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This report addresses three issues that are becoming more important as Medicare makes greater use of capitation arrangements. First, the average adjusted per capita cost (AAPCC) is tied to the costs of the fee-for-service system, which means it fluctuates with the mix of risks using the fee-for-service system. Addressing this issue will require adjusters in the AAPCC that are more sensitive to the mix of risks. Second, the AAPCC as now estimated appears to exhibit too much geographic variance. So-called shrinkage estimators may mitigate this problem. Third, it is widely agreed that the present AAPCC formula requires new adjusters that will yield more homogeneous risk classes. Without such adjusters a portion of the Medicare population may experience serious access problems at alternative delivery systems. Developing such adjusters will require a substantial research effort. In the interim, or in the long run if the research effort is not sufficiently successful, it seems better to rely upon a blend of capitation and fee-for-service than the present AAPCC for paying alternative delivery systems. One way to do this is to add prior utilization to the AAPCC as an adjuster, but using a weighted average of current utilization and capitation appears preferable. As adjusters improve, the weight on the capitated amount could increase. In effect, such a blend attempts to compromise between the goals of economic efficiency and access for all Medicare beneficiaries.

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