In September 2004, the government announced that health insurance premiums for Medicare beneficiaries would rise by 17.4 percent next year. That is the largest premium increase in fifteen years for the federal health insurance program covering Americans aged 65 and over. The premium, which will increase from $66.80 to $78.20 a month, provides for Medicare physician and outpatient coverage under Part B of the program. (Part A, which mainly covers inpatient hospital costs, is financed primarily through a payroll tax on salaries and wages.) Because the hike comes in the wake of the Medicare reform law enacted late in 2003, beneficiaries and their families are understandably alarmed and confused about the extent to which the new legislation is causing their premiums to soar relative to other factors.

This primer answers frequently asked questions about the big hike and the underlying challenges confronting Medicare and the nation's health care system generally.

Is the new prescription drug benefit in last year's legislation responsible for the big premium increase?

No, because the drug coverage will have its own separate premium when it takes effect beginning in 2006. In the interim, a prescription drug discount card program began in June 2004, but it also has nothing to do with the premium increase.

To a significant extent, yes. In particular, the new legislation increased payments to physicians by 1.5 percent, in contrast to what would have been a reduction of 4.5 percent in compensation to doctors under previous law. That change is intended to encourage doctors to continue accepting Medicare patients. The provision of new preventive benefits, such as routine physicals and diabetes screening, which will begin in 2005 also contributes in small measure to the premium increase.

Most important is the overall rise in medical costs well above the general inflation rate. Those same cost increases throughout the health care system have resulted in comparable premium increases for private health insurance.

After the full drug benefit is implemented in 2006, it is estimated that Medicare beneficiaries will pay an average of over 37 percent of their Social Security income on Medicare premiums, co-payments, and out-of-pocket expenses. That will be a substantial increase over the 20 percent of their Social Security income that they are expected to spend on those costs in 2005.

Unfortunately, the response to this program has been poor so far. Just 4.3 million beneficiaries currently are enrolled in the discount card programs, and most of those were automatically enrolled because they are members of private Medicare health plans. The original expectation was that 7 million seniors would enroll by the end of 2004. This slow response can be largely attributed to the considerable difficulties faced by beneficiaries in signing up for the cards, the varying prices for different drugs, and beneficiary confusion about which cards offer them the best discount.

For a small annual fee, beneficiaries without Medicaid or employer coverage are eligible for the cards, which are offered by various sponsors and paid for in large part by drug companies. Several studies have shown that beneficiaries can obtain substantial savings by using these cards. The Kaiser Family Foundation, based on a limited review of ten drugs in the Baltimore area for a seven-week period, found that beneficiaries could save from 17 percent to 32 percent on prices compared to those reported by the state or offered by mail-order drug firms. The Lewin Group and the Healthcare Leadership Council calculated that more than half the discount cards would deliver savings of better than 17 percent on the 150 drugs most frequently used by seniors. Still, the evidence to date is that most beneficiaries are not sold on the cards.

In April 2004, the trustees for the Medicare trust fund, which accumulates payroll taxes in excess of current benefit outlays to finance future payments for Medicare's Part A hospital insurance, estimated that full benefit payments could be made until 2019. That projection shaved seven years off the estimate from a year earlier. Two of those years are attributable to the new law, including higher payments to rural doctors and private insurers.

A couple of points should be kept in mind about these forecasts. One is that long-range estimates are notoriously uncertain: they can and do shift dramatically based on relatively small changes in assumptions about tax and spending trends. In 1997, for instance, the trustees predicted the depletion of the Part A trust funds by 2001. If productivity rises and the economy grows, the United States will be able to pay for a larger Medicare program and for other things as well, even as the ratio of workers to retired Americans declines. In addition, as Princeton economist Uwe Reinhardt and others point out, rising medical prices and the use of services, not an aging population, are the principal cause of the projected rise in medical costs. This does not mean that Medicare will be immune to the pressures of rising medical costs, but those costs will be faced as well by private insurers and Americans of all ages. Medicare's future is only one piece of a much larger health care challenge confronting the country.

When the new drug benefit takes effect, how will it work?

While many of the questions surrounding the drug benefit await further clarification by the Department of Health and Human Services, some answers are available now:

• Scope of coverage. For seniors with annual pharmaceutical costs between $675 and $2,250, Medicare will cover 75 percent of their drug costs; poorer beneficiaries will have all or most of their expenditures covered. For annual expenses ranging between $2,250 and $5,100, no subsidy will be available for most beneficiaries. Above $5,100, as much as 95 percent of expenses will be covered.
  
  
• Drugs to be included. The government has stipulated that private plans that offer the benefit must pay for at least two drugs in each therapeutic class, such as antidepressants, and that each plan's list of covered drugs must include "a full range of drug therapies necessary to adequately support current medical practice." It is still unclear, however, just what will be covered. For example, decisions have not been made about brand-name versus generic drugs. Also unclear is how much the coverage will vary from plan to plan and how much beneficiaries will pay out of pocket. The government anticipated that premiums for the benefit would be around $35 a month, but this number will depend heavily on who signs up and what drugs are available in each plan.
  
  
• Accommodating existing prescription coverage for beneficiaries. About 9 million Medicare beneficiaries, or about one-third of those with existing drug coverage, receive a drug benefit through a former employer. Such coverage, which has been dropping steadily, may further erode when the Medicare drug benefit is enacted. The Congressional Budget Office has estimated that as many as 3 million beneficiaries may be dropped from retiree drug coverage, which is typically more generous than other forms of insurance, as a result of the bill.
  
  
• Impact on drug prices and out-of-pocket costs. For seniors who currently lack any form of drug insurance, and for the near-poor, the Medicare drug benefit will provide access to drugs at a greatly reduced price. For other beneficiaries, the picture is less clear. Studies conducted in the summer of 2004 by American Association of Retired Persons (AARP) and by Families USA suggest that the drug savings for seniors under the Medicare benefit may be undercut by the rapidly increasing costs of brand-name drugs. AARP, which examined 155 drugs, found that the annual average increase in 2003 was 6.9 percent-more than triple the inflation rate. The Families USA study, which looked at the thirty drugs most frequently prescribed to seniors, calculated that the prices of these drugs rose at 4.3 times the rate of inflation in the same year.

Observing these trends, and doubting the ability of private pharmacy benefit managers to control drug costs, many policymakers and Medicare advocacy groups have urged that the federal Medicare program be allowed to negotiate directly with pharmaceutical companies over drug prices, just as the Veteran's Administration currently does. However, the new law expressly prohibits the Secretary of Health and Human Services "from interfering with the negotiations between drug manufacturers and pharmacies and sponsors of prescription drug plans."

Leif Wellington Haase is program officer and senior health care fellow at The Century Foundation.