Will risk-adjustment decrease health care costs? New evidence from the Medicare Advantage Program

To combat adverse selection, governments increasingly base payments to health plans and providers on enrollees' scores from risk-adjustment formulae. But because the variance of medical costs increases with the predicted mean, incentivizing enrollment of individuals with higher scores can increase the scope for enrolling "over-priced" individuals with costs significantly below the formula's prediction. We show that after Medicare risk adjusted capitation payments to private Medicare Advantage plans, plans enrolled individuals with higher scores but significantly lower costs conditional on their score, and overpayments to plans actually increased. Our results have implications for many cost-control reforms that use risk adjustment.