Audits of the Health Care Financing Administration's (HCFA) financial statements estimated that the Medicare fee-for-service (FFS) program improperly paid providers $23.2 billion in Fiscal Year (FY) 1996 and $20.3 billion in FY 1997. Therefore, the capitation rate setting methodology for managed care organizations (MCO) is flawed because the methodology is based in part on Medicare's FFS system with capitation rates for MCOs set at 95 percent of the average cost of treating the beneficiary in Medicare's FFS program. As such, 95 percent of improper FFS payments are included when MCO capitation rates are calculated. Unless these improper payments are removed from MCO rate calculations, they will continue to result in the equivalent of an overpayment in the Medicare managed care program at taxpayers' expense. We recommended that HCFA pursue legislation that will allow modifications to MCO capitation rates which would include an adjustment for the estimated amounts of unrecovered improper payments that are included in MCO rate calculations.