Budget Explainer: Medicare

by Peterson Foundation


Medicare was signed into law by Lyndon B. Johnson in 1965 to provide health insurance to people aged 65 and older. Since then, the program has been expanded to serve the blind and disabled.

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 third largest program in the federal budget. It cost $590 billion in FY 2017 — representing 15 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 nearly 40 percent of all home health spending.
  • The number of Medicare beneficiaries has more than doubled since 1970. In 25 years, enrollment is projected to reach nearly 90 million.2
  • Medicare spending is a major driver of long-term federal spending and is projected to double from 3.1 percent of GDP in FY 2017 to 6.1 percent in FY 2047 due to the retirement of the baby boom generation and fast growth of healthcare costs per person.

What is Medicare? How does it work? How much does it cost?

Medicare is a major federal program that provides health insurance to people who are 65 and older, blind, or disabled. In 2017, Medicare provided benefits to over 15 percent of the population, or 57 million people — including 48 million seniors and 9 million persons with disabilities. The number of people enrolled in Medicare has more than doubled since 1970, climbing from 20 million in 1970 to 59 million in 2017, and it is projected to reach 89 million by 2042.

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 65.3 Parts B, C, and D are voluntary and require enrollees to pay premiums in order 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 premiums paid by beneficiaries and general revenues. Part C is paid for through funds from both the HI and SMI trust funds, and collects its revenues from a combination of general revenues, payroll taxes, beneficiary premiums, and out-of-pocket charges.

In FY 2017, the Medicare program cost $590 billion, about 15 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.

Between 2011 and 2029, the nation’s 76 million baby boomers will turn 65 and become eligible for Medicare, boosting program enrollment from 49 million to 80 million over the same period. If current policies continue, Medicare spending will rise from 3.1 percent of GDP in 2017 to 6.1 percent of GDP in 2047.

The growth of healthcare costs will put increasing pressure on the system’s finances — and the rest of the budget. Altogether, the growth of federal spending on Medicare and other major healthcare programs (Medicaid, the Children’s Health Insurance Program, and subsidies for the health insurance exchanges) is projected to account for about 90 percent of the rise in federal non-interest spending over the next 25 years.

Who pays for Medicare?

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, premiums, and other receipts covered only 58 percent of Medicare’s costs in 2017. General federal revenues from U.S. taxpayers made up most of the difference.

Medicare financing has changed significantly over the past forty years. In 1970, payroll taxes financed 62 percent of the Medicare spending. In 2017, however, payroll taxes cover only 38 percent of the program’s costs. This 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, increasing employer and employee’s contribution rates each from 0.6 percent to 1.45 percent of wages.4 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 of 2012 (ACA) increased payroll tax rates for high earners by an additional 0.9 percentage points beginning in 2013. Unfortunately, all of these changes will not be sufficient to offset future cost growth.

Premiums play only a modest role in funding the Medicare program. They financed about 14 percent of Medicare’s overall costs in 2017, about the same share as in 1970.

In 2017, general federal revenues were the largest single source of Medicare financing. 42 percent of Medicare’s income came from general revenue funds, up from 25 percent in 1970. Looking forward, general revenues are projected to continue funding a major share of the Medicare program. By 2050, the trustees project that the general revenue 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 in 2017. This is not surprising as hospitalizations are associated with very 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 22 percent of all physician expenses.5 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 improve the program overall. Mirroring national healthcare trends, Medicare is increasingly concerned with changing how care is delivered and paid for. In this 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. These and other solutions are likely to gain momentum as Medicare’s financial pressures mount.

In order 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

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