We Can Incentivize States to Police Their Own Medicaid Waste

Tomas Philipson has a piece for NRO today arguing that the federal government should use its funding leverage to force new requirements against waste and fraud on state-administered Medicaid programs. The Department of Health and Human Services, he writes, “should take a fine-tooth comb to states’ funding formulas and threaten to withhold federal matching until they cut out the excess.”

That’s a good idea, and the Trump administration is right to aggressively prosecute cases of outright fraud in Medicaid. Even better than imposing a new layer of bureaucratic oversight, however, would be to use the magic of economic incentives to make states do the work of policing their own expenditures. This can be done by delegating responsibility for Medicaid spending to the endpoint payer.

As Philipson notes, “Medicaid currently operates on a matching grant system where, for every dollar spent by a state, the federal government matches with a dollar — or as high as $9. This gives free-riding states an incentive to operate leaky ships, assuming Washington will foot the bill for whatever they claim to need.” Economists call it the third-party payer problem, in which the entity writing the checks isn’t who truly pays, incentivizing them to overspend — or at least not be too scrupulous. States pay for only 35 percent, on average, of all Medicaid dollars — including those lost to fraud and waste.

Asking states to suddenly absorb the entire cost of their Medicaid spending would be highly disruptive and politically impossible. But the federal government can restructure its share of spending to incentivize better practices on states’ own initiative. The best reform would be to scrap the percentage-based spending model and instead pay states a predictable, fixed dollar amount, either per Medicaid eligibility group or per enrollee, that grows only with inflation. Any spending above that amount would be borne by state governments and their taxpayers.

Under this system, every added dollar of Medicaid spending from waste would fall completely on the states. It would come either from their fixed federal transfer, leaving less of that money to spend on legitimate services, or from a state’s general budget. By the same token, all money saved by eliminating needless costs would accrue wholly to states’ benefit, affording them an equivalent amount to spend elsewhere or cut in taxes.

One way the states might improve waste prevention is by further delegating payment responsibility to private insurers. Most states already manage a large share of their Medicaid populations by enrolling them in plans administered by a company, called a Managed Care Organization (MCO), and paying those firms a fixed capitation rate per beneficiary. The private plan assumes all risk for patient spending. A dollar wasted cuts into the bottom line; a dollar saved raises profits. Accordingly, detected Medicaid fraud is typically found in Medicaid’s traditional fee-for-service model — in which the state pays directly — rather than in MCO spending.

To reduce waste, states that don’t use MCOs could begin allowing them, and states that already have MCOs could expand their responsibility to more spending categories and enrollees. (Some states, for example, foolishly choose to fund autism therapy entirely through fee-for-service instead of “carving” it into MCO plans.) States and the federal government should also give MCOs more flexibility in how they manage different services and providers, as coverage mandates and minimum reimbursement rates tend to inflate their outlays and ultimately capitation rates.

Federal oversight of Medicaid programs can be powerful, but economic incentives are even more so. Make states and insurers pay for their own wasteful spending and then watch it fall.