Since its inception over four decades ago, New York State’s Medicaid program has expanded inexorably. Today it is the nation’s most expensive by far, projected to spend a mind-boggling $49.2 billion in 2010—roughly 14 percent of the nation’s total Medicaid budget, though the state holds just 7 percent of the nation’s population. The program’s enormous size has helped saddle New York taxpayers with some of the highest state and local taxes in the United States, killing jobs and siphoning support from other vital public needs.

As Richard Daines, the commissioner of the state’s Department of Health, put it in early 2009, when lawmakers were facing a $15 billion budget deficit: “With Medicaid making up 20 percent of the total state budget, it’s impossible to exclude Medicaid funding from the deficit-reduction measures.” It may be impossible to exclude it—and it’s actually closer to one-third than one-fifth of the budget—but Albany is trying hard to do so. In the 2009–10 budget, Governor David Paterson claimed $2.3 billion in Medicaid “savings”—but much of these were actually revenues from new taxes and fees, including over $700 million in new taxes on privately purchased health insurance and $400 million in delayed Medicaid payments. Actual savings were much smaller than advertised: $545 million. Further, the Medicaid budget is critically dependent on federal stimulus money—$1.3 billion of it in 2008–09, and $3.7 billion in 2009–10. If you include those funds, state Medicaid spending has increased by just under 11 percent.

Though the governor has wrung some minor concessions from the powerful special interests that depend on Medicaid, far, far more will be needed to bring costs under control. It is no exaggeration to say that New York’s fiscal well-being depends on it.

Created in 1965 as part of President Johnson’s Great Society, Medicaid is a joint federal-state program that provides health care to the poor. The feds split the Medicaid bill with the states, paying 50 percent of the program’s cost in richer states like New York and a larger fraction in poorer ones. Spending is open-ended: the more money states spend on Medicaid, the more money Washington sends them as its match. Crucially, though federal regulators set minimum requirements for who’s eligible and what services they receive, states can offer a range of additional services (prescription drugs, say), for which the feds nevertheless have to chip in.

These federal dollars are a huge incentive for states to expand their health-care initiatives. And when Medicaid was new, nobody extended his hand to the federal till more enthusiastically than New York governor Nelson Rockefeller, who wanted his state to offer the most lavish Medicaid benefits in the country. Rocky also asked New York cities and counties to contribute half of the program’s nonfederal costs—meaning that state lawmakers could drive up spending using federal and local dollars without assuming the full brunt of the fiscal or political cost. Medicaid spending immediately shot far beyond even Rockefeller’s grandiose expectations. In 1966, his administration estimated that annual Medicaid costs would be $80 million; by 1969, they had exploded to $330 million.

Medicaid’s perverse funding formula is just one reason for its enormous costs. The other is politics. Albany legislators quickly realized that increased Medicaid spending could be a powerful tool to get themselves reelected, since various constituencies emerged that benefited directly from it, including hospitals, nursing homes, and the mighty health-care union SEIU 1199. Savvy policymakers, noted former New York State comptroller Ned Regan, began using spending to win “gratitude and campaign contributions from health care providers and union organizations, and the support and votes from Medicaid clients and those who work in the health care system.”

Medicaid thus came to dictate spending priorities in Albany. The most recent (and glaring) example is the career of Republican governor George Pataki, who arrived in office in 1995 railing against Medicaid overspending but then blasted it even higher by cutting politically expedient deals. In 1999, Pataki added billions to Medicaid with funds from cigarette taxes and the states’ share of revenues from the national Master Tobacco Settlement. The next year, he signed the Health Care Reform Act, which used Medicaid dollars to offer a new plan, Family Health Plus, that extended coverage to adults who earned too much to qualify for traditional Medicaid. And in 2002, to help cement his reelection bid, Pataki helped funnel an additional $1.8 billion in Medicaid funds into raises for SEIU 1199’s private-sector home-care workers; a few months after the bill passed, the union endorsed Pataki in the general election. Pataki won, but New York paid a steep price: by the time he left office in 2006, Medicaid spending had nearly doubled since 1995.

Federal matching dollars and corrupt state politics, then, help explain the multitude of optional services that Medicaid offers in New York State, the generous coverage that it extends, and the enormous amounts that get spent. According to 2006 data from the Kaiser Family Foundation, New York spends about 73 percent more per Medicaid enrollee than the national average—$7,927 versus $4,575. The vast funding devoted to Medicaid allows it to cover about one out of every five New Yorkers.

Fraud has become endemic, making the budget drain still worse. In a 2005 exposé, the New York Times reported on a Brooklyn dentist who billed the state for nearly 1,000 procedures in a single day; expensive ambulettes ferrying healthy Medicaid recipients around New York City at public expense; and over $1 billion in “questionable” payments for speech therapy for low-income New Yorkers. The Medicaid program was “so huge, so complex and so lightly policed,” the Times wrote, “that it is easily exploited,” with billions likely stolen annually. (A 2007 FBI report estimates that 3 percent to 10 percent of all health-care expenditures nationally are lost to swindlers.) And that’s just outright fraud. One former state Medicaid investigator suggested to the Times that 20 percent to 30 percent of New York’s program might be lost to noncriminal waste or abuse—tens of billions of dollars misspent annually.

With Medicaid expenditures rising so fast, New York policymakers at last began to act over the last several years, though intermittently and with minor success. To crack down on fraud, for example, the legislature created an independent office in 2006, the Medicaid Inspector General, which has since won praise from the federal government for its undercover sting operations to catch cheaters. Last year, according to the Inspector General, the state recovered more than $550 million—just a fraction of the billions lost to fraud, but a start.

To try to reduce the billions of dollars that Medicaid was pouring into New York’s bloated and expensive hospital and nursing-home industries, in 2005 Pataki and the state legislature created the Berger Commission, chartered with making recommendations for restructuring and closing unneeded hospitals and nursing homes. (The state controls these institutions by issuing the certificates that they need to operate legally.) As the commission’s final report noted, “empty beds, wards, and buildings that are unused and unstaffed have fixed costs that must be paid,” which hospitals pass along to Medicaid by admitting more patients, keeping them longer, or running more tests and procedures than are medically necessary. Initially, the commission suggested that the state might have as many as 20,000 excess hospital beds, but its final recommendations—accepted by the state—were modest. Only nine hospitals have closed, reducing the state’s bed count by just 1,700, with another 1,700 beds slated for elimination by next year.

Governors Spitzer and Paterson have pursued another strategy for cutting costs: encouraging preventive and primary-care services, hoping that they will help patients with chronic diseases like diabetes manage their illnesses better and thus lower Medicaid expenditures. The 2009–10 budget reduces spending on expensive inpatient hospital treatment by $225 million annually, with some of the money saved going to community clinics and doctors who specialize in primary care. To ease opposition from hospitals, the state has set aside about $150 million for them—and it’s worth remembering that in the past, hospitals have managed to transform such temporary subsidies into permanent new revenue streams. Still, over the long term, New York may be able to reduce its dependence on costly hospital care.

Unfortunately, Paterson is also looking to expand Medicaid enrollments. By 2013, the administration projects that one out of every four state residents will be in the program, a growth of 1.1 million enrollees. Busting the budget still more, the governor has also asked the Obama administration for permission to raise the maximum eligible income for Family Health Plus. (Through another Medicaid-funded program, Child Health Plus, New York already insures children in families with incomes up to 400 percent of the poverty level—about $80,000 a year for a family of four.)

New York’s addiction to Medicaid spending won’t change overnight, but there’s much more reformers can do to make the program fiscally sustainable. One step would be to freeze cities’ and counties’ contribution to new Medicaid costs. Beginning in 2006, the state capped that contribution at an approximately 3 percent annual growth rate, after counties protested skyrocketing property-tax hikes. But the built-in increase still gives the state too much leeway to increase spending. A freeze would make state lawmakers feel more political pain for every dollar they spent.

Transparency is another key, as the work of the Medicaid Inspector General has shown. In one demonstration project, Monroe County hired Salient Corporation to use data-mining technology to identify fraud, waste, and abuse in its Medicaid expenditures. The findings were eye-opening, including 73 providers who “paid for claims for dates after client was deceased”; dozens of cases of Viagra abuse (charging Medicaid for the drugs and then selling them); and ten Medicaid recipients with a total of 800 emergency-room claims in one year, including 55 for headaches. Data mining should be extended statewide and opened to researchers and the public so that policymakers and taxpayers can see where (and how) their dollars are spent.

Many states, including New York, have been removing healthy adults and children from traditional “fee-for-service” Medicaid, which pays for their health care directly, and instead paying managed-care plans like HMOs to cover them. These managed-care plans receive a prepaid sum per enrollee, typically focus on primary care and prevention, and have been shown to reduce costs compared with fee-for-service. New York should do the same with its highest-cost patients—the disabled and elderly—offering lump-sum payments to insurers that will cover them, and then holding those insurers responsible for improving outcomes and containing costs.

One more way to reduce costs involves affluent elderly New Yorkers who intentionally divest themselves of assets, giving their money away to family members so that they can qualify for Medicaid nursing-home coverage. Administrators should check people’s financial history as far back as 60 months, instead of the current 36, to make sure that they haven’t engaged in this fraudulent practice. Another way to rein it in: requiring people to contribute available assets to pay for their spouses’ health care.

Finally, New York’s dysfunctional private health-insurance market drives people away from buying insurance and into the arms of Medicaid. New York could take various steps to make private coverage affordable again (see sidebar, page 51), and with more people buying it, scarce state funds could be reserved for the poorest and sickest New Yorkers.

It’s difficult to predict how much these measures might ultimately save, especially given the Medicaid-dependent special interests’ ability to game the system. But that there’s a lot of fat to cut from the program—billions and billions of dollars’ worth—is indisputable. If policymakers simply brought New York’s per-enrollee costs more in line with those of other states, the savings would be massive. According to a 2007 report by the Empire Center for New York State Policy (a project of the Manhattan Institute), if New York spent at the same level as other states in just four categories of service for the elderly—hospitals, nursing homes, home health care, and personal care—it would save nearly $5 billion annually.

Ultimately, the most perverse incentives in the Medicaid program result from the fact that state policymakers can continue to draw down federal dollars with every state expenditure. Ideally, the federal government would give each state a set amount of Medicaid funding—a block grant—and then get out of the way, giving states full responsibility for spending those dollars effectively. The Obama administration is unlikely to agree to any such move. But there’s lots New York can do right now to keep out-of-control Medicaid expenditures from clouding its future.

Paul Howard is director of the Manhattan Institute’s Center for Medical Progress and the managing editor of its web-based journal Medical Progress Today.