As medical costs continue to soar, Palo Alto officials are exploring ways to revamp the health care plans the city offers to its employees and retirees -- an effort that is already creating anxiety and threats of lawsuits from labor unions.

The Palo Alto City Council discussed the deeply contentious topic of rising health care costs at length on Monday night. And while members didn't adopt any changes, they directed staff to explore the city's options for health plans, including a "flexible benefit plan" (also known as a "cafeteria plan") in which an employee can choose from a menu of benefit options.

The Monday conversation was the latest installment in a series of meetings the council set up last year to tackle the complex and contentious problems of rising pension and health care costs. According to a new city report, the city's health care expenses in fiscal year 2013 totaled $27.3 million, up from $11.5 million in 2003. The report from City Manager James Keene states that health care costs "will continue to rise at an estimated rate of 6 to 7 percent in 2013, for active employees, retirees, and their dependents, consuming a greater portion of the general fund budget."

"Containing health care costs will be important for the financial health of the City and all employees," the report states. "Providing employees with competitive benefit choices while stabilizing costs have been the City's guiding principles."

Human Resources Director Kathryn Shen told the council that health care is slated to increase faster than inflation by 2 to 5 percent, a trend that she called "sobering."

"And as it grows, it impacts both the city and the retirees," Shen said. "From a retiree's perspective, you're on a smaller income and your health care costs are going up more than inflation."

This also creates a problem for the city, Shen said, because it impacts the city's ability to provide health care.

The city's proposal to revamp health care for employees and retirees hit a speed bump last year, when the Palo Alto Police Officers Association signed a new contract that offered various concessions on pensions and health care. But the union also vehemently rejected changing health care benefits for future retirees. The city and the police union have remained at an impasse on this single issue and are now engaged in a "fact-finding" process regarding this topic.

Recent overtures by city management on this issue during informal discussions have not gone smoothly. Mayor Greg Scharff said three different labor groups had offered to give 10-minute presentations to the council to express their views on the subject. All three canceled Monday morning, he said. At the same time, two labor representatives submitted letters that were sharply critical of the city's effort to institute health care reform.

Peter Hoffmann, an attorney whose firm Rains, Lucia, Stern, PC, serves as legal counsel to the police union, challenged Keene's assertion in a staff report that "a few active employees" have expressed concerns about the city renegotiating its health care plans to lessen the employer share. In a scathing letter to the council, Hoffmann suggested that attempts to change terms for retirees would lead to litigation.

"Indeed, the number would be much closer to 'all of them' -- particularly among the City's longest-tenured employees who stand to see their promised retirement benefits eliminated, just as they approach the end of their careers," Hoffmann wrote.

He also argued that Keene's recommendations "seek to do nothing more than foster a litigious relationship between the City and its employees. While the City Council may welcome a spate of legal challenges, it should at least make an informed decision on such matters."

Evelyn Gutierrez, an organizer for Service Employees International Union, Chapter 521, also challenged the city's proposal, claiming in a letter that the a "cafeteria" plan would "selectively cut retirement medical benefit for long-term employees while leaving it intact for newer employees."

Gutierrez, whose union represents about half of the city's workforce, wrote that "real engagement and dialogue" should be a goal shared by all parties before the council takes any action on the "long-standing vested interests" of the employees.

"In Palo Alto, fully vested long-term employees have no idea what they are vested in anymore as the City has linked future retiree medical to what active employees get for medical from time to time, which could be nothing under a Cafeteria Plan," Gutierrez wrote.

Union opposition has prompted City Attorney Molly Stump to recommend that the city set aside its conversation about "vested contractual rights to health benefits" until after the council discusses the subject in a closed session. Stump said the city has received "a number of communications" from labor leaders, who indicated that "should the city move in the direction that they do not agree with, they would consider litigation against the city."

The council has already made some progress on health care. Since 2009, it has renegotiated its labor agreements so that the city would no longer pay the entire share of employee medical costs. Under the terms that the city imposed on the SEIU in 2009 and that the union ratified in a 2010 labor agreement, employees and future retirees are now required to pay 10 percent of their premium costs. The city later reached similar agreements with its non-unionized group of managers and with its public-safety workers (with the notable exception of its ongoing dispute with the police union over retiree health care).

The switch to the cafeteria option would carry some political and financial risks. Since 1993, the city's health care plan has been administered by the California Public Employees' Retirement System (CalPERS), which also oversees Palo Alto's pension plan. Just like with pensions, the city's options for curbing costs are sharply limited. The council has the option of choosing one of six plans offered by the CalPERS Health Benefits Program (down from 12 plans in 1993), which is governed by the Public Employees Medical and Hospital Care Act. To pursue the "flexible plan" option, Palo Alto would have to reach an agreement with its workers on the changes through collective bargaining.

Furthermore, if the city were to leave CalPERS only to find even higher rates on the open market, it would not be able to rejoin the system for five years.

Councilman Greg Schmid was one of several council members who argued that it's in the best interests of both the city and its employees to come up with a more sustainable and predictable health care system.

"I think both the city and the staff are interested in a healthy functioning city budget," Schmid said. "I think the city's future and the retirees' future depends upon healthy finances and I think that's where we share a common goal."

But if the early reaction from the unions are any indication, cooperation on this topic is by no means a given. Keene and Shen stressed Monday that the city has not yet made any decisions and that much more outreach to city workers has to happen. But they both noted that the issue is a tough one to discuss in an open forum, given that health care is both an emotional topic and one subject to the formal bargaining process. Shen said it's a difficult "balancing act" for the city to engage with employees on this topic without directly negotiating.

"We can do surveys," Shen said. "We can do focus groups. We can have an open forum or a council meeting at a less formal place where employees and representatives can feel comfortable coming and talking. But there is no quick or easy solution that I see."

Keene also disputed allegations from the unions that the city is rushing into health care reform without considering the views of city workers.

"While we have certainly talked very clearly with everybody that we think a flexible-benefits plan is one of the things we ought to look at -- that's as far as we've gone. Along with: Are there other options?" Keene said.