Source: Wikimedia Commons courtesy Evan-Amos.

Medicare is an essential part of how most Americans age 65 or older handle their healthcare costs. But the program is far from perfect. In particular, what has become known as the Medicare donut hole forces participants to face an expensive gap in coverage in their Part D prescription drug plans, and even though the government is taking steps to make this gap less severe, it nevertheless plays a key role in the financial decisions that Medicare participants have to make every year. Below, we'll take a closer look at the Medicare donut hole and how it actually works.

What is the Medicare donut hole?
The donut hole is a gap in benefits built into Medicare's Part D prescription drug coverage. Under Medicare Part D, the costs of prescription drugs covered by a plan get split up in various ways, depending on your total prescription costs for a given year.

First, Medicare participants are responsible for the cost of all drugs up to any applicable annual deductible amount. For 2015, the maximum a plan can charge as a deductible is $320, but some plans offer immediate benefits with no deductible at all.

After you cover any deductible due, you split further drug costs with your plan according to its provisions. For instance, some plans cover a percentage of costs while leaving you to pick up the remainder. Other plans charge fixed dollar amounts as copayments and cover the remainder themselves. Regardless of the structure of the payment, coverage continues until the combined total that you and your Part D plan pay for prescription drugs reaches $2,960.

Beyond that amount, however, there is a coverage gap. Catastrophic coverage for Medicare Part D plans kicks in once you've paid $4,700 in out-of-pocket costs on prescription drugs. However, depending on how much of your drug costs your plan covered out of the initial $2,960, the delay in trigger catastrophic coverage creates a donut hole that can lead to thousands of dollars in uncovered costs.

Filling in the donut hole
For years, the Medicare donut hole simply forced participants to pay these additional drug costs entirely on their own, causing huge financial stress for many cash-strapped retirees. The passage of the Affordable Care Act, however, started to fill in the donut hole.

Specifically, Obamacare required that drugmakers give participants the right to buy drugs at a discount. For brand-name prescription drugs, the discount for 2015 is 50%, with the government contributing another 5% reduction in cost. On a $100 prescription, that gives participants a $50 discount from the drugmaker and a further $5 paid by the government, leaving just $45 for the participant to pay. With brand-name drugs, Obamacare called for participants to get credit for donut-hole purposes for the undiscounted amount, even though the participant didn't actually pay that amount. Therefore, in the example above, the participant is treated as if the cost had been $95 -- the $45 actual cost plus the $50 drugmaker discount.

Discounts for generics are less, as the government hasn't asked generic drugmakers to take a haircut on what they receive. For 2015, participants will pay 65% of the cost of generic drugs. Unlike with brand-name drugs, you'll only get credit for what you actually pay for purposes of determining out-of-pocket costs and therefore whether you're still in the donut hole.

Why the donut hole still matters
Over time, these discounts will gradually rise so that by 2020, participants will pay only 25% of the net cost of brand-name and generic prescription drugs. Because coinsurance offered by plans often requires a 25% contribution from the participant, the government sees an eventual 75%/25% split as having closed the donut hole, ensuring a smooth transition between initial coverage and catastrophic coverage.

In the meantime, though, Medicare participants will have to deal with at least some of the effects of the donut hole for several years. If you need enough prescription drugs for the donut hole to be an issue for you, therefore, you'll still need to account for the financial impact in order to ensure that you can afford them.