Jul 10, 2018

Medicare is an essential health insurance program serving millions of Americans, and a major part of the federal budget and our fiscal outlook. It was signed into law by Lyndon B. Johnson in 1965 to provide health insurance to people age 65 and older. Since then, the program has been expanded to serve the blind and disabled.

The number of people enrolled in Medicare has tripled since 1970, climbing from 20 million in 1970 to 60 million in 2018, and it is projected to reach 90 million in 30 years. A major driver of Medicare enrollment is the increase of the number of Americans age 65 and older. There are currently 51 million people age 65 and older, and that number is projected to increase by 60 percent by 2048. In addition to those age 65 and older, Medicare also covers certain younger people with disabilities or specific illnesses.

One of the biggest misconceptions about Medicare is that it is self-financed by current beneficiaries through premiums and by future beneficiaries through payroll taxes. In fact, payroll taxes and premiums together only cover about half of the program’s cost. The rest is financed largely by general federal revenues.

This budget explainer describes the Medicare program, how it is financed, what it pays for, what role it plays in financing American healthcare, and what is projected for the future.

Key Facts

  • Medicare is the second largest program in the federal budget. The Congressional Budget Office (CBO) projects that it will cost $583 billion in FY 2018 — representing 14 percent of total federal spending.1
  • Medicare has a large impact on the overall healthcare market: it finances about one-fifth of all health spending and about 40 percent of all home health spending.
  • In 2018, Medicare will provide benefits to 18 percent of the population.2
  • Medicare spending is a major driver of long-term federal spending and is projected to double from 2.9 percent of GDP in FY 2018 to 5.9 percent in FY 2048 due to the retirement of the baby boom generation and the rapid growth of healthcare costs per person.

What are the components of Medicare? How much does it cost?

Medicare is a federal program that provides health insurance to people who are age 65 and older, blind, or disabled. Medicare consists of four program "parts," offering three types of health coverage:

  • Part A pays for hospital care;
  • Part B provides medical insurance for doctor’s fees and other medical services;
  • Part C is Medicare Advantage, which allows beneficiaries to enroll in private health plans to receive Part A and Part B Medicare benefits;
  • Part D covers prescription drugs.
  • Almost all seniors are automatically enrolled in Part A at no additional cost once they turn 65. Parts B, C, and D are voluntary and require enrollees to pay premiums to receive coverage.

Medicare is financed by two trust funds: the Hospital Insurance trust (HI) fund and the Supplemental Medical Insurance (SMI) trust fund. The HI trust fund finances Medicare Part A, and collects its revenue primarily through a payroll tax on all U.S. workers and employers. The SMI trust fund supports both Part B and Part D. Funding for SMI comes mostly from general revenues; premiums cover about one-quarter of all costs. Part C is paid for through funds from both the HI and SMI trust funds, and collects its income from a combination of general revenues, payroll taxes, premiums paid by beneficiaries, and out-of-pocket charges.

In FY 2018, the Medicare program cost $583 billion, about 14 percent of total federal government spending. After Social Security, Medicare was the second largest program in the federal budget last year.

In coming years, the Medicare program faces significant financial pressures. Although the growth of overall healthcare spending appears to have slowed over the past few years, federal costs are still expected to grow as a share of the economy over the next several decades, largely because of the retirement of the baby boomers, longer life expectancies, and a rate of growth in healthcare costs that exceeds the growth in the economy.

If current policies continue, Medicare spending is projected to rise from 2.9 percent of GDP in 2018 to about 5.9 percent of GDP 30 years from now.

Who pays for Medicare?

Today Medicare is financed by a combination of sources. Payroll taxes, premiums, and other receipts covered only 57 percent of Medicare's costs in 2018. General federal revenues from U.S. taxpayers made up most of the difference.

Medicare financing has changed significantly over the past 40 years. In 1970, payroll taxes financed 62 percent of the Medicare spending. In 2018, however, payroll taxes cover only 36 percent of the program’s costs. That decline occurred despite changes in the structure of the Medicare payroll tax, which increased payroll tax revenue. In 1986, for example, the payroll tax rate for Medicare increased the contribution rates for both employers and employees from 0.6 percent to 1.45 percent of wages.3 Later, in 1994, the cap on earnings, which limited the amount of income subject to the Medicare payroll tax, was eliminated (the cap on earnings for the payroll tax that funds Social Security, however was not eliminated). Most recently, the Affordable Care Act increased payroll tax rates for high earners by an additional 0.9 percentage points beginning in 2013. Unfortunately, all of those changes will not be sufficient to offset future cost growth.

Premiums play only a modest role in funding the Medicare program. They financed 15 percent of Medicare’s overall costs in 2018, about the same share as in 1970.

In 2018, general federal revenues were the largest single source of Medicare financing — 43 percent of Medicare’s income came from general revenue funds, up from 25 percent in 1970. Looking forward, such revenues are projected to continue funding a major share of the Medicare program. By 2050, the trustees project that the general revenues will cover the costs of about half of the program.

Medicare pays for a diverse range of services

Medicare finances an array of health services. Hospital expenses are the largest single component of Medicare’s spending, accounting for about 40 percent of the program’s spending. That is not surprising as hospitalizations are associated with high-cost health episodes.

However, the share of spending devoted to hospital care has declined since the program's inception. While spending for physician services has hovered between 20 and 25 percent for most of the program's history, the share devoted to other benefits has grown. Most notably, the introduction of the prescription drug benefit significantly shifted the composition of Medicare spending.

Medicare plays an important role in financing American healthcare

Medicare is a major player in our nation's health system. The program pays for about a fifth of all healthcare spending in the United States, including 30 percent of all prescription drug costs, 25 percent of all hospital bills, and 23 percent of all physician expenses.4 Medicare pays for an even greater share of home health spending in the United States (about 40 percent), which includes in-home care by skilled nurses to support recovery and self-sufficiency in the wake of illness or injury.

The future of Medicare

Some important first steps have already been taken to constrain Medicare’s growing costs and to improve the program. Mirroring national healthcare trends, Medicare is increasingly concerned with changing how care is delivered and paid for. In that vein, the program has begun to embrace an effort to better coordinate care for patients with multiple or chronic conditions. Another shift that has begun to emerge is the movement away from the fee-for-service payment structure, which incentivizes physicians to prioritize volume over value when providing care. Those and other solutions are likely to gain momentum as Medicare’s financial pressures mount.

To preserve Medicare and to put the nation on a sustainable fiscal path in the long term, more reforms are required and policymakers will need to address the program’s growing costs, one of the primary drivers of our federal debt. Balancing cost concerns with considerations about the health and welfare of our nation’s older citizens will be important for coming to a successful long-term solution.

1 Unless otherwise indicated, all numbers on Medicare spending in this paper are calculated net of premiums and payments from the states. Those receipts were $124 billion in 2018. (Back to citation)

2 Unless otherwise noted, all years indicate calendar year. (Back to citation)

3 The 2.9 percent payroll tax was split evenly between employers and employees (1.45 percent each). Self-employed people paid the entire 2.9 percent themselves. (Back to citation)

4 The numbers here reflect gross Medicare spending. (Back to citation)

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