Origins in fee-for-service Medicare
Traditional Medicare pays for care on a fee-for-service (FFS) basis, split into Part A (hospital services) and Part B (outpatient and physician services). After 1984, hospitals were paid according to Diagnosis-Related Groupings (DRGs) for Part A services. In the 1990s, Relative Value Units (RVUs) became the basis for paying physicians and outpatient facilities under Part B. Both are government-administered classification systems that assign a standardized price to a given health care service.
Total hospital reimbursement is derived from the costs hospitals report annually to CMS, divided among DRG categories. Total outpatient and physician spending is set by statute.
Medicare+Choice and the three-part payment problem
When Medicare+Choice — later renamed Medicare Advantage — was created in 1997, policymakers needed a method for determining how much Medicare should pay private plans to cover beneficiaries who opted out of traditional Medicare. Broadly, payments were tied to the cost of covering comparable beneficiaries in traditional Medicare, adjusted for beneficiary characteristics and local costs.
Designing a payment system for a private option competing alongside a public one required addressing three separate objectives at once:
- Beneficiaries needed an incentive to switch to lower-cost private plans,
- Private plans needed to be able to afford to cover their enrollees, and
- Taxpayers needed to not pay more for beneficiaries in private plans than they would have paid for the same beneficiaries in traditional Medicare.
To address all three, Congress defined a benchmark — the average cost of a comparable beneficiary in traditional Medicare, adjusted for some demographic characteristics — and paid private plans according to that figure. (See How MA Plans Get Paid for the full mechanics.)
Favorable selection and risk adjustment
Under this system, policymakers became concerned that private plans were attracting healthier, less costly enrollees than the average traditional Medicare beneficiary — a pattern known as favorable selection. Because plans were paid according to the average beneficiary's cost while covering a less costly population, favorable selection had the effect of raising Medicare's overall spending rather than reducing it.1
To address this, policymakers introduced risk adjustment beginning in 2004 — adjusting each plan's payment up or down based on the diagnosed health status of its enrollees, intended to reduce the financial incentive to enroll healthier beneficiaries. (See Risk Adjustment and the HCC Model for how this works in practice, including the coding-intensity dynamics it introduced.)
2003: Competitive bidding introduced
The 2003 Medicare Modernization Act (MMA) added a market-based mechanism to the payment system by requiring private plans to submit a bid — their own estimate of the cost to cover a risk-adjusted average enrollee — rather than being paid a fixed, administratively-set amount. Comparing a plan's bid to its benchmark determines its payment and, if the bid is below the benchmark, generates a rebate that plans use to fund supplemental benefits, reduced cost-sharing, or reduced premiums.
2010: The Affordable Care Act's benchmark reforms
Medicare Advantage continued to grow through the 2000s. The ACA made three significant changes to how benchmarks and payments work:
- Coding-intensity adjustment. A uniform reduction (currently a statutory floor of 5.9%) was applied to plan risk scores to offset the tendency of MA plans to document more diagnoses per enrollee than an equivalent traditional Medicare population — a dynamic explored further in Risk Adjustment and the HCC Model.
- Quality Bonus Program. Plans rated four or five stars by CMS receive increased benchmarks and, correspondingly, larger rebates. See Star Ratings and the Quality Bonus Program.
- Geographic benchmark scaling. Benchmarks are scaled up in counties with lower average traditional Medicare costs and scaled down in higher-cost counties, detailed in How MA Plans Get Paid.
Enrollment growth
Medicare Advantage enrollment has grown steadily since the early 2010s, both in absolute terms and as a share of the total Medicare-eligible population.
Timeline
- 1984Hospital payments (Part A) begin using Diagnosis-Related Groupings.
- 1990sPhysician and outpatient payments (Part B) shift to Relative Value Units.
- 1997Medicare+Choice is created, establishing a benchmark-based payment system for private plans.
- 2004Risk adjustment is introduced to address favorable selection.
- 2003The Medicare Modernization Act introduces competitive bidding, renaming the program Medicare Advantage.
- 2010The Affordable Care Act adds the coding-intensity adjustment, the Quality Bonus Program, and geographic benchmark scaling by cost quartile.
- 2026MA enrollment reaches 55% of eligible Medicare beneficiaries, roughly 34.9 million people.