(Reuters) — As cash-strapped U.S. cities and states struggle to address gaping budget holes, a long-honored benefit for public-sector workers has come into the cross-hairs of budget cutters: retiree health insurance.

A growing number of states and cities are eliminating or reducing health coverage for retirees, a benefit that has long fallen by the wayside for most private-sector workers.

But the coverage, which has meant that most retired public workers have all their medical bills fully paid, is expensive and hugely underfunded. And because health coverage does not typically have the strong legal protections that hamstring changes to public pension benefits, it is easier for governments to scale back.

The trend could leave millions of public workers with thousands of dollars in unanticipated health care costs.

"In 20 years, very few people will have this benefit," said Dennis M. Daley, a public management professor at North Carolina State University in Raleigh, N.C.

Illinois, which has some of the nation's largest pension liabilities, approved legislation in June that would for the first time require retirees to pay an increasing amount for previously free retiree health insurance. The state expects to save $800 million annually.

More than 77% of the roughly 19 million employees of large U.S. state and local governments were eligible in 2012 for retiree health insurance. That is in sharp contrast with the private sector, where employers pay for retirement health care costs of only about a quarter of workers, according to the most recent Kaiser Family Foundation survey.

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But rising health care costs, plummeting tax revenues and unfunded pension liabilities — which have forced some towns into bankruptcy — have forced states and cities into a rethink.

Many have increased eligibility ages, hiked out-of-pocket expenses and dropped coverage for family members. In some cases, they have eliminated insurance altogether. Others are planning similar scalebacks.

Almost a quarter — 23% — of local governments with at least 250 workers did not offer retiree coverage in 2012, compared with 17% in 2011, according to an October report by Cobalt Community Research, a nonprofit research coalition in Lansing, Mich. Smaller governments provide even less help. Only 39% of governments with 51 to 100 employees offered retiree health insurance in 2012 vs. 55% a year ago.

"I don't think any local government wants to hurt employees or retirees and reduce coverage, but they are balancing that with the challenge of lower revenues," said William SaintAmour, executive director of Cobalt, noting the stark choice between providing core services for citizens and benefits for employees. "It's been very much a pills or potholes discussion."

Fidelity Investments estimates that a healthy couple retiring in 2012 with only insurance coverage from Medicare, the government program for the elderly, would spend about $240,000 on out-of-pocket health care costs before they die on average 17 years later for men and 20 years later for women. The savings for state and local governments could be much higher because many public employees retire in their 50s, long before they're eligible at age 65 for Medicare.

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In addition, retiree health insurance is relatively low-hanging fruit for government budget cutters because there is no legal obligation for coverage, sparing governments from the type of lawsuits filed by labor unions over cuts to pension benefits for workers such as teachers, police officers and janitors.

"There is no guarantee for retiree health, there never has been," said Paul Fronstin, senior research associate at the Employee Benefit Research Institute in Washington. "It is not as simple to cut as it is in the private sector, but it's a target and it's unfunded."

Accounting rules only require governments to report but not set aside funds in advance for future health care obligations. As a result, most states typically use a pay-as-you-go method.

On average, states have set aside only about 5% of what is estimated to be their retiree health care and other nonpension benefits such as life insurance. At the end of 2010, that left a $627 billion gap, not far from the $757 billion hole seen for public pensions, according to a report by the Pew Center on the States.

Seventeen states had saved nothing and only seven states — Alaska, Arizona, North Dakota, Ohio, Oregon, Virginia and Wisconsin — had funded 25% or more of these obligations.

The report said states should have set aside almost $51 billion for these obligations during 2010, but they contributed only $17 billion.

Most states have cut back on their commitments. Almost 60% of state and local governments have changed the health insurance they provide to current and retired workers, according to a survey released in April by the Center for State and Local Government Excellence. Almost 11% had shifted more costs to retirees.

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"It's the smaller changes where you're shifting a lot of the costs," said Mr. Daley of North Carolina State University. "It's the nickel and diming — your co-payment goes up from $20 to $25."

For example, beginning in 2014, the Ohio Public Employees Retirement System will change eligibility requirements for retiree health care coverage, restricting coverage to those at least 60 years old with at least 20 years of service, up from 10 years of service. Retirees will also face higher premiums and out-of-pocket expenses and will lose spousal coverage.

Ohio, with 986,000 members and about 184,900 retirees and beneficiaries, spends about $1.5 billion a year on retiree health care.

Without the changes, the retiree health care fund would be zero by 2020, said Julie Graham-Price, the system's spokeswoman. "People are living longer, which is great for the retirees, but a little tougher on the pension," she said.