Medicare's Role in Determining Prices Throughout the Health Care System

Prices set by fee-for-service Medicare have a direct effect on prices paid by private insurers throughout the health care system. While this link is widely recognized, there is disagreement about whether higher Medicare prices lead to lower or higher prices for private health insurance. We review the evidence that informs this debate. Next, we define the “optimal” prices as the prices corresponding to demand in a competitive market with insurance policies that pay lump-sum transfers tied to illness. Real-world Medicare prices do not correspond to these optimal prices. We identify a number of problems with the approach that the Centers for Medicare and Medicaid Services use to set Medicare prices. But even if these problems could be solved, a pricing system based on administrative data that attempts to create the semblance of marketprices will always be problematic. The paper closes with suggestions that might move real-world Medicare prices closer to the optimal prices.