Last month, the Department of Health and Human Services touted the supposed effects of inflation penalties on 64 prescription drugs included in Medicare. Secretary Xavier Becerra claimed that the fees, enacted in 2022 and imposed on certain drugmakers when their prices rise faster than inflation, are “putting money back in the pockets of seniors and people with disabilities.”
The reality is less encouraging. According to a Centers for Medicare and Medicaid Services fact sheet, the resulting decline in patients’ cost-sharing was less than 2 percentage points for the overwhelming majority of drugs. The agency also conveniently failed to mention that the inflation penalty distorts launch prices and generic competition.
Medicare should, of course, seek to maximize value and lower drug costs. As I discovered during my time as a health-care advisor in the Trump White House, a design flaw in Medicare allows manufacturers of certain therapies to keep prices, and the resulting government payments, high. But neither of the two major proposals on offer to address runaway prices—President Biden’s 2022 Inflation Reduction Act (IRA) price controls, and former President Trump’s most favored nation (MFN) policy, which would tie Medicare’s drug prices to those charged in other developed countries—will solve this underlying problem.
To understand how that bug keeps Medicare prices elevated, consider the data. The fastest-growing part of Medicare is Part B prescription drug spending, concentrated in a very small segment of therapeutics. Per-beneficiary spending on physician-administered drugs in Part B grew 9.2 percent between 2008 and 2021, which more than tripled per-beneficiary spending growth on retail pharmaceuticals (those obtained at the pharmacy counter) under Part D (2.6 percent). Health and Human Services reported that, in 2018, the ten highest-cost drugs by total spending accounted for 46 percent of Part B, and only 18 percent of Part D, outlays.
Medicare sets prices for Part B therapies by taking the average of discounts obtained by private insurers in commercial (non-Medicare) markets. For most Part B drugs, this works fine. If a manufacturer depends on robust sales outside of Medicare and/or faces brand or generic competition, the program benefits from these private insurer discounts.
The arrangement is more problematic, however, if a drug manufacturer has a novel therapy that faces no competition and for which it expects to derive most of its revenue from Medicare patients. This is true of many drugs of the oncology, rheumatology, and ophthalmology therapies primarily used by seniors and covered by Part B. Such drugmakers have little reason to offer discounts in the commercial market, since any price concession would undermine their largest revenue source—Medicare. In these cases, the manufacturer effectively dictates the price that Medicare pays for the therapy, leaving little recourse for government or patients.
Neither the IRA nor MFN approach solve this problem. The IRA excludes these novel drugs from its main price-setting provisions until 2028 and for the first 13 years that they are on the market. (See page 23 here.) The MFN policy would use a foreign reference to set Medicare prices, which assumes the therapies in question are available in other nations. Often, however, the United States is the first to access novel therapeutics. If MFN were adopted, this would happen even more often, as drug manufacturers would be more reluctant to come to market in foreign nations or offer large discounts for fear of the impact on Medicare revenues.
What is the solution? Instead of hoping manufacturers will grant price concessions even when it’s against their best interest, policymakers should empower the private insurers that cover more than 50 percent of Medicare beneficiaries (as part of Medicare Advantage) to get discounts from manufacturers in exchange for coverage of their drug. Those insurers that get the best deals should be able to keep part of the savings, while those that negotiate bad deals suffer a moderate loss. Once a certain threshold of plans (e.g., enough plans to cover 50 percent of Medicare Advantage enrollees) reached a deal with the manufacturer, the therapy would be covered by all of Medicare—including “traditional” fee-for-service. Reimbursement would be set at the discounted price negotiated by Medicare Advantage plans, and in traditional fee-for-service, physicians would receive that payment plus a set percentage, as under current rules.
Why not just apply the IRA price controls to these drugs? Because well-designed market-based pricing mechanisms are inherently superior to government price controls, such as those established by IRA. This is primarily because the market mechanisms integrate the value judgments of numerous buyers and sellers, and therefore are less likely to distort the market. State-imposed controls, by contrast, rely on the limited knowledge of a small group of politicians or bureaucrats, and are prone to create shortages and to suppress innovation.
The IRA gives government officials near-total discretion in setting reimbursement levels. Where prices are set has huge implications for care delivery, including which drugs get favored and where investment will flow—and thus the direction of future innovation. The process by which these decisions are made is opaque. Anyone who disagrees with CMS’s announced price is left with little recourse but to petition Congress. Further, Medicare has imposed price controls for over 40 years on hospitals and physicians, and these services still constitute roughly the same outsize share of overall spending.
My proposal, by contrast, has several built-in feedback loops to prevent market distortions. The participants would be, first and foremost, Medicare Advantage enrollees who choose from among various plans based on the drugs covered, the network of providers, the associated cost-sharing, and the premium rate. Providers decide which plans they contract with at what rate and have leverage via the recommendations that they give patients about which plan to choose. Drug companies weigh the level of discount to offer a plan based on its utilization management and associated patient cost-sharing. Insurers must balance costs and accommodate the desires of potential enrollees, providers, and drug manufacturers as they negotiate contracts, or risk losing enrollees to other plans.
Medicare’s goal should neither be to guarantee access to new therapies, whatever the cost, nor to reimburse manufacturers only for the bare bones cost of production. Instead, policymakers should seek to give beneficiaries access to therapies at a cost commensurate with the added benefit, expand access to effective medications, and encourage innovation that advances Americans’ standard of living.
My proposal does just that. Instead of relying on the biases of a handful of government officials, it incorporates the voluntary decisions of millions of buyers and sellers. Leveraging market forces in this way can help lower the runaway prices that imperil the future of Medicare—and impose crushing costs on its beneficiaries.
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