This paper studies the role of Medicare's premium policy in sorting beneficiaries between traditional Medicare (TM) and managed care plans in the Medicare advantage (MA) program. Beneficiaries vary in their demand for care. TM fully accommodates demand but creates a moral hazard inefficiency. MA rations care but disregards some elements of the demand. We describe an efficient assignment of beneficiaries to these two options, and argue that efficiency requires an MA program oriented to serve the large middle part of the distribution of demand: the “middle class.” Current Medicare policy of a “single premium” for MA plans cannot achieve efficient sorting. We characterize the demand-based premium policy that can implement the efficient assignment of enrollees to plans. If only a single premium is feasible, the second-best policy involves too many of the low-demand individuals in MA and a too low level of services relative to the first best. We identify approaches to using premium policy to revitalize MA and improve the efficiency of Medicare.
