What Is The Right Price To Pay For Drugs? Part III

In the previous two columns, we saw how a free health care market would arrive at prices for brand drugs. In this column I will briefly discuss what the federal government is now doing, why political decision-making faces perverse incentives, why private insurers also face perverse incentives and how we can move in the direction of free market reforms.

Medicare negotiated prices: offers that can’t be refused

Some time ago, the Congressional Budget Office (CBO) investigated whether the federal government could save significant money by negotiating with drug manufacturers over the price of drugs covered by Medicare. The CBO concluded that the government would be unlikely to do much better than private negotiators as long as Medicare covers every drug. In other words, without the ability to walk away from the bargaining table and refuse to buy the drug at all, there is only so much that negotiation can accomplish.

With the passage of the Inflation Reduction Act (IRA), the word “negotiation” becomes little more than a euphemism for price controls. The “negotiated” prices under the IRA are not the result of typical free-market negotiations. The federal government—through the Department of Health and Human Services (HHS)—sets a “maximum fair price” for selected drugs. Any company that refuses to comply with the negotiation process will be hit with an excise tax that starts at 65% of a product’s sales in the U.S. and increases by 10% every quarter, to a maximum of 95%.

As an alternative to paying the tax, manufacturers can choose to withdraw all of their drugs from coverage under Medicare and Medicaid. (This would be like giving up from 40% to 45% of all the manufacturer’s sales.) Also, drug manufacturers are required to pay rebates to Medicare if they increase prices for certain drugs faster than the rate of inflation.

Bad as all this is from the industry’s point of view, the picture could be worse. Under Canada’s compulsory licensing law, the Canadian government asserts the right to produce patented drugs without the permission of the patent holder—and selling the same drug at a lower price. Although this isn’t done very often, the threat must surely be in the back of the minds of industry representatives when price negotiations take place.

The politics of medicine: perverse incentives

In all government-run health care systems all over the world, politicians face perverse incentives to favor the healthy over the sick.The reason: In any given year, in any health insurance pool, about 5 percent of the enrollees will account for about half of the spending. Yet in a democracy it is hard to expect public officials to spend half the health care budget on 5 percent of the voters. In our analysis of foreign health care systems, my colleagues and I found that in country after country a persistent pattern emerged: over-provision to the healthy and under-provision to the sick.

You can see the same pattern in our Medicare system. From its beginning in 1965, Medicare paid for small expenses that relatively healthy people could easily pay from their own resources, while leaving those with serious medical problems exposed for thousands of dollars of out-of-pocket expenses.

This pattern was also repeated in Medicare Part D (drug coverage), which started in 2003. Seniorshad first-dollar coverage for inexpensive drugs, while being exposed to catastrophic expenses if they incurred serious medical problems.

In 2022 the IRA law did provide extra protection for the sickest enrollees. But in deciding which drugs to include in the initial price “negotiations,” the government chose those drugs that were costing Medicare the most money, not the drugs that placed the greatest financial burden on the enrollees.

Private insurance: perverse incentives

Because of unwise regulations, private insurers also face perverse incentives. With one exception described below, no insurer in our health care system wants to enroll a sick person. No employer. No commercial insurer in the marketplace. No Medicaid managed-care plan. And no safety net institution.

Every time someone with an expensive medical problem enters one of these plans, the organization loses money. If the patient leaves the plan (for whatever reason), the plan makes money. If the plan develops a reputation for being really good at handling serious medical problems, it will attract more sick people and incur more losses.

Given the horrible economic incentives that government regulation has created, the surprise is not that some patients experience mistreatment. The surprise is how few there are.

One notable exception to these observations is the Medicare Advantage program.

More than half of Medicare enrollees are now in private health insurance plans. Like everyone else in the country, they pay community-rated premiums that are independent of their health status. But unlike everyone else, their premiums are topped up by Medicare based on individual risk assessments.

As a result, the total premium that the plans receive makes the healthy and the sick equally attractive from a financial point of view.

Free market reforms

As noted in Part II, in a free market for health insurance, companies would use objective data to determine whether a drug was cost-effective. They would publish the standard they use to make these determinations (how much to spend per year of life saved, e.g.). People who are more risk- averse than average could purchase “top up” insurance that pays for drugs not covered by their health plan. Also, different plans could have different cost-benefit standards, provided that these are fully disclosed.

We could do this right now with the Medicare Advantage (MA) program. As suggested in Part II, we could also consider setting aside the antitrust law and allowing the MA insurers to bargain collectively with drug companies as a group. That would allow monopsony on the buyer side to bargain with monopoly on the seller side.

What about traditional Medicare? In addition to the perverse political incentives discussed above, there is another problem: Medicare’s drug coverage and its medical coverage are the responsibility of different insurers with conflicting interests. If a chronic patient doesn’t take his medications, the company insuring the drug gains financially, because it avoids the medication costs. But if the patient shows up in an emergency room because he hasn’t taken the medications, that cost is covered by the insurer of medical care.

This problem doesn’t arise in the Medicare Advantage program because a single insurer is covering all costs. That is why some MA plans make maintenance drugs available to chronic enrollees free of charge. The plans believe that the cost of the drugs is lower than the cost of ER visits and hospital admissions that might occur with noncompliant patients.

One answer to the dysfunctional arrangement in traditional Medicare is to encourage MA enrollment by (1) deregulating and making these plans more attractive, and (2) making MA enrollment the default choice for new Medicare enrollees. Since the MA program has lower costs and higher quality than traditional Medicare, these would be good things to do in any event. A final step is to let traditional Medicare pay the drug prices that are negotiated by the MA plans instead of government negotiation and government-imposed price controls.

Then, we could reform the individual market (where people not on Medicare buy their own insurance) along the lines of Medicare Advantage— a reform Prof. Lawrence Kotlikoff and I suggested several years ago. Something similar could be done with Medicaid managed care.

That leaves the employer market. Space does not permit a lengthy discussion of how to reform it, but Stanford economist John Cochrane has shown how the market for private insurance could function in a way so that insurers do not have perverse incentives to attract the healthy and avoid the sick. In fact, without unwise government interference, that type of insurance would have evolved naturally through free market competition.