The Heritage Foundation

Executive Summary #1764 on Health Care

May 25, 2004

May 25, 2004 | Executive Summary on Health Care

Executive Summary: Compromising Quality: The High Cost of Government Drug Purchasing

Revised estimates of the new Medicare prescription drug benefit's projected cost have re-ignited congressional debate about the merits and design of the recently enacted Medicare legislation. One argument in particular has received renewed attention: the contention that the new drug benefit will be unnecessarily costly because the legislation does not allow the government to use the "enormous market clout" of the 41 million Medicare beneficiaries to drive down the price of drugs.

The truth is that the legislation's authors knew of Medicare's history of distorting the delivery of medical care by setting prices for hospitals and physicians. To prevent that from happening with drugs, they included "non-interference" provisions in the law to prohibit Medicare from interfering in negotiations between private plans, pharmacists, and drug companies or from imposing a national formulary or single-price schedule.

Success of Private Insurers and PBMs
Striking the right balance between drug price and availability is difficult. Unlike commodities such as wheat or oil, drugs are not easily substitutable for all patients, and there are varying degrees of price competition in the pharmaceutical market.

That is why the authors of the new Medicare law gave the job of striking the right balance to those with the most experience in doing it--private insurers and pharmacy benefit managers (PBMs). The private plans devised by PBMs and private insurers employ proven strategies for reducing the cost of prescription drugs while also promoting better patient outcomes and constraining overall health system costs.

Government Limitations
Critics argue that as a single, large purchaser, Medicare could do a better job of obtaining the best prices for drugs than PBMs and private insurers. Such assumptions are empirically wrong.

  • Less Market Clout. Medicare is not as large as the critics believe. The number of enrollees in each of the three largest PBMs far exceeds the current 41 million Medicare enrollees. Thus, simply on the grounds of relative market share, having Medicare beneficiaries obtain drugs through existing PBMs would seem sound. After all, Medicare enrollees would be able to join large, private buying groups that already successfully provide drug benefits for millions of Americans.
  • Market Inexperience. Unlike the managers of private drug benefit plans, who have decades of experience in managing prescription drugs, Medicare's managers have no previous experience buying outpatient prescription drugs and are notorious for inefficient bureaucracy. Thus, in order to obtain the necessary expertise, Medicare would likely have to rely on private PBMs anyway.

Harmful Government Strategies
As a sole purchaser of drugs for seniors, the government could employ four additional strategies that are not available to private insurers or PBMs in order to extract further discounts from drug makers. The unintended consequences of those strategies, however, could be to:

  • Impose increased substitution. Unlike private insurers and PBMs, who must maintain a careful balance between encouraging drug substitution and satisfying consumers, the government can impose a single, restrictive drug formulary that puts price considerations ahead of patient benefit or clinical appropriateness. This would leave patients with no alternatives--at least none for which the government will help to pay the costs.
  • Restrict market access. If a manufacturer refuses to charge prices that are acceptable to the government, the government can simply deny seniors access to those drugs. Yet patients denied access to drugs under a government program cannot simply choose a different plan as they could in the private sector.
  • Control intellectual property and limit pricing freedom. Governments establish patent laws to reward manufacturers for developing innovative products. Such laws grant those manufacturers market exclusivity for a period of time. But a government intent upon coercively controlling costs could decide to reduce or eliminate a company's patents, thereby allowing others to copy the innovation and impeding a company's ability to recover its investment costs. Such a move would seriously undermine future innovation, as well as international patent laws, and restrict the flow of new products to consumers.
  • Extract price concessions by non-market means. Government can also use its powers over aspects of a manufacturer's business that are not directly related to its products--such as tax policy, financial market access, and a host of other regulatory regimes--to extract price concessions. For example, pending legislation would penalize any drug company that limited sales of its products to wholesalers who re-import them to the U.S. from countries with drug price controls. It does so by prohibiting the manufacturer from deducting advertising and marketing expenses, which are normal deductible business expenses under corporate tax law. Yet such moves would undermine market confidence in the fairness and predictability of corporate tax laws among other companies and industries. It could also spark trade conflicts between the U.S. and other countries if drug makers responded by refusing to sell their products in those countries.

Conclusion
While there is much to criticize about the design of the new Medicare prescription drug benefit, the basic structure of coverage provided by competing private plans, free of government interference, is actually a commendable feature of the legislation. Any attempt by the government to circumvent those market mechanisms out of a desire to pay even lower prices would have an unfavorable impact on pharmaceutical investments, research, and development while also diminishing the quality of health care received by America's seniors.

Edmund F. Haislmaier is Visiting Research Fellow in the Center for Health Policy Studies at The Heritage Foundation.

About the Author

Edmund F. Haislmaier Senior Research Fellow, Health Policy Studies
Center for Health Policy Studies