In 1990, after a decade of rapid cost growth, Congress made two major changes to the Medicare program in an attempt to control expenditures for physicians' services. It implemented a fee schedule and a payment update system for physicians' services. The goal of this fee schedule was to set relative payment rates that would reflect the time, effort, and expense of providing each listed service. The goal of the payment update system, called the Volume Performance System (VPS), was to limit increases in physician fees by linking them to historical rates of increase in the volume of physicians' services. This system led to high rates of growth in the early 1990s, and was criticized for distorting relative payment levels in its use of different updates for surgery versus primary care payments, for setting unrealistic expenditure targets (because of relying on historical trends and legislated reductions), and for relying on two-year old data to set targets. In 1997, Congress established a new system for determining the annual update for Medicare payment rates for physicians' services. This system, known as the Sustainable Growth Rate (SGR) system, seeks to constrain costs by tying increases in physician payments to real per capita growth in the gross domestic product (GDP). In implementing the SGR, Congress agreed, in principle, that a system that would allow expenditures for physicians' services to grow at the same rate as the economy as a whole was affordable and reasonable. However, the SGR system is now under criticism by health care providers, members of Congress, and the Medicare Payment Advisory Commission (MedPAC), who are calling for its revision. Intensifying the debate is the fact that for the year 2002, the fee paid per unit of physician service decreased by 5.4 percent. This decrease is the result of a number of factors including the slowing economy and errors made in estimating expenditures in prior years. The major problem with the SGR system, its critics maintain, is that, in setting fees, it does not directly consider changes in the actual costs of providing physician services to the Medicare population. Such changes are driven by a confluence of progress in medical technology, changes in provider productivity, and changes in the health of beneficiaries in the traditional Medicare fee for service (FFS) program. Other systems used by Medicare to update payment rates implicitly include allowances for such changes. With Medicare physician payments currently exceeding $40 billion per year, the payment update factor has important implications for the Medicare budget, as well as other possible consequences. Too small an update might limit beneficiary access to care, "unfairly" penalize physicians, or create incentives to funnel treatment to other types of services having no expenditure target. In the longer term, inadequate payment updates might discourage the development and adoption of new technologies for treating Medicare patients. In light of these concerns, Congress mandated a study of sources of changes in FFS Medicare expenditures for physicians' services. The tasks we undertook in response to the Congressional mandate were the following: Describe the processes used to update payment rates for Medicare physicians' services; Analyze national trends in expenditures for physicians' services; and Disaggregate the changes in Medicare expenditures for physicians' services into the components specified in the legislation, to the extent possible.