NEW YORK (Money Magazine) - If you've been following the news about Medicare, you may well think that adding a prescription-drug benefit is the biggest issue facing the program. The drug provisions of the two separate bills passed by the House and the Senate early in the summer have been dissected in the media, and the biggest question on Capitol Hill since the end of the recess has been what kind of compromise can be worked out.

But a much more fundamental debate is raging over Medicare: Should this massive creation of the Great Society era remain a government-run program that gives all beneficiaries the same slate of benefits at essentially the same price? Or should it become a more freewheeling system under which seniors choose from competing health plans that might provide different benefits at different prices?

This debate is not a new one; Medicare has often been a target for reformers. But the prospect of baby boomers swelling the ranks of beneficiaries -- and of a drug benefit boosting already soaring costs -- gives the argument a greater sense of urgency. In just 10 years, one of the program's two trust funds will be paying out more than it takes in. Eventually, Medicare could consume 70 percent of all federal income tax revenue.

In this story, we'll outline the financial challenges Medicare faces and sift through claims and counterclaims to help you decide whether it would be better to refine the existing system or to change it radically.

Before we begin, however, there's one thing you should know: Neither side in this debate can claim a magic bullet that will dramatically reduce the cost of Medicare. Health-care expenses are escalating throughout American society, not just within Medicare. Whatever type of Medicare program we end up with will have to grapple with this underlying fact -- as well as the very real possibility that whichever path we take, Medicare will require more money from both beneficiaries and taxpayers.

Medicare is the second-largest federal entitlement program behind Social Security (although at the rate spending is growing, it will overtake Social Security in 50 years -- sooner if a drug benefit is added). Medicare now covers some 41 million seniors and disabled persons and will spend some $279 billion this year, just under $7,000 per enrollee.

From a beneficiary's point of view, the program's design is relatively simple. The federal agency that oversees Medicare -- the Centers for Medicare and Medicaid Services, or CMS -- decides which medical procedures and services are covered. Beneficiaries then get care from virtually any hospital or doctor they choose. From the individual's standpoint, the payment system is also straightforward. Under Medicare Part A, which covers hospitalization, patients pay an $840 deductible for hospital stays of 60 days or less, and Medicare picks up the rest of the tab for covered services. In Medicare Part B, which covers tre atment in a doctor's office or in a hospital's outpatient department, beneficiaries pay a premium (currently $58.70 a month), which is usually deducted from their Social Security checks, plus a $100 annual deductible. After that, Medicare picks up 80 percent of the bills for covered services.

Beneath this simple veneer, however, is a formidable administrative bureaucracy that, among other things, sets reimbursement rates for virtually every medical treatment. In order to determine payments for hospital stays, Medicare classifies patients into one of more than 500 DRGs, or Diagnosis Related Groups. (For more on DRGs, see "The $49,000 Hip," on page 48.) For doctors, payments are based on the RBRVS, or Resource-Based Relative Value Scale, a system that estimates the time and intensity that some 8,000 procedures require as well as related overhead and malpractice costs. Medicare's defenders refer to this procedure as administrative pricing. Critics call it price fixing.

The system by which the government finances the Medicare program is no less elaborate. Two separate funds finance benefits. One covers bills in hospitals and nursing homes; the second, physician services and other outpatient care. Let's start with the hospital trust fund. This operates much like the Social Security retirement fund. It gets revenue primarily from payroll taxes, currently 2.9 percent of wage income, with employers and employees each paying half. If the fund takes in more than it needs to pay benefits, it invests the excess in Treasury bonds. This year it will collect roughly $180 billion and pay out about $156 billion. That leaves $24 billion to boost the value of the fund.

Given current projections, however, the situation will be reversed in about 10 years. As baby boomers begin to hit 65, the number of Medicare enrollees will grow faster than the number of workers supporting them with payroll taxes (see the charts on page 76). At the same time, health-care costs are expected to grow much more quickly than wages and the economy. That's partly due to rising demand for health care, but technology also plays a role.

Typically, we think of technology as a force that drives prices down, as it has for PCs and software. But technological advances in health care create an ever-expanding roster of treatments and make existing procedures available to more people. The result is more spending on health care, not less. By 2013 the hospital trust fund will be taking in less than it pays out. At that point, it will rely on the interest and eventually the redemption of its cache of Treasury bonds. In 2026, Medicare actuaries project, the fund will run out of bonds, and revenue from payroll taxes will cover only about 73 percent of expenses -- and the outlook will deteriorate from there, until about 75 years from now taxes will cover only 30 percent of spending.

People fixate on 2026, when the hospital fund exhausts its stash of bonds, but the strain on the federal budget begins in only 10 years. The reason: Clipping interest coupons and redeeming Treasury bonds is simply taking an asset held by one arm of government, the trust fund, and presenting it to another, the Treasury. To redeem the bonds, the Treasury must divert revenue from other programs, raise taxes or borrow.

Then there's the SMI (Supplementary Medical Insurance) fund, which provides funds for physician and outpatient services. Medicare beneficiaries pay monthly premiums equal to about 25 percent of SMI costs, and the federal government kicks in the rest. In essence, the government writes a blank check, assuring that federal revenue will roll in automatically to cover whatever beneficiaries' premiums don't.

So the SMI fund, at least in theory, can never run out of money. But it will place an increasing burden on beneficiaries and taxpayers alike. Last year, just below 8 percent of federal income taxes were channeled into the SMI fund. At the current rate of spending, that share would increase to almost 21 percent by 2040, assuming taxes stay at the same level they are today relative to the size of the economy. By 2077, as far out as the actuaries make predictions, the fund would soak up almost a third of income taxes. Beneficiaries will also feel the pinch. Today SMI premiums eat up 7 percent of the typical 65-year-old retiree's Social Security check. In 20 years that percentage will nearly double, to 12.4 percent.

Because the two funds don't operate the same way, it's difficult to gauge the future impact that Medicare will have on the federal budget. But there is a way: Calculate the share of federal income tax revenue (which makes up nearly 90 percent of government income) that would be required to fund both the 75 percent of the SMI trust's spending that beneficiaries' premiums don't cover and the projected shortfalls the hospital trust fund will experience beginning in 2013. Go through this analysis and you find that the percentage of federal income tax revenue required for Medicare expands dramatically. In the absence of higher taxes or increased borrowing, it will become increasingly difficult to pay for Medicare without taking money from defense, education and other programs.

And even these figures may be too low. The projections assume that long-term health-care spending will grow one percentage point a year faster than per capita gross domestic product. Historically, however, Medicare's spending has grown at a rate closer to three percentage points over per capita GDP, although much of that can be traced to earlier years when Medicare was less rigorous about spending controls. Truth is, such long-term projections, no matter how sophisticated, always involve an element of guesstimation. "Whether it will be GDP or GDP plus one or two percentage points, we just don't know," says Medicare's chief actuary, Rick Foster.

None of these figures take into account a prescription-drug benefit. Based on what's been proposed by the House, the Senate and President Bush, experts estimate that a drug benefit could boost Medicare spending by 10 percent to 15 percent a year -- and increase the draw on federal tax revenues by roughly 20 percent, according to Medicare trustee Thomas Saving. Which means that unless we raise taxes, Medicare could consume just over 40 percent of all federal income tax revenue by 2043 and 70 percent by 2075.

Do Medicare's escalating demands on our resources, both individually and as a nation, amount to a crisis? And if so, what should we do? For the most part, the politicians and policy wonks who look seriously at Medicare fall into one of two camps. Each is defined as much by beliefs about the respective roles of government and the markets as by an analysis of the numbers.

The first group -- we'll call them the Medicare traditionalists -- holds that the best, most efficient way to provide health care to the most vulnerable part of the population is a program that is largely administered by a single payer, the government, and assures everyone a given set of benefits at the same price. Among the traditionalists is Marilyn Moon, a former Medicare trustee and a health-care economist at the American Institutes for Research.

Moon sees challenges looming for Medicare, but not crisis. "We'll make adjustments," she says. "We always do." She sees administrative pricing as one of the system's strengths. Moon argues that, as the Big Kahuna in the market, Medicare can use its buying power to negotiate lower payments to health-care providers. That's not to say the program can't do a better job holding the line on costs, she says, but that can be done within the existing program. One proposal: having Medicare fund more outcomes research, which would give doctors and patients more information about which treatments really work and thus encourage cost-effective spending.

As for the projections that Medicare will eat up much more of our taxes, Moon says rising health-care costs and the influx of baby boomers into the program mean that raising taxes is virtually inevitable. "We want Tiffany health care at K Mart prices," she says. "But people have to understand that we'll either have to pay up or cut benefits."

The second group -- we'll call them the competition crowd -- maintains that Medicare's burden on taxpayers is unsustainable and that market forces are more likely to reduce that burden and still produce acceptable health care for the elderly. Two leading advocates of competition are Medicare trustee Saving, who is also a director of the Private Enterprise Research Center at Texas A&M, and Robert Moffit, director of the Heritage Foundation's Center for Health Policy Studies.

Supporters of competition want to correct what they see as two serious flaws in the current Medicare program. The first is pricing. While they admit that Medicare has some bargaining leverage, they argue that price controls can cause distortions in the market for medical services -- doctors, for example, may game the system by performing more services than are necessary -- and can restrict access to health services and lower the quality of care.

The second fundamental flaw, say advocates of competition, is that seniors have no incentive to shop for the best deal for medical services. With few e xceptions, the patient's bill is the same, wherever he goes for care. What's the point in comparison shopping?

The solution to both problems, Moffit asserts, is replacing the current system with a new "premium support" system. Enrollees would choose between traditional Medicare and a menu of private health plans that would be required to offer benefits comparable to or better than Medicare's. Every year, based on the average cost of Medicare and the private plans, the government would determine how much to contribute toward recipients' health-care costs. That contribution would be applied to whichever plan an individual chose. If the plan costs less than the government subsidy, the beneficiary would get a rebate or possibly access to additional health benefits. If the plan costs more than the subsidy, the beneficiary would have to make up the difference. The Federal Employees Health Benefits Program, which provides insurance to 8 million federal employees and their dependents, as well as members of Congress, works on this principle. The Medicare bill passed by the House would launch such a plan in 2010.

Proponents of premium support believe that competition among insurers could stem the rise in health-plan premiums and -- since the government's contribution is pegged to the average premium -- the cost to the taxpayers. And, they say, seniors would be more likely to shop for cost-efficient plans. Beyond that, trustee Saving hopes that private plans would eventually offer policies with high annual deductibles, say, $2,500 a year vs. Medicare's current $100 deductible, to give consumers more incentive to be judicious about which health services, and health-care providers, they use. Ideally, says Saving, the combination of competition and incentives would contain spending better than Medicare administrators can.

In addition, the competition crowd says that private plans looking to woo customers while containing premiums might be more apt than traditional Medicare to develop innovative and cost-efficient ways of treating patients and overseeing all facets of their health.

Where the competition crowd sees opportunity and potential savings, the traditionalists see potential problems. One is that Medicare recipients might have a difficult time sorting through a smorgasbord of plans with different prices and services. "You're talking about a lot of 85-year-olds among whom the incidence of mental impairment may be as high as one-third and disabled people with a variety of difficulties," says Henry Aaron, a health-care economist at the Brookings Institution. "That's a minority [of Medicare recipients], but still a sizable group that needs help choosing insurance."

Competition advocates respond that seniors already deal with two sets of premiums and deductibles when they match gaps in their Medicare coverage with employer plans or Medigap policies. "What we have now is a much more complicated system," asserts the Heritage Foundation's Moffit.

Another of the traditionalists' concerns is that private plans might cherry-pick healthier retirees with lower health-care costs, leaving Medicare with a higher percentage of chronically ill people who need expensive treatment. The fear is that eventually Medicare could be the victim of an insurance spiral in which rising premiums drive out healthier enrollees, boosting premiums even higher and forcing out yet more healthy enrollees. Ultimately only the sickest seniors would be left in Medicare -- and they would face the highest premiums. Backers of premium-support plans argue that risk adjustment, in which the government would raise or lower its contribution based on the enrollee's health, can discourage cherry-picking. But for now, at least, risk adjustment is a crude science at best.

In the end, there is no definitive evidence that competition would lower Medicare's long-term spending. Thomas Saving points to a 15-year study by the Rand Corp.; it found that when higher deductibles and co-payments made people feel the effects of health-care costs, they tended to use fewer services and seek better value in their medical choices. Joseph Newhouse, who was the principal director of the study and is now a professor at the Harvard School of Public Health, agrees that some groups in the study lowered spending by as much as 30 percent without adversely affecting their health. But he also offers a significant caveat: The experiment was limited to people under the age of 65. It's not clear to what extent the study's results can be extrapolated to Medicare's older and sicker population.

Evidence that managed care can deliver medical care at a lower cost than traditional Medicare is also mixed. According to Congressional Budget Office director Douglas Holtz-Eakin, HMOs that operate as part of Medicare's Medicare+Choice program provide medical care at an average of about 5 percent below the traditional program's costs. (Medicare+Choice, which at its peak covered some 16 percent of Medicare enrollees, now covers just 11 percent.)

Similarly, CMS administrator Thomas Scully told the Senate Finance Committee that the most efficient preferred-provider organizations (PPOs) have the potential to deliver the same benefits as Medicare for an average of 2.3 percent less.

But there are important qualifications in both cases. HMO savings vary widely by region; in some areas HMOs actually cost more than traditional Medicare. As for the PPOs, Scully's comments were based on a demonstration project that has been operating for less than a year. And there too the savings potential depends on several factors, including how aggressively PPOs bid for Medicare enrollees and whether enough people enroll to provide economies of scale. So far, seniors seem to favor the current program. Asked in a recent survey by the Kaiser Family Health Foundation and the Harvard School of Public Health whether they would rather get health insurance in retirement through Medicare or a private plan, 63 percent of those 65 or over chose Medicare and only 19 percent a private plan. (The other 18 percent didn't answer.) Those under 65 chose private plans by a 56 percent to 31 percent margin.

Even if competition were to produce savings, they wouldn't necessarily translate to lower costs for Medicare. In the early '90s, researchers studying Medicare HMOs estimated that they delivered care for about 10.5 percent less than did traditional Medicare. But Medicare pays HMOs on a per-person basis -- rather than the per-procedure or per-diagnosis bases it uses for doctors and hospitals -- and those payments did not reflect the fact that healthy seniors were much more likely to enroll in HMOs. The result: Medicare ended up paying almost 6 percent more on the HMO members than it would have if they'd stayed in traditional Medicare.

Ultimately, what we should do about Medicare -- tinker with the current system or transform it -- is a philosophical and political question. Both choices present opportunities; both present risks. If competition can deliver lower costs but seniors can't get the services they need, social and political costs could outweigh financial savings. And if the savings come from cutting benefits, Medicare might spend less, but seniors would likely pay more. As for traditional Medicare, it may offer beneficiaries more security with its set benefits and more stable costs, but that security depends both on the willingness of Congress to raise taxes and the power of Medicare to use its leverage in setting reimbursement rates.

Whichever way we go, we'll have to grapple with the underlying forces that are driving health spending ever higher. "The growth rate in health care is affected by the number of beneficiaries -- which is a demographic fact -- and by medical capabilities, which have been expanding due to increased knowledge," says Harvard's Newhouse. "These factors show no signs of slowing down that I can detect." So in all likelihood, Medicare will continue to absorb a larger slice of our resources. Still, that prospect isn't as bleak as it may seem, since the rising productivity of U.S. workers means that the larger slice will come from a larger pie.

The decisions we make about Medicare will determine what kind of health-care system seniors have, how its costs are shared between beneficiaries and taxpayers, and what value we get for the money we spend. But one fact is inescapable: Health care isn't cheap, and if we want high-quality care, we must pay for it.