Are Medicare Administrative Costs High?

by Tom Bozzo

A few weeks ago, reader Pete emailed a link to Real Clear Politics, where Tom Bevan cited an analysis by Robert Book of the Heritage Foundation that purports to show that Medicare administrative costs, widely claimed (e.g.) to be far lower than comparable private sector costs when expressed as a fraction of expenditures, actually are higher when expressed on a per-beneficiary basis. This got its share of big-league attention at the time, with Greg Mankiw linking, Andrew Gelman reporting the result with some skepticism, and Paul Krugman offering the always worthwhile advice never to trust Heritage Foundation analysis. More recently, Gelman posted to the effect that Heritage is shopping Book’s administrative cost claim (among others) as part of a broadside against government-run health care.

What seems to have gotten less attention is that even using Book’s preferred comparison (i.e. administrative expense per beneficiary instead of administrative expense as a fraction of outlays), the claim is bunk. This is because Book, referencing an analysis by Benjamin Zycher of the (also right-wing) Manhattan Institute, takes a reasonable proposition — that the federal government incurs some Medicare-related costs not explicitly included in the Medicare budget — and proceeds to allocates billions of dollars with little or no causal nexus to the Medicare program as Medicare administration costs. Book and Zycher call the resulting total of the budgeted and allocated costs the Medicare administrative costs and get the result that Medicare administration costs more than private-sector insurance per beneficiary. Unfortunately for them, the result does not withstand a sane allocation of the federal expenditures they consider.

Details and a couple of ironies below the fold.

Directly measured Medicare administrative costs are 38 percent lower than private sector costs on the per-beneficiary measure Book prefers. Thus one must find a lot of unmeasured Medicare cost to make Medicare look relatively costly in administration. Indeed, Zycher and Book manage to come up with an allocation of indirect costs amounting to roughly 80 percent of the directly reported Medicare administration expenses.

The sign that something is seriously amiss is the large assignment of costs from the “administration of justice” function. For Fiscal 2005, Zycher locates $42.1 billion in such costs in the federal budget and assigns $7.2 billion of that to Medicare, representing 75 percent of the indirect cost assignment. That’s the share of Medicare costs in nondefense discretionary spending, an allocation method (which happens to assign a quite high share of costs to Medicare) that Zycher defends on the grounds that military justice is administered via the defense budget.

Neither Zycher nor Book seem to have given much consideration to what the “administration of justice” money is actually spent on, and particularly that much if not most of it might be spent administering justice (at least notionally) on behalf of society as a whole and not just other federal programs. But there is such a thing as the Expenditure and Employment Statistics from the U.S. DOJ’s Bureau of Justice Statistics. For FY2005, DOJ statistics indicate that $40 billion was spent in three main categories as follows: “police protection” ($22.5 billion), “judicial and legal” ($10.9 billion), and “corrections” ($6.6 billion). Those figures include both spending on federal government programs and transfers to state and local government.

So if you were to think that even two or three billion dollars a year was being spent policing the Medicare program and locking up Medicare fraud perpetrators, then it would have to be that the federal courts are jammed with Medicare cases and not, say, civil litigation, drug prosecutions, etc. There is, though, evidence of the actual scale of Medicare fraud prevention expenses. The FY2010 budget includes $311 million for Medicare “program integrity” activities, which is a 50 percent increase over FY09. The interagency Medicare Fraud Strike Force program filed 125 criminal cases [PDF] from March ’07 to July ’09, leading to prison sentences for 122 people averaging 49 months. DOJ’s share of the increase is $19 million for FY2010, according to the CMS budget justification [PDF]. So we’re looking at on the order of tens of millions of dollars in expenditures for other agencies policing the program, not billions.

So almost all of the $7.2 billion should be taken away from the allocated indirect Medicare expenses. Being generous to Book and Zycher and taking away only $6 billion reduces the per-beneficiary expense for FY 2005 from Book’s $509 to $356. That compares to $453 for private sector insurance. So without addressing any of the other questionable expense allocations, Medicare administrative expense per beneficiary is at least 21 percent lower than that of private insurance.

Zycher also allocates an array of “general government” expenses in proportion to Medicare’s share of total federal expenditures. Among the main contributors here is the cost of running the legislative branch and administering the tax system. From an economist’s (versus an accountant’s) perspective, it is questionable whether much of these properly represent marginal or incremental costs of Medicare (something which Book, a PhD alum of the Chicago economics program, could be expected to consider in a perfect world). For that matter, a program such as Medicare may well require less than it’s expense share of certain expenses as it’s funded largely through a simpler-to-administer tax and may not require the amount of legislative attention as much smaller discretionary programs.

But that doesn’t really matter, since the general government costs a la Zycher are not enough in themselves to make Medicare administration more costly per beneficiary than private insurance.

As for the ironies, here are a couple. First, the “direct” Medicare administrative expenditures include a portion of the subsidies provided to private insurers under the Medicare Advantage program — a bit of Bush-era corporate welfare that subsidizes the private sector so that it can compete with traditional Medicare. Second, much of Medicare administration, for instance claims processing, is contracted out. So much of the comparison is of private sector entities operating under different incentive systems.

Finally, Zycher argues that even the inclusion of indirect costs understates the true cost of Medicare as it does not factor in the the economic burden of funding Medicare through distortionary taxes. There’s less to this than meets the eye, regardless of how distortionary you think a payroll tax of a few percent might be. The problem is that such Medicare tax distortion as there may be is not incurred against an alternative world of complete markets and perfect competition. Real insurers charge at least average incremental costs (and thus exert some market power in the sense of being able to charge prices above marginal cost), and in the current private system many losses are uninsured or uninsurable. Insofar as universal public health care provision can (or would) address a number of the private sector market imperfections, it’s at least a matter for careful analysis which system has the bigger economic losses.