Order Code RL32440
CRS Report for Congress
Received through the CRS Web
Implications of the Medicare Prescription Drug
Benefit for State Budgets
June 23, 2004
Analyst in Social Legislation
Domestic Social Policy Division
Specialist in Tax Economics
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress
Implications of the Medicare Prescription Drug Benefit
for State Budgets
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003
(MMA, P.L. 108-173) made several major changes to Medicare including (1) adding
a voluntary Medicare Part D outpatient prescription drug benefit effective January 1,
2006; (2) offering Medicare beneficiaries discounted prescription drugs in 2004 and
2005 through an endorsed discount card; (3) modifying various Medicare payment
The new Medicare drug benefit is funded in two ways: (1) by traditional
Medicare funding through enrollee payments and the Health Insurance Trust Fund;
and (2) by phased-down (commonly referred to as “clawback”) payments from the
states to the federal government. The state payments reflect the fact that starting in
2006, Medicare Part D will replace the prescription drug benefits currently received
by dual eligibles (individuals enrolled in both Medicaid and Medicare) through state
The funding mechanism for the new Medicare prescription drug benefit has the
potential to reduce both Medicaid and other state health expenditures. However, two
types of issues associated with the financing of Part D may affect the potential for
state budget savings: (1) technical issues associated with the formula for calculating
phased-down state payments to the federal government; and (2) policy issues raised
by MMA that may directly or indirectly impact Medicaid and other state health
This report outlines the issues associated with the financing of Part D coverage
through phased-down state payments to the federal government, as well as the
potential impacts of the Medicare drug benefit on Medicaid and other state health
expenditures. It will not be updated.
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Phased-Down State Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Phased-Down State Payment Formula Issues . . . . . . . . . . . . . . . . . . . . . . . . 3
Inflation Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Selection of 2003 as the Base Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Quality and Availability of Base Year Data . . . . . . . . . . . . . . . . . . . . . . 3
State Medicaid Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Low-Income Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Administrative Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
New Enrollee Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Pharmacy Plus and Other Section 1115 Waivers . . . . . . . . . . . . . . . . . . . . . . 6
Future Drug Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Other State Health Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
State Pharmacy Assistance Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
State Retiree Health Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
List of Tables
Table 1. Calculation of Phased-Down State Payments . . . . . . . . . . . . . . . . . . . . . 2
Implications of the Medicare Prescription
Drug Benefit for State Budgets
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003
(MMA, P.L. 108-173) made several major changes to Medicare including (1) adding
a voluntary Part D outpatient prescription drug benefit effective January 1, 2006; (2)
offering Medicare beneficiaries discounted prescription drugs in 2004 and 2005
through an endorsed discount card; (3) modifying various Medicare payment rates.1
In general, Medicare is the primary payer for those services covered by both
Medicare and Medicaid, and Medicaid usually covers those costs in excess of what
is covered by Medicare. For Medicaid benefits that are not available under Medicare
(for example, many long-term care services), Medicaid covers the entire cost unless
there is another third-party payer. While these rules will still apply for most Medicare
and Medicaid services, MMA will significantly change the interaction of Medicare
and Medicaid for coverage of prescription drugs.
Federal Medicaid law allows states to offer a number of benefits that are not
covered by Medicare, including (at state option) prescription drugs. All 50 states and
the District of Columbia currently cover prescription drugs for at least some
Medicaid enrollees. Starting in 2006, full-benefit dual eligibles2 will qualify for
prescription drug benefits under Medicare Part D, and states will no longer be
allowed to claim federal Medicaid matching funds for state dollars spent on drug
coverage for these individuals. In order to receive prescription drug coverage, fullbenefit dual eligibles must enroll in the new Medicare Part D benefit. This benefit
will be offered through drug plans that have received approval from the Secretary of
Health and Human Services (HHS).
The new Part D benefit is funded in two ways: (1) by traditional Medicare
funding through enrollee payments and the Health Insurance Trust Fund; and (2) by
phased-down (commonly referred to as “clawback”) state payments to the federal
For additional information, see CRS Report RL31966, Overview of the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003, by Jennifer O’Sullivan
et al. and CRS Report RL32283, Medicare Endorsed Prescription Drug Discount Card
Program, by Jennifer O’Sullivan.
The term “dual eligible” refers to individuals who qualify for both Medicare and Medicaid.
Some dual eligibles receive only a limited set of Medicaid benefits (for example, pharmacy
only or assistance with Medicare Part A and Part B premiums and cost-sharing only). Those
who receive the full range of Medicaid benefits offered in their state are referred to as “fullbenefit” dual eligibles.
government. The state payments reflect the fact that starting in 2006, Medicare Part
D will replace the prescription drug benefits currently received by full-benefit dual
eligibles through state Medicaid programs.
Two types of issues associated with the financing of Part D may have an impact
on state budgets: (1) technical issues associated with the formula for calculating
phased-down state payments to the federal government; and (2) policy issues raised
by MMA that may directly or indirectly affect Medicaid and other state health
programs. This report focuses on these issues for the Part D provisions in MMA that
may impact state budgets.3 It does not address other provisions with a potential
impact on states, including disproportionate share hospital (DSH) payment changes
and new Medicare payments for services that previously have been covered by
Medicaid for dual eligibles (for example, initial preventive physical exams).
Phased-Down State Payments
Starting in 2006, full-benefit dual eligibles will qualify for Medicare Part D
coverage, and states will no longer be allowed to claim federal Medicaid matching
funds for state dollars spent on prescription drug benefits for these individuals.
However, states will continue to be responsible for a significant portion of their drug
costs through phased-down payments to the federal government. These monthly
amounts are calculated under a formula (see Table 1) relating past state Medicaid
drug expenditures and the current number of full-benefit dual eligibles in a state.
Table 1. Calculation of Phased-Down State Payments
[ (1/12) x Base year per capitastate x (1-FMAPstate) x Inflation
adjustment ] x Enrollmentstate x Annual adjustment factor
Base year per capitastate
Annual adjustment factor
State Medicaid per capita spending on covered Part D drugs for
full-benefit dual eligibles in 2003
Federal matching assistance percentage (FMAP) is the federal
share of Medicaid financing for a given state (determined by a
formula related to state personal income); one minus FMAP is
the state share of Medicaid financing
For 2006, the annual increase in per capita expenditures for all
prescription drugs from National Health Expenditure
projections; for later years, the annual increase in actual per
capita expenditures for drugs covered under Part D
State number of full-benefit dual eligibles in a given month
90% for 2006, declining to 75% for 2015 and later years
Source: Table prepared by the Congressional Research Service (CRS) based on Section 1935(c) of
the Social Security Act.
For a discussion of the impact on dual eligibles and on state Medicaid programs, see CRS
Report RS21837, Implications of the Medicare Prescription Drug Benefit for Dual Eligibles
and State Medicaid Programs, by Karen Tritz.
The phased-down payment formula is designed to approximate what the state
share of Medicaid spending on prescription drugs for dual eligibles would have been
in the absence of the new Medicare Part D benefit and to provide some shifting of
these costs to the federal government. The partial shifting of prescription drug costs
for these individuals from the states to the federal government is done over time
through the annual adjustment factor (the factor is 90% for 2006 and gradually
declines to 75% for years after 2014).
Phased-Down State Payment Formula Issues
Inflation Adjustment. As with most inflation adjustments, the inflation rate
used in the phased-down state payment formula is calculated on a national basis.
However, the new Part D benefit provides coverage through approved plans on both
a national and a regional basis. Differences between regions and plans related to
drug formularies, ability to negotiate drug prices, and cost control mechanisms may
lead to differences in increases in prescription drug prices. Using a national inflation
adjustment assumes that there are no such differences. Another issue is that until the
new Medicare Part D benefit begins, the inflation rates used for 2004, 2005, and
2006 will be based on increases for all prescription drugs, not just those covered
under the Part D benefit. To the extent that the prices of Part D drugs grow at a rate
that is different than the average for all drugs, phased-down state payments will not
reflect the difference until 2007.
Selection of 2003 as the Base Year. One issue associated with the base
year per capita expenditure amounts is the timing of the data used to calculate them.
The use of 2003 locks in a base level of state funding that does not reflect recent
changes made by states to control their Medicaid drug spending. To the extent that
a state made changes after 2003, including the use of a drug formulary or co-pays to
limit costs under Medicaid, the state will not realize these savings in their phaseddown payments.4 The use of 2003 also locks in a base level of state funding that
reflects the profile of a state’s full-benefit dual eligible population in one particular
year. As a result, states with higher levels of drug utilization in 2003 will have
higher base year per capita drug expenditures and will permanently fund the
Medicare drug benefit at a higher rate than other states. Regardless of how utilization
patterns may change in future years, phased-down state payments will continue to
reflect the level of full-benefit dual eligible drug utilization in 2003.
Quality and Availability of Base Year Data. The first piece of
information needed for the calculation of base year per capita expenditures is the
number of full-benefit dual eligibles enrolled in Medicaid fee-for-service and
managed care arrangements in 2003. While states are required to submit information
to the Centers for Medicare & Medicaid Services (CMS) on the dual eligible status
of every Medicaid enrollee through the Medicaid Statistical Information System
A recent survey of the 50 states found that 46 took some type of pharmacy cost
containment action in state fiscal year (SFY) 2003; 44 took action in SFY2004. See Kaiser
Commission on Medicaid and the Uninsured, States Respond to Fiscal Pressure: State
Medicaid Spending Growth and Cost Containment in FY2003 and FY2004 (Sept. 2003),
Appendices B — E.
(MSIS), some have difficulty doing so. Based on fiscal year (FY) 2001 data, nine
states could not identify the Medicare status (that is, whether or not an individual was
enrolled in the program) of 10% or more of Medicaid enrollees.
Even when states are able to identify dual eligibles in their MSIS data, they may
not be able to identify whether or not they are entitled to full Medicaid benefits. In
FY2001, 18 states could not identify the benefit status (that is, whether an individual
was entitled to full benefits or limited assistance only) of 25% or more of dual
eligibles.5 CMS is currently working with the states to improve the quality of data
reporting in this area, but if some states are not able to provide complete information
for 2003, it is unclear how the number of full-benefit dual eligibles will be
determined for purposes of calculating base year per capita expenditures and how this
will affect the size of phased-down state payments.
Also required for the calculation of base year per capita expenditures is total
Medicaid spending on covered Part D drugs for full-benefit dual eligibles in 2003.
This may come from some combination of MSIS and Medicaid financial
management (Form CMS-64) information submitted by the states. However, there
are a number of data issues that will need to be addressed. One such issue is the fact
that CMS-64 reports do not include a separate accounting for the cost of outpatient
prescription drugs provided under capitated plans. A second issue is that
expenditures for drugs purchased directly from physicians or included in claims for
other services (such as institutional and home and community-based care) may also
not be identified separately in these reports. While MMA addresses managed care
by specifying that an estimated actuarial value of drug benefits provided under
capitated plans be used in base year per capita expenditure calculations, it does not
address how the other types of non-itemized drug spending mentioned above will be
included in the calculations.
A third issue with Medicaid spending data and the calculation of base year per
capita expenditures is the identification of expenditures attributable to drugs not
covered under Part D. MMA specifies that these are to be excluded from the base
year calculations, but it is unclear how non-covered drugs will be defined and how
the non-covered drug expenditures will be separated out from available data.6
State Medicaid Expenditures
Starting in 2006, full-benefit dual eligibles will qualify for prescription drug
benefits under Medicare Part D, and states will no longer be allowed to claim federal
Medicaid matching funds for state dollars spent on drug coverage for these
individuals. However, as discussed below, state Medicaid savings that result from
CRS analysis of MSIS state summary data provided by CMS.
For example, if a state covered a broad range of brand-name drugs in 2003 that are not
available or not widely available through Part D prescription drug plans (presumably
because the plan formularies include less expensive substitutes), it is not clear whether the
full cost of providing the brand-name drugs will be included in the calculation of base year
per capita expenditures.
this shift may be offset if the screening process for the Part D low-income subsidy
program leads to a greater proportion of Medicare beneficiaries being identified as
eligible for Medicaid benefits. Depending on whether or not dual eligibles enrolled
in Medicaid waiver programs are included in the base year per capita expenditures
used to calculate phased-down payments to the federal government, some states may
be able to realize savings by allowing the cost of drug coverage for these enrollees
to fall solely on the Medicare program.
According to Congressional Budget Office (CBO) estimates, the elimination of
Medicaid prescription drug coverage for full-benefit dual eligibles will reduce state
Medicaid spending by $114.6 billion between FY2004 and FY2013. However, all
but $17.2 billion of this amount will be offset by phased-down state payments ($88.5
billion), spending on new dual eligibles7 ($5.8 billion), and administrative and other
costs ($3.1 billion).8
Under MMA, certain low-income Medicare beneficiaries are entitled to
subsidies that provide assistance with Part D premiums and cost-sharing (deductibles,
co-insurance, and co-payments). State Medicaid agencies are responsible for
determining eligibility for these subsidies and are likely to incur both administrative
and new enrollee costs as a result of the subsidy screening process.
Administrative Costs. As a condition of receiving federal financial
participation for their Medicaid programs, states are required under MMA to
determine eligibility for Medicare Part D’s low-income subsidy program for all
Medicare beneficiaries, not just those who are dual eligibles. Social Security offices
will also share in this responsibility. CBO estimates that more than 14 million
individuals will be eligible for low-income subsidies in 2006, although not all of
them are expected to participate in the program. State Medicaid programs will
receive federal reimbursement for 50% of costs associated with administering the
subsidy, such as hiring new staff and modifying eligibility determination systems.
New Enrollee Costs. Starting in 2006, full-benefit dual eligibles will qualify
for Medicare Part D and will no longer be eligible for Medicaid prescription drug
benefits. Despite the fact that this will lead to a decrease in Medicaid prescription
drug expenditures, total state Medicaid expenditures may still increase if the Part D
subsidy screening process leads to a greater proportion of Medicare beneficiaries
being identified as eligible for Medicaid benefits.
When screening Medicare beneficiaries for Part D subsidy eligibility, states
must determine their eligibility for Medicaid-funded subsidies that provide assistance
This includes both full-benefit dual eligibles and those who receive limited assistance (for
example, Medicare Part A and Part B premium and cost-sharing subsidies only).
Congressional Budget Office, letter to Senator Don Nickles (Nov. 20, 2003), Table 3.
with Medicare Part A and Part B premiums and cost-sharing.9 They may also
determine eligibility for full Medicaid benefits.10 Although states will not be allowed
to claim federal Medicaid matching funds for state dollars spent on drug coverage for
full-benefit dual eligibles, they will continue to receive federal reimbursement for a
portion of the other Medicaid costs associated with serving dual eligibles (including
both full-benefit dual eligibles and those who receive limited assistance only).
Pharmacy Plus and Other Section 1115 Waivers
Under MMA, it is unclear which, if any, Medicare beneficiaries who receive
prescription drugs through a Section 1115 Medicaid waiver11 will be considered fullbenefit dual eligibles for purposes of calculating phased-down state payments.
Section 1115 waivers vary in their scope and comprehensiveness, and CMS has yet
to release official guidance on the treatment of dual eligibles covered under these
programs. Pharmacy Plus waivers, which are Section 1115 waivers that give states
the option to extend Medicaid drug coverage to certain low-income elderly and
disabled individuals who otherwise are not eligible for Medicaid benefits and who
have limited or no access to prescription drug coverage, may have a particular impact
on some state budgets.
The majority of current Pharmacy Plus enrollees are Medicare beneficiaries who
will qualify for Part D in 2006. However, since they do not receive full Medicaid
benefits, Medicaid drug expenditures made on their behalf in 2003 will likely not be
included in the base year per capita expenditures used to calculate phased-down state
payments. States, therefore, will not be required to share in the financing of Part D
benefits for these individuals, and they may choose to abandon or revise their waivers
to allow the cost of drug coverage for dual eligible Pharmacy Plus enrollees to fall
solely on the Medicare program. In three of the four states with programs in FY2003,
state spending on Pharmacy Plus benefits was approximately $945 million.12
Although states may opt to allow the cost of drug coverage for some dual
eligible waiver enrollees to fall on the Medicare program, the impact this will have
on beneficiaries may be a consideration. Currently, state Medicaid programs are
permitted to impose nominal co-payments for prescription drugs (with most falling
between $0.50 and $3.00 per prescription) on non-institutionalized Medicaid
beneficiaries, and they are prohibited from imposing co-payments on institutionalized
These Part A and Part B subsidies are also known as the Medicare Savings Programs.
For individuals eligible for both Medicare and full Medicaid benefits, Medicare is the
primary payer. Medicaid covers the cost of services above the Medicare payment, as well
as the cost of state-offered Medicaid services that are not covered by Medicare (such as
Section 1115 of the Social Security Act allows the federal government to waive certain
sections of Medicaid law for research and demonstration purposes.
Estimate based on CRS analysis of waiver data provided by CMS.
beneficiaries. There are no premiums charged and there is no additional cost-sharing
required for Medicaid prescription drug coverage.13
Under Part D, individuals who reside in an institution will have no cost-sharing
obligations, and those who are full-benefit dual eligibles will qualify for a premium
subsidy equal to the weighted average Part D plan premium for their region or the
actual premium amount for basic coverage under the plan they enroll in (whichever
is less). As a result, the amount that institutionalized dual eligibles pay for
prescription drugs under Part D may not differ substantially from what they would
have paid under Medicaid. However, for dual eligibles who do not reside in an
institution, they amount they pay for prescription drugs may increase under Part D.
The size of that increase is unknown and will vary by person depending on income
level, the prescription drugs used, increases in the Consumer Price Index (CPI), and
increases in Part D expenditures.14
Future Drug Expenditures
Medicaid law requires drug manufacturers that wish to have their drugs
available for Medicaid enrollees to enter into rebate agreements with the Secretary
of HHS, on behalf of the states. Under these agreements, manufacturers must
provide state Medicaid programs with rebates on drugs paid for on behalf of
Medicaid beneficiaries. The “best price” formulas used to compute the rebates are
intended to ensure that Medicaid pays the lowest price offered by the manufacturer
for the drugs. In exchange, states are required to cover all drugs marketed by the
manufacturers. A few states have negotiated supplemental rebates in addition to the
The potential impacts of MMA on drug prices paid by state Medicaid programs
are unclear. Since more than half of Medicaid expenditures for outpatient
prescription drugs are for dual eligibles,15 it remains to be seen whether the reduction
in purchasing volume created by the shifting of these individuals to Part D in 2006
will affect the ability of state and federal Medicaid officials to negotiate rebates with
drug manufacturers. A separate issue is the effect of an MMA provision that
exempts prices negotiated for drugs under Medicare-endorsed discount drug card
plans, Part D plans, and certain other qualified entities from the best price formulas
used by manufacturers in calculating rebates to the states. If the prices negotiated by
these exempt purchasers are lower than those negotiated by non-exempt purchasers,
states will not be allowed to benefit from these lower prices through increased rebates
on their Medicaid drug expenditures.
See CRS Report RL3076, Prescription Drug Coverage Under Medicaid, by Jean Hearne
and April Grady.
For more information, see CRS Report RS21837, Implications of the Medicare
Prescription Drug Benefit for Dual Eligibles and State Medicaid Programs, by Karen Tritz.
See CRS Report RL31987, Dual Eligibles: Medicaid Expenditures for Prescription Drugs
and Other Services, by Karen Tritz and Megan Lindley.
Other State Health Expenditures
State Pharmacy Assistance Programs
State Pharmacy Assistance Programs (SPAPs) are state-sponsored programs that
provide prescription drug subsidies and discounts, most often for low-income aged
and disabled individuals who do not qualify for Medicaid. Twenty-nine states
currently have SPAPs in operation, and nine have enacted laws to create programs
but have not yet implemented them. States appropriated an estimated $1.5 billion for
SPAPs in 2001.16
Starting in June 2004, Medicare beneficiaries (with the exception of those who
have Medicaid drug coverage) will have access to Medicare-endorsed discount cards
that provide some assistance with drug costs until Part D is implemented in 2006.
States may use SPAP dollars to cover discount card enrollment fees for beneficiaries.
They may also continue to assist individuals with their drug costs. Beneficiaries may
be enrolled in both a Medicare discount card program and an SPAP, and states may
encourage them to utilize their Medicare benefits before turning to the SPAP for
Starting in 2006, many Medicare beneficiaries who currently qualify for SPAPs
will be eligible for the Part D low-income subsidy program. Regardless of
beneficiaries’ low-income subsidy eligibility, states may choose to use SPAP dollars
to supplement beneficiaries’ Part D coverage by (1) purchasing additional benefits
from a qualifying Medicare prescription drug plan; (2) by providing their own state
programs; or (3) by helping beneficiaries meet their Part D premium and cost-sharing
In June 2004, the Secretary of HHS announced the appointment of a 24-member
State Pharmaceutical Assistance Transition Commission. The commission was
mandated by MMA and is charged with developing a detailed proposal to address
issues faced by SPAPs and SPAP beneficiaries as a result of the new Medicare drug
benefit. A report from the group is due to the President and Congress in January
State Retiree Health Plans
MMA provides financial incentives for employers, including the states, to
continue offering prescription drug coverage for retirees. Starting in 2006, employers
that elect to provide drug plan benefits that are at least as generous as Part D will
receive direct subsidies from Medicare equal to 28% of drug costs incurred between
$250 and $5,000 per retiree who is eligible for Part D but chooses not to enroll.
Employers that instead provide wrap-around or supplemental benefits for retirees
with Part D coverage will not qualify for the subsidy. Further, their contributions
will not count toward retirees’ Part D cost-sharing for purposes of calculating
whether an individual has reached the catastrophic out-of-pocket limit for Part D.
National Health Policy Forum, State Pharmacy Assistance Programs (Apr. 26, 2004).
Based on a recent survey, an estimated 1.7 million Medicare-eligible individuals
were enrolled in state-based retiree health plans (all of which offered prescription
drug benefits) in 2002. When asked in the survey to speculate on what would happen
if a Medicare prescription drug benefit were to be enacted by Congress, more than
three-fourths of responding states anticipated retaining their drug coverage as a wraparound supplement to whatever Medicare offered. A small number anticipated either
dropping coverage altogether or retaining their current coverage in exchange for a
federal subsidy.17 In light of the budgetary pressures faced by states, those that wish
to retain some type of prescription drug benefit for retirees have a strong incentive
to choose the least expensive option, whether it be comprehensive coverage with a
federal subsidy or limited wrap-around coverage with no subsidy.
However, as with the decision over whether to allow prescription drug costs for
dual eligible Medicaid waiver enrollees to fall solely on the Medicare program, the
impact on beneficiaries may be a factor in a state’s decision over whether to provide
comprehensive drug coverage for retirees. Individuals who do not qualify for lowincome subsidies under Part D may be subject to significantly higher out-of-pocket
prescription drug costs than they would be under a state-based retiree health plan.
As a result, budget costs may be only one consideration when states determine the
level of prescription drug benefits that will be offered to retirees.
Jack Hoadley, How States Are Responding to the Challenge of Financing Health Care for
Retirees (Henry J. Kaiser Family Foundation, Sept. 2003).