Will competitive bidding decrease Medicare prices?

• Author: Katzman, Brett
• Position: Author abstract

1. Introduction

   The Balanced Budget Act of 1997 granted the Centers for Medicare and Medicaid Services (CMS) congressional approval to implement up to three demonstration projects to investigate competitive bidding as a means of choosing Medicare providers. Officially deemed Durable Medical Equipment and Prosthetics, Orthotics, and Supplies (DMEPOS) Competitive Bidding Demonstration Projects, three experiments have been completed. Two projects were conducted in the Polk County, Florida, area (Polk County Round I and Polk County Round II), and another was implemented in the San Antonio, Texas, area (San Antonio).

   Experimentation with DMEPOS, in which area Medicare expenditures currently total over $6 billion, is based on CMS's expectation of significant savings relative to the past procedure for setting reimbursement prices. This expectation of savings is no more evident than in the following excerpt from the Request for Bids sent to potential Polk County suppliers in January of 1999. It stated, "Medicare payments for DMEPOS are based on outdated fee schedules required by law. Studies by the General Accounting Office (GAO) and the Office of the Inspector General have found that payments allowed currently by Medicare fee schedules often include unreasonably high markups. These studies show that Medicare payments for certain DMEPOS items are greater than payments made by other insurers and sometimes greater than prices charged at retail outlets for customers who are not Medicare beneficiaries."

   The decision to use competitive bidding as an alternative to outdated, inflated fee schedules was based on two appealing properties of competitive bidding. First, competitive bidding is commonly lauded for the competition it promotes, and CMS expected lower reimbursement prices to result from increased competition. (1) Second, the competitive bidding procedure gives CMS a hand in determining firm eligibility, thus ensuring quality service for Medicare recipients and protecting against collusion. The premise of our paper is that while utilizing competitive bidding in the Medicare process is an excellent idea, the format with which CMS experimented hinders both CMS and its beneficiaries from achieving greater savings.

   The CMS bidding process consists of three stages. A pre-screening stage determines each firm's ability to supply quality service to Medicare beneficiaries within different categories of goods (e.g., surgical supplies, oxygen equipment). In stage 2, eligible firms submit bids on each and every individual good within the categories on which they are bidding, and winners are determined. Finally, the price of an individual good is determined using a weighted average of the winners' bids on that good. (2)

   While the pre-screening stage appropriately identifies quality Medicare providers, the rules for determining winners and setting prices are complex. Both processes involve an aggregation of bids on individual goods within a given product category. The process for determining winners requires the calculation of a "composite bid" (weighted average) (3) for each firm based on its individual bids on the different goods within a category. Those firms with the lowest composite bids win the bidding process and are deemed official Medicare providers. The price that official Medicare providers are allowed to charge for individual units of a good is then a weighted average of the winning bids on that good. (4)

   In designing the competitive bidding experiment, CMS envisioned a process in which the individual bids submitted by firms would represent the lowest price at which they were willing to supply each good. Unfortunately, our theoretical models show that equilibrium bidding is conflated by the aggregation rules and that truthful bidding of costs is not elicited by the CMS rules. This, in turn, implies that there are circumstances in which the CMS mechanism will fail to select the lowest cost providers.

   The root of the problem is that a firm's composite bid, and not its individual component bids, determines whether or not the firm is given Medicare provider status. Thus, while the individual bids are used to calculate Medicare prices, the composite bid determines whether or not the firm becomes a Medicare provider. As the composite bid is a linear function of individual bids, this avails the firm of a number of ways of achieving a targeted composite bid regardless of the cost of supplying individual goods. At best, this leads to vast uncertainty regarding prices on individual goods. At worst, it opens the door for "gaming" of the system.

   Instances of gaming linear composite-type bidding systems have been documented for auctions of U.S. timber (see Baldwin, Marshall, and Richard 1997; Athey and Levin 2001) and California electricity (see Bushnell and Oren 1994; Gribik 1995). The basic idea extends to the CMS rules, and our models below show that "gaming" is in fact optimal behavior for firms. Specifically, if a firm believes that CMS has underestimated relative demand for a good, it can increase its bid on that good while lowering its bid on a good for which it believes relative demand forecasts are too high, all while simultaneously maintaining its targeted composite bid. In doing so, it will be able to increase the price of the good that it believes will have relatively high demand by simply lowering its bid on the good for which it forecasts relatively low demand. This is clearly a profitable strategy that has adverse pricing repercussions.

   The main prediction from our model is that while the CMS format will achieve price reductions on some goods, this will most likely occur at the expense of increased prices on other goods. Using data from completed demonstration projects, we establish preliminary evidence that this is the case, adding fuel to the growing literature on the inefficient pricing structure within the Medicare program (see Dor, Held, and Pauly 1992; Cutler 1995; Dot and Watson 1995; Dor 2004). We find that price increases occur often and that the gains from competitive bidding (in its current form) may not be as large as CMS had hoped. The fact that when a firm bids high on one good it must correspondingly bid low on another good in order to reach its targeted composite bid introduces additional, less quantifiable ramifications as well. Specifically, if the price of a good is bid too low, firms may tacitly avoid supplying it, thereby increasing consumer search costs and decreasing quality of service. (5)

   Finally, it is our contention that the shortcomings of the CMS design relate to a fundamental misunderstanding of auctions. A common misconception is that the desirable properties of single-unit auctions extend to multi-unit auctions (see Ausubel and Cramton 2002, p. 1, for a discussion). However, recent theoretical breakthroughs show that there are actually very few multi-unit auctions that possess the famous efficiency and revenue-generating properties of single-unit auctions. In fact, the majority of multi-unit auctions are inefficient and can deliver vastly different expected outcomes (see Engelbrecht-Wiggans and Kahn 1995; Noussair 1995; Katzman 1999; Ausubel and Cramton 2002). Even the famed Vickrey (1961, 1962) auction, lauded for eliciting bids equal to costs/values, is susceptible to collusion and third-party manipulation (see Graham and Marshall 1987; Rothkopf, Teisberg, and Kahn 1990). Fortunately, recent developments in auction design by Ausubel (2004), Reny and Perry (2005), Ausubel and Milgrom (2006), and Ausubel, Cramton, and Milgrom (2006) have addressed the shortcomings of existing auction formats and provide a wealth of realistic alternatives. In the end, we encourage CMS to investigate the merits of these new bidding processes.

2. The CMS Bidding Process

   The competitive bidding projects were run in Polk County, Florida, and San Antonio, Texas. The product categories targeted by CMS for the Polk County Round I, San Antonio, and Polk County Round II projects appear in the first column of Table 1. The choice of these categories was based on the anticipation of significant savings on these types of equipment. Any firm wishing to provide goods in the categories listed in Table 1 to Medicare beneficiaries in Polk County or San Antonio during the project was required to participate in the process. That is, firms not submitting bids or firms who were unsuccessful at the auction could not supply any good in the categories listed in Table 1 to Medicare beneficiaries in the respective regions. (6)

   At the inception of a project, a Request for Bids (RFB) was sent out to potential suppliers. The RFB detailed the process that firms had to follow to be eligible for consideration; it also explained the overall process. In addition, past demand data were provided to aid firms in estimating demand in subsequent years. Included in these data were the turnover of beneficiary users for each good within each product category, the total number of beneficiary users for all goods in each product category, the number of new beneficiary users for each good in a product category, and trends in beneficiary usage.

   The initial stage of each project focused on eligibility. CMS's goal was to choose firms that would provide reliable, quality service to Medicare beneficiaries. At a minimum, firms had to comply with all state and federal regulatory requirements, all Medicare and Medicaid statutes and regulations, all billing guidelines pertaining to Medicare, and all National Supplier Clearinghouse standards. If a firm met all of these criteria, it was invited to submit bids. (7)

   Bidding by eligible firms was done by category. Firms that submitted bids in a given product category were directed to submit a bid on every individual good in that category. That is, a firm that bid on one good in a category had to bid on all goods in that category. Once bids were received, they were reviewed, and a 10-day grace period...