How Is Medicare Funded?

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Tens of millions of Americans participate in Medicare coverage, and many more expect to take advantage of the program in the future. In order to ensure its continuing viability, it's important to understand where Medicare gets its money. The program works differently from Social Security, but the two share many of the same concerns about their joint financial future. Below, we'll look more closely at how Medicare is funded and what that means for current and future participants in the healthcare program.

Where Medicare funding comes from

Medicare gets revenue from a relatively wide variety of sources, but three major ones stand out. First, the program collects payroll taxes from working Americans. Those payroll taxes made up 38% of all Medicare revenue in 2014, making it the second biggest provider of funding for the healthcare program.

In addition, premium income that participants pay helps to provide money for Medicare. Those premiums bring in about 13% of Medicare's overall $600 billion in revenue. Participants pay monthly premiums for Part B medical coverage as well as Part D prescription drug coverage. However, the premiums aren't designed to cover the bulk of the costs of those parts of the Medicare program.

Finally, Medicare has a source of funding that Social Security doesn't: the general fund of the U.S. federal budget. In 2014, fully 41% of Medicare's money needs came from general tax revenue, making it the most important source of funding on which retirees and other Medicare participants rely.

Image source: Author based on data from 2015 Medicare Trustees Annual Report.

Medicare Part A Hospital Coverage and the Medicare HI Trust Fund

When you drill down on the different parts of Medicare, it's easier to see how various funding sources are dedicated to specific parts of the program. For instance, Medicare collects payroll taxes in the amount of 1.45% from employees and a matching 1.45% from employers. Self-employed workers pay the full 2.9% themselves. Unlike with Social Security, which imposes a wage base limit above which Social Security payroll taxes are no longer owed, Medicare charges its payroll tax on an unlimited amount of earned income.

All of those payroll taxes go toward funding Medicare Part A, which is the part of the program that provides coverage for hospital stays and other inpatient medical needs. Part A gets about 87% of its funding for its $261 billion budget from Part A payroll tax withholding. Most of the remainder came from interest on the Medicare Hospital Insurance Trust Fund, which holds accumulated payroll taxes from past years that weren't necessary in order to pay current-year benefits.

One concern about Medicare Part A is that the Medicare Hospital Insurance Trust Fund is expected to run out of money in 2030. A rising number of baby boomers is ramping up the need for healthcare spending from Medicare, and a smaller number of workers means fewer people are coming with money to pay for baby boomers' needs.

Medicare Part B and D

By contrast, Medicare outpatient and drug coverage don't raise the same concerns, because the government already goes beyond its payroll sources and provides money from general revenue to help fund the vast majority of the other offering. However, increases in those costs will simply translate to greater drains on those resources, and imposing higher premiums on participants will also cause financial hardship to many who rely on Medicare in order to get the healthcare coverage they need.

To some extent, the Medicare Supplemental Medical Insurance Trust Funds provide protection against future shortfalls. Yet because those funds are supported not by payroll taxes but rather from general revenue, the role of the SMI Trust Funds is different from the HI Trust Fund or the Social Security Trust Fund.

What's ahead for Medicare?

The key variable for Medicare is the pace at which healthcare costs rise. Recent slowdowns in the growth rate for medical costs have given the program greater long-term viability. Yet in the past, changes in costs have been cyclical in nature. If expenses accelerate, then trust fund depletion could happen in less than the roughly 15 years that is currently projected. On the other hand, efforts to rein in future cost increases have gained steam in recent years, especially after the passage of the Affordable Care Act. If those efforts continue to be successful, then lower than expected increases in costs could prolong Medicare's solvency. Beyond the 2030 date, the government would need to step in to make up any shortfall from other funding sources.

Medicare is a vital program for millions of Americans, many of whom wouldn't be able to afford to pay their healthcare costs without it. Ensuring stable funding for the long run is crucial in order to continuing meeting this need and keeping Medicare financially strong for decades to come.

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