Medicare 101 for Digital Health Part 1: What is Medicare and how did it get this way?

An intro to Medicare, and how digital health companies can impact the nation’s biggest payer.
By Gwendolyn Lee & Dan Gebremedhin, MD
04:41 pm

Despite its attractive large market size, Medicare has long frustrated early stage healthcare companies. The complex federal health insurance system, mired in statutory constraints, has arguably discouraged entry from would-be external innovators.

Regulations intended to prevent fraud, waste, and abuse, also create barriers to adoption for innovative value-creating products and services. The goal of this two-part series is to demystify Medicare and highlight select value-creation opportunities for digital health startups in this integral sector of the US healthcare industry. 

In Part 1 of this article, we introduce Medicare and its covered services along with rationales for digital health startups to engage with the nation’s largest payer. These motivations include Medicare’s large and growing beneficiary base, access to the nation’s largest and influential payer, and movement toward value-based care. 

In Part 2, we brainstorm ways early stage companies can penetrate the Medicare market. We highlight several early stage companies, many VC/PE backed, that have applied some of these principles and are experiencing meaningful traction in the Medicare market.

Why Medicare? Five reasons startups should care

Below are five factors that position Medicare as perhaps the most significant market opportunity for digital health startups, namely access to:

  1. The nation’s single largest payer for healthcare.
  2. A patient population with generally similar, common medical conditions that generate higher spending than the commercial population.
  3. A rapidly growing customer base of not only Medicare beneficiaries, but also Medicare-approved providers, suppliers and private Medicare Advantage plans
  4. The nation’s leader in payment policy and healthcare regulation, driving early shifts in health reform.
  5. Greater opportunities to generate value as Medicare is increasingly transitioning to outcomes-based models.

First, by innovating for Medicare, startups access the Centers for Medicare and Medicaid Services (CMS), which administers Medicare. CMS is the nation’s single largest payer for healthcare, covering 90 million lives. The Medicare program includes 61.4 million individuals and had total expenditures of $779.6 billion in 2019. For comparison, UnitedHealth Group (UHG), the nation’s largest private health insurer, covered 49.1 million lives with annual medical costs of $156 billion in 2019.

Figure 1. Medicare vs. Private Health Insurance Spending (source)

Second, Medicare’s beneficiary population is relatively homogeneous in terms of demographics, such as age, health concerns and goals, compared to the commercial population. More importantly, the senior population’s medical conditions are more costly than commercial counterparts. Historically, Medicare spending per enrollee is two to three times as costly as private health insurance comparables.

Third, the Medicare customer base of patients over the age of 65 and eligible for Medicare is large and only growing. Projections indicate the volume of Medicare beneficiaries will surpass 80 million by 2030. In addition to a large number of beneficiaries, there is a large marketplace of suppliers and vendors, including Medicare-approved healthcare providers, medical equipment suppliers, and private Medicare Advantage plans.

Fourth, by innovating for Medicare, startups have early access to market shifts that may predominate the healthcare industry. For decades, Medicare has strongly influenced payment policy for the private insurance market. For example, CMS created procedure codes such as diagnosis-related groups and implemented new payment technology such as the resource-based relative value scale, both of which guide payment by private health insurers as well.

Finally, Medicare has led the ongoing shift toward value-based care –and away from its origins in fee-for-service. The fee-for-service system reimburses care for each service rendered, incentivizing increased volumes of cases or procedures. Increasingly, Medicare Advantage and Medicare’s other value-based programs have shifted towards incentivizing high quality, cost-effective care through outcomes-based payment models. 

History of Medicare

Medicare was created in 1965 when President Lyndon B. Johnson signed an amendment to Social Security Act of 1935 into law. Medicare originally included only Part A (Hospital Insurance) and Part B (Medical Insurance) for individuals 65 or older. Together, Parts A and B are known as “Original Medicare” (OM). 

Since then, Medicare has been expanded to cover additional individuals and expand benefits to include additional forms of insurance coverage. In 1972, President Richard Nixon signed into law an added amendment that expanded Medicare to also provide healthcare coverage for disabled individuals and patients diagnosed with end-stage renal disease (ESRD) requiring long-term dialysis or kidney transplant. 

In 1997, President Bill Clinton signed into law an amendment that created Medicare Part C, then known as the Medicare+Choice (M+C) program. The M+C program allowed CMS to contract with public or private organizations to expand health plan options, including coordinated care plans, provider sponsored associations, and preferred provider organizations. This new private-public partnership administering Medicare benefits would soon take off and become known as Medicare Advantage.

In 2003, President George W. Bush signed the Medicare Prescription Drug Improvement and Modernization Act of 2003 (MMA) into law, creating Medicare Part D. The MMA expanded Medicare to include an optional prescription drug benefit allowing Medicare beneficiaries to receive insurance coverage for costly medications. The MMA also renamed M+C plans as Medicare Advantage Plans under Medicare Part C, and also allowed most of these plans to offer prescription drug coverage.

In March 2010, the Affordable Care Act (ACA) was enacted by Congress and signed into law by President Barack Obama. The CMS Innovation Center (CMMI), created via legislation in the Affordable Care Act, tests new value-based models to improve care, reduce costs, and align payment systems to support patient-centered practices. 

Although Original Medicare (i.e. Medicare Parts A and B) operates as a traditional fee-for-service (FFS) program today, CMS and CMMI are committed to furthering value-based care payment models. Today, Medicare offers many value-based programs, including the End-Stage Renal Disease Quality Incentive Program, the Oncology Care Model and Home Health Value-Based Programs.

The Four Parts of Medicare

As introduced earlier, Medicare can be grouped into four main “parts”:

  • Part A (hospital insurance)
  • Part B (medical insurance)
  • Part C (Medicare Advantage)
  • Part D (prescription drugs)

Figure 2. Original Medicare vs. Medicare Advantage (source)

Medicare Part A

Medicare Part A provides hospital insurance for services related to “acute” and “post-acute” care. This care is meant to treat an acute illness or the exacerbation of a chronic condition and has traditionally been provided in a facility-based setting. Typical facilities of care are emergency rooms, inpatient hospitals, and skilled nursing facilities (SNF).

Other forms of care related to a hospitalization, such as home health and hospice care, also fall under the Part A budget. In total, 7.6 million individuals were served by Part A, resulting in $190.7 billion in program payments in 2018 (Figure 3).

Inpatient hospital “acute” care is the service utilized by the greatest number of beneficiaries and is the main cost driver for Medicare Part A. Acute care was responsible for nearly 70% of all Part A payments, compared to “post-acute” care accounting for the remaining 30% of payments.

Figure 3. Original Medicare Persons Served and Payments (source)

Part A providers are paid through payment systems specific to the setting where care is provided, such as for inpatient hospitalizations and SNF stays. These fixed-payment models give a financial incentive to providers to control internal care-related costs.

The payment amount is determined through consideration of a handful of inputs, including average care-appropriate spending for a particular condition and the severity of disease. For example, inpatient hospital cases are categorized by diagnosis-related groups (DRG). Each DRG is assigned a payment weight based on the average resources needed to treat a Medicare patient, with their associated clinical conditions. 

A Skilled Nursing Facility (SNF) is a patient care facility designed for extended nursing care to manage a clinical condition. Care usually begins in an acute-care hospital, but once the medical condition has been stabilized, patients are often transferred to a SNF to continue a high level of nursing support.

In October 2019, the CMS changed the SNF reimbursement methodology from the historical fee-for-service-driven Resource Utilization Groups (RUG) system to a system known as patient-driven payment model (PDPM). This new payment model ties the reimbursement of clinical care to the clinical complexity of patients, as opposed to the legacy system, which tied payment to the volume of services delivered. This change will increasingly prompt SNFs to manage care and add capabilities to serve increasingly complex medical populations in a cost-effective way. 

Confusingly, home healthcare is covered by both parts of Original Medicare (Parts A and B). In addition to the hospitalization episode, the first 100 days of post-acute home healthcare is covered by Part A. Importantly, home health is only covered if the beneficiary spent at least three consecutive days in the hospital or in a Medicare-covered SNF for the same illness or exacerbation of chronic condition.

On the other hand, Part B covers home healthcare without the three-day stay requirement and is intended for home-bound beneficiaries that require skilled care. While home healthcare can be initiated under Part B coverage, Part B also extends coverage by covering any additional days past the first 100 covered by Part A.

Hospice is a team-based approach to care that is designed for patients who are presumed to be within the last six months of life. Although hospice care can be delivered in a facility or in a hospital, approximately 96% of hospice care is routine home care, delivered to ensure comfort and prevent hospitalization.

To qualify for hospice, a physician familiar with the patient’s care must certify the Medicare beneficiary is expected to live no more than six months. Because of the reimbursement structure, the Medicare hospice benefit requires a patient to forgo treatments aimed at curing a terminal illness.

Hospice providers receive largely fee-for-service payments that can amount to as much as $5,000 a month. In 2018, approximately 1.6 million people utilized this benefit, which cost Medicare over $19 billion. While hospice seems expensive, it presumably offsets much more expensive hospital care.  

While many believe Medicare to be a “free” program for beneficiaries, there are actually out-of-pocket (OOP) costs for Part A beneficiaries. Although most beneficiaries do not pay a monthly premium for Part A, patients were required to pay a $1,408 deductible toward inpatient care in 2020.

After paying the deductible, Medicare beneficiaries have additional OOP costs if hospital or SNF stays extend beyond 60 and 20 days, respectively. For these reasons, Medicare beneficiaries also have financial “skin in the game,” and are thus given incentive to receive cost-effective, value-based care.

Medicare Part B

Medicare Part B provides medical insurance for a wide range of services and supplies focused on non-acute, episodic or longitudinal care. Examples include doctors’ outpatient visits, telehealth, ambulance services, durable medical equipment (DME), physical therapy, mental healthcare, certain medications not covered by traditional prescription drug coverage (such as injectable and infused drugs) and some home healthcare (as covered above). In total, 34.2 million individuals were served by Part B, resulting in $198.8 billion in program payments in 2018 (Figure 3).

Together, physician and DME services were utilized by the greatest number of beneficiaries and generated the greatest program payments, accounting for 55% of all Part B payments (Figure 3). Physicians and DME vendors are both categorized as Part B “suppliers” by CMS. A supplier is defined as a physician or other practitioner that delivers healthcare services under Medicare.

Outpatient services, including laboratory tests, X-rays and other radiology services, preventive and screening services, and other services, generated 39% of Part B payments or $78 billion. Home healthcare served the fewest beneficiaries, at 2 million served, and had the lowest program payments from Part B, still at an astounding $11 billion.

While the total program payments for Parts A and B are comparable, Part B has substantially higher growth rates over time (Figure 4). This data underscores the decades-long shift of care from higher-cost acute settings to lower-cost non-acute or post-acute settings.

Slower growth in Medicare spending from 2010-2018, with almost no growth in Medicare Part A, can be in part attributed to value-based care policy changes adopted as part of the ACA and the Budget Control Act of 2011 (BCA). Accelerated by the COVID-19 pandemic, the industry has seen an even more dramatic shift within Part B spend as care is shifting from the outpatient doctor’s office to telehealth. 


Figure 4. Actual and Projected Average Annual Growth in Medicare
Beneficiary Costs for Part A, Part B and Part D, 1990-2028 (source)

How do providers and suppliers get paid in Part B?

Providers and suppliers must apply and be approved by CMS to be covered and paid by Medicare Part B.

Physicians receive Part B payments based on the average cost or resources required to provide a particular service to treat a Medicare patient. Within this "resource-based relative value system” (RBRVS), each service is categorized by current procedural terminology (CPT) codes, which are assigned relative value units (RVU). RVUs are adjusted based on factors such as time and skill required, office-based practice costs, and malpractice liability. 

These payment factors are often shaped by the American Medical Association, which works with national medical specialty societies to offer recommendations to CMS. RVUs help calculate how much a physician is paid, and they can be controversial, considering the wide variability in RVU classification, depending on specialty.

For example, physician annual work RVUs range from 9,822 for cardiovascular and cardiothoracic surgeons to only 3,689 for psychiatrists. This translates to median cash compensation of $654,500 for cardiovascular and cardiothoracic surgeons and $241,200 for psychiatrists. This variability in physician compensation is also correlated to provider shortages in less compensated fields such as primary care, family medicine and psychiatry.

For suppliers to obtain Medicare approval, they must obtain the required National Provider Identification Number (NPI), a surety bond and/or other accreditation, in addition to completing the relevant enrollment application. Qualified, accredited suppliers then participate in Medicare’s Competitive Bidding Program for durable medical equipment, prosthetics, orthotics and supplies (DMEPOS) to be chosen as Medicare contract suppliers. 

What medications are covered by Part B?

Medications covered by Part B have been the source of much contention. These drugs are covered under Part B because they are generally biological compounds (as opposed to standard pills) injected or infused into a patient and historically delivered in an office-based setting under the supervision of licensed clinician. These Part B drugs are purchased by healthcare providers, who are subsequently reimbursed by CMS. 

major source of controversy is the pricing associated with these drugs and the implied margin retained by health systems or physician groups in the transaction. Providers who serve a disproportionate share of under-resourced patients can receive a discount when purchasing Part B drugs through the 340B Program

Healthcare providers retain the difference between Part B reimbursement and the 340B discounted cost, which has historically been a significant difference and a substantial profit. Understandably, many provider organizations have been accused of aggregating 340B discounts and profits inappropriately. Given this concern for profiteering, CMS has iterated on ways to cap profits to providers.

Due to the predictable utilization of nonacute Part B services, beneficiaries have a sizeable premium for beneficiaries when compared to Part A. In 2020, the monthly income-adjusted premiums for Part B ranged from $145 to $492.

In addition, beneficiaries pay an annual Part B deductible of $198. As care continues to shift to the outpatient setting, beneficiaries are incentivized to conscientiously utilize healthcare services. 

Medicare Part C

Medicare Part C, also known as Medicare Advantage, is essentially Original Medicare (i.e. Medicare Parts A and B) managed by a private health insurer or provider group with expanded flexibility on supplemental product addition, administration and pricing. Medicare Advantage plans have more latitude than FFS Original Medicare in keeping providers accountable through unique value-based arrangements. 

Medicare Advantage rising

Medicare Advantage and value-based care are becoming increasingly popular among beneficiaries enrolling in Medicare. Medicare Advantage enrollment has grown dramatically over the past decade. It's gone from 13% of all Medicare beneficiaries in 2005 to 37% in 2019, and it's expected to reach 47% by 2029. The 22 million individuals enrolled in Medicare Advantage produced $203 billion in healthcare spending annually. 

Figure 5. Managed Care as a Proportion of Medicare Benefits (source)

Many market observers view Medicare Advantage as the “health plan of the future” – giving insurance companies unique latitude within the overall large market of Medicare to provide cost-effective, value-based care. In addition to growing demand from increased beneficiary enrollment, the supply of Medicare Advantage plans has also grown.

The number of MA plans offered has increased by 50% from 2015, with over 3,000 plans being offered in 2020. Of note, several startup Medicare Advantage plans have collectively raised over $3.9 billion in private funding, continuing this trend of increasing choice for MA beneficiaries. 

How do MA plans get paid?

Medicare Advantage is particularly conducive to innovation due to its payment structure. MA plans receive premium payments on a “capitated” monthly basis in line with a beneficiary’s expected medical cost. The expected medical cost is defined by the beneficiary’s risk adjustment factor (RAF) score.

The RAF score is based on the beneficiary’s demographic factors and health conditions represented by corresponding CMS Hierarchical Condition Categories (HCC). Given the centrality of RAF for determining payments, there is a long history of MA plans attempting to over-optimize these coding processes, leading to frequent lawsuits from the Department of Justice alleging Medicare Fraud.

If a beneficiary’s premium is greater than their direct medical costs, Medicare Advantage plans can make money. With this aim, plans assume financial risk from CMS and use a variety of innovative care-management tools to deliver higher quality, lower cost care.

In many cases, Medicare Advantage plans can “sub-capitate” payments to provider groups, in turn delegating this financial risk to providers. Providers will receive upfront monthly payments that can be invested in proactive, longitudinal care that is a significant departure from Original Medicare’s fee-for-service Part A and Part B legacy constructs.

However, CMS does limit how profitable Medicare Advantage plans can be through the medical loss ratio (MLR). Insurance companies must spend at least 85% of a beneficiary’s premium on medical care, including direct medical care, as well as innovative, cost-effective tools for prevention and management.

Unlike Original Medicare, Medicare Advantage plans’ premiums, deductibles, coinsurance and other payments vary based on the beneficiary’s specific plan. Premiums include both the monthly Part B premium (at least $144.60 in 2020) and an additional monthly Medicare Advantage premium.

The average additional premium for Medicare Advantage plans that cover drug prescriptions is $29 in 2020, resulting in a total monthly premium of $173.60 (Figure 5).To further protect patients, Medicare Advantage has a maximum out-of-pocket spending limit, which is at most $6,700, and averages $5,000 across plans in 2020.

Figure 6. Medicare Advantage Sample Premium Calculation (source)

The price of the premium and levels of cost-sharing are major buying criteria for MA beneficiaries when they select a health plan. For this reason, MA plans are incentivized to provide cost-effective care to lower out-of-pocket costs and advertise low-cost plans to members.

We anticipate further development of patient-consumerization behavior and tools as MA competition and penetration increases and the industry better understands beneficiaries’ needs and preferences. 

Medicare Part D

Medicare Part D provides an optional prescription drug benefit that can be added to both Original Medicare (i.e. Parts A and B) and Medicare Advantage (i.e. Part C). Like a mini-health plan with defined premiums and cost sharing, Part D provides financial support for beneficiaries, who on average have over $3,000 in prescription drug costs annually.

An important concept in Part D plans is the “formulary,” the master list of prescription drugs covered by a particular plan that can vary across Part D plans. In each therapeutic class, there are several medications that have both branded and generic options, as well as comparable options between pharmaceutical manufacturers. Part D plans have general flexibility in concocting their own formularies that cover each major therapeutic area for their beneficiaries.

In addition to inclusion on the formulary, many plans manage cost and incentivize patient behavior by categorizing medications into several cost-sharing tiers. The lowest tier typically has the most generic, lowest cost medications and thus the lowest patient copayment levels. The higher tiers generally have costlier brand-name, non-preferred prescription drugs, and thus higher patient copayment levels. 

In addition to providing insurance coverage, MA plans offering Part D plans are incentivized to ensure effective and safe use of covered medications. Medication nonadherence can be a challenge for some individuals in the Medicare population.

To combat nonadherence, CMS reimburses special Medication Therapy Management (MTM) programs, which provide additional medication management support for members with complex medication regimens. In this 2017 article, we wrote extensively about the opportunity for digital health startups to serve Part D plans and beneficiaries by improving medication access, adherence, and management.

In 2020, beneficiaries had a monthly Part D income-adjusted premium ranging from $12 to $76. MA plan members have an annual deductible of up to $435 and a maximum out-of-pocket spending limit of $6,350. Although Part D is an optional program, the majority of Medicare beneficiaries participate. In 2018, 43.5 million beneficiaries, comprising 72.5% of all Medicare beneficiaries, were served by Part D, resulting in $95.2 billion in program expenditures.


In the first half-century of Medicare, our perception is that startups have historically avoided the Medicare market space. As we enter the second half-century of Medicare, we are seeing both startups and CMS make inroads to further collaboration.

In this article, we’ve attempted to apply an entrepreneurs’ lens to highlight key aspects of the expansive Medicare program. Our goal is to encourage startups to enter the Medicare market space and positively impact this massive government program through higher-quality and more cost-effective care.

In Part 2 of this article, we offer insights into value creation opportunities and examples of digital health companies serving Medicare populations. 

About the Authors

Gwendolyn Lee is a member of the 2020 Flare Capital Partners Scholars program. While completing her MPP at Harvard Kennedy School, she interned at the Massachusetts Health Policy Commission and the Massachusetts eHealth Institute. She is currently a third-year medical student at the David Geffen School of Medicine at UCLA.


Dan Gebremedhin, MD (@dangebremedhin) is a partner at Flare Capital Partners, a healthcare technology and services-focused VC firm. Prior to Flare Capital, he served as a practicing physician at the Massachusetts General Hospital, a medical director at the Harvard Pilgrim Health Plan and an entrepreneur in the health IT industry.

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