U.S. social insurance programs traditionally have been paid out to beneficiaries directly by the federal government. But the last two decades have seen an accelerated effort to subsidize private health insurance plans to provide Medicare and Medicaid benefits.

The United States has a large private health insurance sector — accounting for more than $1.1 trillion of health-care spending in 2016. Yet the taxpayer-funded Medicare and Medicaid (including special insurance for children ) account for even more than that, about $1.2 trillion, or some 40 percent of overall health-care spending in this country.

In Medicaid, which provides health care to low-income Americans, as many as 80 percent of beneficiaries are enrolled in publicly-funded, but privately-run managed care plans. That figure for Medicare, which covers the elderly and disabled, stands at more than 30 percent for their medical coverage, and many more for their drug coverage.

Over the past decade, the share of subsidization of privately run insurance plans as opposed to direct reimbursement of providers in public spending on Medicare and Medicaid has almost doubled, increasing from 22 percent to 40 percent.

“These changes raise very different policy questions, as this moves us from thinking about how, for example, Medicare should reimburse health-care providers, to how it should pay private insurers,” said Stanford Health Policy health economist, Maria Polyakova.

With the growing overlap between the public and private sources of health insurance, Polyakova worries that there is too much room for costly mistakes, or outright shenanigans.

“There’s a lot of confusion among Medicare beneficiaries about who pays how much for their benefits, as subsidies to private insurers are complex and not transparent,” said Polyakova, an assistant professor of Health Research and Policy at the School of Medicine and faculty fellow at the Stanford Institute for Economic Policy Research.

“Similarly, for policymakers, figuring out how to pay insurers rather than health-care providers raises complicated policy design questions,” Polyakova said. “We have to set up subsidies in a way that benefits patients and a competitive market, but also be aware that the private firms operating in these markets are very sophisticated and will take any advantage of any design loopholes.”

Polyakova and colleagues set out to find a formula that could benefit all sides. To do so, they focused on the private provision of prescription drug benefit in Medicare Part D. Their findings were recently released in a working paper by the National Bureau of Economic Research. 

More than 50 million individuals benefit from Medicare, which accounts for $500 billion in annual budgetary outlays by the federal government. Once enrolled in Medicare, consumers have a choice of more than a dozen Prescription Drug Plans (PDP) under what is known as the Medicare Part D program. This drug program launched in 2006 is a rapidly growing market that accounts for about a fifth of overall federal spending in Medicare, about $100 billion.

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“Beyond its sheer economic size, this market further plays an important role in policymaking, as it has become the role model for private provision of publicly funded social insurance,” wrote Polyakova and her co-authors.

Consumers of Part D bear only a small portion of the program’s cost. A consumer pays on average a $40 monthly premium, although premiums vary widely. For each consumer, the government is sending on average an additional $55 to the plan in which the consumer is enrolled, with much higher subsidies for consumers with greater health problems. The government pays the full premium for low-income beneficiaries.

The independent insurance firms are quite satisfied with the 50-percent-or-higher subsidy that comes from Washington and attracts more consumers into the market.

But is that the best use of our tax dollars?

Polyakova and her colleagues used a dataset that contains detailed information about plan prices and characteristics for all Part D plans in all markets from 2007 to 2010. The data also includes information on individual enrollment in prescription drug plans and records of drug purchases that consumers make after enrolling in a plan

They created a model that focused on two things: 

1. They first developed and estimated a model of supply and demand for drug plans. With the model, they could compute how much of government dollars benefit consumers and how much ends up being captured by insurers.
2. With this supply-and-demand model, they could simulate whatever market structure they wanted, imagining what would happen if the government gave each Medicare Part D consumer a voucher of, for example, $700 to pay for their prescription medications.

What they found is that, at least for Part D, the current mechanisms do a surprisingly good job at keeping costs low.

“On the supply-side, we find, perhaps surprisingly, that the current structure of the program mutes insurers’ ability to strategically raise subsidies, and hence positively affects total program efficiency,” they wrote.

At the same time, they also find that taxpayer dollars could be spent even more efficiently. 

Currently, the subsidy is found through a formula that uses prices set by insurers. Their simulation suggests that setting a fixed voucher-like subsidy would encourage insurers to lower prices for their plans even more. If insurers knew the fixed subsidy level in advance, then they would have a strong incentive to price as close as possible to this subsidy. Any difference between the subsidy and the premium would have to be paid by consumers, so costlier insurers may lose customers. 

Under the current system, the ultimate subsidy is linked to insurer prices and is not known in advance of insurers submitting their price bids, which makes the incentives to reduce prices slightly less strong. Great caution is required when setting such voucher-like subsidies, however. If they are set too low, insurers may be forced to quit the market or provide poor quality products.

Even more return on the taxpayer’s dollar could be achieved by setting higher vouchers for more economically efficient (but not lower quality) plans and lower vouchers for plans that have higher operating costs. Improving the return on the dollar could allow the government to spend less and still allow the same number of consumers to purchase coverage. 

“Most of our government health-care dollars are increasingly spent through this indirect mechanism of giving money to private firms and simply hoping that things will somehow work out,” Polyakova said. “But the way we design these mechanisms are hugely important: You may be wasting billions of dollars if these are not set up properly — and there are not that many people working on this, as these rules are incredibly involved.”