SPECIAL REPORT:

The Impact of Sequestration

Analysis of Impact on Medicare Providers, NonDefense Discretionary Programs & Defense

November 28, 2011

Washington Strategic Consulting 1825 Eye Street, NW, Suite #600 Washington, DC 20006 www.wscdc.com www.wscblog.com

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Purpose of this Special Report

Washington Strategic Consulting (WSC) is pleased to provide this analysis of the impact of sequestration on Medicare providers, non-defense discretionary programs, and defense programs.1 While many observers expect that Congress will reverse or mitigate the impact of sequestration, WSC prepared this report because it is important that advocates of impacted programs understand how the process will work so as to properly inform lawmakers, congressional staff, and grassroots advocates of the real-world implications of sequestration if it is permitted to proceed as spelled out in the Budget Control Act of 2011 (BCA).

Introduction The Impact of Sequestration

The failure of the Joint Select Committee on Deficit Reduction (a.k.a., the congressional supercommittee) to report deficit reduction legislation has triggered a provision in the BCA requiring across-the-board cuts (i.e., sequestration) for many federal programs beginning in January 2013. The sequestration process remains in effect from fiscal year (FY) 2013 FY 2021, unless it is changed by Congress. This memorandum intends to clarify how the sequestration process will work and its expected impact on Medicare providers, non-defense discretionary programs, and defense programs. Due to the vagaries of the sequestration formula established by the BCA, government programs will be impacted inequitably by the sequestration process. And as this memorandum will explain, the significance of the impact is likely to be different than has been reported in the press. Specifically, the impact of sequestration on Medicare providers is likely to be more dramatic than has been portrayed. Conversely, the impact of sequestration on non-defense discretionary programs such as biomedical research supported by the National Institutes of Health (NIH), public health programs supported by the Centers for Disease Control and Prevention (CDC), community health centers funding and health care workforce programs supported by the Health Resources and Services Administration (HRSA), and mental health programs supported by the Substance Abuse and Mental Health Services Administration (SAMHSA) is likely to be less severe than has been reported in the media. While the sequestration process will be painful for all non-exempt government programs, it is critical to understand how the process will work in practice in order to ascertain its true impact and to plan for any advocacy response.

Budget Control Act Sequestration Formula

The sequestration process established by Section 302 of the BCA requires automatic spending reductions (sequestration) to occur if legislation originated by the congressional supercommittee reducing the federal deficit by at least $1.2 trillion over the period FY 2012 FY 2021 is not signed into law by January 15, 2012. The BCA established a deadline of November 23, 2011, for the supercommittee to approve a proposal, and a subsequent deadline of December 23, 2011,
1

The data and information contained in this report is derived from a review of the Budget Control Act of 2011 (P.L. 112-25) (125 Stat. 240) and a September 12, 2011 report by the Congressional Budget Office (CBO), Estimated Impact of Automatic Budget Enforcement Procedures Specified in the Budget Control Act.

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Washington Strategic Consulting | www.wscdc.com for the House of Representatives and the Senate to pass the supercommittees proposal and send it to the President for signature. Since the supercommittee failed to report any legislation prior to its mandated deadline, the sequestration process has been triggered and will begin on January 2, 2013, unless Congress intervenes. The BCA establishes a formula for determining the amount of spending to be sequestered and tasks the White House Office of Management and Budget (OMB) with calculating the amount of sequestration required in aggregate and annually from FY 2013 FY 2021. Specifically, the formula requires OMB to: 1. Determine the aggregate amount to be sequestered by reducing the $1.2 trillion deficit reduction goal by 18% to account for debt service2 2. Divide the result by nine (9) to determine the total annual amount to be sequestered3 3. Allocate half the annual reduction to defense programs and half to non-defense programs The formula ensures that $1.2 trillion in deficit reduction occurs by FY 2021. The result of the BCA calculation is that $984 billion must be sequestered in aggregate from FY 2013 FY 2021 with the remaining $216 billion in deficit reduction deriving from reduced debt service. Approximately $109.33 billion must be sequestered each year from FY 2013 FY 2021, with $54.67 billion coming from defense programs and $54.67 billion from non-defense programs.

Impact of Sequestration Medicare, Non-Defense Discretionary, & Defense

For purposes of context, $109.33 billion equates to about 3% of the overall annual federal budget. As mentioned previously, the sequestration process established by the BCA does not impact every government program equally. Several mandatory or entitlement programs are fully or partially exempt, meaning that the impact on non-exempt programs is significantly greater than 3%. The impact of sequestration on Medicare providers, non-defense discretionary spending, and defense spending is discussed below.

Medicare Providers
Medicare is a mandatory program; that is, its spending is mandated in law. It is also referred to as entitlement spending since individuals meeting program requirements spelled out in statute are entitled to government assistance. Examples of other mandatory or entitlement programs include Social Security, Medicaid, the Childrens Health Insurance Program (CHIP), and food stamps. In total, mandatory spending accounts for about $2 trillion, or two-thirds of the entire annual federal budget.

Every dollar that the federal government does not spend as a result of deficit reduction or sequestration results in less borrowing, thus reducing the amount that the federal government must spend to service (i.e., pay interest on) its overall debt. 3 The sequestration process lasts for nine fiscal years (FY 2013 FY 2021)).

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Washington Strategic Consulting | www.wscdc.com The BCA exempts most mandatory spending from the sequestration process. According to the September 2011 report by the CBO, approximately 70 percent of all mandatory spending is exempted, including Social Security, Medicaid, CHIP, Veterans program, and food stamps. This means that these programs will see no impact from the sequestration process whatsoever. The Medicare program is not exempt from sequestration, but the impact of the process is blunted; the BCA prohibits Medicare from being cut by more than 2% of the programs overall expenditures.4 The BCA further requires that all spending reductions as a result of sequestration must be borne by health care providers; no cuts to beneficiaries benefits are permitted. In FY 2013, CBO estimates that Medicare providers will be cut by about $10.8 billion via sequestration, or 2% of overall program expenditures. Since the Medicare program is expected to grow from $542 billion in FY 2013 to $860 billion in FY 2021, the dollar amount sequestered from Medicare will increase annually, reaching an estimated $17.2 billion in FY 2021, but the amount sequestered will not exceed 2% of overall program expenditures. This chart shows the expected annual amount to be sequestered from Medicare providers under the sequestration process:

Impact of Sequestration on MEDICARE Providers

FY13 Amount Sequestered ($B) Percent Reduction of Program Expenditures FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21

$10.84B $11.42B $11.96B $12.88B $13.42B $14.00B $15.12B $16.12B $17.20B

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

In total, approximately $122.96 billion will be cut from Medicare providers between FY 2013 FY 2021 as a result of sequestration. It is not entirely clear, however, how OMB will implement these cuts. The BCA orders OMB to sequester 2% of aggregate Medicare expenditures annually, but it provides no instructions on how OMB and the Centers for Medicare and Medicaid Services (CMS) will reduce payments to specific provider types. Since the BCA does not restrict the growth of Medicare expenditures, any cuts to providers presumably will be implemented after all relevant annual payment updates are factored in. This includes: base market basket updates and geographic wage index adjustments; related statutory adjustments to the base market basket update per the Affordable Care Act (ACA); productivity adjustments to the base market basket update per the ACA; adjustments for outlier payments, disproportionate share (DSH), and graduate medical education (IME); and performance-related adjustments for failure to demonstrate meaningful use of certified electronic health records technology, value-based purchasing, excessive readmissions, etc.
4

Without the 2% cap, Medicare would have been subject to cuts of about 5% from sequestration.

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Washington Strategic Consulting | www.wscdc.com The 2% cuts will have a dramatic impact on Medicare providers. While the press has focused on how the cuts are limited to just 2%, it is plausible that most Medicare providers could face negative net annual payment adjustments for nine (9) consecutive years. For example, historically the base market basket update for acute care hospitals has been approximately between 2% - 3%, but with the statutory adjustments and productivity adjustments mandated by the ACA, plus any performance-related downward adjustments, the net annual adjustment for individual providers, pre-sequestration, is likely to be less than 2%. Thus, a subsequent 2% reduction via sequestration means that the sequestration process would cause payment rates to decline in real dollars. If an acute care hospitals net pre-sequestration update is 1.5%, the post-sequestration adjustment would be -0.5%. Clearly, a retraction in payment rates for nearly a decade would cripple most acute care hospitals, inpatient rehabilitation hospitals, skilled nursing facilities, and other provider types.

Non-Defense Discretionary Programs

Non-defense discretionary programs such as those funded by NIH, CDC, HRSA, and SAMHSA, are fully subject to sequestration. It must be noted, though, the impact of sequestration on these programs has been overstated in the press. While sequestration will no doubt be devastating, it will not cause these programs to receive annual cuts through FY 2021. Rather, sequestration will result in a significant reduction in FY 2013, only.5 In subsequent fiscal years (FY 2014 FY 2021), non-defense discretionary spending is permitted to increase in aggregate by an average of 2.4% annually from FY 2013 post-sequestration levels. In fact, by FY 2021, aggregate non-defense post-sequestration discretionary spending levels would be about 20% higher than FY 2013 aggregate non-defense post-sequestration discretionary spending levels (see chart on page 5). In the out-years (FY 2014 FY 2021), the deficit reduction derived from the sequestration process comes not from annual cuts in spending, but by reducing aggregate non-defense discretionary spending caps from the levels established in the BCA; once the baseline is lowered in FY 2013, aggregate non-defense discretionary spending is permitted to increase annually from the new baseline. In other words, the cuts in the out-years are actually reductions in the spending caps, meaning a reduction in money that has not been spent. Thus, sequestration likely would result in a dramatic reduction in government services, but it is incorrect to assert that such programs will be cut each year for nine years. The annual impact of sequestration on non-defense discretionary spending is as follows: FY 2012: FY 2013: No impact sequestration does not begin until FY 2013. In January 2013, OMB will claw back about 7.8% from the FY 2013 enacted spending levels for each non-defense discretionary program.6

Non-defense discretionary programs likely will be cut by about 7.8% in FY 2013 under sequestration. It is anticipated the Congress will have completed the FY 2013 appropriations process by January 2013. OMB must claw back budget authority provided by the FY 2013 appropriations bills in order to adhere to the requirements of the sequestration process established by the BCA. The claw back will be in the form of an acrossthe-board cut for all non-defense discretionary programs.
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FY 2014 Aggregate non-defense discretionary spending is permitted to increase by an average of 2.4% annually starting from a baseline of FY 2013 postFY 2021 sequestration aggregate levels. Specific spending decisions for individual programs will be made by the congressional appropriations committees through the regular appropriations process.7

The chart below demonstrates the impact of sequestration on aggregate non-defense discretionary spending from FY 2013 FY 2021:

Impact of Sequestration on Aggregate NON-DEFENSE Discretionary Spending

FY12 Total ($B) Percent Annual Change $499 FY13* $462 FY14 $472 FY15 $483 FY16 $494 FY17 $505 FY18 $517 FY19 $532 FY20 $545 FY21 $558

-0.67%

-7.41%

+2.16%

+2.33%

+2.28%

+2.23%

+2.38%

+2.90%

+2.44%

+2.39%

*Sequestration takes place in January 2013; the % change is (-7.78%) from the expected FY 2013 enacted levels ($501B). Since Congress will continue to determine specific spending levels for individual programs through the annual appropriations process, it is plausible that certain politically popular programs, such as the NIH, could receive above average increases in FY 2014 FY 2021. That is, while the aggregate non-defense discretionary spending levels are capped at average annual increases of 2.4% from FY 2014 FY 2021, this does not mean that every relevant program will receive funding equivalent to this percentage increase. Some programs will receive more funding in relative terms while others will receive less. Additionally, Congress could position politically popular programs to receive significant increases in the FY 2013 appropriations bills in order to mitigate the claw back. It will be critical for advocates of specific programs to position their favored programs in order to lessen the impact of sequestration.

Defense Discretionary Programs

Defense programs face the most dramatic spending reductions under the sequestration process in percentage terms. In January 2013, these programs face a cut of about 10%. In subsequent fiscal years, though, defense spending is permitted to increase annually by an average of 2.3%. While this is significantly less than the historical growth of such spending, it is incorrect to assert that defense spending will be cut each year. In summary, the annual impact of sequestration on defense spending is as follows:
The Presidents annual budget request must include the revised post-sequestration spending caps for non-defense discretionary spending for each relevant fiscal year. The congressional appropriations committees must adhere to these aggregate spending caps when determining spending levels for individual programs.
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FY 2012: FY 2013:

No impact sequestration does not begin until FY 2013. In January 2013, OMB will claw back about 10.1% from the FY 2013 enacted spending levels for each defense programs.

FY 2014 Aggregate defense spending is permitted to increase by an average of 2.3% annually starting form a baseline of FY 2013 post-sequestration levels. FY 2021 Specific spending decisions for individual programs will be made by the congressional appropriations committees through the regular appropriations process.

The chart below illustrates the impact of sequestration on aggregate defense discretionary spending from FY 2013 FY 2021.

Impact of Sequestration on Aggregate DEFENSE Discretionary Spending

FY12 Total ($B) Percent Annual Change $554 FY13* $491 FY14 $501 FY15 $511 FY16 $522 FY17 $535 FY18 $548 FY19 $561 FY20 $575 FY21 $589

-0.67%

-9.74%

+2.04% +2.00% +2.15% +2.49% +2.43% +2.37% +2.50% +2.43%

*Sequestration takes place in January 2013; the % change is (-10.07%) from the expected FY 2013 levels enacted ($546B).

Looking Ahead: Potential Congressional Response

Most observers predict that Congress will step in and eliminate, or at least mitigate, the sequestration process. It is not an accident that congressional leaders set the start date for sequestration as January 2, 2013 rather than at the beginning of FY 2013 (October 1, 2012); the delay ensures a start date after the 2012 presidential and congressional elections and permits a lame-duck Congress to amend the BCAs sequestration provisions post-election. At this time, President Obama and Speaker of the House John Boehner (R-OH) both have indicated that they do not wish to see the sequestration provisions reversed. Indeed, the President has issued a veto threat against any such effort. Suffice it to say that this is simply political posturing it is highly unlikely that the President or Congress will simply stand by and permit the Pentagon to be cut by over 10% in January 2013. On the domestic side, one can expect Medicare providers to lobby hard against a process that essentially ensures negative reimbursement updates annually for nearly a decade. And while the cuts to non-defense discretionary spending are not as dramatic as have been reported in the press, Page 6 of 7

Washington Strategic Consulting | www.wscdc.com a 7.8% cut in FY 2013 to biomedical research, public health programs, community health centers, workforce training programs, and substance abuse programs would significantly impact government services and could trickle down through a fragile economy. It seems unlikely that Congress and the President could resist pressure to make changes to the sequestration process as it applies to non-defense discretionary programs. While a reversal or mitigation of the sequestration process seems likely, it is nevertheless critical that advocates pressure Congress and the White House on this matter. Understanding the sequestration process is the first step in this effort.

Contact Information
Washington Strategic Consulting (WSC) is prepared to provide a more detailed, in-person analysis of the impact of sequestration upon request. Please do not hesitate to contact Spencer Perlman (sperlman@wscdc.com) at (202) 207-3655 if you have any questions about the contents of this memorandum or the sequestration process in general.

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