://www.ama-assn.org/ama/pub/article/4077-5048html] (accessed October 17, 2001)
28 Thompson, Tommy G. Testimony before the House Committee on Ways and Means,
Hearings on Administration’s Principles to Strengthen and Modernize Medicare, July 19,
2001.

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CRS-24
private contract with a Medicare patient, that physician must agree to forego any
reimbursement by Medicare for all Medicare beneficiaries for 2 years. The patient
is not subject to the 2-year limit; the patient would continue to be able to see other
physicians who were not private contracting physicians and have Medicare pay for
the services.
How Private Contracting Works. HCFA issued regulations November 2,
1998 (as part of the 1999 physician fee schedule regulations) which clarified private
contracting requirements. The following highlights the major features of private
contracting arrangements.
! Physicians and Practitioners. A private contract may be entered
into by a physician or practitioner. Physicians are only doctors of
medicine and osteopathy. (Not included are chiropractors,
podiatrists, dentists, and optometrists.) Practitioners are physician
assistants, nurse practitioners, clinical nurse specialists, certified
registered nurse anesthetists, certified nurse midwives, clinical
psychologists, and clinical social workers.
! Beneficiaries. Private contracting rules apply only to persons who
have Medicare Part B.
! Contract Terms. The contract between a physician and a patient
must: (1) be in writing and be signed by the beneficiary or the
beneficiary’s legal representative in advance of the first service
furnished under the arrangement; (2) indicate if the physician or
practitioner has been excluded from participation from Medicare
under the sanctions provisions; (3) indicate that by signing the
contract the beneficiary agrees not to submit a Medicare claim;
acknowledges that Medigap plans do not, and that other
supplemental insurance plans may choose not to, make payment for
services furnished under the contract; agrees to be responsible for
payments for services; acknowledges that no Medicare
reimbursement will be provided; and acknowledges that the
physician or practitioner is not limited in the amount he or she can
bill for services; and (4) state that the beneficiary has the right to
obtain Medicare-covered items and services from physicians and
practitioners who have not opted-out and that the beneficiary is not
compelled to enter into private contracts that apply to other services
provided by physicians and practitioners who have not opted-out.
A contract cannot be signed when the beneficiary is facing an
emergency or urgent health care situation.
! Affidavit. A physician entering into a private contract with a
beneficiary must file an affidavit with the Medicare carrier within 10
days after the first contract is entered into. The affidavit must: (1)
provide that the physician or practitioner will not submit any claim
to Medicare for 2 years; (2) provide that the physician or practitioner
will not receive any Medicare payment for any services provided to
Medicare beneficiaries either directly or on a capitated basis under

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CRS-25
Medicare+Choice; (3) acknowledge that during the opt-out period
services are not covered under Medicare and no Medicare payment
may be made to any entity for his or her services; (4) identify the
physician or practitioner (so that the carrier will not make
inappropriate payments during the opt out period); (5) be filed with
all carriers who have jurisdiction over claims which would otherwise
be filed with Medicare; (6) acknowledge that the physician
understands that a beneficiary (who has not entered a private
contract) who requires emergency or urgent care services may not be
asked to sign a private contract prior to the furnishing of those
services; and (7) be in writing and be signed by the practitioner.
! Effect on Non-Covered Services. A private contract is unnecessary
and private contracting rules do not apply for non-covered services.
Examples of non-covered services include cosmetic surgery and
routine physical exams.
! Services Not Covered in Individual Case. A physician or
practitioner may furnish a service that Medicare may cover under
some circumstances but which the physician or practitioner
anticipates would not be considered “reasonable and necessary” in
the particular case (for example, multiple visits to a nursing home).
If the beneficiary receives an Advance Beneficiary Notice” (ABN)
that the service may not be covered, a private contract is not
necessary to bill the patient if the claim is subsequently denied by
Medicare. There are no limits on what may be charged for the non-
covered service.
! Medicare+Choice and Private Contracting. A private contracting
physician may not receive payments from a Medicare+Choice
organization for Medicare-covered services provided to plan
enrollees under a capitation arrangement.
! Ordering of Services. Medicare will pay for services by one
physician which has been ordered by a physician who has entered a
private contract (unless such physician is excluded under the
sanctions provisions). The physician who has opted out may not be
paid directly or indirectly for the ordered services.
! Timing of Opt-Out. Participating physicians can enter a private
contract, i.e. “opt out,” at the beginning of any calendar quarter,
provided the affidavit is submitted at least 30 days before the
beginning of the selected calendar quarter. Nonparticipating
physicians can opt out at any time.
! Early Termination of Opt-Out. A physician or practitioner can
terminate an opt-out agreement within 90 days of the effective date
of the first opt out affidavit. To properly terminate an opt-out, the
individual must: (a) notify all carriers with which he or she has filed
an affidavit within 90 days of the effective date of the opt-out

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CRS-26
period; (b) refund any amounts collected in excess of the limiting
charge (in the case of physicians) or the deductible and coinsurance
(in the case of practitioners); (c) inform patients of their right to have
their claims filed with Medicare for services furnished during the
period when the opt-out was in effect. In addition, there was a one
time opportunity for physicians who completed opt-out before
January 1, 1999 to terminate the opt-out during the first 90 days of
1999. (This was to allow an individual to change a previous opt-out
decision based on the November 1998 regulations.)
Current Issues. Prior to passage of the BBA provision, HCFA had
interpreted Medicare law to preclude private contracts. Proponents of private
contracting argued that private contracting is a basic freedom associated with private
consumption decisions. Patients should be allowed to get services from Medicare
and not have Medicare billed for the service. Advocates of private contracting
generally object to Medicare’s payment levels and balance billing limitations. They
state that if Medicare is not paying the bill, physicians who choose to private contract
should not be governed by Medicare’s rules.
Opponents of private contracting contend that the ability to enter into private
contracts benefits the pocketbooks of physicians and creates a “two-tiered system”
— one for the wealthy and one for other Medicare eligibles. The two-tiered system
would allow wealthier beneficiaries to seek care outside of Medicare and could
conceivably create a situation where only wealthier beneficiaries have access to the
Nation’s, or an area’s, leading specialists for a medical condition. A further concern
is that beneficiaries living in areas served by only private contracting specialists
would be unable to afford the bill (which could be any amount) and therefore forgo
needed care.
The BBA 97 provision provided a limited opportunity for private contracting.
However, the 2-year exclusion proved very controversial. Proponents of private
contracting view the 2-year exclusion as a disincentive to enter these arrangements.
They argue that physicians should not be excluded entirely from Medicare because
of their decision to contract in an individual case. Other observers are concerned that
removal of the 2-year limit would place beneficiaries at risk. They contend that more
physicians would elect to private contract if they could do it on a service-by-service
basis. Beneficiaries might not know sufficiently in advance whether or not a
particular service would or would not be paid by Medicare. Following enactment of
the private contracting provision in 1997, some efforts were made to eliminate the
2-year exclusion. However, the provision has not been amended or repealed.
Current Prospects
The negative update for physician payments in 2002 concerned a number of
Members of Congress. Many heard reports of some physicians not taking new
Medicare patients. Despite the fact that most Members agreed that the payment issue
should be addressed, the 107th Congress did not take final action. This was because
the Congress was unable to come to agreement on the scope of a Medicare bill.

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Many Members were unwilling to pass a bill that addressed only physician payment
issues without also increasing payments for some other health care provider
categories. At the same time, the Administration wanted only a limited provider
“give-back” bill. Further, many Members expressed reluctance to pass any “give-
back” measure without enacting a drug benefit for beneficiaries.
These same issues faced the 108th Congress. However, as noted previously, the
Congress passed, and the President signed into law, the CAR (P.L.108-7) which had
the effect of increasing the conversion factor for 2003. However, this law does not
address the underlying issues related to application of the formula for the annual
payment update. It is possible that the Congress may look at this issue later this year
as part of the overall discussion on Medicare reform issues. However, it is difficult
to predict the scope and timing of any final legislation.

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CRS-28
Appendix: Geographic Adjustments
to the Physician Fee Schedule
Section 1848(e) of the Social Security Act requires the Secretary of the
Department of Health and Human Services (HHS) to develop indices to measure
relative cost differences among fee schedule areas compared to the national average.
Three separate indices are required – one for physician work, one for practice
expenses and one for malpractice costs. The law specifies that the practice expense
and malpractice indices reflect the full relative differences. However, the work index
must reflect only one-quarter of the difference. Using only one-quarter of the
difference generally means that rural and small urban areas would receive higher
payments and large urban areas lower payments than if the full difference were used.
The indices are updated every 3 years and phased-in over 2 years.
Legislative Background
The physician fee schedule represented the culmination of several years of
examination by the Congress, HHS, and other interested parties on alternatives to the
then existing charge-based reimbursement system. In 1986, Congress enacted
legislation providing for the establishment of the Physician Payment Review
Commission (PPRC) to provide it with independent analytic advice on physician
payment issues. A key element of the Commission’s charge was to make
recommendations to the Secretary of HHS respecting the design of a relative value
scale for paying for physicians services. The Commission’s March 1989 report
presented the Commission’s proposal for a fee schedule based primarily on resource
costs. It recommended that the initial basis for the physician work component should
be the work done by William Hsiao and his colleagues at Harvard University.
The 1989 PPRC report examined issues related to geographic variations. It
noted that adjustments could be made to reflect nonphysician inputs (overhead costs
such as office space, medical equipment, salaries of nonphysician employees, and
malpractice insurance) and physician inputs of their own time and effort (which is
generally measured by comparing earnings data of nonphysicians). It concluded that:
Payments under the fee schedule should vary from one geographic locality to
another to reflect variation in physician costs of practice. The cost-of-living
practice index underlying the geographic multiplier should reflect variation only
in the prices of nonphysician inputs.29
PPRC stated that the fee schedule should only reflect variation in overhead costs.
Other observers, however, suggested that since physicians, as well as other
professionals, compete in local markets, local market conditions should be reflected
in the payments.
Three congressional committees have jurisdiction over Medicare Part B (which
includes physicians services). These are the House Energy and Commerce, House
Ways and Means, and Senate Finance. Each of these committees considered
29 Physician Payment Review Commission, Annual Report to Congress 1989. 1989.

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CRS-29
differing versions of the physician fee schedule as part of the budget reconciliation
process in 1989. Both the Ways and Means Committee measure and the Senate
Finance Committee measure included a geographic adjustment for the overhead and
malpractice components of the fee schedule, but not for the physician work
component. However, the Energy and Commerce Committee version provided for
an adjustment. The Committee noted:
The PPRC, in its annual report for 1989, recommended that the physician work
effort component of the fee schedule not be adjusted at all for geographic
variations, on the grounds that the physician’s time and effort should be given the
same valuation everywhere in the country. The Committee does not agree with
this recommendation. The Committee recognizes that the cost-of-living varies
around the country and that other professionals are compensated differently,
based on where they perform their services. The Committee is concerned that,
if no adjustment is made in the physician work effort component, fees in high
cost areas may be reduced to such an extent that physician services in such areas
would become inaccessible. The Committee is also concerned, however, that a
full adjustment of this component, in accord with the index developed by the
Urban Institute, would be disadvantageous to the low valuation areas and would
not serve the Committee’s policy goal of fostering a better distribution of
physician personnel. Fees in those areas might be too low to attract physicians
and to resolve problems of access that have occurred.
The index chosen by the Committee tries to balance these concerns. It makes the
adjustment in the physician work effort component, but cuts the impact of the
original Urban Institute index in half ...30
The reconciliation bill passed by the House included both the Ways and Means
Committee and Energy and Commerce Committee versions of reform. The Senate
Finance Committee version was not in the Senate-passed version because all
Medicare and non-Medicare provisions which did not have specific impact on outlays
(and therefore could not withstand a point of order based on the “Byrd rule”) were
struck from the Senate bill. Since the physician payment reform provisions were
designed to be budget neutral they were not included. Therefore, the Senate
physician fee schedule provisions were not technically in conference.
After considerable deliberation, the conference committee approved a
reconciliation bill which included physician payment reform. The conference
agreement provided that one-quarter of the geographic differences in physician work
would be reflected in the fee schedule. The accompanying report described the
provision but contained no discussion of this issue.
30 U.S. Congress. House. Committee on the Budget. Omnibus Budget Reconciliation Act
of 1989. Report to accompany H.R. 3299. September 20, 1989.

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Calculation 31
Work Component. The law defines the physician work component as the
portion of resources used in furnishing the service that reflects physician time and
intensity. The geographic adjustment to the work component is measured by net
income. The data source used for making the geographic adjustment has remained
relatively unchanged since the fee schedule began in 1992. The original
methodology used median hourly earnings, based on a 20% sample of 1980 census
data of workers in six specialty occupation categories with 5 or more years of college.
(At the time, the 1980 census data were the latest available.) The specialty categories
were: (1) engineers, surveyors, and architects; (2) natural scientists and
mathematicians; (3) teachers, counselors, and librarians; (4) social scientists, social
workers, and lawyers; (5) registered nurses and pharmacists; and (6) writers, artists,
and editors. Adjustments were made to produce a standard occupational mix in each
area. HHS has noted that the actual reported earnings of physicians were not used
to adjust geographical differences in fees, because these fees in large part are the
determinants of earnings. HHS further stated that they believed that the earnings of
physicians will vary among areas to the same degree that the earnings of other
professionals will vary.
Calculations for the 1995 through 1997 indices also used a 20% census sample
of median hourly earnings for the same six categories of professional specialty
occupations. However, the 1990 census no longer used a sample of earnings for
persons with 5 or more years of college. For 1990, data were available for all –
education and advanced degree samples. HHS selected the all education sample
because it felt the larger sample size made it more stable and accurate in the less
populous areas. The 1995 through 1997 indices also replaced metropolitan-wide
earnings with county-specific earnings for consolidated metropolitan statistical areas
(CMSAs) which are the largest metropolitan statistical areas.
Virtually no changes were made in the 1998 through 2000 work indices from
the indices in effect for 1995 through 1997. Similarly, virtually no changes were
made in the 2001-2003 work indices.32 This was because new census data were not
available. HHS examined using other sources (including the hospital wage index
used for the hospital prospective payment system); however, for a variety of reasons,
it was unable to find one that was acceptable. It felt that making no changes was
preferable to making unacceptable changes based on inaccurate data. It further noted
that updating from the 1980 to 1990 census (for the 1995-1997 indices) had generally
resulted in a small magnitude of changes in payments. Presumably, the 2004-2007
update will be able to use the 2000 census data.
31 Much of the discussion in this section is drawn from: (1) Medicare Program; Revisions
to Payment Polices Under the Physician Fee Schedule for Calendar year 2001; Proposed
Rule. Federal Register, v. 65, no 137, July 17, 2000. p. 44189-44196; and 2)Medicare
Program; Revisions to Payment Polices Under the Physician Fee Schedule for Calendar year
2001; Final Rule. Federal Register, v. 65, November 1, 2000. p. 65404.
32 In both cases very slight, very technical adjustments were made.

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CRS-31
Practice Expense Component. The geographic adjustment to the practice
expense component is calculated by measuring variations for three categories:
employee wages, office rents, and miscellaneous.
Employee wages are measured using median hourly wages of clerical workers,
registered nurses, licensed practical nurses, and health technicians. Initially a 20%
sample of the 1980 census data were used. The 1990 census was used for the 1995-
1997 revision. As is the case for calculating the work indices, changes will only be
made when the 2000 census data become available. HHS again noted that updating
from the 1980 to 1990 census (for the 1995-1997 indices) had generally resulted in
a small magnitude of changes in payments. As was the case for the work indices, the
1995 to 1997 indices provided for the use of county-specific earnings for CMSAs.
Office rents are measured by using residential fair market rental (FMR) data for
residential rents produced annually by the Department of Housing and Urban
Development (HUD). Commercial rent data has not been used because HHS has
been unable to find data on commercial rents across all fee schedule areas.

The 2001-2003 indices are based on 2000 FMR data. HUD publishes the data
on a metropolitan area basis. It made a special county-specific calculation, based on
1990 census data, for the 1995-1997 indices. Beginning with the 1998-2000 indices,
HHS decided, for a variety of reasons, that county-specific data should not be
retained except for the New York City area.
The costs of medical equipment, supplies, and miscellaneous expenses are
assumed not to vary much throughout the country. Therefore, this category has
always been assigned the national value of 1.000.
Malpractice component. Malpractice premiums are used for calculating the
geographic indices. Premiums are for a mature “claims made” policy (a policy that
covers malpractice claims made during the covered period) providing $1 million to
$3 million coverage. Adjustments are made to incorporate costs of mandatory patient
compensation funds. Initially, premium data were collected for three risk classes:
low risk (general practitioners), moderate risk (general surgeons), and high risk
(orthopedic surgeons). Subsequently data was collected on more specialties and from
more insurers. An average of 3-years of data is used to smooth out year-to-year
fluctuations. Premiums data for 1996-1998 was used for the 2001-2003 indices.

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