Medicaid/Medicare Pharmaceuticals

Medicare Part D lowers Pharmaceutical prices?

Jason Shafrin

What is Medicare Part D?

Medicare Part D began in 2006 and provides insurance coverage for pharmaceuticals for the elderly. The program is set up so that the government does not purchase the drugs directly, but subsidizes private prescription drug plans, which then negotiate prices with the pharmaceutical companies. There are two types of Part D plans. The first are prescription drug plans (PDP) which only cover drugs. Medicare Advantage plans (MA-PD) are comprehensive, managed care insurance plans which also include insurance coverage for pharmaceuticals.

Typical Part D coverage includes a $250 deductible, with 75% coverage for the first $2000 (after the deductible). Part D defers 0% of the cost of drugs between $2000 and $3599–the “donut hole”–and then once annual spending reaches $3600, Part D pays only 95% of the costs.

The government subsidies these PDP and MA-PD plans based on a bidding process. A national average bid is calculated and multiplied by some constant percentage (it was 34% in 2007) to determine what premium the enrollees will pay. The 66% subsidy is distributed to the plans as a lump sum, so that if plans offer higher or lower premiums, the enrollee incurs the full cost (benefit) for higher (lower) premiums.

To reduce the possibility of crowd-out, CMS subsidies firms that provide prescription drug coverage to their retirees.

What does economic theory predict about Medicare Part D’s influence on prices?

Many economists would at first glance believe that this would lead to an increase in prices. Consumers should be have less elastic demand since they will only be paying for a fraction of the drug cost if they have Part D insurance. An NBER working paper by Duggan and Morton (2008) believe that this will not be the case. First, PDPs and MA-PD have large customer bases and can negotiate bulk discounts. Individuals do not have the buying power to negotiate these discounts. Further, drug companies often use formularies which advise patients as to alternative drugs (e.g., generics) which are cheaper. Physicians advice patients as to the most medically effective drug, but not the most cost effective treatment. Thus, insurance company formularies can make patient cross price demand elasticities for drugs more elastic since they are more aware of comparable drug substitutes.

Further, the production of pharmaceuticals is one with extremely high fixed costs (e.g., R&D, advertising) and very low, relatively flat marginal costs. Thus, prescription drug insurance will likely increase pharmaceutical utilization, which will decrease average costs.

Medicare Part D’s impact on Price

Duggan and Morton find the Medicare Part D decreased average overall price by 12%. Patients of course pay even less than this 12% figure, because insurance pays for a portion of the drug costs. Thus, for patients moving from cash payment to Medicare Part D, net drugs prices for them decreased 24%.

This decrease, however, could have reflected an overall decrease in drug costs and may be unrelated to Part D insurance. To test this, Duggan and Morton examine the prices of drugs in “protected” therapeutic classes. The government mandate that insurance companies must cover all drugs for treatment categories such HIV, anti-cancer, immunosuppressant, etc. Because the Part D plans are mandated to cover all drugs in the category, plans cannot 1) use their buying power to negotiate lower prices since producers know that the drug must be covered and 2) use formularies to direct enrollees to less expensive alternatives since all drugs must be covered. Thus, the authors predict that for drugs in these protected classes, their should be no price decrease. This is exactly what the authors find.

“The results…suggest that drug prices offered by Medicare part D plans grew with others in those therapeutic categories where their ability to move market share was most limited. This provides some support for our model…which predicted smaller price declines (or larger price increases) for those treatments without good substitutes.”