Analysis: Medicaid’s Huge Hidden Costs

Published June 1, 2006

In the 40 years since it was created to provide medical care to the needy, Medicaid has expanded far beyond that original mission. In 2004, Medicaid spending totaled $309 billion. The program now consumes a larger share of state budgets than elementary and secondary education.

Medicaid’s dramatic growth in the 1990s was a result of several factors, including federal State Children’s Health Insurance Program (SCHIP) funding, booming tax revenues, eligibility expansions, and an increased reliance on Medicaid-financed long-term care for seniors. But tax revenues dropped in 2001, which left states unable to manage the fiscal burden of their Medicaid programs.

In a Washington Times op-ed last October, Rep. Joe Barton (R-TX) noted, “[Medicaid] is both ‘free’ and break-the-bank expensive. … In a sense, the program is a victim of its own success. It has grown so expansive that even the nation’s governors recognize that the future without reform is grim.”

States Seek Reform

Faced with unsustainable Medicaid growth, all 50 states have taken steps to contain spending, including more restrictive drug formularies, freezing or cutting provider payments, reducing eligibility, cutting benefits, and increasing beneficiary co-payments.

Other states are seeking federal waivers to pursue more wholesale restructuring of their Medicaid programs, such as allowing different sets of benefits for different groups of beneficiaries or moving toward a defined-contribution model.

South Carolina, for example, is trying to change its Medicaid program so that each beneficiary would receive a lump sum with which to purchase coverage (keeping any leftover money in a Health Savings Account). The governors of Florida and Colorado have expressed interest in Medicaid vouchers as well.

Mark McClellan, director of the Centers for Medicare & Medicaid Services, said in an August 8, 2005, Business Week article the agency was generally on board with such plans: “These kinds of approaches can lead to lower costs and more effective treatment. … You can’t treat chronic illness without active patient involvement. And you can’t get that through some government pricing program.”

Savings Unlikely

But vouchers or HSAs may be a counterproductive way for states to rein in their Medicaid spending. With Medicaid HSAs making benefits more attractive, more eligible people would likely enroll in Medicaid (only about two-thirds of those eligible sign up at present), and would stay enrolled for longer periods. Furthermore, when gaps in coverage arise after beneficiaries deplete their HSA funds, states will step in to cover those gaps, obliterating any potential savings. That means higher taxes and greater dependence, two things that real Medicaid reform should avoid at all costs.

Before implementing ambitious Medicaid reform proposals, states need to examine ways to maintain the delicate balance between providing care for the truly poor and discouraging dependency on government. The road to Medicaid reform must begin with an honest assessment of all of its costs–those that appear in states’ budget reports and those that don’t.

‘Crowds Out’ Private Coverage

Supporters often claim Medicaid “picks up the slack” when the number of Americans with private health coverage declines. In reality, Medicaid crowds out private coverage.

As states expand their Medicaid programs to cover more benefits for more people, employers of low-income workers often drop the coverage they previously offered. In addition, many low-income workers decline coverage offered through their workplace and opt for Medicaid instead, which is virtually free to them at the point of service.

More than a dozen studies show Medicaid eligibility expansions reduce the number of low-income Americans with private coverage. In some cases, increases in Medicaid enrollment are completely offset by the reductions in private coverage.

Encourages Dependence

A corollary to the crowding out is dependence: Allowing 50 million Americans to consume health care as if it were free encourages many to avoid productive behaviors that might get them off the Medicaid rolls, like working or saving more in order to purchase private coverage.

Aaron Yelowitz of the University of Kentucky and Jonathan Gruber of MIT found non-elderly Medicaid-eligible households increased their economic consumption to stay eligible for benefits by reducing their personal wealth. In 1993, Medicaid eligibility was associated with reduced wealth accumulation equal to $1,600 to $2,000 in today’s dollars.

Another study, by Jeffrey Brown of the University of Illinois and Amy Finkelstein of the National Bureau of Economic Research, found Medicaid–which finances a large proportion of long-term care for the elderly and disabled–discourages between 66 and 90 percent of seniors from purchasing insurance for long-term care needs.

Spurs Higher Spending

Furthermore, Medicaid’s joint federal-state financing mechanism gives states an incentive to spend as much as they can on the program. Each dollar a state spends on Medicaid is matched by an average of $1.30 from Washington. Thus, $1 of a state’s budget spent on Medicaid yields $2.30 (or more) in total benefits, which encourages states to expand their Medicaid programs beyond what is truly necessary to help the poor.

The Urban Institute found close to one-fifth of Medicaid-eligible adults and children have private coverage–strong evidence Medicaid has grown far beyond its original purpose.

Hikes Private Costs

Finally, Medicaid increases the cost of health care for those with private coverage. States set below-market reimbursement rates for providers, who then make up the difference by charging private payers more. This, in turn, leads to higher premiums for those with private coverage.

This cost-shifting affects prescription drug spending, too. Mark Duggan of the University of Maryland and Fiona Scott Morton of Yale University found Medicaid increases the price of non-Medicaid prescriptions by 13.3 percent.

As an open-ended entitlement program that is obligated to reimburse all services for which beneficiaries are eligible, Medicaid must rely on cost-shifting rather than cost-containment strategies. Most of the reform proposals being floated on the state and federal levels–reducing reimbursements, capping utilization, increasing co-payments–merely tinker around the edges of this massive program.

Real Medicaid reform would mimic 1996’s successful welfare reform law. Congress should let states set their own rules for eligibility and benefits; freeze federal payments at the 2006 amount and block-grant them to the states instead of matching all state spending dollar-for-dollar; and give states the flexibility to use federal Medicaid funds for a few broad goals, such as targeting assistance to the truly needy, reducing dependency, reducing crowd-out of charitable care, and promoting competitive markets for private coverage.

Michael F. Cannon ([email protected]) is director of health policy studies at the Cato Institute and a writer whose articles have appeared in major news publications around the country. He is the co-author of Healthy Competition: What’s Holding Back Health Care and How to Free It (Cato, 2005).

For more information …

“Public Health Insurance and Private Savings,” by Jonathan Gruber and Aaron Yelowitz, is available at

“The Interaction of Public and Private Insurance: Medicaid and the Long-Term Care Insurance Market,” by Jeffrey R. Brown and Amy Finkelstein, may be downloaded at

“The Distortionary Effects of Government Procurement: Evidence from Medicaid Prescription Drug Purchasing,” by Mark Duggan and Fiona M. Scott Morton, is available at