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January 2007

Letting Medicare "Negotiate" Drug Prices: Myths vs. Reality

by David Hogberg, Ph.D.


The opening of the 110th Congress will witness the return of the debate over Medicare and prescription drugs. 

In 2003, Congress and President Bush enacted the "Medicare Prescription Drug, Improvement and Modernization Act," which established a prescription drug program for Medicare.  That legislation expressly prohibited Medicare from negotiating drug prices with pharmaceutical companies.  Rather, any negotiation that takes place is to be between pharmaceutical companies and the insurance companies that administer the Medicare prescription drug program.

Congressional Democrats have made it clear that they want to eliminate that prohibition.  As the official website of the Democrats in the House of Representatives put it, "Medicare must have the authority to negotiate with drug companies for lower drug prices."1  Now that the Democrats control Congress, they are expected to eliminate the prohibition.  Speaker-elect Nancy Pelosi has promised that the Democrats in the House will move various pieces of legislation in the first 100 hours of the 110th Congress, one of which will be aimed at "fixing the Medicare prescription drug program [and] putting seniors first by negotiating lower drug prices."2

Unfortunately, a host of myths - if not outright falsehoods - comprise the intellectual ammunition for the push to let Medicare negotiate drug prices.  The political left is misleading the American public by portraying these as established facts. 

Examining these myths in detail yields the truth: Letting Medicare negotiate drug prices means putting price controls on prescription drugs.  It also would mean higher health insurance costs for the private sector, less pharmaceutical research and development, fewer new drugs and lower quality of life for Americans.

*     *     *

Myth:  Medicare will "negotiate" drug prices.

Reality:  Medicare will put price controls on drugs.

Merriam-Webster defines "negotiate" as "to confer with another so as to arrive at the settlement of some matter."3  Using the word negotiate obscures the truth about the way Medicare works.  Medicare does not confer with medical providers about prices.  Rather, it sets prices.  If providers don't accept these prices, then they will not be reimbursed for treating Medicare patients.

That is exactly how Medicare functions in the area where it pays for drugs directly.  Medicare Part B - which covers outpatient services - pays for prescription drugs that are not usually self-administered, such as a tetanus shot.4  Medicare does not bargain with the sellers of these drugs to arrive at the price it will pay.  Rather, Medicare bases its payment on the average price of the drug in the private sector.  Specifically, as the U.S. Department of Health and Human Services has described the process, "the Medicare reimbursement amount for a covered drug is 95 percent of the drug's average wholesale price (AWP). Of this amount, Medicare pays 80 percent while the beneficiary is responsible for a 20 percent co-payment."5 

The term for this is not "negotiation."  It is "price control."  If that's what the proponents of this Medicare "reform" want, then they should be open and honest about it.

Myth:  Letting Medicare set drugs prices will keep drug prices down.

Reality:  Letting Medicare set drug prices will increase drug prices and, hence, health insurance costs for the private sector.

Typical of the myopic view of the effect of letting Medicare set drug prices is an analysis by Dean Baker of the left-of-center Center for Economic and Policy Research.  Baker claims that Medicare "negotiations should in principle allow for very substantial reductions in price, because the pharmaceutical industry sells prescription drugs for prices that are typically more than 200 percent above their cost of production."6  But as the great French economist Frederic Bastiat pointed out:

In the economic sphere an act, a habit, an institution, a law produces not only one effect, but also a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.7

The reduction in drug prices for Medicare will be the "seen" effect.  The subsequent rise is drug prices in the private sector, however, will be the "unseen" effect.  Drug prices will rise in the private sector because drug companies will want to maximize the price they receive from Medicare.  The price Medicare will pay will be based on the average price in the private sector.  So, the higher prices are in the private sector, the greater the average price will be.  The higher the average price, the greater the reimbursement the pharmaceutical company will receive from Medicare.

This phenomenon has already played itself out in Medicaid, the government health insurance program for the poor.  Medicaid, like Medicare Part B, bases the price it pays for drugs on the average private-sector price.  According to Professors Mark Duggan and Fiona M. Scott Morton, "When Medicaid is a large part of the demand for a drug, this creates an incentive for its maker to increase prices for other health care consumers."  Duggan and Morton's "estimates imply that a 10-percentage point increase in the [Medicaid market-share of a prescription drug] is associated with a 7 to 10 percent increase in the average price of a prescription."8

In 2004, those most likely to be eligible for Medicaid accounted for about 11 percent of all drug purchases over $300.  Those eligible for Medicare accounted for about 30 percent.9  Letting Medicare put price controls on drugs would, therefore, have an even bigger effect of increasing the price of drugs in the private sector than does Medicaid.  With rising drug prices in the private sector, health insurance companies that cover prescription drugs will have little choice but raise the price they charge for premiums.  The increase in the price of health insurance is likely to result in some companies cutting back on, or canceling entirely, employees' health insurance coverage.

Myth:  Europe and Canada impose price controls and other restrictions on drug use, and those systems work.

Reality:  Europe's and Canada's systems delay access to innovative drugs, which results in otherwise preventable deaths.

According to a report prepared by House Democrats:

The United States is unique among industrialized countries because it is the only country that fails to protect its citizens from discriminatory pricing of prescription drugs.  Canada, France, Italy, Germany, Japan, and the United Kingdom all negotiate on behalf of their citizens to obtain lower prices for brand name drugs.  As a result, purchasers in these countries pay significantly less for prescription drugs than uninsured senior citizens in the United States.10

Organization of Economic Development (OECD) member countries, excluding the United States, use a mix of price controls and volume controls (limits on how much of a drug can be sold) to keep downward pressure on the price of prescription drugs.  However, these restrictions come with a high cost.

As one study explained, "Patients in OECD countries typically gain access to innovative medicines - if at all - only after a substantial delay and at a level of availability usually well below that enjoyed by U.S. patients."11  The study measured the lag between the U.S. launch of a new drug and the OECD launch.  The average lags for various drugs ranged from six months for a cancer drug up to 24 months for an anti-depressant.  Because of volume controls, the rate of utilization of innovative drugs is much lower in OECD countries, averaging about 50 percent of U.S. levels three years after the launch of the drug.

Due to price controls and other regulation, a Lewin Group study found that statins, a class of drugs for those with high cholesterol, were slow to be utilized in Europe in the 1990s.12  The study estimated that over a five-year period, this led to 28,000 preventable deaths in Germany, 26,000 in Italy, and 19,000 in the United Kingdom.

The proper conclusion to draw from Europe's experience is that permitting Medicare to control the price of drugs will ultimately be hazardous to Americans' health.

Myth:  Medicare should adopt a "formulary," since formularies have saved money on drugs in Medicaid, the Veteran's Administration and the private sector.

Reality:  While formularies may save money on drugs, the savings are offset by higher spending in other areas of the health care system, such as doctors' visits and hospitalization.

A formulary, also known as a preferred-drug list, is a list of approved drugs that an insurance program will pay for.  If a drug is not on the list, then the insurance program will either refuse to pay for it or the patient will have to go through a special approval process to get the program to pay for it.

Jonathan Cohn of The New Republic recently advocated that Medicare "create a formulary system, with lists of drugs for which it would either pay in full, pay in part, or not pay at all - and base inclusion on price or quality or, ideally, both."  He dismissed any concerns with using formularies:

Drug-makers also caution that, if the government adopts formularies, they would block access to necessary drugs for severely ill patients. But private insurers - including the ones now serving Medicare beneficiaries - use formularies, too. And studies of the [Veterans Administration] formulary by both the Government Accountability Office and the Institute of Medicine found no evidence of access problems.13

Actually, the GAO report did note some problems with VA's formulary.  It stated that two of the facilities it reviewed had yet to include about 140 drugs that were on the VA's formulary.  Furthermore, "the approval process for the use of nonformulary drugs across VA's health care system does not ensure that all facilities have an efficient and timely process."  There was "wide variability in how requests are made, who approves such requests, and how much time it takes."14

Other research shows that the VA's formulary may even have deadly consequences. Economist Frank Lichtenberg examined the VA's practice of using its formulary to discourage the use of newer drugs, and concluded that it may lower the average age at death among VA patients by about two months.15

Studies of other drug formularies have found that costs savings are illusory.  Patients have different reactions to different drugs, and generic drugs (which are usually preferred by formularies because they are cheaper) do not always work as well as brand-name ones.  One study of HMOs found that the more restrictive the formulary, the higher the rate of patient office visits, emergency room visits and hospitalization, while a study of Medicaid formularies concluded, "Savings in the drug budget appear to be completely offset by increased expenditures elsewhere in the system."16  The lesson is clear: impose a formulary on Medicare patients and Medicare will see increased costs for doctors' visits and hospitalization.17

Myth:  Medicare price controls will have no effect on pharmaceutical industry research and development, especially as most drug research is conducted by the National Institute of Health.

Reality:  The National Institute of Health plays an important but limited role in drug research.  Furthermore, price controls in OECD countries have already caused a decline in pharmaceutical industry research and development and, thus, the development of new drugs.

Jonathan Cohn provides a typical disparagement of the importance of pharmaceutical industry research and design (R&D):

...the most important basic medical and scientific research that leads to major medical breakthroughs usually takes place under government auspices - typically, through grants from the National Institutes of Health.  In other words, taxpayers - not drug companies - are the ones financing the most important drug research today.  So, even if the pharmaceutical industry did reduce its research and development investment because of declining revenues, what we'd lose probably wouldn't be the next cure for cancer - it would be the next treatment for seasonal allergies, and likely no better than the ones we have already.18

A systematic study conducted by the National Institute of Health (NIH) suggests that the NIH's role is not as large as Cohn suggests it is.  The NIH funds a lot of "basic research," and the study noted, "technologies developed in basic research laboratories are nascent, requiring extensive further development."19  It is the pharmaceutical companies that fund that further development.  The study also examined pharmaceuticals that had at least $500 million in sales in the U.S.  Of the 47 drugs that met that standard, the NIH determined that it had involvement in only four of them.  The other 43 included drugs for bacterial infections, diabetes, hypertension, high cholesterol and Hepatitis C - hardly mere "treatments for seasonal allergies."

A bevy of research shows that price controls in OECD countries have diminished drug R&D by private companies and, as a result, the number of new drugs available to patients:

* A U.S. Department of Commerce study estimates that OECD price controls reduced annual R&D by $5 billion to $8 billion.  Were R&D to increase by $5 billion to $8 billion, three to four new drugs would be being developed each year.20

* The Boston Consulting Group estimated even larger effects:  "OECD government interventions are effectively discouraging the incremental investment of $17-22 billion in annual global biopharmaceutical R&D."  This loss of R&D results in the loss of "10-13 additional drug launches" annually.  Furthermore, it is not just Europe that suffers:  "The U.S. consumer and economy bear their share of the consequences, in the form of fewer innovative medicines, fewer drugs competing in any given category to drive prices lower, fewer jobs and a slower growth trajectory for one of the preeminent U.S. industries."21

* University of Connecticut economist John A. Vernon found a negative relationship between price controls in OECD countries and drug R&D.  Extending this to the U.S., he finds that similar regulations here would reduce R&D by 36-47 percent.22  With colleagues Rexford E. Santerre and Carmelo Giacotto, Vernon projects the effects of Medicare price controls.  Using an infinite time horizon, they conclude that the present value of lost R&D is $508 billion resulting in 277 million lost "life years" in the general population.23

* Benjamin Zycher of the Manhattan Institute also examined the future effect of permitting Medicare to impose price controls on prescription drugs.  He concluded that R&D would decline by $10 billion annually, resulting in the loss of six to twelve new drugs every year.   This "would yield a lost of 5 million expected life-years annually, an adverse effect that can be valued conservatively at about $500 billion per year, an amount in excess of total annual U.S. spending on pharmaceuticals."24


Letting Medicare set drug prices has only one short-term benefit: Lowering drug prices for seniors on Medicare right now.  It also has many harmful consequences.  These include higher drug prices in the private sector, higher health insurance prices in the private sector, a reduction in research and development of new drugs, fewer new drugs and shorter life-spans.

For the sake of Americans' health, as well as the pocketbooks of many, Congress should keep Medicare out of the drug pricing business.

# # #

David Hogberg, Ph.D. is senior policy analyst at The National Center for Public Policy Research in Washington, D.C.  Comments may be sent to [email protected].



1 HouseDemocrats.Gov, "Medicare Must Have Negotiating Authority," June 27, 2006, available at http://www.housedemocrats.gov/news/librarydetail.cfm?library_content_id=798 as of December 15, 2006.

2 "100 Hours," available at http://democraticleader.house.gov/about/100hours.cfm as of December 15, 2006.

3 Merriam-Webster Online Dictionary, "negotiate," available at http://www.m-w.com/dictionary/negotiate as of December 15, 2006.

4 The U.S. Administration on Aging, "Medicare Drug Coverage Under Part A, Part B, and Part D," available at http://www.aoa.gov/Medicare/resources/PartsBDFeb6finaldraftV6.doc as of December 15, 2006.

5 HHS Office of the Inspector General, "Medicare Reimbursement of Prescription Drugs," January 2001, p. i, available at http://oig.hhs.gov/oei/reports/oei-03-00-00310.pdf as of December 5, 2006.

6 Dean Baker, "The Savings From an Efficient Medicare Prescription Drug Plan," Center for Economic and Policy Research, January 2006, p.6, available at http://www.cepr.net/publications/efficient_medicare_2006_01.pdf as of December 5, 2006.

7 Frederic Bastiat, "What Is Seen and What Is Not Seen," The Library of Economics and Liberty, available at http://www.econlib.org/library/Bastiat/basEss1.html as of December 15, 2006.
8 Mark Duggan and Fiona M. Scott Morton, "The Distortionary Effects of Government Procurement:  Evidence From Medicaid Prescription Drug Purchasing," NBER Working Paper No. 10930, June 2005, p.2.

9 Medical Expenditure Panel Survey 2004, available at http://www.meps.ahrq.gov as of December 8, 2006.  Variables used:  RXEXP04, AGE, POVCATO4.

10 "Prescription Drug Prices in Canada, Europe, and Japan," Prepared by Minority Staff, Special Investigations Division, Committee on Government Reform, U.S. House of Representatives, April 11, 2001, p. 1, available at http://www.democrats.reform.house.gov/Documents/20040629103247-74022.pdf as of December 8, 2006.

11 The Boston Consulting Group, "Adverse Consequences of OECD Government Intervention in Pharmaceutical Markets on the U.S. Economy and Consumer," BCG White Paper, July 1, 2004, p. 12, available at http:// http://www.ita.doc.gov/td/health/phRMA/PhRMA%20-%20ANNEX%20D.pdf as of November 22, 2006.

12 Kevin A. Hassett, "Price Controls and the Evolution of Pharmaceutical Markets," American Enterprise Institute, July 22, 2004, available at  http://www.aei.org/publications/pubID.20971/pub_detail.asp as of November 22, 2006.

13 Jonathan Cohn, "Private Lesson," The New Republic, November 20, 2006, pp. 16-17.

14 U.S Government Accountability Office, "VA Drug Formulary: Better Oversight Is Required, but Veterans Are Getting Needed Drugs," January 29, 2001, GAO-01-183, p. 5, available at http://www.gao.gov/new.items/d01183.pdf as of November 22, 2006.

15 Frank R. Lichtenberg, "Older Drugs, Shorter Lives? An Examination of the Health Effects of the Veterans Health Administration Formulary," Center for Medical Progress, Medical Progress Report No. 2. October 2005, available at http://www.manhattan-institute.org/html/mpr_02.htm as of November 21, 2006.

16 Susan D. Horn, Phoebe D. Sharkey et al. March 1996. "Intended and Unintended Consequences of HMO Cost-Containment Strategies: Results from the Managed Care Outcomes Project," The American Journal of Managed Care, March 1996 II(3), p. 262. William J. Moore and Robert J. Newman, "Drug Formulary Restrictions as a Cost-Containment Policy in Medicaid Programs," Journal of Law and Economics, April 1993, Vol. 36, No. 1, pp.71-97.

17For an extensive review of the literature on Medicaid formularies, see Linda Gorman, "Medicaid Drug Formularies," Independence Institute, Issue Paper Number 2-20, April 2002.

18 Cohn, "Private Lesson."

19 National Institutes of Health, "NIH Response to the Conference Report Request for a Plan to Ensure Taxpayers' Interests are Protected," July 2001, available at http://www.nih.gov/news/070101wyden.htm as of November 20, 2006.

20 U.S. Department of Commerce, International Trade Administration, "Pharmaceutical Price Controls in OECD Countries.  Implications for U.S. Consumers, Pricing, Research and Development, and Innovation," December 2004, p. x, http://www.ita.doc.gov/drugpricingstudy as of November 22, 2006.

21 The Boston Consulting Group, "Adverse Consequences of OECD Government Intervention in Pharmaceutical Markets on the U.S. Economy and Consumer," pp.34-35.

22 John A. Vernon, "Drug Research and Price Controls," Regulation, Winter 2005-2006, pp. 22-25.

23 John A. Vernon, Rexford E. Santerre, and Carmelo Giaccotto, "Are Drug Price Controls Good for Your Health?" Center for Medical Progress, Medical Progress Report No.1, December 2004, available at http:// www.manhattan-institute.org/pdf/mpr_01.pdf as of November 22, 2006.

24 Benjamin Zycher, "The Human Cost of Federal Price Negotiations: The Medicare Prescription Drug Benefit and Pharmaceutical Innovation," Center for Medical Progress, Medical Progress Report No.3, October 2006, p. i, available at http://www.manhattan-institute.org/pdf/mpr_03.pdf as of November 30, 2006.

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