Published 7/1/2012
John M. Froelich, MD; Roshan P. Shah, MD, JD

What’s Behind the SGR Formula?

One of the most confusing subjects of any healthcare reform discussion is the Sustainable Growth Rate (SGR) formula. The SGR formula is used by the Centers for Medicare & Medicaid Services to control spending by Medicare on physician services. This article aims to demystify the concept and help readers better understand this aspect of U.S. healthcare policy.

In 1965, the United States government became the single largest healthcare insurance provider with the establishment of the Medicare and Medicaid programs. At first, Medicare reimbursed physicians for services provided based on a ‘usual, customary, and reasonable’ rate. Over the years, however, the cost of Medicare steadily crept higher.

Under the Omnibus Budget Reconciliation Act of 1992, Congress initially attempted to curb Medicare costs by establishing relative values for all services and applying common conversion factors to determine reimbursement rates. Importantly, this legislation failed to establish any substantial penalties if proposed budgetary goals were not met.

Fast-forward 5 years, and with new leadership in the House of Representatives, the Balanced Budget Act of 1997 (BBA) was passed. A key portion of the BBA was the introduction of the SGR formula to control Medicare costs.

The SGR and physicians
Although many people don’t realize it, one key feature of the SGR formula is that it applies only to physician services under Medicare Part B. Specifically, the SGR formula does not affect or apply to hospital reimbursement rates.

The SGR formula attempts to rein in Medicare costs at a constant proportion of the federal budget by tying the Medicare budget to the Gross Domestic Product (GDP). For the first time in U.S. history, healthcare spending was tied directly to the country’s economic performance.

The overall SGR calculated each year uses the following four basic estimations to formulate the target Medicare budget for a given year:

  • estimated changes in physician fees
  • estimated changes in number of Medicare beneficiaries
  • 10-year average annual percentage change in GDP per capita
  • Medicare budgetary changes based on current legislation

The exact calculation of the Target Medicare budget is more complex than the scope of this article, but the take-home message for every practicing physician can be summed up in this simple formula: tRVU (total relative value units) × conversion factor = Medicare payment.

The tRVU is established by the Relative value scale Update Committee (RUC), but the catch is the ‘conversion factor.’ The conversion factor is composed of two basic elements—the Medicare economic index (MEI) and the update adjustment factor (UAF)—and is determined by the following formula: [(MEI + 1) × (UAF + 1)] – 1 = conversion factor.

Simply, the MEI is the estimated cost of doing business in a geographic region. It includes several regional expenses such as the cost of medical liability insurance, staffing salaries, and building costs.

The UAF is the driving force of cost control in calculating the SGR. The complex calculations behind the annual target budget are beyond the scope of this article, but it is obvious that the final UAF is a continual balance between achieving the target costs versus actual costs, as shown in Fig. 1.

The reason physicians are now facing progressively larger cuts in reimbursements (requiring legislative patches) is shown in red. Based on this portion of the formula, any deviation from the target expense will be carried over from year to year until it is paid-off or balanced. Therefore, each year’s adjustment factor decreases reimbursements until the total compounded difference between actual expenditures and target expenditures is rectified.

Based on current spending trends and legislative patches, the accumulated difference between the target and actual expenditures continues to grow and cannot be “zeroed out” unless large payment cuts are allowed to occur. The lack of flexibility to readjust the growing difference in target and actual expenditures and the across-the-board cut to all providers (no matter specialty or resource utilization) are two reasons the SGR is considered flawed. The compounding effect of the SGR is why temporary legislative patches lead to larger cuts in reimbursement in the future. What is needed is a legislative solution that addresses the basic math at the core of the SGR.

What’s next?
Although the SGR was created to keep Medicare from overtaking the federal budget by tying target expenditures to the GDP, its formula includes a fatal flaw. The goal of the SGR was simple: to balance the target and actual expenses of Medicare. The catch, however, is that any yearly deficit is carried forward and will influence the UAF for the next fiscal year.

This glimpse into the complexity of the SGR may give readers a better understanding of why we, as physicians, face enormous cuts with the expiration of every temporary patch. Over the coming months leading up to the next general election, the AAOS Washington Health Policy Fellows will provide brief informative articles about key issues in health policy.

John M. Froelich, MD, and Roshan P. Shah, MD, JD, have both served as AAOS Washington Health Policy Fellows. Dr. Froelich is currently completing a Hand Fellowship at the Mayo Clinic and will be joining the faculty at the University of Colorado. Dr. Shah is in his fourth year of residency at the University of Pennsylvania.