Two cheers for Democrats' proposed drug payment reforms

Over recent years, presidential candidates from both parties have proposed caps on Medicare payments for newly-developed prescription drugs. Yet, such caps would have eliminated the incentives to invest in many new drugs, without tackling the fundamental cause of rising drug costs felt primarily by seniors.  

The recent proposal by congressional Democrats takes a better approach. It would reform Medicare’s Part D benefit by capping seniors’ exposure to catastrophic out-of-pocket costs, strengthen the incentive for drug plans to negotiate lower prices from manufacturers, and only cap prices for older drugs where competition is inadequate. The proposed reform is for the most part well-designed, but its price caps on older drugs need stronger safeguards to ensure they do not erode patent protections that are necessary to reward the development of new drugs.

Rising prices for prescription drugs have captured many headlines over recent years. One study of pharmacy sales found that list prices for drugs increased by 129 percent from 2010 to 2016.   Yet, list prices are misleading, because most drugs are subject to large rebates and discounts that may offset the majority of the sticker price. In fact, from 2015 to 2018, the reduction in drug spending resulting from price declines because of the expiration of patents for branded drugs was more than twice as great as the increase in expenditures from price increases.

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Nonetheless, Americans are not wrong to feel pinched by the rising cost of prescription drugs.  This is largely because of rising out-of-pocket costs, particularly for those covered by Medicare. Whereas individuals bear only 3 percent of hospital expenditures out-of-pocket, they must pay 18 percent of drug costs directly. In 2015, out-of-pocket prescription drug costs incurred by Medicare beneficiaries were more than three times as great as those covered by private insurance. This was partly because of age (individuals use more drugs as they get older), but also because of design flaws in Medicare’s Part D prescription drug benefit. 

Medicare did not pay for prescription drugs at all until 2006, when Part D came into effect. The federal government pays Part D plans to procure prescription drugs from manufacturers. Plans can drive down prices by steering patients toward drugs for which they have negotiated a better deal — most effectively, in the case of generic drugs where those are available. This produces a nuanced set of price signals, which reward investment in developing valuable new drugs while encouraging intense price competition for drugs whose market exclusivity protections have expired.   

But the incentives for Part D plans to negotiate aggressively for lower drug prices have become distorted. If beneficiaries’ gross (i.e., excluding rebates and discount) annual drug consumption exceeds a catastrophic threshold ($10,048 in 2021), the federal government picks up 80 percent of the cost directly — leaving drug plans off the hook. That has given drug plans and manufacturers a big incentive to inflate list prices and rebates to trigger these catastrophic reinsurance subsidies. The 2010 Patient Protection and Affordable Care Act drove list prices even higher by requiring manufacturers to provide rebates worth 70 percent of the sticker cost. Medicare beneficiaries, who are required by federal law to pay a percentage of list prices as co-insurance — 100 percent up to $445 in gross annual drug consumption, then 25 percent up to $10,048 and 5 percent above that — have seen their out-of-pocket drug costs rise steadily as a result. 

Congressional Democrats have assembled a proposal that largely would fix this primary problem. It would cap beneficiaries’ out-of-pocket drug costs at $2,000 per year, protecting the most seriously ill seniors from catastrophic prescription drug expenses. It also would reduce the mandatory 70 percent rebate on list prices prior to the catastrophic threshold to 10 percent, and require a 20 percent rebate after that threshold — which would eliminate the artificial incentive for drug makers and plans to inflate list prices with rebates. The proposal also would greatly strengthen the incentive for drug plans to drive down total costs, by increasing their responsibility for catastrophic drug expenditures from 15 percent to 60 percent.

Though these reforms to protect seniors from out-of-pocket costs and to strengthen the incentive for drug plans to negotiate aggressively are significant, other proposals to directly regulate drug prices have done more to capture media attention. 

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High prices are typically concentrated among specialty drugs, which account for 2 percent of prescriptions but 49.5 percent of U.S. drug spending. These are often biologics, which are less easily subject to competition following patent expiry. As manufacturers occasionally have sought to cultivate a thicket of associated patents to inhibit competition after loss of market exclusivity, a reasonable case can be made for establishing regulations as a backstop to limit prices in the limited circumstance where patents expire and competition is infeasible. 

The Democratic proposal clearly attempts to do this — empowering the Secretary of Health and Human Services (HHS) to extend price caps every year to 20 additional “single source drugs outside their initial exclusivity periods.” 

Yet, the periods designated — nine years after market entry for small molecule drugs and 12 years for biologics — do not align with the complex variety of existing intellectual property protections, such as those to provide incentives for the development of drugs for “orphan diseases” that failed to attract adequate investment. They therefore would inadvertently erode patent protections, rather than simply checking prices under circumstances where policymakers desire full competition.

While the proposal requires the HHS secretary to cap prices for regulated drugs, it sets no floor on this price. Given short-term fiscal pressures, the absence of such a floor could eliminate the incentive for drug makers to invest in demonstrating the safety and efficacy of additional indications for drugs. Furthermore, it may even serve to increase drug prices in the long run, by making it difficult for manufacturers to profit from developing early generic competitors.  

The proposal to effectively prohibit drug prices from increasing faster than the general rate of inflation likely would have little effect other than to encourage drug makers to introduce products at initially higher prices, and is likely neither to generate substantial fiscal savings nor to deter valuable new drugs from being appropriately priced. 

Nonetheless, the pricing reforms proposed are less significant than the media make them out to be, and with modest tweaks their flaws easily could be fixed. Reforming Medicare Part D’s benefit structure is more important for protecting seniors from high drug costs, and the proposed changes do a good job of that.

Chris Pope is a senior fellow at the Manhattan Institute. Follow him on Twitter @CPopeHC.