The Impact of the Federal Spending Reductions

Budgetary battles continue to dominate the debate in Washington with more than $1 trillion in automatic spending cuts looming. Absent a last-minute deal, the reductions will hit nearly every corner of the health sector, from researchers to hospitals to drug companies.

There is a lot of discussion about the sequester. PwC's Health Research Institute (HRI) has distilled the information coming from Washington, D.C. to provide you with the information you need. Below we have included some information about what the sequester is and who will be impacted.

What is the sequester and why is it dominating the headlines? Simply put, the "sequester" is Washington budget speak for the automatic federal spending reductions enacted in the Budget Control Act of 2011. The law imposes $1.2 trillion in cuts over the next nine years, divided equally between defense and more general domestic spending.

When do the spending reductions kick in? The cuts were originally set for January 2, 2013 but an 11th-hour agreement to avert the "fiscal cliff" pushed the start date to March 1. Negotiations continue, but agreement on a deal to further delay the cuts may not happen.

Who will be impacted? Nearly every corner of the federal bureaucracy will be affected from government engineers to emergency first responders. According to the nonpartisan Congressional Budget Office, federal spending through September 2013 will be reduced by $85 billion compared to original spending targets, with most coming from the "discretionary" side of ledger. That includes the government’s Public Health and Social Services Emergency Fund ($47 million reduction), early childhood programs ($30 million reduction), and a $275 million cut to the Substance Abuse and Mental Health Services Administration. Another $14 billion will be cut from mandatory spending on programs such as Medicare and unemployment benefits.

With the delay from January to March, the Office of Management and Budget estimates that the cuts will effectively require annual reductions of about 9% for nondefense programs, and roughly 12% for defense programs for the rest of the fiscal year.


Under the sequester, seniors won’t see any reductions in Medicare benefits. Rather, the budget cuts are focused on providers and on private plans under Medicare—and are capped at 2%.

What happens to Medicare? Some parts of Medicare, such as low-income subsidies for prescription drugs and Part B premiums, are exempt. And Medicare’s benefits structure remains unchanged. The CBO estimates that the 2% cap will result in a $9.9 billion reduction in payments to hospitals, physician services and drug plans. The sequester also takes another $28.7 billion from discretionary spending that is not related to defense, which could impact childhood vaccines, public and mental health programs, and clinical research.

So hospitals should brace for lower payments in March? Yes and no. Most of the reductions take effect on March 1. But Medicare gets a one-month reprieve, meaning doctors and hospitals won’t see a reduction in reimbursements until after April 1 at the earliest.

From a hospital perspective, who is impacted the most? Teaching hospitals with a strong link to federally-funded research could shoulder the brunt. Industry estimates show that academic medical centers could lose up to $14 million in Medicare payments, and another $25 million from research programs funded by the National Institutes of Health (NIH) -- this year alone. The cuts could also adversely impact graduate medical education. Critical access hospitals and other types of facilities that operate on the financial margins may also be impacted. With a Medicare reduction of 2%, reimbursements to critical access hospitals would likely fall below cost of delivering care..

What about Medicare payments for physician-administered drugs? The automatic 2% Medicare cut includes payments for medications administered in doctors’ offices, such as chemotherapy drugs. If implemented, the cuts would effectively reduce payments from 106% of a drug’s average sales price to 104%. While doctors would face the brunt of these cuts, it could trickle down to the actual drug manufacturers—especially if physicians change their prescribing habits under the lower reimbursement rate.

How will private prescription drug plans be impacted under Medicare Part D?
Part D plans could feel the effects of reduced payments. Formularies and benefits criteria are already set for 2013, so Part D plans cannot make changes that could be perceived as negatively impacting members. Plans may attempt to renegotiate better rebates with drug manufacturers, and may also redesign formularies and benefits for 2014 to help offset the cuts. With many plans already exiting the marketplace due to declining profit margins, the additional sequester cuts could fuel additional consolidation and encourage insurers to bundle drug plan offerings with Medicare Advantage and MediGap policies.

How will Medicare Advantage plans be affected? Medicare Advantage plans already face a reimbursement drop between 6% to 8% resulting from recently announced rate cuts and other factors such as the Affordable Care Act-mandated health industry tax. The additional 2% Medicare sequester cuts will likely add additional pressure on plans, which are prohibited from passing on costs to beneficiaries that exceed $30 per member/per month starting in 2014. The cuts will likely be most difficult for smaller plans and non-profits, which may already be operating on lower profit margins.

Medicare managed care plans should also brace for tight financial times. To compensate, plans may lower profit targets, make additional administrative cuts, reduce medical expenses through clinical programs such as medication therapy management, and renegotiate provider rates.

What about Medicaid and the Children's Health Insurance Program? Both programs are exempt from the automatic cuts.

Federal Agencies

The budget cuts affect nearly every corner of the healthcare industry. Nowhere is that more evident than in the planned reductions to some of the government’s key health agencies.

How will cuts to government agencies impact hospitals, insurers and pharmaceutical companies? As many government agencies feel the pinch, the trickle down effect could impact a broad cross section of healthcare. Here are a few examples:

  • National Institutes of Health (NIH): A $1.54 billion reduction from its $30 billion budget could result in research projects that are delayed or completely stopped. Among those directly affected: academic medical centers and other types of research institutes that rely on NIH grants.
  • Food & Drug Administration (FDA): The agency’s budget will be cut by $209 million—much of it affecting the pharmaceutical and device manufacturing sectors. The White House has said that cuts could result in reduced operational support, which in turn could delay drug and device approvals. The FDA may have fewer resources to conduct facility inspections, which could cause manufacturing delays.
  • Mental health and substance abuse services: A $168 million cut could result in reduced mental healthcare for 373,000 mentally ill adults and children, and potentially increase hospitalizations.
  • AIDS and HIV treatment: Budget cuts could result in 7,400 fewer patients having access to HIV medications, and approximately 424,000 fewer HIV tests conducted by the Centers for Disease Control. Such reductions could impact physicians, community clinics and other caregivers, as well as drug companies.

Are any of the Affordable Care Act programs affected?

Much of the 2010 law is protected, but some key provisions could struggle under reduced funding. Health insurance marketplaces, known as exchanges, will see about $44 million in lost grant money, which could dampen enthusiasm for adopting the state-based model. And the law’s prevention and public health fund, created to help erase medical disparities, protect against emerging health threats and boost public health effectiveness, will see a $51 million cut.

Next steps for the health sector

How can the industry prepare? The sequester has many moving parts and is just one element of a much broader fiscal debate. Many experts suggest the cuts will be temporary—lasting a month or so. Even if the cuts are a small fraction of Medicare payments, hospital executives and physicians should consider belt-tightening measures.

  • Prepare for delayed or reduced payments – Reduced or delayed payments may deplete cash on hand and make payroll and vendor payments more difficult. It’s critical to review financial metrics, including cash reserves, bond covenants and vendor contracts. Even if the sequester proves only a temporary speed bump, it’s important to create an orderly plan to manage a possible cash crunch.
  • Review research budgets – While the NIH has already cut back on some of its research grants, teaching hospitals that already budgeted for the money could come up short compared to their financial projections. As future research grants and payments may be eliminated, review research priorities and look for opportunities through non-NIH research grants as a bridge to soften federal reductions.
  • Recalibrate timelines for work involving government agencies--Federal agencies may have reduced work hours. These furloughs could affect contracting as well as the implementation of pilot projects for accountable care, bundled payments and health insurance exchange grants.
  • Prepare for population health changes – Federal agencies charged with public health and safety such as the Centers for Disease Control and Prevention may have fewer resources for immunization programs, community health centers and other programs effecting population health.

Well, what happens if Congress actually delays or overrides the cuts?

Right now, providers look at the 2% Medicare cut with concern—especially when couched with other annual pay reductions. But if lawmakers thwart any or all of the sequester, they may need to find other savings to make up for the changes. The cost for the Medicare portion of the sequester as it stands would run more than $100 billion over the next decade. Hospitals and physicians worry that the cuts Congress could find to offset the cost of the sequester could be even more detrimental than the 2% they’re facing now.