Prescription Drug Coverage and Medicare Spending among U.S. Elderly*

The introduction of Medicare Part D has generated interest in the cost of providing drug coverage to the elderly. Of paramount importance—often unaccounted for in budget estimates—are the salutary effects that increased prescription drug use might have on other Medicare spending. This paper uses longitudinal data from the Medicare Current Beneficiary Survey to estimate how prescription drug benefits affect Medicare spending. We compare spending and service use for Medigap enrollees with and without drug coverage. Owing to concerns about selection, we use variation in supply-side regulations of the individual insurance market—including guaranteed issue and community rating—as instruments for prescription drug coverage. We employ a discrete factor model to control for individual-level heterogeneity that might induce bias in the effects of drug coverage. We find Medigap prescription drug coverage significantly increases drug spending and reduces Medicare Part A spending. Medigap prescription drug coverage reduces Medicare Part B spending, but the estimates are not statistically significant. Furthermore, the substitution effect decreases as income rises, and thus provides support for the low-income assistance program of Medicare Part D.